Valuation 3 Valuation Frameworks Discounted Cash Flow DCF

Valuation

3 Valuation Frameworks Discounted Cash Flow (DCF) Comparables Option Value 3

3 Valuation Frameworks Discounted Cash Flow (DCF) Comparables Option Value 4

DCF Valuation Spreadsheet Approach

Economic Valuation 0 1 2 k . . . Value PV = n C 1 (1+ k) 1 + C 2 (1+ k) 2 +. . . + Cn Cn (1+ k) n .

Capital Projects As Cash Flow Tradeoffs Capital Recovery Net Benefits TIME Additional Outlay Initial Outlay Match initial investment with the combined PV of all future cash flows

Capital Project Valuation Annual cash flow $20 $20 1 2 3 4 5 6 10 k Investment $100 NPV = $13

Discounting Example Yr 1 2 3 Cash Flow $ 20 20 20 Discount Factor*. 9091. 8264. 7513 P. V. Cash Flow $ 18. 18 16. 53 15. 03 Cumul. P. V. $ 18. 18 34. 71 49. 74 10 20 . 3855 7. 71 113. 00 * Discount Factor = 1/(1+. 10)n

Corporate Value infinity Value = t=0 Cash Flowt (1 + Cost of Capital)t

Free cash flow is the basis of value! Investors watch this pattern…… Trend Time …. which is “cash in and cash out” Free cash flow = NOPAT adjusted for depreciation and other accounting elements Less net investment in working capital, fixed assets, capitalized R&D, etc.

PLEASE DO NOT DISTURB Working on A big project !!!

STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION

STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION

STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION

STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION

Portal. com Example

Portal. com 2001 Valuation Cash Flows Customers $12, 000 Revenue Working Capital Cash 150 Receivables 1, 100 Inventory 1, 100 Payables -1, 010 -------$1, 340 Cash Expense COGS 3, 500 SG&A 3, 000 ------$6, 500 Investment $2, 000 Taxes $2, 100 Available to Shareholders and Debt Suppliers $60

Company Valuation 7, 044 Terminal Value Annual cash flow 845 545 327 60 170 k 0 1 2 3 4 5

Free Cash Flow Valuation $0 $5, 245 $2, 000 $5, 245 $3, 245 Value of Marketable Market Value of Operating Securities & of Entity Debt and other Cash Flows Non-operating Cash Flows Liabilities Market Value of Equity

Adjusted Present Value (APV) Value of financing side effects Interest tax shields Base-case value APV = Value of the project as if it were financed with equity Costs of financial distress + Subsidies Hedges Issue costs

DCF Valuation Formula Approaches

Company Valuation Free Cash Flow Formulas No growth: NOPAT 0 V = ---------k Constant growth: NOPAT 0(1 - b)(1 + g) V = ----------------k - g NOPAT 0 = initial after-tax earnings before interest and taxes (EBIT) b = rate of investment period divided by NOPAT g = growth in free cash flows. The subscripts s and c refer to the supernormal growth rate and the constant growth rate. n = number of periods of supernormal growth k = the company’s weighted average cost of capital WACC

Company Valuation Free Cash Flow Formulas Temporary supernormal growth, then no growth: n (1 + g) t NOPAT 0(1 + g)n+1 V = NOPAT 0 (1 - b) --------- + ------------- t=1 (1 + k) t k (1 + k)n Temporary supernormal growth, then constant growth: n (1 + g s)t NOPAT 0 (1 - bs) (1 + g s)n+1 V = NOPAT 0 (1 - b) --------- + ----------- x ------ t=1 (1 + k) t k - g (1 + k) n NOPAT 0 = initial after-tax earnings before interest and taxes (EBIT) b = rate of investment period divided by NOPAT g = growth in free cash flows. The subscripts s and c refer to the supernormal growth rate and the constant growth rate. n = number of periods of supernormal growth k = the company’s weighted average cost of capital WACC

DCF Approaches to Estimate Continuing Value g = 0 In a perfectly competitive market, in the long-term companies earn their cost of capital, resulting in zero economic profit and hence zero cash flow growth rate g = industry average Zero growth rates may be too conservative in the cases of some industries. In that case, it is reasonable to assume that companies’ cash flow will grow at the average industry rate g = Forecasted long-term inflation growth rate Usually, both revenues and costs are equally affected by inflation and hence inflation has no or little effect on a firm’s growth rate. In some cases, especially in certain consumer industries, inflation affects the revenues more than the costs. In this case, the forecasted perpetual inflation growth rate is a good proxy for the firm’s revenue growth rate and consequently its cash flow growth rate. g = Forecasted long-term GDP growth rate It is reasonable that in the long-term the growth rate of companies will fade to that of the growth rate of the overall economy. If a company grows at a sustained rate higher than that of the economy, eventually it will become larger than the economy itself, which of course is not possible.

Valuation Framework V = NOPAT ------K + R - K ------ * I * T K WHERE: NOPAT = NET OPERATING PROFITS AFTER TAX K = COST OF CAPITAL R = RETURN ON CAPITAL I = ANNUAL INCREMENTAL INVESTMENT T = NO. OF YEARS THAT I CAN BE INVESTED AT R > K V = AS IS VALUE + VALUE GROWTH OPPORTUNITIES

3 Factors in Value Creation ÊROI > WACC ËAmount of Investment ÌInterval of Competitive Advantage Note: – Forward-looking – Expected cash flows

Value Creation - Another View Value Created = (Return On Investment - Cost of Capital) X Capital employed Dependent Upon: F Cost of Capital Spread F Duration of Spread F Amount of Capital Employed

Economic Profit (EP) (R - K) NOPAT Operating profits x - capital K x capital a capital charge EP ties directly to NPV: NPV = market value - capital NPV = the present value of projected EP Market value = Capital + PV of projected EP K = WACC R = NOPAT / Capital

Economic Profit Discounted Cash Flow Approach: Yr. 0 NOPAT P. V. Perpetuity Investment NPV @ 10% $2, 500 ($1, 000) $1, 500 Yr. 1 $250 Yr. 2 $250. . .

Economic Profit Discounted EP Approach: Yr. 0 Nopat Investment Capital Charge Yr. 2 $250. . . $100. . . $150. . . $1, 000 EP NPV @ 10% Yr. 1 $250 $1, 500

NPV and the Regulatory Process F Remember: NPV = Cash Inflow - Cash Outflow where Cash Inflow = Revenues - Costs F But in a regulated environment, Revenues = Costs + Return x Investment F Therefore, the NPV is always zero

NPV and the Regulatory Process n NPV = t=1 (R - C)t (1 + K)t -I but R = C + KI n = t=1 (KI)t (1 + K)t -I (C + KI - C)t (1 + K)t = (KI) K -I -I = 0

3 Valuation Frameworks Discounted Cash Flow (DCF) Comparables Option Value 40

Comparables: An Example MULTIPLIER COMPANY DATA VALUE 1. 5 x book value $23. 2 $34. 8 9 x cash flow $3. 6 $32. 4 7 x EBIT $4. 3 $30. 1 25 x 2000 earnings $1. 5 $37. 5 20 x 2001 earnings $1. 7 $33. 0 --------- Average Estimate $33. 6