Valuation: Cash Flow-Based Approaches

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Valuation Cash Flow-Based Approaches

• Dr. Nancy Mangold
• California State University, East Bay

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Valuation

• Security Analyst and Investment Bankers
• Make buy, sell, or hold recommendations
• Right Price for IPO
• Price for a corporate acquisition

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Valuation

• Economic Theory
• Value of any resource equals the present value of
  the returns expected from the resource,
  discounted at a rate that reflects the risk
  inherent in those expected returns

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Valuation
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Rationale for Cash-Flow Based Valuation

• Cash is the ultimate source of value
• Cash serves as a measurable common denominator
  for comparing the future benefits of alternative
  investment opportunities

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Cash Flow vs Earnings

• Investors cannot spend earnings for future
  consumption
• Accrual earnings are subject to numerous
  questionable accounting methods
• Pooling vs purchase in acquisition valuation
• Expensing of R D costs
• Earnings are subject to purposeful management by
  a firm

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Cash Flows vs Earnings

• Earnings are not as reliable or meaningful as a
  common denominator for comparing investment
  alternatives as cash
• 1 earnings (Firm 1) not equal to 1 earnings
  (Firm 2).
• 1 Cash (Firm 1) 1 Cash (Firm 2)

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Cash Flow-Based Valuation

• Three elements needed
• Expected periodic cash flows
• Residual (Terminal) value - Expected cash flow at
  the end of the forecast horizon
• Discount rate used to compute the present value
  of the future cash flows

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I. Periodic Cash Flows

• Cash Flow to the Investor vs Cash Flow to the
  Firm
• Cash Flow to the Investor CF dividends expected
  to be paid to the investor
• Cash Flow to the Firm (CF dividends CF retained
  by firm)
• If the rate of return of retained CF equals the
  discount rate, either CF will yield the same
  valuation
• Use Cash Flow to the Firm

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Periodic Cash Flows Relevant Firm Level Cash
Flows

• Which cash flow amounts from the projected
  statement of cash flows the analyst should use to
  discount to present value when valuing a firm
• Unleveraged free cash flows
• leveraged free cash flows

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Periodic Cash Flows Relevant Firm Level Cash
Flows

• Unleveraged free CF is CF before considering debt
  vs equity financing
• Unleveraged free cash flows
• CFO interest cost (net of tax)
• (-) Cash flow for investing activities
• This pool of cash flows is available to service
  debt, pay dividends and provide funds to finance
  future earnings

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Leveraged free cash flows

• Leveraged free cash flows
• CFO - Cash flow for investing activities
• (-) net change in ST LT borrowing (-)
  Changes and dividends on on preferred stock
• Cash flows available to the common shareholders
  after making all debt service payments to the
  lenders and paying dividends to preferred
  shareholders

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Measurement of Unleveraged and Leveraged Free
Cash Flows

• Leveraged Free CF
• CFO before interest
• - Cash outflows for interest costs (net of tax
  savings)
• leveraged CFO
• (-) CF for Investing Act.
• (-)CF for changes in STLT borrowing
• (-)CF for changes in and Dividends on preferred
  stock
• leveraged Free CF to Common Shareholders

• Unleveraged Free CF
• Cash Flow from Operations before subtracting Cash
  outflows for interest costs (net of tax savings)
• Unleveraged CFO
• (-) CF for Investing Act.
• Unleveraged Free Cash Flow to All Providers of
  Capital

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Unleveraged Free Cash Flows

• If the objective is to value the assets of a
  firm, then the unleveraged free cash flow is the
  appropriate cash flow
• Discount rate should be weighted average cost of
  capital

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Leveraged Free Cash Flows

• If the objective is to value the common
  shareholders equity of a firm, then the
  leveraged free cash flow is the appropriate cash
  flow
• Discount rate should be the cost of equity capital

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Unleveraged vs Leveraged Free Cash Flows

• The Valuation Difference the value of total
  interest-bearing liabilities and preferred stock

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Unleveraged vs Leveraged Free Cash Flows

• Value interest-bearing liabilities by discounting
  debt service costs (including repayments of
  principal) at the after tax cost of debt capital

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Unleveraged vs Leveraged Free Cash Flows

• Valuing preferred stock by discounting preferred
  stock dividends at the cost of preferred equity

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Unleveraged vs Leveraged Free Cash Flows

• Valuation for total assets (unleveraged Free CF)
  
• Valuation for common equity (leveraged Free CF)
• Value of interest-bearing liabilities
• Value of preferred stock

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Acquiring the operating assets of of another firm

• Acquiring firm will replace with its own
  financing structure
• Price to pay for the divisions assets?

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Acquiring the operating assets of of another firm

• CF these assets will generate
• Use unleveraged free cash flows (Operating cash
  flows - cash outflow for investing)
• Discount these projected cash flows at the
  weighted average cost of capital of the new
  division

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Engage in a leveraged buy out (LBO) of a firm

• Managers offer to purchase the outstanding common
  shares of the target firm at a particular price
  if current shareholders will tender them
• The managers invest their own funds for a portion
  of the purchase price (usualy 20 - 25) and
  borrow the remainder from various lenders

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Engage in a leveraged buy out (LBO) of a firm

• The managers use the equity and debt capital
  raised to purchase the tendered shares
• After gaining voting control of the firm, the
  managers direct the firm to engage in sufficient
  new borrowing to repay the bridge loan obtained
  to execute LBO

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Engage in a leveraged buy out (LBO) of a firm

• The lenders have a direct claim on the assets of
  the firm
• Managers shift any personal guarantees they made
  on the bridge loans to the firm

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Price of LBO

• Use Valuation of common equity
• Leveraged free cash flows discounted at the cost
  of common equity capital

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Price of LBO

• Or Use Valuation of total assets and subtract the
  market value of the debt raised to execute the
  LBO.
• PV of unleveraged free cash flows using the
  weighted average cost of debt and equity capital

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Price of LBO

• The projected debt service costs after the LBO
  will differ significantly
• Valuation of the equity must reflect the new
  capital structure and the related debt service
  cost
• The cost of equity capital will increase as a
  result of the higher level of debt in the capital
  structure

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Nominal Vs Real Cash Flows

• Nominal cash flows include inflationary or
  deflationary components
• Real cash flows filter out the effect of changes
  in general purchasing power
• Valuation should be the same whether one uses
  nominal cash flow amounts or real cash flow
  amounts, as long as discount rate used is
  consistent with CF

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Nominal Vs Real Cash Flows

• If projected cash flows ignore changes in the
  general purchasing power of the monetary unit
• Then the discount rate should incorporate an
  inflation component
• Nominal CF 1.15 million (land price)
• Discount rate s/b 1/1.02 /1.1
• Interest rate 2 and inflation rate 10
• Value 102.5

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Nominal Vs Real Cash Flows

• If projected cash flows filter out the effects of
  general price changes
• Then the discount rate should exclude the
  inflation component
• Real CF 1.15 million (land price)/1.1
  (inflation rate)
• Discount rate s/b 1/1.02
• Land Value 102.5

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Nominal Vs Real Cash Flows

• A firm owns a tract of land that it expects to
  sell one year from today for 115 million
• The selling price reflects a 15 increase in the
  selling price of the land
• General price level is expected to increase 10
• The real interest rate is 2

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The Value of Land
Discount rate including expected inflation 115m x
1/(1.02)(1.1) 102.5 million
Discount rate excluding expected inflation (115
million/1.10) x 1/1.02 102.5 million
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PreTax vs After-Tax Cash Flows

• Discount pretax cash flows at a pretax cost of
  capital
• Discount after-tax cash flows at an after-tax
  cost of capital
• Valuation will be the same

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Selecting a Forecast Horizon

• For how many future years should the analyst
  project periodic cash flows?
• Theoretically the expected life of the resource
  to be valued (machine, building )
• To value the equity claim on the portfolio of net
  assets of a firm, the resource has indefinite
  life
• Analyst must project the years of CF and
  residual value at the end of forecast horiz.

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Selecting a Forecast Horizon

• Prediction of CF requires assumptions for each
  item in the IS and BS and then deriving the
  related CF

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Selecting a Forecast Horizon

• Using a relatively short forecast horizon (3-5
  years) enhances the likely accuracy of the
  projected periodic cash flows
• near term cash flows is often an extrapolation of
  the recent past
• near term cash flows have the heaviest weight in
  the PV computation
• But a large portion of the total PV will be
  related to the residual value

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Selecting a Forecast Horizon

• The valuation is difficult when near-term cash
  flows are projected to be negative in rapidly
  growing firm that finances its growth by issuing
  common stock
• All of the firms value relates to the less
  detailed estimation of the residual value

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Selecting a Forecast Horizon

• Selecting a longer period in the forecast of
  periodic cash flows (10-15 years)
• Reduces the influence of the estimated residual
  value on the total PV
• Predictive accuracy of detailed cash flow
  forecasts this far into the future is likely to
  be questionable

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Selecting a Forecast Horizon

• It is best to select as a forecast horizon the
  point at which a firms cash flow pattern has
  settled into an equilibrium
• This equilibrium position could be either no
  growth in future cash flows or growth at a stable
  rate
• Security analysts typically select a forecast
  horizon in the range of 4-7 years

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II. Residual Value

• Residual Value at end of Forecast Horizon
• Periodic Cash Flow n-1 x 1g
• r-g
• Where
• n forecast horizon
• g annual growth rate in periodic cash flows
  after the forecast horizon
• r discount rate

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Residual Value

• Leveraged free cash flow of a firm in year 5 is
  30 millions
• 0 growth expected
• Cost of equity capital 15
• Residual value
• 30 x (10.0)/(.15-0.0) 200 million
• PV of RV (in Year 5) 200 x 1/(1.15)5 99.4
  million

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Residual Value

• Add growth rate 6
• Residual value
• 30 x (10.06)/(.15-0.06) 353.3 million
• PV 353.3 x 1/(1.15)5 175.7 million

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Residual Value

• Add growth rate -6
• Residual value
• 30 x (1-0.06)/(.15 - (-0.06) 134.3 million
• PV 134.3 x 1/(1.15)5 66.8 million
• Analysts frequently estimate a residual value
  using multiples of 6-8 times leveraged free cash
  flows in the last year

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Difficulty in Using Residual Value

• When the discount rate and growth rate are
  approximately equal
• The denominator approaches zero and
• The multiple becomes exceedingly large.
• When the growth rate exceeds discount rate
• The denominator becomes negative, the resulting
  multiple becomes meaningless

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Alternative Approach to Estimate Residual Value

• Use free cash flow multiples for comparable firms
  that currently trade in the market
• this model provides a market validation for the
  theoretical model
• The analyst identifies comparable companies by
  studying growth rates in free cash flows,
  profitability levels, risk characteristics and
  similar factors.

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III. Cost of Capital

• The analyst uses the discount rate to compute the
  present value of the projected cash flows
• The discount rate equals the rate of return that
  lenders and investors require the firm to
  generate to induce them to commit capital given
  the level of risk involved

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Cost of Capital

• Cost of debt capital equals the after-tax cost of
  each type of capital provided to a firm

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Cost of Debt Capital

• Common practice excludes operating liability
  accounts from weighted average cost of capital
• The present value of unleveraged free cash flows
  is the value of total assets net of operating
  liabilities which equals debt plus shareholders
  equity

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Cost of Debt Capital

• The cost of debt capital equals
• (1- marginal tax rate) x yield to maturity of
  debt
• The yield to maturity is the rate that discounts
  the contractual cash flows on the debt to the
  debts current market value
• The yieldcoupon rate if the debt sells at
  par(face) value

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Cost of Debt Capital

• Capitalized lease obligation have a cost equal to
  the current interest rate on collateralized
  borrowing with equivalent risk

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Cost of Debt Capital

• The analyst should include the present value of
  significant operating lease commitment in the
  calculation of the weighted average cost of
  capital

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Cost of Debt Capital

• If the analyst treats operating leases as part of
  debt financing, then the cash outflow for rent
  should be reclassified as interest and repayment
  of debt in leveraged and unleveraged free cash
  flow

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Cost of Preferred Equity Capital

• Dividend rate on the preferred stock

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Cost of Common Equity Capital

• Capital Asset Pricing Model (CAPM)
• In equilibrium, the cost of common equity capital
  equals the market rate of return earned by common
  equity capital

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Cost of Common Equity Capital

• R(i) R(f) b (R(m) - R(i))
• Cost of common equity
• Interest rate on risk free securities
• Market beta (Average return on the market
  portfolio - Interest rate on risk free securities)

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Cost of Equity Capital
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Risk Free Interest Rate

• Yield on LT US government securities
• Not a good choice, the longer the term to
  maturity, more sensitive to changes in inflation
  and interest rates, greater systematic risk
• Common practice to use the yield on either short
  or intermediate-term US government securities as
  risk free rate
• Historically averaged around 6

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Market Return

• Depends on period studied
• Historically the market rate of return has varied
  between 9 and 13
• The excess return over the risk free rate has
  varied between 3 and 7 percentage points

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Market Returns

• Financial reference sources publish market equity
  beta for publicly traded firms
• Standard Poors Stock Reports
• Value Line, Moodys
• Considerable variation in the published amounts
  for market beta among different sources due to
  period used to calculate the betas

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Adjusting Market Equity Beta

• to Reflect a New Capital Structure
• The market equity beta computed using past market
  price data reflects the capital structure in
  place at a particular time
• Analyst can adjust this equity beta to
  approximate what it is likely to be after a
  change in the capital structure

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Adjusting Market Equity Beta

• Unleverage the current beta
• then releverage it to reflect the new capital
  structure
• Current leveraged equity beta
• Unleveraged Equity beta 1(1-income tax rate) (
  Current market value of debt)/ current market
  value of equity)

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Adjusting Market Equity Beta

• Equity Beta 0.9
• Income tax rate .35
• Debt/equity ratio .60
• Change D/E ratio to 140
• Unleveraged equity beta x
• 0.9 X 1 (1 - 0.35) (0.60/1.0)
• X 0.65

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Adjusting Market Equity Beta

• Releveraged market beta
• Y 0.65 1 (1- 0.35)(1.4/1.0)
• Y 1.24

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Evaluating the Cost of Equity Capital Using CAPM
Criticisms

• Market betas do not appear to be stable over time
  and are sensitive to the time period used in
  their computation
• The excess market rate of return is not stable
  over time and is likewise sensitive to the time
  period
• Fama and French suggests that during the 1980s
  size was a better proxy for risk than market beta

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Weights Used for Weighted Average Cost of Capital

• Should use the market values of each type of
  capital
• Market value of debt securities is disclosed in
  notes to financial statements
• Market price quotations for equity securities
  provide the amounts for determining the market
  value of equity

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A Firms Capital Structure on Balance Sheet
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Cost of Capital

• LT Debt
• 8 x (1-.35) 5.2
• Preferred Equity
• 4
• Common Equity
• 6 .9 (13 - 6) 12.3

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Weighted AverageCost of Capital
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Valuation of a Single Project

• Investment 10 million
• Unleveraged CF 2 million/year forever
• Financing 6 million debt
• Financing 4 million Common Equity
• Debt interest rate 10
• Tax rate 40
• Cost of Capital 25.625

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Value of Common Equity
Unleveraged Free Cash Flow 2,000,000
Interest paid on Debt .106,000,000 (600,000)
Income Tax Savings on Interest .4600,000 240,000
Leveraged Free CF 1,640,000

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Value of Common Equity

• The value of the project to the common equity
• 1640000/.256256,400,000
• Excess over investment
• 6,400,000-4,000,0002,400,000
• The factor of PV of an annuity that last forever
  is 1/r

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Value of Debt Equity

• Value of Debt
• After tax cost for debt is 6
• 6 (10 (1-40))
• The common equity cost .25625

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Value of Debt Equity
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Value of Debt Equity
Type of Capital Amt Weight Cost Weighted Average
Debt 6M .48387 .06 .02903
Common Equity 6.4M .51613 .25625 .13226
Total 12.4 M 1.00 .16129
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Value of Debt Equity

• PV (Debt Equity) is
• 2,000,000/.16129 12,400,000
• Subtracting 6 million of debt
• Common Equity is 6.4 million

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Valuation of Coke
Yr 8 Yr 9 Yr 10 Yr 11 Yr 12
CF from Operations 3,610 3,788 3,974 4,166 4,366
CF from Investing -1,198 -1,390 -1,534 -1,691 -1,866
CF from Debt Financing 1,017 1,355 1,619 1,835 1,988
Leveraged Free CF 3,429 3,753 4,059 4,310 4,488
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Year 12 Residual Value

• The analyst make assumption about net cash flows
  after year 12
• The average compound growth rate of leveraged
  free CF between year 8-12 is 7, assume it will
  remain at 7

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Year 12 Residual Value

• Yr 7 market beta is .97
• Risk free rate 6
• Excess Mkt Return over Risk Free Rate 7
• Cost of Equity Capital
• 6 .97(7) 12.8
• 4,488 x 1.07 82,796
• 0.128 - .070

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Present Value
Year CF 12.8 Factor PV
8 3,429 .88652 3,040
9 3,753 .79719 2,992
10 4,059 .69674 2,828
11 4,310 .61768 2,662
12 4,488 .54759 2,458
Aft 12 82,796 (4488x(1.07/0.128-.07)) .54759 45,338
Total 59,318
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Price per Share

• price per share
• 59,318 million/2,481 million shares 23.91
• Cokes market price in yr 7 52.63

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Price Difference

• Inaccurate projections of future cash flow
• Errors in measuring the cost of equity capital
• Market inefficiencies in the pricing of Coke

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Advantages- Present Value of Cash Flow Valuation

• Focus on cash flows
• Projected amounts of CF result from projecting
  likely amounts of revenues, expenses, assets,
  liabilities and shareholders equity which
  require the analyst to think through many future
  operating, investing and financing decisions of a
  firm

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Disadvantages of the PV of Future Cash Flow
Valuation

• The residual or terminal value tends to dominate
  the total value in many cases
• This residual value is sensitive to assumptions
  made about growth rates after the forecast
  horizon
• The projection of cash flows can be time
  consuming and costly when analyst follow many
  companies and identify under and overvalued firms
  regularly.