DES Chapter 13

1
Chapter 13

• The Valuation of an Actual
• Company Home Depot

2
Steps to estimate value using the Corporate
Valuation Spreadsheet

• The valuation spreadsheet has seven interrelated
  worksheets, each of which performs an essential
  function
• (1) Proj Val
• (2) Inputs
• (3) WACC
• (4) Hist Analys
• (5) Condensed
• (6) Comprehensive
• (7) Actual

3
Horizon Value Methods

• Recall what the Proj Val sheet does
• This sheet automatically forecasts the future Pro
  Forma financial statements, based on data in the
  Inputs Sheet.
• It automatically calculates future expected Free
  Cash Flows (FCF) from the Pro Formas.
• It then calculates Present Value (PV) of future
  expected FCF and finds estimated price per share.

(continued)
4
Horizon Value Methods (continued)

• The value of a company is the present value of
  all future free cash flows
• A realistic approach to valuation involves
• analysts only forecast a finite number of years
  (20 years is more than adequate)
• the last year in the forecast is called the
  horizon (i.e., it begins the steady state, period
  of constant growth)

(continued)
5
Horizon Value Methods (continued)

• The discounting of the future free cash flows
  involves three steps
• find the value of all free cash flows beyond the
  horizon, discounted back to the horizon.
• find the present value of the firms horizon
  value and all of its forecasted free cash flows
  for the years up to the horizon.
• add the two components of value together

(continued)
6
Horizon Value Methods (continued)

• There are four ways to calculate the horizon
  value
• continuing value method
• book value method
• convergence value method
• general value method

(continued)
7
Horizon Value Methods (continued)

• 1) The Continuing Value Horizon Formula
• Suppose the WACC10, and ROIC for the last year
  in the forecast is 15.
• Q can the company earn a return in excess of its
  cost of capital indefinitely?
• Are barriers protecting this company from the
  forces of competition?
• Will future competition in the period after our
  last forecasted year fail to drive down the
  companys ROIC?

(continued)
8
Horizon Value Methods (continued)

• If you think the answers to these questions are
  Yes, then use the Continuing Value Horizon
  Formula
• Where HVT is the horizon value at year T.

(continued)
9
Horizon Value Methods (continued)
2) The Book Value Horizon Formula Suppose that
immediately after the horizon year, competition
will force the ROIC on existing capital and on
new investment to the WACC. As of that time, the
NPV of all the firms assets and future
investment is zero, and the horizon value equals
book value of capital as of the beginning of the
horizon
(continued)
10
Horizon Value Methods (continued)

• 3) The Convergence Value Horizon Formula
• Suppose ROIC on existing capital can be
  maintained, but competition will force ROIC on
  new capital (after the horizon) to equal the
  WACC. Then horizon value is just the value of the
  free cash flows from existing capital.
• Eventually the ROIC of the firm converges the
  WACC.

(continued)
11
Horizon Value Methods (continued)
4) The General Value Horizon Formula Competition
will result in a gradual reduction of the return
on new capital, forcing the ROIC on new capital
to fall from ROICT to some long-term sustainable
ROICL, which may be greater than the WACC.
12
Valuing Operations Home Depot
Recursive Calculation of Value The Val Proj
worksheet starts (in cell W97) with the horizon
value as the value at year T (2023) of free cash
flow beyond year T. This is V2023 HV2023 The
value at T-1 (2022) is the free cash flow during
year T and subsequent years V2022(FCF2022V2023
)/(1WACC) And so on, back to year 2003.
(continued)
13
Valuing Operations Home Depot, 2021 and beyond
14
The Half-Year Adjustment
Cash flows occur throughout the year and not just
on the last day of the year. The estimate of
the value of operations based upon year-end cash
collection understates the true value of
operations. The half-year adjustment treats the
total yearly cash flow as if it occurs at
mid-year VAfter AdjustmentVBefore
Adjustment(1WACC)0.5.
(continued)
15
The Half-Year Adjustment for Home Depot
16
Target Valuation Date
Cells in the Calculating Value section of the
worksheet give the valuation calculations as of
the end of the most recent fiscal year. Its
usually desirable to calculate value as of the
current date, or some other target date,
usually the date on which the valuation estimate
is completed.
(continued)
17
Target Valuation Date (continued)
Cells in the Price per share on target date
section adjust value of operations for the
elapsed time from last FYR date to the target
date by compounding at the WACC Vtarget date
VFYR date (1 WACC)days/365
(continued)
18
Target Valuation Date (continued)
Target date adjustments for Investments and
nonequity claims use linear interpolation between
FYR ends Xtarget date XFYR date
Adj, Where Adj XFYR date 1 year -
XFYR date(days/365). (X stands for either
investments or nonequity claims.)
(continued)
19
Target Valuation Date Adjustments for Home Depot
20
Valuation of Home Depot

• Once satisfied that the projected financials
  are plausible, look closely at the projected
  ROIC
• actual ROIC for 2003 was 19.2
• declines gradually to 16.2 by 2023
• assumed long-term ROIC is 10, compared to WACC
  of 8.51

(continued)
21
Valuation of Home Depot (continued)

• Summary of valuation (worksheet row numbers in
  parentheses)
• (Row 97) the present value of all forecasted
  future free cash flows as of 2/2/2003 is about
  75.0 billion
• (Row 98) the half-year adjustment give the value
  of operations on the target date of 5/21/03 at
  about 78.2 billion

(continued)
22
Valuation of Home Depot (continued)

• Summary of valuation (continued)
• (Row 99) add nonoperating investments, which are
  less than 0.1 billion
• (Row 101) subtracting nonequity claims of 1.8
  billion

(continued)
23
Valuation of Home Depot (continued)

• Summary of valuation (continued)
• (Row 102) total value of equity of 76.4 billion
• (Row 104) dividing by shares outstanding gives
  intrinsic value for the most recent fiscal
  year-end, 2/02/2003, of 32.71 per share

(continued)
24
Valuation of Home Depot (continued)

• Summary of valuation (continued)
• (Row 117) Finally, making the adjustments for
  target date valuation results in a target dated
  estimated share value of 33.45.

(continued)
25
Valuation of Home Depot (continued)
Perspective on value To gain some
perspective on the valuation result, put the
intrinsic value estimate in the context of recent
stock prices for Home Depot. As of this writing,
there are almost five months of hindsight on the
5/21/2003 value estimate
(continued)
26
Home Depot stock prices October 2002-October 2003
Source marketguide.com (http//www.multexinvestor
.com/Home.aspx)
27
Other Financial Measures

• (Row 120) Economic profit - profit that the
  company generated during the year in excess of
  the profit that investors required at the
  beginning of the year
• EP NOPAT Capital charges
• NOPAT WACC(Op. capital at the beg. of the
  year).

(continued)
28
Other Financial Measures (continued)

• (Row 121) Market value added (MVA) - the
  estimated value of operations minus the total
  operating capital (at current book value)
• MVA Value of operations Operating capital

(continued)
29
Other Financial Measures (continued)

• (Rows 122-125) Comparative valuation approaches
• P/E (or just PE) ratio
• market to book ratio
• Value/Sales ratio
• Value/EBITDA ratio
• (EBITDA is earnings before interest, taxes,
  depreciation,and amortization.)

(continued)
30
Other Financial Measures (continued)

• (Rows 126-127) Capital structure
• market-based percent of the firm that is financed
  with debt
• times-interest-earned ratio

(continued)
31
Other Financial Measures (continued)

• (Rows 149-157) Net cash flow from financing
  activities
• short-term borrowing/ short-term investments
• long-term borrowing

32
Reverse Engineering

• What if intrinsic value estimates are
  substantially different from current market
  price?
• Reverse engineering is the process of discovering
  what changes in the analysts input choices would
  give an intrinsic value estimate that equals the
  markets price.

(continued)
33
Reverse Engineering (continued)

• Is the market price reasonable?
• If you only have to make small changes in the
  inputs that reflected your best judgment to get
  the models price equal to the markets price,
  then the stock is probably fairly priced.

(continued)
34
Reverse Engineering (continued)

• Is the market price reasonable? (continued)
• If not, then the market may be wrong. Perform
  sensitivity analysis to identify critical inputs,
  and determine how your valuation holds up under
  plausible variation in those inputs.

(continued)
35
Scenario Analysis Assessing the Impact of
Managerial Decisions

• The FCF model is very useful in assessing the
  impact that operating decisions or external
  events have on the firms value.
• Change sales growth
• Change profitability (margin)
• Change working capital requirements
• Change fixed asset requirements

(continued)
36
Scenario Analysis (continued)

• The financial projections from the free cash flow
  model may be used to facilitate long-term
  financial planning.
• Change in dividend policy
• Change in financial structure
• Stock repurchases