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Unformatted text preview: Applied Equity Analysis and Por3olio Management Lecture 8 Steps in a Valua<on • Analyze historical performance • Forecast short term performance • Value cash ﬂows beyond short term horizon using con<nuing value formula • Es<mate cost of capital • Calculate and interpret results Valua<on 101 • A company is worth the sum of the future cash ﬂows that it is able to generate • Investors will adjust the value or “discount” these cash ﬂows based on risk PV of Cashﬂow from Opera<ons PV of Cashﬂow from Non Opera<ng Ac<vi<es = Enterprise Value Cash Available to Debt Equivalents Cash Available to Equity Equivalents The Length and Detail of the Forecast • Before you begin forecasting individual line items, determine how
many years to explicitly forecast and how detailed your forecast
should be. A good forecast model is broken into three time periods:
Today Years 1−5 Build a detailed five to sevenyear forecast that develops
complete balance sheets and
income statements with as
many links to real variables
(e.g., unit volumes, cost per
unit) as possible. Years 6−15 Use a simplified forecast for
the remaining years,
focusing on a few important
variables, such as revenue
growth, margins, and capital
turnover. Years 16+ Value the remaining
years by using a
perpetuitybased
formula, such as the key
value driver formula. The Length and Detail of the Forecast • The explicit forecast period must be long enough for the company to reach
a steady state, defined by the following characteristics:
• The company grows at a constant rate and reinvests a constant proportion of its
operating profits into the business each year.
• The company earns a constant rate of return on new capital invested.
• The company earns a constant return on its base level of invested capital. • In general, we recommend using an explicit forecast period of 10 to 15
years—perhaps longer for cyclical companies or those experiencing very
rapid growth.
• Using a short explicit forecast period, such as five years, typically results in a
significant undervaluation of a company or requires heroic longterm growth
assumptions in the continuing value. Overview of the Forecas<ng Process Although the future is unknowable, careful analysis can yield insights into how
a company may develop. We break the forecasting process into six steps:
1. Prepare and analyze historical financials. Before forecasting future
financials, you must build and analyze historical financials. In many cases,
reported financials are overly simplistic. When this occurs, you have to
rebuild financial statements with the right balance of detail.
2. Build the revenue forecast. Almost every line item will rely directly or
indirectly on revenue. You can estimate future revenue by using either a
topdown (marketbased) or a bottomup (customerbased) approach.
Forecasts should be consistent with historical evidence on growth.
3. Forecast the income statement. Use the appropriate economic drivers to
forecast operating expenses, depreciation, interest income, interest
expense, and reported taxes. Overview of the Forecas<ng Process We break the forecasting process into six steps:
4. Forecast the balance sheet: invested capital and nonoperating assets.
On the balance sheet, forecast operating working capital; net property,
plant, and equipment (PP&E); goodwill; and nonoperating assets.
5. Forecast the balance sheet: investor funds. Complete the balance sheet
by computing retained earnings and forecasting other equity accounts. Use
cash and/or debt accounts to balance the cash flows and balance sheet.
6. Calculate ROIC and FCF. Calculate ROIC to ensure forecasts are
consistent with economic principles, industry dynamics, and the company’s
competitive advantage. To complete the forecast, calculate free cash flow
as the basis for valuation. Future FCF should be calculated the same way
as historical FCF.
Let’s examine each step in detail… Other Issues in Forecas<ng 1. Nonfinancial operating drivers. In industries where prices or
technologies are changing dramatically, your forecast should
incorporate operating drivers like volume and productivity.
2. Fixed versus variable costs. The distinction between fixed and
variable costs at the company level is usually unimportant because
most costs are variable. For individual production facilities or retail
stores, this is not the case; most of their costs are fixed.
3. Inflation. Often, the cost of capital is estimated using nominal terms. If
this is the case, forecast in nominal terms. Be careful, however, as high
inflation will distort historical analyses. Income Statement Forecast Line item
Operating • Cost of goods sold
(COGS)
• Selling, general, and
administrative
(SG&A)
• Depreciation
Non
operating • Nonoperating income Recommended
forecast driver
• Revenue
• Revenue Recommended
forecast ratio
• COGS/revenue
• SG&A/revenue • Prior year net property, • Depreciation/net plant, and equipment
(PP&E) • Appropriate nonoperating asset, if
any • Interest expense • Prior year total debt • Interest income • Prior year excess cash PP&E • Nonoperating income/
nonoperating
asset or growth in
nonoperating
income
• Interest expense
(t)/
total debt (t1)
• Interest income (t)/
excess cash (t1) Balance Sheet Forecast Typical forecast driver Typical forecast ratio • Accounts receivable
• Inventories
• Accounts payable
• Accrued expenses
• Net PP&E
• Goodwill • Revenue
• Cost of goods sold
• Cost of goods sold
• Revenue
• Revenue
• Acquired revenues • Accounts receivable/ revenue
• Inventories/COGS
• Accounts payable/COGS
• Accrued expenses/revenue
• Net PP&E/revenue
• Goodwill/acquired revenue Nonoperating line items
• Nonoperating assets
• Pension assets or liabilities
• Deferred taxes • None
• None
• Adjusted taxes • Growth in nonoperating assets
• Trend towards zero
• Change in deferred taxes/ Operating line items adjusted taxes Con<nuing Value • To estimate a company’s value, we
separate a company’s expected
cash flow into two periods and
define the company’s value as
follows: Home Depot: Estimated Free Cash Flow 12,000 Present Value of Cash Flow 10,000 during Explicit Forecast Period +
Present Value of Cash Flow $ million Value = 8,000
6,000
4,000 after Explicit Forecast Period
2,000 • The second term is the continuing
value: the value of the company’s
expected cash flow beyond the
explicit forecast period. 0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Explicit Forecast
Period Continuing
Value Con<nuing Value Methods Common Con<nuing Value Forecast Errors • A common error is that the length of the explicit forecast aﬀects the company’s value • Confusion concerning the rela<onship of con<nuing value to the length of <me a company is forecast to earn returns on invested capital greater than its cost of capital—its compe<<ve advantage period • Some analysts incorrectly infer that a large con<nuing value rela<ve to the company’s total value implies that value crea<on occurs primarily aXer the explicit forecast period Key Value Driver Formula • Although many continuingvalue models exist, we prefer the key value driver (KVD)
model. The key value driver formula is superior to alternative methodologies because it
is cash flow based and links cash flow to growth and ROIC.
Aftertax operating
profit in the
base year RONIC equals return on invested capital for new
investment. ROIC on existing investment is
captured by NOPLATt+1 g ⎞ྏ
⎛ྎ
NOPLATt +1 ⎜ྎ1 −
⎟ྏ
RONIC ⎠ྏ
⎝ྎ
Continuing Value t =
WACC − g
Weighted average cost of
capital, based on longrun target
capital structure Expected longterm growth
rate in revenues and
cash flows • The continuing value is measured at time t (not today), and thus will need to be
discounted back t years to compute its present value. The Diﬀerence between RONIC and ROIC • Let’s say you decide to use an explicit forecast period of 10 years, followed by a
continuing value estimated with the KVD formula. In the formula, you assume RONIC
equals WACC. Does this mean the firm creates no value beyond year 10? • No, RONIC equal to WACC implies new projects don’t create value. Existing projects
continue to perform at their baseyear level.
Gradual Decline in Average ROIC According to ContinuingValue Formula
20 ROIC on base capital ROIC (percent) 16 ROIC on total capital 12 RONIC 8 4 0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Year Economic Proﬁt Model • When using the economicprofit approach, do not use the traditional key value driver
formula, as the formula would doublecount cash flows.
• Instead, a formula must be defined that is consistent with the economicprofitbased
valuation method. The total value of a company is as follows:
!
Value of
operations !
!
= Invested
capital at
beginning
of forecast !
!
+ Present value of
forecasted economic
proﬁt during explicit
forecast period !
Present value of
! forecasted economic
+ proﬁt after explicit
forecast period Explicit Forecast Period
Continuing value
represents only longrun value creation,
not total value. Economic Proﬁt Model • The continuingvalue formula for economicprofit models has two components: CVt = ICt (ROICt +1 − WACC) PV(Economic Profit t + 2 )
+
WACC
WACC − g Value created on current capital,
based on ROIC at end of forecast
period (using a nogrowth
perpetuity). Value created (or destroyed) on new
capital using RONIC. New capital
grows at g, so a growing perpetuity
is used. • The present value of economic profit at t+2 equals EVA/WACC (i.e., no growth):
New Investment Economic Spread ⎛ྎ g ⎞ྏ
NOPLATt +1 ⎜ྎ
⎟ྏ (RONIC − WACC)
⎝ྎ RONIC ⎠ྏ
PV(Economic Profit t + 2 ) =
WACC
Value Using Perpetuity Economic Proﬁt Approach Beginning
PV Forecasted EP
PV Forecasted EP
Value = Invested Capital + during forecast period + after forecast period CVt = Economic Pr ofit t +1
+
WACC g
)( RONIC − WACC )
RONIC
WACC (WACC − g) ( NOPLATt +1 )( Economic Profit = Normalized EP in the year after the end of the
forecast period
NOPLAT = Normalized NOPLAT in the year after the end of the
forecast period
g = Expected growth in NOPLAT in perpetuity
RONIC = Expected ROIC on new invested capital
WACC = Weighted average cost of capital Comparison of KVD and Economic Proﬁt CV • Consider a company with $500 in capital earning an ROIC of 20 percent. Its expected
baseyear NOPLAT is therefore $100. If the company has an RONIC of 12 percent, a cost
of capital of 11 percent, and a growth rate of 6 percent, what is the company’s (continuing)
value?
• Using the KVD formula:
6% ⎞ྏ
⎛ྎ
$100 ⎜ྎ1 −
⎟ྏ
12% ⎠ྏ
⎝ྎ
Continuing Valuet =
= $1,000
11% − 6% • Using the economicprofitbased KVD, we arrive at a partial value:
⎛ྎ 6% ⎞ྏ
100 ⎜ྎ
⎟ྏ (12% − 11%)
⎝ྎ 12% ⎠ྏ
PV(Economic Profit t + 2 ) =
= $4.54
11% CVt =
Note how economicprofit CV
does not equal total value. To
arrive at total value, add
beginning value ($500). $500(20% − 11%)
$4.54
+
11%
11% − 6% CVt = 409.1 + 90.9 = 500.0 Step 1 Step 2 Length of Explicit Forecast Does Not Ma\er • While the length of the explicit forecast period you choose is important, it does not aﬀect the value of the company; it aﬀects only the distribu<on of the company’s value between the explicit forecast period and the years that follow. • In the example below, the company value is $893, regardless of how long the forecast period is. Short forecast periods lead to higher propor<ons of con<nuing value. Comparison of TotalValue Estimates Using Different Forecast Horizons
percent
100% = $893 Continuing value 79 Value of e xplicit free c ash f low 21
5 $893 $893 67 60 33 40 8 10 $893 46 54 15 Length of e xplicit forecast period (years) $893 Modeling assumptions 35 Growth
65 20 RONIC
WACC
Spread Years 1–5 Years 6+
9
6
16
(12)
4 12
(12)
0 Common Pi3alls: Distor<ng the KVD Formula • Simplifying the key value driver formula can result in distortions of continuing value.
Rates of Return Implied by Alternative ContinuingValue Formulas
percent
25 NOPLAT
CV =
WACC  g 20 Overly aggressive?
Assumes RONIC
equals infinity! Implied ROIC
15 CV = 10 WACC
5
0
1 2 3 4 Explicit forecast period 5 6 7 8 9 Con<nuing value period 10 NOPLAT
WACC Overly conservative?
Assumes RONIC equals
the weighted average
cost of capital. Common Pi3alls: Overconserva<sm Naive Overconservasm • The assump<on that RONIC equals WACC can be faulty, because strong brands, plants, and other human capital can generate economic proﬁts for sustained periods of <me, as is the case for pharmaceu<cal companies, consumer products companies, and some soXware companies. Purposeful Overconservasm • Many analysts err on the side of cau<on when es<ma<ng con<nuing value because of its size and uncertainty. But to oﬀer an unbiased es<mate of value, use the best es<mate available. The risk of uncertainty will already be captured by the weighted average cost of capital. • An eﬀec<ve alterna<ve to revising es<mates downward is to model uncertainty with scenarios and then examine their impact on valua<on. Con<nuing Value Considera<ons • • • • The level of NOPLAT should be based on a normalized level of revenues and sustainable margin and ROIC. The normalized level of revenues should reﬂect the midpoint of its business cycle and cycle average proﬁt margins. The expected rate of return on new invested capital (RONIC) should be consistent with expected compe<<ve condi<ons. Economic theory suggests that compe<<on will eventually eliminate abnormal returns, so for many companies, set RONIC equal to WACC. However, for companies with sustainable compe<<ve advantages (e.g., brands and patents), you might set RONIC equal to the return the company is forecast to earn during later years of the explicit forecast period. Few companies can be expected to grow faster than the economy for long periods. The best es<mate is probably the expected long term rate of consump<on growth for the industry’s products, plus inﬂa<on. Sensi<vity analyses are also useful for understanding how the growth rate aﬀects con<nuing value es<mates. The weighted average cost of capital should incorporate a sustainable capital structure and an underlying es<mate of business risk consistent with expected industry condi<ons. ...
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 Spring '07
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