Lezioni, Advance Corporate Finance

FORECASTING PERFORMANCE!

To value a company’s operations using enterprise DCF, we discount each year’s forecast

• of free cash flow for time and risk. In this presentation, we analyzed a six-step process

for forecasting a company’s financials, and subsequently its free cash flow.!

While you are building a forecast, it is easy to become engrossed in the details of

• individual line items. But we stress, once again, that you must place your aggregate

results in the proper context.!

Always check your resulting revenue growth and ROIC against industry-wide historical

• data. If required forecasts exceed other companies’ historical performance, make sure

the company has a specific and robust competitive advantage.!

• Finally, do not make your model more complicated than it needs to be. Extraneous

• details can cloud the drivers that really matter. Create detailed line item forecasts only

when they increase the accuracy of the company’s key value drivers.!

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CONTINUING 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:!

Value= Present Value of Cash Flow during Explicit Forecast Period + Present Value of

Cash Flow after Explicit Forecast Period!

The second term is the continuing value: the value of the company’s expected cash

• flow beyond the explicit forecast period.!

Recommended Approaches:!

Key value driver (KVD) formula. The key value driver formula is superior to alternative

• methodologies because it is cash flow based and links cash flow to growth and ROIC.!

Economic-profit model. The economic-profit model leads to results consistent with the

• KVD formula, but explicitly highlights expected value creation in the continuing-value

(CV) period.!

KVD characteristic: !

Although many continuing-value 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.

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Continuing value is extremely sensitive to long-run growth rates when RONIC is much

• greater than WACC.!

Economic-Profit Model Characteristic:!

When using the economic-profit approach, do not use the traditional key value driver

• formula, as the formula would double-count cash flows.!

Instead, a formula must be defined that is consistent with the economic-profit-based

• valuation method. The total value of a company is as follows:! !

The continuing-value formula for economic-profit models has two components:!

COMPARISON BETWEEN KVD AND ECONOMIC-PROFIT!

Note how economic-profit CV does not equal total value!

LONG OF EXPLICIT FORECAST!

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 distribution of the company’s value between

the explicit forecast period and the years that follow.!

CONCLUSION:!

Continuingvaluecandrivealargeportionoftheenterprisevalueandshould therefore be

• evaluated carefully.!

Several estimation approaches are available, but recommended models (such as the

• key value driver and economic-profit models) explicitly consider four components:!

! 1.! Profits at the end of the explicit forecast period—NOPLAT !

t+1

! 2.! The rate of return for new investment projects—RONIC !

! 3.! Expected long-run growth—g !

! 4.! Cost of capital—WACC !

A large continuing value does not necessarily imply a noisy valuation. Other methods,

• such as business components and economic profit, can provide meaningful perspective

on your continuing-value forecasts.!

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COST OF CAPITAL: COST OF EQUITY!

To value a company using enterprise DCF, we discount free cash flow by the weighted

• average cost of capital (WACC). The WACC represents the opportunity cost that

investors face for investing their funds in one particular business instead of others with

similar risk.!

In its simplest form, the weighted average cost of capital is the market-based weighted

• average of the after-tax cost of debt and cost of equity: formula!

To determine the weighted average cost of capital, we must calculate its three

• components: (1) the cost of equity, (2) the after-tax cost of debt, and (3) the company’s

target capital structure.!

The three most common asset-pricing models differ primarily in how they define risk.!

• The capital asset pricing model (CAPM) states that a stock’s expected return is

• driven by how sensitive its returns are to the market portfolio. This sensitivity is

measured using a term known as beta.!

The Fama-French three-factor model!

• The arbitrage pricing theory (APT)!

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CAPM:!

When the beta is high, the stock is considered more risky than the market.!

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COST OF CAPITAL: COST OF DEBT!

When purchasing a bond, investors require compensation. The discount factor used to

• value a bond is known as its yield to maturity (YTM).!

! A bond’s yield to maturity (YTM) is dependent on two factors:!

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Factor #1: the bond’s time to maturity (duration) !

Factor #2: the credit spread for default risk!

Yield to maturity is not an expected return. It is the return earned if the obligation is paid

• on time and in full. Since distressed companies have a significant chance of default, the

yield to maturity is a poor proxy for expected return.!

One alternative for computing expected return is the capital asset pricing model (CAPM)

• measuring bond betas (via regression analysis).!

We do not use bond betas to get expected returns for bonds given the absence of

• symmetry in returns for each of these asset classes. Stocks, which have potentially

unlimited upside potential as well as significant downside potential, have much more

symmetric returns than bonds. Thus, they tend to fit in much more cleanly into the mean-

variance framework than do bonds.!

Corporate bonds have some upside potential, but it is limited by the fact that bonds can

• at best become default-free. Consequently, the risk measure that we have to use has to

be a downside risk measure, which is what default risk and ratings measure.!

Alternatively it’s possible to use an option-based approach to estimate beta debt (that

• we don’t deepen in this course and that is in any case difficult to test empirically).!

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ENTERPRISE VALUE!

! When you have completed the valuation of core operations, you are ready to estimate

• three values: enterprise value, equity value, and value per share.!

1. To determine enterprise value, add to the value of core operations the value of

nonoperating assets, such as excess cash and nonconsolidated subsidiaries.!

2. To convert enterprise value to equity value, subtract short-term and long-term debt,

debt equivalents (such as unfunded pension liabilities), and hybrid securities (such as

employee stock options).!

3. To estimate value per share, divide the resulting equity value by the most recent

number of undiluted shares outstanding.!

Enterprise value (i.e., a company’s value to all financial stakeholders) equals the

• combined value of a company’s operations and the value of its nonoperating assets.!

A company’s value is shared between nonequity claims and equity holders. The equity

• value of a company equals enterprise value less the value of nonequity claims.!

1. Non operating assets are assets that do not generate free cash flow (or economic profit)

and, therefore, do not impact the value of operations.!

• Excess cash and marketable securities. Under U.S. generally accepted accounting

principles (GAAP) and International Financial Reporting Standards (IFRS), companies

must report such assets at their fair market value on the balance sheet. Therefore, use

the most recent book value as a proxy for the current market value.!

• Nonconsolidated subsidiaries. Nonconsolidated subsidiaries and equity investments

are companies in which the parent company holds a noncontrolling equity stake.

Because the parent company does not have formal control over these subsidiaries, their

financials are not consolidated, so these investments must be valued separately from

operations.!

• Customer financing arms. Because financial subsidiaries differ greatly from

manufacturing and services businesses, it is critical to separate revenues, expenses,

and balance sheet accounts associated with the subsidiary from core operations.!

The preceding items are typically the most significant nonoperating assets. However,

companies can have other forms of nonoperating assets as well:!

• Tax loss carry-forwards: Create a separate account for the accumulated tax loss

carry-forwards, and forecast the development of this account by adding any future

losses and subtracting any future taxable profits on a year-by-year basis. Discount at

the cost of debt.!

• Discontinued operations: Most recent book value is a reasonable approximation

since assets and liabilities associated with discontinued operations are written down to

fair value and disclosed as a net asset on the balance sheet.!

• Excess real estate and other unutilized assets: Identifying these assets is nearly

impossible unless they are specifically disclosed in a footnote. For excess real estate,

use the most recent appraisal value, an appraisal multiple such as value per square

meter, or discounting of future cash flows.!

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2. To find the value of common equity, deduct the value of all nonequity financial claims

from enterprise value. Although there are many forms of nonequity claims, these claims fall

into four primary categories:

1. Traditional corporate debt such as corporate bonds, short-term and long- term bank

loans, and credit lines.!

2. Debt equivalents such as operating leases, unfunded pension liabilities, specific

types of provisions, preferred stock, and contingent liabilities (e.g., outstanding claims

from litigation).!

3. Hybrid financial claims such as employee stock options and convertible bonds.

Hybrid claims have an equity component, but are not controlled by holders of common

stock.!

4. Minority interests is the portion of partially owned subsidiaries owned by other

companies.!

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3. How you determine the value per share depends on how options and convertible debt

are valued. The two methods are:!

Option-Based Valuation!

Divide the total equity value by the number of undiluted shares outstanding.!

• Use undiluted shares outstanding because the value of convertible debt and stock

options has already been deducted from the enterprise value.!

• The number of shares outstanding is the gross number of shares issued, less the

number of shares in treasury.!

Conversion and Exercise Value Method!

Divide th