12. Cash Flow based valuation

Transcription

1 12. Cash Flow based valuation 1. Dividend Growth Model 2. Earnings Growth Model These use publicly available figures and very simple assumptions such as no growth or constant growth 3. Free Cash Flow based Model 1

2 Valuation Present Value = Discounted Value of Future Expected Free Cash Flows For simplicity, we will say Present Value n = (1 + 0 FCF i r) i We will study how this is used 2

3 1 Dividend Growth Model PV of a perpetuity of C per period: PV = C/r If the same dividend is expected in perpetuity: PV = D/r This means that the Dividend is not growing P = 0 D R 1 e This is called the constant dividend model But dividend may be growing at rate g. Present Value of constant dividend growth company D P0= 1 R -g e 3

4 2 Earnings Growth Model All the Earnings belong to the shareholders The shareholders may decide to distribute them as dividends (no growth) or not (maximum growth). Present Value of constant earnings firm P 0 = E R 1 e Present value of growing earnings firm P 0 = E1 R -g e 4

5 Comment on the Earnings method The Earnings method assume that Earnings = Cash Flow This could be true if, for example, earnings were constant and the company was not growing beyond that level So depreciation = capital expenditure for replacement No capital expenditure for expansion No increase in working capital 5

6 From Earnings to Cash Flow Earnings can be manipulated by accounting entries. This would mean that two firms with identical businesses but with different reported earnings would have different values Therefore, people prefer to use free cash flows instead of earnings The following model brings in more realistic observations 6

7 3 Free Cash Flow based valuation 1. Projecting future cash flows 2. Horizon 3. Terminal Value 4. Discount rate 5. Applying this discount rate to the future cash flows and terminal value. 7

8 3.1 Projecting future cash flows Usually Free Cash Flows are used Based on non-financial flows So start with NOPAT Add depreciation Adjust for operating working capital Less Capital expenditure 8

9 Reminder NOPAT and FCF Below is a recent income statement for ABC Company. Net sales $1,000 Cost of sales (including depreciation of $100) 600 Gross profit 400 Selling and admin. Exp (including interest of $60) 200 Income before tax 200 Tax 68 Income after tax $132 Calculate ABC's free cash flow in this year assuming it spent $80 on new capital equipment and increased working capital $40. 9

10 3.2 Horizon This is the period over which cash flows can be predicted with some certainty For risky businesses (high discount rate) the horizon is short (e.g. high tech) For stable businesses (lower discount rate) the horizon is longer (e.g. Water supply) 10

11 3.3 Terminal Value Terminal value is often calculated by determining cash flow in the period beyond the last projected period. Assume no salvage value; or Assume perpetuity; or Assume constant growth This predicted future cash flow is then capitalized by a percentage k or (k-g) This is terminal value in, say, end of year 5 NB: This capitalized figure has still to be discounted back to the present using the discount rate. 11

12 Terminal Value A company has FCF of 100, 120, 140, 160, 180 in the first five years It grows 3% thereafter Its cost of capital is 13% Calculate the terminal value of the growth Calculate the present value of the terminal value Calculate the present value of the company 12

13 Answer: Terminal Value Year onwards Real Cash Flow Discount by 13% Present Value Terminal value year 5 = FCF 6 / (k-g) Discount by Present Value Total Present Value Cumulated Present Value of Firm 13

14 3.4 Discount rate The discount rate for the free cash flows would be WACC 14

15 3.5 Discounting future cash flows and terminal value. The Free cash flows for the horizon period And the Terminal Value Are discounted at the appropriate rate (WACC) This gives the value of the net assets From this the value of the Debt is to be reduced to get the value of the equity. 15

16 Question DCF: Grubb Free cash flow next year will be $100 million It is expected to grow at a 4 % annual rate indefinitely. The company's WACC is 10 % Market value of its liabilities is $1 billion, 20 million shares outstanding. a. Estimate the price per share of Grubb's common stock. b. Pickens believes that by selling the company DC 10, increasing the work day to eight hours, and instituting other cost savings, he can increase Grubb's free cash flow next year to $110 billion and can add a full percentage point to Grubb's growth rate without affecting its cost of capital. What is the maximum price Pickens can afford to bid for control of Grubb? 16

17 Answer: Grubb a. Price per share of Grubb stock = b. Fair market value of equity per share after change in ownership =. 17

18 Shapiro 11-5 What is the general stock price reaction to news that a company is increasing its spending on research and development? What implications does this reaction have for investment decision making? Answer. 18

19 Shapiro On May 19, 1988, Citicorp's chairman, John Reed, announced that Citicorp was adding a staggering $3 billion to its reserves against losses on Third World loans. Reed's decision created a $2.5 billion loss for the quarter and resulted in a loss for the year. Nonetheless, Citicorp's stock rose from $ to $ in the week following the announcement. Why did the market respond so positively to this disastrous earnings report? Answer. 19