Cass Business School

Transcription

1 on ly ol Sc ho ine ss us sb as rc Fo Cass Business School Financial modeling

2 Cass Business School Financial modeling AMT Training

3 Welcome to the course, where you will be trained with AMT Training, a world leader in financial learning!

4 Copyright Adkins Matchett & Toy Limited ( AMT ) All Rights Reserved. Adkins Matchett & Toy Limited is a part of Wilmington plc. AMT owns legally and beneficially all of the Intellectual Property Rights in the content of this document. No reproduction, copy or transmission whatsoever of any part of this document may be made without prior written permission. Please be advised that AMT will vigorously prosecute any unauthorised use.

5 Contents Assessment information... 1 Indicative reading list... 3 Integrated financial model standards... 6 Integrity and error checking Excel power modeling and DCF fundamentals AMT Training info@amttraining.com

6 Disclaimer Disclaimer Whilst every effort has been made to ensure accuracy regarding the content of these slides / notes, Adkins Matchett & Toy cannot be held responsible in any way for consequences arising from the information given. No decisions should be taken on the basis of information included in the slides / notes without reference to specialist advice. AMT Training info@amttraining.com

7 Assessment information AMT Training

8 Assessment Assessment This module will be assessed by a computer-based test weighed at 100% Standard MSc grade related assessment criteria will apply. All the contents of the module are examinable. The pass mark for the module is 50%. The test is Moodle-based and includes 3 question types: multiple choice questions, an Excel download requiring formulas to be written, and short essay-type open questions. You must take the test on a PC (desktop or laptop) of your choosing, either on-site or off-site. Please note that, if you decide to take the test onsite, computer usage will be on a first-come firstserved basis (it is not possible to book a computer). You will need internet access throughout the duration of the test. If you are overseas please ensure you can access the internet and Moodle within the specified testwindow UK times. You will be responsible for your IT setup (i.e. ensuring your computer works properly, the battery is charged, you have internet access etc). Cass will not take any responsibility for your IT setup and exam conditions. We recommend you do NOT use a Mac to take the test. The Excel version used for the test must be 2007 or later. We recommend you plan well in advance your IT setup and where to take the test. AMT Training info@amttraining.com

9 Indicative reading list AMT Training info@amttraining.com

10 Indicative reading list Indicative reading list A list of relevant resources is provided below. Please note that no single textbook covers all the module contents. Corporate financial modelling in Excel Crunch The Numbers - Modeling (published by AMT Training and available for purchase on This manual covers the process of building a corporate forecast model in Excel. It is directed to the professional user and is used widely by investment bankers worldwide. Crunch The Numbers - Power Modeling (published by AMT Training and available for purchase on This manual covers many applications of Excel for financial analysis and modelling, like scenario building, creating flexible output tables and sensitivity analyses. Building Financial Models, (J Tjia), McGraw Hill, 2nd ed. (2009) This textbook is a thorough resource on building a corporate forecast model in Excel. It also includes a section on VBA (Visual Basic) and on building a discounted cash flow model. Financial Analysis in Excel Financial Modeling (S Benninga) MIT press, 4th ed. (2014) This is an excellent resource on using Excel for financial analysis, as it covers a wide range of applications: corporate forecasting and valuation, bond valuation, portfolio analysis, option valuation and Monte Carlo methods. However, the depth of each section is often limited. It comes with a CD. Excel Modeling in Corporate Finance (C Holden), Pearson, 4th ed. (2011) This is a workbook consisting of a series of problems related to corporate financial analysis in Excel. Each problem has its own one-pager model in Excel. It comes with a CD. Mastering Cash Flow and Valuation Modelling, (A Day), FT / Prentice Hall, 2nd ed. (2007) This book illustrates some of the modeling techniques covered in the module. It comes with a CD. AMT Training info@amttraining.com

11 Indicative reading list Discounted Cash Flow Valuation Model Most corporate finance textbooks describe the fundamentals of the DCF valuation method. A comprehensive analysis of the DCF approach can be found in the following textbooks: Investment Valuation, (A Damodaran), Wiley, 3rd ed. (2012) Valuation: Measuring and Managing the Value of Companies, (T Koller et al), Wiley, 5th ed. (2010) Excel guides The following two manuals provide extensive guidance on using Microsoft Excel: Microsoft Excel 2010 in Depth, (B Jelen) QUE (2010) Excel 2010 Bible, (J Walkenbach), Wiley (2010) AMT Training info@amttraining.com

12 Integrated financial model standards AMT Training info@amttraining.com

13 Financial modeling Using Excel 2010 or info@amttraining.com

14 Contents Best practice Excel settings Navigating, selecting, formatting and entering data Building a corporate forecast model Model structure Efficient formula building Using a plug account for the balance sheet Building the cash flow statement Managing circularities 6 info@amttraining.com

15 Using Excel for financial applications Navigating, selecting, formatting and entering data 7 info@amttraining.com

16 First excel file Open Excel file AMT warmup std Quick and efficient navigation around a model Setting best practice Excel procedures for creating models Basic formulas used in models 4 8

17 What is a spreadsheet? Spreadsheets are one of the primary tools used for financial analysis A spreadsheet is an electronic sheet made up cells arranged in rows and columns A cell reference consists of the column letter followed by the row number (e.g. A1) The cell reference for the active cell is shown in the name box (on the left-hand side corner of the spreadsheet) 5 9

18 The Excel 2010 interface The Ribbon: Excel is controlled from here. For example, open files, formatting, copy and pasting, etc Sheet tabs: Click to select different worksheets or use CTRL PgUp and CTRL PgDn Formula bar: Shows the content of a cell 6 Status bar: Provides vital information relating to inputting and circular references 10

19 The Excel 2007 interface The Ribbon: Excel is controlled from here. For example, open files, formatting, copy and pasting, etc Sheet tabs: Click to select different worksheets or use CTRL PgUp and CTRL PgDn Formula bar: Shows the content of a cell 7 Status bar: Provides vital information relating to inputting and circular references 11

20 Optimal settings Open the Excel options dialog box (ALT + F, then I or T) Category Setting Formulas Enable background error checking: off Advanced Editing options Allow editing directly in cell: off Zoom on roll with IntelliMouse: on Extend data range formats and formulas: off Enable automatic percent entry: on Enable AutoComplete for cell values: off Cut, copy and paste Show paste options buttons: off Show insert options buttons: off 8 12

21 Access keys Use the KEYBOARD for frequently used commands: Every command in Excel can now be accessed with a keyboard accelerator To access the accelerators, press the ALT key and let go. Accelerator keys appear above each command. Press the desired accelerator key. For example, to access font color, press ALT + H F C in sequence Press Esc to back-up. For example, if you press ALT + M, which takes you to the Formulas ribbon, and realize you actually wanted the Home ribbon, simply press escape to back-up a level 9 13

22 Navigating the worksheet Use the arrow keys Or click cells using the mouse (not recommended!) CTRL and arrow keys CTRL + HOME moves to the top left hand corner of the worksheet CTRL + END moves to the last occupied cell in the worksheet CTRL + PgUp / PgDn to change worksheets 10 14

23 Navigating shortcuts Summary Navigate: ARROW One cell up / down / left / right CTRL + ARROW Edge of block of cells PAGE UP / DOWN CTRL + PAGE UP / DOWN ALT + PAGE UP / DOWN HOME CTRL + END CTRL + HOME F5 Goto a specific cell One screen up / down One worksheet left / right One screen left / right To left most cell in row To last cell formatted or occupied on the sheet Move to cell A

24 Selecting cells Hold down SHIFT and press the arrows keys Or click and drag with the mouse (not recommended!) CTRL and click will select noncontiguous cells Shift + spacebar to select a row CTRL + spacebar to select a column 12 16

25 Selecting shortcuts Summary Selecting cells: SHIFT + ARROW Extend selection by one cell CTRL + SHIFT + ARROW Extend selection to last nonblank cell CTRL + SHIFT + * Select current region around active cell SHIFT + HOME Extend selection to start of row CTRL + SHIFT + HOME Extend selection to top left CTRL + SHIFT + END Extend selection to last cell used CTRL + SPACEBAR Select the entire column SHIFT + SPACEBAR Select the entire row CTRL + A Select the entire worksheet (may need to hit twice) SHIFT + PAGE DOWN Extend the selection down one screen SHIFT + PAGE UP Extend the selection up one screen END, SHIFT + ARROW KEY Extend selection to the last nonblank cell END, SHIFT + HOME Extend selection to bottom right END, SHIFT + ENTER Extend selection to the last cell in row 13 17

26 Entering and editing data Cells can contain: text; values; and formulas To enter data in a cell: select the cell to contain the data, start typing and press enter To change data in a cell: Press F2; or Click the formula bar (not recommended!) 14 18

27 Important data entering shortcuts Cut, copy & paste: CTRL + C Enter CTRL + V CTRL + R CTRL + D ALT + CTRL + V CTRL + X Tip: Copy Paste (once only) Paste (paste multiple times when copying) Copy (or fill) right Copy (or fill) down Paste special (for all paste options) Cut (move) Avoid empty columns between columns of data, set up traveling columns 15 19

28 Absolute vs. relative references Relative references Relative formulas adjust to their new location. In the example above think of the tax formula as "four cells up multiplied by eight cells up" F4 is the absolute reference shortcut 16 Absolute references To lock a reference, use dollar signs. In this example above, the tax rate reference C4 is locked. When the tax formulas is copied across the reference C3 will not adjust as it is absolute. 20

29 Formatting Important formatting shortcuts CTRL SHIFT %: percentage style CTRL SHIFT currency sign: currency style CTRL SHIFT!: number style CTRL B, or I or U: bold/italics/underlined Format cells dialog box (CTRL + 1) Use styles for advanced formatting 17 21

30 File commands shortcuts Summary Use CTRL for file command shortcuts: CTRL + O Open a file CTRL + N CTRL + S CTRL + P CTRL + F2 CTRL + Tab ALT + Tab CTRL + Z CTRL + Y Create a new file Save Print Print preview Switch between open files Switch between open applications Undo last command Undo CTRL + Z 18 22

31 Excel users: amateurs vs. professionals What professionals do Use the keyboard Empty cells using the delete key Use F2 to edit a formula Use Ctrl + Tab to move to another spreadsheet Build formulas by referencing other cells 19 What amateurs do Use the mouse Hit the space bar Click on the formula bar Click on the taskbar Hard-code numbers in formulas 23

32 Building formulas in financial models 24

33 Functions There are 100s of functions in Excel Designed to perform a variety of calculations Some important functions: SUM (ALT + =) AVERAGE MAX, MIN IF PV, FV, Rate, NPV 21 25

34 SUM =SUM(C14:C27), or: =SUM(C14,D16,C24,E15) The SUM function shortcut: Hold down the ALT key then press the = key Press enter to confirm selection and complete the function OR Hold down the ALT key and press the = key twice Note: The SUM function calculates vertically by default, but if there are no vertical numbers it calculates horizontally 22 26

35 Key modeling formulas Growth formula: % Previous quantity * (1 + growth rate) = Year 0 sales * (1 + Year 1 sales growth) $ Amount previous quantity + growth amount = Year 0 assets + growth in assets 23 27

36 Key modeling formulas Relation formula: Note: % of means MULTIPLY Percentage * driver = COGS % of sales * Sales Percentage Driver 24 28

37 Building a financial model Theory and practice 29

38 Logic flow in financial models Debt Secondary calculations Assumptions Inputs Outputs Analysis Cash flow statement Balance sheet Income statement Valuation Ratios summary

39 Model structures Open Excel file AMT structures std Different types of modeling structures Turn off iterations Open the Excel options dialog box (ALT + f i) Go to the Formulas tab Deselect the Enable iterative calculation box Exit the dialog box If the circular references window alert opens, close any other Excel files that are open 27 31

40 Model structure Assume I/S B/S TOWER: All on one sheet 28 Assume I/S B/S MATRIX: Spread across multiple sheets 32

41 Important modeling rules Always put the ASSUMPTION FIRST in formulas Never HARD CODE in a formula Build YEAR 1 only (do not copy across line by line) COPY existing formulae across (do not re-build them) Once year 1 is complete, copy across the WHOLE section Always build the model with ITERATIONS OFF 29 33

42 Cross-sheet formulas Sales = (1 + Assumptions!C5) * B5 sheet name separator cell address Note: DO NOT type the sheet name, click on the cell reference 30 34

43 Cross-sheet formulas Example: COGS = Assumptions!C6 * IncState!C5 1. Type = 2. Go to assumptions 3. Click on year 1 assumption 4. Type operation sign * 5. Go to IncState 6. Click on driver 7. Enter Note: ALWAYS put the assumption first 31 35

44 First full model Open Excel file AMT simple model std This is a full 3 statement model Assumptions are on a separate sheet Some parts have already been completed Ensure iterative calculations are disabled (in Excel tools) 32 36

45 Simple model: modeling steps 1. Income statement forecast 2. Balance sheet forecast Except for cash! 3. Cash flow statement forecast 4. Balance the balance sheet Use the cash amount calculated in the cash flow statement 33 37

46 Retained earnings calculation Retained earnings is an account within shareholders equity It records the cumulation of earnings (net income) produced by the firm year by year, net of the dividends paid This example assumes zero dividends Balance Sheet Retained earnings, beg. balance + Net income + Net income Retained earnings, end. balance 34 Income Statement 38

47 Rules of cash Assets USE cash: Assets Assets Cash Cash Liabilities & equity PROVIDE cash: L&E Cash L&E Cash 35 39

48 The two pillars of model auditing Does it look correct? The two pillars of integrity checking 36 Have the formulas been checked? 40

49 Important auditing shortcuts Tracing precedents and dependents in a workbook: 1 On the same sheet as the formula cell: CTRL + [ Highlight precedent cells CTRL + ] Highlight dependent cells Enter Move between each precedent / dependent cell F5 + Enter Return to original starting point 2 When the formula is on a different sheet CTRL + [ Go to first precedent cell F5 + Enter Return to original starting point 37 41

50 Building a full model Open Excel file AMT genlite std First real 3 statement model Ensure iterative calculations are disabled (in Excel tools) Examine the model: Flip through the sheets Similar to Simple Model but accounts are more complex Find the hidden hints in column A (financial statements) 38 42

51 Genlite GENLITE What s different? Calcs sheet PP&E BASE analysis Retained earnings BASE analysis, including dividends Operating working capital calculation Debt schedule (simple) More complex balance sheet 39 43

52 Genlite s driver What is the driver in GENLITE? Hint: Which account affects many other accounts? Notice most assumptions are based on percentage of sales Project sales Use percentage of sales method to model most of other accounts 40 44

53 Genlite modeling steps 1. Income statement Complete the historical calculations then the forecast 2. Balance sheet Complete the historical calculations then the forecast Build the balance check formula (use IF) Leave forecast cash empty Use calcs sheet for secondary calculations 3. Cash flow statement 4. Balance the balance sheet Use the cash amount calculated in the cash flow statement 41 45

54 Base analysis A simple tool to organize forecasts clearly and accurately Beginning Addition Subtraction Ending Example Beginning PP&E Capital expenditure Depreciation Ending PP&E 42 46

55 PP&E calculations Inputs Outputs Net PP&E, beginning balance Income statement + CAPEX Depreciation Annual depreciation Net PP&E, ending balance Balance sheet Net PP&E CFS + Depreciation (operating) CAPEX (investing) 43 47

56 Retained earnings calculations Inputs Outputs Retained earnings, beg. balance Income statement + Net income + Net income Dividends Dividends Retained earnings, end. balance Balance sheet Retained earnings, end. balance 44 48

57 Stress test Genlite What if dividends were 10% of net income? What happens to cash? Does the balance sheet still balance? When this is finished, restore dividends to 20% of net income 45 49

58 Stress test Genlite Problem! What if the debt repayment schedule were: Year 1 Year 2 Year 3 Year 4 Year 5 Repay What happened to cash? Does the balance sheet still balance? Does the cash account make sense? 46 50

59 Genlite Not good enough! Genlite is too simple Can t provide for negative cash Negative cash occurs when assets exceed L&E Negative cash represents a gap in the company s financing 47 51

60 Negative cash Not enough cash the company has a financing gap Assets 48 Financing Gap L&E 52

61 The revolver When there s not enough cash: The company must fill the gap in their financing Companies usually fill financing gaps with debt The financing gap account: Revolver 49 53

62 The revolver Open Excel file AMT genrevolver std Ensure iterative calculations are disabled (in Excel tools) Examine the model: Just like GenLite, but with a revolver account Check debt schedule, CFS and balance sheet Revolver is often ST debt and appears at top of L&E on balance sheet 50 54

63 Cash Rule: Cash should never be less than 0 How can this be applied? Answer: Use an IF statement Test: is cash > 0? if test is true, show cash if test is false, show 0 = IF(test, output if true, output if false) 51 55

64 If statement for cash D5 = IF(Cash!D24>0, Cash!D24, 0) test output if true 52 output if false 56

65 If statement for revolver In order to balance the revolver, reverse the cash formula: D16 = IF(-Cash!D24>0, -Cash!D24, 0) test output if true output if false

66 Basic relationships Income statement Cash flow statement Net income Net income Cash Balance sheet Total assets Revolver Retained earnings Total L&E Cash from operations Net change in cash Excess cash / (revolver)

67 What about interest? Open Excel file AMT geninterest std Ensure iterative calculations are disabled (in Excel tools) Examine the model: Just like GenRevolver, but with interest expense and interest income added Check debt schedule, income statement and balance sheet 55 59

68 New cash / (rev) formula Another calculation for cash / revolver: Instead of IF statement, use a MAX function = MAX(cell1,cell2,cell3:cell6) Apply it to the following two items: 1. Cash / (revolver) on CFS 2. 0 MAX will show the larger number 56 60

69 Full debt schedule Debt schedule structure: A complete debt schedule is organized into 3 sections: 1. Individual short term debt issuances 2. Individual long term debt issuances 3. Summary of debt and interest 57 61

70 Timing and interest Scenario 1 : Repayment on FY day million note at 10% FY beginning balance FY ending balance 100 (50) What is the interest expense? 58 62

71 Timing and interest Scenario 12 : Repayment on FY day million note at 10% FY beginning balance FY ending balance (50) 50 What is the interest expense? 59 63

72 Timing and interest Compromise: Average debt 100 million note at 10% FY beginning balance FY ending balance Average debt over year: 75 = ( ) / 2 What is the interest expense? 60 64

73 Circular errors What is a CIRCULAR error? CIRC = formula that includes itself in its formula CIRC, See Circular error Circular error, See CIRC 61 65

74 Circular errors A =SUM(A1:A3) The formula in A3 is adding itself into the total, which causes a CIRCULAR REFERENCE 62 66

75 Circular errors The 2 warning signs: 1. 0 in formula cell when the answer should be some other number 2. The circular message on the status bar 63 67

76 Expert knowledge Check the status bar: Cell reference: formulas on this sheet are involved in the CIRC No cell reference: there s a CIRC on another sheet in an open file 64 68

77 The circularity Cash, int. inc. calc. Cash, B/S Interest income, I/S Cash, CFS 65 Net income Cash from operations 69

78 The circularity Revolver, int. exp. calc. Revolver, B/S Interest expense, I/S Revolver, CFS 66 Net income Cash from operations 70

79 Interest on interest Borrow $100 at 10% interest No positive cash flows in first year How much is needed to borrow? Principal + Interest = Total 100???? 67 71

80 Interest on interest Principal + Interest = Total = = = =

81 Iteration What is the purpose of iteration? Iteration recalculates formulas multiple times In each recalculation, Excel begins with the answer from the previous recalculation When does iteration stop? When: It reaches its preset number of tries, or The answer differs from the previous answer by the preset amount (a small number) 69 73

82 If iteration is used... TRACK THE CIRCs Iterative errors can quickly be fixed if the location of the CIRCs are known REMOVE ITERATION TO EDIT Remove CIRCs Turn off iteration 70 74

83 If iteration is used... Copy circular formulas into the margin: A B C D H I J 2 Income statement Year Year 1 Year 5 11 EBIT Interest income Interest expense Net interest expense Copies of circular formulas 75

84 Using the circular toggle A circular toggle makes it easier to manage circularities A circular toggle is a 1 or 0 switch that introduces and removes intentional circular references Use an IF statement when building interest income and interest expense: =IF(CIRC = 1, SHOW INTEREST, SHOW ZERO) 72 76

85 Documentation 1. Add comments 2. Make clear assumption labels 3. Color-code input cells 4. Show audit trails: break complex formulas into simple steps 73 77

86 Comments Comments make a model more user friendly and easier to understand especially when sharing. Roll the mouse near the red flag to read the comment Double-click or SHIFT + F2 to open the comment Esc + Esc to leave comment Insert: SHIFT + F2 or ALT + r c Delete: ALT + r d or Esc + Delete (if already open) Note: Your name is added automatically to every comment you create 74 78

87 Checking 1. Does the balance sheet balance? 2. Are the results clear and make sense? 3. Is the file free from errors? 4. Proofread the formulas? 5. Do you have only absolutely necessary circularities? 6. Stress test the model? 75 79

88 Prepare for handoff 1. Prepare a cover page 2. Check work for accuracy 3. Beauty save with cursor homed on each sheet and placed on opening sheet 76 80

89 Beauty save Beauty save the model: Make the model look presentable and user-friendly, for others who may use it 1. Position pointer at top of each sheet 2. Move to best opening sheet in the model 3. Save Tip: Consider creating a macro to beauty save 77 81

90 Summary Modeling standards Models must be accurate and well-structured Avoid hard coded assumptions in output formulas Formulas are linked assumptions Changes in assumptions create changes in outputs Models must be user-friendly Model has matrix integrity (for multiple sheet models) Multiple sheets are formatted alike Complex calculations are split into steps Model is well documented 78 82

91 Summary 10 modeling steps 1. Set up MODELING template 2. Input historicals 3. Build assumptions about the future 4. Build the income statement (no interest) 5. Build the balance sheet (no cash accounts) 6. Build the cash flow statement 7. Balance the balance sheet 8. Wire up interest 9. Perform ratio analysis 10. Perform analysis LBO DCF ratio credit analysis 79 83

92 Summary Modeling rules Always build the model with ITERATIONS OFF Ensure the model has MATRIX INTEGRITY Always check formulas for MATRIX INTEGRITY Keep formulas Tight (only include cells needed in the formula) Always put ASSUMPTIONS first Always COPY totals across COPY ACROSS section by section Check for HOCKEY STICKS Stress test Only ONE ENTRY POINT for a number Never HARD CODE in a formula Always leave AUDIT TRAILS and INSERT COMMENTS 84 80

93 Midnight manuals Practical reference guides We publish two modeling manuals: Find them on our website: store.amttraining.com/uk/ They are very popular with investment bankers all over the world!

94 Appendix Key Excel functions 82 86

95 Key excel functions Mean (average) Median = AVERAGE(C14:D14) * D15 or = AVERAGE(C14,D14) * D15 = MEDIAN(C14:D14) * D15 or = MEDIAN(C14,D14) * D

96 Key excel functions Max / min 84 88

97 Key excel functions IF statements How to automate decision-making in your model = IF(statement, action if true, action if false) = IF(Cash!D24>0, Cash!D24, 0) 85 89

98 Logical operators Equal to = Greater than > Less than < Not equal to <> Greater than or equal to >= Less than or equal to <= 86 90

99 Financial training, your competitive advantage Please note: All materials are the intellectual property of AMT Training. London New York Hong Kong Please visit us on: 91

100 Passwords for session 1 Passwords for session 1 Class files AMT warmup std 2015.xlsx AMT simple model answer std 2013.xls AMT simple model std 2013.xls AMT genlite answer std 2013.xls AMT genlite std 2013.xls AMT FSM baseaccounts std 2013.xls Homework files AMT simpcorp answer std 2013.xls AMT simpcorp std 2013.xls H&M forecast template lite 2012.xls H&M forecast answer lite 2012.xls BurgerKing forecast template lite 2010.xls BurgerKing forecast answer lite 2010.xls Password bricks harry initial harry almond basic Password harry biscuit borough lambeth loche pug AMT Training info@amttraining.com

101 Passwords for session 2 Passwords for session 2 Class Files AMT geninterest answer std 2013.xls AMT geninterest std 2013.xls AMT genrevolver answer std 2013.xls AMT genrevolver std 2013.xls AMT FSM circularity std 2013.xls AMT excoprob xxx std 2013.xls Homework Files AMT typica std 2013.xls AMT typica answer std 2013.xls BurgerKing forecast template std 2010.xls BurgerKing forecast answer std 2010.xls GAP forecast template std 2012.xls GAP forecast answer std 2012.xls AMT find the errors exco lite 2013.xls Password bracken filbert harry cashew headache marin Password walnut bracken burger chips spotty superted rada AMT Training info@amttraining.com

102 Integrity and error checking AMT Training

103 Integrity checking Finding errors in models 95

104 First step when opening a model 1. Check the status bar for circularities a) Circular message b) Calculate message 2. Turn off iteration a) Tools, Options (Calculations tab) Excel 2003 b) Office Icon, Options (Formulas tab) Excel Go to the model documentation, see where the circularities are and remove them 4. If there is a circ switch in the model, turn it off 2 96

105 See if the balance sheet balances Go to the balance sheet and check that it balances This is where problems often start Use some models to practice Important helpers: 1) Make sure the amount of the difference is known, as this often helps to find the error 2) Divide this difference by 2, because if there is a sign problem on the cash flow statement, the difference would have been doubled 3 97

106 Integrity checking Does it look right? Sanity check The two pillars of integrity checking 4 Are the formulas correct? Matrix check 98

107 Sanity check Does it look right? Look for hockey sticks Watch for accounts that suddenly drop or leap up from one time period to the next Past 5 99 Future

108 B Sanity check Hist. year Year 1 Year 2 Year 3 COGS Other Taxes

109 Matrix integrity check Set up a matrix template for all sheets Put the same time period in the same column on all sheets A B C A B C D A B C D D nd Year

110 Matrix integrity check Are the formulas right? Bad clicks (matrix integrity violations) Look for the off-column reference and investigate they may be wrong =C8 * B14 =C8 * C

111 Matrix integrity check Matrix integrity checking would have found this mistake. Proj. Year 1 depreciation should link to column D. You are off by one column in every year.

112 Excel can help you edit your model Some useful edit and calculate shortcut keys: F2 Edit cell contents (useful for formulas with precedents on same screen) F9 Calculate (manual calculations) F2 then F9 Calculate the answer (useful for calculating parts of a suspicious formula)

113 Excel can help you edit your model Some useful auditing shortcuts keys: When a formula uses references from the same sheet CTRL + [ Trace precedents CTRL + ] Trace dependents Enter + Enter Scrolls through formula references F5 + Enter Takes you back to the start Note: On different sheets CTRL + [ will highlight the first reference only (F5 + Enter to return) CTRL + ` Switch between displaying a formula or value CTRL + Copy the formula above Note: Some shortcuts will not work on non-us keyboards

114 Excel can help you edit your model Some useful auditing shortcuts keys: Excel 2003 Excel 2007 Trace precedents ALT + t u t ALT + m p Trace dependents ALT + t u d ALT + m d Remove arrows ALT + t u a ALT + m a Note: 1. The shortcut keys above will highlight the dependents and precedents by directing you to related cells via arrows. These sequences of keys will NOT scroll through affiliated cells like the CTRL + [ or CTRL + ] shortcuts do 2. References on other sheets are represented by a worksheet icon

115 If it does not balance in ~20 minutes Go to the balance sheet Build a column of data that calculates the between the historic balance sheet and the first year of the forecast Then compare each line item in this column with the CFS line items For example: in PP&E Depn + Capex from CFS in RE = NI + Divs from CFS

116 If it does not balance in ~20 minutes Assets Current assets Change in cash Cash Accounts receivable (5.7) =C6-D6 Inventories (2.7) =C7-D7 Total current assets Non-current assets Net PP&E (28.0) =C11-D11 Total assets Liabilities Current liabilities Revolver Accounts payable =D17-C17 Total current liabilities Non-current liabilities Total long-term debt =D21-C21 Total liabilities Equity Common stock =D25-C25 Retained earnings =D26-C26 Total equity Total Liab.& Equity Balance? Remember 1) An increase in assets represents a decrease in cash and vice versa 2) An increase in L&E represents an increase in cash and vice versa

117 If it does not balance in ~20 minutes Assets Current assets Cash Accounts receivable Inventories Total current assets Non-current assets Net PP&E Total assets Liabilities Current liabilities Revolver Accounts payable Total current liabilities Non-current liabilities Total long-term debt Total liabilities Equity Common stock Retained earnings Total equity Total Liab.& Equity Balance? Cash flow from operations Net income 40.5 Depreciation 13.8 (Increase in operating working capital) (5.1) Total cash from operations 49.2 Cash flow from investing (Capital expenditure) (43.9) Total cash from investing (43.9) Cash flow from financing Increase (decrease) in LTD 10.0 Increase (decrease) in Common stock 0.0 (Dividends) (8.1) Total cash from financing 1.9 Total net change in cash 7.2 Change in PP&E = (28.0), yet depreciation + capex on CFS = (30.1) Something is wrong here - need to investigate! Change in RE = 32.4, and NI + dividends on CFS = 2.4 Perfect! 109

118 If it does not balance in ~20 minutes Assets Current assets Cash Accounts receivable Inventories Total current assets Non-current assets Net PP&E Total assets Liabilities Current liabilities Revolver Accounts payable Total current liabilities Non-current liabilities Total long-term debt Total liabilities Equity Common stock Retained earnings Total equity Total Liab.& Equity Balance? Cash flow from operations Net income 40.5 Depreciation 15.9 (Increase in operating working capital) (5.1) Total cash from operations 51.3 Cash flow from investing (Capital expenditure) (43.9) Total cash from investing (43.9) Cash flow from financing Increase (decrease) in LTD 10.0 Increase (decrease) in Common stock 0.0 (Dividends) (8.1) Total cash from financing 1.9 Total net change in cash 9.3 Change in PP&E = (28.0), and now depreciation + capex on CFS = (28.0) And the balance sheet balances! 110

119 Check for errors A balancing balance sheet does not imply an error free model Sanity check the output Matrix integrity check the formulas Stress test the model Try to break it Change assumptions and check the predicted output

120 Extreme checking Print a copy showing rows and columns Check for hockey sticks Print a copy showing formulas CTRL + ` Check for matrix integrity Start checking

121 Working with intentional circular references safely All models that are intentionally circular should include a circular toggle A circular toggle is a 1 or 0 switch that introduces and removes intentional circular references Use an IF statement when building interest income and interest expense: =IF(CIRC = 1, SHOW INTEREST, SHOW ZERO)

122 Working with intentional circular references safely State Notes Finished Iterations active Circular toggle = on Work in progress Iterations inactive Circular toggle = off Putting a model into a work-in-progress state protects the model from hidden unintentional circular references Hidden unintentional circular references are hard to detect time bombs

123 Working with intentional circs To correct a model that has gone into error state, follow the steps below: 1. Set the circular toggle to 0 to remove circularity from the model 2. Find and correct the problem that initially caused the model to go into the error state 3. Set the circular toggle to 1 to re-introduce circularity These steps should ensure the model is no longer in error state

124 Protecting a model from unintentional circular references When working on a model (when in work-in-progress state) ensure: 1. Iterations are off 2. Circularities are deactivated with the circular toggle 3. No circular message on status bar close other circular files This will protect the model from unintentional circular references. An error message will appear when building a formula that creates a circular reference (see next page) Ensure the model is in work-in-progress state

125 Debugging a model of unintentional circs Elimination method: When using this method the status bar must be active e.g. shown at the bottom of your Excel window Excel 2003: Excel 2007:

126 Debugging a model of unintentional circs Elimination method steps: Delete parts of the model and check for the circular message on the status bar (if the terms Circular References or Calculate are not present in the lower left corner of the status bar, no circular references exist in your model) If the message has not disappeared, undo what you have deleted and then delete another cell(s) Repeat the above process until you have found the cause of the circular problem (i.e. until the Circular References or Calculate terms have disappeared)

127 Using the circular reference toolbar The iteration option must be turned off in order to allow the circular reference toolbar to appear Make sure other files (especially those with circs) are closed, since the circular reference toolbar works on all open workbooks To bring up the circ toolbar: Excel 2003: View, Toolbars, Circular Reference Excel 2007: Formulas, Error Checking (K), Circular References

128 Using the circular reference toolbar The circ toolbar allows you to trace the cells involved in the circular reference For example, on the CFS, typically the cell in the lowest numbered row involved in the circ provides the biggest clue as to which account is causing the circular reference since the other cells are largely subtotals (see next 2 slides)

129 Using the circular reference toolbar 27 The circular reference toolbar allows you to trace all the cells involved in the circular reference in this case, we can see that the circular reference involves the debt tab as well as line 18 on this tab 121

130 Using the circular reference toolbar Of the cells listed in the circular references toolbar above, cell D14 contains the account which is directly causing the problem, since D24 feeds off D23, which feeds off D19, which feeds off D17, which is a result of D14, which incorrectly links to the debt tab

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132 Excoprob files - Solution key Excoprob files - Solution key List of errors File Issue Explanation 1 Balance Sheet. Total current assets. 2 Cash Flow Statement. Capex is positive. 3 Balance Sheet. Accounts payable. 4 Income Statement. SG&A. 5 Balance Sheet. Total long-term debt is zero. The sum is missing the cash. Wrong sign used to link capex into the cash flow statement. The forecast accounts payable is negative. It should be positive. SG&A forecast is using the wrong assumption. The LT debt forecast has been linked to an empty cell. 6 Cash Flow Statement. Change in long-term debt is missing from the cash flow statement. 7 Balance Sheet Revolver forecast is linked to the debt sheet, rather than being linked to the cash flow statement. This mistake creates a circularity. 8 Calcs Sheet OWC includes cash. This mistake creates a circularity. AMT Training info@amttraining.com

133 Find the errors exercise: Exco lite model Find the errors exercise: Exco lite model Instructions The Exco lite model has 10 errors. You must find each error and fix it. Once you have fixed all the errors, the balance sheet should balance, the file should not have any unnecessary circularity and all calculations should be mathematically and financially correct. If you cannot find all 10 errors, the following suggestions may help you: Have you checked the calculation of all profit margins in the income statement? Have you compared the value in the historical year with the first forecast year for each item in each sheet? Investigate any big variation. Does the cash flow statement correctly reflect the change in all balance sheet lines? Are there any unnecessary circularities in the file? The solutions to the errors are shown on the next page. AMT Training

134 Find the errors exercise: Exco lite model List of errors Issue 1 Change in Revolver included in CFS Explanation Change in revolver must not be included in the CFS. It makes the model circular and throws the model off-balance. This is the only unintentional circularity in this model. A good circularity check would find this immediately (the model is unnecessarily circular). 2 C10 IncState Wrong formula for historical operating profit. Should deduct SG&A. 3 COGS forecast (IncState) Wrong link (using assumption for SG&A). 4 Change in common stock missing from CFS 5 Dividends in CFS are positive The change in common stock must be included in the cash flow statement, representing an issuance of new shares or a repurchase of shares. This issues throws the balance sheet off-balance. Wrong sign - dividend is a cash outflow. Throws the balance sheet off balance. 6 Receivables on BS Matrix error in the forecasts: each year is linked to the assumption for the following year (rather than for the same year). This error is easily spotted: receivables are zero in the last forecast year. 7 PP&E BASE (Calcs) Historical PP&E has been hard-coded and it is different from the one on balance sheet. This error throws the model off balance. 8 OWC (Calcs) The sign of the accounts payable is wrong, resulting in a wrong OWC. A visual check of the calcs page would spot this, as this is the only row of negative numbers on this sheet. 9 Revolver (Debt) Interest rate link is wrong. A careful check of the Debt sheet would find that the interest rate on revolver and on LT debt are the same. 10 Total interest expense (Debt) Total interest expense is not including the interest on revolver. A careful circularity check would find this, as revolver is not making the model circular (it should). Another sign of this problem is that the formula for the total interest expense is a SUM function that includes only one cell, which is odd. AMT Training info@amttraining.com

135 Excel power modeling and DCF fundamentals AMT Training

136 Flexible output tables 128

137 Objectives By the end of this session, the following functionality will be covered: Use various functions to look up information State the difference between the different functions 2 129

138 Content What is a flexible output table? VLOOKUP HLOOKUP INDEX MATCH 130 info@amttraining.com

139 What is a flexible output table? An output table summarizes information from a financial model Tables should be flexible so that the information presented can be changed easily and quickly 4 131

140 LOOKUP functions There are two main lookup functions in Excel: 1. VLOOKUP 2. HLOOKUP 5 132

141 VLOOKUP function The VLOOKUP function looks for a value specified in the first column of a table and returns the corresponding value in a specified table column. It has the following syntax: =VLOOKUP(lookup_value, table_array, col_index_num, range_lookup) lookup_value is the value to be looked up in the first column of the lookup table table_array is the range than contains the lookup table col_index_num is the column number within the table from which the corresponding matching value is returned range_lookup allows you to specify an exact match with FALSE 6 133

142 VLOOKUP function 7 1. Looks up lookup value (C3) in first column of table (B9:D14) 2. Returns information from column 3 3. As range lookup is omitted, an exact match is not required 4. The VLOOKUP function finds the next largest value that is less than lookup value 5. The first column of the table must be in numerical order 134

143 VLOOKUP function 8 1. Looks up lookup text (C3) in first column of table (B9:D13) 2. Returns information from column 3 3. As range lookup is FALSE, an exact match is required 4. There is no need for the first column of the table to be in alphabetical order 135

144 HLOOKUP function 1. Looks up lookup text (C3) in first row of table (B8:G10) 2. Returns information from row 3 3. As range lookup is FALSE, an exact match is required 4. There is no need for the first row of the table to be in alphabetical order 9 136

145 LOOKUP & MATCH functions One dimensional lookups have now been covered: VLOOKUP looks vertically HLOOKUP looks horizontally Using the MATCH function in conjunction with the lookup functions will create two dimensional lookups: VLOOKUP will look vertically and the MATCH function can be used to look horizontally HLOOKUP will look horizontally and the MATCH function can be used to look vertically

146 MATCH function MATCH function: The MATCH function returns the relative position of an item in an array. It is powerful when used in conjunction with other functions such as VLOOKUP and HLOOKUP and has the following syntax: =MATCH(lookup_value, lookup_array, match_type) Lookup_value is the value that you want to match in lookup_array. It can be a value (number, text, or logical value) or a cell reference to a number, text, or logical value Lookup_array is a contiguous range of cells containing possible lookup values Match Type MATCH finds the largest value, less than or equal to lookup_value finds the first value, exactly equal to lookup_value; default finds the smallest value, greater than or equal to lookup_value Match_type is the number -1, 0, or 1.It specifies how Microsoft Excel matches lookup_value with values in lookup_array Lookup_array sort Ascending Any Order Descending

147 VLOOKUP & MATCH Lookup array for MATCH 12 MATCH used as the column index number for VLOOKUP. In this example, it returns 3 Lookup value for MATCH 139

148 HLOOKUP & MATCH Lookup array for MATCH MATCH used as the row index number for HLOOKUP. In this example, it returns 3 Lookup value for MATCH

149 INDEX function INDEX function: The INDEX function returns the value of an item in a table selected by the row and column index numbers and has the following syntax: =INDEX(array, row_num, column_num) array is a range of cells from which you want to return information row_num selects the row in the array from which to return a value. If row_num is omitted, column_num is required column_num selects the column in the array from which to return a value. If column_num is omitted, row_num is required

150 INDEX function Table range 15 INDEX returns the content of a cell which is in the 3 rd row and 3 rd column of the table B10:D14 142

151 INDEX with one MATCH function Lookup array for MATCH 16 The MATCH function returns the row number for INDEX Lookup value for MATCH 143

152 INDEX with two MATCH functions Lookup value for first MATCH Lookup value for second MATCH First MATCH function returns the row number for INDEX Lookup array for second MATCH Lookup array for first MATCH Second MATCH function returns the column number for INDEX

153 Data validation Drop-down menus can be added using Data Validation to the Information Type and Company Name fields Searching for information in the model is more user friendly and efficient. Drop downs also act as important input masks To add a data validation drop down, follow the steps below: 1. Select the cell to contain the drop down 2. Select Data Validation located in the Data Tools group of the Data ribbon 3. Select List from the Allow drop down 4. In the Source field specify the range of cells containing the line items to appear in the drop down do this by clicking or dragging with the mouse 5. Select OK

154 Data validation Note: Data Validation drop down added to cell C3 The drop down can be accessed by selecting the cell and clicking the down arrow Alternatively, select the cell and press ATL + down arrow to activate the dropdown If the source of the list is not on the same sheet as the data validation, range name the source and enter = range name in the source field when setting up the validation

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156 Sensitizing models 148

157 Objectives By the end of this session, the following functionality will be covered: Perform sensitivity analysis using data tables Create one-input, one-output data tables Create one-input, multiple-output data tables Create two-input data tables State best practices and common pitfalls for using data tables Sensitize more than two variables 2 149

158 What is sensitivity analysis? Sensitivity analysis is the study of how Model Outputs vary with changes in Model Inputs There are many applications of sensitivity analysis. They include: a) DCF: Sensitivity of a company s value to changing WACC and long-term growth rates b) LBO & Merger: Sensitivity of returns to purchase price of business c) Merger: Sensitivity of accretion / dilution to purchase price of business The easiest way to perform a sensitivity analysis in Excel is with the data table tool Using Excel s data table functionality in a traditional way allows up to 2 inputs on a model s output Using Excel s data table functionality in a non-traditional way allows more than 2 inputs on a model s output 3 150

159 One-input vertical data table Step 1: Supply inputs in a column Step 3: Select the data table range Step 4: Choose What-If Analysis, Data Table from the Data Tools group of the Data ribbon Step 2: Link output formula one cell above and one cell to the right of inputs The inputs are substituted into the column input cell specified 4 151

160 One-input vertical data table 5 Change the formula cell font color to white to make it invisible Data table results 152

161 One-input horizontal data table Step 2: Link output formula one cell below and one cell to the left of inputs The inputs are substituted into the row input cell specified Step 4: Choose What-If Analysis, Data Table from the Data Tools group of the Data ribbon Step 1: Supply inputs in a row Step 3: Select the data table range

162 One-input horizontal data table Change the formula cell font color to white to make it invisible 7 Data table results 154

163 One-input multi-output vertical data table Output formulas Hint: Link the two output formulas as shown. There is only one input - the column input cell in this example is B

164 One-input multi-output horizontal data table Output formulas Hint: Link the two output formulas as shown. There is only one input - the row input cell in this example is B

165 Two-input data table Step 2: Link output formula in the top left of the data table range Step 4: Choose What-If Analysis, Data Table from the Data Tools group of the Data ribbon Step 1: Supply inputs in a row and a column 10 The row and column input cells are substituted into the row input and column input cells specified Step 3: Select the data table range 157

166 Two-input data table 11 Font color made white to hide the formula cell 158

167 Data table secrets Input cells must be on the same sheet as the data table unless you create clone cells Formula cell can be on another sheet, but it must be fed directly or indirectly by the input cells The same cell cannot drive the input variables and the row and column input cells; if they do, the data table won t work properly

168 Data table secrets Avoiding the circular Master Clone WACC 8.0% 8.0% Growth 3.0% 3.0% Formula Var 1 Var 1 Var 1 Var 2 data data data Var 2 data data data Var 2 data data data

169 Sensitizing more than two variables Additional variables can also be added to columns if necessary Text functions used to strip out variables into individual cells. The resulting values feed formula used in the data table Two variables are supplied in the row of this example

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171 Discounted cash flow (DCF) valuation A fundamental valuation technique 163 info@amttraining.com

172 Contents Discounted cash flow valuation DCF valuation steps Free cash flow calculation Weighted average cost of capital calculations Terminal value estimation Discounting Derivation of equity value Common DCF mistakes 164

173 Major valuation methods Who asks the question? Which valuation methods do they mainly use? How much should you pay for a minority stake? Equity research analysts Equity capital markets Investment bankers (sector coverage, capital markets discussions with senior management) Trading comparables What are the multiples of comparable companies trading in the market? Discounted Cash Flow What is today s value of the estimated future cash flows the business can generate? 3 How much should you pay for control? Investment bankers (M&A, Financial Sponsors Group) Trade buyers Private equity Transaction comparables What multiples have buyers paid in the past for the control of similar businesses? Leveraged Buyout value How much can a private equity house pay for a business if they want to achieve a minimum return? 165

174 Discounted cash flow valuation Valuation based on your forecast of future cash flows Discounted back to today reflecting the time value of money and risk in the cash flows Your forecast = your assumptions = your value Allows you to run sensitivities on forecast assumptions Particularly useful for: Early-stage companies, projects with finite lives and companies with highly predictable cash flows Valuing divisions of businesses Valuing synergies Additional reference point in your valuation matrix 4 166

175 Discounted cash flow valuation Advantages Forces serious consideration about valuation assumptions Highlights an overheated market or an undervalued asset Helps avoid accounting issues (assuming your calculations of cash flows are correct) Useful if there are limited comparables or the focus is on a division 5 Disadvantages Number of assumptions Sensitivity to assumptions, particularly Long-term growth Discount rate The valuation is only as reasonable as the assumptions used to build it 167

176 DCF valuation is like valuing a bond Step 1: Forecast a company s key numbers and calculate the free cash flows Step 5: The PV of the cash flows = enterprise value. Convert the EV into an implied share price and sensitize to get a range of values Step 2: Calculate the WACC Step 3: Calculate a terminal value for the company at the end of the forecast period; either use a growing perpetuity method (using a LT growth rate and the weighted average cost of capital (WACC)), or the multiple method Step 4: Discount the cash flows and TV to present value using WACC

177 Five steps to DCF valuation 1. 1 Forecast the free cash flows Use an existing model if one is already built Don t build a full set of financial statements if there is no existing model; just focus on the items required to calculate the free cash flows Do check the forecast for consistency with consensus forecast for the first few years 2. 2 Calculate the WACC (weighted average cost of capital) Use assumptions reflecting the long term There is no correct answer here as this is just an estimate 3. 3 Calculate the terminal value A large % of the company s value is contained in the terminal value (typically between 60% and 80%) The result is very sensitive to assumptions, so be careful 4 Discount the cash flows and terminal value back to today, and make the mid-year adjustment 1. 5 Convert EV into implied share price Sensitize the results to get a range of share prices Establish a reasonable share price range Always sanity check the results 7 169

178 Step 1: forecast the free cash flows What are they? Before starting, think about what is being valued: the core business Generally, it is best to exclude any financial investments and non-core assets, so that a more appropriate valuation technique can be used for these items Add on the value of any financial investments the business owns Value assets which are not included in FCF separately and add on Only the core business is valued by the DCF Cash Non-core assets PV of free cash flows = core enterprise value 8 Debt Equity value 170

179 Step 1: forecast the free cash flows What are they? The net cash flow generated by operations net of investment in operating assets or How much cash the business can generate to pay out to debt and equity holders after investing for future growth Typical forecast period is for 5 to 10 years Consider different scenarios for your operational forecast Towards the end of your forecast period, the business should be in a steady state 9 171

180 Step 1: forecast the free cash flows What are they? Continuing operating profit (EBIT) Tax = NOPAT Use the long-term effective tax rate (often similar to the corporate tax rate in the country concerned) Net Operating Profit After Tax (NOPAT) sometimes known as Earnings Before Interest After Tax on operational profits (EBIAT) (30) + Depreciation 30 - Capital expenditure 70 (40) - Increase in OWC (10) + / - Changes in other operating assets / liabilities (5) = Free cash flow 45 Cash available to pay out to debt and equity holders After-tax profit generated by the business Amount reinvested in the business to maintain existing assets and support future growth

181 Step 2: calculate the WACC To value the cash flows today, we need to use a discount rate which reflects both: The time value of money and The riskiness of the cash flows Typically there are two types of investors: Debt and Equity WACC measures their weighted average expected return for investing in the company Expected return for the investors is cost of capital for the company

182 Step 2: calculate the WACC Market value of the company s equity Expected return for investors buying shares in the company s stock WACC = Cost of equity * Equity Capital Market value of the company s debt Expected return for investors lending money to the company + Cost of debt * Capital = market value of debt + equity Debt Capital Company s marginal tax rate * 1 - MTR

183 Step 2: calculate the WACC The cost of debt The cost of debt (Kd) is the yield required by debt investors There are many ways to estimate Kd If the company has traded debt - take the yield to maturity Establish a credit rating for the company and use the corresponding credit spread to estimate Kd Kd = risk-free rate + credit risk premium Use the rate paid by the company for recent debt issuances with similar characteristics Use the effective interest rate (interest expense / average debt). This should only be used as a cross check (it is historic and may not be relevant for the future) The yield to the investor is pre-tax BUT there is a tax shield on interest so the cost to the company is less: Kd * (1 - MTR)

184 Step 2: calculate the WACC The cost of equity Ideally the Ke could be measured by asking all investors what expected return they anticipate for investing in the company s shares Difficult in practice to ask all the investors! So estimate the expected return Several methods exist but the most commonly used is the Capital Asset Pricing Model (CAPM) Calculates equity returns using building blocks + Get out of bed return + Premium required for taking general equity risk +/-Adjustment for the risk profile of the company = Cost of equity (Ke)

185 Step 2: calculate the WACC The cost of equity The minimum expected return investors require for investing their money. Similar to the opportunity cost of money. The ten-year government bond rate is typically used Significant controversy over the exact number for the market risk premium - usually between 5% and 8% Ke = risk free rate + (market risk premium x beta) Measures the volatility of returns (the risk) from the specific stock against the volatility of returns (the risk) of the market

186 Step 3: calculate the terminal value The business has value after the forecast period The terminal value estimates the continuing value after the projected period Captures the value of all future cash flows from the end of the forecast period Typically represents a significant proportion of the company s overall value Small changes in assumptions result in big changes to the terminal value Terminal value calculations assume the business has reached a steady state

187 Step 3: calculate the terminal value Possible approaches 1 2 Exit multiple Use a multiple of earnings in the final year to get enterprise value at the end of the forecast period A short cut method drawing upon experience in the sector Choose the multiple carefully - the number reflects steady state growth and margins Exit multiple should normally be lower than today s LTM multiple 17 Growing perpetuity Assumes the free cash flow in the last forecast year grows into perpetuity at a constant rate Ensure you normalize your assumptions in the final forecast year Easy to make timing mistakes when discounting 179

188 Step 3: calculate the terminal value Exit multiple method 1 Only use enterprise value multiples (EBITDA, EBIT or other performance metrics) Both the exit multiple and earnings should reflect the steady state Use trading comparables, since acquisition comparables will reflect a change of control premium Take multiples of companies reflecting the growth and margins of the business in its steady state Often the current multiples don t reflect steady state If the industry is cyclical, then take both an average of the multiples over the cycle and an average margin calculation for your case company

189 Step 3: calculate the terminal value Exit multiple example Historic Year Year 1 Year 2 Year 3 Year 4 Year 5 Free cash flows Sales , , , , ,297.6 EBIT (operating profit) % tax Capex (70.0) (77.0) (82.4) (86.5) (89.5) Depreciation (Inc) / dec in OWC (11.0) (10.0) (7.7) (5.9) (6.2) Free cash flow Ratios Sales growth 10.0% 7.0% 5.0% 5.0% ROIC 12.4% 12.3% 11.9% 11.9% 11.9% OWC as % of sales 10.0% 10.0% 10.0% 10.0% 10.0% NFA as % of sales 52.0% 49.5% 48.7% 48.7% 48.7% Reinvestment rate 40.3% 43.3% 43.2% 40.6% 39.1% DCF Discount rate (WACC) 8.0% PV of cash flows Terminal value multiple 9.5x Terminal value 1,232.8 Growth declines as the business reaches a steady state As competition intensifies, ROIC and margins settle As growth slows, less profit is reinvested in the business The terminal value multiple reflects the margins and growth from the end of the forecast onwards

190 Step 3: calculate the terminal value Growing perpetuity method 2 Another way to calculate the terminal value is to assume the final cash flow continues to grow at a constant growth rate into perpetuity The method is very sensitive to changes in WACC and growth rate used Terminal value N = Terminal value in the last forecast year Steady state cash flow must reflect the reinvestment required to support the LT growth rate steady state FCF N x (1 + LT growth rate) (WACC LT growth rate) LT growth rate is the growth rate into perpetuity so don t use a larger growth rate than nominal GDP

191 Step 3: calculate the terminal value Perpetuity growth example Historic Year Year 1 Year 2 Year 3 Year 4 Year 5 Free cash flows Sales , , , , ,297.6 EBIT (operating profit) % tax Capex (70.0) (77.0) (82.4) (86.5) (89.5) Depreciation (Inc) / dec in OWC (11.0) (10.0) (7.7) (5.9) (6.2) Free cash flow Ratios Sales growth 10.0% 7.0% 5.0% 5.0% ROIC 12.4% 12.3% 11.9% 11.9% 11.9% OWC as % of sales 10.0% 10.0% 10.0% 10.0% 10.0% NFA as % of sales 52.0% 49.5% 48.7% 48.7% 48.7% Reinvestment rate 40.3% 43.3% 43.2% 40.6% 39.1% DCF Discount rate (WACC) 8.0% PV of cash flows Terminal value LT growth rate 3.0% Terminal value 1, The LT growth rate should not be higher than nominal GDP The terminal value, using a growing perpetuity method, falls in the middle of the last forecast year (assuming a mid-year convention is used for cash flows)

192 Step 4: discount cash flows and TV to PV Cash flow timing issue Always calculate the implied multiple to sanity check the answer Note the significance of the TV in the final answer. Can be 90% or more in some cases Note the timings used for discounting. This model assumes a midyear adjustment

193 Step 5: convert enterprise value into implied share price + Core enterprise value + Non-core assets + Non-controlled investments Pension surplus? Derivatives? + Cash equivalents Financial investments Equity method investments Cash Money market investments Loans and financial receivables - Debt - Debt equivalents Operating leases Pension deficit OPEB deficit Derivatives? Debt-like provisions Other fixed claims Preference shares - Noncontrolling interests = Ordinary equity (incl. dilution)

194 Step 5: convert enterprise value into implied share price Equity value divided by the diluted number of shares outstanding 24 All these items are included at market value 186

195 Step 5: convert EV into implied share price Sensitivity analysis We only have two answers so far for our DCF valuation The two biggest areas of uncertainty are the WACC and the LT growth rate Using both the growing perpetuity and exit multiple methods, we want to build a data table of implied share prices for different combinations of assumptions Five different assumptions for the discount rate (WACC) Three different assumptions for the LT growth rate Table of 15 (= 3 * 5) answers for different combinations of WACC and LT growth

196 Step 5: convert EV into implied share price Sensitivities

197 Discounted cash flow valuation Common mistakes Cash flows from changes in long-term operational assets / liabilities omitted from free cash flow Terminal value assumptions too aggressive Long-term growth rate too high Implied returns in steady state cash flows too high Terminal value multiple greater than current multiple Inappropriate capital structure used in WACC calculation Components of capital structure missing Book value used instead of market value Discounting issues Timing issues especially when valuing a partial year Mid year convention inappropriately applied Incorrect derivation of equity value from enterprise value Components completely omitted Failure to take components at today s valuation

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