Valuing the Firm Sometimes called financial modeling

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70391 - Finance Valuing the Firm Sometimes called financial modeling 70391 Finance Fall 2016 Tepper School of Business

1 Finance Valuing the Firm Sometimes called financial modeling Finance Fall 2016 Tepper School of Business Carnegie Mellon University c 2016 Chris Telmer. Some content from slides by Bryan Routledge. Used with permission :25

2 Question What is the right price-per-share for AEO, GPS? :: What is it now? What should it be? :: What motivates trading? :: Why might management care? NPV 2

3 How to Do it? How do we arrive at price-per-share (PPS): :1: Last week: PDV the dividends :: Sum of all future dividends :: Next period s dividend + share price :: Constant growth short-cuts :2: PDV the FCF: Price per Share (PPS) = PV(FCF) Debt Number of Shares NPV 3

4 Fits in How? Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty NPV 4

5 Fits in How? Intrinsic Value of Operations (Discounted FCF) Discounted by Cost of Capital (%) Investors required rate-of-return Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Market Interest Rates Risk Capital Markets Capital Structure (firm s choice of debt and equity) NPV 4

6 Fits in How? Total Debt Share Price Number of Shares Market Value of Equity Market Value of the Firm Intrinsic Value of Operations (Discounted FCF) Non-Operating Assets (Cash) Efficient Markets Market forces will tend to drive market value toward intrinsic value Discounted by Cost of Capital (%) Investors required rate-of-return Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Market Interest Rates Risk Capital Markets Capital Structure (firm s choice of debt and equity) NPV 4

7 DCF Our approach: risk-adjusted DCF :: Construct FCF forecast, 10 years out. Make assumptions about long-term growth ( horizon value ) :: Estimate appropriate discount rate :: P 0 = PV(Future FCF) NPV 5

8 Reminders NPV 6

9 Free Cash Flow :: Free Cash Flows of the Business = Cash flows from business operations :: Include all business cash flows :: All investments and re-investments (not just income statement items) :: Ignore interest income and expense, dividends, etc. :: Discount rate should capture opportunity cost of capital :: What if AEO s owners took their capital and invested it elsewhere, in an activity of similar risk? NPV 7

10 Free Cash Flow NPV 8

11 Free Cash Flow :: Free Cash Flows of the Business = Cash flows available to pay capital providers :: Available to pay and actually paid are not necessarily the same thing :: But this turns out to not matter :: FCF not paid out as dividends gets held as cash (we ve already incorporated reinvestment of earnings). :: A dollar in a shareholder s pocket is worth the same (to the shareholder) as a dollar in the firm s bank account. FCF that is not paid out just adds to the value of the firm. :: Dividend policy, debt policy, etc. are financial policies ( capital structure decisions ). To value the firm s business assets we focus on operating policies. NPV 9

Financial Modeling of the Retailers Source: Meat and Greet, Financial Times, 29 January 2015, pg 12. Point: SS s roadshow envisioned growth coming from new stores (450 in U.S. alone!

12 Financial Modeling of the Retailers Source: Meat and Greet, Financial Times, 29 January 2015, pg 12. Point: SS s roadshow envisioned growth coming from new stores (450 in U.S. alone!), not sales per store. CAPEX requirements large, and franchising not viable given fine casual business model. Main concept: model growth as arising from growth in the number of stores. Why? Example, just prior to Shake Shack s IPO. NPV 10

13 AEO Spreadsheet: AEO valuation NPV 11

14 Assessment NPV 12

15 Valuation :: Suppose that our estimate is too low. How to interpret? :: We are right, market is wrong? :: Our valuation should be improved upon? :: A better estimate of FCF for next few years? :: Know the business :: Should we change the perpetuity growth rate? :: What are the key assumptions? NPV 13

16 Summary NPV 14

17 Summary :: Valuing a stock is similar to valuing a bond: :: DCF the cash flows: dividend discount model :: But the cash flow to the stockholder depends on the financial policy of the firm. :: So, we just value the entire firm s cash flow, paying careful attention to timing (this is what the F in FCF means). Then we subtract the debt and divide by number of shares. :: We can also use the constant growth framework. Good for back-of-the-envelope (a lot like multiples ), but very limiting. NPV 15

Module 4: Free Cash Flow (FCF) Which cash flows do we discount?

70391 - Finance Module 4: Free Cash Flow (FCF) Which cash flows do we discount? 70391 Finance Fall 2016 Tepper School of Business Carnegie Mellon University c 2016 Chris Telmer. Some content from slides