Lecture 7

Valuation Models

DDM and DCF Agenda

• Basic concepts

• Absolute (cash flow based) models ‒ DDM ‒ FCFF and FCFE ‒ One adjustment: excess cash

2 Firm or equity valuation?

Assets Liabilities

Enterprise (or firm) valuation

Assets in place Debt

Equity valuation Growth assets Equity

3 Overview of valuation models Absolute/ relative/ Discounted/compared Valuation model acrrual Valued entity cash flow or asset Discounted model Absolute Equity Dividend (DDM) DCF: FCFF Absolute Firm Cash flow to firm DCF: FCFE Absolute Equity Cash flow to equity DCF: Absolute Firm Cash flow to firm Residual income (RI) Accrual Equity RI to equity Economic profit (EP) Accrual Firm RI to firm P/E Relative Equity P/FCFE Relative Equity FCFE P/S Relative Equity Sales P/B Relative Equity Book value of assets EV/EBITDA Relative Firm EBITDA EV/EBIT Relative Firm EBIT Venture capital method Both Firm Equity value at maturity Real options Absolute Equity Equity value at maturity 4 Agenda

• Basic concepts

• Absolute (cash flow based) valuation models ‒ DDM ‒ FCFF and FCFE ‒ One adjustment: excess cash

5 DDM computes value of equity as sum of discounted

• Value of company for shareholders is the present value of all expected future dividends, discounted at the cost of equity.

D D D ¥ D 1 + 2 +...+ n +... i • V0 = 2 n = å i (1+ rE ) (1+ rE ) (1+ rE ) i=1 (1+ rE )

where

V0 = Equity value at time 0 (present moment)

Di = Dividend at time i

rE = cost of equity (required rate of return for this )

rE ( and D/E) should remain constant

6 If dividends follow a constant growth rate, DDM can be written as Gordon’s model

¥ Di D1 V 0 V 0 = = å i => i=1 (1+ rE ) (rE - g)

• Geometric series and defined when (-1 < g < r)

• Gives crazy valuation results if rE is close to g

• If g > rE, the formula is not defined (gives negative values)

7 DDM also allows for different growth stages

• It is also possible to write DDM using different growth stages.

• Consider, for example, a company with growth rate g1 for years 1-5, g2 for years 6-10, and g3 from year 11 into perpetuity. Then DDM can be written as:

PV of cash

(1+ g 3)D10 flows in 5 i 10 i years 11 –> (1+ g 1) D0 (1+ g 2) D5 rE - g 3 V 0 = å i +å i + 11 at t = 11 i=1 (1+ rE) i=6 (1+ rE) (1+ rE) PV of cash PV of cash Discounting flows in flows in cash flows years 1 - 5 years 6 - 10 from t=11 to t=0 Explicit forecasting period Terminal

value (TV) 8 Positives and negatives of DDM

Positives Negatives

• Conceptually convincing • Dividend policy is irrelevant in • Computationally easy perfect markets, not value • Connected to P/E multiples driver • Problematic with young, growing companies with no dividends • Dividends are decision, not performance variables • Actual current dividends may differ from sustainable dividends • Need very forecasting periods, not easy to forecast

• Basis for other more realistic approaches • Works well if stable payout ratio

9 Dividend policy is irrelevant in DDM if rE = g • Assume that an all-equity company can produce a return at cost of equity 10% for all its capital. Let capital C(0) = 100, value of dividend

at t=1 D1, and value of firm V0

D1 (100(1+ 0.1) - D1)1.1 V 0 = + 1+ 0.1 (1+ 0.1)2

D1 D1 V 0 = +100 - 1+ 0.1 1+ 0.1

• Dividend policy is irrelevant in DDM if rE = g

– A company with g > rE should have 0% dividend policy

– A company with g < rE should…?

10 Agenda

• Basic concepts

• Absolute (cash flow based) valuation models ‒ DDM ‒ FCFF and FCFE ‒ One adjustment: excess cash

11 to Firm (FCFF) Model • FCFF uses the same (DCF) formula than DDM – The interpretation of the variables is different – FCFF uses Free cash flows (to debt and equity) and the discount rate is Weighted Average and the result is Corporate (=enterprise and firm) value – Some sources use the term FCF instead of FCFF. These slides use FCFF to be specific about cash flows to firm rather than to equity ¥ FCFF • FCFF model of corporate value i å i i=1 (1+WACC) where FCF(i) = Free cash flow in period i WACC = weighted average cost of capital

• Equity Value = Corporate value – Market value of debt

12 Positives and negatives of FCFF

Positives Negatives

• Strong link to finance theory • FCFF can be negative for and NPV extended period of time • Not dependent on accounting • Requires long forecasting rules or choices periods • Popular among investment • Most of the value often in bankers uncertain • Cash flows are easy to • Easy to make unrealistic understand and “real” forecasts (check balance sheet and key accounting ratios for maintaining realism) • Lots of moving parts (FCFF, beta of equity, D/E, g, equity premium etc.)

13 Similar to DDM, FCFF can be written as sum of explicit forecasting period and terminal value PVs

T FCFF TV V = i T 0 å i + T i=1 (1+WACC) (1+WACC)

Explicit Terminal forecasting value (TV) period where

FCFFT +1 TVT = WACC - g

14 What is a Free Cash Flow ?

• FCFF = How much cash “business operations” produce for suppliers of capital (equity and debt) after tax and after all needed investments in working capital and fixed capital have been made • Major annoyance: academic and practioner authorities disagree on the exact formulation of FCFF, although in spirit they agree • FCFF constructed indirectly from financial statements, especially when it is supposed to be informative for forecasting purposes, is always an approximation: – Accounting laws dictate the format of cash flow statement (if available) and it is based on history rather than designed to be good basis for forecasting – ”Perfect” direct FCFF would only be possible when constructed directly from cash receipts – Outside-in FCFF, especially a simple one, will deviate from accountant’s cash-flow statement – A more detailed outside-in FCFF will of course be closer to accountant’s cash flow statement

15 Definitions of FCFF starting from net income

Definition

Net income + Interest expense x (1- Tax rate) + Noncash charges - Investments in fixed capital - Same overall logic Pinto et al. Investment in working capital in all approaches:

• Start with what is left to equity- and Net profit less adjusted taxes debtholders after (NOPLAT, excludes interest and taxes nonoperating income) + Noncash Koller et al. operating expenses – Investments in • Add back noncash invested (fixed and working) capital charges

• Take out Net profit + after-tax net interest investments in expense – change in fixed capital – capital Palepu et al. change in working capital

16 Our simple model for FCFF starting from operative cash flows

+ Sales – Cost of goods sold – Selling, general & administrative expenses = Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) – Depreciation (tax deductible) – [Amortization (if tax deductible, like in Finland, unlike in the US)] = Operating Profit (EBIT) – Taxes on operating profit (cash taxes) = Net operating profit less adjusted tax (= NOPLAT) + Depreciation (tax deductible) + [amortization (if tax deductible)] – Increase in working capital requirement – Capital expenditures (CAPEX) = FREE CASH FLOW TO FIRM (FCFF)

17 Ok, but what on earth is NOPLAT?

• It is a measure of operating profit available to all (equity and debholders) after tax • Interest paid on outstanding debt is not deducted from NOPLAT • Operating income not generated by invested capital is not part of NOPLAT (e.g., shares held in unaffiliated companies, which are valued separately on top of FCFF valuation) • NOPLAT takes out taxes on operating income (different from accountant’s taxes in income statement) – Hypothetical taxes on operating income as if the company were 100% equity financed – WACC will take care of the of debt

18 Definitions of operating working capital

Our definition Definition

(Current assets – Cash and marketable securities) Same overall logic – in all approaches: Pinto et al. (Current liabilities – Current debt and current portion of non-current debt) • Operating working capital (OWC) is different from Accounts receivable + inventory + accountants working (excl. excess) cash balance + working capital prepaid expenses Koller et al. – • OWC = Operating Accounts payable – Accrued expenses assets – Operating – Deferred revenue liabilities (Current assets – Cash and • (Excess) cash not marketable securities) part of OWC Palepu et al. – (Current liabilities – Current debt and current portion of non-current debt)

19 Typical non-cash charges

• Depreciation of tangible assets or LT discounts In our • Amortization of intangible assets FCFF • Deferred revenue and prepaid expenses (saadut ja formula maksetut ennakot) • Depletion of natural resources • Restructuring charges • Losses/gains on sale of non-operating assets • Write-downs of assets Not in our • Deferred taxes (depends): FCFF – If financial reporting = depreciation schedule, then no formula, change in deferred taxes left out for – If accelerated reporting, tax savings now, pay later (in simplicity the long-term will even out) – For complicated tax structures (e.g., M&A), items may be large enough to warrant detailed investigation, if small, don’t bother 20 Realized or adjusted FCFF as basis for forecasting?

• Actual, realized FCFF can be measured by standardized Cash flow statement (Palepu)

• For valuation forecasting purposes it makes sense to leave out non-recurring, one-time or extraordinary items for future years (adjusted FCFF). Also it makes sense to assume nominal or average tax rates even if starting year taxes had been exceptional.

• The purpose is to estimate the cash generating power of company operations – For this reason Interest expense after tax has to be added back if they were deducted in Cash flow from operations

21 Free Cash Flow to Equity (FCFE) Model

• Value of Equity is estimated by discounting future Free cash flows to Equity (FCFE) with cost of equity (DCF formula). If there are not share issues/repurchases, FCFE tells what amount could be paid out as dividends from annual cash flow.

T FCFE TV i + T Equity value0 = ∑ i T i=1 (1+ re ) (1+ re )

FCFET+1 Terminal value of equity VT = re − g

22 Surprise! Academics and pracioners have also different definitions for FCFE

FCFE = Pinto et al. Koller et al. Palepu et al. FCFF – Interest(1 – Tax Rate) + Net Borrowing

Net income + Non-cash Recommen- charges – CAPEX – Net OWC ded for simple investment + Net borrowing models

CFO – CAPEX + Net Borrowing from Standardized Cash Flow Statement (Palepu)

23 Agenda

• Basic concepts

• Absolute (cash flow based) valuation models ‒ DDM ‒ FCFF and FCFE ‒ One adjustment: excess cash

24 Adjustments in FCFF and FCFE valuation

• Using a simple FCFF or FCFE skips some details in valuation. These details include: – Excess cash (and other nonoperational assets held for sale) – – Extraordinary items included in net income – Modeling deferred tax asset and liability separately (cash flow timing impact of accountant’s vs. taxmans depreciation) – Capitalizing operating leases and other off-balance sheet liabilities – Treating expensed R&D as capital expenditure rather than cost • In the interest of time, we cover just excess cash

25 Excess cash is the amount of ”unnecessary” cash that could be paid out or used to retire debt

Assets Liabilities

Assets in place Equity

Growth assets Net debt

Excess cash Gross debt

26 Excess cash is not king and should be thrown out from valuation

• Simplest way: verify that there is no excess cash. Small amount of cash is necessary anyway for smooth business • Simple way: in case of excess cash, keep cash and associated interest income out from valuation and add back book value of cash after you are done • Complex way: include interest income from cash. Adjust discount rate to incorporate the low-risk of cash: cash is a zero-beta asset

27 Excess cash: simple way

• If there is substantial excess cash (or other non-operating assets) not needed in operations, they can be taken out from valuation and treated separately • Treat company as sum of parts: – Operations + – Cash and other non-operating assets (e.g., assets held for sale, shares held in unaffiliated companies)

• VC = Value of the company = Value of Operations (VO) + Excess Cash • If you decide to take out excess cash, then also use net debt (gross debt – cash) for WACC market values and all financial ratios

28 Review: what does all of this mean?

• FCFF, calculated from EBIT and excluding any non-recurring items (forecasting rather than accountants FCFF) • Terminal Value from EV/EBITDA multiples or using TV formula • Check if excess cash: – If trivial amount, do not bother and use gross debt in WACC calculations – If nontrivial amount, take out from balance sheet, value separately and use net debt in WACC calculations

29