Summary Valuation Exam
Value vs. Price
Price is what you pay; value is what you get.
In efficient markets, on average, value and price converge
Control premium à you pay more for shares wwhen you’re a majority shareholder
Valuation techniques
Fundamental valuation à Absolute, e.g., in dollars
Income-based determines the intrinsic value
Relative valuation à Benchmarked
- Compare assets with other assets
- Essentially a method of “pricing”
Scope of the course: Discounted Cash Flow Valuation & Trading Multiples
Discounted Cash Flow Valuation
,What drives cash flows?
Why use cash flows and not earnings?
• Earnings do not represent actual amounts available for distribution to capital providers
unlike the Free Cash Flow.
• Note that accounting cashflows are not the same as free cash flows. They need to be
adjusted with (mostly) non-cash items.
• Roughly, the Free Cash Flow includes:
o (Adjusted) earnings
o (+) non-cash operating expenses
o (-) non-cash operating income
o (-) statutory taxes
o (-) capital & working capital investments
o (+) change in provisions
o (+) change in deferred tax liability
o (+/-) other non-cash expenses (income)
The 6 steps in DCF valuation:
The discounted cash flow value gives you the market value of equity:
à Market value of operating assets: DCF value of the projection period CFs & the DCF value of the
continuing CFs
• (+) value of non-operating assets
o Deferred tax assets; investment in associates and JVs etc.
• (-) value of non-operating liabilities
o Pension deficits, minority interest, etc.
à Corporate value
• (-) net debt
o Long and short-term interest-bearing debt – excess cash
à Market value of equity
• (-) Equity adjustments
o Preferred equity, equity compensation, etc.
à Market value of common equity
,Alternatively, the excess cash can be added together with the non-operating assets, and debt is
deducted from the corporate value instead of net debt.
STEP 1: reorganize the balance sheet to identify operating capital
Goal: to separate sources of cashflow from distribution of cashflows among capital providers (i.e.,
debt and equity). Group all the operating assets & liabilities and non-operating assets & liabilities on
one side; leave financing – i.e., debt, preferred equity and common equity on the other side.
STEP 2: Estimate free cash flow in the base year
Step 2a: Calculate adjusted earnings
Step 2b: calculate the reinvestment made by the firm
Step 2c: calculate key ratios
Goal: to get a sense of the firm’s:
- Cost structure
- Reinvestment patterns
- Leverage levels
Adjustments that may be needed:
- Capitalization of R&D expenses
- Capitalization of operating lease liabilities
- Non-recurring income and expense items
- Removal of income from associates from operating income
Reinvestment in tangibles should include:
- Organic capex (R&D spending)
- Net acquisition spending
STEP 3: forecast future cash flows
Step 3a: forecast cashflows in projection period
Step 3b: forecast stable growth rate
Length of the projection period should reflect the stage in the firm’s lifecycle.
CF forecasts involve forecasting of:
- Revenues
- Costs
- Reinvestments
And should reflect economic realities and strategic direction of the firm.
Stable growth rate should reflect economic realities such as competitive landscape, firm’s ability to
obtain a price premium.
Implied stable growth rate = reinvestment rate * return on newly invested capital (RONIC). It is
bounded by:
- Growth in the domestic/world economy
- Growth in firm’s industry
, STEP 4: calculate the discount rate
Step 4a: estimate cost of debt
Step 4b: estimate cost of equity
Risk-free rate:
- No default risk, no reinvestment risk and matches timing of cash flows
- For counties with higher default probability à take risk-free rate form a low-default
probability country and apply a country-default spread
Cost of debt:
- Risk-free rate + default spread
- Default spread depends on the (synthetic) credit rating of the firm
Cost of equity:
- Bottom-up beta: estimate the levered equity of peers (CAPM); unlever to uncover the asset
beta (or business risk) and then re-lever to the leverage level of the firm that is being valued.
- Use market index proxy which is specific to the location of the marginal investor
Discount rate (unlevered cost of capital or WACC):
- Should match the currency of cash flows
- Generally, unlevered cost of capital > WACC
- In theory, it is possible for WACC to exceed the unlevered cost of capital if the firm is beyond
the optimal D/E ratio
STEP 5: Calculate PV of discounted cash flows
STEP 6: make adjustments to account for non-operating assets and liabilities, net debt and other
equity claims to go from operating enterprise value to market value of common equity.
Value vs. Price
Price is what you pay; value is what you get.
In efficient markets, on average, value and price converge
Control premium à you pay more for shares wwhen you’re a majority shareholder
Valuation techniques
Fundamental valuation à Absolute, e.g., in dollars
Income-based determines the intrinsic value
Relative valuation à Benchmarked
- Compare assets with other assets
- Essentially a method of “pricing”
Scope of the course: Discounted Cash Flow Valuation & Trading Multiples
Discounted Cash Flow Valuation
,What drives cash flows?
Why use cash flows and not earnings?
• Earnings do not represent actual amounts available for distribution to capital providers
unlike the Free Cash Flow.
• Note that accounting cashflows are not the same as free cash flows. They need to be
adjusted with (mostly) non-cash items.
• Roughly, the Free Cash Flow includes:
o (Adjusted) earnings
o (+) non-cash operating expenses
o (-) non-cash operating income
o (-) statutory taxes
o (-) capital & working capital investments
o (+) change in provisions
o (+) change in deferred tax liability
o (+/-) other non-cash expenses (income)
The 6 steps in DCF valuation:
The discounted cash flow value gives you the market value of equity:
à Market value of operating assets: DCF value of the projection period CFs & the DCF value of the
continuing CFs
• (+) value of non-operating assets
o Deferred tax assets; investment in associates and JVs etc.
• (-) value of non-operating liabilities
o Pension deficits, minority interest, etc.
à Corporate value
• (-) net debt
o Long and short-term interest-bearing debt – excess cash
à Market value of equity
• (-) Equity adjustments
o Preferred equity, equity compensation, etc.
à Market value of common equity
,Alternatively, the excess cash can be added together with the non-operating assets, and debt is
deducted from the corporate value instead of net debt.
STEP 1: reorganize the balance sheet to identify operating capital
Goal: to separate sources of cashflow from distribution of cashflows among capital providers (i.e.,
debt and equity). Group all the operating assets & liabilities and non-operating assets & liabilities on
one side; leave financing – i.e., debt, preferred equity and common equity on the other side.
STEP 2: Estimate free cash flow in the base year
Step 2a: Calculate adjusted earnings
Step 2b: calculate the reinvestment made by the firm
Step 2c: calculate key ratios
Goal: to get a sense of the firm’s:
- Cost structure
- Reinvestment patterns
- Leverage levels
Adjustments that may be needed:
- Capitalization of R&D expenses
- Capitalization of operating lease liabilities
- Non-recurring income and expense items
- Removal of income from associates from operating income
Reinvestment in tangibles should include:
- Organic capex (R&D spending)
- Net acquisition spending
STEP 3: forecast future cash flows
Step 3a: forecast cashflows in projection period
Step 3b: forecast stable growth rate
Length of the projection period should reflect the stage in the firm’s lifecycle.
CF forecasts involve forecasting of:
- Revenues
- Costs
- Reinvestments
And should reflect economic realities and strategic direction of the firm.
Stable growth rate should reflect economic realities such as competitive landscape, firm’s ability to
obtain a price premium.
Implied stable growth rate = reinvestment rate * return on newly invested capital (RONIC). It is
bounded by:
- Growth in the domestic/world economy
- Growth in firm’s industry
, STEP 4: calculate the discount rate
Step 4a: estimate cost of debt
Step 4b: estimate cost of equity
Risk-free rate:
- No default risk, no reinvestment risk and matches timing of cash flows
- For counties with higher default probability à take risk-free rate form a low-default
probability country and apply a country-default spread
Cost of debt:
- Risk-free rate + default spread
- Default spread depends on the (synthetic) credit rating of the firm
Cost of equity:
- Bottom-up beta: estimate the levered equity of peers (CAPM); unlever to uncover the asset
beta (or business risk) and then re-lever to the leverage level of the firm that is being valued.
- Use market index proxy which is specific to the location of the marginal investor
Discount rate (unlevered cost of capital or WACC):
- Should match the currency of cash flows
- Generally, unlevered cost of capital > WACC
- In theory, it is possible for WACC to exceed the unlevered cost of capital if the firm is beyond
the optimal D/E ratio
STEP 5: Calculate PV of discounted cash flows
STEP 6: make adjustments to account for non-operating assets and liabilities, net debt and other
equity claims to go from operating enterprise value to market value of common equity.
