Valuation summary
Lecture 1 & 2
Price is what you pay; value is what you get
Valuation techniques.
During the course we will only focus on one fundamental valuation and one relative valuation
Fundamental: Discounted cash flow valuation
Relative valuation: Trading multiples
There is also a distinguishing within the discounted cashflow valuation method: Free cashflow to the
firm (FCFF) and Free cashflow to equity (FCFE). During this course we will only focus on the Free
cashflow to firm (FCFF).
FCFF:
Aggregate CF available to all providers of capital
Does not distinguish between debt & equity holders
Two methods for FCFF
1. Weighted Average Cost of Capital (WACC) method
a. Discounted rate: WACC -> MV of operating assets
It is the most commonly used valuation technique
2. Adjusted Present Value (APV) method
a. Separates value into two parts
- Value of firms operations (Discounted FCFF by unlevered cost of equity).
- Value created from financing
,Discounted cash flow valuation
First two of six steps in DCF valuation
Step 1: Re-organize the balance sheet to identify operating capital
Step 2: Understand the cost structure and reinvestment patterns
Step 2a: Adjust (accounting) earnings by:
- Capitalizing R&D expenses
- Capitalizing operating lease expenses
- Excluding for non-recurring income and expenses
- Excluding income form minority investments
What drives value?
Why cashflows and not earnings?
Earnings do not represent actual amounts available for distribution to capital providers (FCF).
Note: accounting cashflows is not equal to free cashflows available to capital providers.
Roughly,
FCF = Adjusted earnings after tax + non-cash operating expenses – non-cash operating income –
invst. in tangible & intangible assets – net working capital investments + change in provisions +
change in deferred tax liability
The six steps in DCF valuation
,This picture illustrates how you can go from DCF value -> MV of equity (which is your goal)
Alternatively
, DCF Valuation Step 1: Reorganize the balance sheet
It reorganizes a balance sheet from accounting standards to finance standards.
You eventually want to create a list of total capital which consist of a list that generates cash flow and
have on the other side the cashflow distribution
Step 2: Understand the cost structure & Re-investment patterns
Step 2a: Calculate adjusted earnings
Four types of adjustments: (we only focus on the first two)
1. Adjusting for accounting misclassifications (accounting adjustments)
2. Adjustments for non-recurring items
Accounting misclassifications
Companies have three types of expenses
o Operating expenses -> generate benefits for only in the current period.
E.g. Labor costs, cost of fuel and other materials
Capital expenses -> generate benefits over multiple periods. E.g. cost associated with
building a manufacturing facility, developing a new drug.
Financial expenses -> costs associated with non-equity capital raised by the firm. E.g. interest
expenses, interest liabilities on leased assets
Accounting earnings can be misleading because some capital and financial expenses are misclassified
as operating expenses
Major misclassification
1. R&D expenses
2. Operating lease expenses
R&D expenses treated as operating expenses:
- Rationale: outcome of R&D is uncertain and hard to quantify -> reduces operating income
and profitability only in current period
- Consequence: R&D spending is not reflected in the balance sheet -> understates invested
capital
Lecture 1 & 2
Price is what you pay; value is what you get
Valuation techniques.
During the course we will only focus on one fundamental valuation and one relative valuation
Fundamental: Discounted cash flow valuation
Relative valuation: Trading multiples
There is also a distinguishing within the discounted cashflow valuation method: Free cashflow to the
firm (FCFF) and Free cashflow to equity (FCFE). During this course we will only focus on the Free
cashflow to firm (FCFF).
FCFF:
Aggregate CF available to all providers of capital
Does not distinguish between debt & equity holders
Two methods for FCFF
1. Weighted Average Cost of Capital (WACC) method
a. Discounted rate: WACC -> MV of operating assets
It is the most commonly used valuation technique
2. Adjusted Present Value (APV) method
a. Separates value into two parts
- Value of firms operations (Discounted FCFF by unlevered cost of equity).
- Value created from financing
,Discounted cash flow valuation
First two of six steps in DCF valuation
Step 1: Re-organize the balance sheet to identify operating capital
Step 2: Understand the cost structure and reinvestment patterns
Step 2a: Adjust (accounting) earnings by:
- Capitalizing R&D expenses
- Capitalizing operating lease expenses
- Excluding for non-recurring income and expenses
- Excluding income form minority investments
What drives value?
Why cashflows and not earnings?
Earnings do not represent actual amounts available for distribution to capital providers (FCF).
Note: accounting cashflows is not equal to free cashflows available to capital providers.
Roughly,
FCF = Adjusted earnings after tax + non-cash operating expenses – non-cash operating income –
invst. in tangible & intangible assets – net working capital investments + change in provisions +
change in deferred tax liability
The six steps in DCF valuation
,This picture illustrates how you can go from DCF value -> MV of equity (which is your goal)
Alternatively
, DCF Valuation Step 1: Reorganize the balance sheet
It reorganizes a balance sheet from accounting standards to finance standards.
You eventually want to create a list of total capital which consist of a list that generates cash flow and
have on the other side the cashflow distribution
Step 2: Understand the cost structure & Re-investment patterns
Step 2a: Calculate adjusted earnings
Four types of adjustments: (we only focus on the first two)
1. Adjusting for accounting misclassifications (accounting adjustments)
2. Adjustments for non-recurring items
Accounting misclassifications
Companies have three types of expenses
o Operating expenses -> generate benefits for only in the current period.
E.g. Labor costs, cost of fuel and other materials
Capital expenses -> generate benefits over multiple periods. E.g. cost associated with
building a manufacturing facility, developing a new drug.
Financial expenses -> costs associated with non-equity capital raised by the firm. E.g. interest
expenses, interest liabilities on leased assets
Accounting earnings can be misleading because some capital and financial expenses are misclassified
as operating expenses
Major misclassification
1. R&D expenses
2. Operating lease expenses
R&D expenses treated as operating expenses:
- Rationale: outcome of R&D is uncertain and hard to quantify -> reduces operating income
and profitability only in current period
- Consequence: R&D spending is not reflected in the balance sheet -> understates invested
capital
