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A Complete Corporate Valuation for a Simple Company

DES Chapter 2

Three types of value

- Book value: the company’s historical value as shown on its financial statements.
- Market value: the current price at which an asset can be bought or sold.
- Intrinsic value: estimate of the value an individual buyer places on an asset.

DES Chapter 2

Objective:

- Objective is to provide a sound basis for estimating the intrinsic value of a stock.
- This intrinsic value is also called its fundamental value.
- The process is known as fundamental valuation—Warren Buffet is very successful at identifying a company’s fundamental value!

DES Chapter 2

The three basic concepts of valuation

- Investors can only spend cash so "Cash is good and more cash is better."
- Cash today is worth more than cash tomorrow.
- Risky cash flows are worth less than safe cash flows.
- These three imply the value of a company depends on the size, timing, and riskiness of its cash flows.

DES Chapter 2

Steps in the corporate valuation

- Determine weighted average cost of capital
- Estimate expected future free cash flows---cash flows available to all investors—called free cash flows (FCFs).
- Discount free cash flows at the average rate of return required by all investors
- Find value of company

DES Chapter 2

Estimating the Weighted Average Cost of Capital (WACC)

- Company has two types of investors
- Debtholders
- Stockholders
- Each type of investor expects to receive a return for their investment
- The return an investor receives is a “cost of capital” from company’s viewpoint.

DES Chapter 2

Cost of Debt

- MPR’s cost of debt: rD = 9%.
- But MPR can deduct interest, so cost to MPR is after-tax rate on debt.
- If tax rate is 40%, then after-tax cost of debt is:
- After-tax rD = 9%(1-0.4) = 5.4%.

DES Chapter 2

Cost of Equity

- Cost of equity, rs, is higher than cost of debt because stock is riskier.
- MPR: rs = 12%

DES Chapter 2

Weighted Average Cost of Capital

- WACC is average of costs to all investors, weighted by the target percent of firm that is financed by each type.
- For MPR, target percent financed by equity:
- wS = 70%
- For MPR, target percent financed by debt:
- wD = 30%

(More….)

DES Chapter 2

Free Cash Flow (FCF)

- FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.
- A company’s value depends upon the amount of FCF it can generate.

DES Chapter 2

Calculating FCF

- FCF = net operating profit after taxes minus investment in operating capital

DES Chapter 2

Financial Statements

- Balance sheet
- Assets (all of MPR’s assets are used in operations)
- Operating assets
- Operating current assets
- Property, plant, and equipment (PPE)

DES Chapter 2

Operating Current Assets

- Operating current assets are the CA needed to support operations.
- Op CA include: cash, inventory, receivables.
- Op CA exclude: short-term investments, because these are not a part of operations.

DES Chapter 2

Operating Current Liabilities

- Operating current liabilities are the CL resulting as a normal part of operations.
- Op CL include: accounts payable and accruals.
- Op CA exclude: notes payable, because this is a source of financing, not a part of operations.

DES Chapter 2

Balance Sheet: Assets

200720082009

Op. CA 162,000.0168,000.0176,400.0

Total CA 162,000.0 168,000.0 176,400.0

Net PPE 199,000.0210,042.0220,500.0

Tot. Assets 361,000.0 378,042.0 396,900.0

DES Chapter 2

Balance Sheet: Claims

200720082009

Op. CL 57,911.562,999.766,150.0

Total CL 57,911.5 62,999.7 66,150.0

L-T Debt 136,253.0143,061.0150,223.0

Total Liab. 194,164.5 206,060.7 216,373.0

Equity 166,835.5171,981.3180,527.0

TL & Eq. 361,000.0 378,042.0 396,900.0

DES Chapter 2

Income Statement

200720082009

Sales 400,000.0 420,000.0 441,000.0

Costs 344,000.0361,994.2374,881.6

Op. prof. 56,000.0 58,005.8 66,118.4

Interest 11,678.712,262.812,875.5

EBT 44,321.3 45,743.0 53,242.9

Taxes (40%) 17,728.418,297.221,297.2

NI 26,592.7 27,445.8 31,945.7

Dividends 21,200.022,300.023,400.0

Add. RE 5,392.7 5,145.8 8,545.7

DES Chapter 2

NOPAT (Net Operating Profit After Taxes)

- NOPAT is the amount of after-tax profit generated by operations.
- NOPAT is the amount of net income, or earnings, that a company with no debt or interest-income would have.

NOPAT = (Operating profit) (1-T)

= EBIT (1-T)

DES Chapter 2

Calculating NOPAT

NOPAT = (Operating profit) (1-T)

= EBIT (1-T)

NOPAT09 = 66.1184 (1-0.4) = 39.67104 million.

DES Chapter 2

Calculating Operating Capital

- Operating capital (also called total operating capital, or just capital) is the amount of assets required to support the company’s operations, less the liabilities that arise from those operations.
- The short-term component is net operating working capital (NOWC).
- The long-term component is factories, land, equipment.

DES Chapter 2

Net Operating Working Capital

NOWC = Operating current assets

– Operating current liabilities

This is the net amount tied up in the “things” needed to run the company on a day-to-day basis.

DES Chapter 2

Net Operating Working Capital

NOWC = Operating CA – Operating CL

NOWC09 = $176.4 – $66.15

= $110.25 million

DES Chapter 2

Operating Capital

- Operating capital =
- Net operating working capital (NOWC) plus
- Long-term capital, such as factories, land, equipment.

DES Chapter 2

Operating Capital = NOWC + LT Op. Capital

Capital09 = $110.25 + $220.50

= $330.75 million

This means in 2009 MPR had $330.75 million tied up in capital needed to support its operations. Investors supplied this money. It isn’t available for distribution.

DES Chapter 2

Investment in operating capital

- Operating capital in 2008 was $315.0423 million
- Operating capital in 2009 was $330.75 million
- MPR had to make a net investment of $330.75 – $315.0423 = $15.7077 million in operating capital in 2009.

DES Chapter 2

Calculating FCF

FCF = NOPAT – Investment in operating capital

FCF09 = $39.67104 – (330.75 – 315.0423)

= $39.67104 – $15.7077

= $23.96334 million

DES Chapter 2

There are five ways for a company to use FCF

1. Pay interest on debt.

2. Pay back principal on debt.

3. Pay dividends.

4. Buy back stock.

5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

DES Chapter 2

NOPAT

Dividends

Buy back stock

Working Capital

Pay interest

Fixed Assets

Buy non-op assets

Pay principal

Free Cash FlowBucket

ReinvestmentBucket

DES Chapter 2

How Did MPR use its FCF?

- Paid dividends: $23.4 million
- Paid after-tax interest of: $12,875.5 (1-0.4) = $7.7253 million
- For a total of $31.1253 million! This is $7.162 million more than the $23.9 million FCF available! Where did it come from?
- MPR increased its borrowing by $150.223 – $143.061) = $7.162 million to make up the difference.

DES Chapter 2

Corporate Valuation

- Forecast financial statements and use them to project FCF.
- Discount the FCFs at the WACC

This gives the value of operations

DES Chapter 2

Constant growth

- If free cash flows are expected to grow at a constant rate of 5%, then this is easy:

200920102011201220132014

FCF 23.963 25.161 26.419 27.740 29.127 30.584

There is an easy formula for the present value of free cash flows that grow forever at a constant rate…

DES Chapter 2

The value of operations

DES Chapter 2

Value of Equity

- Sources of Corporate Value
- Value of operations = $501.225 million
- Value of non-operating assets = $0 (in this case)
- Claims on Corporate Value
- Value of Debt = $150.223 million
- Value of Equity = ?
- Value of Equity = $501.225 - $150.223 = $351.002 million, or just $351 million.

DES Chapter 2

Value of Equity

Price per share

= Equity / # of shares

= $351 million / 10 million shares

= $35.10 per share

DES Chapter 2

A picture of the breakdown of MPR’s value

DES Chapter 2

Return on Invested Capital (ROIC)

ROIC can be used to evaluate MPR’s performance:

ROIC = NOPAT / Total operating capital in place at the beginning of the year

DES Chapter 2

ROIC calculation

ROIC09 = NOPAT09 / Capital08

ROIC09 = 39.67104 / 315.0423 = 12.6%.

This is a good ROIC because it is greater than the return that investors require, the WACC, which is 10.02%. So MPR added value during 2009.

DES Chapter 2

Economic Value Added (EVATM) (also called Economic Profit)

- EVA is another key measure of operating performance.
- EVA is trademarked by Stern Stewart, Inc.
- It measures the amount of profit the company earned, over and above the amount of profit that investors required.
- EP = NOPATt – WACC(Capitalt-1)

DES Chapter 2

Calculating EVA

EVA = NOPAT- (WACC)(Begng. Capital)

EVA09 = NOPAT09 – (0.1002)(Capital08)

EVA09 = $39.67104 – (0.1002)(315.0423)

= $39.67104 – $31.56742

= $8.1038 million

(More…)

DES Chapter 2

Economic profit…

This shows that in 2009 MPR earned about $8 million more than its investors required.

Another way to calculate EP is

EPt = (ROIC – WACC)Capitalt-1

= (0.125923 – 0.1002)$315.0423

= $8.1038 million

DES Chapter 2

Intuition behind EP

If the ROIC – WACC spread is positive, then the firm is generating more than enough “profit,” and is increasing value. But, if the ROIC – WACC spread is negative, then the firm is destroying value, in the sense that investors would be better off taking their money and investing it elsewhere.

DES Chapter 2

Applications of the corporate valuation model

- Mergers and acquisitions
- Evaluate how much a target is worth under various operating scenarios
- Value-based management
- Make decisions with the goal of increasing the company’s value
- Fundamental investing
- Identify firms that are worth more than the current stock price

DES Chapter 2

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