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Video 25 (Topic 5.3): Free Cash Flow Valuation and Market Multiple Analysis

Video 25 (Topic 5.3): Free Cash Flow Valuation and Market Multiple Analysis. FIN 614: Financial Management Larry Schrenk, Instructor. Topics. What is Free Cash Flow (FCF)? Calculating Free Cash Flow Finding Firm, Equity and Share Prices Market Multiple Analysis. Overview of Free Cash Flow.

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Video 25 (Topic 5.3): Free Cash Flow Valuation and Market Multiple Analysis

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  1. Video 25 (Topic 5.3):Free Cash Flow Valuation and Market Multiple Analysis FIN 614: Financial Management Larry Schrenk, Instructor

  2. Topics • What is Free Cash Flow (FCF)? • Calculating Free Cash Flow • Finding Firm, Equity and Share Prices • Market Multiple Analysis

  3. Overview of Free Cash Flow • Cash Flow Available for Distribution to All Investors • Valuation of Firm or Equity • Application of Discounted Cash Flow • Contrast with Dividends

  4. Problems with Dividends • Firm may not be Paying Dividends • Dividends at Discretion of Board • Dividends Uncertain • Cannot be Used for Internal Divisions

  5. Free Cash Flow Valuation • Value of Firm = PV(FCF) • r = Weighted Average Cost of Capital (WACC)

  6. Calculating FCF • FCF = NOPAT – Net Investment in Operating Capital • NOPAT = EBIT(1 –tc) • NOPAT = Net Operating Profit after Taxes (but without Interest being Deducted) • EBIT = Earnings before Interest and Taxes • tc = Corporate Tax Rate • Net Investment in Operating Capital includes changes on Long Term assets and Working Capital

  7. Calculating FCF: Example A firm has an EBIT of 50 and its marginal tax rate is 40%. Its working capital was 10 last year and 12 this year, while its long term operating assets were 100 last year and 105 this year. What is its FCF? NOPAT = 50(1 – 0.40) = 30 Net Investment in Operating Capital = (105 + 12) - (100 + 10) = 8 FCF = 30 – 8 = 22

  8. FCF Operations Valuation • A firm has the following FCF’s and its WACC is 8%. What is its value of operations? • NOTE: Same methodology as mixed model for equity.

  9. FCF Firm and Equity Valuation The firm’s value of operations is $3,439.39, it has $500 in financial (non-operating) assets, $1,000 in debt, no preferred shares and has issued 300 shares of common stock. What is the value of the firm? = value of operations + value of non-operating assets = $3,439.39 + 500 = $3,939.39 What is the value of the firm’s equity? = Firm Value – (debt + preferred shares) = $3,939.39 - $1,000 = $2,939.39 What is the price per share? = Equity Value/Shares Outstanding = $2,939.39/300 = $9.80

  10. Market Multiple Approach • Approach • Similar Assets, Similar Prices • Ratios Similar for Similar Firms • Value as a Multiple of a Market Metric • Comparison with Similar Firms • Relative Valuation

  11. Relative Valuation • Most common valuation measure used on Wall Street • Almost 85% of equity research reports are based on multiples and comparables • Nearly 50% of all acquisition valuations are based on multiples • Different companies can be compared through common metrics or ratios • Ratios can often be abused or manipulated

  12. Market Multiple Analysis • Select a company to value. • Create a set of comparable companies. • For each comparable company, calculate ratios to compare to the selected company • Price/ Earnings • Price/ Sales • Use the multiples for the comparable companies to create a price.

  13. Market Multiple: Example I • Dell: P/E ratio = 21.63, price = $29.40, • P/E = Price per Share/Earnings per Share • Earnings per Share = Price per Share/(P/E) • Therefore E/S = $1.36 = 29.40/21.63 • Find the average P/E ratio for comparable companies: 24.46 • Multiple the Dell’s EPS by the industry average P/E ratio for a ‘relative’ price of $33.27 • 1.36 x 24.46 = 33.27

  14. Market Multiple: Example • Implication: Dell’s price could be about $33.27 • if it kept the same E/S of $1.36, and • it’s P/E ratio increased to match its competition • Dell is slightly underpriced on a P/E basis when compared to its competition

  15. Video 25 (Topic 5.3):Free Cash Flow Valuation and Market Multiple Analysis FIN 614: Financial Management Larry Schrenk, Instructor

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