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Frameworks for DCF-Based Valuation

Model

Measure

Discount factor

Assessment

Enterprise discounted cash flow

Free cash flow

Weighted average

cost of capital

Works best for projects, business units, and companies that manage their capital structure to a target level

Economic profit

Economic profit

Weighted average

cost of capital

Explicitly highlights when a company creates value

Adjusted present value

Free cash flow

Unlevered cost of equity

Highlights changing capital structure more easily than WACC-based models.

Capital cash flow

Capital cash flow

Unlevered cost of equity

Compresses free cash flow and the interest tax shield in one number, making it difficult to compare performance among companies and over time

Equity cash flow

Cash flow to equity

Levered cost of equity

Difficult to implement correctly because capital structure is embedded within cash flow. Best used when valuing financial institutions

Using DCF to Value Companies- There are five well-known frameworks for valuing a company using DCF, the most common being enterprise DCF.
- In theory, each framework will generate the same value. In practice, the ease of implementation and the interpretation of results varies across frameworks.
- In this presentation, we examine how to value a company using each of the five frameworks.

The Valuation Process using Enterprise DCF

1. Analyze Historical Performance

By thoroughly analyzing the past, we can document whether the company has created value, whether it has grown, and how it compares with its competitors.

- Valuation is an iterative process…

5. Calculate and Interpret Results

Once the model is complete, examine valuation results to ensure your findings are technically correct, your assumptions are realistic, and your interpretations plausible.

2. Forecast Financials & Cash Flows

Project financials over the short and medium term. Short-term forecasts should be consistent with announced operating plans. Medium-term forecasts should focus on operating drivers, such as margins, and capital turnover.

4. Compute the Cost of Capital

To value the enterprise, free cash flow is discounted by the weighted average cost of capital. The cost of capital is the blended rate of return for all sources of capital, specifically debt & equity.

3. Estimate a Continuing Value

To forecast cash flows in the long-term future, use a perpetuity that focuses on the company’s key value drivers, specifically ROIC and growth.

Begin the process by analyzing historical performance…

2001

2003

2002

Analyze Historical Performance: Analyzing ROIC

- 1. Analyze Historical Performance
- Before projecting future cash flow, examine the company’s historical performance. A good analysisfocuses on the key drivers of value: return on invested capital (ROIC) and growth.
- ROIC measures a company’s ability to create value.
- Both Home Depot and Lowe’s improved ROIC between 2001 and 2003. Historically speaking, Home Depot has performed better than Lowe’s. Going forward, will Home Depot be able to maintain this advantage?

ROIC Analysis: Home Depot vs. Lowes

Home Depot

Lowe's

How do we compute ROIC?

ROIC is computed by comparing after-tax operating profits to invested capitalAnalyze Historical Performance: Computing ROIC

NOPLAT

After-tax operating profit equals revenues minus operating costs, less any taxes that would have been paid if the firm held only core assets and were finance only with equity.

Invested Capital

Invested capital equals the operating assets required for core business activities (such as inventory and PP&E) less any financing provided by customers, employees, and suppliers (such as accounts payable).

Home Depot

Lowe’s

2003

2001

2002

2003

Net sales

Cost of merchandise sold

Selling, general and admin

Depreciation

Operating lease interest

53,553

(37,406)

(10,451)

(756)

288

64,816

(44,236)

(12,658)

(1,075)

276

58,247

(40,139)

(11,375)

(895)

260

30,838

(21,231)

(5,671)

(758)

114

Adjusted EBITA

5,228

7,123

6,098

3,292

Operating taxes

(2,020)

(2,117)

(2,040)

(1,069)

3,208

5,083

3,981

2,223

NOPLAT

Invested capital

Operating working capital

Net property and equipment

Capitalized operating leases

Net other assets

2,552

15,375

5,459

(216)

2,674

20,063

6,554

(524)

2,746

17,168

5,890

(247)

1,363

11,945

2,762

211

Invested capital (w/o goodwill)

23,170

28,767

25,557

16,281

419

46

833

55

Intangibles and goodwill

Cumulative amortization

575

54

0

730

29,655

26,185

17,012

23,635

Invested capital (w/ goodwill)

ROIC w/ goodwill (average)

14.3%

16.0%

18.2%

13.9%

Forecast Financials: ROIC versus WACC

- 2. Forecast Financials
- To compute a company’s value using enterprise DCF, future free cash flow is discounted by the weighted average cost of capital. Rather than forecast FCF directly, however, forecast the financials that drive free cash flow.
- One of the primary drivers of free cash flow is return on invested capital. For simplicity, we assume each company’s financial performance will remain constant. In actuality, these figures will change over time, and this must be modeled.

Forecasting ROIC: Home Depot versus Lowe’s

Forecast

Historical

2005

2001

2002

2003

2004

2006

NOPLAT

Depreciation

6,342

1,459

5,741

1,321

3,208

756

3,981

895

5,083

1,075

5,185

1,193

Gross cash flow

4,876

3,964

6,157

6,378

7,801

7,062

Investment in operating working capital

Net capital expenditures

Investment in capitalized operating leases

Investments in intangibles and goodwill

Decrease (increase) in net other assets

Increase (decrease) in other comp income

(318)

(3,708)

(780)

(99)

62

0

834

(3,063)

(775)

(113)

105

(153)

(194)

(2,688)

(430)

(164)

31

138

72

(3,970)

(664)

(259)

277

172

(344)

(4,036)

(842)

(107)

67

0

(294)

(3,399)

(721)

(92)

58

0

Gross investment

(3,307)

(4,372)

(3,165)

(4,448)

(4,843)

(5,261)

Free cash flow ($ millions)

1,930

799

1,569

1,785

2,219

2,539

Forecast Financials: Free Cash Flow

- Forecast Free Cash Flow (FCF)
- Free cash flow, which is driven by revenue growth and return on invested capital, provides the basis for enterprise DCF valuation.
- The computation of FCF should be consistent with that of ROIC. Free cash flow begins with NOPLAT, adds depreciation, and subtracts investments in invested capital.

Gross

Cash

Flow

Investments in

Invested

Capital

NOPLAT plus depreciation, less investments in invested capital

Continuing Value

- 3. Continuing Value
- To estimate a company’s value, we separate a company’s expected cash flow into two periods and define the company’s value as follows:

Present Value of Cash Flow

during Explicit Forecast Period

+

Value =

Present Value of Cash Flow

after Explicit Forecast Period

- The second term is the continuing value: the value of the company’s expected cash flow beyond the explicit forecast period.

Explicit Forecast Period

Continuing Value

Continuing Value: The Key Value Driver Formula

- Although many continuing-value models exist, we prefer the key value driver model. The key value driver formula is superior to alternative methodologies because it is based on cash flow and links cash flow to growth and ROIC.

g

RONIC

1 -

RONIC is the return on new investment, return on existing investment is captured in NOPLAT

NOPLATt + 1

Continuing valuet

=

WACC - g

4.0%

9.3%

1 -

$12,415

Continuing valuet

=

9.3% - 4.0%

The continuing value is measured as of 2013. This value must still be discounted to present day.

=

$133,360

Weighted Average Cost of Capital

- 4. Weighted Average Cost of Capital
- When performing and Enterprise DCF, make sure to choose the cash flows and discount factor consistently. Since free cash flows are the cash flows available to all investors, the discount factor for free cash flow must represent the risk faced by all investors.
- The weighted average cost of capital (WACC) blends the required rates of return for debt kd and equity ke based on their target market values.

Target (market-based) weights on debt and equity

Home Depot Cost of Capital

After-tax opportunity cost

Contribution to weighted average

Proportion of total capital

0.2

9.1

2.9

9.9

8.3

91.7

100.0%

9.3%

After-tax cost of equity

After-tax cost of debt

Putting It all Together: Enterprise DCF Valuation

Home Depot Valuation

Discount factor

@ 9.3%

Free cash flow (FCF)

$ Million

Present value of FCF

$ Million

Year

1,766

1,857

1,944

2,026

2,104

2,175

2,241

2,301

2,355

2,402

54,757

0.915

0.837

0.766

0.700

0.641

0.586

0.536

0.491

0.449

0.411

0.411

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Continuing value

1,930

2,219

2,539

2,893

3,283

3,711

4,180

4,691

5,246

5,849

133,360

To determine the value of operations, discount free cash flow at the weighted average cost of capital.

To determine the enterprise value, add the value of non-operating assets, such as excess cash.

75,928

Present value of cash flow

1,046

Mid-year adjustment factor

79,384

Value of operations

1,609

84

Value of excess cash

Value of other nonoperating assets

To determine the equity value, subtract the value of non-equity financial claims, such as debt and capitalized operating leases.

81,077

Enterprise value

(1,365)

(6,554)

Value of debt

Value of capitalized operating leases

73,158

Equity value

Frameworks for DCF-Based Valuation

Model

Measure

Discount factor

Assessment

Enterprise discounted cash flow

Free cash flow

Weighted average

cost of capital

Works best for projects, business units, and companies that manage their capital structure to a target level

Economic profit

Economic profit

Weighted average

cost of capital

Explicitly highlights when a company creates value

Adjusted present value

Free cash flow

Unlevered cost of equity

Highlights changing capital structure more easily than WACC-based models.

Capital cash flow

Capital cash flow

Unlevered cost of equity

Compresses free cash flow and the interest tax shield in one number, making it difficult to compare performance among companies and over time

Equity cash flow

Cash flow to equity

Levered cost of equity

Difficult to implement correctly because capital structure is embedded within cash flow. Best used when valuing financial institutions

Economic Profit Valuation Models- The economic profit model highlights how and when the company creates value yet leads to a valuation that is identical to that of enterprise DCF.
- An advantage of the economic profit model over the DCF model is that economic profit is a useful measure for understanding a company’s performance in any single year, whereas free cash flow is not.

Defining Economic Profit

- Economic profit translates size, return on capital, and cost of capital into a single measure. Economic profit equals the spread between the return on invested capital and the cost of capital times the amount of invested capital.

Economic profit = Invested Capital x (ROIC – WACC)

- The above formula for economic profit can be rearranged and defined as after-tax operating profits less a charge for the capital used by the company:

Economic profit = NOPLAT - (Invested Capital x WACC)

- This approach shows that economic profit is similar in concept to accounting net income, but it explicitly charges a company for all its capital, not just the interest on its debt.

2002

2004 E

2001

2003

Method 1

ROIC

16.8%

15.0%

19.4%

17.5%

9.0%

10.1%

9.3%

- WACC

9.3%

= Economic spread

7.9%

4.9%

10.1%

8.2%

X Invested capital

21,379

23,635

26,185

29,655

= Economic profit

( in $ millions)

1,857

1,048

2,645

2,424

2002

2004 E

2001

2003

Method 2

Invested capital

23,635

21,379

26,185

29,655

WACC

9.0%

10.1%

9.3%

9.3%

Capital charge

2,124

2,159

2,438

2,761

NOPLAT

3,981

3,208

5,083

5,185

Capital charge

(2,124)

(2,159)

(2,438)

(2,761)

Economic profit

1,857

1,048

2,645

2,424

Economic Profit at Home Depot- Consider both measures of economic profit for Home Depot. Since Home Depot has been earning returns greater than its cost of capital, its historical economic profit is positive.
- Not every company has a positive economic profit. In fact many companies earn an accounting profit (net income greater than zero), but can’t earn their cost of capital.

Discounted Economic Profit Leads to Same Results as DCF

- To demonstrate how economic profit can be used to value a company—and to demonstrate its equivalence to enterprise DCF, consider a stream of growing cash flows valued using the growing-perpetuity formula,

- Using a few algebraic transformations and the assumption that the company’s ROIC on new projects equals the company’s current ROIC, we can transform the cash flow perpetuity into an economic-profit based key value driver model,

- Substituting the definition of economic profit,

Home Depot: Economic Profit Valuation

Home Depot Valuation

Present value of economic profit

$ Million

Economic profit

$ Million

Discount

factor

@ 9.3%

Invested

Capital

$ Million

WACC

Percent

ROIC

Percent

Year

2004

29,655

17.5

9.3

2,424

0.915

2,217

The value of operations equals:

the sum of discounted economic profit

0.837

2,677

17.4

32,910

2,241

9.3

2005

0.766

2,950

17.4

36,432

2,259

9.3

2006

0.700

3,242

17.4

40,235

2,271

9.3

2007

0.641

3,556

17.3

44,329

2,278

9.3

2008

3,890

17.3

0.586

48,729

2,281

9.3

2009

4,247

17.3

0.536

53,445

2,278

9.3

2010

0.491

4,627

17.2

58,488

2,270

9.3

2011

+

0.449

5,031

17.2

63,870

2,258

9.3

2012

0.411

5,458

current invested capital

69,600

2,241

9.3

17.2

2013

57,671

0.411

23,679

Continuing value

46,273

Present value of economic profit

29,655

Invested capital*2004

75,928

Economic Profit leads to the same value for operations as Enterprise DCF!

Invested capital plus present value of economic profit

1.046

Mid-year adjustment factor

79,384

Value of operations

* Measured at the beginning of the year

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