MBA 643 Managerial Finance Lecture 10: Corporate Valuation (Discounted Cash Flow Analysis)

1. MBA 643Managerial FinanceLecture 10: Corporate Valuation (Discounted Cash Flow Analysis) Spring 2006 Jim Hsieh

2. Overview • DCF Analysis is one of the most popular methods in corporate valuation. • Total Firm Value (V) = Debt (D) + Equity (E) • Total firm value should be generated by accumulating future net cash flows.  … NCF1 NCF2 NCF3

3. Implementation • It is difficult to forecast NCFs into infinity. • But we still can apply the formula if we make some assumptions. • V = D + E = PV(All Future Net Cash Flows) = PV(NCFs from Operations in the “Forecast Period”) + PV(Terminal Value from Operations) + PV(Excess Assets from Non-operations) • If we forecast NCFs for T periods:

4. Three Main Issues • Net Cash Flows (NCF), Cost of Capital (r), and Estimation Period (T) • Cash flow estimates should be consistent and unbiased. • Both NCF and r are usually estimated out for 5, 7, 10 or more years in most practical applications. • A rule of thumb is to forecast CFs until the firm is expected to reach its long-run competitive equilibrium. • It requires a detailed analysis of the firm, its industry, and the overall macroeconomic environment.

5. DCF Analysis – WACC Approach-- Price the company as a whole • General Rule: V = D + E → E = V – D • Step 1: Estimate the after-tax CFs. • Step 2: Discount all CFs at the WACC. • Step 3: Subtract the value of the debt to obtain the value of the equity. The value of the equity is then divided by the total shares outstanding to get the stock price per share.

6. Forecast Net Cash Flows • NCF = EBIT(1-t) + Depreciation – Investments = NOPAT + Depreciation – (Cap. Exp. + ∆NWC) • Calculate NOPAT: • Forecast Net Revenue • Forecast Operating Margin • EBIT = Net Revenue * Operating Margin • t: Corporate marginal tax rate • NOPAT = EBIT(1-t)

7. Forecast Investments • Investments = Capital Expenditures (Investment in PP&E) + Incremental Working Capital • Both are considered as cash outflows • Investment in Incremental WC = ∆Accounts Receivable + ∆Inventory – ∆Accounts Payable • A common (practical) method to estimate Investment in Incremental WC is to estimate the average ratio R: • R = (Current Assets – Current Liabilities)/Net Sales • Investment in Incremental WC = R * (forecasted change in Net Sales)

8. Example 1 • Use the following data to estimate P&G’s Investment in Incremental WC in 2003 and 2004:

9. Estimate Terminal Value (Residual Value) • Terminal value captures the PV of all cash flows beyond the forecast period. • Beyond the forecast period, the firm is expected to grow at a constant (steady) rate, g. • g = Estimated long-term nominal growth rate = inflation rate + real growth rate • If we further assume Dep = Inv, then

10. Estimate Excess Assets • Excess assets include excess cash, marketable securities, sale of real estate, or other assets or liabilities not required in firm’s daily operations. • We need to consider after-tax excess assets/liabilities.

11. Estimate Cost of Capital • r = WACC = (D/V)*rD*(1-t)+ (E/V)*rE • (D/V) = Long-run target leverage ratio in terms of market values. • rE = rf + E*(rm – rf) • Since forecasted cash flows are nominal, all returns should be nominal. • rf is Treasury bond of long duration. • E can be estimated or obtained directly from Value Line.

12. Example 2: Find the share price of Mason Control • Forecast period: 2003–2005. Assume the appraisal date is January 1, 2003. • Net sales of $1,000 in 2003 grows at 10% through 2003. Net sales in 2006 equals net sales in 2005. • Operating margin: 25%. • Corporate tax rate: 40%. • Depreciation: $100 per year. • Investment in PP&E is $150 annually during 2003-2005. It reduces to $100 per year thereafter. • Incremental working capital is $25 annually for the first two years, and then $21.5 afterward. • Growth rate in perpetuity (g): 2%. • WACC: 10%. • LT debt: $528 • Number of common shares outstanding: 50.

13. Sensitivity Analysis • DCF Analysis involves many assumptions. • The final firm value is sensitive to those assumptions. • Fortunately, not all assumptions are critical in your valuation. • Sensitivity analysis is a valuable tool for assessing which variable has a greater impact than others on the final firm value. It is done by changing one variable at a time and holding other variables constant. • Example 3: The management in Mason Control predicts that the sales growth rate could range from 5% to 15% and operating margin from 15% to 30%. What’s the impact on MC’s stock price?

14. Alternative Valuation Methods-- (1) Multiples Approach • The multiples approach uses the price multiples of comparable firms to provide an appropriate valuation range. • The multiples (ratios) commonly used are: • Price/Earnings, Price/Sales, Price/Cash Flows, Price/EBITDA • Example 4: The following are P/E ratios from Dell’s main competitors: HP: 18.82, IBM: 15.36, Sun: 20.10. Given Dell’s current EPS of 1.274, what is Dell’s stock price?

15. Multiples Approach • Advantages: • Simple • Based on one simple assumption: • Arbitrage arguments • Comparable companies should sell at comparable prices. • Disadvantages: • It often provides a wide range of valuations. • How “comparable” is comparable?

16. Alternative Valuation Methods-- (2) Control Premiums Approach • Also called Comparable Transactions Approach • Control premium = (Offer price – Pre-announcement market price)/Pre-announcement market price • Example 5: Bidder: SemGroup, Target: TransMontaigne

17. Control Premiums Approach • In control premiums approach, the potential bidder compares the premium with the premiums paid in the most recently completely transactions. • Premiums should reflect the value of the synergies that will be created, or the inefficiencies that can be eliminated by the new management teams. • Other issues that need to be considered: • Industry specific? • Business cycle? • Used with the multiples approach?