Joy Global (JOY) Module 5: Valuation Using Forecasts of Cash Flows

1. Joy Global (JOY) Module 5: Valuation Using Forecasts of Cash Flows Thomas Maguire 2/6/2014

2. Joy Global Background • Manufactures and services mining equipment • Focus on: Coal, Copper, Iron Ore, Oil Sands, and Gold • Revenue split between • Surface Mining Equipment • Underground Mining Machinery

3. Free Cash Flow Valuation • Free Cash Flow Valuation Method- Value is estimated based on expected future cash flows • Value represents the opportunity to receive cash payoffs in the future • Use of expected future payoffs- distributions to the investor- is intuitive, the challenge comes in: • Determining the amount, timing and uncertainty of future payoffs • Expected Future Payoffs can be state in terms of: • Cash Flows OR • Accounting Numbers • Earnings & Enterprise Profits

4. Free Cash Flow Valuation • Important to Understand Future Payoffs can be stated in terms of Accounting Numbers- Not ONLY Cash Flow Numbers • Accounting Reports are readily available and give us useful information to form expectations of future payoffs • Accounting recognizes that users of financial statements are seeking future payoffs and must use accounting information to help them project their payoffs • However, Accounting numbers will not tell you how much something is worth • In this module we will use Accounting Information and Cash Flows to come up with Value using a Discounted Cash Flow Valuation

5. Free Cash Flow Valuation & The Enterprise • Looking at a business enterprise, cash flows can be payable either to: • Debt Holders • Equity Holders- Owners of the Company • Benefits of Ownership and Related Cash Flows are used to pay both debt and equity holders • These proceeds from enterprise operations are know as “Free Cash Flow From Operations” • Modeling cash generated by the enterprise • Instead of a finite life, the enterprise is considered to be a going concern and has an infinite stream of future cash flows • Enterprise is viewed as sum of all the cash flows of all the projects the firm has and will undertake in the future

6. Relation Between Free Cash Flows and Accounting Numbers • Cash distributed to equity holders is “free cash flow” or “dividends” from the enterprise • The enterprise operations of the firm can be valued based on these distributions • These numbers can be derived from accounting data from the financial statements • Beginning Net Enterprise Assets PLUS Enterprise Profits After Tax LESS Free Cash Flow (Distributions) EQUALS Ending Net Enterprise Assets • Simplified- Free Cash Flow = EPAT -∆NEA

7. Parsimonious Forecasts of Enterprise Operations • Useful forecasts for valuation would be expectations of either: • The stream of future FCF, which may be forecasted directly OR • The stream of future FCF, which may be forecasted indirectly from forecasts of the stream of future EPAT and NEA • Direct forecasting of FCF is not normally done because it can be difficult to determine the amount and timing of distributions that will be made to debt and equity holders in the future- controlled by management • Forecasts of EPAT and NEA can be simpler to achieve using assumptions of sales growth, profit margins, and asset turnover ratios • We made these assumptions in order to forecast future EPAT and NEA in our Module 4 Parsimonious Forecast…

8. Joy Global Forecast Assumptions • After analysis of Joy Global’s and competitor’s financial statements over the past four years, we have come to reasonable assumptions for the foreseeable future using parsimonious forecasting • Sales Growth Rate– 3% • Enterprise Profit Margin (EPM)– 14.98% • Enterprise Asset Turnover (EATO)– 1.65 • Using the assumptions above as inputs, we can forecast our expectations of Joy Global’s future Sales, EPAT and NEA

9. Joy Global 5 Year Forecasts of Sales, EPAT and NEA

10. Use of Forecasts • We can now use the forecasts of EPAT and NEA to obtain forecast of Free Cash Flow (FCF) which is: • EPAT Less ∆NEA • This is the standard calculations seen in most valuation outlines, NEA is broken into several components: • Change in Working Capital • Depreciation • Capital Expenditure

11. Joy Global Calculation of Free Cash Flow

12. Joy Global Forecast of Free Cash Flow • We now have forecasted FCF on a parsimonious basis through 2018 • However, we need the expectations of ALL future free cash flows • This includes all years past 2018 • Not practical to forecast an infinite stream of cash flows no matter what method is used • Must come up with a forecasted value at the end of the forecast horizon • Captures the value of expected payoffs in all periods after the forecast

13. Continuing Values in the Free Cash Flow Model • Must capture payoffs beyond the five year forecast horizon • Compute continuing value • Need to make assumption that future payoffs will follow a predictable pattern • Show a constant growth rate • Discount rate must be greater than the growth rate • Valuation of firm will not make sense if this does not hold • Nominal Discount Rates and Nominal Payoffs are used as opposed to “Real”

14. FCF Valuation of Joy Global Enterprise Operations Using Parsimonious Forecasts • For now, we assume a cost of capital for operations- commonly referred to as weighted average cost of capital (WACC)- of 10% • This assumption will be addressed in Module Six but will work as a proxy for this exercise • Additional Assumptions • 3% growth rate beyond 5 year forecast • Growth Rate in Sales and Growth Rate in Free Cash Flow Converging • Over time a firm’s growth rate is driven by ability to grow revenue

15. Valuation of Joy Global’s Enterprise Operations Using Discounted Cash Flows

16. Joy Global DCF Enterprise Value • Calculated Enterprise Value- $11,341,583 • This represents the estimated intrinsic value of the enterprise operations based on our assumptions thus far • We will refine however, this provides a good starting point

17. Questions? Thank You!