A Complete Corporate Valuation for a Simple

Company

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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.

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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!

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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.

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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

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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.

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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%.

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Cost of Equity

• Cost of equity, rs, is higher than cost of debt

because stock is riskier.– MPR: rs = 12%

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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%

9(More….)

WACC (Continued)

WACC = wD rD (1-T) + wS rS

= 0.3(9%)(1 - 0.4) + 0.7(12%)

= 10.02%

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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.

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Calculating FCF

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

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Financial Statements

• Balance sheet– Assets (all of MPR’s assets are used in operations)

• Operating assets– Operating current assets– Property, plant, and equipment (PPE)

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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.

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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.

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Balance Sheet: Assets2012 2013 2014

Op. CA 162,000.0 168,000.0 176,400.0 Total CA 162,000.0 168,000.0 176,400.0Net PPE 199,000.0 210,042.0 220,500.0Tot. Assets 361,000.0 378,042.0 396,900.0

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Balance Sheet: Claims2012 2013 2014

Op. CL 57,911.5 62,999.7 66,150.0 Total CL 57,911.5 62,999.7 66,150.0L-T Debt 136,253.0 143,061.0 150,223.0 Total Liab. 194,164.5 206,060.7 216,373.0Equity 166,835.5 171,981.3 180,527.0 TL & Eq. 361,000.0 378,042.0 396,900.0

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Income Statement2012 2013 2014

Sales 400,000.0 420,000.0 441,000.0Costs 344,000.0 361,994.2 374,881.6 Op. prof. 56,000.0 58,005.8 66,118.4Interest 11,678.7 12,262.8 12,875.5 EBT 44,321.3 45,743.0 53,242.9Taxes (40%) 17,728.4 18,297.2 21,297.2 NI 26,592.7 27,445.8 31,945.7Dividends 21,200.0 22,300.0 23,400.0Add. RE 5,392.7 5,145.8 8,545.7

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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)

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Calculating NOPAT

NOPAT = (Operating profit) (1-T)= EBIT (1-T)

NOPAT14 = 66.1184 (1-0.4) = 39.67104

million.

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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.

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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.

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Net Operating Working Capital

NOWC = Operating CA – Operating CL

NOWC14 = $176.4 – $66.15

= $110.25 million

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Operating Capital

• Operating capital = – Net operating working capital (NOWC)

plus– Long-term capital, such as factories, land,

equipment.

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Operating Capital = NOWC + LT Op. Capital

Capital14 = $110.25 + $220.50

= $330.75 million

This means in 2014 MPR had $330.75 million tied up in capital needed to support its operations. Investors supplied this money. It isn’t available for distribution.

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Investment in operating capital

• Operating capital in 2013 was $315.0423 million

• Operating capital in 2014 was $330.75 million• MPR had to make a net investment of $330.75

– $315.0423 = $15.7077 million in operating capital in 2014.

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Calculating FCF

FCF = NOPAT – Investment in operating capital

FCF14 = $39.67104 – (330.75 – 315.0423)

= $39.67104 – $15.7077= $23.96334 million

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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.)

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ReinvestmentBucket

Free Cash FlowBucket

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.

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Corporate Valuation

• Forecast financial statements and use them to project FCF.

• Discount the FCFs at the WACC

This gives the value of operations

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Value of Operations:

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1 1tt

tOp

WACC

FCFV

Of course, this requires projecting free cash flows out forever.

Constant growth

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

2014 2015 2016 2017 2018 2019FCF 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…

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Constant Growth Formula

• The summation can be replaced by a single formula:

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gWACC

)g1(FCF

gWACC

FCFV

0

1Op

The value of operations

million 225.501$

05.01002.0

)05.01(96334.23$

)1(0

Op

Op

V

gWACC

gFCFV

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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.

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Value of EquityPrice per share

= Equity / # of shares= $351 million / 10 million shares= $35.10 per share

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A picture of the breakdown of MPR’s value

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Equity

Debt

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

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ROIC calculation

ROIC14 = NOPAT14 / Capital13

ROIC14 = 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 2014.

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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)

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Calculating EVA

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

EVA14 = NOPAT14 – (0.1002)(Capital13)

EVA14 = $39.67104 – (0.1002)(315.0423)

= $39.67104 – $31.56742

= $8.1038 million

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(More…)

Economic profit…

This shows that in 2014 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

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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.

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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

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