Valuation Concepts

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[accordion title=”DCF” is_open=”no”]

The discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth. The concept of DCF valuation is based on the principle that the value of a business or asset is inherently based on its ability to generate cash flows for the providers of capital. To that extent, the DCF relies more on the fundamental expectations of the business than on public market factors or historical precedents, and it is a more theoretical approach relying on numerous assumptions. A DCF analysis yields the overall value of a business (i.e. enterprise value), including both debt and equity.

The DCF method of valuation involves projecting FCF over the horizon period, calculating the terminal value at the end of that period, and discounting the projected FCFs and terminal value using the discount rate to arrive at the NPV of the total expected cash flows of the business or asset.

Free cash flow (FCF) – Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.

Terminal value (TV) – Value at the end of the FCF projection period (horizon period).

Discount rate – The rate used to discount projected FCFs and terminal value to their present values.

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[accordion title=”EV” is_open=”no”]

Enterprise value (EV) is a financial matrix reflecting the market value of the entire business after taking into account both holders of debt and equity. EV, also called firm value or total enterprise value (TEV), tells us how much a business is worth.

It is the theoretical price an acquirer might pay for another firm, and is useful in comparing firms with different capital structures since the value of a firm is unaffected by its choice of capital structure. EV is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, etc.

EV equals market capitalization plus seasonally adjusted net debt, pension provisions, the value of minorities and other provisions deemed debt.

EV = Equity Value + Net Debt + Non controlling Interest + Preferred Stock – Investment in Associates

Illustration:

Company A has 250 million shares outstanding currently trading at $200 each and net debt (total debt – cash & cash equivalents) of $39,712 million. Non controlling interest stands at $ 5,000 million. What is the EV of Company A.

EV = Equity Value + Net Debt + Non controlling Interest + Preferred Stock – Investment in Associates

EV = (250 X $ 200) + $ 39,712 + $ 5,000

EV = $ 94,712 million.

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[accordion title=”Free Cash Flow to Firm (FCFF) & Free Cash Flow to Equity (FCFE):  ” is_open=”no”]

Free cash flow to the firm is the amount of cash available to all investors (both equity and debt holders) of the company after it has paid all of its expenses. It can be calculated using Net Income or Cash Flow from Operations (CFO).

Calculation of FCFF using Cash Flow from Operations (CFO):

FCFF is the cash flow allocated to all investors including debt holders, the interest expense which is cash available to debt holders must be added back. The amount of interest expense that is available is the after-tax portion, which is shown as the interest expense multiplied by 1-tax rate.

ex4

Calculation of FCFF using Net Income(NI):

The calculation using Net Income is similar to the one using CFO except that it includes the items that differentiate Net Income from CFO. To arrive at the right FCFF, working capital investments must be subtracted and non-cash charges must be added back to produce the following formula:

ex5

 

Free Cash Flow to Equity (FCFE), the cash available to stockholders can be derived from FCFF. FCFE equals FCFF minus the after-tax interest plus any cash from taking on debt (Net Borrowing). The formula equals:

ex6

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[accordion title=”Net Present Value (NPV)” is_open=”no”]

Net present value is the present value of net cash inflows generated by a project including salvage value, if any, less the initial investment on the project.

NPV compares the value of an investment today to the value of that same investment in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects.

Example:

An initial investment on plant and machinery of $10,000  is expected to generate cash inflows of $3,000 , $4,100 , $5,800  and $2,000  at the end of first, second, third and fourth year respectively. At the end of the fourth year, the machinery will be sold for $1,000 . Calculate the present value of the investment if the discount rate is 16%.

 

Year 1 2 3 4
Net Cash Inflow $3,000 $4,100 $5,800 $2,000
Salvage Value 1000
Total Cash Inflow $3,000 $4,100 $5,800 $3,000
× Present Value Factor              0.86          0.74          0.64          0.55
Present Value of Cash Flows $2,586.21 $3,046.97 $3,715.81 $1,656.87
Total PV of Cash Inflows $11,006
− Initial Investment ($10,00)
Net Present Value $1,006

 

Since NPV of the project is positive, hence, project can be accepted.

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[accordion title=”Compounded Annual Growth Rate (CARG)” is_open=”no”]

CAGR is compound annual growth rate and it is used to calculate what your principal would grow to – if your interest earned is invested back at the same rate for a given time frame.

In other words, CAGR helps one to calculate the amount of money that you would have after a certain period of time, if you were to invest a certain sum now at a given rate of interest. For example,  if you invest $100 at 10% per annum for two years, it will become $121 in two years time.

CAGR is not an accounting term, but it is often used to describe some element of the business, for example revenue growth,  growth in units delivered, growth in registered users, etc.

Example:

We will compute the CAGR over three periods. Presume that the year-end revenues of a business for four years, are:

Year 2004 2005 2006 2007
Revenue $9,000 $8,450 $9,900 $11,000

CAGR = ((X/Y)^(1/n))-1

 where:

X = Latest Year Revenue, 2007 in this case

Y = Base Year Revenue, 2004 in this case

n = no. of years for CAGR calculation, 3 (2007-2004) in this case

CAGR = (($11,000/$9,000)^(1/3))-1

CAGR = 6.9%

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