Chapter 12

Equity Valuation

The Basic Steps (1)

• Gather Current and Historical data– Several years on financial statements– Firm level non-financial data– Industry data– Demographic data– Anything else that can help forecast the future

The Basic Steps (2)

• Analyze the current data– Quality of earnings– Trend analysis– Ratio analysis

• Common size statements

The Basic Steps (3)

• Create Pro-forma statements– Three to five years minimum– Ten years maximum– A terminal year

• Steady state

The Basic Steps (4)

• Choose a valuation method– Discounted cash flows– Residual income– Comparable firms

The Basic Steps (5)

• Apply your data to the valuation model– Determine appropriate discount rate

The Basic Steps (6)

• Determine if your answer appears reasonable

Pro-forma statements (1)

• Forecast future revenue– The single most important ingredient!– Most other items are a function of revenue

Pro-forma statements (2)

• Forecast other income statement items that are a function of sales.– COGS– SG&A

• Use common-size percentages if appropriate

Pro-forma statements (3)

• Forecast balance sheet items that support the level of forecasted revenue– Inventory

• Turnover ratio

– A/R• Turnover ratio

– A/P• Turnover ratio

Pro-forma statements (4)

• Forecast balance sheet items that support the level of forecasted revenue– PP&E

• Turnover

• Forecast depreciation as a function of PP&E

Pro-forma statements (5)

• Forecast the level of debt needed to finance operations and capital investments– Maintain a targeted capital structure

• Forecast interest expense as a function of debt

Pro-forma statements (6)

• Forecast any remaining income statement items.

• Forecast income taxes

Pro-forma statements (7)

• Forecast retained earnings based on net income and expected dividends

Pro-forma statements (8)

• Make sure the balance sheet balances

• It probably will not at this point

• Choose a plug account– Something with few or no dependencies

Pro-forma statements (8)

• Forecast the statement of cash flows from the forecasted balance sheets and income statements– Indirect method

Pro-forma statements (8)

• Determine a terminal year growth rate for the terminal year.– Make sure it is realistic since it is assumed to

be a perpetuity.

Pro-forma statements

• Note that this is just one approach to forecasting financial statements. It is completely acceptable to use any other reasonable approach such as common-size percentages, etc. Just be sure the numbers appear to make sense.

Discounted Cash Flow

• Any asset (e.g., a bond, a machine, a firm) is worth the present value of the future cash flows that come from the ownership of the asset.

• Therefore the task is to extract the future cash flows from the pro-forma statements.

Discounted Cash Flow

• Partition the future into two sections– The forecast period– The period thereafter

• Continuing value or terminal value• Assumes a steady state perpetuity

TV = FCF / (discount rate – growth rate)

Free Cash Flow

• All capital providers

• Equity holders only

Free Cash Flow to Common Equity

1. Dividends – Net Stock Issuance

2. CFFO – Increase in cash + CFFI + Increase in debt

3. Net income – Increase in common equity

Free Cash Flow to Common Equity

• Discount FCF at the firm’s cost of equity

• CAPM

Rate = risk-free rate + (beta x risk premium)

Residual Income Model

• Used earnings rather than cash flow

• Based on theory that value comes from earning more than the opportunity cost of the investment.

RI = NI – r(CE)

Comparable Firms

• PE multiples– Trailing– Forward

• More of a short-cut practical approach than a theory-based approach.