Business Analysis

and Valuation
Discounted
Cash Flows
Valuation
Cases

Prof. Arturo Capasso

[email protected]
 Some seasoned cases…
• Con Ed Stable DDM
• ABN Amro 2-Stage DDM
• Sony Stable FCFE
• Nestle 2-Stage FCFE
• Daimler-Chry Stable FCFF
• Hansol Paper 2-stage FCFF
• Amazon.com n-stage FCFF
2
 Companies Valued
Company Model Used Remarks
Con Ed Stable DDM Dividends=FCFE, Stable D/E, Low g
ABN Amro 2-Stage DDM FCFE=?, Regulated D/E, g>Stable
Sony Stable FCFE Understated Earnings?
Nestle 2-Stage FCFE Dividends≠FCFE, Stable D/E, High g
Amazon.com n-stage FCFF Varying margins over time
 General Information
The following cases are only teaching examples
being referred to more than 20 years ago.
They are solely aimed to exemplifying the diverse
valuation techniques and their implementation.
The risk premium in the August and December 1999
valuations for mature equity markets is 4%.
For the other valuations the risk premium is 5.5%.
 Con Ed: Rationale for Model
• The firm is in stable growth; based upon size and the
area that it serves. Its rates are also regulated; It is
unlikely that the regulators will allow profits to grow at
extraordinary rates.
• Firm characteristics are consistent with stable, DDM
model firm
– The beta is 0.80 and has been stable over time.
– The firm is in stable leverage.
– The firm pays out dividends that are roughly equal to FCFE.
• Average Annual FCFE between 1994 and 1998 = $ 553 m
• Avg Annual Dividends between 1994 and 1998 = $ 532 m
• Dividends as % of FCFE = 96.2%
 Con Ed: A Stable Growth DDM:
December 30, 1999
• Earnings per share for last 4 quarters = $ 3.12
• Dividend Payout Ratio over the 4 quarters = 68.59%
• Dividends per share for last 4 quarters = $ 2.14
• Expected Growth Rate in Earnings and Dividends =4%
• Con Ed Beta = 0.80
• Cost of Equity = 6.5% + 0.80*4% = 9.70%
• Value of Equity per Share = $2.14 *1.04 / (.097 -.04) = $ 39.05

The stock was trading at $34.75 on December 30, 1999

 Con Ed: Break Even Growth Rates

Value vs. Expected Growth

$80,00
Value of Stock

$70,00
$60,00
$50,00
$40,00
$30,00
$20,00
$10,00
$0,00

Expected Growth Rate

 Estimating Fundamental Growth Rate
Fundamental growth rate = Plowback ratio * ROE
Company A has a total equity equal to 100
ROE = 20% therefore E = 20
Assume pay-out ratio is equal to 40% so the amount paid
in dividend is equal to 8 retained earnings are equal to 12
The plowback ratio is 60% since 12/20 = 60%
Assuming next year the ROE remains stable, earnings are
expected as 20% * 112 = 22,4
22,4/20 = 1,12 therefore the growth rate in earning is 12%
12% = plowback ratio * ROE = 60% * 20%
 Estimating Implied Growth Rate
• To estimate the implied growth rate in Con Ed’s current
stock price, we set the market price equal to the value,
and solve for the growth rate:
– Price per share = $ 34.75 = $2.14 *(1+g) / (.097 -g)
– Implied growth rate = 3.34%
• Given its retention ratio of 31.41% and its return on
equity in 1999 of 10.31%, this is almost exactly equal to
the fundamental growth rate:
• Fundamental growth rate = (.3141*.1031) = 3.24%
 POOL

• When you do any valuation, there are three

possibilities. The first is that you are right and
the market is wrong. The second is that the
market is right and that you are wrong. The
third is that you are both wrong. In an efficient
market, which is the most likely scenario?
• Assume that you invest in a misvalued firm, and
that you are right and the market is wrong.
• Will you definitely profit from your investment?
 ABN Amro: Rationale for 2-Stage DDM

• As a financial service institution, estimating FCFE

or FCFF is very difficult.
• The expected growth rate based upon the current
return on equity of 15.56% and a retention ratio
of 62.5% is 9.73%. This is higher than what would
be a stable growth rate (roughly 5% in Euros)
 ABN Amro: Summarizing the Inputs
• Market Inputs
– Long Term Riskfree Rate (in Euros) = 5.02%
– Risk Premium = 4% (U.S. premium : Netherlands is AAA rated)
– Current Earnings Per Share = 1.60 Eur; Current DPS = 0.60 Eur;
Variable High Growth Phase Stable Growth Phase
Length 5 years Forever after yr 5
Return on Equity 15.56% 15% (Industry average)
Payout Ratio 37.5% 66.67%
Retention Ratio 62.5% 33.33% (b=g/ROE)
Exp. growth .1556*.625= 9,73% 5% (Est.)
Beta 0.95 1.00
Cost of Equity 5.02%+0.95(4%) 5.02%+1.00(4%)
=8.82% =9.02%
 ABN Amro: Valuation
Year EPS DPS PV of DPS
1 1.76 0.66 0.60
2 1.93 0.72 0.61
3 2.11 0.79 0.62
4 2.32 0.87 0.62
5 2.54 0.95 0.63
Expected EPS in year 6 = 2.54(1.05) = 2.67 Eur
Expected DPS in year 6 = 2.67*0.667=1.78 Eur
Terminal Price (in year 5) = 1.78/(.0902-.05) = 42.41 Eur
PV of Terminal Price = 42.42/(1.0882)5 = 27.79 Eur
Value Per Share = 0.60 + 0.61+0.62+0.62+0.63+27.79 = 30.87 Eur
The stock was trading at 24.92 Eur on December 30, 1999
 Nestle: Rationale for Using Model
• Earnings per share at the firm has grown about 5% a
year for the last 5 years, but the fundamentals at the
firm suggest growth in EPS of about 11%. (Analysts
are also forecasting a growth rate of 12% a year for
the next 5 years)
• Nestle has a debt to capital ratio of about 37.6% and
is unlikely to change that leverage materially. (How
do I know? I do not. I am just making an assumption.)
• Like many large European firms, Nestle has paid less
in dividends than it has available in FCFE.
 Nestle: Summarizing the Inputs
• General Inputs
– Long Term Government Bond Rate (Sfr) = 4%
– Current EPS = 108.88 Sfr; Current Revenue/share =1,820 Sfr
– Capital Expenditures/Share=114.2 Sfr;
Depreciation/Share=73.8 Sfr
High Growth Stable Growth
Length 5 years Forever after yr 5
Beta 0.85 0.85
Return on Equity 23.63% 16%
Retention Ratio 65.10% (Current) NA
Expected Growth 15.38% 5.00%
WC/Revenues 9.30% (Existing) 9.30% (Grow with earnings)
Debt Ratio 37.60% 37.60%
Cap Ex/Deprecn Current Ratio 150%
 Estimating the Risk Premium for Nestle
Revenues Weight Risk Premium
North America 17.5 24.82% 4.00%
South America 4.3 6.10% 12.00%
Switzerland 1.1 1.56% 4.00%
Germany/France/UK 18.4 26.10% 4.00%
Italy/Spain 6.4 9.08% 5.50%
Asia 5.8 8.23% 9.00%
Rest of W. Europe 13 18.44% 4.00%
Eastern Europe 4 5.67% 8.00%
Total 70.5 100.00% 5.26%
• The risk premium that we will use in the valuation is 5.26%
• Cost of Equity = 4% + 0.85 (5.26%) = 8.47%
 Nestle: Valuation
1 2 3 4 5
Earnings $125.63 $144.95 $167.25 $192.98 $222.66
- (Net CpEX)*(1-DR) $29.07 $33.54 $38.70 $44.65 $51.52
-D WC*(1-DR) $16.25 $18.75 $21.63 $24.96 $28.79
Free Cashflow to Equity $80.31 $92.67 $106.92 $123.37 $142.35
Present Value $74.04 $78.76 $83.78 $89.12 $94.7

Earnings per Share in year 6 = 222.66(1.05) = 231.57

Net Capital Ex 6 = Deprecn’n6 * 0.50 =73.8(1.1538)5(1.05)(.5)= 49 Sfr
Chg in WC6 =( Rev6 - Rev5)(.093) = 1538(1.1538)5(.05)(.093)=8.6 Sfr
FCFE6 = 231.57 - 49(1-.376) - 8.6(1-.376)= 173.93 Sfr
Terminal Value per Share = 173.93/(.0847-.05) = 3890.16 Sfr
Value=$74.04 +$78.76 +$83.78 +$89.12 +$94.7 +3890/(1.0847)5=3011Sf

The stock was trading 2906 Sfr on December 31, 1999

 Nestle: The Net Cap Ex Assumption
• In our valuation of Nestle, we assumed that cap ex
would be 150% of depreciation in steady state. If,
instead, we had assumed that net cap ex was zero, as
many analysts do, the terminal value would have been:
FCFE6 = 231.57 - 8.6(1-.376) = 222.93 Sfr
Terminal Value per Share = 222.93/(.0847 -.05) = 4986 Sfr
Value= =$74.04 +$78.76 +$83.78 +$89.12 +$94.7 +
4986/(1.0847)5= 3740.91 Sfr
 The Effects of New Information on Value
• No valuation is timeless. Each of the inputs to the model are
susceptible to change as new information comes out about the
firm, its competitors and the overall economy.
– Market Wide Information
• Interest Rates
• Risk Premiums
• Economic Growth
– Industry Wide Information
• Changes in laws and regulations
• Changes in technology
– Firm Specific Information
• New Earnings Reports
• Changes in the Fundamentals (Risk/Return)
Nestle: Effects of an Earnings Announcement
• Assume that Nestle makes an earnings announcement
which includes two pieces of news:
– The earnings per share come in lower than
expected. The base year earnings per share will be
105.5 Sfr instead of 108.8 Sfr.
– Increased competition in its markets is putting
downward pressure on the net profit margin. The
after-tax margin, which was 5.98% in the previous
analysis, is expected to shrink to 5.79%.
Nestle: Effects of an Earnings Announcement
• There are two effects on value:
– The drop in earnings will make the projected
earnings and cash flows lower, even if the growth
rate remains the same
– The drop in net margin will make the return on
equity lower (assuming turnover ratios remain
unchanged). This will reduce expected growth.
 Financing Weights A RE-VALUATION OF NESTLE (PER SHARE)
Debt Ratio = 37.6%
Cashflow to Equity Expected Growth
Net Income 105.50 Retention Ratio *
- (Cap Ex - Depr) (1- DR) 25.19 Return on Equity
- Change in WC (!-DR) 4.41 =.651*.2323 =15.12% Firm is in stable growth:
= FCFE 75.90 g=5%; Beta=0.85;
Cap Ex/Deprec=150%
Debt ratio stays 37.6%

Terminal Value= 164.84/(.0847-.05)

Value of Equity 76.48 Sfr 88.04 Sfr 101.35 Sfr 116.68 Sfr 134.32 Sfr = 3687
per Share = .........
2854 Sfr Forever
Discount at Cost of Equity

Cost of Equity
4%+0.85(5.26%)=8.47%

Riskfree Rate :
Risk Premium
Swiss franc rate = 4% Beta 4% + 1.26%
+ 0.85 X

Bottom-up beta Market Base Equity Country Risk

for food= 0.79 D/E=11% Premium: 4% Premium:1.26%
DaimlerChrysler: Rationale for Model
• DaimlerChrysler is a mature firm in a mature
industry. We will therefore assume that the firm is in
stable growth.
• Since this is a relatively new organization, with two
different cultures on the use of debt (Daimler has
traditionally been more conservative and bank-
oriented in its use of debt than Chrysler), the debt
ratio will probably change over time. Hence, we will
use the FCFF model.
 Amazon.com: The Facts as of 1/1/00
• Amazon.com retails books online. It started
operations in 1995 and increased revenues from $0.5
million to $ 15.7 million in 1996. In 1998, it had
revenues of about $ 610 million.
• The company has never been profitable. It lost $ 5.8
million in 1996 and lost 5 times as much in 1997. Its
earnings before interest and taxes for 1998 was – $
62 million.
• It did an initial public offering in May 1997 at $ 18 per
share. There are 340.78 million shares trading at the
beginning of 2000.
 Amazon.com: The Facts as of 1/1/20
• Amazon annual revenue for 2019 was $280.522B, a
20.45% increase from 2018.
• Amazon annual revenue for 2018 was $232.887B, a
30.93% increase from 2017.
• Amazon annual revenue for 2017 was $177.866B, a
30.8% increase from 2016
 Amazon.com: Model Discussion
• In valuing Amazon, in 1999, there are several
factors to consider.
– The firm has negative earnings and EBIT currently.
The negative earnings are not due to poor
management or an abnormal year, but can be
attributed to the fact that this firm is still young,
has made significant investments in establishing a
presence in the web retail market and has low
revenues. Furthermore, there is not much
financial history to base the valuation on.
 Amazon.com: Model Discussion
– We looked at specialty retailers, in general. The
average EBITDA/Sales margin for these firms is
10%, and the average debt to capital ratio at these
firms is 15%.
– There are Internet based firms (Netscape, Yahoo..)
which are publicly traded. Though they have not
been listed very long, the average beta for these
firms is 1.60. Amazon is assumed to have a similar
beta.
To value Amazon, we will use a FCFF Model, with
year-specific margins
 Using Updated Information
• While the 1999 financial statements are not out, the 1998
data is clearly dated, given Amazon’s growth in 1998. In
November 1999, Amazon reported that it had revenues of $
356 million in the third quarter of 1999 and revenues of the
previous four quarters of $1.117 billion. (Last quarter of 1998
and first 3 quarters of 1999)
• It reported an operating loss of -369 million for the first three
quarters of 1999, and a trailing four-quarter loss of -$410
million. The net operating loss carried forward at the end of
1998 is estimated to be $ 500 million.
• The firm had depreciation of $ 31 million and capital
expenditures of $ 243 million over the trailing four quarters.
The capital expenditures include acquisitions.
 Amazon.com: Inputs
Year Growth Rate in COGS as % of Growth Rate
Growth Rate in Working Cap.
Revenue Revenue Cap Ex Depreciation % of Revenue
1 150.00% 105% 75% 100% 3.00%
2 100.00% 102% 50% 75% 3.00%
3 75.00% 100% 30% 50% 3.00%
4 50.00% 99% 25% 30% 3.00%
5 30.00% 98% 20% 25% 3.00%
6 25.20% 96.4% 16% 20% 3.00%
7 20.40% 94.8% 11% 16% 3.00%
8 15.60% 93.2% 6% 11% 3.00%
9 10.80% 91.6% 6% 6% 3.00%
10 6.00% 90% 6% 6% 3.00%
 Amazon.com: Explaining the Inputs
• Revenue growth is anticipated to remain strong but become
lower (in percentage terms) as the firm becomes larger. In
steady state, revenue is expected to grow 6%.
• The EBITDA margin next year will be -5%. Over the next 10
years, the margin will approach the average for specialty
retailers
• Cap Ex will lead revenue growth by two years. Depreciation
will lag cap ex by 1 year. After year 10, cap ex will be 110% of
depreciation.
• Non-cash working capital as a percent of revenues will be 3%.
This is lower than the average for specialty retailers (about 6-
8%), because we assume that a web-based retailer can
maintain lower inventories.
 Amazon.com: Cash Flows

1 2 3 4 5 6 7 8 9 10 Terminal Year
Revenues $2.792,50 $5.585,00 $9.773,75 $14.660,63 $19.058,81 $23.861,63 $28.729,41 $33.211,19 $36.798,00 $39.005,88 $41.346,24

- COGS $2.932,13 $5.696,70 $9.773,75 $14.514,02 $18.677,64 $23.002,61 $27.235,48 $31.484,21 $34.295,74 $35.729,39 $37.211,61
- Depreciation $61,33 $107,33 $161,00 $209,30 $262,04 $315,50 $364,72 $404,11 $428,35 $454,06 $481,30

EBIT ($200,96) ($219,03) ($161,00) ($62,69) $119,13 $543,52 $1.129,21 $1.322,87 $2.073,91 $2.822,44 $3.653,32

- EBIT*t $226,86 $463,01 $725,87 $987,85 $1.278,66

EBIT (1-t) ($200,96) ($219,03) ($161,00) ($62,69) $119,13 $543,52 $902,35 $859,87 $1.348,04 $1.834,58 $2.374,66

+ Depreciation $61,33 $107,33 $161,00 $209,30 $262,04 $315,50 $364,72 $404,11 $428,35 $454,06 $481,30

- Capital Spending
$424,67 $637,00 $828,10 $1.036,78 $1.248,28 $1.443,02 $1.598,86 $1.694,79 $1.796,48 $1.904,27 $529,43

- Chg. Working$50,27
Capital $83,78 $125,66 $146,61 $131,95 $144,08 $146,03 $134,45 $107,60 $66,24 $70,21
Free CF to Firm($614,56) ($832,48) ($953,76) ($1.036,78) ($999,05) ($728,08) ($477,83) ($565,27) ($127,69) $318,13 $2.256,32

Present Value ($544,78) ($654,18) ($664,40) ($640,23) ($546,89) ($355,43) ($209,23) ($223,26) ($45,73) $103,87
NOL $700,96 $919,99 $1.080,99 $1.143,69 $1.024,55 $481,03
 The Tax Effect
• In discounted cash flow valuation, we always
begin with after-tax operating income, which
we compute as EBIT (1-t). Why is there no tax
effect in the first five years?

• Why is there no tax effect in years 5 and 6?

• Estimate the tax effect in year 7

 Amazon.com: Costs of Capital

Tax Rate 23% 35% 35% 35% 35%

Beta 1,60 1,60 1,60 1,60 1,60 1,48 1,36 1,24 1,12 1,00 1,00
Cost of Equity 12,90% 12,90% 12,90% 12,90% 12,90% 12,42% 11,94% 11,46% 10,98% 10,50% 10,50%
Cost of Debt 5,20% 5,20% 5,20% 5,20% 5,20% 5,20% 5,20% 5,20% 5,20% 5,20% 5,20%
Debt Ratio 1,20% 1,20% 1,20% 1,20% 1,20% 3,96% 6,72% 9,48% 12,24% 15,00% 15,00%
Cost of Capital 12,81% 12,81% 12,81% 12,81% 12,81% 12,13% 11,49% 10,87% 10,27% 9,71% 9,71%
 Amazon.com: Terminal Value

Free Cash Flow to the firm in year 11

EBIT(1-t) = $2,374.66
+ Depreciation= $481.30
- Cap Ex = $529.43
- Chg in WC= $70.21
FCFF = $2,256.32
Terminal Value = 2256.32/(.0971-.06) = $60,899 million
 Amazon.com: Valuation
Year FCFF Terminal Value Present Value
1 ($614.56) ($544.78)
2 ($832.48) ($654.18)
3 ($953.76) ($664.40)
4 ($1,036.78) ($640.23)
5 ($999.05) ($546.89)
6 ($728.08) ($355.43)
7 ($477.83) ($209.23)
8 ($565.27) ($223.26)
9 ($127.69) ($45.73)
10 $318.13 $60,899.33 $19,986.47
Value of Firm $16,102.32
- Value of Debt $ 349
Value of Equity $15,753 million
 Value of Options in Common Stock
• There were 38 million options outstanding, with an
average exercise price of $ 13.375, and the stock
price was about $ 84 per share. The average maturity
of these options was 8.4 years.
• Using an annualized standard deviation of 50%, the
estimated market value of these options was $2.892
billion.
 Value Per Share
• Value of Equity in Firm = $ 15,753
• - Value of Options = $ 2,892
• Value of Equity in Stock = $ 12,861
• Value per Share = $12,941/340.79 = $ 37.74
Using Valuation Methodologies

Discounted Cash Flows

Free Cash Flow
& Valuation
 Cash Flows
If applied to dividends, the DCF model is the
dividend discount model (DDM)

DCF analysis evaluates a firm and the firm’s

equity securities by valuing its free cash flow
to the firm (FCFF) and free cash flow to
equity (FCFE).
 Summing up
Dividends are the cash flows actually paid to
stockholders

Free cash flows to equity (FCFE) are the cash

flows available for distribution to equityholders.

Free cash flows to firm (FCFE) are the cash flows

available for distribution to equityholders plus the
cashflows that goes to debtholders.
 Intro to Free Cash Flows
Analysts like to use free cash flow valuation models
(FCFF or FCFE) whenever one or more of the
following conditions are present:
• the firm is not dividend paying,
• the firm is dividend paying but dividends differ significantly
from the firm’s capacity to pay dividends,
• free cash flows align with profitability within a reasonable
forecast period with which the analyst is comfortable, or
• the investor takes a control perspective.
 Intro to Free Cash Flows

Common equity can be valued by either

• directly using FCFE or

• indirectly by first computing the value of the firm

using a FCFF model and subtracting the value of
non-common stock capital (usually debt and
preferred stock) to arrive at the value of equity.
 Defining Free Cash Flow
Free cash flow to the firm (FCFF) is the cash flow

available to the firm’s suppliers of capital after all

operating expenses have been paid and necessary

investments in working capital and fixed capital have

been made.
 Defining Free Cash Flow
Free cash flow to the firm (FCFF)

FCFF is the cash flow from operations minus capex.

To calculate FCFF, differing equations may be used depending

on what accounting information is available.

The firm’s suppliers of capital include common stockholders,

debtholders, and, sometimes, preferred stockholders.

 Defining Free Cash Flow
Free cash flow to equity (FCFE) is the cash flow
available to the firm’s common equity holders after
all operating expenses, interest and principal
payments have been paid, and necessary
investments in working and fixed capital have been
made.
 Defining Free Cash Flow
Free cash flow to equity (FCFE)

FCFE is the cash flow from operations minus

capex (capital expenditures) minus payments

to (and plus receipts from) debtholders.

 Valuing FCFF
The FCFF valuation approach estimates the value of the
firm as the present value of future FCFF discounted at
the weighted average cost of capital (WACC)


Firm Value = ∑ (1 FCFF

t t
t 1
WACC)
• Discounting FCFF at the WACC gives the total value of
all of the firm’s capital. The value of equity is the value
of the firm minus the market value of the firm’s debt
 Valuing FCFF

Equity Value = Firm Value – Market Value of Debt

Dividing the total value of equity by the number of

outstanding shares gives the value per share.
 Calculating a WACC
• The cost of capital is the required rate of return

that investors should demand for a cash flow

stream like that generated by the firm.

• The cost of capital is often considered the

opportunity cost of the suppliers of capital.

 Calculating a WACC
If the suppliers of capital are creditors and stockholders, the
required rates of return for debt and equity are the after-tax
required rates of return for the firm under current market
conditions. The weights that are used are the proportions of the
total market value of the firm that are from each source, debt and
equity.
D (debt) E (equity)
re
WACC  rd (1  Taxrate) 
D (debt)  E (equity) D (debt)  E (equity)

D(debt) and E (equity) are the current market values of debt and
equity, not their book values. The weights will sum to 1.0.
 Valuing FCFE
• The value of equity can also be found by discounting
FCFE at the required rate of return on equity (r):
 FCFE
Equity Value  ∑ t

t 1 (1  r) t
• Since FCFE is the cash flow remaining for equity
holders after all other claims have been satisfied,
discounting FCFE by r (the required rate of return on
equity) gives the value of the firm’s equity.
• Dividing the total value of equity by the number of
outstanding shares gives the value per share.
 Single-stage constant-growth FCFF valuation

FCFF in any period is equal to FCFF in the previous

period times (1 + g):
• FCFFt = FCFFt–1 (1 + g).

The value of the firm if FCFF is growing at a

constant rate is
FCFF FCFF0 (1 g)
Firm Value = 1 
WACC  g WACC  g

Subtracting the market value of debt from

the firm value gives the value of equity.
 Single-stage, constant-growth FCFE valuation

FCFE in any period will be equal to FCFE in the preceding

period times (1 + g):
• FCFEt = FCFEt–1 (1 + g).

The value of equity if FCFE is growing at a constant rate is

Equity Value 
FC FE 1 FC FE 0 (1  g )

rg rg

The discount rate is r, the required return on equity. The

growth rate of FCFF and the growth rate of FCFE are
frequently not equivalent.
 Computing FCFF from Net Income
Free cash flow to the firm (FCFF) is the cash flow available to the firm’s
suppliers of capital after all operating expenses (including taxes) have
been paid and operating investments have been made.
The firm’s suppliers of capital include creditors and bondholders and
common stockholders (and occasionally preferred stockholders that we
will ignore until later). Free cash flow to the firm is:
• FCFF = Net income available to common
shareholders
• Plus: Net Non-Cash Charges
• Less: Investment in Working Capital
• Plus: Interest Expense times (1 – Tax rate)
• Less: Investment in Fixed Capital
 Computing FCFF from Net Income
• This equation can be written more compactly as

FCFF = NI + NCC + Int(1 – Tax rate) – Inv(FC)

– Inv (NWC)
 Computing FCFF from CFO
To estimate FCFF by starting with cash flow from operations
(CFO), we must recognize the treatment of interest paid. If,
as the case with U.S. GAAP, the after-tax interest was taken
out of net income and out of CFO, after-tax interest must be
added back in order to get FCFF.
So free cash flow to the firm, estimated from CFO, is
FCFF = Cash Flow from Operations
Plus: Interest Expense times (1 – Tax rate)
Less: Investment in Fixed Capital
 Computing FCFF from CFO
Or you can write the equation as:
FCFF = CFO + Int(1 – Tax rate) – Inv (FC)
 Finding FCFE from FCFF
• Free cash flow to equity is cash flow available to equity
holders only. It is therefore necessary to reduce FCFF by
interest paid to debtholders and to add any net increase
in borrowing (subtract any net decrease in borrowing).
• FCFE = Free cash flow to the firm
• Less: Interest Expense times (1 – Tax rate)
• Plus: Net Borrowing
• Or FCFE = FCFF – Int(1 – Tax rate) + Net borrowing
 Finding FCFE from NI or CFO
Subtracting after-tax interest and adding back net borrowing
from the FCFF equations gives us the FCFE from NI or CFO:

FCFE = NI + NCC – Inv(FC) – Inv(WC) + Net borrowing

FCFE = CFO – Inv(FC) + Net borrowing

 Finding FCFF from EBIT
FCFF and FCFE are most frequently calculated from a
starting basis of NI or CFO. Two other starting points
are EBIT or EBITDA.

To show the relation between EBIT and FCFF, let us start

with the FCFF equation and assume that the non-cash
charge (NCC) is depreciation (Dep):
FCFF = NI + Dep + Int(1 – Tax rate) – Inv(FC) – Inv(WC)
 Finding FCFF from EBIT
Net income (NI) can be expressed as
NI = (EBIT – Int)(1 – Tax rate) = EBIT(1 – Tax rate) - Int(1 – Tax rate)

If this equation for NI is substituted for NI in the previous

equation, we have
FCFF = EBIT (1 – Tax rate) + Dep – Inv(FC) - Inv(WC)

To get FCFF from EBIT, multiply EBIT times (1 – Tax rate),

add back depreciation, and then subtract the investments in
fixed capital and working capital.
 Finding FCFF from EBITDA
• To show the relation between FCFF from EBITDA
(Earnings Before Interest, Taxes, Depreciation and
Amortization), use the formula for FCFF:
FCFF = NI + Dep + Int(1 – Tax rate) – Inv(FC) – Inv(WC)

Net income can be expressed as

NI = (EBITDA – Dep – Int)(1 – Tax rate)

NI = EBITDA(1 – Tax rate) – Dep(1 – Tax rate) – Int (1 – Tax rate)

 Finding FCFF from EBITDA
Substituting this for NI in the FCFF equation results in
FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – Inv(FC) – Inv(WC)

To get FCFF from EBITDA, multiply EBITDA times (1 – Tax

rate), add back depreciation times the tax rate, and then
subtract the investments in fixed capital and working
capital
 Forecasting free cash flows
Computing FCFF and FCFE based upon historical accounting data
is straightforward. Often times, this data is then used directly in a
single-stage DCF valuation model.

On other occasions, the analyst desires to forecast future FCFF or

FCFE directly.

In this case, the analyst must forecast the individual components of

free cash flow. This section extends our previous presentation on
computing FCFF and FCFE to the more complex task of forecasting
FCFF and FCFE.
 Forecasting free cash flows
• Given that we have a variety of ways in which to derive
free cash flow on a historical basis, it should come as no
surprise that there are several methods of forecasting free
cash flow.

• One approach is to compute historical free cash flow and

apply some constant growth rate.

• This approach would be appropriate if free cash flow for

the firm tended to grow at a constant rate and if historical
relations between free cash flow and fundamental factors
 Forecasting FCFF
One approach recognizes that capital expenditures have
two components; those expenditures necessary to
maintain existing capacity (fixed capital replacement) and
those incremental expenditures necessary for growth.
When forecasting, the former are likely to be related to the
current level of sales, while the latter are likely to be
related to the forecast of sales growth.
 Forecasting FCFF
When forecasting FCFE, analysts often simplify the
estimation of FCFF and FCFE.
Equation can be restated as
FCFF = NI + Int (1 – Tax rate) - (Capex – Dep) – Inv(WC)
which is equivalent to:
FCFF = EBIT (1 – Tax rate) - (Capex– Dep) – Inv(WC)

The components of FCFF in these equations are often

forecasted in relation to sales.

* Capex is a shortening for Capital Expense

 Forecasting FCFE
If the firm finances a fixed %age of its capital spending and
investments in working capital with debt, the calculation of
FCFE is simplified. Let DR be the debt ratio, debt as a
%age of assets. In this case, FCFE can be written as
FCFE = NI – (1 – DR)(Capex – Dep) – (1 – DR)Inv(WC)

When building FCFE valuation models, the logic, that debt

financing is used to finance a constant fraction of
investments, is very useful. This equation is pretty common.
 Two-stage FCF models
• FCF models are much more complex than DDMs because
the analyst usually estimates sales, profitability,
investments, financing costs, and new financing to find
FCFF or FCFE.

• In two-stage FCF models, the growth rate in the second

stage is a long-run sustainable growth rate. For a declining
industry, the second stage growth rate could be slightly
below the GDP growth rate. For an industry that will grow in
the future (relative to the overall economy), the second
stage growth rate could still be slightly greater than the
 Two-stage FCF models
The two most popular versions of the two- stage
FCFF and FCFE models are:
• the growth rate is constant (or given) in stage one, and
then it drops to the long- run sustainable rate in stage two.

• the growth rates are declining in stage one, reaching the

sustainable rate at the beginning of stage two. This latter
model is like the H model for dividend valuation.
 Two-stage FCF models
• The growth rates can be applied to different variables.
• The growth rate could be the growth rate for FCFF or
FCFE, or the growth rate for income (such as net income),
or the growth rate could be the growth rate for sales.
• If the growth rate were for net income, the changes in
FCFF or FCFE would also depend on investments in
operating assets and financing of these investments.
 Two-stage FCF models
• When the growth rate in income declines, such as
between stage one and stage two, investments in
operating assets will probably decline at the same time.
• If the growth rate is for sales, changes in net profit
margins as well as investments in operating assets and
financing policies will determine FCFF and FCFE.
 Two-stage FCF models
A general expression for the two-stage FCFF valuation model is

n
FCFFt
Firm Value= ∑ t
+
1
FCFFn (1+WACC) n
(1+WACC) (WACC-g)
t 1
1

The summation gives the present value of the first n years’

FCFF. The terminal value of the FCFF from year n+1
onward is FCFFn+1 / (WACC– g), which is discounted at
the WACC for n periods.
Subtracting the value of outstanding debt gives the value of
equity.
 Two-stage FCF models
The general expression for the two-stage FCFE valuation
model is
n FCFE
FCFE n1 1
∑
t
Equity +

t r  g (1 r) n
t 1 (1 r)

The summation is the present value of the first n years’

FCFE, and the terminal value of FCFEn+1 / (r– g) is
discounted at the required rate of return on equity for n years.
The value per share is found by dividing the total value of
equity by the number of outstanding shares.
 Nonoperating assets and firm value
Analysts usually segregate operating and non- operating
assets when they value a firm.
•Many non-operating assets are financial assets that can be
directly valued at their market prices.
•It is unnecessary to use a valuation model when the market
value can be observed reliably.

• Non-operating assets not contributing operating income to the

firm could be sold (without change in operating margin).

• The liquidation value of these non-performing assets could then

be added to the value of the performing assets.
 Nonoperating assets and firm value
Finally, if non-operating assets are not segregated, the cash flows
from these assets could be combined with the cash flows of the
operating assets, often making it difficult to find the cash flows of
the operating assets.
For example, interest and dividend income and capital gains from
an investment portfolio could mask the fact that the company’s
operating profitability is poor. The value of the firm should be the
value of its operating and non-operating assets:
Value of firm =
Value of operating assets + Value of non-operating assets.
 Nonoperating assets and firm value
• When calculating FCFF or FCFE, investments in working capital do
not include any investments in cash and marketable securities.
• The value of cash and marketable securities should be added to the
value of the firm’s operating assets to find the total firm value.

• Some companies have substantial non-current investments in

stocks and bonds that are not operating subsidiaries but financial
investments.

• These should be reflected at their current market value.

• Based on accounting conventions, those securities reported at book

values should be revalued to market values.
 Nonoperating assets and firm value

Finally, many corporations have overfunded or

underfunded pension plans. The excess pension fund
assets should be added to the value of the firm’s
operating assets.
Likewise, an underfunded pension plan should result in
an appropriate subtraction from the value of operating
assets.
 Nonoperating assets example
• Virginia Mak is estimating the value of Charleson
Partners, a non- publicly traded Canadian food
wholesaler.
• Mak has assembled the following information for her
appraisal.
• The firm’s operating assets generated a FCFF of CD35M
in the year just ended. A perpetual growth rate of 5% is
expected for FCFF.
• The weighted average cost of capital is 11%.
 Nonoperating assets example
• Charleson Partners has non-operating assets of
• CD12 million of cash and short-term marketable securities
• CD105 million in a diversified portfolio of common stocks
and bonds
• Pension fund assets of CD75 million and pension fund
liabilities of CD58 million.

• Charleson has total debts (notes and bonds payable)

with an estimated market value of CD 108 million.
• There are 8,250,000 outstanding shares.
 Nonoperating assets example
The value of the operating assets (in million CD) is
FCFF0 (1 g)
Value(Operating)  22(1.05) 23.1
  CD 385
 WACC  g 0.11  0.05 0.06

The value of the non-operating assets is:

Cash and short-term investments CD 12 million

Stock and bond portfolio CD 105 million
Pension fund surplus (75 – 58) CD 17 million
Total non-operating assets: CD 134 million
 Nonoperating assets example
The total value of the firm is
Value of operating assets
+ Value of non- operating assets =
385 + 134 = CD 519 million.
The value of equity is the total value of the firm less the
market value of its debt obligations, or 519 – 108 = CD 411
million.
Finally, the value per share is CD 411 million / 8,250,000
shares = CD 49.82.
 Proust Company
Proust Company has free cash flow to the firm of
$1.7 billion and free cash flow to equity of $1.3 billion. Proust’s weighted
average cost of capital is 11 % and its required rate of return for equity is
13 %. FCFF is expected to grow forever at 7 % and FCFE is expected to
grow forever at 7.5 %. Proust has debt outstanding of $15 billion.

•What is the total value of Proust’s equity using the FCFF valuation?

•What is the total value of Proust’s equity using the FCFE valuation?
 Proust Company solution
A. The Firm Value is the present value of FCFF discounted at
the weighted average cost of capital (WACC), or

FCFF1 FCFF0 (1 g) 1.7(1.07) 1.819

Firm     
WACC g
45.475 WACC  g 0.11 0.04
0.07

The market value of equity is the value of the firm minus

the value of debt:
Equity = 45.475 – 15 = $30.475 billion.
 Proust Company solution
B. Using the FCFE valuation approach, the present value of
FCFE, discounted at the required rate of return on equity,
is FCFE1  FCFE 0 (1 g)  1.3(1.075)  1.3975  25.409
PV 
rg rg 0.13  0.075 0.055

The value of equity using this approach is $25.409

billion.
 Taiwan Semiconductor
In 2001, Quinton Johnston is evaluating Taiwan
Semiconductor Manufacturing Co., Ltd, (NYSE: TSM)
headquartered in Hsinchu, ROC, Taiwan.
In 2001, the company is unprofitable.
Furthermore, TSM pays no dividends on common
shares. So, Johnston is going to value TSM using his
forecasts of free cash flow to equity.
 Taiwan Semiconductor
Johnston is going to use the following assumptions.
• 17.0 billion outstanding shares
• Sales will be $5.5 billion in 2002, increasing at 28 % annually for the next four
years (through 2006).
• Net income will be 32 % of sales
• Investments in fixed assets will be 35 % of sales, investments in working capital
will be 6 % of sales, and depreciation will be 9 % of sales.
• 20 % of the investment in assets will be financed with debt.
• Interest expenses will be only 2 % of sales.
• The tax rate will be 10 %.
• TSM’s beta is 2.1, the risk-free government bond rate is 6.4 %, and the market
risk premium is 5.0 %.
• At the end of 2006, TSM will sell for 18 times earnings.

• What is the value of one ordinary share of Taiwan Semiconductor

Manufacturing Co., Ltd?
 Taiwan Semiconductor solution

The required rate of return found with the CAPM is:

r = E(Ri) = RF + bi[E(RM) – RF] = 6.4% + 2.1 (5.0%) = 16.9%.

The table below shows the values of Sales, Net income,

Capital expenditures less Depreciation, and Investments in
working capital.
 Taiwan Semiconductor solution
The free cash flow to equity is equal to net income less the
investments financed with equity, which is:
FCFE = Net income – (1 – DR)(Capital expenditures – Depreciation)
– (1 – DR)(Investment in working capital)

Since 20 % of new investments are financed with debt, 80 %

of the investments are financed with equity, reducing FCFE
by 80 % of (Capital expenditures – Depreciation) and 80 %
of the investment in working capital.
 Taiwan Semiconductor solution
All data in $ billions 2002 2003 2004 2005 2006

Sales (growing at 28%) 5.500 7.040 9.011 11.534 14.764

Net Income = 32% of sales 1.760 2.253 2.884 3.691 4.724

Capex – Dep = (35% – 9%) × Sales 1.430 1.830 2.343 2.999 3.839
Inv(WC) = (6% of Sales) 0.330 0.422 0.541 0.692 0.886
0.80 × [Capex – Dep + Inv(WC)] 1.408 1.802 2.307 2.953 3.780

FCFE = NI–0.80×[Capex–Dep+Inv(WC)] 0.352 0.451 0.577 0.738 0.945

PV of FCFE discounted at 16.9% 0.301 0.330 0.361 0.395 0.433

Terminal stock value 85.040

PV of Terminal value discounted at 16.9% 38.954

Total PV of first five years’ FCFE 1.820

Total value of firm 40.774
 Taiwan Semiconductor solution
• The terminal stock value is 18.0 times the earnings in year
2006, or 18 × 4.724 = $85.04 billion.

• The present value of the terminal value ($38.95 billion) plus

the present value of the first five years’ FCFE ($1.82 billion)
is $40.77 billion.

• Since there are 17 billion outstanding shares, the value per

share is $2.398.
 BHP Billiton Ltd.

Watson Dunn is planning to value BHP Billiton Ltd.

using a single-stage free cash flow to the firm
approach. BHP Billiton, headquartered in Melbourne
Australia, is a provider of a variety of industrial metals
and minerals.
 BHP Billiton Ltd.
The financial information Dunn has assembled for his
valuation is:
•1,852 million shares outstanding
•market value of debt is $3.192 billion
•free cash flow to the firm is currently $1.559 billion
•equity beta is 0.90, the market risk premium is 5.5 %, and the risk-
free discount rate is 5.5 %
•before-tax cost of debt is 7.0 %
•tax rate is 40 %
•for purposes of calculating the WACC (firm is financed 25 % debt)
•FCFF growth rate is 4 %
 BHP Billiton Ltd.
Using Dunn’s information, calculate:

A. The weighted average cost of

capital

B. Value of the firm

C. Total market value of equity

D. Value per share

 BHP Billiton Ltd. solution
A.The required return on equity is r = E(Ri) = RF + bi[E(RM)
– RF]
= 5.5% + 0.90(5.5%) = 10.45%
The weighted average cost of capital is
WACC = 0.25(7.0%)(1 – 0.40) + 0.75(10.45%) = 8.89%
B.Firm Value = FCFF0(1 +g) / (WACC – g)
Firm Value = 1.1559(1.04) / (0.0889 – 0.04) = $24.583
billion
 BHP Billiton Ltd. solution
C.Equity Value =
Firm Value – Market Value of Debt Equity Value =
24.583 – 3.192 = $21.391 billion

D. Value per share =

Equity Value / Number of Shares Value per share =
21.391 / 1.852 = $11.55.
 Alcan, Inc
An aggressive financial planner is courting one of your clients.
The planner claims that the best way to find the value of a stock is to
divide EBITDA by the risk-free bond rate.
The planner is urging your client to invest in Alcan, Inc. (NYSE: AL).
Alcan is the parent of a group of companies engaged in all aspects of
the aluminum business.
The planner says that Alcan’s EBITDA of $1,580 million divided by the
long-term government bond rate of 7 % gives a total value of
$22,571 million.
Since there are 318 million outstanding shares, this gives a value per
share of $70.98.
Shares of Alcan, Inc. are currently trading for $36.50, and the planner
wants your client to make a large investment in Alcan through him.
 Alcan, Inc.
A. Criticize the valuation approach that the aggressive financial
planner used.
B. Provide your client with an alternative valuation of Alcan
based on a two- stage FCFE valuation approach. Find the
value per share of Alcan using the following assumptions:
 Alcan, Inc.
• Net income is currently $600 million and it will grow by 20% annually
in the next 3 years.
• The net investment in operating assets (capex – dep – increase in wk)
will be $1,150 million next year and grow at 15% in the next 2 years.
• 40% of the net investment in operating assets will be financed with net
new debt financing.
• Alcan’s b is 1.3, the risk-free rate is 7%, and the market premium is
4%
• After 3 years, the growth rate of net income will be 8% and the net
investment in operating assets (capex – dep – increase in wk) each
year will drop to 30% of net income.
• Debt financing will continue to fund 40 % of the net investment in
operating assets.
• There are 318 million outstanding shares.
 Alcan, Inc. solution
B. Using the CAPM, the required rate of return for Alcan is: r = E(Ri) = RF
+ bi[E(RM) – RF] = 7% + 1.3(4%) = 12.2%.
To estimate FCFE, use the relation
FCFE = Net income – (1 – DR)(Capex – Depreciation)
– (1 – DR)(Invest in WC)

The table below shows net income, which grows at 20 % annually for
years 1, 2, and 3, and then at 8 % for year 4. Investments (Capex –
Dep + Investment in WC) are 1,150 in year 1 and grow at 15 %
annually for years 2 and 3. Debt financing is 40 % of this investment.
FCFE is NI – investments + financing. Finally, the present value of
FCFE for years 1, 2, and 3 is found by discounting at 12.2 %.
 Alcan, Inc. solution
The value of FCFE after year 3 is found using the constant growth
model:
FCFE4  918.19  $21,861.67
P 
3 rg 0.122  0.08

The present value of P3 discounted at 12.2 % is $15,477.64 million. The

total value of equity, the present value of the first three years’ FCFE plus
the present value of P3, is $15,648.36 million. Dividing by the number of
outstanding shares (318 million) gives a price per share of $49.21. For the
first three years, Alcan has a small FCFE because of the high investments
it is making during the high growth phase.
 Alcan, Inc. solution
Year 1 2 3 4

Net income 720.00 864.00 1,036.80 1,119.74

Investment in operating assets 1,150.00 1,322.50 1,520.88 335.92

New debt financing 460.00 529.00 608.35 134.37

Free cash flow to equity 30.00 70.50 124.28 918.19

PV of FCFE discounted at 12.2% 26.74 56.00 87.98

 Alcan, Inc. solution
The planner’s estimate of the share value of $70.98 is much higher than
the FCFE model estimate of $49.21.
There are several reasons for the differing estimates.
•Taxes and interest expenses, which were $254 and $78 million, have a
prior claim to the company’s cash flow and should be taken out. These
cash flows are not available to equity holders.
•EBITDA does not account for the company’s reinvestments in
operating assets. By distributing depreciation charges (which were $561
million), the planner is essentially liquidating the firm over time, much
less accounting for the net investments that the firm is making over
time.
 Alcan, Inc. solution
• EBITDA does not account for the firm’s capital structure. Using
EBITDA to represent a benefit to stockholders (as opposed to
stockholders and bondholders combined) is a mistake.

• Dividing EBITDA by the bond rate commits major errors, as well. The
risk-free bond rate is an inappropriate discount rate for equity cash
flows. The required rate of return on the firm’s equity should be used.
Dividing by a fixed rate also assumes erroneously that the cash flow
stream is a fixed perpetuity. EBITDA cannot be a perpetual stream
because, if it were distributed, the stream would eventually decline to
zero (because of no capital investments). Alcan is actually a growing
company, so assuming it to be a non- growing perpetuity is a mistake.
 Bron
Bron has earnings per share of $3.00 in 2002 and expects
earnings per share to increase by 21 % in 2003.
Earnings per share are going to grow at a decreasing rate
for the following five years, as shown in the table below. In
2008, the growth rate will be 6 % and is expected to stay at
that rate thereafter.
Net capital expenditures (Capital expenditures minus
depreciation) will be $5.00 per share in 2002, and then
follow the pattern predicted in the table.
 Bron
In 2008, net capital expenditures are expected to be $1.50,
and then to grow at 6 % annually after that.
The investment in working capital parallels the increase in
net capital expenditures and is predicted to equal 25 % of
net capital expenditures each year.
In 2008, investment in working capital will be $0.375 and is
predicted to grow at 6 % thereafter.
Bron will use debt financing to fund 40 % of net capital
expenditures and 40 % of the investment in working capital.
 Bron
Year 2003 2004 2005 2006 2007 200
8
Growth rate eps 21% 18% 15% 12% 9% 6%

Net capex per share 5.00 5.00 4.50 4.00 3.50 1.50

The required rate of return for Bron is 12 %. Find the value

per share using a two-stage FCFE valuation approach.
 Bron solution
FCFE is shown in this table:
Year 2003 2004 2005 2006 2007 2008

Growth rate for earnings per 21% 18% 15% 12% 9% 6%

share
Earnings per share 3.630 4.283 4.926 5.517 6.014 6.374

Capital expenditure per share 5.000 5.000 4.500 4.000 3.500 1.500

Investment in WC per share 1.250 1.250 1.125 1.000 0.875 0.375

New debt financing = 40% of
[Capex + Inv(WC)] 2.500 2.500 2.250 2.000 1.750 0.750

FCFE = NI – Capex –
Inv(WC) +
New debt financing –0.120 0.533 1.551 2.517 3.389 5.249
 Bron solution
The present values of FCFE from 2003 through 2007 are given in the
bottom row of the table. The sum of these five present values is
$4.944. Since the FCFE from 2008 onward will be growing at a
constant 6 %, the constant growth model can be used to value these
cash flows
P2007 FCFE2008  5.249  $87.483
 rg 0.12  0.06

The present value of this stream is $87.483 / (1.12)5 = $49.640.

The value per share is the value of the first five FCFE (2003 through
2007) plus the present value of the FCFE after 2007, or
$4.944 + $49.640 = $54.58.