Free Cash Flow Valuation and Market-based Valuation: Price Multiples, Study notes of Financial Market

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• Equity Valuation
  • Investment and Risk Management 2020-

Today …

• (^) Free Cash Flow (FCF) Valuation
• (^) Market-based Valuation: Price and Enterprise Value Multiples

FCF Valuation

FCF Computation

• (^) Free cash flow to the firm (FCFF) is

defined as the cash flow generated by

the firm’s operations that is in excess

of the capital investment required to

sustain the firm’s current productive

capacity.

• (^) Free cash flow to equity (FCFE) is the

cash available to stockholders after

funding capital requirements and

expenses associated with debt

financing.

FCF Valuation

FCF Computation

• (^) The value of the firm’s equity is the present value of the expected future FCFE discounted at the required return on equity :
• (^) Given the value of the firm, we can also calculate equity value by simply subtracting out the market value of the debt:
• Details of the calculations are discussed later in this topic review. However, this is an extremely important concept, so memorize it now.
• (^) The value of the firm is the present value of

the expected future FCFF discounted at the

WACC (this is so important we’re going to

repeat it as a formula):

• The weighted average cost of capital is the

required return on the firm’s assets. It’s a

weighted average of the required return on

common equity and the after-tax required

return on debt. The formula is presented

later in this topic review.

FCF Valuation

Fixed Capital vs Working Capital

where NI=Net Income NCC=Non Cash Charges Int=Interest charge FCInv=Fixed Capital Investment WCInv=Working Capital Investment Notice that net income does not represent free cash flows defined as FCFF, so we have to make four important adjustments to net income to get to FCFF: noncash charges, fixed capital investment, working capital investment, and interest expense.

• (^) The basic idea is that we can arrive at

FCFF by starting with one of four

different financial statement items

(net income, EBIT, EBITDA, or cash

flow from operations [CFO]) and then

making the appropriate adjustments.

Then we can calculate FCFE from FCFF

or by starting with net income or CFO.

• (^) Calculating FCFF from net income.

FCFF is calculated from net income as:

FCF Valuation

Fixed Capital vs Working Capital

• If long-term assets were sold during the year , then:
  • (^) Determine capital expenditures from either (1) an item in the statement of cash flows called something like “purchase of fixed assets” or “purchases of PP&E” under cash flow from investing activities, or (2) data provided in the vignette.
  • Determine proceeds from sales of fixed assets from either (1) an item in the statement of cash flows called something like “proceeds from disposal of fixed assets,” or (2) data provided in the vignette.
• (^) Working capital investment****. The investment in net working capital is equal to the change in working capital, excluding cash, cash equivalents, notes payable, and the current portion of long-term debt. Note that there would be a + sign in front of a reduction in working capital; we would add it back because it represents a cash inflow.
• (^) Noncash charges****. Noncash charges are added back to net income to arrive at FCFF because they represent expenses that reduced reported net income but didn’t actually result in an outflow of cash. The most significant noncash charge is usually depreciation.
• (^) Fixed capital investment****. Investments in fixed capital do not appear on the income statement, but they do represent cash leaving the firm. That means we have to subtract them from net income to estimate FCFF.
• If no long-term assets were sold during the year :

FCF Valuation

Different stage FCF Models

• (^) The single-stage FCFF model is useful

for stable firms in mature industries.

The model assumes that (1) FCFF

grows at a constant rate ( g ) forever,

and (2) the growth rate is less than the

weighted average cost of capital

(WACC).

• (^) The formula should look familiar; it’s

the Gordon growth model with FCFF

replacing dividends and WACC

replacing required return on equity.

• (^) The single-stage FCFE model is analogous to the single-stage FCFF model, with FCFE instead of FCFF and required return on equity instead of WACC:
• (^) The single-stage FCFE model is often used in international valuation, especially for companies in countries with high inflationary expectations when estimation of nominal growth rates and required returns is difficult. In those cases, real (i.e., inflation-adjusted) values are estimated for the inputs to the single-stage FCFE model: FCFE, the growth rate, and the required return.

FCF Valuation

Different stage FCF Models

2-stage FCF Model

• Two-stage FCFF model in which FCFF is projected to grow at 20% for the first four years and then 4% every year thereafter.
• Two-stage FCFE model in which FCFE declines from 20% to 4% over four years and then stays at 4% forever.
• (^) Two-stage FCFE model in which sales grow at 20% for four years, the net profit margin is constant at 8%, fixed capital investment is equal to 60% of the dollar increase in sales, working capital investment is equal to 25% of the dollar increase in sales, and the debt ratio is 50%. Given a starting value for sales, we have all we need to forecast FCFE for the first four years.

or

Market-based Valuation

P/E multiple

• (^) There are a number of rationales for using price-

to-earnings (P/E) ratio in valuation:

• (^) Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
• (^) The P/E ratio is popular in the investment community.
• Empirical research shows that P/E differences are significantly related to long-run average stock returns.
• (^) On the other hand, P/E ratios have a number of

shortcomings:

• Earnings can be negative , which produces a meaningless P/E ratio.
• (^) The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts.
• (^) Management discretion within allowed accounting practices can distort reported earnings, and thereby lessen the comparability of P/Es across firms. - (^) Trailing P/E ratio - (^) Leading P/E ratio (forward or

prospective)

Market-based Valuation

P/B multiple

• (^) The Price-to-Book ratio is defined as follows:

where

Market-based Valuation

P/S multiple

Advantages

• (^) P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and P/B ratios, which can be negative.
• (^) Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly affected by accounting conventions.
• (^) P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis when earnings for a particular year are very high or very low relative to the long-run average.
• P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and start-up companies with no record of earnings. It is also often used to value investment management companies and partnerships.
• (^) Like P/E and P/B ratios, empirical research finds that differences in P/S are significantly related to differences in long-run average stock returns.

Disadvantages

• (^) High growth in sales does not necessarily indicate high operating profits as measured by earnings and cash flow.
• (^) P/S ratios do not capture differences in cost structures across companies.
• (^) While less subject to distortion, revenue recognition practices can still distort sales forecasts. For example, analysts should look for company practices that speed up revenue recognition. An example is sales on a bill-and-hold basis, which involves selling products and delivering them at a later date. This practice accelerates sales into an earlier reporting period and distorts the P/S ratio.

𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠 𝑎𝑟𝑒h

𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑠 𝑎𝑟𝑒h

Market-based Valuation

P/CF multiple

Advantages

• (^) Cash flow is harder for managers to manipulate than earnings.
• (^) Price to cash flow is more stable than price to earnings.
• Reliance on cash flow rather than earnings handles the problem of differences in the quality of reported earnings, which is a problem for P/E.
• (^) Empirical evidence indicates that differences in price to cash flow are significantly related to differences in long-run average stock returns.

Disadvantages

• (^) Items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimate is used. For example, noncash revenue and net changes in working capital are ignored.
• (^) From a theoretical perspective, free cash flow to equity (FCFE) is preferable to operating cash flow. However, FCFE is more volatile than operating cash flow, so it is not necessarily more informative.

𝑓𝑟𝑒𝑒 𝑐𝑎𝑠h 𝑓𝑙𝑜𝑤

𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠 𝑎𝑟𝑒h

𝐹𝐶𝐹 𝑝𝑒𝑟 𝑠 𝑎𝑟𝑒h

Market-based Valuation

Core vs normalized earnings

• Calculating the P/E ratio is easy, and estimating

the market price is usually straightforward.

• However, estimating the appropriate earnings

measure is crucial to successfully using the P/E

ratio in market-based valuation. The key focus of

an analyst is estimating underlying earnings

(a.k.a. persistent, continuing, or core earnings),

which are earnings that exclude nonrecurring

components, such as gains and losses from asset

sales, asset write-downs, provisions for future

losses, and changes in accounting estimates.

• For comparative purposes, analysts generally use

diluted EPS, so that the effect of any dilutive

securities is taken into account.

• (^) Analysts adjust P/Es for cyclicality by estimating

normalized (or normal) earnings per share ,

which is an estimate of EPS in the middle of the

business cycle. The following two methods are

used to normalize earnings:

• (^) Under the method of historical average EPS , the normalized EPS is estimated as the average EPS over some recent period, usually the most recent business cycle.
• (^) Under the method of average return on equity , normalized EPS is estimated as the average return on equity (ROE) multiplied by the current book value per share (BVPS). Once again, average ROE is often measured over the most recent business cycle. The reliance on BVPS reflects the effect of firm size changes more accurately than does the method of historical average EPS.

Market-based Valuation

Justified P/E multiple