- September 13, 2020
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
Common Valuation Frameworks
An enterprise’s value derives from its capability to earn a healthy return on invested capital (ROIC) and its capacity to grow. Healthy rates of return and growth generate future cash flows, the ultimate source of value. When i perform valuations, i concentrate on two approaches: enterprise discounted cash flow (DCF) and discounted Economic Profit. DCF relies on cash flow in and out of the company, rather than on accounting-based earnings. The discounted economic-profit valuation model can be very relevant due to its close link to business theory and competitive strategy. Economic Profit highlights whether a business is earning more than its WACC and quantifies the value generated each year. This post will provide my insights on the most common valuation frameworks applied to value an enterprise.
The enterprise DCF and economic-profit models operate on the weighted average cost of capital (WACC) model. WACC-based models operate best when a firm controls a moderately stable debt-to-value ratio. If a firm’s debt-to-value ratio changes, DCF models can still return accurate results but are challenging to execute flawlessly.
Common Valuation Frameworks –Discounted Cash Flow Model
The DCF model discounts free cash flow (FCF), indicating the cash flow accessible to all investors—equity holders, debt holders, and any other investors—at the WACC. The company’s debt and other non-equity claims on cash flow are deducted from enterprise value to define equity value. Equity valuation models, in opposition, value the equity holders’ cash flows directly.
Valuing a company’s equity applying enterprise DCF is a four-step process:
- Value the enterprise’s operations by discounting free cash flow at the WACC.
- Identify and value non-operating assets not added in the free cash flow. The non-operating assets cover excess cash and marketable securities, nonconsolidated subsidiaries, and other non-operating assets. When we sum the value of operations and non-operating assets, we derive the enterprise value.
- Recognize and value all the debt and other non-equity claims against the enterprise value. Debt and other non-equity claims include fixed-rate and floating-rate debt, debt equivalents such as unfunded pension liabilities and restructuring provisions, employee options, and preferred stock.
- Deduct the value of debt and other non-equity claims from enterprise value to define equity value. To calculate a value per share, divide the equity value by the number of current shares outstanding.
The value of operations equals the discounted value of future free cash flow. Free cash flow equals the cash flow produced by the company’s operations, less any reinvestment back into the business. Free cash flow is the cash flow accessible to all investors—equity holders, debt holders, and any additional investors—so it is free of how the company gets financed. Thus, FCF must get discounted using the WACC because the WACC represents return rates required by its debt and equity holders. It is the firm’s opportunity cost of capital.
Reorganizing the Financial Statements
Although ROIC and FCF are fundamental to the valuation process, the two dimensions cannot be measured easily from a company’s financial statements, which blend operating performance and capital structure. Hence, to estimate ROIC and FCF, first reorganize the accounting financial statements into new statements that separate operating items, non-operating items.
This reorganization drives two new terms: invested capital and net operating profit after taxes (NOPAT). Invested capital depicts the investor capital needed to fund operations without specifying how the capital gets financed. NOPAT describes the total after-tax operating income generated by its invested capital, accessible to all investors.
To evaluate NOPAT, subtract only operating costs and depreciation from revenue. Do not subtract interest expense or add non-operating income; they will be scrutinized and valued separately as a non-operating asset and debt section. Operating taxes are estimated on operating profit and denote the level of taxes paid if the firm were financed solely by equity and kept only operating assets. A proper valuation will adjust net income to NOPAT. The reconciliation will limit unintentional omissions and force distinct alternatives about how each data item will get incorporated into the valuation.
Invested capital comprises working capital, property, plant, equipment, and other operating assets, net of other operating liabilities. Measure invested capital, both adding and omitting goodwill and acquired intangibles. By separating invested capital with and without goodwill, we can evaluate acquisitions’ influence on prior performance. A company with healthy margins and lean operations can have low ROIC with goodwill because of the high prices it paid for acquisitions. To determine ROIC, divide NOPAT by the prior-year invested capital.
Analyzing Historical Performance
Once the firm’s financial statements get reorganized into NOPAT and invested capital, examine its historical financial performance. By thoroughly analyzing the past, we can surmise whether the business has generated value, how quickly it has grown, and how it relates to its competitors. A meticulous analysis will concentrate on the critical drivers of value: ROIC, revenue growth, and FCF. Knowing how these drivers performed in the past will help you make more stable future cash flow assessments.
Forecasting Revenue Growth, ROIC, and FCF
Based on insights from the past analysis and projections of financial and industry trends, build a set of integrated financial statements in the future. The three statements – Balance Sheet, Income Statement, and Cash Flow should get combined so that net income flows into the statement of equity, which should balance the corresponding account in the balance sheet. Employ excess cash, debt, dividends, or a combination to assure that the balance sheet balances.
When developing the forecast model, use discretion on how much detail to project at different points. Over the short-term (the initial few years), outline each financial-statement line item, such as gross margin, selling expenses, accounts receivable, and inventory. It will let you organize apparent trends in individual line items. For additional years, individual line items become challenging to project, and a high level of detail can veil the crucial value drivers. Hence, over the medium horizon (5 to 15 years), the company’s key value drivers, such as operating margin, the operating tax rate, and capital efficiency, should be focused. At some point, predicting even crucial drivers on a year-by-year basis becomes ineffective. To value cash flows past this period, apply a continuing-value formula, usually called the terminal value. Picking an appropriate point of transition depends on the firm and how it is evolving. A company experiencing meaningful change may need a long, detailed window, whereas a stable, mature company may need very little detail in the forecasts. Subsequent, utilize the reorganized financial statements to compute free cash flow.
Common Valuation Frameworks – Evaluating Terminal Value
At the period where predicting the specific key-value drivers on a year-by-year basis becomes ineffective, do not alter the individual drivers over time. Alternatively, use a perpetuity-based continuing value, such that:
Value of Operations = PV of FCF during the explicit forecast duration + PV of FCF after the explicit forecast period.
Discounting Free Cash Flow at the WACC
In an enterprise valuation, free cash flows are available to all investors. Consequently, the discount factor for FCF must represent the risk faced by all investors. The WACC blends the return rates required by debt holders and equity holders. For a company financed solely with debt and equity, the WACC is:
WACC = D/(D+E)Kd (1-Tm) + E/(D+E)Ke
Where debt (D) and equity (E) are measured using market values, note how the cost of debt gets reduced by the marginal tax rate (Tm). The rationale for doing this is that the tax shield attributable to interest gets excluded from FCF. Since the interest tax shield (ITS) has value to the shareholder, it must get incorporated in the valuation. Enterprise DCF values the tax shield by reducing the weighted average cost of capital.
Why push interest tax shields from FCF to the cost of capital? By estimating free cash flow as if the firm was financed entirely with equity, one can distinguish operating performance across companies and over time without considering capital structure. By concentrating only on operations, it is feasible to uncover a more distinct picture of historical performance, leading to more reliable performance measurement and forecasting.
Common Valuation Frameworks – Identifying and Valuing Non-operating Assets
Many companies own assets with value but whose cash flows are not covered in operating Profit. Thus, the cash generated by these assets is not part of free cash flow and must be valued independently. The non-operating assets constitute excess cash, tradable securities, and customer-financing business units.
Identifying and Valuing Debt and Other Non-equity Claims
To change enterprise value into equity value, deduct debt and other non-equity claims, such as unfunded retirement liabilities, capitalized operating leases, and outstanding employee options. Equity is a residual claimant, earning cash flows only after the firm has satisfied its other contractual claims. A thorough analysis of all potential claims against cash flows is consequently crucial.
If possible, debt can use all outstanding debt’s market value, including fixed- and floating-rate debt. If that data is unavailable, the book value of debt is a fair proxy. Unless the likelihood of default is high or interest rates have shifted dramatically since the debt was originally issued. Any valuation of debt, nevertheless, should be logical with your estimates of enterprise value.
Leases – Rather than purchase assets, numerous firms lease specific assets for a fixed period. Any lease payments listed as interest expense and not rental expenses must be valued independently and subtracted from enterprise value.
Common Valuation Frameworks – Economic Profit-Based Valuation Models
However, one shortfall of DCF is that every year’s cash flow provides limited insight into its competitive position and economic performance. Declining free cash flow can indicate either inadequate performance or investment for the future. The economic-profit model highlights how and when the firm generates value, yet adequately implemented; it leads to an identical enterprise DCF.
Economic Profit = Invested Capital (ROIC – WACC)