lOMoARcPSD|7158806

Chapter 2 Financial Modeling

CHAPTER 2
2.1. CORPORATE VALUATION OVERVIEW

What is Corporate Valuation About?

When we discuss the valuation of a company, we may be referring to any of the following:
Enterprise value: Valuing the company’s productive activities.
Equity: Valuing the shares of a company, whether for the purpose of buying or selling a single
share or valuing all of the equity for purposes of a corporate acquisition.
Debt: Valuing the company’s debt. When debt is risky, its value depends on the value of the
company that has issued the debt.
Other: We may want to value other securities related to the company—for example, the firm’s
warrants or options, employee stock options, etc.
2.2. Four Methods to Compute Enterprise Value (EV)
 The accounting approach to EV moves items on the balance sheet
 The efficient markets approach to EV revalues
 The discounted cash flow (DCF) approach values the EV
 Free Cash Flows Based on Consolidated Statement of Cash Flows (CSCF)
The key concept in corporate valuation is enterprise value. The enterprise value (EV) of the firm
is the value of the firm’s core business activities and forms the basis of most corporate valuation
models. We distinguish between four approaches to computing the enterprise value:
The accounting approach to EV moves items on the balance sheet so that all operating items
are on the left-hand side of the balance sheet and all financial items are on the right-hand side.
Although most academics sneer at this approach, it is often a useful starting point for thinking
about the enterprise value.
The efficient markets approach to EV revalues—to the extent possible— items on the
accounting EV balance sheet at market values. An obvious revaluation is to replace the firm’s
book value of equity with the market value of the equity. To the extent that we know the market
value of other firm liabilities— debt, pension obligations, etc.—this market value will also
replace the book values.
The discounted cash flow (DCF) approach values the EV as the present value of the firm’s
future anticipated free cash flows (FCFs) discounted at the weighted average cost of capital

1
(WACC). The FCFs can best be thought of as the cash flows produced by the firm’s productive
assets—its working capital, fixed assets, goodwill, etc.
2.3. Using Accounting Book Values to Value a Company: The Firm’s Accounting
Enterprise Value
While we would rarely use accounting numbers to value a company, the balance sheet of a
company is a useful starting framework for the valuation process. In this section we show how
accounting statements can help us define the concept of enterprise value (EV). As a starting
point, consider the balance sheet for XYZ Corp.:
A B C D E
1 XYZ CORP BALANCE SHEET
2 Assets Liabilities and equity
3 Short-term assets Short-term liabilities
4 Cash 1,000 Accounts payable 1,500
5 Marketable securities 1,500 Taxes payable 200
6 Inventories 1,500 Current portion of long-term debt 1,000
7 Accounts receivable 3,000 Short-term debt 500
8
9 Fixed assets Long-term debt 1,500
10 Land 150 Pension liabilities 800
Plant, property and equipment at
11 Cost 2,500
12 Minus accumulated depreciation -700 Preferred stock 200
13 Net fixed assets Minority interest 100
15 Equity
16 Goodwill 1,000 Stock at par 1,000
17 Accumulated retained earnings 3,500
18 Stock repurchases -350
19 Total assets 9,950 Total liabilities and equity 9,950

We rewrite this balance sheet:

 We separate the operational versus financial items in short-term assets and short-term
liabilities.
 We move the operational current assets to the left side of the balance sheet.
 We move all the debt (short-term debt, current portion of long-term debt, and long-term)
into one debt item.

2
 A B C D E F
XYZ BALANCE SHEET
Operational current liabilities moved to left side
All financial liabilities in one account on right side
1
2 Assets Liabilities and equity
Liquid assets (cash +
3 marketable securities) 2,500 Financial debt
Current portion of
long-
4 term debt 1,000
5 Current assets, operational Short-term debt 500
6 Inventories 1,500 Long-term debt 1,500
7 Accounts receivable 3,000 Total financial debt 3,000
8 Minus, current liabilities, operational
9 Accounts payable -1,500
10 Taxes payable -200 Pension liabilities 800
11 Net working capital 2,800 =SUM(B6:B10)
12 Preferred stock 200
13 Fixed assets 1,950 Minority interest 100
14
15 Goodwill 1,000 Equity 4,150
16
Left-hand side of
rewritten 8,250 Right-hand side of 8,250
=B11+B13+B15+S rewritten balance =E7+E10+SU
balance sheet UM sheet M(
17 (B3:B4) E12:E15)

In the next step we subtract liquid assets (cash and marketable securities) from financial debts, to
get the firm’s net financial debt. When we finish this step, we have all of the firm’s productive
assets on the left side of the balance sheet and all of its financing on the right side. The left-hand
side of the resulting balance sheet is the firm’s enterprise value, defined as the value of the firm’s
operational assets: These are the assets that provide the cash flows for the firm’s actual business
activities:
A B C D E F
1 XYZ ENTERPRISE VALUE BALANCE SHEET
Liabilities and
2 Assets equity
Net working
3 capital 2,800 Total financial debt 3,000
4 Minus liquid assets -2,500
5 Fixed assets 1,950 Net debt 500

3
 6
7 Goodwill 1,000 Pension liabilities 800
8
9 Preferred stock 200
10 Minority interest 100
11
12 Equity 4,150
13
14 Enterprise value 5,750=B3+B5+B7 Enterprise value 5,750=E5+E7+SUM(E9:E12)
Caterpillar Corporation Example
To show the rewriting of the balance sheet in practice, here is the 31 December 2011 balance
sheet for Caterpillar Corp. (CAT):
CATERPILLAR CORP., BALANCE SHEET
31 December 2011

Current assets Current liabilities

Cash and cash equivalents 3,057,000 Accounts payable 16,946,000
Short-term investments Short-term debt 9,648,000
Net receivables 19,533,000 Other current liabilities 1,967,000
Inventory 14,544,000 Total current liabilities 28,561,000
Other current assets 994,000
Total current assets 38,128,000 Long-term debt 24,944,000
Other liabilities 14,539,000
Long-term investments 13,211,000
Property, plant, and equipment
(net) 14,395,000 Minority interest 46,000
Goodwill 7,080,000 Total liabilities 68,090,000
Intangible assets 4,368,000
Other assets 2,107,000 Stocks, options, warrants 473,000
Deferred long-term asset charges 2,157,000 Common stock 4,273,000
Retained earnings 25,219,000
Treasury stock -10,281,000
Other stockholder equity -6,328,000
Total equity 13,356,000
Total assets 81,446,000 Total equity and liabilities 81,446,000

4
To get to the enterprise value balance sheet for Caterpillar, we move financial items from the left
side of the balance sheet to the right, and we move operating current liabilities from the right side
of the balance sheet to the left. Notice that we netted out liquid assets (cash and marketable
securities) from the financial debts of the company. The assumption is that these assets are not
needed for the core business activities of Caterpillar. The book value of Caterpillar’s enterprise
value is $59,476,000:

A B C D E F
CATERPILLAR CORP., 2011 ENTERPRISE VALUE BALANCE SHEET
1 Book values
Net working capital 16,158,000 Net financial debt 31,535,000
=19533000+1454 =9648000+24944000-
4000+994000- 3057000
16946000-
2 1967000
3 Long-term investments 13,211,000 Other liabilities 14,539,000
Property, plant, and
4 equipment 14,395,000
5 Goodwill 7,080,000 Minority interest 46,000
6 Intangible assets 4,368,000
7 Other assets 2,107,000 Equity 13,356,000
Deferred long-term
8 asset charges 2,157,000
9 Enterprise value 59,476,000 =SUM(B2:B8) Enterprise value 59,476,000 =SUM(E2:E7)

2.4. The Efficient Markets Approach to Corporate Valuation

The Caterpillar example above assumes that the book value is a correct valuation of the
company. But a simple calculation shows how problematic this is: At the end of 2011 Caterpillar
had 624.72 million shares outstanding, and the market price per share was $90.60. This suggests
that the Caterpillar’s enterprise value is $102.720 billion—a far cry from the book value of the
enterprise value of $59.476 billion.
A B C
CATERPILLAR VALUATION OF EQUITY AND FINANCIAL LIABILITIES:

EFFICIENT MARKETS APPROACH

Most figures in thousand $
1
2 Number of shares outstanding 624,722.72 thousand shares
3 Price per share 90.60 30dec2011
4 Equity value ("Market Cap") 56,599,878 =B2*B3, thousand $
5
6 Cash and cash equivalents 3,057,000
7 Short-term debt and current portion of long-term debt 9,648,000

5
 8 Long-term debt 24,944,000
9 Net debt 31,535,000 =SUM(B7:B8)-B6
10
11 Other liabilities 14,539,000
12
13 Minority interest 46,000
14 Preferred stock 0
15
Enterprise value: Equity + Net debt+ Minority Interest +
Preferred
102,719,878 =SUM(B4,B9,B11,B13)

The efficient markets approach to the valuation of Caterpillar’s equity and financial liabilities
assumes that the market value of a company’s shares or debt is simply the market value at the
time of valuation.

Applying the efficient markets approach to the Caterpillar Enterprise Value Balance sheet
gives 102,719,878 for the right-hand side of the enterprise value balance sheet. This means,
of course, that we have to revalue the left-hand side of the balance sheet. One approach to
bringing this enterprise value balance sheet into balance is to assume that the networking
capital’s book value is a reasonable approximation to its market value. We can then
recompute the market value of the firm’s long-term assets to bring the balance sheet into
balance.
A B C D E F

CATERPILLAR CORP., 2011 ENTERPRISE VALUE BALANCE SHEET

Right-hand side revalued at market values
Left-hand side brought into balance with right-hand side by adjusting long-term assets
1
Net working capital 16,158,000 Net financial debt 31,535,000
=19533000+1454 =9648000+24944000-
4000+994000- 3057000
16946000-
2 1967000
3 Long-term investments Other liabilities 14,539,000
Property, plant, and
4 equipment
5 Goodwill Minority interest 46,000
86,561,878 =E10-B2
6 Intangible assets
7 Other assets Equity 56,599,878 Market cap
Deferred long-term
8 asset charges
9
10 Enterprise value 102,719,878=SUM(B2:B8) Enterprise value 102,719,878 =SUM(E2:E7)

6
11
12
13
14

We have to be careful: Market prices change over time, often precipitously. The efficient
markets hypothesis only says that it is impossible to predict market prices beyond the
information compounded into current market information. Note that we could also apply the
market valuation to other components of the right-hand side of the balance sheet we could try to
revalue the firm’s financial obligations, its other liabilities, and minority interest. This is usually
not done, unless there is a convincing case that the book values for these liabilities differ
materially from their market value.
2.5. Enterprise Value (EV) as the Present Value of the Free Cash Flows: DCF “Top
Down” Valuation
In the previous section we valued the EV by using the market value of the right-hand side of the
firm’s enterprise value balance sheet—using the market value of its equity and perhaps the
market valuation of other elements of the firm’s financing. In this section we concentrate on the
left-hand side of the enterprise value balance sheet. The discounted cash flow (DCF) method
focuses on two central concepts:
The firm’s free cash flows (FCFs) are defined as the cash created by the firm’s operating
activities.
The firm’s weighted average cost of capital (WACC) is the risk-adjusted discount rate
appropriate to the risk of the FCFs.
The firm’s enterprise value (EV) is the present value of the future FCFs discounted at the

WACC: EV=
FCFt
 (1  WACC
. The idea is to value a company by considering the present value
)
of the FCFs, where FCF is defined as the cash flow to the firm from its assets (the word assets is
used broadly, and can be fixed assets, intellectual and trademark assets, and net working capital).
The next subsection discusses this concept in more detail.
In these chapters we often make two additional assumptions: We assume a limited number of
predictive periods for the FCFs and we assume that cash flows occur throughout the year. This
leads to
7
EV=
FCFt Ter min alValue
 (1  WACC )t0.5 + (1  WACC) N0.5

FCFt Ter min alValue

= 0.5
(1  WACC )t0.5 + (1  WACC) N
(1+WACC)

Terminal value (TV) is the value of an asset, business, or project beyond the forecasted period
when future cash flows can be estimated.
The assumption that, for valuation purposes, cash flows occur approximately in mid-year is
meant to capture the fact that most corporate cash flows occur throughout the year and that it is
therefore a mistake to value them as if they occur at year-end. As can be seen from the above
formula, the mid-year assumption is easy to compute in Excel: We simply take the Excel NPV
and multiply it by (1 + WACC) 0.5.
2.6. Free Cash Flows Based on Consolidated Statement of Cash Flows (CSCF)
The consolidated statement of cash flows is part of every financial statement. It is the
accountant’s explanation of how much cash was generated by the business, and how this cash
was generated. The consolidated statement of cash flows (CSCF) is composed of three sections:
Operating cash flows, investment cash flows, and financing cash flows.
CSCF, Section 1: Operating Cash Flows
The operating cash flows adjust the firm’s net income for non-cash deductions to the income and
for changes in the firm’s operating net working capital. Because modern accounting statements
include many non-cash items, translating the firm’s accounts to a cash basis necessitates many
adjustments. A classic adjustment is to add back depreciation to the firm’s income: Since
depreciation is a non-cash charge on the firm’s income, it must be added back when making the
adjustment for cash. But depreciation is just the tip of the non-cash iceberg:
When firms issue stock options to employees, the value of these options is deducted from the
firm’s income. The logic behind this that in giving its employees options, the firm has given
them something of value which must be accounted for in its income statement is impeccable. But
the actual charge for options is a non-cash deduction, and in the consolidated statement of cash
flows, it is added back. A firm’s income statements must reflect the decrease in goodwill (so-
called “impairment”). This impairment the loss in economic value of an intangible asset that was
purchased by the firm is an economic loss to the firm’s share-holders. But it is not a cash flow
loss, and in the consolidated statement of cash flows it is added back.

8
For purposes of computing the firm’s free cash flows, we can usually leave all the items in the
operating cash flow section of the CSCF.
SCF, Section 2: Investment Cash Flows
The second section of the CSCF includes all investments made by the firm. These investments
include both investments in securities and investments in operating assets of the firm. Investment
in securities can refer to the sale or the purchase of securities held by the firm. Investment in
securities is not part of the firm’s free cash flows, which are intended to measure solely cash
flows related to the firm’s core business activities. Investments in fixed assets are usually related
to the firm’s FCFs. For purposes of computing the firm’s free cash flows, we need to distinguish
between financial investment cash flows (not part of the FCF) and investment in assets used to
produce the firm’s business income (part of the FCF).
CSCF, Section 3: Financing Cash Flows
The last section of the CSCF deals with changes in the firm’s financing. For FCF purposes, we
can ignore this section.