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Topic 3 FM Presentation1 Lidia's

The document discusses cash-based valuation methods, specifically the free cash flow valuation method. It provides details on: 1) Calculating free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) by outlining the key formulas and accounting adjustments. 2) Forecasting growth in free cash flows using historical estimates, analyst forecasts, and Gordon's growth model. 3) Directly calculating the value of equity by discounting estimated future FCFE at the cost of equity using the Gordon growth model. 4) Explaining the dividend valuation model for valuing a company based on the present value of expected future dividends discounted at the required rate of return.

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Lidia Samuel
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44 views19 pages

Topic 3 FM Presentation1 Lidia's

The document discusses cash-based valuation methods, specifically the free cash flow valuation method. It provides details on: 1) Calculating free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) by outlining the key formulas and accounting adjustments. 2) Forecasting growth in free cash flows using historical estimates, analyst forecasts, and Gordon's growth model. 3) Directly calculating the value of equity by discounting estimated future FCFE at the cost of equity using the Gordon growth model. 4) Explaining the dividend valuation model for valuing a company based on the present value of expected future dividends discounted at the required rate of return.

Uploaded by

Lidia Samuel
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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2.

CASH BASED VALUATION METHODS


Assumption:
• The value of the company should be equal to the discounted value of future
cash flows.
Cash-flow based approaches
• The FCF methods are the most theoretically attractive because they can be
adapted to reflect the impact of the acquisition on business and financial risk.
The Free Cash Flow Method can be used :
To determine the price in a merger or acquisition
To identify a share price for the sale of a block of shares
To calculate the ‘shareholder value added’(SVA) by management from one
period to another.

• Technically, to accurately determine the value of the business, FCF for all future years
should be estimated. However, instead of attempting to predict the free cash flows of a
company for every year, in practice a short cut method is applied. Future cash flows are
divided into two periods;
 Those that occur during the planning horizon and
 Those that occur after the planning horizon/Terminal Value 1
N.B. Planning Horizon is
the period where;

i. The firm can earn


above average
returns
ii. Cash flows are
assumed to grow
overtime
2
The Free Cash Flow Valuation Methods
Free Cash Flow valuation views the intrinsic value of a company
as the present value of its expected future cash flows.
• Two methods to value a company using Free Cash Flow
method are by valuing
i. Free Cash Flow to the Firm (FCFF) and
ii. Free Cash Flow to Equity (FCFE)

i. Free Cash Flow to the Firm (FCFF):


• FCFF (Free cash flow to firm), also known as unlevered cash
flow, is the cash flow that is available to all funding
providers including debt holders and share holders.
• Is the amount before deducting Interest and Debt
repayment. 3
Usage of FCFF
 To assess the cash generating abilities of the firm (liquidity &
profitability)
 Discounted by WACC (cost of debt plus cost of equity) to find the
valuation of the whole firm.
 To find the valuation of equity (Value of the whole Firm-Value of
Debt)

ii. Free Cash Flow to Equity (FCFE):


• FCFE (Free cash flow to Equity), also known as levered free cash flow,
is the total amount of cash available only to the company’s equity
shareholders,
• It is labelled levered cash flow as it factors in the effects of
debt/leverage in its calculations.
• Is the amount the company has after all the investments, debts, and
interests are paid off. 4
Usage of FCFE
 To assess the value accruing to shareholders only.

 May give additional insights for heavily leveraged


firms.
 Discounted by Cost of Equity to find the valuation
of the equity of firm.
 Useful in an M & A, where the acquirer values the
equity that it wishes to buy out.
5
• 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:
∞
Firm value =∑ FCFFt
t=1 (1+WACC)t
∞

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


value of the firm’s debt:

Equity value = Firm value – Market value of


Debt
6
2.1 Calculate value of firm using PV of free cash
flows

7
2.2 Calculating Free Cash Flow using accounting
Method
i. Free Cash Flow to the Firm (FCFF):
• FCFF (Free cash flow to firm), is the cash flow from
the operations of the company after subtracting
working capital, depreciation, taxes and other
investment costs from the revenue and it represents
the amount of cash flow that is available to all the
funding holders – be it debt holders, stock holders,
preferred stock holders or bond holders. 8
i. Free Cash Flow to the Firm (Cont’d)
Calculating the level of Free Cash Flows to the Firm:

Free Cash Flow = Earnings before Interest and Taxes (EBIT)


Less taxation on EBIT
Add non cash charges (e.g. depreciation)
Less capital expenditure
Less net working capital increases
Plus net working capital decreases

☟ Formula to Remember
FCFF = EBIT (1-tax rate) + Depreciation- Capital Exp -
Change in Working Capital
9
ii. Free Cash Flow to Equity (FCFE):
• The free cash flow to equity determines the dividend
capacity of a firm i.e. the amount the firm can afford to
pay out as a dividend. Although FCFE may calculate the
amount available to shareholders, it does not necessarily
equate to the amount paid out to shareholders.

• The free cash flow to equity only can be calculated by


taking the FCFF and:
 deducting debt interest paid
 deducting any debt repayments
 adding any cash raised from debt issues.

10
Calculating FCFE
☟Formula to Remember
FCFE = FCFF – [ Interest x (1-tax)] + Net
Borrowings

Or
FCFE = EBIT – Interest – Taxes + Depreciation &
Amortization + Changes in WC + Capex + Net
Borrowings

11
12
13
Forecasting growth in free cash flows
• To forecast the likely growth rate for the free cash flows, the following three
methods can be used:

i. Historical Estimates

ii. Analyst Forecasts- forecasts of market analysts

iii. Fundamental Analysis- The formula for Gordon's growth approximation


can be used to calculate the likely future growth rate. The formula is based on
the assumption that growth will be driven by the reinvestment of earnings.

g=r×b
where r =company's return on equity (cost of equity)
b =earnings retention rate

14
Direct method of calculating FCFE
• The value of equity can be found directly by discounting free
cash flow TO EQUITY at the cost of equity.
• If FCFE is assumed to be growing at a constant rate every year
into perpetuity, the following formula aka Gordon model can
be applied

Ve = FCFE0 (1 + g)
(ke – g)
• Where ke = cost of capital
g= growth rate in earnings and dividends
ÞThis formula is based on the dividend valuation model
theory.
ÞFCFE is sometimes called dividend capacity. This
reinforces the conceptual link between the dividend
valuation model and the approach being used here. 15
2.3 Dividend Valuation Model
• Theory: The value of the share is the present value of the
expected future dividends discounted at the shareholders’
required rate of return.

P0 = Do (1+ g)
re - g

• Where D0 = dividend paid now


re = cost of equity of the target
g = growth rate in dividends
Notes
1. If D0 is given as dividend per share, then P0 will refer to the
value of the share.
2. If D0 is given as total dividend, then P0 will refer to the total
value of the company. 16
DVM (Cont’d)
• Advantages:
 Based on expected future income
 Useful for valuing a minority stake in an organisation

• Disadvantages:
 Growth rate can be difficult to estimate
 It can be difficult to estimate a cost of equity for an
unlisted company
 Companies that don’t pay and are not expected to pay
dividends do not have a zero value

17
Illustration of Dividend Valuation Method (DVM)
Target paid a dividend of $250,000 this year. The current
return to shareholders of companies in the same industry
as Target is 12%, although it is expected that an additional
risk premium of 2% will be applicable to Target, being a
smaller and unquoted company. Compute the expected
valuation of Target if:
(a) The current level of dividend is expected to continue
into the foreseeable future; or
(b) (b) The dividend is expected to grow at a rate of 4%
p.a. into the foreseeable future.

18
Illustration of Dividend Valuation Method (DVM)

19

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