Unit 4

CHAPTER 8

Discounted Cash Flow Analysis

As discussed in Chapter 7, in order to properly value a business based on cash flows, we need to first establish the appropriate cash flows to value—the unlevered free cash flow (UFCF). Once we have properly calculated UFCF we can project and discount the cash flows to present value (PV). We then estimate a terminal value, which is a representation of the value of the business after the last projected year. The sum of the present values of each cash flow is added to the PV of the terminal value to give us the total value of the business.

MID-YEAR VS. END-OF-YEAR CONVENTION

The formula to calculate PV is UFCF × (1 + DiscountRate)period. When discounting cash flows in valuation, there are two methods to determine the period: the mid-year convention and the end-of-year convention.

The end-of-year convention assumes each cash flow is discounted at a full year. Year 1 is discounted by one full year, Year 2 by two full years, and so on.

The mid-year-convention discounts each cash flow by half a year. Year 1 is discounted by half a year (0.5), Year 2 by 1.5 years, and so on. The concept here is we don’t know exactly when these cash flows come in. Technically, if the end-of-year convention is used where we discount the cash flows by one year in full, we are assuming the cash flow has come in one lump sum at the end of the year. The mid-year convention slightly adjusts for this by discounting half a year.

UNLEVERED FREE CASH FLOW

Unlevered Free Cash Flow (UFCF) is cash that is available to all capital providers including equity holders and lenders. In other words, it is a measure of cash flow before equity holders and lenders have been paid. Further, as valuation is a measure of a company’s core operating assets of a business, UFCF should represent the cash generated or lost based on the core operations of the business. To clarify, let’s take a look at Walmart’s complete cash flow statement. (See  Table 8.1 .)

To get to an unlevered cash flow amount, we want to remove all cash flows related to the capital structure. So we eliminate dividend payouts, non-controlling interests, share issuances, share buybacks, debt raises, and debt paydowns; the entire financing activities section is removed.

Further, we want a measure of cash that approaches everyday activity, so non-recurring and extraordinary items such as acquisitions and divestitures will be removed. In the investing activities section, we are left with capital expenditures. (See  Table 8.2 .)

Simplifying the leftover cash flows give us:

Unlevered Free Cash Flow

Net income

+ Depreciation & amortization

+ Deferred taxes

+ Other non-cash items

+ Working capital changes

− Capital expenditures

Finally, since we are trying to capture a complete measure of cash before lenders have been paid, we also need to adjust the net income for interest expense. So we need to add one more line item: after-tax net interest expense.

Unlevered Free Cash Flow

Net income

+ Depreciation & amortization

+ Deferred taxes

+ Other non-cash items

+ Working capital changes

− Capital expenditures

+ A/T Net interest expense

= Total unlevered free cash flow

TABLE 8.1  Consolidated Statements of Cash Flows

TABLE 8.2  Consolidated Statements of Cash Flows

There’s often a lot of confusion as to whether these line items should be added or subtracted. The best rule of thumb is to follow how the cash flow statement is making these adjustments. We are trying to replicate a form of cash flow, so if the cash flow statement is adding the item, we should also add it; if the cash flow statement is subtracting the item, we should subtract. According to a standard cash flow statement, the flow should be:

Yes, it is plus working capital, because the cash flow statement adds working capital to the net income to get to cash from operations. We get confusion here a lot because many textbooks suggest subtracting working capital. They are actually referring to subtracting the balance sheet working capital changes. In other words, if accounts receivable increased from $0 to $1, 000, or if the change is $1, 000, then we know the cash flow change is −$1, 000, because an increase in an asset reflects a cash outflow. However, if we take the actual working capital number directly from the cash flow statement, which is already represented as a negative (−$1, 000), we just add it.

It is crucial to note that there can be other items in the investing activities other than CAPEX that could arguably be attributable to everyday operations. Although it’s not explicitly defined in the UFCF formula, the point of the entire analysis is to get to a number that reflects the cash we expect to be generated from the future operations of the business. Further, in the operating activities, there may be other adjustments that are not categorized within the standard UFCF definition. It is important to step back and think about how these line items are affecting net income to decide if they should also be adjusted in the UFCF. In other words, if these line items are actually non-cash items that need to be adjusted to net income in order to get to a closer measure of cash from net income, then they should be included in the analysis. However, if these are truly non-recurring events, and if we have already pulled them out of net income on the income statement, adjusting them here may not be correct. This is one example of how important it is to fully understand where UFCF is coming from and why it is being used as opposed to just taking and using the formula as printed.

Now, the previous definition is not the most standard definition of UFCF. Typically, we use EBIT as a starting point, not net income. It is easier to project an income statement from revenue down to EBIT only, rather than all the way down to net income, especially since we are adding back so many items anyway. However, either way will get you the same results. So if we had EBIT as a starting point, we still have to make the same core adjustments:

Note here we have to double-check once again which line items we are (or are not) including as other non-cash items, and for different reasons: If the particular non-cash item was a net income adjustment for a line item that was below the EBIT line, which we didn’t even include anyway, adjusting it here would be incorrect.

We still have to make one more adjustment: taxes. We do not need to adjust for interest expense as EBIT is already before interest expense. But, EBIT is also before taxes. So in order to adjust for taxes we need to take EBIT × Tax%. It is important to note we do not take the exact number of taxes from the income statement as that number includes the effects of interest.

It is important to note here the importance of understanding the derivation of UFCF. In this ever-changing market environment with new and evolving business models, the standard “textbook” definition of UFCF may need to be adjusted to be a true measure of value for a particular entity. Understanding the purpose of UFCF as a measure of value will help one to create his or her own adjustments to get to the true value of an entity.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Note: We will knowingly take an over-simplistic view of WACC in this book. Again, there are many great books out there that focus solely on this topic, and although important to valuation, the purpose of this book is not to focus solely on WACC but to understand it just enough to use it as a tool for analysis.

Now that we have UFCF, we need to discount the flows to PV. The rate at which we discount them is determined by how much an investor expects to be returned for his or her particular investment. For a company with both debt and equity in its capital structure, we would calculate a weighted average of the returns the equity investors would expect and the returns the lenders would expect weighted by the amount of equity versus debt in the business.

For example, if our company had both equity investors and debt lenders, and if the equity investors expect a 25 percent rate of return and the debt lenders expect a 10 percent rate of return, our WACC would be a weighted average of the equity investors’ and lenders’ required rate of returns to the actual amount of debt and equity invested in the business. So if the business contains $100 of equity and $200 of debt, the equity investors expect a $25 ($100 × 25%) annual return, and the lenders expect a $20 ($200 × 10%) annual return, or, we would need to return $45 ($25+ $20) each year. This represents a combined 15 percent ($45 / $300) expected rate of return. We have ignored tax here for simplicity.

This is the weighted average cost of capital. More specifically, the formula is:

Note that we apply (1 − Tax%) to the cost of debt as those interest payments are tax deductible.

We can apply this to the previous example:

Note that we assumed 0% taxes in this simple example.

This gives us 15 percent.

Although this is the fundamental definition of WACC, true WACC would take into account all types of debts and equity a company may have in the following way. Let’s say a company has long-term debt, mezzanine debt, common equity, and preferred capital. And, let’s call total capital the sum of the long-term debt, mezzanine debt, common equity, and preferred capital. So, the WACC would be:

We assume here the interest payments on the long-term and mezzanine debts are tax deductible, and we also assume there are no tax-deductible payments made on the preferred securities.

WACC should be a current value based on market trends, so it is appropriate to take the market value of equity, and the market value of debts and interests (when available) to calculate the most current WACC.

Cost of Debt

The cost of debt is the expected return to the debt lenders, or the interest rate. It is important to use the most current interest rates if available.

Cost of Equity

The cost of equity is the expected return to the equity investors. To estimate the cost of equity, we must determine the expected rate of return of a company. Since the expected rate of return is not directly obtainable, especially for a public company, we must rely on an asset-pricing model. Asset-pricing models base expected return on the risk of an entity. There are several different asset-pricing models; each differs in the way risk is defined and interpreted into an appropriate return. The most common used in investment banking is the Capital Asset Pricing Model (CAPM).

The general idea of the CAPM is based on the graph in  Figure 8.1 .

Here the  x-axis represents the risk and the  y-axis represents return. This graph can represent any investment within the universe of investments from playing poker to investing in the S&P 500. In such an environment, given that it is a rational environment, where we assume all investors are making rational investment decisions, we assume there is always some investment with zero risk. This investment could have a 0 percent return or a negative return, but we assume if that was the case, no investors would be interested. So, we assume there exists some riskless investment with some minimal return. We understand that many investments do not work out, but we are making assumptions in an environment of expected returns. In the U.S. markets, we can take the U.S. Treasury bonds as an example of an arguably riskless investment at a 2.93 percent return as of October 9, 2012. CAPM states if such an investment exists, no rational investor would make an investment that would bring about the same return but would contain risk. (See  Figure 8.2. )

FIGURE 8.1  Capital Asset Pricing Model

Why would we take additional risk for the exact same return when we can get that return with zero risk? CAPM goes further to state that an investor would accept greater risk in a particular investment if there is an equivalent potential to receive a greater rate of return. (See  Figure 8.3. )

FIGURE 8.2  Capital Asset Pricing Model: Risk-Free Rate

We would never invest in the shaded area, which is less return for additional risk.

FIGURE 8.3  Capital Asset Pricing Model: Risky Investment

This can go on with an investment of even greater risk. A rational investor would only consider an investment of greater risk than the previous investment if there is an equivalently greater return. This would continue out to the line in  Figure 8.4 , below where all rational investments should center around.

It is important to note that although there are investments that have poor results, there will never be a rational investor making continuous poor-return investments with great risk. For that reason there should not be a majority of investments made below the drawn line.

Further, if there exist investments that produce a higher return, or investments above the line, then all rational investors would eventually gravitate to that investment and would form a new basis of what levels of returns an investor would expect for the associated risk. Therefore, if that was the case, then there would be a new line drawn, a new basis. (See the dotted line in  Figure 8.5 , which would replace the solid line.)

Given the fact that that line would exist if it could exist, and further given the fact that it does not exist, implies that it cannot exist.

FIGURE 8.4  Capital Asset Pricing Model: Average Risk/Return

FIGURE 8.5  Capital Asset Pricing Model: Theoretical New Average Line

This line is expected to be an average, and in reality there are investments that can fall anywhere in the box, but the main idea is that on average they should hover around the line. (See  Figure 8.6 .)

In order to find the cost of equity of our investment, we need to locate the dot representing the expected risk/return of Walmart.

Market Risk Premium

Before locating the risk/return of Walmart, it is important to find the estimated expected return of the entire market. Based on the logic of the previous section, the average return of an index, such as the S&P 500, should be somewhere on the line drawn in  Figure 8.6  as this is an indicator of where one would hope rational investors would gravitate toward, at least in theory. There are several ways to estimate this return. One is by taking the historical average of the index or portfolio over the last 10, 20, 30 years through the last 100 years, and then taking a median of those averages.

FIGURE 8.6  Capital Asset Pricing Model: Average Line with Additional Investments

Ibbotson Associates is an expert consulting firm that provides great data on market risk premiums; however, it is not a free resource. We strongly recommend Mr. Aswath Damodaran’s web site, which can be found at  http://pages.stern.nyu.edu/∼adamodar /.

Another method is based on the dividend model. The dividend model states the expected return is equal to the dividend yield plus the growth in dividends of the stocks that make up a particular index.

For CAPM, we are concerned about the spread between the expected return of the market and the risk-free rate—the premium. This is called the market risk premium. Ibbotson also has research on the spread between the historical returns of the market and the historical risk-free rates to calculate the market risk premium. (Note: This valuation section is designed to be light on the theory and cut to the practical methods. For a more thorough and complete theoretical understanding of CAPM, I highly recommend Aswath Damodaran’s books on valuation.)

The market risk premium answers this: How much above the risk-free rate can I expect to return from my investment? Let’s say the expected return of the S&P 500 is shown in  Figure 8.7 .

This implies that the components of the S&P 500 index, the individual stocks that make up the index, should hover somewhere around the S&P 500 index. Although there will be exceptions, there should be a radius from where all investments that make up the index should lie. (See  Figure 8.8 .)

So, if we find a way to pinpoint where Walmart can be within this radius, we can estimate its expected return. This is where Beta helps us.

FIGURE 8.7  Capital Asset Pricing Model: Expected Market Return

FIGURE 8.8  Capital Asset Pricing Model: Expected Return of S&P 500 Companies

BETA

Beta is a correlation coefficient that represents how closely one set of historical returns correlates or moves with another. In other words, if we compare the historical returns of Walmart with the S&P 500, and if Walmart has a Beta of 1, this means that Walmart is perfectly correlated with the S&P 500. Or, if the S&P 500 is expected to return 5 percent, then Walmart will be expected to return 5 percent. If, however, Beta is 0.5, then if the S&P 500 is expected to return 5 percent, Walmart will be expected to return 2.5 percent. Further, if Beta is −1, then if the S&P 500 is expected to return 5 percent, the Walmart will be expected to return −5 percent.

Walmart’s Beta is achieved by comparing the last  x years of its historical returns to the S&P 500, where  x can be 10 years, 30 years, up to 100 years, or more.

The formula for the beta of an asset is

Where  ra measures the rate of return of the asset,  rp measures the rate of return of the index or portfolio, Cov( ra,  rp) is the covariance between the rates of return of the asset and the index, and Var ( rp) is the variance between the rates of return of the index.

There are many resources that have Beta data. Barra ( www.barra.com ) is a research firm known to accurately calculate Betas over many different time periods. Unfortunately this data is not free, but if one has Bloomberg, Thompson, Capital IQ, or a similar data resource, many of them either pull in Barra Betas or calculate their own Betas. Yahoo! Finance is a good free resource that also contains Beta information.

Levering and Unlevering Beta

Since Beta as defined previously is based on market value returns, it is often believed that removing the leverage from such Betas would give a closer estimate of the Beta directly related to the operating assets of the business. This concept of “unlevering” and “levering” the Beta can be achieved by the following formula:

In practice, this can be used for purposes of valuation. In addition to calculating a company’s Beta in relation to the market, or looking up a calculated Beta, one can take an average of the comparable company’s Betas. However, since companies have varying capital structures, one can first “unlever” each Beta, take the average, then re-lever the beta using the target company’s (Walmart’s) capital structure. This can be helpful when trying to assess the Beta of a private company or if the company you are trying to assess has for some reason a very unusual Beta. It may also be useful to try several methods and compare. Also, the concept of utilizing an unlevered Beta can be a useful approximation of the Beta directly related to the operating assets of the business.

So in terms of CAPM, the Beta of a particular stock can help us identify what its expected return can be. So Beta times the market risk premium (MRP) is the effective expected return of our investment. But note the MRP, and effectively the Beta times MRP (Beta × MRP) is just the expected premium above the risk-free rate. So in order to get the estimated total equity return of a particular investment, we need to add back the risk-free rate of return (rf). So:

When calculating this formula for a particular investment, it is crucial to understand the drivers, even at this most basic level, as they may change in different markets or for unique investments. First, timing is an important consideration. One must consider whether to use a 10-year treasury rate for the risk-free rate, or a 30-year rate. One must also consider using 10-year calculated Betas or 30-year calculated Betas. The first rule of thumb is to be consistent. If using a 30-year risk-free rate of return, then one should us 30 year Betas and an MRP based on 30-year average returns. Some investors prefer to calculate shorter-term Betas based on 10-year metrics; we prefer longer-term Betas, as a discounted cash flow (DCF) analysis is a representation of a business far into maturity and perpetuity. But we respect the 10-year argument as well.

It is also important to consider the relative markets. If one is valuing a German company, for example, one would not use the S&P 500 and the U.S. treasury rates as basis, but rather a German index and German risk-free rate of return.

TERMINAL VALUE

Once we have the discount rate, we will use that rate to discount the projected cash flows. This only gives us the value of the company over the first few projected years. What about the value of the company after the last projected year? In other words, if we have built a five-year model, discounting the UFCFs gives us the implied value of the company for just the first five years.

The terminal value of a company estimates the value of the business after the last estimated year. There are two major methods for calculating the terminal value of a company:

· Multiple method

· Perpetuity method

Multiple Method

The multiple method applies a multiple to the final projected year’s financials. Typically, an EBITDA multiple is applied to the company’s final year EBITDA. The value of the company in year 2017, for example, is the value we can sell the company for in 2017. So if we are using a 5× EBITDA multiple, and if the company’s 2017 EBITDA is 100, 000, then we believe we can sell the company for 500, 000. The multiple to use can come from comparable companies, or we can take the company’s current market EBITDA multiple. Taking the company’s current market multiple can be considered a conservative approach (unless the company is extremely overvalued). In other words, if we sell the company in five years for at least what it is worth today (on a multiple basis), and we assume EBITDA is growing, then the total sale value should be higher.

Once we have the terminal value, we then discount that value back to PV.

Perpetuity Method

The perpetuity method is based on a typical perpetuity, which is a steady stream of cash flows with no end. The formula for a perpetuity terminal value is:

where  r is the discount rate (the WACC) and  g should represent the perpetual rate of cash flow growth. “ g” is not easy to estimate. Some people suggest using the GDP growth rate (currently 2−3%) or the rate of inflation (1−2%), but remember this is supposed to represent the growth rate for many years, even if the current environment is sluggish.

Once a terminal value is established, this is also discounted to PV.

It is important to understand the differences between the terminal value of a business based on the multiple and the terminal value based on perpetuity. The perpetuity is based on cash flow and some low growth. The terminal value based on a multiple is driven by the market. It is good practice to run both methods and compare the two. If the multiple method is much higher than the perpetuity, maybe the markets are overvalued, or maybe the cash flow projections are too low (low perpetuity value). Or if the multiple method is much lower than the perpetuity method, maybe our projections are too aggressive, or maybe the markets are undervaluing the business (low multiple). Or, in the best case, both methods produce similar results, which can imply the cash projections are in line with market expectations. These are meant to just be a few of the many ways to interpret the terminal value.

It is interesting to note that in 2008 and 2009, during the recession, we saw many companies whose terminal values utilizing the multiple method were significantly lower than the perpetuity method. This implies the companies’ cash flows were strong, but the market was undervaluing the businesses; potentially a rare and good investment opportunity. Today most of those stocks have increased back to normal levels.

Once we have a terminal value, we would add the terminal value to the sum of the PV of the company’s projected cash flows to get a total enterprise value for the business. Let’s run the analysis for Walmart to get a better picture of the process.

WALMART DCF ANALYSIS

We will build a five-year DCF analysis for Walmart. We could have done a seven-year or 10-year, but we felt anything beyond five years would be too uncertain. This is more a matter of preference than rule. We will utilize the DCF tab in the spreadsheet for this analysis. As per the UFCF formula, we need to first locate Walmart’s projected 2013 EBIT. This can be found on the income statement in Cell G24. So, we can have G7 on the DCF tab be

The rest of the line items in the UFCF analysis should come from the cash flow statement. Remember: The goal is to get an accurate measure of cash produced from the company’s operations. However, we take EBIT as opposed to net income, as EBIT already has interest and potentially some other items adjusted, so in that respect it is a closer measure of cash and a better starting point.

Depreciation and amortization will come from Row 9 in the cash flow statement. Or, G8 will read

Deferred taxes, Row 9 on the DCF tab, will be linked in from Row 10 in the cash flow statement. Or, G9 on the DCF tab equals

“Other” is a tricky “catch-all” row. This reflects any non-cash items that are not standard to the unlevered cash flow formula for which we may need to adjust. (Please refer to the “Unlevered Free Cash Flow” section earlier in this chapter for a more detailed description.) We should look to the cash flow statement for any other possible adjustments to be considered. Row 8 in the cash flow statement, for example, entitled “Loss (income) from discontinued operations to net cash” is projected at “0, ” so whether we adjust for it or not will not make a difference. However, for purposes of instruction, it is important to note that we should not adjust for this. (We should not include this in the DCF “other” line.) This is because we notice the 2012 historical adjustment ($67MM) was an add-back from an adjustment made below the net income line on the income statement (income statement Row 37). Since we are building our DCF analysis from EBIT, before those income statement adjustments are made, it would not make sense to add back that line item in the cash flow statement. Or, in other words, adding back that line item would effectively be double counting. There is also a line called “Other operating activities.” We had taken the conservative approach to project this line item out earlier. Without too much information gained from doing research, we do have two helpful clues to determine if we should be including this into our UFCF analysis:

· This is within a section entitled “Adjustments to reconcile income from continuing operations to net cash provided by operating activities.” This suggests this is certainly a non-cash adjustment; and

· It clearly states this is an adjustment to an “operating” activity. Based on our best guess, we will assume this is a component of operating expenses, which is a part of EBIT.

So, if the cash flow statement is adjusting for this, then we would suggest this is a valid non-cash adjustment that will also need to be made to EBIT. We should include this in our “other” line. So, Row 10 of our DCF tab should be

“Changes in working capital, ” Row 11 of our DCF tab, will come from the changes in working capital section of our cash flow statement. So, in Cell G11 we will have

Remember the rule here on keeping the working capital flowing exactly as it is flowing in the cash flow statement. Often people get confused, as definitions of UFCF suggest working capital should be subtracted. While, yes, we are adding working capital here, we are effectively subtracting the year-to-year working capital changes from the balance sheet. Please refer to the “Unlevered Free Cash Flow” section earlier in this chapter for more clarification.

Capital expenditures will come from the investing activities section of the cash flow statement. So Cell G12 will be

Finally, taxes will be re-calculated here. Don’t make the mistake of taking taxes from the income statement. The income statement taxes take into account the effects of interest; EBIT does not. So we need to recalculate taxes based on EBIT. Or, Taxes = EBIT × Tax%, so Cell G13 should be

Remember to put a “ -” before this formula, as we want to subtract the taxes from the cash flows.

Now we can sum up the cash flow in Row 14. G14 is

We can highlight every cell from G7 through G14 and copy every formula to the right to get the projected cash flows shown in  Table 8.3 .

Now that we have calculated UFCFs, we need to calculate the PV of each. Notice there is a “period” row (Row 16), where we list the discount period for each year. We will use end-of-year convention. So, since 2013 is one year away, we will have a discount period of 1. In 2014, we will have a discount period of 2, and so on, through 5. So, we will simply hardcode 1 in Cell G16, 2 and H16, and so on.

Before we can actually discount each cash flow we need to calculate the weighted average cost of capital (WACC).

WACC

There is a box beginning in Cell J20 that can help us lay out the inputs for this calculation. Before beginning it is important to consider the time frame and geographic scope of our analysis. Should we create a 10-year WACC or a 30-year WACC? Please refer to the “Weighted Average Cost of Capital” section earlier in this chapter for more detail on the thought process and the differences. Let’s create a 30-year WACC, as we like the theory that we are creating a value of the business through perpetuity, a long-term value. In terms of geography, even though Walmart is a global business, they are U.S.−based and a component of the S&P 500. So we need to be sure to use a 30-year U.S. Treasury rate and 30-year BETA. We also need to use an MRP based on the S&P 500.

Cost of Equity

Cost of Equity = rf + Beta( β) × MRP, where rf is the risk-free rate and MRP is the market risk premium. The best place to get the U.S. Treasury rate is from the Department of Treasury (ustreasury.gov). Googling “U.S. Treasury Rate” will lead you to the page shown in  Figure 8.9 .

TABLE 8.3  Walmart Unlevered Free Cash Flow

FIGURE 8.9  U.S. Department of the Treasury Resource Center

As of October 9, 2012, it looks like the 30-year U.S. Treasury rate is 2.93 percent. So we can enter 2.93% into Cell L21.

Now we need to find the market risk premium. We can find MRP data on Mr. Aswath Damodaran’s web site, which can be found at  http://pages.stern.nyu.edu/∼adamodar/ .

Once arriving at Damodaran’s web site, selecting “Updated Data” on the left will bring up a series of spreadsheets that contain market statistic and multiples for the United States and worldwide. This site is a great reference, and can be utilized to cross-check various market and statistical data. We can scroll down to the “Data Sets” section, and within that section selecting “Risk Premiums for Other Markets” will bring up a file of market risk premiums for the United States and other markets throughout the world. (See  Figure 8.10 .)

In  Figure 8.10 , it can be seen that the current market risk premium for the United States is 6.0 percent. Let’s use this. We can hardcode 6% into Cell L22.

We now need Beta to be able to calculate the cost of equity. As mentioned earlier in this chapter, there are many resources that have Beta data. A good public and free resource is Yahoo! Finance. If we go to finance.yahoo.com, and type in WMT in the “Ticker” section of the site, a company description for Walmart will come up. We can select “Key Statistics” on the left. (See  Figure 8.11 .)

FIGURE 8.10  Country Risk Premiums

We can see on the right side of the page in  Figure 8.11  “Beta” is listed at 0.42. Note this is a relatively low Beta. As Walmart is a very large and relatively un-volatile business, we expect the Beta to be quite low. A Beta of a technology company, for example, could be as high as 2.5 or even higher. Let’s type 0.42 into Cell L23. We can now calculate the cost of equity by multiplying the Beta times the market risk premium, and then adding the risk-free rate of return. Or, in Cell L24,

FIGURE 8.11  Walmart Key Statistics

This gives us a 5.45 percent cost of equity. This is relatively low, and not unexpected for a company with such low volatility and low Beta. For comparison, if a company has a Beta of 1, which implies that the volatility of the company is in line with that of the S&P 500, then the MRP × Beta would be 6 percent. Adding a 2.93 percent risk-free rate would give us 8.93 percent cost of equity. If the Beta was 1.5, the cost of equity would be 11.93 percent.

The cost of debt of a company should be based on the interest rate of debt raised today. It is important to note that the cost of debt should not represent the interest rate on past debts. If the company has a current corporate debt rating, that would be preferred. If not, one would need to estimate the current rate by taking the rate of the most recent debt raised. One can also estimate the rate by looking at similar debts from competitors, but one must make sure that the competitor’s capital structure and other factors that may affect the rating are similar.

The best public information we can get is via Morningstar Research. (See  Figure 8.12 .)

According to Morningstar, the most recent debt issued was in 2011 and has an interest rate of 5.625 percent. Although it would be better to get more current information, the rate on this long-term bond is a good proxy. We can hardcode 5.625% into Cell L25. We can now use these rates to calculate the WACC.

FIGURE 8.12  Morningstar Research Debt Yields

As WACC is the weighted average cost of Capital, we need to weight the Cost of Equity and Cost of Debt, by the amount of equity in the business versus debt. Is it is important to note we should take the most current value of the business’s equity (market capitalization) and the most current value of the business’s debt (if available). Taking Walmart’s most current stock price of $73.82, and diluted shares outstanding of 3, 365, 741, 174 (see Chapter 1 for more about diluting shares), gives us a market capitalization of $248, 459.0MM (after dividing the shares by 1, 000, 000 so we can continue reporting in $MM). We can hardcode the most current Walmart stock price into Cell O22 and the shares outstanding (divide the shares by 1, 000, 000) into Cell O23. The equity value in Cell O24 will just be the product:

For total Walmart debt, we can add the latest value of short-term debts, long-term debts, and capital leases as per the latest balance sheet. This gives us $4, 047+ $1, 975+ $326+ $44, 070+ $3, 009, or $53, 427. Or, in Cell O21,

We can apply all these inputs to the WACC formula:

Or, in Cell L27,

The WACC is 5.16 percent. (See  Table 8.4 .)

We can now discount each cash flow using the formula:

Let’s first link the WACC calculated in Cell L27 into Cell F17 to discount the cash flows. So, in Cell F17,

TABLE 8.4  Walmart WACC

And in Cell G17, we will discount the 2013 UFCF using the discount rate (WACC) in Cell F17 and the period of one year from Cell G16. Or, in Cell G17,

Notice we have put dollar signs in the reference to Cell F17. We can copy this formula to the right and all references will shift except for the reference to the discount rate, which we want to be fixed.

Finally, in Cell G18 we can sum up all of the discounted cash flows (see  Table 8.5 ):

So $67, 814.7MM is the expected PV of Walmart’s cash flows for the next five years. To complete the total value of the business we need to calculate the terminal value, which is the implied value of the business after Year 5. As previously discussed, we will calculate it two ways and compare.

EBITDA Method

For this method, we will take the 2017E EBITDA and multiply it by some EBITDA multiple. It is most common to take an average or median multiple from the comparable company analyses. We also recommend, as another conservative approach, to calculate Walmart’s current EBITDA multiple. Let’s take the latter approach, and upon conclusion we will cross-check with the comparable company analysis multiples.

TABLE 8.5  Discounted Cash Flow Analysis

In Cell F21, we can pull in the company’s 2017E EBITDA:

We can now calculate Walmart’s current (2012) EBITDA multiple in Cell F22. The formula is:

where enterprise value is the market capitalization plus debts, capital leases, non-controlling interests, preferred securities, less cash and cash equivalents. We already have calculated the market capitalization in Cell O24 and the total debt in Cell O21. We have already included capital leases in the total debt value, and it does not look like the company has listed preferred securities, so we only need to include the non-controlling interests and remove cash to get to enterprise value. Notice Walmart has two non-controlling interest lines: “Redeemable noncontrolling interest” (Row 31) and “Noncontrolling interests” (Row 38). So we will add total debt plus the non-controlling interests less cash to the market capitalization for enterprise value. And we can then divide that enterprise value by the 2012 EBITDA on the income statement to get the multiple. So Cell F22 will look like this:

This gives us 8.7×. Again, we will later compare this with the EBITDA multiples in the comparable company analysis. It’s a tough judgment call to determine which are the most appropriate multiples to use. Once the analysis is done we can play around with a few different multiples to see if it has a major effect on the overall analysis.

So for the terminal value in Cell F23, we multiply the multiple by the 2017 EBITDA, or

We then need to discount this value back to PV. As this EBITDA is based on a 2017 metric, we will discount this back five years. So, in F24 we will have

So the PV of Walmart’s terminal value is $281, 669.1MM. (See  Table 8.6 .)

TABLE 8.6  EBITDA Method Terminal Value

In order to get the total enterprise value for Walmart based on the EBITDA method, we would add this to the PV of UFCF calculated in Cell G18. We have a place for this calculation in Cell E34, and we can calculate this now. First, we can pull in the total of PV of cash flows into Cell E32; that would be “=G18.” We can then pull in the PV of terminal value into Cell E33, or “=F24.” Now we can just add those two rows together into Cell E34: “=E32+ E33.”

This gives us $349, 483.8MM. (See  Table 8.7 .)

Let’s now take a look at the equity value. Directly below Cell E34 is a place for net debt, non-controlling interests, and preferred securities. Let’s calculate this using the total debt we have already calculated in Cell O21, adding in non-controlling interests and subtracting cash from the balance sheet. So in E35 we have

TABLE 8.7  Enterprise Value Based on the EBITDA Method

Discounted Cash Flow Total Valuation	EBITDA Method
Total of Present Value of Cash Flows	67, 814.7
Present Value of Terminal Value	281, 669.1
Total Enterprise Value	349, 483.8
Net Debt, Non-controlling Interests, Preferred Securities
Equity Value
Share Count (millions)
Estimated Equity Value per Share

TABLE 8.8  Equity Value per Share Based on the EBITDA Method

Discounted Cash Flow Total Valuation	EBITDA Method
Total of Present Value of Cash Flows	67, 814.7
Present Value of Terminal Value	281, 669.1
Total Enterprise Value	349, 483.8
Net Debt, Non-Controlling Interests, Preferred Securities	51, 727.0
Equity Value	297, 756.8
Share Count (millions)	3, 365.7
Estimated Equity Value per Share	$88.47

We can subtract this from the enterprise value. So Cell E36 will read “=E34-E35, ” which gives us $297, 756.8MM.

We can now divide the equity value by the number of shares outstanding calculated in O23. So, E37 can read “=O23.” And we can divide, so Cell E38 will be “=E36/E37.” This will give us $88.47 based on the EBITDA method. (See  Table 8.8 .)

We can compare this to the company’s current stock price of $73.82. This may suggest that the company is still slightly undervalued. Or maybe we had chosen a multiple that is too high. However, this is the multiple at which the company is currently trading. This is the thought process one should be going through. We need to continue with the analysis and compare with other methods before we can truly formulate an opinion. Let’s compare this to the enterprise and equity value we get from the perpetuity method for more input.

Perpetuity Method

The perpetuity method takes the company’s final projected UFCF and applies the perpetuity formula:

where  r is the WACC and  g is some low growth rate. We recommend in this market environment using something low (close to 1 percent or 2 percent). Remember that this percentage represents the annual growth of cash for the entire life of the business. Even though the growth rate of cash now is higher, we assume as the business approaches maturity, the growth would be very low.

In Cell F26, we can pull in the 2017 UFCF, from Cell K14, or

In Cell F27, let’s for now hardcode 1% in as a safe growth assumption. As with the multiple in the EBITDA method, we reserve the ability to adjust these assumptions once the valuation is complete.

In Cell F28, we can calculate the perpetuity formula:

And we can discount this to PV in Cell F29:

This gives us $308, 174.4MM. (See  Table 8.9 .)

It is interesting to note that this value is higher than the net PV based on the EBITDA terminal value. Remember: The perpetuity method is more fundamentally based on the financials than the EBITDA method, as the EBITDA method is highly dependent on the market multiple. A big exception here is if there is some major Walmart announcement that would force us to lower our projections, but that has not happened. Let’s calculate on.

We can now calculate total enterprise value based on the perpetuity method. First, we can pull in the total PV of cash flows into Cell F32, so that would be “=G18.” We can then pull in the PV of terminal value into Cell F33, or “=F29.” Now we can just add those two rows together into Cell F34: “=F32+F33, ” which gives us $375, 989.1MM.

We have already calculated net debt, non-controlling interests, and preferred securities in Cell E35, so we can just use that number cell F35, or Cell F35 will be “=E35.” We can subtract this from the enterprise value. So Cell F36 will read “= F34-F35, ” which gives us $324, 262.1MM.

TABLE 8.9  Perpetuity Method Terminal Value

TABLE 8.10  Discounted Cash Flow Total Valuation

Discounted Cash Flow Total Valuation	EBITDA Method	Perpetuity Method
Total of Present Value of Cash Flows	67, 814.7	67, 814.7
Present Value of Terminal Value	281, 669.1	308, 174.4
Total Enterprise Value	349, 483.8	375, 989.1
Net Debt, Non-Controlling Interests, Preferred Securities	51, 727.0	51, 727.0
Equity Value	297, 756.8	324, 262.1
Share Count (millions)	3, 365.7	3, 365.7
Estimated Equity Value per Share	$88.47	$96.34

We can now divide the equity value by the number of shares outstanding calculated in Cell O23. So, Cell F37 can read “=O23.” And we can divide in Cell F38, which will be “=F36/F37.” This will give us $96.34 based on the perpetuity method. (See  Table 8.10 .)

Is this an appropriate value for Walmart? What does the Street say? How about adjusting the variables? We will first consider the other two valuation methods and utilize all to discuss possible answers to these questions in the final chapter.