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1. The Discounted Free Cash Flow Model

2. Valuation Based on Comparable Firms

LECTURE 5

Stock Valuation: A Second Look

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1. The Discounted Free Cash Flow Model

The Discounted Free Cash Flow Model focuses on the cash flows to all of the firm’s investors, both debt and equity holders.

Enterprise value is also called “operating value”.

(Eq. 10.1)

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Valuing the Enterprise

To estimate a firm’s enterprise value , we compute the present value of the firm’s free cash flow.

Free cash flow is the cash flow generated from a firm’s operating activities that is available to pay all investors after necessary capital expenditure and investment in working capitals.

EBIT (1-Tax Rate): NOPAT (net operating profit after tax), or,

Unlevered Net Income

(Eq. 10.2)

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Implementing the Model
Since we are discounting the cash flows to all investors, we use the weighted average cost of capital (WACC), denoted by rwacc
Forecast free cash flow up to some horizon, together with a terminal value of the enterprise:

(Eq. 10.5)

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Estimate the terminal value by assuming a constant long-run growth rate gFCF for free cash flows beyond year N.

The long-run growth rate gFCF is typically based on expected long-run growth rate of revenues

(Eq.10.6)

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Discounted Free Cash Flow Model

Given the enterprise value, use Eq.1 to solve for the value of equity and divide by the total number of shares outstanding.

(Eq. 10.4)

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Example 10.1. Valuing Nike, Inc., Stock Using Free Cash Flow

Problem:

Recall our example of Nike, Inc., from an earlier chapter Nike had sales of $25.3billion in 2012. Suppose you expect its sales to grow at a rate of 10% in 2013, but then slow by 1% per year to the long-run growth rate that is characteristic of the apparel industry—5%—by 2018. Based on Nike’s past profitability an investment needs, you expect EBIT to be 10% of sales, increases in net working capital requirements to be 10% of any increase in sales, and capital expenditures to equal depreciation expenses. If Nike has $3.3 billion in cash, $1.2 billion in debt, 893.6 million shares outstanding, a tax rate of 24%, and a weighted average cost of capital of 10%, what is your estimate of the value of Nike’s stock in early 2013?

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Solution:

Plan:

We can estimate Nike’s future free cash flow by constructing a pro forma statement.

Because we expect Nike’s free cash flow to grow at a constant rate after 2015, we can use Eq. 6 to compute a terminal enterprise value. The present value of the free cash flows during the years 2013–2018 and the terminal value will be the total enterprise value for Nike. Using that value, we can subtract the debt, add the cash, and divide by the number of shares outstanding to compute the price per share (Eq. 10.4).

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Execute:

The spreadsheet below presents a simplified pro forma for Nike based on the information we have:

Year	2012	2013	2014	2015	2016	2017	2018
FCF Forecast ($ million)
Sales	25,300.0	27,830.0	30,334.7	32,761.5	35,054.8	37,158.1	39,016.0
Growth Versus Prior Year	10%	9%	8%	7%	6%	5%
EBIT (10% of sales)	2,783.0	3,033.5	3,276.1	3,505.5	3,715.8	3,901.6
Less: Income Tax (24%)	667.9	728.0	786.3	841.3	891.8	936.4
Plus: Depreciation
Less: Capital Expenditures
Less: Increase in NWC (10% Δ Sales)	253.0	250.5	242.7	229.3	210.3	185.8
Free Cash Flow	1,862.1	2,055.0	2,247.2	2,434.8	2,613.7	2,779.4

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Because capital expenditures are expected to equal depreciation, lines 7 and 8 in the spreadsheet cancel out. We can set them both to zero rather than explicitly forecast them.

Given our assumption of constant 5% growth in free cash flows after 2018 and a weighted average cost of capital of 10%, we can use Eq. 10.6 to compute a terminal enterprise value:

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Connection to Capital Budgeting
Free cash flow is the sum of the free cash flows from the firm’s current and future investments, so enterprise value is the sum of the present value of existing projects and the NPV of future new ones.

NPV of any investment represents its contribution to the firm’s enterprise value.

To maximize share price, we should accept projects that have a positive NPV.

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We must forecast all the inputs to free cash flow.

This process gives us flexibility to incorporate many details.

However, some uncertainty surrounds each assumption.

Given this fact, sensitivity analysis is important
Translates the uncertainty into a range of values for the stock.

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Example 10.2. Sensitivity Analysis for Stock Valuation

Problem:

In Example 10.1, Nike’s EBIT was assumed to be 10% of sales. If Nike can reduce its operating expenses and raise its EBIT to 11% of sales, how would the estimate of the stock’s value change?

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Solution:

Plan:

In this scenario, EBIT will increase by 1% of sales compared to Example 1. From there, we can use the tax rate (24%) to compute the effect on the free cash flow for each year. Once we have the new free cash flows, we repeat the approach in Example 1 to arrive at a new stock price.

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Execute:

In year 1, EBIT will be 1% X $27,830 million = $278.3 million higher. After taxes, this increase will raise the firm’s free cash flow in year 1 by (1-0.24) X $278.3 million = $211.5 million, to $2,073.6 million. Doing the same calculation for each year, we get the following revised FCF estimates:

Year	2013	2014	2015	2016	2017	2018
FCF	2,073.6	2,285.5	2,496.2	2,701.2	2,896.1	3,075.9

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Evaluate:

Nike’s stock price is fairly sensitive to changes in the assumptions about its profitability. A 1% permanent change in its margins affects the firm’s stock price by 10%.

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Figure 1. A Comparison of Discounted Cash Flow Models of Stock Valuation

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2. Valuation Based on Comparable Firms

Another application of the valuation principle is the method of comparables.

Estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future.

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Consider the case of a new firm that is identical to an existing publicly traded firm.

The Valuation Principle implies that two securities with identical cash flows must have the same price.

If these firms will generate identical cash flows, we can use the market value of the existing company to determine the value of the new firm.

We can adjust for scale differences using valuation multiples.

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Valuation Multiples

A ratio of a firm’s value to some measure of the firm’s scale or cash flow.

Price-Earnings ratio

Enterprise Value Multiples

Other multiples
Multiples of sales
Price-to-book value of equity
Industry- specific ratios

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Price-Earnings Ratio

Most common valuation multiple
Usually included in basic statistics computed for a stock
Share price divided by earnings per share

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Example 10.3 Valuation Using the Price-Earnings Ratio

Problem:

Suppose furniture manufacturer Herman Miller, Inc., has earnings per share of $1.38. If the average P/E of comparable furniture stocks is 21.3, estimate a value for Herman Miller’s stock using the P/E as a valuation multiple. What are the assumptions underlying this estimate?

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Solution:

Plan:

We estimate a share price for Herman Miller by multiplying its EPS by the P/E of comparable firms:

Execute:

P0=$1.38 × 21.3 = $29.39.

This estimate assumes that Herman Miller will have similar future risk, payout rates, and growth rates to comparable firms in the industry.
Although valuation multiples are simple to use, they rely on some very strong assumptions about the similarity of the comparable firms to the firm you are valuing.

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We can compute a firm’s P/E ratio using:
Trailing earnings
Forward earnings

The resulting ratio is either:
Trailing P/E
Forward P/E
For valuation purposes, the forward P/E is generally preferred, as we are most concerned about future earnings.

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Enterprise Value Multiples

P/E ratio relates exclusively to equity, ignoring the effect of debt.

Enterprise value multiples use a measure of earnings before interest payments are made
EBIT
EBITDA
Free cash flow
Because capital expenditures can vary between years, most common is to use enterprise value to EBITDA multiples

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When expected free cash flow growth is constant, we can write EV to EBITDA as:

(Eq. 10.8)

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Example 5. Valuation Using the Enterprise Value Multiple

Problem:

Fairview, Inc., is an ocean transport company with EBITDA of $50 million, cash of $20 million, debt of $100 million, and 10 million shares outstanding. The ocean transport industry as a whole has an average EV/EBITDA ratio of 8.5. What is one estimate of Fairview’s enterprise value? What is a corresponding estimate of its stock price?

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Execute:

Fairview’s enterprise value is $50 million × 8.5 = $425 million

Next, subtract the debt from its enterprise value and add in its cash:

$425 million - $100 million + $20 million = $345 million, which is the equity value.

Its stock price is equal to its equity value divided by the number of shares outstanding:

$345 million ÷ 10 million = $34.50

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Evaluate:

If we assume that Fairview should be valued similarly to the rest of the industry, then $425 million is a reasonable estimate of its enterprise value and $34.50 is a reasonable estimate of its stock price.

However, we are relying on the assumption that Fairview’s expected free cash flow growth is similar to the industry average.

If that assumption is wrong, so is our valuation.

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Other multiples

Multiples of sales can be useful if it is reasonable to assume margins are similar in the future.

Price-to-book value of equity can be used for firms with substantial tangible assets.

Some multiples are specific to an industry
e.g. Cable TV – Enterprise value per subscriber

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Limitations of Multiples

Firms are not identical
Usefulness of a multiple depends on the nature of the differences and the sensitivity of the multiples to the differences.
Differences in multiples can be related to differences in
Expected future growth rate
Risk (cost of capital)
Differences in accounting conventions between countries

Comparables provide only information regarding the value of the firm relative to other firms in the comparison set
Cannot help determine whether an entire industry is overvalued.
Internet boom example

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Table 1. Stock Prices and Multiples for the Footwear Industry, July 2013

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Comparison with Discounted Cash Flow Methods

Valuation multiple does not take into account material differences between firms.
Talented managers
More efficient manufacturing processes
Patents on new technology

Discounted cash flow methods allow us to incorporate specific information about cost of capital or future growth
Potential to be more accurate

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Stock Valuation Techniques: The Final Word

No single technique provides a final answer regarding a stock’s true value

Practitioners use a combination of these approaches

Confidence comes from consistent results from a variety of these methods

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Figure 4. Range of Valuations for Nike Stock Using Various Valuation Methods

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Lecture Highlights

FCF

Enterprise value

How do you use the discounted FCF method to predict stock value?

How do you value a stock based on the information on comparable firms?

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Project

Valuate the stock using the discounted FCF method.

Valuate the stock using valuation multiple method.

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