Valuation

A1. Discounted Cash‐Flow valuation

A2. The WACC parameters

JM Gaspar DCF Valuation Appendix 1/21

A1. DCF Basics Valuation overview

Appendix

JM Gaspar DCF Valuation Appendix 2/21

A1. DCF Basics DCF Valuation steps


SELECT FORECAST HORIZON,
BUSINESS PERIMETER

 SELECT / ANALYSE KEY RATIOS BUILD EXCEL MODEL OF

PROJECTED PERFORMANCE


 E   D 
RWACC     RE     R D  1  t c 
DE  DE 

COMPUTE COMPUTE
 COST OF
CAPITAL
CASH‐FLOWS

VALUATION:  COMPUTE
 VALUE THE BUSINESS TERMINAL VALUE

T
FCFt 1 FCF  1  g
V    T
t 1 1  RWACCt 1  RWACCT
RWACC  g


VALUE THE EQUITY




CHECK, COMPARE, SIMULATE

JM Gaspar DCF Valuation Appendix 3/21

A1. DCF Basics  Forecasting cash‐flows

 Determine length and detail of the forecast. The forecast horizon

must capture at least a full business cycle

 Construct a line-by-line forecast of income statements, balance

sheets, cash-flow statements, etc. in a fully linked Excel spreadsheet

1. Build the revenue forecasts, based on prospective sales volume, sales

price and product mix.
2. Forecast operating items by linking them to revenues via activity or
turnover ratios.
3. Forecast non-operating items like long-term debt and interest expense.
4. Forecast equity. Equity should equal previous year equity plus net
income and share issues minus dividends and share repurchases.
5. Use the excess cash / debt accounts to plug the balance sheet.
6. Check the forecast for internal consistency using ROIC and key ratio
analysis. Go back to step 1 and re-iterate.

 This method is called the percentage sales method, because

forecasted sales drive most of the projection

 The same sales forecast might have different implications depending

on the industry, due to excess capacity, economies of scale and
lumpy assets

JM Gaspar DCF Valuation Appendix 4/21

A1. Performance Analysis Measuring financial health: ratios

 Financial ratios check the firm’s financial health, benchmark its

performance, and set objectives/projections for the future
ST Assets
Short-term Solvency Current Ratio 
ST Liabilitie s
STAssets  Inventorie s
Quick Ratio 
ST Liabilitie s

Revenues t
Activity Sales growth 
Revenues t-1
Revenues
Asset Turnover 
Total Assets
Acc. Receivable
Receivable s' Days in Sales   365
Revenues
Inventory
Days in Inventory   365
Cost of Goods Sold
Payables
Days in Payables   365
Cost of Goods Sold

NWC
NWC  to  Sales 
Sales

Net Income
Profitability Net Profit Margin 
Revenues
EBIT
EBIT Margin 
Revenues
EBITDA
EBITDA Margin 
Revenues
EBIT
Return on Assets (ROA) 
Total Assets
Net Income
Return on Equity (ROE) 
Equity
Capex
Investment Capex - to - EBITDA 
EBITDA
D& A
D & A - to - EBITDA 
EBITDA
Property, Plant & Equip.
Asset tangibilit y 
Total Assets

JM Gaspar DCF Valuation Appendix 5/21

A1. Performance Analysis ROIC measurement

 Return On Invested Capital

Operating CF - Depreciation 
ROIC 
Total Invested Capital

 Note that

Operating CF - Dep.  EBIT - t c  EBIT  Dep. - Dep.

 EBIT  1  t c 

 So
EBIT  1 - t c 
ROIC 
Total Invested Capital

 Dividing and multiplying by revenues, we get the ROIC tree

EBIT Revenues
ROIC    1 - t c 
Revenues Total Invested Capital

EBIT margin Capital turnover Tax effect


Depreciation is subtracted because Total Invested Capital (the denominator of ROIC) is calculated using net assets
(assets minus accumulated depreciation). To ensure consistency between the numerator and the denominator, we
subtract depreciation from the operating cash-flow as well.

JM Gaspar DCF Valuation Appendix 6/21

A1. DCF Basics  Setup the Model
 It is recommended to use nominal cash-flows (calculated using
current prices as opposed to inflation debased real prices)

 Follow the rules of incremental cash-flow calculation

1. Cash is king!
2. Ignore sunk costs
3. Include opportunity benefits and/or opportunity costs
4. Don’t forget side-effects between different areas of the firm

 Check for consistency across different assumptions

Capital turnover
Sales price growth Revenue

Volume growth
Long-term fixed
Receivables
Terms of payment assets
Payables
Operating working
Raw material price
capital
growth
Cost structure
Wage growth

 Recognize erosion of competitive advantage and existence of

business cycles (avoid “hockey stick” effects)

 Develop a fully linked model with the basic accounting links

JM Gaspar DCF Valuation Appendix 7/21

A1. DCF Basics  Calculating cash‐flow
Income Statement Balance Sheet
+ Revenues Long‐term Assets Equity
– Cost of goods sold + Fixed assets + Capital stock
– Selling, gen. and admin. costs + Retained earnings
= EBITDA Long‐term liabilities
– Depreciation + Long-term debt
= EBIT
+ Interest income Short‐term assets +Other LT liabilities
– Interest expense + Inventories Short‐term liabilities
= Earnings before taxes + Accounts receivable + Accounts payable
– Taxes + Operating cash + Bank debt
= Net income + Excess cash + Other operating ST debt

Financial Balance Sheet

Long‐term Net Equity
Total Operating Assets* + Capital stock
Invested + Retained earnings

Capital
Financial Debt
+ Long-term debt
Operating
+ Bank debt
Working Capital**

Excess cash
* Fixed assets – Other LT liabilities
** Inv. + Acc. Receivable + Op. cash – Acc. payable – Other op. ST debt

Free Cash-Flow Calculation

+ Revenues + Interest Expense after tax
– CGS – Interest income after tax
– SGA = Net Interest Paid after tax (1)
= EBITDA
– Depreciation Dividends (2)
= EBIT
– Taxes on EBIT - Financial debt issues
+ Depreciation + Financial debt repayments
= Operating CF (A) =Net Debt Repaid (3)
+ Sales of LT Assets - Equity issues
– Acquisitions of LT Assets + Equity repurchases
= CF from Capital Spending (B) = Net Equity Repaid (4)
+ Decreases in NWC
– Increases in NWC Changes in Excess Cash (5)
= CF from Changes in NWC (C)

Free Cash Flow = (A) + (B) + (C) Financial Flow = (1)+(2)+(3)+(4)+(5)

JM Gaspar DCF Valuation Appendix 8/21

A1. DCF Basics  Calculating cash‐flow
Example : EssilorLuxottica (ENXTPA:EL), FY2013
Millions of EUR

Income Statement Balance Sheet

+ Revenues 5,065 Long-term Assets Equity
– Cost of Goods Sold 2,227 + Fixed assets 4,546 + Capital stock 3,163
– SGA, R&D, & oth. op. expenses 1,737 + Retained earnings 593
= EBITDA 1,101 Long-term liabilities
– Depreciation 253 + Long-term debt 607
= EBIT 848 Short-term assets +Other LT liabilities 1,176
+ Interest income 18 + Inventories 869
– Interest expense 26 + Accounts receivable 1,192 Short-term liabilities
= Earnings before taxes (EBT) 839.8 + Operating cash 0 + Accounts payable 502
– Taxes @ 23.6% 197.8 + Excess cash 791 + Short-term debt 567
= Net income 642 + Other oper. ST assets 179 + Other operating ST liab. 969
Total 7,577 Total 7,577
Effective tax rate = Taxes / EBT
Assumption: operating cash is set to zero.
Often done, b ut unrealistic.
Ex: op. cash equal to 1 week of sales (7/365 of sales).

Financial Balance Sheet

Long-term Net Equity
Operating Assets 3,370 + Capital stock 3,163
+ Retained earnings 593
Operating Net
Working Capital 769 Financial Debt
+ Long-term debt 607
Excess cash 791 + Short-term debt 567
Total 4,930 Total 4,930

Free Cash Flow Financial Flow

+ Revenues 5,065 + Interest Expense after tax 20 = 26 x ( 1 - 23.6%)
– Cost of Goods Sold 2,227 – Interest income after tax 14 = 18 x ( 1 - 23.6%)
– SGA, R&D, & oth. op. expenses 1,737
= EBITDA 1,101 + Dividend Payments 186
– Depreciation 253
= EBIT 848 + Financial debt repayments 1
– Taxes on EBIT @ 23.6% 200 – Financial debt issues 281
+ Depreciation 253
= Operating CF (A) 901 + Equity (capital stock) repurchases 169
– Equity (capital stock) issues 68
+ Sales of LT Assets 2
– Acquisitions of LT Assets 627
= CF from Capital Spending (B) -625
+ Changes in excess cash 169
– Increases in NWC 94
= CF from Changes in NWC (C) -94

Free Cash Flow = (A) + (B) + (C) 182 = Financial Flow 182

Op. NWC in FY2012 = 675. Then

Chg. in NWC in FY2013 is 769 - 675 = 94

JM Gaspar DCF Valuation Appendix 9/21

A1. DCF Basics  Steps in calculating cash‐flow

Step 1: Distinguish between operating items and non‐operating

(financing) items.

 Financial vs. operating debt. Usually only interest-bearing liabilities

are included in financial debt.
 Interest income and expense. Any financing related items are not
counted as cash-flow generated by the business.
 Taxes. Should be seen as: taxes paid as if the business did not have
financing debt (i.e. had only operating debt); minus the tax saving
borne by the existence of tax-deductible interest on the financing debt.
 Cash. The cash account usually contains operating cash (necessary to
make payments related to the business) as well as excess cash, a non-
operating item (the CFO could use it to pay back debt or pay a dividend
or to make an acquisition soon)
 Operating working capital (“Net working capital”). The difference
between short-term operating assets and short-term operating
liabilities.

Step 2: Distinguish between “true” cash and non‐cash items.

 Depreciation. Depreciation is an accounting movement that only

serves to save tax. We add it up after calculating the tax saving.

Step 3: Apply recipe: FCF=OCF + CF from Capex + CF from Chg. in NWC

 CF from Capex is negative most of the time, and CF from Changes in

NWC is equal to the negative of Changes in NWC, so

FCF = OCF – Capex – Δ NWC

JM Gaspar DCF Valuation Appendix 10/21

A1. DCF Basics  Steps in calculating cash‐flow II

 Remark 1. Note that you have two equivalent ways of calculating

OCF:

OCF = EBIT x ( 1 – tc) + Dep. = EBITDA x ( 1 – tc) + tc x Dep.

1. The term tc × Dep. is known as the depreciation tax shield.

 Remark 2. You can also write

FCF = EBIT x (1 – tc) + Dep. – Capex – Δ NWC

= EBIT x (1 – tc) – (Capex – Dep.)– Δ NWC

Net Capex

= EBIT x (1 – tc) – (Capex – Dep. + Δ NWC)

Net Investment

 Remark 3. Obsession with EBITDA (“EBEETDAH”) is explainable

because Capex, Dep, etc. can be seen as a function of EBITDA.

JM Gaspar DCF Valuation Appendix 11/21

A1. DCF Basics  The cost of capital

 The weighted average cost of capital or WACC (rimes with quack)

is
 E   D 
RWACC     RE     R D  1  t c 
DE  DE 

where RE is the cost of equity

RD is the cost of debt
D/(D+E) is the ratio of the market value of debt to the
market value the firm (debt + equity)
tc is the corporate tax rate

 The WACC is the “blended” rate that reflects how much investors
(both equityholders and bondholders) require to invest in a firm.

 The firm value and the cost of capital are mirror images of each
other.

 The WACC is fully market-based: all discount rates and ratios of

debt-to-equity are computed at market values.
1. E = Market value of equity = shares outstanding × share price
2. D =Market value of debt = market price of firm’s debt
3. Exception: for D debt book value is used

JM Gaspar DCF Valuation Appendix 12/21

A1. DCF Basics  Terminal or continuing value

 The Terminal Value is the value of the business at the end of the
forecast horizon. To compute it usually a perpetuity is used
1. Growth rate must reflect long-run competition and limits to growth

Total Present Present value of FCF Present value of FCF

Value of FCF = during forecast period + after forecast period
t = 1,2,…,T t = T +1, T +2,...

T
FCFt 1 FCFT  1  g 
V   
t 1 1  RWACC  1  RWACC T RWACC  g
t

Discount factor to
bring the terminal
value to date 0

Steady state free

cash‐flow

WACC reflecting Steady state growth

steady state capital rate of free cash‐flow
structure

 The sum of the present value of the free cash flows during the
horizon period plus the terminal value is the Enterprise Value

1. The enterprise value is the value of the business. To get the value of
the equity, we have to add cash and subtract debt.
2. Adjust for mid-year discounting by capitalizing the result for the
number of months elapsed since the beginning of the year.


Example: you’re valuing a company on September 30, 2023. Suppose that the first yearly cash-flow of your
spreadsheet refers to 2023 (by convention, cash-flows are received at the end of the period, so the cash-flow for
2023 is supposed to be received on December 31, 2023). When you discount the cash-flows, you’ll get the value of
the company on January 1st, 2023. You should then capitalize this value for 9 months (using whatever rate of return
is applicable) to get the value on September 30, 2023.

JM Gaspar DCF Valuation Appendix 13/21

A1. DCF Basics  Equity value

Enterprise Value –Debt + Cash= Equity Value

 Details
1. In addition to cash, add value of non-operating assets excluded from the
calculation of FCF (usually investments in unconsolidated subsidiaries).
2. Subtract financial debt (all interest-bearing non-operating debt) as well
as quasi-debt items like leases and pension-related liabilities.
3. Subtract quasi-equity items like preferred stock and minority interests.

Non-operating
assets
Financial Debt
Excess cash
Leases Preferred
stock Minority
Present interests
value of FCF
a.k.a.
“Enterprise
Value” Equity
value

 Value per share: divide Equity Value by

1. Basic Shares Outstanding (BSO) at the valuation date. Sources for this
number: annual report, 10-K, press releases, financial databases
2. Fully Diluted Shares Outstanding at the valuation date: BSO plus
shares that would be issued if all warrants, convertibles, and
executive stock options would be exercised. Source: footnotes to the
annual report, financial databases.
3. Variant on this: consider only instruments that are in the money at the
valuation date.

JM Gaspar DCF Valuation Appendix 14/21

A1. DCF Basics Why DCF methods are important

 Advantages
1. Forces collective brainstorming to produce forecasts
2. Generates lots of information
3. RWACC is analogous to calculation of a internal rate of return
4. Very good for performing sensitivity / scenario analysis
5. Often produced to justify a price
6. Obtain IRR for investors (PE deals)

 Disadvantages
1. Time consuming
2. Requires careful analysis of underlying assumptions
3. Industry knowledge is very important
4. Dependent on accounting data
5. Special care needed when calculating terminal value
6. Best results if done with inside knowledge about the firm

 The biggest advantage of DCF methods is that they force the analyst
to think WHY the company creates value

 This advantage far surpasses all its disadvantages

JM Gaspar DCF Valuation Appendix 15/21

A2. Cost of capital inputs The MM‐CAPM‐WACC framework

RE  R f  βE  RM  R f 

Beta of Market risk

Risk‐free rate premium
levered equity

Market value
capital structure
weights

D E
RWACC   RD  1  t c    RE
DE DE

Required rate of Marginal Required rate of

return on debt corporate tax rate return on levered
equity

FCFt
VWACC  
t 1  RWACC t

Enterprise value Weighted Average

(present value of FCF) Cost of Capital

JM Gaspar DCF Valuation Appendix 16/21

A2. Cost of capital inputs Discount rate inputs I

Rates on risk‐free government debt denominated in home

currency
Risk‐free rate Possible alternatives:
Rf  Short-term forward rates obtained from term structure
 5‐10 yr long bond yields [recommended]
 Bonds with matching duration of the project being valued
Sources: Bloomberg, ThomsonReuters, financial press

Example of 10-year government bond yields

Source: https://markets.ft.com/data/bonds/government-bonds-spreads
(Click on the link above to see the most recent data)

Excess long‐term return of the stock market over risk‐free bonds

Broad guidelines:
Market risk
 Calculate the average arithmetic return…
premium
 …of a broad stock market index of the country…
R M  Rf   …over longest period possible…
 …and subtract the average risk-free long‐term bond rate
Sources: Investment banking reports, financial data vendors, academic
studies

JM Gaspar DCF Valuation Appendix 17/21

A2. Cost of capital inputs Discount rate inputs II

Measure of systematic risk of the firm’s equity

Beta of
β
~ ~
Cov R i , R M 
levered equity σ 2M
βE Beta is positively related to:
 Sensitivity of revenues to economic cycle
 Operating leverage (% of fixed costs in the cost structure)
 Financial leverage (% of debt in the capital structure)
Possible alternatives:
 Direct estimation using the appropriate time horizon, market
index, and estimation technique
 Betas from comparable companies or industries
Sources: Bloomberg, Capital IQ, ThomsonReuters, analyst reports

Example of industry (levered) betas for U.S. listed firms

Source: http://www.stern.nyu.edu/~adamodar/pc/datasets/betas.xls
(Click on the link above to see the full and most recent data)

Number of  Effective Tax  Unlevered 

Industry Name Beta  D/E Ratio
firms rate beta

Advertising 48 1.22 71.06% 5.69% 0.79

Aerospace/Defense 85 1.24 25.39% 11.40% 1.04
Air Transport 18 1.02 89.82% 6.48% 0.61
Apparel 50 0.93 35.00% 14.19% 0.74
Auto & Truck 14 0.79 195.44% 10.15% 0.32
Auto Parts 52 1.17 39.95% 11.57% 0.90
Bank (Money Center) 10 0.71 203.85% 26.01% 0.28
Banks (Regional) 633 0.57 76.51% 26.99% 0.36
Beverage (Alcoholic) 31 1.30 34.18% 2.55% 1.03
Beverage (Soft) 37 1 18 23 53% 3 87% 1 00
…
Software (System & Application) 355 1.23 12.87% 4.62% 1.12
Steel 37 1.62 50.25% 4.18% 1.18
Telecom (Wireless) 21 1.26 115.78% 2.38% 0.68
Telecom. Equipment 98 1.09 18.05% 6.20% 0.96
Telecom. Services 67 1.22 89.20% 3.72% 0.73
Tobacco 17 1.29 25.23% 7.27% 1.09
Transportation 19 1.14 42.47% 5.29% 0.87
Transportation (Railroads) 10 2.47 26.93% 0.00% 2.05
Trucking 28 1.22 103.10% 1.23% 0.69
Utility (General) 18 0.27 71.36% 14.66% 0.17
Utility (Water) 19 0.42 43.00% 9.49% 0.32
Total Market  7209 1.12 66.64% 8.76% 0.75
Total Market (without financials) 6004 1.21 34.51% 6.21% 0.96

JM Gaspar DCF Valuation Appendix 18/21

A2. Cost of capital inputs Discount rate inputs III

Optimal or target capital structure

Steps:
1. Review current capital structure
 Market value of equity = number of shares × share price
Market value  Market value of debt = market price of firm’s bonds (remark:
capital structure often debt book value  market value)
weights  This is the basis for the currently observed levered beta
D 2. Formulate the target future capital structure
DE  Check consistency with overall strategy
 Review capital structures of comparable companies and
industries
 Review management’s financing philosophy

Example of capital structure ratios per industry for U.S. listed firms
Source: http://www.stern.nyu.edu/~adamodar/pc/datasets/dbtfund.xls
(Click on link above to see the full and most recent data)

Number of  Book Debt to  Market Debt to 

Industry Name Market D/E Debt/EBITDA
firms Capital Capital

Advertising 48 74.88% 35.00% 53.84% 4.95

Aerospace/Defense 85 57.77% 19.22% 23.80% 2.86
Air Transport 18 57.65% 35.65% 55.40% 3.56
Apparel 50 41.16% 18.45% 22.62% 3.61
Auto & Truck 14 75.94% 65.88% 193.06% 7.12
Auto Parts 52 40.56% 26.33% 35.75% 1.82
Bank (Money Center) 10 67.06% 66.73% 200.57% NA
Banks (Regional) 633 46.26% 42.30% 73.32% NA
Beverage (Alcoholic) 31 45.17% 24.92% 33.19% 3.53
Beverage (Soft) 37 62 86% 18 66% 22 94% 3 79
…
Transportation 19 58.88% 23.51% 30.73% 3.12
Transportation (Railroads) 10 47.26% 20.09% 25.14% 2.56
Trucking 28 64.85% 47.88% 91.87% 6.08
Utility (General) 18 57.91% 41.25% 70.21% 5.14
Utility (Water) 19 56.47% 29.86% 42.57% 4.83
Total Market  7209 62.72% 38.74% 63.24% 7.60
Total Market (without financials) 6004 49.71% 23.69% 31.04% 3.64

JM Gaspar DCF Valuation Appendix 19/21

A2. Cost of capital inputs Discount rate inputs IV

Unleveraging and re‐leveraging

Two approaches:
1. Directly via MM proposition II

2. Indirectly via the Capital Asset Pricing Model (CAPM)

 Unlever and re-lever the equity beta rather than the cost of
capital
 The cost of capital of any security i is given by
Ri  R f  βi RM  R f 
 The two approaches deliver the same result as long as the
beta of debt D is consistent with the observed RD

Approach 1 D
RE  R D 1  t 
RU  E
 D RU
RE  1  1  t  
Current cost of  E Cost of
levered equity unlevered equity

RE
New cost of
D
levered equity RE  RU  RU  RD 1  t 
E

D
Approach 2 β E  β D 1  t 
βU  E
βE  D βU
 1  1  t  
Current beta of  E Beta of
levered equity unlevered equity

βE
New beta of
levered equity D
β E  βU  βU  β D 1  t 
E

JM Gaspar DCF Valuation Appendix 20/21

A2. Cost of capital inputs Discount rate inputs V

Rate of return demanded by investors on the firm’s bonds

Required rate of
RD is usually measured using yield to maturity.
return on debt
Major determinants:
RD  Average level of risk-free interest rates
 Credit rating of the firm
 Current / future credit spreads associated with each rating
Possible alternatives:
 Yields of the firm’s currently outstanding bonds
 Yields of bonds of comparable-risk firms
 Sum the implied credit rating spread and the risk‐free rate
Sources: S&P, Moody’s, financial data vendors, IB reports

Example of coverage ratios and implied ratings for U.S. listed firms
Source: http://www.stern.nyu.edu/~adamodar/pc/ratings.xls
(Click on the link above to see the full and most recent data)
For large manufacturing firms

If interest coverage ratio is
Rating is Spread is
> ≤ to
‐100000 0.20 D2/D 19.38%
0.20 0.65 C2/C 14.54%
0.65 0.80 Ca2/CC 11.08%
0.80 1.25 Caa/CCC 9.00%
1.25 1.50 B3/B‐ 6.60%
1.50 1.75 B2/B 5.40%
1.75 2.00 B1/B+ 4.50%
2.00 2.25 Ba2/BB 3.60%
2.25 2.50 Ba1/BB+ 3.00%
2.50 3.00 Baa2/BBB 2.00%
3.00 4.25 A3/A‐ 1.56%
4.25 5.50 A2/A 1.38%
5.50 6.50 A1/A+ 1.25%
6.50 8.50 Aa2/AA 1.00%
8.50 100000 Aaa/AAA 0.75%

JM Gaspar DCF Valuation Appendix 21/21