Equity Valuation

Содержание

Слайд 2

Deck 2 Agenda Free Cash flows & financing cash flows Financial

Deck 2

Agenda
Free Cash flows & financing cash flows
Financial statement analysis
Common sized

financial statements
Review of Financial Ratios
Liquidity ratios
Efficiency ratios & profitability ratios
Market ratios
Dupont analysis
limitations of Ratio analysis
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Section I Free Cash flows & financing cash flows

Section I
Free Cash flows & financing cash flows

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Let’s dive into Cash Flows CF versus profit Firms with recurring

Let’s dive into Cash Flows

CF versus profit
Firms with recurring negative cash

flows can go bankrupt, even with positive net incomes
Слайд 5

Cash flows? Free Cash Flow ? cash flow from assets FCF

Cash flows?

Free Cash Flow ? cash flow from assets
FCF = Operating

cash flow + Investing cash flow
FCF is matched by the Financing Cash Flow
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CF statement The CF Statement shows the financial flows (cash received

CF statement

The CF Statement shows the financial flows (cash received or

disbursed) when they actually happened, classified as:
– cash flow from operations (CFFO);
– cash flow from investing (CFFI);
– cash flow from financing (CFFF).
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Sections in the Cash Flow Statement Cash flow from operations includes

Sections in the Cash Flow Statement

Cash flow from operations includes the

cash flow consequences of the revenue-producing activities of the company.
Cash flow from investing is the cash flow resulting from: acquisition (or sale) of property, plant & equipment; acquisition (or sale) of a subsidiary; purchase (or sale) of investments in other firms.
Cash flow from financing is that resulting from: issuance (or retirement) of debt; issuance (or retirement) of shares; dividends paid to shareholders.
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Free Cash Flow Free Cash Flow (FCF): cash flow that is

Free Cash Flow

Free Cash Flow (FCF): cash flow that is free

and available to be distributed to the firm’s investors. It is obtained after a firm has paid off all its operating expenses, taxes, and made all of its investments in operating working capital and assets.
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Operating cash flows Cash flows linked to the core activities. Positive

Operating cash flows

Cash flows linked to the core activities.
Positive operating

cash flow generally indicates a healthy business
Negative operating CF is always a warning sign for trouble.
When trend remains negative, the destruction of value will lead to bankruptcy
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Computing Operating CF Operating CF = EBIT + Depreciation – taxes

Computing Operating CF

Operating CF = EBIT + Depreciation – taxes
NB: this

approach differ from typical accounting definitions of Operating cash flows
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Investing cash flows Cash flows describing the investments (or divestiture) in

Investing cash flows

Cash flows describing the investments (or divestiture) in fixed

and current assets
Negative investing cash flows generally correspond to expansion of the business
Positive flows to sale of assets
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Computing Investing CF investing cash flow has two main components: The

Computing Investing CF

investing cash flow has two main components:
The investment in

long term asset, also called Capital spending or CAPEX:
CAPEX = Gross Fixed assets (end of period) – Gross Fixed Assets (beginning of period)
We can rewrite the previous formula:
CAPEX = Net fixed assets (end of period) – Net Fixed assets (beginning of period) + Depreciation (for the period) 
2. The investment in Operating Working Capital (OWC) which is computed as follows:
Change in OWC = OWC (end of period) - OWC (beginning of period)
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Financing Cash Flows A firm can either receive money from or

Financing Cash Flows

A firm can either receive money from or distribute

money to its investors or both. The firm can:
Pay interest to lenders.
Pay dividends to stockholders.
Increase or decrease its interest bearing long-term or short-term debt.
Issue stock to new shareholders or repurchase stock from current shareholders.
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Computing the Financing CF Financing Cash Flow = net new borrowings

Computing the Financing CF
Financing Cash Flow = net new borrowings –

interest paid + net new equity – dividend payments
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Cash Flow Statement Direct vs. Indirect Method –direct method (adopted by

Cash Flow Statement Direct vs. Indirect Method
–direct method (adopted by less than

3% of companies) CFFO reports actual cash receipts and payments.
–indirect method CFFO is computed by adjusting net profit for non-cash revenues and expense (e.g. depreciation and amortization expense), and for all non cash changes in operating assets and liabilities (e.g. change in working capital).
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FCF FCF = Operating CF + investing CF When negative implies

FCF

FCF = Operating CF + investing CF
When negative implies a need

for further financing
FCF is used as the base for valuation in DCF
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Interpreting Free Cash Flows Does Positive or Negative free cash flow

Interpreting Free Cash Flows

Does Positive or Negative free cash flow maximize

shareholder wealth?
Need more information to answer this question.
We need to consider the trend in cash flows and also analyze the possible causes of positive or negative free cash flows. Specifically, we need to look closely at cash flows relating to operations, working capital, long-term assets, and financing.
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Incremental cash flows Further, after-tax free cash flows must be measured

Incremental cash flows

Further, after-tax free cash flows must be measured incrementally.


Determining incremental free cash flow involves determining the cash flows with and without the project. Incremental is the “additional cash flows” (inflows or outflows) that occur due to the project.
Слайд 19

Beware of diverted cash flows Not all incremental free cash flow

Beware of diverted cash flows

Not all incremental free cash flow is

relevant.
Thus new product sales achieved at the cost of losing sales from existing product line are not considered a benefit.
However, if the new product captures sales from competitors or prevents loss of sales to new competing products, it would be a relevant incremental free cash flow.
Слайд 20

Working capital requirement New projects require infusion of working capital (such

Working capital requirement

New projects require infusion of working capital (such as

inventory to stock the shelves), which would be an outflow.
Generally, when the project terminates, working capital is recovered and there is an inflow of working capital.
Слайд 21

Sunk Costs Sunk costs are cash flows that have already occurred

Sunk Costs

Sunk costs are cash flows that have already occurred (such

as marketing research) and cannot be undone. Sunk costs are considered irrelevant to decision making.
Managers need to ask two basic questions:
Will this cash flow occur if the project is accepted?
Will this cash flow occur if the project is rejected?
If the answer is “Yes” to #1 and “No” to #2, it will be an incremental cash flow.
Слайд 22

Opportunity Costs Opportunity cost refers to cash flows that are lost

Opportunity Costs

Opportunity cost refers to cash flows that are lost because

of accepting the current project.
For example, using the building space for the project will mean loss of potential rental revenue.
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Overhead Costs Incremental overhead costs or costs that were incurred as

Overhead Costs

Incremental overhead costs or costs that were incurred as a

result of the project and relevant to capital budgeting must be included.
Note, not all overhead costs may be relevant (for example, the utilities bill may have been the same with or without the project).
Слайд 24

Interest Payments and Financing Costs Interest payments and other financing cash

Interest Payments and Financing Costs

Interest payments and other financing cash flows

that might result from raising funds to finance a project are not relevant cash flows.
Reason: Required rate of return implicitly accounts for the cost of raising funds to finance a new project.
Слайд 25

What is FCFF? The Free Cash Flow to Firm (FCFF) is

What is FCFF?

The Free Cash Flow to Firm (FCFF) is a

measure of the (after tax) cash flow which would be available to the Target’s claim-holders (debt holders and shareholders) should Target be unlevered. The FCFF IS net of the required capital expenditures necessary to:
cover the replacement cost of the Target’s productive capacity consumed (Capital Expenditures)
support incremental revenue generating activities (e.g. Working Capital)
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Indirect methods for FCFF FCFF = Net Income + Interest –

Indirect methods for FCFF
FCFF = Net Income + Interest – Change

(OWC) – Capex + Depreciation
Note that we could start from a different point in the income statement (and get the same result:
FCFF = EBIT –Taxes (Cash) – Change (OWC)– Capex + Depreciation
FCFF= EBITDA –Taxes (Cash) – Change (OWC) – Capex
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Section II Financial statement analysis

Section II
Financial statement analysis

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Standardized Financial Statements Common-Size Balance Sheets: Compute all accounts as a

Standardized Financial Statements

Common-Size Balance Sheets: Compute all accounts as a percent

of total assets
Common-Size Income Statements: Compute all line items as a percent of sales
Standardized statements make it easier to compare financial information, particularly as the company grows
They are also useful for comparing companies of different sizes, particularly within the same industry
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Why Use Ratios? Useful financial ratios: identify a company’s situation and

Why Use Ratios?

Useful financial ratios:
identify a company’s situation and its financial

strengths and weaknesses
establish the relationship between various pieces of financial information.
compare a company’s financial situation through time
compare companies with different sizes
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Main areas of investigation (1) The main ratios examine important questions:

Main areas of investigation (1)

The main ratios examine important questions:
How liquid

is the company? Are there any solvency issues?
How efficient is the management in using the company’s asset?
Is management generating sufficient profitability?
Слайд 31

Main areas of investigation (2) For publicly traded companies, market ratios:

Main areas of investigation (2)

For publicly traded companies, market ratios:
Assess relationship

between Market price and company fundamental data
Are driven by investors’ expectations
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Short-term Solvency ratios Current Ratio = current assets/current liabilities Quick Ratio

Short-term Solvency ratios

Current Ratio = current assets/current liabilities
Quick Ratio = (Current assets

– inventory) / current liabilities
Слайд 33

Long-term solvency measures Debt ratio is the % of assets financed

Long-term solvency measures

Debt ratio is the % of assets financed by

debt
Debt ratio= Total Debt / Total Assets
Alternatively:
Debt ratio= (Total assets-Total equity) / Total Assets
Debt to equity ratio = Total debt/Total equity
Times interest earned ratio = EBIT/Interest
Слайд 34

Efficiency ratios (1) Inventory Turnover: How many times is inventory rolled

Efficiency ratios (1)

Inventory Turnover: How many times is inventory rolled over

during the year? (*Note)
Inventory Turnover = Cost of Goods Sold / average Inventory
Days' sales in inventory = 365 days/inventory turnover
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Efficiency ratios (2) Account receivables turnover: How many times accounts receivable

Efficiency ratios (2)

Account receivables turnover: How many times accounts receivable (AR)

are “rolled over” during a year?
Account receivables turnover = credit sales/ average AR
Days' sales in receivables = 365 days/AR turnover
benchmark for days’ sales in receivables is the company’s credit terms
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Efficiency ratios (3) Account payables turnover: How many times accounts payables

Efficiency ratios (3)

Account payables turnover: How many times accounts payables (AP)

are “rolled over” during a year?
Account payables turnover = COGS/ AP
Days of payable outstanding= 365 days/AP turnover
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Cash Conversion Cycle Sum of the days of sales outstanding (average

Cash Conversion Cycle

Sum of the days of sales outstanding (average collection

period) and days of sales in inventory less the days of payables outstanding.
Cash Days of Days of Days of
Conversion = Sales + Sales in - Payables
Cycle Outstanding Inventory Outstanding
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Asset Turnover ratios Total Asset Turnover = Sales / Total Assets

Asset Turnover ratios

Total Asset Turnover = Sales / Total Assets
NB: It

is not unusual for TAT < 1
Fixed asset Turnover = Sales / Fixed assets
Net Working Capital Turnover = ?
Слайд 39

Operating Profitability measures Operating Profitability measures focus on the core results

Operating Profitability measures

Operating Profitability measures focus on the core results of

a business before the impact of financing costs and taxes
Operating profit margin = operating income/Sales ? = EBIT/sales
Operating return on asset = Operating Income/Total Assets
(also called Operating Income Return on Investment)
We can decompose it as follows:
OIROI =Operating Profit Margin X Total Asset Turnover
Слайд 40

Net Profitability measures The focus here is on the bottom line

Net Profitability measures

The focus here is on the bottom line
Net profit

margin = Net income/sales
Return on asset (ROA) = NI/Total assets
Return on equity (ROE) =NI/Total equity
Слайд 41

Deriving the DuPont Identity ROE = NI / Total Equity Multiply

Deriving the DuPont Identity

ROE = NI / Total Equity
Multiply by (TA/TA)

and then rearrange
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * Equity Multiplier
Multiply by (Sales/Sales) again and then rearrange
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = Profit Margin * TAT * EM
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Using the DuPont Identity ROE = Profit Margin * Total Asset

Using the DuPont Identity

ROE = Profit Margin * Total Asset Turnover

* Equity Multiplier
Profit margin is a measure of the firm’s operating efficiency – how well it controls costs
Total asset turnover is a measure of the efficiency with which a firm uses its assets – how well it manages its assets
Equity multiplier is a measure of the firm’s financial leverage
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Market ratios (1) Earnings per share= total Net Income / #

Market ratios (1)

Earnings per share= total Net Income / # of

shares
Market to book ratio = Market value per share/ Book value per share
Price earnings ratio (PE)= Market value per share/ earnings per share
Слайд 44

Market ratios (2) Market ratios reflect investors’ expectations How could you

Market ratios (2)

Market ratios reflect investors’ expectations
How could you interpret a

high PE versus a low PE?
Similarly, what could mean a high Market to book ratio versus a low one?
Слайд 45

Remember why we compute ratios A ratio needs to tell you

Remember why we compute ratios

A ratio needs to tell you something

about the company you analyze.
Ratio analysis will allow you to:
connect various components of a business and high light its strengths and weaknesses
Catch the trends (in other words evolution through time) of those components
Compare a company with its competitors and more broadly to its industry
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Benchmarking (1): Trend analysis Analyzing data through time: Quarterly evolutions: spots

Benchmarking (1): Trend analysis

Analyzing data through time:
Quarterly evolutions: spots seasonality and

or extraordinary events
Annual comparisons allows an analysis of bigger trends and often underline the impact of macro economic cycles
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Benchmarking (2): Peer group and competitor analysis Makes sense both from

Benchmarking (2): Peer group and competitor analysis

Makes sense both from a

managerial and an investment point of view
Highlight the specific competitive advantages of the company as well as its differences in capital structure
leads a “normative” view on the company performance
Highlight differences between industries
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Limitations of Ratio analysis Differences in accounting practices Subjectivity in the

Limitations of Ratio analysis

Differences in accounting practices
Subjectivity in the interpretation

of ratios
Seasonal biases
Difficulty in identifying proper comparable peers.
Published peer group or industry averages are only approximations and subject to distortion.
Industry averages are not always desirable targets or norms? e.g. industry downfall or market wide overvaluation.
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