Category: Essential Concepts for Level II

09-12-19 Essential Concept 51: FCFF and FCFE Approaches to Valuation

Free cash flow to the firm (FCFF) is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made. A firm’s suppliers of capital include common stockholders, bondholders, and preferred stockholders. Free cash flow to equity (FCFE) is the cash flow available to the company’s common stockholders after all operating expenses, interest, and principal payments have been paid and necessary investments in working and fixed capital have been made. The two methods to value equity using free cash flows are: Discount FCFF… Read More

101 concepts level II

09-12-19 Essential Concept 52: Calculating FCFF and FCFE

FCFF FCFF from NI: FCFF = NI + NCC + Int (1 – tax rate) – FCInv – WCInv FCFF from EBIT: FCFF = EBIT (1 – Tax rate) + Dep – FCInv – WCInv FCFF from EBITDA: FCFF = EBITDA (1 – Tax rate) + Dep (Tax rate) – FCInv – WCInv FCFF from CFO: FCFF = CFO + Int (1 – Tax rate) – FCInv FCFE FCFE from FCFF: FCFE = FCFF – Int (1 – Tax rate) + Net Borrowing FCFE from NI: FCFE = NI + NCC – FCInv – WCInv + Net borrowing FCFE… Read More

101 concepts level II

09-12-19 Essential Concept 53: Estimating Company Value using Cash Flow Models

Single-stage (constant-growth) FCFF and FCFE models: Multi-stage FCFF and FCFE models There are several versions of the multi-stage model. In one version, we estimate the free cash flows up to a certain number of years and assume that the free cash flows will grow at a constant rate from there on. The formulas for this version are: Another version assumes declining growth in Stage 1 followed by a long-run sustainable growth rate in Stage 2. We can use the H-model formula (discussed in DDM) for this version. Three-stage growth models are appropriate for companies that have three distinct… Read More

101 concepts level II

09-12-19 Essential Concept 54: Commonly Used Price Multiples

Price to earnings (P/E): Ratio of a stock’s market price to its earnings per share. There are two variations of P/E: the trailing P/E and the forward P/E. Trailing P/E is a stock’s current market price divided by the most recent four quarters’ EPS. The forward P/E or leading P/E, is a stock’s current price divided by next year’s expected earnings. Rationales for using P/E include: Earnings are the key driver of value. P/E ratio is widely recognized and used by investors. Differences in P/Es may be related to differences in long-run average returns. Drawbacks of using P/E include: Earnings can… Read More

101 concepts level II

09-12-19 Essential Concept 55: EV Multiples

Enterprise value is measured as: Enterprise value = Market value of common equity + Market value of preferred stock + Market value of debt – Cash and investments EV/EBITDA is one of the most widely used enterprise value multiples. It is the ratio of the total company value to EBITDA. The rationales for using EV/EBITDA are as follows: For companies with different financial leverage, EV/EBITDA is a better choice than P/E as it is a pre-interest figure. It increases the comparability across businesses as the age of the assets (and hence, depreciation and amortization) may vary. EBITDA is often positive,… Read More

101 concepts level II

09-12-19 Essential Concept 56: Residual Income, Economic Value Added (EVA), and Market Value Added (MVA)

Residual income is defined as the earnings for a given period minus the opportunity cost of equity holders. It can be calculated in two ways: Residual income = net income – (equity capital x cost of equity) Residual income = EBIT (1 – tax rate) – (total capital x WACC) EVA is a commercial implementation of the residual income concept. EVA = NOPAT – (C% * TC) where, NOPAT = company’s net profit after taxes C% = cost of capital TC = total capital. MVA is based on the idea that a company must generate economic profit for its… Read More

101 concepts level II

09-12-19 Essential Concept 57: Residual Income Model

According to the residual income model, the intrinsic value of equity is a sum of two components: The current book value of equity The present value of expected future residual income There are three ways to express the value of a stock under this model: As compared to the DDM and FCFE/FCFF models, residual income models are less sensitive to terminal value estimates. This is because, RI models include the company’s current book value which usually represents a large portion of the estimated intrinsic value.

101 concepts level II

09-12-19 Essential Concept 58: Residual Income Valuation

In a multistage residual income model, we assume different growth rates for the short term and the long-term. We forecast the residual incomes over a short term horizon and estimate a terminal value based on the assumption made about continuing residual income over the long term. Continuing residual income is residual income after the forecast horizon. Usually, one of the following assumptions is made for continuing residual income: Residual income continues indefinitely at a positive level. Residual income is zero from the terminal year forward. Residual income declines to zero as ROE reverts to the cost of equity through time…. Read More

101 concepts level II

09-12-19 Essential Concept 59: Strengths and Weaknesses of Residual Income Models

Strengths of the residual income model include: The model gives less weight to terminal value. RI models use readily available accounting data. It can be used to value non-dividend paying companies. It can be used to value companies with no positive expected near-term free cash flows. It can be used when cash flows are unpredictable. Weaknesses of the residual income model include: The model is based on accounting data that is prone to manipulation. The accounting data may need adjustments. The model assumes that the clean surplus relation holds good. The model assumes that the cost of debt is equal… Read More

101 concepts level II

09-12-19 Essential Concept 60: Market Approach Methods for Valuing Private Companies

The three methods used in a market approach are: Guideline public company method (GPCM): Value based on multiples of comparable public companies; multiples are adjusted to reflect differences in the relative risk and growth prospects. The advantage is the availability of a large number of guideline companies with financial and trading information. The disadvantage is that risk and growth adjustments to the pricing multiple are subjective. Guideline transactions method (GTM): Value based on pricing multiples derived from the acquisition of control of entire public or private companies that were acquired. Whereas GPCM uses a multiple that could be associated with… Read More

101 concepts level II