AF616- Financial Statement Analysis
Module 13: Cash Flow
Based Valuation
Kun Yu, Financial Statement Analysis 13-1
Discounted Cash Flow (DCF) Model
𝐹𝐶𝐹𝐹1 𝐹𝐶𝐹𝐹2 𝐹𝐶𝐹𝐹3
𝐼𝑉0 = + + +⋯
1+ 𝑟𝑤 (1+ 𝑟𝑤) (1+ 𝑟𝑤)
2 3
FCFF is free cash flows to the firm, defined as operating cash flows net of
the expected new investments in net operating assets (such as property,
plant and equipment) that are required to support the business.
FCFF = NOPAT – Increase in NOA
The weighted average cost of capital (WACC), not the cost of equity
capital, is used to discount the expected future free cash flows.
Kun Yu, Financial Statement Analysis 13-2
DCF model with increasing
perpetuity
Free cash flows to the firm (FCFF) for the first n periods are
FCFF1, FCFF2,…, FCFFn.
The first n periods are referred to as the horizon period
FCFF becomes FCFFn+1 for period n+1 and grows at a
constant growth rate g thereafter. For example, FCFF at the
end of period n+2 is FCFFn+1*(1+g)
Period n+1 and beyond are referred to as the terminal period
𝐹𝐶𝐹𝐹𝑛+1
Terminal value = FCFFn+1/(rw-g)
𝐹𝐶𝐹𝐹1 𝐹𝐶𝐹𝐹2 𝐹𝐶𝐹𝐹3 𝐹𝐶𝐹𝐹𝑛 𝑟𝑤 −𝑔
𝐼𝑉0 = + + +⋯+ +
1+𝑟𝑤 (1+𝑟𝑤) (1+𝑟𝑤)
2 3 (1+𝑟𝑤) (1+𝑟𝑤)𝑛
𝑛
Kun Yu, Financial Statement Analysis 13-3
Steps in Applying the DCF Model
Application of the DCF model to equity valuation involves
five steps:
1. Determine the key assumptions for the DCF model, including
the appropriate horizon period and terminal period, FCFF
growth rate, and WACC.
2. Forecast FCFF for the horizon period and terminal
period.
3. Compute the present value of all the future FCFF, and add the
present value amounts to yield firm (enterprise) value.
4. Subtract net nonoperating obligations (NNO), along with any
noncontrolling interest (NCI), from firm value to yield equity
value.
5. Divide firm equity value by the number of shares outstanding to
yield stock value per share.
Kun Yu, Financial Statement Analysis 13-4
Step 1: Determine Key Assumptions
Use P&G as an example
Assume that today is the end of fiscal year 2016: June 30,
2016.
Horizon period: 2017-2020
Terminal period: 2021 and beyond
FCFF growth rate for the terminal period = 1%
Determine weighted average cost of capital
WACC = rd*(IVdebt/IVfirm)+ rce*(IVce/IVfirm)+ rpe*(IVpe/IVfirm)
rd is the cost of debt, rce is the cost of common equity, and rpe is the
cost of preferred equity
IVdebt, IVce, and IVpe are intrinsic values of debt, common equity and
preferred equity, respectively.
IVfirm = the intrinsic value of the firm = IVdebt+ IVce + IVpe
Kun Yu, Financial Statement Analysis 13-5
P&G’s Cost of Debt Capital
To arrive at the overall cost of debt, we weight the short-term and
long-term average interest rates from the footnotes by the relative
proportion of the ST and LT debt.
P&G discloses $11,653 million book value of ST debt and the
$18,945 million market value of LT debt in the footnotes of the 10-K.
Assume market value of ST debt = book value of ST debt. Market
value of total Debt (IVdebt) = 11,653 + 18,945 = 30,598
Pretax cost of debt
= 0.2%* (11,653/30,598) + 3.1% * (18,945/30,598)
= 2%
Statutory tax rate = 37%
Rd = pretax cost of debt * ( 1 – tax rate) = 2% * (1 – 37%) = 1.26%
Kun Yu, Financial Statement Analysis 13-6
P&G’s Cost of Common and Preferred
Equity
Cost of common equity
Risk free rate (Rf): 10-year treasury bill of 1.49%
P&G’s beta = 0.63
Market premium = 6%
Rce = Rf + beta*market premium = 1.49% + 0.63*6% = 5.27%
Cost of preferred equity = Preferred dividends/Preferred stock
Preferred dividends $255 million
Book value of preferred stock = $1,038 million
Rpe= 255/1,038 = 24.57%
Kun Yu, Financial Statement Analysis 13-7
P&G’s WACC
Capital structure
Market value of Debt (IVdebt)= 11,653 + 18,945 = 30,598
Market value of common equity
No. of shares outstanding from the balance sheet (see Appendix 13A)
= No. of issued shares – No. of treasury shares
= 4,009 – 1,341
= 2,668 million shares
Assume stock price = $72
Market value of common equity (IVce) = 72*2,668 = 192,096
Market value of preferred equity (IVpe) = book value of preferred stock = 1,038
IVfirm = IVdebt + IVce +IVpe = 30,598+ 192,096+ 1,038 = 223,732
IVdebt/Ivfirm = 30,598/223,732 = 13.7%
IVce/IVfirm= 192,096/223,732 = 85.9%
IVpe/Ivfirm= 1 – 13.7% - 85.9% = 0.4%
WACC = rd*(IVdebt/IVfirm)+ rce*(IVce/IVfirm)+ rpe*(IVpe/IVfirm)
= 1.26%*13.7% + 5.27%*85.9%+24.57%*0.4%
= 4.80%
Kun Yu, Financial Statement Analysis 13-8
Step 2: Forecast FCFF
FCFF = NOPAT – Increase in NOA
Forecast NOPAT and NOA for each year during
the horizon period and the terminal year. For
P&G:
Determine NOPAT and NOA for 2016.
Forecast NOPAT and NOA for the horizon years from
2017 to 2020, and those for the terminal year 2021.
Kun Yu, Financial Statement Analysis 13-9
Forecast of P&G Income Statements
Kun Yu, Financial Statement Analysis 13-10
Forecast of P&G Balance Sheets
Kun Yu, Financial Statement Analysis 13-11
NOPAT and NOA for P&G
2017:
NOPAT = 14,773 – [3,594+(579 – 182)*37%] =11,032
NOA = 121,641 – 8,172 – 6,246 – 0 – 9,431 – 7,519 – 9,233 – 10,420 = 70,620
2018:
NOPAT = 15,068 – [3,668+(579 – 182)*37%] =11,253
NOA = 120,334 – 6,130 – 6,246 – 0 – 9,620– 7,669 – 9,418 – 10,629 = 70,622
Kun Yu, Financial Statement Analysis 13-12
Forecast FCFF for P&G
Kun Yu, Financial Statement Analysis 13-13
Step 3: Compute the Present Value of
FCFF
𝐹𝐶𝐹𝐹𝑛+1
𝐹𝐶𝐹𝐹1 𝐹𝐶𝐹𝐹2 𝐹𝐶𝐹𝐹3 𝐹𝐶𝐹𝐹𝑛 𝑟𝑤 − 𝑔
𝐼𝑉0 = + + + ⋯+ +
1+ 𝑟𝑤 (1+ 𝑟𝑤) (1+ 𝑟𝑤)
2 3 (1+ 𝑟𝑤) (1+ 𝑟𝑤)𝑛
𝑛
Discount factor for FCFF1 = 1/(1+0.048) = 0.95420
PV of FCFF1 = 10,803 * 0.95420 = 10,308
Terminal value = = = 291,053
PV of terminal period FCFF
= = = 241,283
Kun Yu, Financial Statement Analysis 13-14
Step 4: Compute the Intrinsic Value of
Equity
Intrinsic value of equity = Intrinsic value of firm – NNO – NCI
Intrinsic value of the firm represents the true value of the
firm’s operating assets
NNO is net nonoperating obligations
NNO = Nonoperating liabilities - nonoperating assets
Note that NNO could be positive or negative
NNO is positive if nonoperating liabilities exceed nonoperating assets
NNO is negative if nonoperating assets exceed nonoperating liabilities
NCI is noncontrolling interest reported on the balance sheet
For P&G, from the balance sheet at the end of FY2016:
NNO = ($2,343 + $11,653 + $18,945) - ($7,102 + $6,246 + $7,185)
= $12,408
NCI = 642
Intrinsic value of equity = 278,208 – 12,408 – 642 = 265,158
Kun Yu, Financial Statement Analysis 13-15
Step 5: Compute Equity Value Per
Share
Kun Yu, Financial Statement Analysis 13-16
Parsimonious Method for Forecasting
NOPAT and NOA
The parsimonious method requires three crucial inputs:
1. Sales growth
2. Net operating profit margin (NOPM) = NOPAT divided by Sales
3. Net operating asset turnover (NOAT) = Sales divided by ending
balance of NOA
We use year-end NOA instead of average NOA because we
want to forecast year-end values.
Kun Yu, Financial Statement Analysis 13-17
Forecasting P&G NOPAT and NOA
Each year’s forecasted sales = Prior year sales * (1 + growth rate)
NOPAT = Forecasted sales each year * base year NOPM
NOA = Forecasted sales / base year NOAT.
Base Year: NOPM = 15.4% and NOAT = 0.93
Kun Yu, Financial Statement Analysis 13-18
A Comprehensive Template
A comprehensive template has been created to help
you understand the application of the DCF model
based on the parsimonious forecast method.
You can find the template in the folder “Week 12” on
the Blackboard.
We start with the financial statements for Cisco
Systems for the year ended on July 25, 2015.
Key assumptions
Sales growth rate for 2016: 1%
Sales growth rate for 2017-2019: 2%
Terminal FCFF growth rate: 1%
WACC: 10%
Kun Yu, Financial Statement Analysis 13-19
Cisco Systems I nc.
Consolidated Statement of Operation
$ millions 25-J ul-15
REVENUE:
Product 37,750
Service 11,411
Total revenue 49,161
COST OF SALES:
Product 15,377
Service 4,103
Total cost of sales 19,480
GROSS MARGIN 29,681
OPERATING EXPENSES:
Research and development 6,207
Sales and marketing 9,821
General and administrative 2,040
Amortization of purchased intangible assets 359
Restructuring and other charges 484
Total operating expenses 18,911
OPERATING INCOME 10,770
Interest income 769
Interest expense (566)
Other income (loss), net 228
Interest and other income (loss), net 431
INCOME BEFORE PROVISION FOR INCOME TAXES 11,201
Provision for income taxes 2,220
NET INCOME 8,981
NOPAT = Net operating profit before taxes – (tax expense – net
nonoperating revenue * tax rate) = 10,770 – 2,220 + 431 * 37% = 8,709
NOPM = 8,709/49,161 = 17.7%
Kun Yu, Financial Statement Analysis 13-20
Cisco Systems I nc.
Consolidated Balance Sheets
$ millions 25-J ul-15 26-J ul-14
Assets
Cash and cash equivalents 6,877 6,726
Investments 53,539 45,348
Accounts receivable, net 5,344 5,157
Inventories 1,627 1,591
Financing receivables, net 4,491 4,153
Deferred tax assets 2,915 2,808
Other current assets 1,490 1,331
Total current assets 76,283 67,114
Property and equipment, net 3,332 3,252
Financing receivables, net 3,858 3,918
Goodwill 24,469 24,239
Purchased intangible assets, net 2,376 3,280
Other assets 3,163 3,267
TOTAL ASSETS 113,481 105,070
Liabilities
Short-term debt 3,897 508
Accounts payable 1,104 1,032
Income taxes payable 62 159
Accrued compensation 3,049 3,181
Deferred revenue 9,824 9,478
Other current liabilities 5,687 5,451
Total current liabilities 23,623 19,809
Long-term debt 21,457 20,337
Income taxes payable 1,876 1,851
Deferred revenue 5,359 4,664
Other long-term liabilities 1,459 1,748
Total liabilities 53,774 48,409
Equity
Common stock and additional paid-in capital (5,085
shares issued and outstanding at July 25, 2015) 43,592 41,884
Retained earnings 16,045 14,093
Accumulated other comprehensive income 61 677
Total Cisco shareholders’ equity 59,698 56,654
Noncontrolling interests 9 7
Total equity 59,707 56,661
TOTAL LIABILITIES AND EQUITY 113,481 105,070
Kun Yu, Financial Statement Analysis 13-21
Computation of NOA and NNO
Nonoperating assets = Cash + Investments
= 6,877 +53,539
= 60,416
Nonoperating liabilities = Short-term debt + Long-term debt
= 3,897 + 21,457
= 25,354
NNO = Nonoperating liabilities - Nonoperating assets
= 25,354 – 60,416
= -35,062
NOA = (Total assets – Nonoperating assets) – (Total liabilities –
Nonoperating liabilities)
= (113,481 – 60,416) – (53,774 – 25,354)
= 24,645
NOAT = Sales / NOA = 49,161/24,645 = 1.99
Kun Yu, Financial Statement Analysis 13-22
Cisco Firm Valuation
2016 2017 2018 2019 Terminal
CI SCO (in millions) 2015 Actual
Estimated Estimated Estimated Estimated Period
ASSUMPTI ONS
Net sales growth 1.00% 2.00% 2.00% 2.00% 1.00%
Net Operating Profit Margin for base year (NOPM) 17.7%
Net Operating Asset Turnover for base year (NOAT) 1.99
Weighted average cost of capital (WACC) 10%
MODEL I NPUTS
Net sales (unrounded) 49,161 49,652.61 50,645.66 51,658.58 52,691.75 53,218.66
Net sales (rounded to the whole number) 49,161 49,653 50,646 51,659 52,692 53,219
NOPAT = Net sales × NOPM (rounded to the whole number) 8,709 8,789 8,964 9,144 9,326 9,420
NOA = Net sales / NOAT (rounded to the whole number) 24,645 24,951 25,450 25,959 26,478 26,743
Net nonoperating obligations (NNO) (35,062)
Noncontrolling interest (NCI) 9
Number of common shares outstanding 5,085
MODEL
NOPAT 8,789 8,964 9,144 9,326 9,420
Increase in NOA 306 499 509 519 265
FCFF (NOPAT - Increase in NOA) 8,483 8,465 8,635 8,807 9,155
Discount factor at WACC (rounded to 5 decimals) 0.90909 0.82645 0.75131 0.68301
Present value of horizon FCFF (rounded to the whole number) 7,712 6,996 6,488 6,015
Cumulative PV of horizon FCFF 27,211
Present value of terminal FCFF (rounded to the whole number) 69,477
Total firm (enterprise) value 96,688
Less Net nonoperating obligations (NNO) (35,062)
Less noncontrolling interest (NCI) 9
Firm equity value 131,741
Shares outstanding 5,085
Stock price per share $25.91
Kun Yu, Financial Statement Analysis 13-23
