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effective method:
● Reflects cash generation ability: OCF (Operating Cash Flow) directly reflects a
company's ability to generate cash from its core business activities. This cash flow is not
affected by accounting factors such as depreciation or taxes, helping investors accurately
assess the profit potential of the company.
● Assess financial health: A high OCF indicates that a company can sustain its operations,
repay debts, and reinvest without relying heavily on external sources of capital. This
demonstrates strong financial health and reduces risk for investors.
● Predict future growth potential: A high OCF suggests that a company has growth
potential in the future. Abundant cash flow enables the company to reinvest, expand
operations, and increase profitability.
Limitations:
● OCF does not reflect the value of non-operating assets or long-term investments.
● OCF can be manipulated by tax or accounting management activities.
● OCF does not predict market risk or fluctuations.
Conclusion:
Valuing a company based on OCF is an effective method to cash generation ability, financial
health, and growth potential. However, investors should combine OCF with other methods for a
comprehensive and accurate assessment of the company's value.
Additionally:
- OCF is used to calculate the value of a business using the Discounted Cash Flow (DCF)
method.
- OCF is an important metric used by investors and analysts to evaluate companies.
WACC formula:
WACC (Weighted Average Cost of Capital): is calculated by the average cost with the
proportion taken according to the types of capital used by the business.
WACC = ( E+ED ) x k + ( E+DD ) x k x ( 1 – T )
e d c
Or
WACC = (Wi x ri) + (Wp x rp) + (WS x rS) + (Wr x rr) + (Wn x rn)
W (%) : the proportion of :
R (%) : cost of:
i: debt (loan & bond) – long-term debt
p: preferred stock
s: common stock
r: retained earnings
n: issuing new stock
❑
∑
❑
W =100% (capital structure)
EXAMPLE: Over five years, a firm’s sales revenue equals $50 000, production costs equal $30
000, depreciation expense for tax purposes equals $8000, corporate tax rate is 20%. Besides, the
capital structure is 40% on debt and 60% on equity. The risk-free rate is 8% and the stock market
return is 10%, beta is 1.5, and the firm is charged 12% on cost of debt. Calculate the value of the
firm at the present.
WACC = kd ( 1 - Tc) x %D + ke x %E
= 10.44%
5
=> PV =∑ ❑ ¿=59677.0444
i=1
2. Assumption of Infinite Period: Simplifies the calculation process and enhances our
understanding of the present value of a series of future cash flows.
- Considers the impact of future cash flows: Business projects often extend over a long
period, and it's challenging to precisely determine the exact end time. Assuming an
infinite period helps eliminate the complexity of pinpointing this exact moment.
- Convenient for calculations.
- Flexibility in estimating value: Creates a more flexible calculation environment when
estimating the present value of cash flows. Supports assessing the impact of variability
and uncertainty in the future.
*** This assumption may not accurately reflect reality, so it should be applied with caution to
avoid deviations in evaluating the actual value of cash flows.
Why Make the Assumption of an Infinite Period Instead of Extending the Estimate of
Operating Cash Flow?
Because it offers a minor benefit - small variations in volatility. If there is significant volatility,
reconsideration and recalculation are necessary.
- Simplification: helps simplify the process of calculating the company's value. Estimating
OCF for a long period can be complex and time-consuming.
- Focus on long-term value: focuses on the long-term value of the company, rather than
short-term cash flow fluctuations.
- Suitable for certain business models: Some business models have relatively stable cash
flows over the long term, such as large companies like Microsoft, Apple, Samsung,...
- Reflects investor expectations: Some investors are concerned about the long-term value
of the company and are willing to invest in companies that can generate stable cash flows
in the future.
Therefore, using the assumption of infinite periods requires careful consideration and should be
combined with other valuation methods to provide a comprehensive assessment of the company's
value.
In addition to the assumption of infinite periods, there are other methods to extend the
estimation of OCF:
- Growth models: Use growth models to estimate the growth rate of OCF in the future.
- Discounted Cash Flow (DCF) model: Use the DCF model to estimate the present value
of OCF over a certain period.
When the growth rate fluctuates downwards, calculating the present value of cash flows in the
infinite period becomes more complex compared to the case with a constant growth rate.
However, there are still several methods to perform this calculation:
- Sum-of-the-parts method (segmentation): Divide the cash flows into smaller groups, each
with a different growth rate. Then, calculate the present value of each group and sum
them to obtain the present value of the entire cash flow.
- Using mathematical formulas: Mathematical formulas can be used to calculate the
present value of cash flows with a growth rate that changes over time. These formulas
often rely on the Gompertz growth model or the Logistic growth model.
- Using financial software: Financial software assists in calculating the present value of
cash flows with a growth rate that changes over time. These software applications
typically employ advanced calculation methods and may provide more accurate results
compared to manual methods.
*** Example: Suppose you have projected cash flows that will grow by 5% for the first 5 years,
then gradually decrease to 2% over the next 10 years, and finally to 1% over the following 15
years. The discount rate is 10%.
The following formula can be used to calculate the present value of cash flows with a growth
coefficient that changes over time:
PV = Σ (OCFt / (1 + r)^t) * (1 - (1 + g)^(-n)) / (r - g)
−n
OCF t (1− (1+ g ) )
( Ghi lại ): PV = Σ x
(1+r )
t
r −g
In which:
PV: Present Value
OCFt: Expected cash flow in year t
r: Discount rate
g: Growth rate
n: Number of years
⇨ Present value of the cash flow to be 1013.59, similar to the result obtained using the
multiplication summation method.
● Using Software:
Financial software such as Microsoft Excel, Financial Calculators, or other specialized software
can be utilized to calculate the present value of the cash flow with a changing growth rate over
time.
Below are the steps to value a stock using the OCF method:
1. Calculate OCF:
Direct method: Obtain the cash flow from operating activities in the cash flow statement.
Indirect method:
● Start with earnings before taxes (EBT).
● Add non-cash expenses (such as depreciation, amortization of intangible assets, provision
for inventory impairment).
● Subtract non-cash revenues (such as gains from the sale of fixed assets).
● Adjust for changes in working capital (such as inventory, accounts receivable, accounts
payable).
2. Project OCF:
Forecast OCF in the future based on the company's growth rate, business plans, and market
analysis.
3. Choose the discount rate:
● The discount rate (WACC) is the investor's required rate of return.
● WACC is calculated based on the cost of equity and the cost of debt, along with the
company's capital structure.
4. Calculate the Net Present Value (NPV) of OCF:
NPV = Σ (OCFt / (1 + WACC)^t)
where t is the number of projected years.
5. Calculate the stock value:
Stock value = NPV / Number of shares outstanding.
NOTES:
- The OCF method may not be suitable for companies with high investment levels or significant
changes in working capital.
- Use other valuation methods to compare and verify the reliability of the results.
ADVANTAGES DISADVANTAGES