FNCE6006 Equity Analysis II BW

SMU Classification: Restricted
FNCE 6006: Equity Analysis and Portfolio Management
Equity Analysis II
Dr Benedict Koh
Professor of Finance (Education)
Price to Book Value Multiple

• Equity Value (E) = P / BV multiple x Firm’s BV of Equity
• Intrinsic Value = E / No of shares
• Frequently used in valuation of capital-intensive
companies
© Benedict Koh
Price to Cash Flow Multiple

• Equity Value (E) = P / CF multiple x Firm’s CF
© Benedict Koh
Price to Sales Multiple

• Equity Value (E) = P / S multiple x Firm’s Revenue
© Benedict Koh
Enterprise Value to EBITDA Multiple

• Enterprise Value (EV) = Market value of debt, equity, preferred
equity, Minority Interest less cash and short-term investment
• EBITDA = Earnings before interest, taxes, depreciation and

amortization
• Enterprise Value of Firm = EV / EBITDA multiple x Firm’s EBITDA
• Market Value of Equity (E) = EV + cash + short-term investments -

debt - pref equity – Minority Interest
• Frequently used in valuation of capital-intensive companies
© Benedict Koh
Enterprise Value Multiple

▪Advantage to P/E
• Less sensitive to differing financial leverage of companies
• Less sensitive to differing depreciation and amortization
policies of companies
• Can be used even when eps is negative
▪Disadvantage of EBITDA
• Overestimate cash flow when companies is growing (growing
working capital and capex)
© Benedict Koh
Cash Flow Valuation Models

•Free Cash Flow to Firm (FCFF)
•Free Cash Flow to Equity (FCFE)
© Benedict Koh
i) FCFF Valuation Model
The value of a firm VF is the present value of all future

expected cash flows discounted at the weighted average cost
of capital.

FCFF t
VF = t
t=1 (1 + r wacc )
© Benedict Koh
i) FCFF Valuation Model
FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 …. TVT
Forecast Period
© Benedict Koh
FCFF Valuation Procedure

1) Project the firm’s annual free cash flow (FCFF) during forecast period
2) Estimate the weighted average cost of capital
3) Compute the present value of free cash flow during the forecast period
4) Estimate the terminal value
5) Estimate the value of non-operating assets such as excess marketable
securities, non-consolidated subsidiaries and other financial investments.
6) Estimate the value of firm’s liabilities and financial claims (debt, pension,
preferred stocks, leases etc)
7) Compute the value of equity
• Ve = PV(FCFF during forecast period) + PV(Terminal Value) + Value of
non-operating assets – Debt – other financial claims
8) Compute the value of firm’s shares
• Value of share = Value of Equity / Number of shares
© Benedict Koh
Free Cash Flow to Firm (FCFF)
Revenue
- Operating expenses
Net Operating Income (EBITDA)
- Depreciation & Amortization
Earnings before interest & taxes (EBIT)
- Taxes
NOPAT
+ Depreciation & Amortization
Gross Cash Flow
- Increase in Working Capital
- Capital Expenditure (Capex)
- Increase in net other assets
Free Cash Flow to Firm
© Benedict Koh
Computing FCFF from Net Income

Revenue
- Operating Expenses
= Net Operating Income (EBITDA)
= Earnings before Interest & Taxes (EBIT)
- Taxes
= NOPAT
- Interest Expenses To debt holders
= Net Income before taxes
- Taxes To Govt
= Net Income
- Dividends To shareholders
= Earnings retained
Free Cash Flow to Firm (FCFF)

EBIT(1 - tax rate) or NOPAT
+ Depreciation & amortisation
- Capital Expenditures
- Change in non-cash working capital
= FCFF
© Benedict Koh
Computing FCFF from Net Income

Net Income (NI)
+ Interest expense x (1 – tax rate)
- Interest income x (1 – tax rate)
+ Net noncash charges such as Depreciation & Amortization
- Increase in other assets
= Free Cash Flow to Firm
© Benedict Koh
Forecast Period
•1, 3, 5 or 10 years?
•Guideline
•project cash flows until steady state or
maturity
© Benedict Koh
Weighted Average Cost of Capital (WACC)
Firms Balance Sheet

Current
Assets Cost of debt = rd
Debt
Fixed
Assets Equity Cost of retained earnings = re
WACC = wd (1 − t )rd + we re
wd = D/(D+E) and we= E/(D+E)
© Benedict Koh
Terminal Value
•Constant Growth TV =
FCFFT +1
(rwacc − g )
•g = ???
• Inflation rate
• Long-term economic growth
• Long-term industry growth
© Benedict Koh
FCFE Valuation Procedure

1) Forecast the annual free cash flow to shareholders
2) Estimate the required rate on return on equity (CAPM)
3) Compute the present value of free cash flow to equity during
the forecast period
4) Estimate the terminal value
5) Compute the value of equity
Ve = PV(FCFE during forecast period) + PV(Terminal Value)
6) Compute the value of firm’s shares

Value of share = Value of Equity / Number of shares
© Benedict Koh
Free Cash Flow to Equity (FCFE)

Earnings before interest & taxes (EBIT)
- Interest Expense
Earnings before tax (EBT)
- Taxes
Net Income (NI)
+ Depreciation & Amortization
Gross Cash Flow
Free Cash Flow from operations
- Preferred Dividends
- Principal repayments
+ Proceeds from new debt issues
© Benedict Koh
Computing FCFE from Net Income

Revenue
- Operating Expenses
= Net Operating Income (EBITDA)
= Earnings before Interest & Taxes (EBIT)
- Taxes
= NOPAT
- Interest Expenses To debt holders
= Net Income before taxes
- Taxes To Govt
= Net Income
- Dividends To shareholders
= Earnings retained

Net Income before extraordinary items
+ Depreciation & amortisation
- Capital Expenditures
- Change in non-cash working capital
= Free cash flow from operations
- Preferred dividends
- Principal repayments
+ Proceeds from new debt issues
= FCFE
© Benedict Koh
Terminal Value
•Constant Growth TV =
FCFE T +1
(re − g )
•g = ???
• Inflation rate
• Long-term economic growth
• Long-term industry growth
• rr * ROE
© Benedict Koh
Which model do you choose in valuing a stock?
Use FCFE:
For firms with stable leverage
Use FCFF
For firms which have high leverage, and expect to lower the
leverage over time, because debt payments do not have to be
factored in & cost of capital does not change dramatically over
time.
© Benedict Koh

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SMU Classification: Restricted

FNCE 6006: Equity Analysis and Portfolio Management

Price to Book Value Multiple

Price to Cash Flow Multiple

Price to Sales Multiple

Enterprise Value to EBITDA Multiple

• EBITDA = Earnings before interest, taxes, depreciation and

• Enterprise Value of Firm = EV / EBITDA multiple x Firm’s EBITDA

• Market Value of Equity (E) = EV + cash + short-term investments -

• Intrinsic Value = E / No of shares

• Frequently used in valuation of capital-intensive companies

Enterprise Value Multiple

Cash Flow Valuation Models

i) FCFF Valuation Model

The value of a firm VF is the present value of all future

i) FCFF Valuation Model

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 …. TVT

FCFF Valuation Procedure

Free Cash Flow to Firm (FCFF)

Computing FCFF from Net Income

Free Cash Flow to Firm (FCFF)

Computing FCFF from Net Income

Weighted Average Cost of Capital (WACC)

Firms Balance Sheet

FCFE Valuation Procedure

6) Compute the value of firm’s shares

Free Cash Flow to Equity (FCFE)

Computing FCFE from Net Income

Free Cash Flow to Equity (FCFE)

Which model do you choose in valuing a stock?

For firms with stable leverage

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