T.

Hanan Eytan

Fundamental Enterprise Valuation:

I. Introduction
The value of an enterprise equals the sum of the values of all its outstanding debt and equity (and hybrid)
claims.

VA = VD + VE

Value of Value of value of

Enterprise Debts Equities and Hybrids
(Assets)

The term "Value" refers to the present value of the future cash flows, discounted at the appropriate, risk
adjusted discount rate. Our objective in this note is to describe, in terms of accounting data, the main
factors ("drivers") that determine the fundamental enterprise value (FEV), show how they interact.

As can be seen from the above equation, the FEV can be calculated by discounting the future cash flows
from the assets (CFAs) or by discounting the future cash flows to the liability holders (creditors and
equity holders). The fundamental (accounting) relationship is that in any given period,

CFA = cash flow to creditors + cash flow to equity.

Cash flows to creditors (CFC) and cash flow to equity (CFE) can be extracted directly from financial
statements. They are defined as follows:

CFC = interest paid – net new borrowing,

CFE = dividend paid – net new equity issued.

The net new borrowing or equity issued can be negative reflecting, respectively, debt redemption in
excess of borrowing and equity repurchase in excess of equity issued. Note that creditors and equity
holders are not just the existing creditors and equity holders, but also include new lenders and equity
investors.

The cash flows from assets can be directly evaluated as follows

CFA = Operating Cash Flow (OCF) – Capital Expenditures (Capex),

where
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 OCF = Earning Before Depreciation and Amortization (EBITDA) – Taxes paid,

and Capex includes all the capital expenditures. I will discuss Capex later in greater detail.

To understand the different approaches to discounted cash flows (DCF) analysis we must first digress to
discuss the Opportunity Cost of Capital and the Weighted Average Cost of Capital.

The Opportunity Cost of Capital, or simply the Cost of Capital (COC) of "something" is the rate of
return that investors expect to earn on investments in capital markets (i.e., on portfolios of traded
securities) that have the same risk as "something". The enterprise COC or the firm COC means the assets'
COC. ('Something" is assets.) The equity COC and the debt COC are defined similarly. When the values
of the assets, equity and debt are at their correct levels, they are expected to earn a rate of return equal to
their respective costs of capital.

Denoting the assets, equity and debt costs of capital by RA, RE, and RD respectively, we can write the
following identity:

VA*RA = VE*RE + VD*RD. (1)

This identity says that the monetary value that the assets are expected to generate is equal to the sum of
the monetary values expected to be earned by equity holders and debt holders. Dividing the identity by
the value of the assets we obtain

RA = (VE/VA)* RE + (VD/VA)*RD, (2)

Which shows that the assets COC is the weighted average of the liabilities (debt and equity) costs of
capital. This relationship is always true, regardless of the existence or absence of taxes. In a model of the
world in which taxes are NOT included, we can say that the assets COC is the Weighted Average Cost of
Capital (WACC). However, in a world with taxes the WACC usually has a slightly different meaning.

The WACC
Consider an enterprise financed with debt and equity (the "levered firm") and compare its CFA to what it
would be if the enterprise were financed only with equity during the current period (the "unlevered firm".)
The levered firm values will have the superscript "L" and the unlevered values will have the superscript
"U". Since interest payments are deductible the only difference between the CFAs of the levered and the
unlevered firms is the tax saving from interest deduction -- the Interest Tax-Shield (ITS). The ITS equals
the interest multiplied by the average tax rate on interest. Assuming for simplicity a single corporate tax
rate denoted by tc, we have

ITS = VD*RD*tc
and
CFAL = CFAU + VD*RD*tc.

Similarly, equation (1) can be restated as follows (values without a superscript are the leveraged firm
values)

VA*RA = VUA*RUA + VD*RD*tc = VE*RE + VD*RD. (3)

Rearranging the equation on the right side of (3) we obtain

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 VUA*RUA = VE*RE + VD*RD*(1-tc). (4)

Let us now define a rate of return (k) such that when we multiply it by the value of the levered firm we
obtain the expected monetary return generated by the assets of the unlevered firm. That is, k satisfies the
following equation

k * VA = VUA*RUA. (5)

Substituting from (4) into (5) and solving for k we obtain

k = (VE/VA)*RE + (VD/VA)*RD*(1– tc). (6)

The rate of return k is the WACC. Note that the WACC defined in this manner is different from the assets
COC defined in (2). The assets COC and k are equal only when tc = 0.

We will now see that discounting the unlevered firm’s cash flows with the WACC results in the value of
the levered firm. First note that since the unlevered firm is unlevered only for the current period, its end
of period value (not including the cash flows of the current period) is the same as that of the levered firm.
Denoting end of period values with the subscript “1”,

VA, 1 = VUA, 1 (7)

Next, from (3)
VA*(1+ RA) = VA + VUA*RUA + VD*RD*tc. (8)

Substituting from (5) into (8),

VA*(1+ RA) = VA +k* VA + VD*RD*tc.

Rearranging, we obtain

VA = [VA*(1+ RA)  VD*RD*tc]/(1+k). (9)

Since VA*(1+ RA) = CFAL + VA,1

It follows that VA = [CFAL1  VD*RD*tc + VA, 1]/(1+k)

which is equivalent to
VA = [CFAU1 + VA, 1]/(1+k). (10)

Since the same argument can be made recursively for all the future periods (i.e., V A, 1 can be obtained from
CFAU2 and VA, 2 and so on…), it follows that the value of the levered firm is the present value of all the
future CFAUs discounted with the WACC.

I want to emphasize that in the discussion so far it was implicitly assumed that the COC and the WACC
do not change over time. This assumption is often made (implicitly) in textbooks and in practical
applications. In reality the COC and the WACC are rarely stationary. When The WACC changes from
period to period, the discounting should, in principle, done by applying to each period its own WACC. I
will come back to this issue later.

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THREE WAYS TO FUNDAMENTAL ENTERPRISE VALUATION

There are three methods to calculate the free enterprise value (which is equal to V A). The methods differ
in their choice of cash flows to discount and the discount rates applied in the discounting. If all are done
correctly they lead to the same answer.

1. The Capital Cash Flows (CCF) Method. With this method the cash flows to discount are the CFAs
of the levered firm (CFALs) and the discount rate is the assets COC (RA).
2. The Free Cash Flows (FCF) Method. This method is also known as the WACC method. With this
method you discount the CFA of the levered firm after you adjust them to eliminate the ITS. That is,
the free cash flow is calculated as
FCF = CFAL  ITS.
The FCFs are the discounted at the WACC. The present value of the Interest tax shields is captured
through the discount rate. The WACC is lower than the assets COC.
3. The Adjusted Present Value (APV) Method. Here you also discount the FCFs, but the
discount rate to be used is assets COC that would prevail if the enterprise were financed only
with equity. The present value of the interest tax shields is captured with a separate
calculation where the ITSs are discounted with their appropriate risk-adjusted discount rate.
The two values are added to obtain the final result.

II. The Free Cash Flows Method

When the enterprise to be valued has a long life, explicit FCF forecasts are made for only a limited
number of periods. The value of the FCFs beyond the explicit forecasting horizon is assessed with the
help of a model. Often such a model requires the explicit estimation of growth rates. For example, in the
valuation of a firm it is customary to assume infinite life and to use the constant growth model (Gordon's
model) at some point in time. Both, the choice of the explicit forecast horizon and the estimation of
growth rates will be discussed later. Currently we will focus our attention on free cash flows. As stated
previously,

FCF = EBITDA  Cash Taxes Paid  Capex  ITS

We now define Net Operating Profit or Loss Adjusted for Taxes (NOPLAT):

NOPLAT = EBITDA -Depreciation Cash Taxes Paid  ITS = EBITDA  Depreciation  Cash Taxes
 (Net Interest paid)(Average tax rate on interest paid.)

In practice, the financial statements of a firm will often reflect revenues and expenses that are not
recurring in nature. While in principle they are part of the FCFs, the forecasting of FCFs is simplified if
such items are separated from the core FCFs. The present value of such "special" and non-operating CFs
should be valued separately. Thus, the EBITDA should include only the operating income, and the taxes
associated with it. The derivation of NOPLATs and FCFs from the financial statements of Hewlett
Packard is shown in the appendix.) FCF can be stated in terms of NOPLAT as follows

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 FCF = NOPLAT + Depreciation  Capex.

Capital Expenditures (Capex) include all the capital expenditures, not just plan and equipment. In
particular, they include investments in Net Working Capital (NWC). Strictly speaking, NWC is Current
Assets (CA) minus Current Liabilities (CL). However, current interest-bearing liabilities are debt
(financing) and should not be included in Capex. Cash and securities held by the firm are part of CA, but
mostly represent delayed distributions to the firm's claim holders and not investments in the firm's
businesses. The required cash for most firms is quite low, about 1% of sales revenue. For some firms it
can be 4 - 5% of sales, rarely more. The excess cash and securities value is not part of the relevant
current assets. (The interest on excess cash and securities is not part of the NOPLAT. This is why the ITS
is calculated in terms of the Net Interest Paid.) The change (from the beginning of the period to the end
of the period) in the relevant NWC (henceforth "Operating NWC") is the investment in Operating NWC.
That is

Investment in Operating NWC = (Operating NWC)

= CA (other than cash and securities)  (non interest-bearing CL) + Sales,

where  represents the fraction of sales for the calculation of required cash ( = 0.005 to 0.05).

Investments in fixed (depreciable) assets are determined from the change in Net Fixed Assets (NFA) and
Depreciation (D) as follows

Investments in Depreciable Assets = NFA  D.

Other capital expenditures are calculated as from the change in other assets (including Intangibles) minus
the change in other non interest-bearing liabilities. Hence,

Capex = NFA  D + CA (other than excess cash and securities)  (non interest-bearing CL)
+  (other assets)   (other non interest-bearing liabilities).

Putting it all together,

FCF = NOPLAT  NFA  CA (other than excess cash and securities)   (other assets)
+ (non interest-bearing CL) +  (other non interest-bearing liabilities).

Once the estimates of future cash flows and discount rates are obtained, the value of the enterprise is
obtained as

FEV = (Present value of FCFs)+ (Present value of after-tax non-operating cash flows
and excess cash and securities).

Students of valuation are often confused about the treatment of future financing (issuing debt and equity
claims) and the treatment of cash flows generated by changes in excess cash and marketable securities. Is
it necessary to forecast future financing and changes in excess cash and securities? Fortunately, the
answer is no. To see it, let us first consider a firm without any additional future financing that currently
has excess cash and marketable securities. Excess cash normally invested to earn a fair return. Future
changes to level of these cash and securities can be likened to a portfolio with reinvestment of the
periodic earnings. The present value of all the future earnings of this portfolio is the current price of the
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portfolio. That is, the NPV of investments in capital markets is, assumed to be zero. Thus, the present
value of all the future proceeds from current cash and securities is simply their current market value.
Similarly, a free cash flow at some time t) that is not immediately distributed to investors is stored as
excess cash and will earn future returns, but the present value at time t of the benefits of this investment is
just the FCF at time t. Thus, we don't need to worry about how FCFs are reinvested when they are not
immediately distributed. So, in the absence of external future financing the FEV boils down to

FEV = Present value of FCFs + Present value of after-tax non-operating cash flows
+ Current market value of excess cash and securities.

Let us now consider future financing. Suppose that we are now valuing a firm that is currently financed
only with common stock, knowing that in a year the firm will issue more common stock. After the issue
the number of shares outstanding will double. The money raised will be partially invested in operations
and the rest will be "excess cash and securities" until such time when it will be used for investment in
operations, or distributed to investors. Suppose that we correctly identify the future FCFs and other cash
flows, we correctly discount them, and we add the current value of excess cash and securities. What does
the resulting FEV represent?

The resulting FEV is the value of the existing shares. To see that, note the FEV next year, immediately
after the issue (FEV1), is equal to the FEV that would have prevailed without raising the new funds plus
that additional excess cash (from the new funds) plus the present value of all the future changes to FCFs.
Put differently, it is equal to the present value of the adjusted FCFs after the financing plus the addition to
excess cash. This is the value of all the shares outstanding after the issue. The value of the newly issued
shares is simply the value of the funds raised (I am ignoring the transaction cost of issuing.) Hence the
value of the old shares is FEV1 minus funds raised. The funds raised equal the investment in operations
plus excess cash. It follows that the value (after issuing) of the old shares is the present value of the
adjusted FCFs in the years following the issue minus the investment in operations. (Note that the
additional excess cash is out of the picture now.) The investment in operation will show up as a
reduction in the FCF next year.

So, calculating the current present value of all future FCFs and adding the currently outstanding cash is
the correct procedure to find the current enterprise value. We can ignore future additions of excess cash
and we can ignore the future need of external capital. However, we should not be too general here. If
future financing alters the WACC, we need to know how it alters it. That requires us to know the nature
of future external financing. However, if the enterprise financing maintains a constant ratio of debt value
to assets value, the WACC is not affected by external financing.

HORIZONS

Most managers are comfortable in generating pro-forma financial statements and forecasting FCFs for the
next three to five years. Valuation specialists may be comfortable with seven years or even ten years.
Intimate knowledge of the industry and deep understanding of the economics of the competition in the
industry may allow meaningful FCFs forecasting for longer periods. However, beyond a certain time in
the future, the forecast has to become less detailed and must rely on some model. Hence, we separate the
future into two horizons: the explicit forecast horizon and the continuation horizon (or interval). In the
valuation of firms, the continuation horizon extends to infinity (unless the firm’s future liquidation or sale
is contemplated.) The value of the firm at the start of the continuation horizon is called the “continuation
value” (CV). In practice the CV is obtained using several methods. These methods fall into one of the
following two categories: a) mathematical financial models of discounted cash flows and, b) methods of
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multiples, which derive the CV as a predetermined multiple a forecast of some value of interest (for
example, an earning forecast multiplied by a P-E ratio.) The FEV is obtained by adding the discounted
value of the CV to the discounted value of FCFs during the explicit forecast horizon.

The advantage horizon is the time interval during which the firm is expected to enjoy some degree of
monopolistic power that allows it to earn a rate of return in excess of its opportunity cost of capital. We
may similarly define the disadvantage horizon as the time interval during which the firm is expected to
earn a rate of return below its OCC. If the firm not expected to earn at least its COC it should be
liquidated since continuation of operation has a negative net present value. However, the liquidation or
sale value of the firm may sometimes be improved by waiting. Hence, firms may operate rationally while
they are in a disadvantage. However, the disadvantage horizon is always short. On the other hand, the
advantage horizon may be very long. A company like Coca Cola can probably maintain its ability to earn
in excess of its COC for tens of years.

There are two schools of thought about the possibility of an infinite length advantage horizon (take it to
mean “extremely long”.) One school says that eventually competitive forces and changes in the
economic environment drive the rate of return on investments to the COC (or lower), thus limiting the
length of the advantage horizon in a meaningful way. That is, the finality of the horizon has to be
explicitly accounted for in modeling future cash flows by setting an end date and by modeling how the
rate of return on investments will decline towards the COC. The other school of thought argues that
competent managers will always find a way to earn (on average) more than the COC. With this view,
competitive forces and changes in the environment never result in a perfectly competitive outcome. If
you adopt this view you will typically use a model that is a variant of the constant growth model, or a
perpetuity model, to value cash flows beyond a certain point in the future.

Note, however, that even if the advantage horizon is assumed to extend to infinity, the firm cannot grow
indefinitely at a rate larger than the COC as that would imply that the current value of the firm is infinite.
Moreover (and often forgotten,) even when the growth rate is less than the COC, the, book value of the
firm’s assets is expected to constantly grow, implying unreasonable size long before infinity.

MODELING CONTINUING VALUE

The model described here is a popular model of based on the constant growth model, and expressed in
terms of the following value drivers: return on invested capital (ROIC), profit (NOPLAT), the growth
rate, and the reinvestment ratio.

We will use the following notation:

Zt = the ROIC at the end of period t. We assume that the distribution of Zt is stationary with mean = Z.
I t = the invested capital at the end of period t. We want the change in invested capital from the beginning
to the end of the period to be equal the investment in excess of depreciation made during the period (i.e.,
equal to capex – depreciation). Hence,

I t = NFA + CA (other than excess cash and securities)  (non interest-bearing CL)
+ (other assets)  (other non interest-bearing liabilities).

g = the growth rate of expected earnings (expected NOPLAT). The growth rate is assumed to persist at
the same level indefinitely.
b =(I t - I t –1)/ NOPLATt is the re-investment ratio, and is assumed to be constant.
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Note now that by the definition of b,

It = It-1 + NOPLATt b= It-1 + It-1 Ztb = It-1 (1+ Ztb),

And by the growth assumption

Et-1[NOPLATt+1] = (1+g) Et-1[NOPLATt].

Hence,

Et-1[NOPLATt+1] = Et-1[Et[NOPLATt+1]] = Et-1[It Z] = It-1 (1+ Zb)Z= (1+g) It-1 Z

implying
g = Zb.

Let the start of the continuation horizon be time t = n. The continuation value is given by the familiar
formula

CVn = En[FCFn+1]/(k-g) = En[(1-b)NOPLATn+1]/(k-g)

CVn = (1-g/Z)En[NOPLATn+1]/(k-g).

The standard prescription in the literature is to use the WACC for k and to find the present value of CV n at
time t = 0, one should calculate

PV0[CVn ]= {(1-g/Z)E0[NOPLATn+1]/(WACC-g)}/(1 +WACC)n .