A Framework for Business Analysis and
Valuation Using Financial Statements
Topic 8b – Valuation
Considerations
Two key issues must be addressed to implement valuation theory:
1. Making forecasts of financial performance
– Detailed forecasts over a number of years
– Arriving at a forecasted terminal value.
2. Determining the appropriate discount rate to use in valuation models
Estimating the Costs of Debt and Equity
Cost of debt:
– Should reflect the current interest rate(s)
– Must be net of taxes because after-tax cash flows are being discounted.
Cost of equity:
– A complex topic
( )
– The CAPM provides one approach r = r + r − r
e f m f
– CAPM may be combined with firm size
– Amount of leverage affects risk.
Estimating KMD’s Cost of Capital
Assumptions:
– Pre-tax cost of debt is 2.88%
– Tax rate is 30%
( )
– After-tax cost of debt is 1.96% r 1−T
d c
– Beta is 0.62
r
– Risk free rate is 0.83%
f
r = r − r
– Equity risk premium is 6.8%
p m f
( )
r = r + r − r
– Cost of equity is 5.05%.
e f m f
Computing a Discount Rate
The appropriate discount rate is the WACC, which takes into account debt and
equity sources of financing:
WACC = % debt financing1 * After-tax cost of debt +
% equity financing * Cost of equity capital
D E
( )
WACC = r 1−T + r
d c e
V V
1 Short- and long-term interest bearing debts, not all liabilities
Terminal Values
The terminal value is the final year of the forecast and represents the PV of
future of abnormal earnings or free cash flows for the remainder of the firm’s
life.
– Assumptions about sales growth beyond the terminal year may be irrelevant because
of competitive equilibrium.
– Alternatively, abnormal earnings on incremental sales may be assumed.
– Terminal values may be forecasted with growth in abnormal earnings and cash flows at
a constant rate.
– A price multiple may be used to calculate terminal value.
– Selecting the terminal year: five- to ten-year forecast horizon should suffice for most
firms.
Terminal Values
Period 0 1 2 3 4 5 6
Net Values $100 $150 $150 $150 $175 $180
Terminal Values
Period 0 1 2 3 4 5 6Everything
after
period 6
Net Values $100 $150 $150 $150 $175 $180
Terminal Values
Period 0 1 2 3 4 5 6Everything
after
period 6
Net Values $100 $150 $150 $150 $175 $180 $184
Growth rate = 2%
Terminal Values
This is a perpetuity
Period 0 1 2 3 4 5 6Everything
after
period 6
Net Values $100 $150 $150 $150 $175 $180 $184
$95 $136 $130 $123 $137 $134
Required rate = 5%
Terminal Values
Period 0 1 2 3 4 5 6Everything
after
period 6
Net Values $100 $150 $150 $150 $175 $180 $184
$95 $136 $130 $123 $137 $134 $6,133
Required rate = 5%
Terminal Values
Period 0 1 2 3 4 5 6Everything
after
period 6
Net Values $100 $150 $150 $150 $175 $180 $184
$6,133
$95 $136 $130 $123 $137 $134 $4,577
Terminal Values
Period 0 1 2 3 4 5 6Everything
after
period 6
Net Values $100 $150 $150 $150 $175 $180 $184
$6,133
$5,332 $95 $136 $130 $123 $137 $134 $4,577
Divide by # shares
Some Practical Issues in Valuation
In practice, analysts must deal with a number of issues having an important
effect on valuation, including:
– Accounting distortions: Accounting choices, though self-correcting, affect both earnings
and book value
– Negative book values: Start-up firms and firms in certain industrial sectors, among
others, may have negative book equity
– Excessive cash balances and cash flows: Firms with cash beyond the level required to
finance operations warrant further investigation to understand whether the excess cash
indicates governance problems.
