Week One Cafm

CAFM® Prin ci pl es

Outline

CAFM® Principles

During t his p resenta tion you will learn th e following :

•

Six important rules you should always remember in financial modeling

•

Excel sheet shortcut keys

•

Dividend Discount Model (DDM Model)

•

Free Cash Flow to the Equity (FCFE)

•

Free Cash Flow to the Firm (FCFF)

•

Return on Capital (ROC)

•

Return on Investments (ROI)

•

Reinvestment Rate

•

The specific usage of each model, purposes and their limitations

Out li ne

CAFM® Pri nc ipl es

During t his p resenta tion you will learn to model the following:

•

Future Values (FV)

•

Net Present Value (NPV)

•

Internal Rate of Return (IRR)

•

Multiple Internal Rate of Return (MIRR)

•

Payback period

•

Discounted Payback

•

Loan Schedule and the PMT function

•

Continuous Compounding

•

Discounting using dated cash flows (XIRR and XNPV)

•

Enterprise Value (EV)

Outline

CAFM® Principles

•

Estimating Betas

•

CAPM (Cost of Equity)

•

Expected returns using different approaches

• •

Cost of Debt WACC analysis-Optimal Capital Structure

•

Gordon Dividend Model-Supernormal growth (two stages and three stages supernormal growth) and constant growth

•

Case: Titan Cements Valuation

Keyboard Na vig atio n Only on Ms Excel!

CAFM® Principles

-Limi ted Use of t he Mou se!



To become a professional financial modeler, you should be able to navigate the spreadsheet with minimal usage of the mouse.



We know it’s difficult to forbid the usage of the mouse as a beginner, yet you should make sure that by the end of the program you’ll be able to navigate the spreadsheet with limited usage of the mouse.

Main Excel Sho rt cut s! 

CAFM® Pri nci pl es

There are about 150 Excel shortcut keys that is embedded in Excel (We will let you have access for all the shortcut keys on Excel!), yet you should be familiar with the most important ones that all professional financial modelers are expected to know and use! (Note:Shortcut Keys change slightly depending on the Excel version you’re using)

Let’ s have fun b y appl ying t he shor tcut keys o n Excel! ShortcutKeys

Definition

Press “Ctrl” + “↓”

Goes Down the cells

Press “Ctrl” + “↑”

Goes Up the cells

Press “Ctrl” + “→”

Goes to the last used cell to the Right

Press “Ctrl” + “←”

Goes to the last used cell to the Left

Press “ Ctrl” + “ G”

Enters a specific reference cell

Press “ Ctrl” + “ Home ”

Goes to the Top of the page

Press “ Ctrl” + “ End”

Goes to the down right of the page

Main Excel Sho rt cut s!

ShortcutKeys Press “ Ctrl” + “ Page Up” / “ Page Down” Press “ Ctrl” + “ Shift” + “ Backspa ce’’ Press “ Shift” + “ Space” Press “ Ctrl” + “ Space” Press “ Ctrl” + “ Shift” + “ +” Press “ Ctrl” + “ -“ Press “ Ctrl” + “ Tab” Press “ Alt” + “ Tab” Press “ Ctrl” + “ X” Press “ Ctrl” + “ R”


Definition

Navigates between sheets Selects the whole data very quickly Selects an entire row Selects an entire column Insert Deletes a row or a column Switches between opened workbooks Switches between applications Cut Copies the left cell to the right one

Main Excel Sho rt cut s! ShortcutKeys Press “ Ctrl” + “ D” Press “ Ctrl” + “ B” Press “ Ctrl” + “ I” Press “ Ctrl” + “ U” Press “ Ctrl” + “ 1” Press “ Alt” + “ H” or “ N” or “ P” or “ M” or “ A” or “ R” or “ W” Press “ Fn” + “ F2” Press “ Fn” + “ F4”

CAFM® Pri nci pl es Definition Copies the upper cell to the down one Bold Italic Underlined To Format cells Switches between home screen tabs i.e : Home (H), Insert (N), Page layout (P), Formulas (M), Data (A), Review (R), View (W) Edits formula of the existing cell Locks the cell with dollar sign i.e. : $F$4 *Press another time “F4”: will lead to fix only the row. *Press another time “F4”: will lead to fix only the column.

Main Excel Sho rt cut s!

ShortcutKeys


Definition

Press “ Alt” + “ =”

Brings you to the sum function

Press “ Shift” + “ F3”

Brings you to the excel function wizard

Press “ Ctrl” + “ ` ” Press “ Ctr l” + “ ` ” a gain

Views all the excel formulas in the spreadsheet Returns to the normal view

Press “ Shift” + “ F10”

Access the right click of the mouse

Press “ Ctrl” + “ F3”

Name a cell

Practicing!

CAFM®Principles



How do you get it to the top? You, practice, practice, practice.



The only way you can learn to develop good financial models is by practicing a lot.



The primary objectives of this program to and show how you to learn and practice financial modeling the rightare way toyou provide with a wide range of real world financial models.

Impor tance of Financial Modeling




Financial modeling is an essential skill for finance professionals and students.



MS Excel and its built in programming language, Visual Basic for Applications (VBA), are the preferred tools for the job.



However, modeling using Excel and VBA is rarely presented as an integrated subject in program certificates.

Impor tance of Financial Modeling




The result is that both practitioners and students follow time-consuming trial and error approaches to modeling and end up with models that are not sufficiently flexible powerful, and dynamic.



By dynamic we mean revolver modeling, that is any change to any assumption cell, should dynamically impact the full model with no manual adjustments.

Pri or Kno wl edg e




Developing good financial models requires combining knowledge of finance, mathematics, Excel and VBA- using modeling skills.



In each of these areas, the following is what the program assumes.



In finance and mathematics, we assume that you have the necessary basic knowledge.

Pri or Kno wl edg e




In Excel, we assume that you know the basics, and we’ll cover the advanced features of Excel that you need for modeling in detail.



VBA will be one of the important languages you will learn from this program. We assume that you know nothing about it!



VBA is a powerful and very useful tool that is already embedded in your MS Excel.

Pri or Kno wl edg e




Very few people use VBA in modeling because they are afraid of learning “programming”.



We will teach you VBA and modeling with VBA using a simple classtested approach.



The key is to learn VBA as a language the same way you learned your mother tongue



You will be surprised to find out how little you have to learn to be able to develop models with VBA that are often more useful, powerful, and flexible than Excel models.

Pri or Kno wl edg e






Finally, we assume that you are new to modeling. Even if you have some experience, you will quickly find yourself challenged as you build on your skills.

You will by imitating andbe practicing on numerous models frombyall areas oflearn finance, and you will able to challenge yourself further developing extensions to these models.

A Financial Model is a Statistical Tool •

CAFM® Principles

In developing a financial model, the basic thing you are doing is summarizing a complex set of technical and economic factors into a number (such as value per share, IRR or debt service coverage). – Forecasting has become an essential tool for any business and it is central to statistics -- in assessing value, credit analysis, corporate strategy and other business functions, you must use some sort of forecast. – Some believe economic forecasting has limited effectiveness and worse, is fundamentally dishonest because uncertain unanticipated events such as the internet growth, high oil prices, sub-prime crisis, falling dollar continually occur.

– The whole idea of modeling, like statistics, is quantification. If a concept cannot be quantified, it is a philosophy. The fundamental notion of statistics is presenting and summarizing information, this is the same as a financial.

Danger of B elie vin g to o Much in Models

CAFM® Principles

•

Alan Greenspan, Financial Times. – “The essential problem is that our models – both risk models and econometric models – as complex as they have become – are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world.”

•

Naseem Taleb: – In the not too distant past, say the pre-computer days, projections remained vague and qualitative, one had to make a mental effort to keep track of them, and it was a strain to push scenarios into the future. It took pencils, erasers, reams of paper, and huge wastebaskets to engage in the activity. The activity of projecting, in short, was effortful, undesirable, and marred with self doubt. – But things changed with the intrusion of the spreadsheet. When you put an Excel spreadsheet into computer literate hands, you get projections effortlessly extending ad infinitum. We have become excessively bureaucratic planners thanks to these potent computer programs given to those who are incapable of handling their knowledge.

Steps in Creati ng A Mode l


Whether

you are creating a financial model using Excel or VBA, you must take a systematic approach. A systematic approach always involves and this takes some time. 1 : Define and Structure the Problem 2 : Define the Input and Output Variables of the Model Step 3 : Decide Who Will Use the Model and How Often (A model that will Step Step

be used frequently should be designed differently) Step Step

4 : Understand the Financial and Mathematical Aspects of the Model 5 : Design the Model Step 6 : Create the Spreadsheets or Write the VBA Codes Step 7 : Test the Model Step 8 : Protect the Model (Don’t bother to protect a VBA model because most users do not even know how to open them!) Step

9 : Document your Model (Diagrams, Flowcharts, assumptions, how it ‘s structured)

Step

10: Update the Model as Necessary

Rules To Rememb er


When you sta rt you r fina ncia l mod el the re are a few rul es you need to remember to buil d a wo rki ng model A model

should identify key industry and business drivers and model around them. These key business and financial drivers should ultimately reconcile with a company’s overall vision and strategic actions. Avoid

modeling around potential drivers that represent averages in themselves. Break them down into inputs and let the output represent the weighted average. This is one of the most significant modeling flaws often leading to wrong outputs. Try

to understand how each driver is likely to behave during the forecast period, e.g., some costs (e.g.,

variable) will behave as a % of sales while others (e.g., fixed) are likely to move more along inflation. Make

sure your model has plenty of cross-checks to ensure that (1) assumptions make sense and (2) your model is built properly. A model

should be dynamic, i.e., any change to any assumption cell should dynamically impact the full model. Beware: there should be no manual adjustment whatsoever. Ideally,

every cell should represent either a single assumption input (A1 = 10) or a formulaic output linking only cells together, i.e., A11 = A1+A10. This is particularly important to build dynamic models that are also easy to audit.

LOOKUP Func ti on s LOOKUP


( Vecto r Form) -We are covering those functions because you are likely

to use in financial modeling Definition: Looks in a one-row or one-column range for a value and returns a value from the same position in a second one-row or one-column range. (This is called the vector form of LOOKUP). 

The

syntax of the vector form of the LOOKUP functions is: LOOKUP (lookup_value,lookup_vector,result_vector)

Lookup_value : is the value that LOOKUP searches for in the first vector- it can be a

number, text, a logical value, or a name or reference that refers to a value. Lookup_vector : is a range that contains only one row or one column-The values in

it can be text ( A..Z), or numbers(-1,0,1), or logical values (True, False). Result_vector : is a range that contains only one row or column. It must be the

same size as lookup_vector

LOOKUP Func ti on s


If LOOKUP cannot find the lookup_value  It matches the largest value in the lookup_vector that is less than the lookup_value. This make it possible to lookup values where the lookup_value falls in range instead of matching a specific value. 

If

the lookup_value is smaller than the smallest value in the lookup_vector  LOOKUP gives the #N/A error value For example: The tax table in the following figure provides information for calculating a single giventax his/her taxable In the table,up theto marginal taxtaxes rate for is 10% and filer the base amount is $0income. for taxable income $8,025. For income between $8,025 and $32,550 they are 15% and $802.50, respectively; and so on. Here is how you will use the LOOKUP function to look up the marginal tax rate and the results you will get for various taxable incomes. =LOOKUP(29000,D9:D14, H9:H14)  will return 15% =LOOKUP(55000,D9:D14, H9:H14)  will return 25% =LOOKUP(400000,D9:D14, H9:H14)  will return 35%

HLOOKUP and VLOOKUP Func ti on s




HLOOKUP and VLOOKUP are parallel functions that work the same way- They

are known as the array form. HLOOKUP: Searches for a value in the top row of a table or an array (range) of values and then returns the value from a specified row in the same column of the table or array. 

VLOOKUP:

Searches a value in the column left mostincolumn of table array (range) and then returns a value for from a specified the same row oforthe table or array. Use

HLOOKUP when your comparison values are located in a row across the top of a table of data, and you want to look down a specified number of rows. Use

VLOOKUP when your comparison values are located in a column of the left of the data you want to find.

HLOOKUP and VLOOKUP Func ti on s 


The syntax of the HLOOKUP function is: HLOOKUP (lookup_value,table_array,row_index_num,range_lookup)

: is the value to be found in the first row of the table. *Lookup_value can be a value, a reference, or a text string.

Lookup_value

Table_array :

is a table of information in which data is looked up. Use a reference to a range or a range name. The values in the first row of table_array can be text, numbers, or logical values. If range_lookup is TRUE, then the values in the first row of table_array must be placed in ascending order. 

: is the row number in table_array from which the matching value will be returned. A row_index_num of 1 returns the first row value in table_array , a row_index_num of 2 returns the second row value intable_array , and so on. Row_index_num

HLOOKUP and VLOOKUP Func ti on s


Range_lookup : is a logical value that specifies whether you wantHLOOKUP to find an exact match or an approximate match. If TRUE or omitted, an approximate match is returned. 

In

other words, if an exact match is not found, the largest value that is less than

lookup_value is returned. If

FALSE, HLOOKUP will look for an exact match. If one is not found, the error value #N/A! is returned. This argument is optional, and if omitted is assumed to be TRUE.

=VLOOKUP(140000,D9:H14,3)  will return $35,650 =VLOOKUP(63000,D9:H14,3)  will return $14,260 =VLOOKUP(140000,D9:H14,3,FALSE)  will return #N/A!(no exact match). VLOOKUP(140000,D9:H14,2,TRUE)  will return 36%

OFFSET Func ti on


OFFSET: Returns the reference to a single cell or a range of cells that is specified number of rows and columns from a cell or range of cells. 



The syntax of the OFFSET function is: =OFFSET(base_reference,rows,columns,height,width)

is the reference to the base cell or range from which the resulting reference is to be calculated. Rows: is the number by which the row number of the resulting reference is to be offset from that of the base_reference . Columns: Work in the same way. Heights and W idth: specifies the number of rows and columns to be included in the resulting reference Base_reference:

PV and NPV Func ti on


Both concepts, present value and net present value, are related to the value today of a set of future anticipated cash flows. 

Present

Valu e (PV ): is used if you need to discount all cash flows expected future

cash flows ( Use if Cash Flows are equal). PV

syntax function is: =PV(rate,nper,pmt,[FV],[type]) Type 0 (Default ) : Payment done at end of each period.

Type 1 Payment done at the beginning of

each period

Net Present Valu e (NPV ): is used to net expected cash flows to its value today ( i.e: Expected revenues –initial investment), Use if Cash Flows are NOT equal. 

NPV

syntax function is: NPV(rate,value1…valuen)

PV and NPV Func ti on

Check 


PV a nd NPV Examp le on Excel Spr eads heet

Check PV with growth periods and PV with growth in infinite perio ds Example on E xcinelNspreadsheet

PMT Funct io n


PMT: Calculates the loan payment based on constant payments and constant discount rate 



PMT function syntax is: =PMT(rate,nper,pv,[fv],[type])

Loan

Schedule:

Check

Loan Schedul e example o n Excel s preadshee t

MIRR and Data Tabl es Graphi cal Pre sentatio n

CAFM® Pri nc ip les

If the investment cash flows include several negative cash flows (i.e.: several investment inflows), then if you compute the IRR, this might mislead your investment decision because such an investment might have Multiple Internal Rates of Return (MIRR). 

If

we graph the NPV ( Y-axis) and the discount rate on (X-axis) and theNPV graph crosses the x-axis twice Then we have Two different IRRMIRR Two IRRs

5.00 0.00 e -5.00 lu a v t -10.00 n e s e-15.00 r p t e-20.00 N

0%

10%

20%

30%

40%

Discount rate

-25.00

Excel’s

IRR function allows us to add an extra argument that will help us find both

IRRs. Instead Note:

of writing =IRR(B6:B11), we write =IRR(B6:B11,guess) The Guess should be any number between 0 and 0.5

MIRR and Data Tabl es Graphi cal Pre sentatio n


If

the NPV graph crosses the X-axis (i.e.: Discount rate axis) one time  There is only one IRR

V P N

1200 1000 800 600 400 200 0 -200 0% -400

NPV of Bond Cash Flows

5%

10%

15%

20%

Discount rate

To

be able to graph the NPV, you should learn how to construct a data table

Data

Tabl e: Are powerful commands that make it possible to do complex

sensitivity analyses. Excel offers the opportunity in which only one variable is changed, or one in which two variables are changed. Check

examp le on Excel sp readsheet-MI RR and One_IRR_Graph

XNPV and XIRR Func ti on s


The XNPV and XIRR functions can be used if the cash flows are occurring not on fixed periodic intervals ( i.e.: not semiannual, or annual). They allow us to do computations on cash flows which occur on specific dates that need not to be even intervals. 

XNPV and XIRR Func ti on s


XIRR: The function [puts annualized return. It works by computing the daily IRR and annualizing it, XIRR=(1+DailyIRR)^365 -1 

The

XIRR syntax function is: =XIRR(values,data,[guess])

XNPV:

Computes the net present Value of a series of cash flows occurring on specific dates The



XNPV syntax function is: =XNPV(rate,values,data)

Check example on Excel Spreadsheet

Gor do n Model and Cos t of Equ it y

Gordon


Model: The va lue of a share is the present value of t he futur e antici pated divi dend st ream fro m the share , where the futu re antici pated dividends are discou nted at the appropriate risk-a djust ed c ost of equity, R e Gordon

Mode l:

Gor do n Model and Cos t of Equ it y


Using

the Gordon Model you can calculate the implied cost of equity the market is using. You

might be interested to look at the cash flow to equity ( i.e.: Dividends, Repurchase of stocks, and stock issuance), then you can get a second implied value for the cost of equity.

Gordon Model and Cost of EquitySupernorm al Growt h

CAFM® Principles

The supernormal growth model can be used to compute the cost of equity, Re, for companies whose historical equity payout data overstate any anticipation of future growth rates. 

The

Growth rate (g) should not be greater than the cost of equity (Re), or else the Gordon Model wouldn’t work. This

will yield us to divide the company growth into phases (Phase one: Supernormal Growth where g>Re, and Phase Two: Where g is expected to remain constant and lower than the cost of equity till perpetuity.

Beta, β

CAFM® Principles

A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns 

Beta

is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A

beta of 1 indicates that the security's price will move with the market.

A beta

of less than 1 means that the security will be less volatile than the market.

A

beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market. Many

utilities stocks have a beta of less than 1. Conversely, most high-tech, Nasdaqbased stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.

Beta, β Modeli ng 


If you would like to calculate theβ of a stock, you should:

1- Get at least a 5 year historical price of the stock (The prices could be monthly prices). 2-Rearrange the prices from oldest to newest. 3-Calcualte the returns of the stock by: (Pe-Pi/Pi). 4-Decide to which benchmark index you would like the stock to be compared. 5-Get at least 5 year historical prices of the benchmark index 6-Rearrange the prices of the index from oldest to newest 7-Calculate the returns of the index by: (Pe-Pi/Pi)-Some modelers use ln(Pe/Pi) 8 -Get the Slope between Returns of the stock (Y-axis) and the Return of the Benchmark(Xaxis) Or Step 8 can be replaced by three additional steps: 8-Calculate the Covariance of the returns between the stock and the benchmark 9-Calculate the Variance of the returns of the benchmark 10-Implement this formula:

rs: Returns of the stock rb: Returns of the benchmark

CAPM, Cost of Equity Modeling

CAFM® Principles



To calculate the Cost of equity using the Capital Asset Pricing Model.



You need to model: 1-Retur n o f the market 2-Risk-F ree rate 3-Beta, β 4-Tax-rate- If you woul d lik e to calcu late the T ax-adjust ed CAP M



The CAPM is: Re = Rf (1-T) + β*[ E(Rm)-Rf (1-T)] Note: The tax rate should be the marginal tax rate. Check the example on the Excel s preadshee t

Arbitrage Pricing Theory-APT

CAFM® Principles

Arbitrage Pricing Theor y: 



Is a well-known method of estimating the price of an asset. The theory assumes an asset's return is dependent on various macroeconomic, market and security specific factors. The APT along with the CAPM is one of two influential theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in its assumptions.

The

APT formula is:

The factors or the Betas can be: 1-Industrial Production 2-CPI 3-Oil Price 4-Many others that you think could effect the asset price…etc

Cost of Debt Cost


of debt is fairly straightforward to calculate.

The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt. 

If the company is not paying market rates, an appropriate market rate payable by the company should be estimated. The estimated value could be computed from: 

1-The most recent issued debt by the company (Figure our the yield of this debt) 2-If you don’t have access neither to the current market borrowing rate specified for the company nor the yield of the most recent issued debt, you should use your common sense in such a situation. Note: A n exampl e is off ered on the Excel spr eadsh eet .

Calcu lating t he Cost of Debt

Because companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment.

Cost of Debt

Calcu lating


t he Cost of De bt

Because companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment.

Weigh ted Average Cost of Capi tal All

capital sources:

1- Common stock 2-Preferred stock 3-Bonds and any other long-term debt

 All


Included in a WACC calculation

else equal, the WACC of a firm increases as the beta and rate of return on

equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

The

WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

Weigh ted Average Cost of Capi tal




Where

We (Weight of equity) , Wd (Weight of debt) , and Wps (Weight of preferred Stocks) refer to the weights of market values of equity, de bt, and prefe rred stoc ks. 

If you have a small % of preferred stocks (below 5 % of capital) some

practitioners add it to debt

The Excel Spreadsheet embeds: Basic WACC Calculations and Advanced one ( The advanced WACC calculation may be complicated but not difficult)

Basic Concepts fo r Valuation Models


There are ma ny d iscou nting methods. All of them give the same re sult s w hen we use the proper cash fl ows and the a ppro priate discoun ting r ate. Fair value ca nnot be dependent on a model. 1. FCFF - fre e cash flo ws to th e firm : The most traditional method, in which operating

and investment cash flows are discounted using WACC 2. FCFE - free cash flow s to equity : In which cash flows are discounted using cost of

equity 3. CCFF - capital cash flow s the firm: In which capital cash flows (CCFE = FCFE +

CFD, CFD-cash flows to debt) are discounted using weighted average cost of capital before tax 4. CCFE - capital ca sh fl ows to equit y: In which capital cash flows (CCFE = FCFF-

CFD, CFD-cash flows to debt) are discounted using adjusted cost of equity before tax 5. EVAF - incr emental economic value a dded to t he firm: In which economic cash

flows to the firm are discounted using WACC



6. EVAE - inc reme ntal econom ic value a dded to equit y: In which economic cash

flows to equity are discounted using cost of equity In which economic cash flows against initial book value of equity and debt are discounted using WACC 7. ECFF - econom ic cash flow s to the firm:

8. ECFE - econom ic cash flow s to e quity : In which economic cash flows against

initial book value of equity are discounted using cost of equity 9. BRAF - busin ess risk adjust ed free cash flows to the firm:

In which cash flows

are discounted using unlevered cost of capital 10.BRAE - busin ess risk adjus ted fre e cash flo ws to equity:

are discounted using unlevered cost of capital

In which cash flows



11. RFAF - ris k-free -rate adju sted free ca sh f low s to th e fi rm: In which cash flows

are discounted using risk-free interest rate 12. RFAE - ris k-free -rate adju sted free cash fl ow s to equity : In which cash flows

are discounted using risk-free interest rate 13. APVF - adjust ed prese nt value: In which cash flows to the firm are discounted

using unlevered cost of capital 14. APVE - adjust ed prese nt v alue: In which cash flows to equity are discounted

using unlevered cost of capital 15.FEVA - fi nancial and economi c value a dded: Which decomposes cash flows into

various streams, and discounts them with unlevered cost of capital



16. DDM - dividend discount models: In which dividends and cash surpluses are discounted using cost of equity 17. Decomposition method: In which operating, investment, tax shield cash and differences between equity cost of capital and external cost of capital flows are discounted using cost of equity. According

to a proposition by Modigiliani and Miller:

The Value of an Enterprise Assets (Va) = Value of debt (Vd) + Value of Equity (Ve)

Then the valuation should be of three parts: 1-Value the company’s debt 2-Value the company’s equity 3-Sum part (1) and part (2) Note: Despite varying world all 17 discounting methods give the same values of the firm and equity.

Divi dend Disc oun t Mod el-DDM


Divid end Discou nt Model- DDM: •Multiple growth rates: two or more expected growth rates in dividends. •Ultimately, growth rate must equal that of the economy as a whole. •Assume growth at a rapid rate for n periods followed by steady growth t

n 1 P0 = ∑ D0( 1 + g1 )t + Dn( 1 + g c ) n t =1 Re -g ( 1 + Re ) ( 1 + Re )

The supernormal grow ing dividends disco unted sepa rate ly at cost o f equit y

Terminal Value Discounted at cost of equity to th e Prese nt Value

FCFE and FCFF


Free Cash Flo w t o Equi ty ( FCFE): What coul d sh areholders b e paid? FCFE = Net Inc. + Depreciation – Change in Noncash Working Capital – Capital Expend. – Debt Repayments + Debt Issuance – Preferred Dividends + New Preferred Stock Issued

Free Cash Flo w to th e Firm ( FCFF): What ca sh is availa ble before a ny fin ancin g co nsid erations? FCFF = EBIT (1-tax rate) + Depreciation – Change in Noncash Working Capital – Capital Expend – Change in PV of OL

Mul ti pl es in Relativ e Valu ation

Relati ve Valuati on :


(Easy and widely used, yet you shouldn’t use it blindly!)

To do relative valuation: 1. We need to identify comparable assets and obtain market values for these assets. 2. Convert these market values into standardized values, since the absolute prices cannot be compared This process of standardizing creates price multiples. 3. Compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is under or overvalued.



Prices

can be standardized using a common variable such as earnings, cashflows, book value or revenues.

– Price/Earnings Ratio (PE) and variants (PEG and Relative PE) – Value/EBIT – Value/EBITDA --Value/Cash Flow – Price/Book Value(of Equity) (PBV) – Value/ Book Value of Assets

– Price/Sales per Share (PS) – Value/Sales (Price/kwh, Price per ton of steel ....)


Relative


Valuation:

1- Define the multiple in use -The same multiple can be defined in different ways by different users.

When comparing and using multiples, estimated by someone else, it is critical that we understand how the multiples have been estimated. 2- Describe the multiple

- Too many people who use a multiple have no idea what its is. If you do not know what the of a multiple is, it is difficult to look at a number and pass judgment on whether it is too high or low.



3- Analyz e the multiple

- It is critical that we understand the fundamentals that drive each multiple, and the nature of the relationship between the multiple and each variable. 4- Apply the mult iple

-Defining the comparable universe and controlling for differences is far more difficult in practice than it is in theory.

You Should ask yourself t he follow ing eve ry t ime you are usi ng a mul tip le fo r Relative V aluation :

-Both the value (the numerator) and the standardizing variable ( the denominator) should be to the same claimholders in the firm. In other words, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or book value.

CAFM® Prin ci pl es Some Valu ati on Tips and Formu las You Shou ld Kno w! FCFF = [(Old EBIT + Current OL Expense – Depreciation OL)(1-tax

rate)] + Current R&D – Amortization of R&D– (Capex - Depreciation – OL Depreciation + M&A) – Change in NCWC – Change in PV of OL

FCFE= NI - (Capex – Depreciation) – (Change in NCWC) – Preferred

Dividends + New Preferred Stock issued + New Debt issued – Debt Repayments

Boo ks References


1. Aswath Damodaran (2001), The dark side of valuation: Valuing young, distressed, and complex Businesses( 2nd ed.) ,FT Press.

2. Alastair L. Day (2012), Mastering financial modeling in Microsoft excel(3rd ed.), FT Publishing. 3. Simon Benninga (2008), Financial modeling (3rd ed.) MIT Press. 4. Chandan Sengupta (2010), Financial analysis and modeling(2nd ed.), Wiley Finance. 5. Masari, M., & Gianfrate, G. (2014). The valuation of financial companies: Tools and techniques to value banks, insurance companies, and other financial institutions(1st ed.). Wiley Finance. 6. Koller, T., & Goedhart, M. (2010). Valuation: Measuring and managing the value of companies (5th ed.). Hoboken, N.J.: John Wiley & Sons.

7. Kieso, D., Weygandt, J., & Warfield, T. (2014). Intermediate accounting (15th ed.). Wiley John, & Sons, Incorporated

Week One Cafm

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