Excerpt

## Contents

1. Introduction

2. Theory of enterprise valuation model

2.1. FCF valuation model

2.2. EVA valuation model

2.3. Comparison of FCF and EVA models

3. Problems in Enterprise valuation

3.1. Ex ante MVA and Ex post MVA

3.2. Calculation of WACC

4. Conclusion

References:

## 1. Introduction

In a market-driven economy investors are looking for the most profitable placement of their capital. This leads to a redistribution of the recourses on economy-wide scale from industries and companies which use investor’s capital inefficiently and destroy wealth to industries and companies which use investor’s capital efficiently and create wealth. For corporate managers, wealth creation is fundamental to the economic survival of the firm. As suggested by Rapport (2006, pp.67-68) managers that fail (or refuse) to see the importance of this imperative in an open economy do so at the peril of the organization and their own careers. There are several analytical tools which can help to make wise decisions in this field. They range from traditional Dividend Discount model and Free Cash Flow (FCF) model to not so long ago created Economic Value Added (EVA) model of enterprise valuation.

At the same time in line with theoretical models for valuing companies there is a market value for companies derived from market supply and demand for their stocks. In general, if we again refer to “one value principle” described in Grant (2003, p.106), both theoretical and market approaches have to lead to the same results. But in reality there is always some discrepancy in those two values which is a result of the influence of the number of factors. Identification and analysis of those factors is of key importance for investors to discover the most profitable investments and for the economy to ensure the most efficient use of capital.

The discrepancy between theoretical and market value of the company, however, should not last forever. If it happens then capital market will be sending wrong signals to the investors about on the one hand industries with high potential which use capital productively and create economic profit and on the other hand industries with low potential who waste capital and achieve economic loss. This would lead to a situation when productive industries will face a deficit of capital and unproductive industries will face a surplus of capital. Such inefficient distribution of capital finally would be a threat for the development of a real sector of the economy.

## 2. Theory of enterprise valuation model

One has to agree with Grant (2003, p.105) saying that while several valuation models exist, the overriding principle to keep in mind is that the value of the firm is, after all, the value of the firm. That is, at any given moment in time, the firm’s value is based on a discounted stream of cash flows generated by its existing and anticipated future growth assets. Regardless of how one defines these cash flows—dividends, free cash flow, or even economic profit—the firm’s enterprise value and its warranted stock price must be consistent across all approaches. To show this we will analyze traditional FCF valuation model and recently developed EVA valuation model.

### 2.1. FCF valuation model

As described in Grant (2003, p.107) according to financial theory, the market value of any company can be expressed as a discounted stream of future cash flows. In formal terms, we can express the enterprise value of the firm as:

Abbildung in dieser Leseprobe nicht enthalten (1)

In this expression, EV denotes enterprise value, Abbildung in dieser Leseprobe nicht enthalten is the firm’s estimated free cash flow (FCF) at period *T* (which represent final year of life for analyzed investment) , and Abbildung in dieser Leseprobe nicht enthalten is the discount rate or firms cost of capital which is measured as a adjusted for taxes weighted average cost of capital (WACC). Detailed calculation of WACC and problems associated with it will be discussed later.

In turn, the firm’s assessed FCF at year T can be viewed as the anticipated net operating profit after tax, NOPAT, less the annual net investment, IN, to support the firm’s growth. In formal terms, we have:

Abbildung in dieser Leseprobe nicht enthalten (2)

Before proceeding, it should be noted that we can make a distinction between gross investment, IG, and net investment, IN. Specifically, gross investment refers to: (1) capital spending required to maintain the economic productivity of the firm’s existing assets; (2) working capital additions to support a growing revenue and earnings stream; and (3) any new investments made by the firm’s managers in—hopefully—positive NPV projects. On the other hand, net investment, IN, refers to gross investment less (in principle) economic depreciation. Summarizing these results, in the traditional free cash flow model, the firm’s enterprise value is equal to the present value of its expected free cash flow stream, where the expected free cash flow at period t can be expressed as NOPAT less the corresponding net investment.

While the generalized cash flow model is helpful in seeing how a company derives its overall market value, the model must be simplified in order to be useful in practice because it is difficult to predict all FCF generated till the last year of investment’s life. Two simplifications are often made to the general discounted cash flow (DCF) model. Firstly, the market value of the firm is viewed as the present value of FCF estimated over a horizon period and residual period or “perpetuity” period. Horizon period represents a period of time in which an investor feels comfortable to predict financial performance of the company. For some companies working in stable and conservative industries (e.g., utilities) 10-20 years horizon period may be considered acceptable and for companies working in fast changing and hardly predictable environment (e.g., biotechnology, IT development) choice of a 5 year horizon period may be thought as unrealistic to predict. In turn, residual period represents time after forecasted period. As a result enterprise value is expressed as a sum of present value of horizon period FCF, horizon value (HV), and present value of residual period FCF, residual value (RV):

Abbildung in dieser Leseprobe nicht enthalten

Secondly, the firm’s estimated value is obtained using simplifying assumptions about how cash flows are growing over time—specifically, either constant growth in cash flow or variable growth in cash flows. For the horizon period investors makes a prediction of firm’s business activities and as a result creates pro forma financial statements. Then through making several adjustments to pro forma measures investors derive FCF cash flow relevant for value of the company on the horizon period. The present value of horizon value is expressed by the formula (1) with the difference that final year of investment’s life (T) is substituted by the final year of horizon period (t):

Abbildung in dieser Leseprobe nicht enthalten (3)

While several assumptions can be made about free cash flow generation during the post horizon years, we make the simplifying (and economically consistent) assumption that the marginal return on the net investment at the end of the horizon period (and beyond) earns a cost of capital return. This is equal to saying that that economic profit generated by the end-of-horizon period net investment is precisely equal to zero. With this zero-NPV assumption, the firm’s residual (or “continuing”) value at year t can be expressed in simple terms of perpetual annuity value of the one-step-ahead measure of adjusted profit, Abbildung in dieser Leseprobe nicht enthalten. One-step-ahead NOPAT, in turn is calculated by multiplying end year NOPAT by the long-term growth rate. The growth in NOPAT, Abbildung in dieser Leseprobe nicht enthalten, can be expressed as the product of the net investment plowback ratio, PBR, times the marginal return on net invested capital, MROC. PBR measures what share of NOPAT is spend on net investment (at end of the horizon period in our case); and MROC measures how much additional NOPAT we get from a unit of net investment. As we have assumed that return on investment earns a cost of capital, our MROC simply equalsAbbildung in dieser Leseprobe nicht enthalten.

Abbildung in dieser Leseprobe nicht enthalten(4)

Abbildung in dieser Leseprobe nicht enthalten (5)

Additionally, for the purpose of our analysis we make assumptions of zero long-term growth of FCF in the residual period. With these two assumptions in mind residual value can be calculated as:

Abbildung in dieser Leseprobe nicht enthalten (6)

As a result future value of the company calculated by FCF model and expressed in dollars of current period is equal to:

Abbildung in dieser Leseprobe nicht enthalten

Having calculated the future value of the company we can derive the equity value,Abbildung in dieser Leseprobe nicht enthalten, and equity value per share in current period, Abbildung in dieser Leseprobe nicht enthalten. To calculate equity value we need to substitute the balance value of the interest bearing debt,Abbildung in dieser Leseprobe nicht enthalten, from the company value and to calculate share value we need to divide the value of the equity by the number of shares outstanding, Abbildung in dieser Leseprobe nicht enthalten. The latter can be expressed as:

Abbildung in dieser Leseprobe nicht enthalten and Abbildung in dieser Leseprobe nicht enthalten (7)

**[...]**

- Quote paper
- Alina Ignatiuk (Author), 2008, The Enterprise Valuation Theory and Practice, Munich, GRIN Verlag, https://www.grin.com/document/130200

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