Welcome, my name is Han Smit. I'm a professor of Corporate Finance at Erasmus School of Economics. In this webcast, we will continue to explain company valuation based on the discounted cash flow method. The learning goal of this webcast is being able to calculate the free cash flow value for the continuation period, that is, the period after the explicit forecasting period. A thoughtful estimate of the continuing value is essential for any valuation, because the continuing value often accounts for 50 to 125 percent of total firm value. This is thus a very, probably most important, step in corporate DCF valuation. There are several recommended approaches. Among the most common are: One. The perpetuity method, which is cashflow-based and links cashflow to growth rate, reinvestment rate, and the return on capital base (ROCB). Types of perpetuity methods are the key value driver approach, the convergence model, and the Gordon growth formula. Two. Exit multiples, such as price-earnings and enterprise value over EBITDA. Exit multiples are normally used by private equity investors as they tend to sell or exit the company. Multiples approaches assume that a company will be worth some multiple of the future earnings or book value in the continuing period. In our valuation of ABC we use the key value driver formula for determining the terminal value and the exit multiple approach as a check. In the value driver formula, the terminal value is estimated as follows: the terminal value is the NOPAT at horizon value, times one minus the growth rate divided by ROCB divided by the WACC minus g. The NOPAT of the terminal value is the NOPAT of the last year of the explicit forecast period, times one plus the long-term growth rate, and ROCB is the return on capital base, or alternatively, the return on new invested capital in the long-run. Suppose that the growth rate of ABC's free cash flows for the continuation period is three percent, and ABC's long-run return on capital base is equal to 10 percent. For ABC, the NOPAT in the first year after the explicit forecast period equals 112.5 million times one plus three percent or approximately 116 million rounded at the nearest whole number. Following the value driver formula, the total terminal value is approximately equal to 116 times one minus three percent divided by 10 percent, and that all divided by nine minus three percent, which equals 1,348 million. This 1,348 million represents the terminal value of free cash flows at the end of the explicit forecast period, so we still need to discount this value with our discount factor to derive the present value of the terminal value. To discount the terminal value we always use the same discount factor as the one applied to the last year of the explicit forecast period. So, one plus nine percent to the power of six in this case. The present value of our terminal value is therefore equal to 1,348 divided by 1.68, which equals about 803 million. Again, rounded to the nearest whole number. A related way to value the terminal value is using exit multiples. This method applies a market multiple to a certain company metric at the last year of the planning period, and assumes that that is what the company will be worth in the continuation period. Typically, practitioners apply multiples to EBIT or EBITDA. Thus, in our example, the valuation of 1,348, due to the fact that EBITDA is used, this metric ignores capital structure, so how the company is financed, and therefore can be used between similar companies in the industry, regardless of their debt-to-EBITDA ratios. In our example we choose an enterprise value-to-EBITDA exit multiple of seven. Applying this multiple to ABC's EBITDA in year six leaves us with a terminal value of seven times 189, is 1,323 million. As you can see, this value lies close to the value we obtained using the perpetuity method. There are several terminal value checks. In cases where the free cash flows are low, the valuation almost comes down entirely to continuing value estimations. Executives must therefore perform checks and corrections of the estimations of each of the components making up the terminal value, to guard against overvaluation. Several important checks include the following: One: the choice of the value-driver formula has to be based on the industry and company analysis of the long-term profitability. The value-driver formula is the preferred choice when the company is expected to maintain a strong competitive advantage and it implies that the company will be able to earn returns in excess of the cost of capital in the long-run. However, if the company is active in a very competitive industry, which is expected to move to a competitive equilibrium, the convergence model could be used. The company will generate returns equal to the cost of capital in the long-run. Third: the terminal value can be based on the growth formula. However, this method is overly aggressive. NOPAT, and not free cash flow, is used in the numerator. The method then implicitly assumes that the company can continue to grow without new investments, which is unrealistic and therefore this method should not be used in this way. Two: a second check is on the extrapolation of historical cash flows during the growth or forecasting period. Estimation of the growth rate after the planning period can be based on the following formula: growth is ROCB times reinvestment ratio, and the reinvestment ratio is equal to the net investments divided by NOPAT, with the net investments equal to investments in net working capital, plus the total capex minus the depreciation. Three: lastly, it's advisable to perform consistency checks on the entry and exit, or terminal, multiple. This check, commonly used in private equity valuations, relates the exit multiple of the DCF calculation at the terminal date at which a company can be sold, to the entry multiple for which it will be acquired. Many financial parties consider multiple arbitrage, that is where the entry multiple is smaller than the exit multiple, as a value-creating strategy. They make the assumption that the company can be sold for more than it is acquired. In reality, multiple arbitrage is unlikely if deal markets are already hot and pricing is at its peak, unless there are clear options for improving the inherent value of the acquired business. For instance, with restructuring or the creation of new growth opportunities, or when there are new sources of value for the buyer at exit. Now, the final step to obtain the total value estimate of ABC involves adding the present value of the explicit forecast period together with the present value of the terminal value. Recall from part one that the present value during the planning period was equal to 398 million. Adding that to the 803 million we obtained from our terminal value using the perpetuity method, gives us a total enterprise value of 1,201 million or 1.2 billion for ABC. Lastly, if you want to know how much of this value is attributable to the shareholders after having fulfilled the requirements to debt holders, you must calculate the equity value of ABC. For that, you subtract the company's net debt, which is the company's debt minus cash in the last year (of the actual financials), from the enterprise values. For ABC, this means taking 1.201 and subtracting 300 minus 40 million, resulting in an equity value of 940 million. Of course, this valuation could be associated with a sensitivity analysis of the various parameters of the valuation, showing you an insight in the accuracy of the outcome. For instance, we can observe how the base case valuation may change in a high growth or low case scenario and when the company can implement margin improvements. So, to conclude: you learned how to perform a step-by-step DCF calculation. You start by calculating the relevant cost of capital: the WACC. The next step is to calculate the present value of cash flows during the explicit forecast period. In this webcast you learned to estimate the terminal value, which is the value of the company's expected cash flow beyond the explicit forecast. The terminal value can make up a large part of the total estimate of the enterprise value, and therefore, it's important to perform various checks on the sensibility of your terminal value estimate. If we then add up the present value of the free cash flows of both the planning period and the terminal value we arrive at the enterprise value. This is the total value of the firm available to both debt and equity holders. To determine the value that is left for shareholders after all obligations of debt have been fulfilled, you must subtract net debt from the enterprise value. Most analysts check their valuations by applying multiples from comparable transactions or publicly traded comparable companies to the target company's historical income or cash flow. A multiple can serve as a useful benchmark check in the valuation process. In the next webcast, we will discuss the multiples methods in more detail. I hope to see you in the next webcast.
