Equity valuation - FCFF
Free Cash Flow to Equity (FCFE)
1. FCFE = NI + NCC - FCInv - WCInv + Net
borrowing
2. FCFE = CFO – FCInv + Net borrowing
3. FCFE = FCFF – Interest*(1 – Tax rate) + Net
borrowing
FCFF and FCFE are related to each other
Linkages between FCFF and FCFE
Free Cash Flow to Firm (FCFF)
1. FCFF = CFO + Interest*(1 – Tax rate) – FCInv
2. FCFF = EBIT*(1 – Tax rate) + Depreciation – FCInv –
WCInv
3. FCFF = EBITDA*(1 – Tax rate) + Depreciation*(Tax
rate)– FCInv – WCInv
4. FCFF = NI + NCC + Interest*(1 - Tax rate) – FCInv –
WCInv
5. FCFF = FCFE + Interest*(1 – Tax rate) – Net borrowing
FCFF and FCFE are related to each other
Where one can apply FCFF or FCFE
The free cash flow approach (FCFF or FCFE) might be appropriate
when the company does not pay dividends, dividends differ
substantially from FCFE, free cash flows align with profitability, or the
investor takes a control (majority ownership) perspective.
FCFF and FCFE are frequently calculated by starting with net income:
ü FCFF = NI + NCC + Interest*(1 - Tax rate) - FCInv - WCInv
ü FCFE = NI + NCC - FCInv - WCInv + Net borrowing
NI = Net Income
NCC = Non-Cash Charges
FCInv = Investment in Fixed Capital (in the specific period for which free
cash flow is calculated)
WCInv = Investment in Working Capital (in the specific period for which
free cash flow is calculated
FCFF and FCFE – arriving at
FCFF and FCFE are related to each other as follows:
FCFE = FCFF – Interest*(1 – Tax rate) + Net borrowing
FCFF and FCFE can be calculated by starting from cash flow
from
operations:
FCFF = CFO + Interest*(1 – Tax rate) – FCInv
FCFE = CFO – FCInv + Net borrowing
FCFF can also be calculated from EBIT or EBITDA:
FCFF = EBIT*(1 – Tax rate) + Depreciation – FCInv – WCInv
FCFF = EBITDA*(1 – Tax rate) + Dep*(Tax rate) – FCInv –
WCInv
Key determinants of FCFF, FCFE
Capital expenditure
Increase or decrease in Working capital
WACC
Debt equity ratio for the particular firm
Future expectations of earnings for the firm
Dividend pay- out for the firm
Growth rate in earnings
Retention ratio
FCFF Valuation
Firm Value = sum(FCFF/( 1+WACC), over n time
period
Equity value = Firm value – Debt value
Value per share = Equity Value /no of equity shares
Firm value – firm growing at constant rate
FCFF0(1+g)/(Wacc-g)
Equity value = sum(FCFE/(1+r)) over n time period
Three stage models considered appropriate
Forecast sales, profitability , investment and financing
derived from sales
FCFF Valuation
Non-operating assets as excess cash and marketable
securities to be valued separately, and added to the
operating assets value. Similarly non-current
investments are valued separately and then added to
operating assets value.
Importance of earnings and cash flows
Importance of Updating earnings
Capital expenses (R &D related) treated as operating
expenses
Capitalising other operating expenses
FCFF Valuation
Determine the period over which the benefit of
capitalised operating expense will flow
Estimate the value of assets created by these
expenses
Adjust the operating income for the expense and the
amortisation of created assets
Cost of Capital and components
What is cost of capital
Importance , relevance and crucial aspect in
valuation
Different sources of cost of capital
Equity shares
Preference shares
Debentures / Convertible debentures
Optionally convertible Preference shares /CCPS
Others
Cost of Capital and components
Debentures/debts – Fixed interest payments at
periodic intervals, cash outflows tax deductible
Preference dividends – Not tax deductible – however
have preference in dividends and capital repayment
Convertible bonds – A combination between
bonds/debts and equity, valuation depends on terms
of conversion of bonds
Preference shares – More difficult to value due to
possible variations in terms of issue of preference
shares and types of Preference shares
Cost of Capital and components
Cumulative , non –cumulative , redeemable and non-redeemable
preference shares
How to compute the cost of capital for each of these components
Applying of standard formula for calculating the cost of capital for
different components and summing up the same
Debt cost =after tax =Kd=(1-t)Kr, where t=tax rate , Kr = cost of
debt
Preference capital cost = Kp=Prefdividend/Value of Share
Equity capital =ke =d/Po+ g , where d= dividend declared , Po=
Price of equity share , g = growth rate . If g=0, then
Ke =d/P0
Ke= d(1+g)/(r-g)
Relevance of COC in valuation
Cost of different components represent the price to
be paid to stakeholders of respective instruments
Higher the cost lower the Net Income, and cash
flows , and ultimately the lower the value of the
potential target or entity or share
Usually the WACC is used in computing the value of
shares, entity , target for enterprise valuation
For Equity valuation of entity – cost of equity is used
WACC =( Debt%*after tax cost of debt)+(equity %*
cost of equity )
Key aspects to be noted for valuation
Computation of FCFF and FCFE – must be familiar
Changes in working capital – be able to ascertain
Capital expenditure to be incurred - need to factor in
Rf, Rm, beta – all are crucial and need to be present to get cost of equity using the CAPM
model
ERP – If Equity Risk premium is given then multiply with beta to arrive at the risk premium ,
add Rf to get final Ke = cost of equity
D-E ratio- Needs to be adjusted for leverage suitably
Beta – Needs to be calculated for the industry –sector and target suitably , crucial for valuation
Reinvestment rate – Growth rate /Return on equity
Reinvestment – figures include Capex, are crucial for correct valuation
FCFF- excludes reinvestment – capex , WC increase
Growth rates – stages –single/two /three stage can be applied
In all cases for valuation the denominator will be a function of WACC and growth rate or
WACC only
Numerator – FCFF , with due modifications for growth if need be
Preference shares and valuation
Preference as to dividend and repayment of capital
Depends on MOA and AOA of entity
Considerations for equity shares do not apply here
Consideration first for rate of capitalisation
Risk is less than in case of equity shares, hence
expected return lower than equity
Capitalisation - depends on dividend +other factors
Preference shares may be cumulative pref shares
Uncertainty of future dividends , will be valued at
lower figures
Preference shares and valuation
Participating preference shares take the nature of
equity shares and capitalisation will not be same as
for fixed dividend .
If restrictions are there on quantum of dividend ,
rate of capitalisation will be in between fixed
preference and equity shares
Possibility of future dividend relevant for
maintainable profit
Right to carry residual value in winding up is also
relevant
Preference shares -valuation
Preference shares may have right that enable it converted to equity ,
OCPS, CCPS
Value depends on terms of rights to conversion , coupon rate, time of
conversion etc
Preference shares may carry voting rights , in case of pvt cos, which are
not subsidiaries of public company , no legal provision to regulate the
rights .
Depends on AOA and MOA – hence this is crucial
Problems can come in valuing preference shares with substantial arrears
of dividends .
If company has been earning profits, the arrear dividends to be added to
value of share
Value of pref shares is equal to value arrived at by dividing the actual rate
of dividend by the expected capitalisation rate
Preference shares valuation
Preference share is a hybrid security with features similar
to common stock and bonds
It is much like Equity ownership, and also like a bond
holder can receive fixed income distributions and
preferential treatments
The dividend rate is usually fixed or adjustable following
movement of market interest rates.
Cumulative preferred stock has lower level of risk
Liquidation coverage becomes important than dividend
coverage since preferred stock owner entitled to
dividends in arrears
Preference shares valuation
Redeemable vs non –redeemable preference shares
Voting vs non-voting preference shares – voting
shares can carry a higher value
Minority and control – The data used typically to
compute control premiums for common stock is not
as directly applicable to preferred stock
Participating v Non –participating
Convertible vs Non –convertible – the former
provides more flexibility to shareholder for exchange
to equity
Preference shares valuation
Put options –grants holder the rights to sell share back
to the company at agreed price often at parvalue
Has the first right after all creditors have received what
is owed , to the issuing company’s assets in liquidation .
As per Hitcher , the most important factors to be
considered while valuing preferred stock are its
yield ,dividend coverage and protection of its liquidation
preference .
Adequacy of dividend rate should be determined by
comparing the dividend with that of high grade publicly
traded stock.
Preference shares valuation
Powers granted to shareholders through voting
rights
Unique provisions and covenants that may have
impact on fair market value of preference shares
P0= D/Kp
Challenges in determining the appropriate yield
The financial strength and the qualitative
characteristics of the issuing company and terms of
specific security must be evaluated .
Dividend rate and liquidation coverage –key factors
Preference shares valuation
Fixed charge coverage ratio=EBIT/(interest +preferred dividends
adjusted for taxes)
The higher the ratio the easier it is for company to pay preferred
dividend and hence lower return required by investor
Revenue Ruling 83-120 of IRS – regulates this
The ruling states that the risk to the shareholder can be measured by
the protection ratio or liquidation coverage ratio , a measure of
protection afforded by company assets
Liquidation coverage =(FMVA –FMVL)/Liq. Of Pref stock
Compare this ratio with that of public traded preferred stocks ,should
be greater than 1 , indicating liquidation preference can be covered
By comparing it with public preferred securities
Preference shares valuation
Preference shares valuation has certain merits
Merits – treated as quasi debt and not equity
Valuation principles as applicable to equity shares will not apply to
preference shares
Rule 11ua of Income tax rules will not apply to preference shares , but
to equity shares only
Issuer can vary terms , special voting rights, rates of dividends can be
changed etc
Can be issued as convertible preference shares , optionally
convertible preference shares or compulsorily convertible preference
shares
Can be tailored to meet the requirements of the investor and thus
affords flexibility
Preference shares valuation
Demerits – valuation becomes complex is many
special factors are involved
Preference dividend is not tax deductible , issuer gets
no advantage of the same.In case of CCPS , it is
merely deferment of time period when the
conversion can happen, at will of the issuer
When special rights are involved, valuation can be
difficult to be made , hence need to be more careful
on the same.
Example of valuation report- Equity shares-
Zomato
Valuation report dated 12th Nov 2019
Valued as per IVS –international valuation
standards
Going concern approach used for valuation
Sources of information –Last two years financials,
provisional financials 30/9/19 , projections – 5 yrs
Three approaches – Income , Market and Cost
approach considered while valuing the shares
Has used the FCFF to value the firm’s equity
WACC has been arrived at, applying CAPM model
Valuation - Zomato
Fair value of equity share arrived at Rs1,51,657/-
Model used – DCF- H model
Discount rate used -22.5% (r)
Long term growth rate – 7% (gl)
Super normal growth – 25%(gs)
Years to taper –gs to gl – 5 yeears
Risk free rate -6.91%- 10 years govt bond yield
Levered equity Beta – 1.24, CRP -3% COE- 22.57%
ERP- 10 year CAGR of Nifty 50 Index
