Description
This is a PPT explaining estimating free cash flow.
Equity Research
Estimating Free Cash Flow
FCF Valuation Model
¿
·
=
+
= +
+
+
+
=
1
2
2 1
) 1 (
...
) 1 ( ) 1 (
t
t
t
wacc
FCF
wacc
FCF
wacc
FCF
Value
Explicit Forecasting Period
FCF Valuation
Value of Company
=
Present value of free cash flows during the explicit
forecasting period
+
Present Value of free cash flows beyond the explicit
forecasting period (continuing value)
The Big Picture: Be Consistent in All
Estimations
Cash Flow Definitions
• Total Operating Income: What is operating income depends on:
• Recurring or non-recurring income
• Depends on Main Business Activities
– An Example: Drugs Importer sells containers.
– Retail companies getting income from credit cards
– Investment Income from Trade Investments
– Does it matter?
• A small example: A company gets half of its revenue from investment income and
the other half from manufacturing computer hardware. Its Beta is 0.6.
• Maintain consistency between the discount rate and your operating income.
• What if the invested company does not give any dividend?
• Total Operating Income for Bajaj Auto
– Include Other Income?
Forecasting Net Sales
• Base initial projections on immediate historical growth rate data, industry
association projections, analysts’ projections, management projections
• Projections based on
– Inflation rate
– Industry growth rate
– Preferable to forecast price and quantity separately
• Start by projecting the key driver and derive sales from it.
– Banking Industry: ????
– Cable TV/Gym/Time Share:????
– Asset Management Company:????
– Consultancy Company:????
• For how long should you forecast?
– A brief case
Brief Case…
• Priyanka works with a consultancy company. Her
assignment is to value a shopping mall in South India for a
client based in Gulf. She projects the cash flows based on…
Year # 1 Year # 2 Year # 3 Year # 4 Year # 5
Occupancy Rate - - 20% 60% 80%
Rental Income,
etc.
- - *** *** ***
Free Cash Flow -ve -ve -ve +ve +ve
Priyanka valued the real-estate company by using a terminal growth rate of 5%
after year #5. She used FCF method to find the enterprise value and the equity
value.
What the management of Bajaj Auto
thinks…
Projections of Net Sales for Bajaj Auto
Limited
Free Cash Flow Definitions, Contd.
• Total Operating Expenses
– Use Matching Concept
– Raw material expenses + wages and salaries +
other manufacturing expenses + selling and
distribution expenses + depreciation + other
administrative expenses
– Interest expenses not to be included
Forecasting Total Operating Expenses
• A good beginning is to first divide the
expenses into fixed and variable expenses
– Link variable expenses to sales and fixed expenses
to inflation
– Link maintenance expenses to gross block
• Club all smaller items into other expenses
Operating Expenses for Bajaj Auto
How to project Depreciation Expenses?
Here I linked to net block. Can I link it to sales? Does it make
sense? When will this make sense? Should it be linked to total net
block?
Free Cash Flow Definitions
• Net Operating Income (NOI)
– Total operating income – total operating expenses
• Net Operating Profit Adjusted for Tax (NOPAT)
– NOI * (1- cash tax rate)
– Use Marginal Tax Rate and not statutory tax rate
– Since it is difficult to forecast cash tax rate for the
explicit forecasting period separately, usually the
statutory tax rate is used.
Tax Rate for Bajaj Auto
• Effective Tax rate:
– 3009/9580.9 = 31.4%
• Statutory tax rate:
– 30% + 10% surcharge (if the income exceeds
Rs.1 crores) + 3% Education cess = 33.99%
Cash Flow Definitions
• Gross Cash Flow
– NOPAT + depreciation
– Why depreciation is added back?
• Gross Investment
– Net capital expenditure + increase in working capital +
increase in other operating assets
• How to treat Investments? How to treat Trade Investments?
• Free Cash Flow (FCF)
– Gross cash flow – Gross investment
– Also equal to NOPAT – net Investments
• Be consistent with all your definitions and
estimations
Gross Investments
• Net Capex: Purchase of assets – minus sale of assets
– Its estimation
• Operating Working Capital
– Cash to be included?
– Divide cash into operating and non-operating cash?
– Which liabilities to include? Which ones to exclude?
• Other Operating Investments
– What are they?
– Include? Exclude?
Gross Investments for Bajaj Auto
• Capex:
• Increase in Operating Working Capital:
• Increase in Technical Know-how
– Operating or non-operating?
– Rs.162.6 million includes Rs.154.1 million as development in
progress
• Treat Investments as Operating Investments?
– Total Investments = Rs.18,085.2 million
• Rs.2464.4 million in Government Securities
• Rs.7637.2 million in Subsidiaries
• Rs.1010.6 million in debentures
• Rs.3785.6 million in bonds
• Rs.3140.8 million in mutual funds
Forecasting Gross Investments…
• Forecasting Capex
– Link to Fixed Assets? Sales?
– Look at the typical capex cycle for the company
• Forecasting Operating Working Capital
– Forecasting Inventories (Use Inventory Turnover)
– Forecasting Sundry Debtors (Use Average Collection Period)
– Forecasting Other Current Assets and Loans and Advances (% of
Sales)
– Current Liabilities (% of Expenses or Sales?)
– Provisions (% of Sales)
• Forecasting Investments
– Is it necessary?
Some Research Data to Help
Forecasting
Rank
Period
Sales
Growth
Rate
Test
Period
Sales
Growth
Rate
P-E ratio
at the
time of
Portfolio
Formation
Group 1 662.31% 72.43% 21.65529
Group 2 60.00% 54.94% 17.71391
Group 3 36.66% 46.63% 18.34813
Group 4 17.89% 49.09% 13.34798
Group 5 -17.35% 704.06% 13.31003
Projected Free Cash Flow for Bajaj
Auto
Existing capacity utilization for 2 and 3 wheelers: 55%
On 15 April 2010, Bajaj Auto announced the delay in the
starting of the 40wheeler project in its Pune factory. Nifty
fell by 0.93% and Bajaj Auto fell by 0.53%. Its beta is 0.57.
Cost of Capital of Bajaj Auto
Valuation of Bajaj Auto
Sensitivity Analysis
• Find the assumptions that can have the
maximum impact on valuation
• Ask questions like how likely it is that these
projections will be achieved
EVA Definitions
• Operating Invested Capital (OIC)
– Operating fixed assets + operating working capital + other
operating assets
– Include all the assets in OIC which have been used to
generate NOPAT
– Estimation of OIC must be consistent with your estimation
of NOPAT and Net Investment
• Return on Operating Invested Capital (ROIC)
– NOPAT divided by OIC (beginning of the year)
EVA Definitions
1 ÷
=
t
t
Capital Invested Operating
NOPAT
ROIC
EVA Definitions
• EVA = Operating Invested Capital * (ROIC –
WACC)
• Also equal to …
. *
* ) ( *
WACC OIC NOPAT
WACC
OIC
NOPAT
OIC WACC ROIC OIC
÷ =
|
.
|
\
|
÷ = ÷
Growth Rate of ABC Limited
• OIC as on 31 March 2010 = Rs.100m
• ROIC = 20%
• Investment rate = 25%
NOPAT
Investment Net
IR Rate Investment
_
) ( _ =
Growth Rate = ROIC * Investment Rate
Valuation of OLP Limited Using EVA
Approach
• Operating invested capital as on 31 March
2009 = Rs.100m.
• Expected ROIC = 20%
• Expected growth rate = 5%
• Cost of capital = 13%
• What is the value of the company?
Value of Company Using EVA Approach
) (EVA PV OIC Value + =
Assets In Place
Present Value of EVA
What is the Value of the Following
Company?
Year 0 1 2 3 4
OIC 100 113 125 135
ROIC 20% 20% 20% 20% 20%
NOPAT 20 22.6 25
Net Investment 13 12 10
Free Cash Flow 7 10.6 15
WACC 13% 13% 13%
EVA 7 7.91 8.75
terminal Growth Rate 5%
Correct Value of the Company
Year 0 1 2 3 4 5
OIC 100 113 125 135
ROIC 20% 20% 20% 20% 20% 20%
NOPAT 20 22.6 25 27
Net Investment 13 12 10 6.75
Free Cash Flow 7 10.6 15 20.25
WACC 13% 13% 13% 13%
EVA 7 7.91 8.75 9.45
terminal Growth Rate 5%
PV(EVA) 6.19469 6.19469 6.064189 81.86655
Value-EVA
PV(FCF) 6.19469 8.301355 10.39575 175.4283
Value-FCF
200.3201199
200.3201199
GROWTH AND VALUE
Growth Rate of ABC Limited
• OIC as on 31 March 2010 = Rs.100m
• ROIC = 20%
• Investment rate = 25%
NOPAT
Investment Net
IR Rate Investment
_
) ( _ =
Growth Rate = ROIC * Investment Rate
Growth and Value
• OIC = 500
• ROIC = 10%
• WACC = 15%
• Growth rate = 0%
• Growth rate = 5%
Growth and Value
• OIC = 500
• ROIC = 15%
• WACC = 15%
• Growth rate = 0%
• Growth rate = 5%
Growth and Value
• OIC = 500
• ROIC = 20%
• WACC = 15%
• Growth Rate = 0%
• Growth rate = 5%
Where to Invest?
Company A Company B Company C
OIC 100 100 100
ROIC 20% 15% 10%
WACC 15% 15% 15%
Growth
Rate
5% 5% 5%
doc_276099587.pptx
This is a PPT explaining estimating free cash flow.
Equity Research
Estimating Free Cash Flow
FCF Valuation Model
¿
·
=
+
= +
+
+
+
=
1
2
2 1
) 1 (
...
) 1 ( ) 1 (
t
t
t
wacc
FCF
wacc
FCF
wacc
FCF
Value
Explicit Forecasting Period
FCF Valuation
Value of Company
=
Present value of free cash flows during the explicit
forecasting period
+
Present Value of free cash flows beyond the explicit
forecasting period (continuing value)
The Big Picture: Be Consistent in All
Estimations
Cash Flow Definitions
• Total Operating Income: What is operating income depends on:
• Recurring or non-recurring income
• Depends on Main Business Activities
– An Example: Drugs Importer sells containers.
– Retail companies getting income from credit cards
– Investment Income from Trade Investments
– Does it matter?
• A small example: A company gets half of its revenue from investment income and
the other half from manufacturing computer hardware. Its Beta is 0.6.
• Maintain consistency between the discount rate and your operating income.
• What if the invested company does not give any dividend?
• Total Operating Income for Bajaj Auto
– Include Other Income?
Forecasting Net Sales
• Base initial projections on immediate historical growth rate data, industry
association projections, analysts’ projections, management projections
• Projections based on
– Inflation rate
– Industry growth rate
– Preferable to forecast price and quantity separately
• Start by projecting the key driver and derive sales from it.
– Banking Industry: ????
– Cable TV/Gym/Time Share:????
– Asset Management Company:????
– Consultancy Company:????
• For how long should you forecast?
– A brief case
Brief Case…
• Priyanka works with a consultancy company. Her
assignment is to value a shopping mall in South India for a
client based in Gulf. She projects the cash flows based on…
Year # 1 Year # 2 Year # 3 Year # 4 Year # 5
Occupancy Rate - - 20% 60% 80%
Rental Income,
etc.
- - *** *** ***
Free Cash Flow -ve -ve -ve +ve +ve
Priyanka valued the real-estate company by using a terminal growth rate of 5%
after year #5. She used FCF method to find the enterprise value and the equity
value.
What the management of Bajaj Auto
thinks…
Projections of Net Sales for Bajaj Auto
Limited
Free Cash Flow Definitions, Contd.
• Total Operating Expenses
– Use Matching Concept
– Raw material expenses + wages and salaries +
other manufacturing expenses + selling and
distribution expenses + depreciation + other
administrative expenses
– Interest expenses not to be included
Forecasting Total Operating Expenses
• A good beginning is to first divide the
expenses into fixed and variable expenses
– Link variable expenses to sales and fixed expenses
to inflation
– Link maintenance expenses to gross block
• Club all smaller items into other expenses
Operating Expenses for Bajaj Auto
How to project Depreciation Expenses?
Here I linked to net block. Can I link it to sales? Does it make
sense? When will this make sense? Should it be linked to total net
block?
Free Cash Flow Definitions
• Net Operating Income (NOI)
– Total operating income – total operating expenses
• Net Operating Profit Adjusted for Tax (NOPAT)
– NOI * (1- cash tax rate)
– Use Marginal Tax Rate and not statutory tax rate
– Since it is difficult to forecast cash tax rate for the
explicit forecasting period separately, usually the
statutory tax rate is used.
Tax Rate for Bajaj Auto
• Effective Tax rate:
– 3009/9580.9 = 31.4%
• Statutory tax rate:
– 30% + 10% surcharge (if the income exceeds
Rs.1 crores) + 3% Education cess = 33.99%
Cash Flow Definitions
• Gross Cash Flow
– NOPAT + depreciation
– Why depreciation is added back?
• Gross Investment
– Net capital expenditure + increase in working capital +
increase in other operating assets
• How to treat Investments? How to treat Trade Investments?
• Free Cash Flow (FCF)
– Gross cash flow – Gross investment
– Also equal to NOPAT – net Investments
• Be consistent with all your definitions and
estimations
Gross Investments
• Net Capex: Purchase of assets – minus sale of assets
– Its estimation
• Operating Working Capital
– Cash to be included?
– Divide cash into operating and non-operating cash?
– Which liabilities to include? Which ones to exclude?
• Other Operating Investments
– What are they?
– Include? Exclude?
Gross Investments for Bajaj Auto
• Capex:
• Increase in Operating Working Capital:
• Increase in Technical Know-how
– Operating or non-operating?
– Rs.162.6 million includes Rs.154.1 million as development in
progress
• Treat Investments as Operating Investments?
– Total Investments = Rs.18,085.2 million
• Rs.2464.4 million in Government Securities
• Rs.7637.2 million in Subsidiaries
• Rs.1010.6 million in debentures
• Rs.3785.6 million in bonds
• Rs.3140.8 million in mutual funds
Forecasting Gross Investments…
• Forecasting Capex
– Link to Fixed Assets? Sales?
– Look at the typical capex cycle for the company
• Forecasting Operating Working Capital
– Forecasting Inventories (Use Inventory Turnover)
– Forecasting Sundry Debtors (Use Average Collection Period)
– Forecasting Other Current Assets and Loans and Advances (% of
Sales)
– Current Liabilities (% of Expenses or Sales?)
– Provisions (% of Sales)
• Forecasting Investments
– Is it necessary?
Some Research Data to Help
Forecasting
Rank
Period
Sales
Growth
Rate
Test
Period
Sales
Growth
Rate
P-E ratio
at the
time of
Portfolio
Formation
Group 1 662.31% 72.43% 21.65529
Group 2 60.00% 54.94% 17.71391
Group 3 36.66% 46.63% 18.34813
Group 4 17.89% 49.09% 13.34798
Group 5 -17.35% 704.06% 13.31003
Projected Free Cash Flow for Bajaj
Auto
Existing capacity utilization for 2 and 3 wheelers: 55%
On 15 April 2010, Bajaj Auto announced the delay in the
starting of the 40wheeler project in its Pune factory. Nifty
fell by 0.93% and Bajaj Auto fell by 0.53%. Its beta is 0.57.
Cost of Capital of Bajaj Auto
Valuation of Bajaj Auto
Sensitivity Analysis
• Find the assumptions that can have the
maximum impact on valuation
• Ask questions like how likely it is that these
projections will be achieved
EVA Definitions
• Operating Invested Capital (OIC)
– Operating fixed assets + operating working capital + other
operating assets
– Include all the assets in OIC which have been used to
generate NOPAT
– Estimation of OIC must be consistent with your estimation
of NOPAT and Net Investment
• Return on Operating Invested Capital (ROIC)
– NOPAT divided by OIC (beginning of the year)
EVA Definitions
1 ÷
=
t
t
Capital Invested Operating
NOPAT
ROIC
EVA Definitions
• EVA = Operating Invested Capital * (ROIC –
WACC)
• Also equal to …
. *
* ) ( *
WACC OIC NOPAT
WACC
OIC
NOPAT
OIC WACC ROIC OIC
÷ =
|
.
|
\
|
÷ = ÷
Growth Rate of ABC Limited
• OIC as on 31 March 2010 = Rs.100m
• ROIC = 20%
• Investment rate = 25%
NOPAT
Investment Net
IR Rate Investment
_
) ( _ =
Growth Rate = ROIC * Investment Rate
Valuation of OLP Limited Using EVA
Approach
• Operating invested capital as on 31 March
2009 = Rs.100m.
• Expected ROIC = 20%
• Expected growth rate = 5%
• Cost of capital = 13%
• What is the value of the company?
Value of Company Using EVA Approach
) (EVA PV OIC Value + =
Assets In Place
Present Value of EVA
What is the Value of the Following
Company?
Year 0 1 2 3 4
OIC 100 113 125 135
ROIC 20% 20% 20% 20% 20%
NOPAT 20 22.6 25
Net Investment 13 12 10
Free Cash Flow 7 10.6 15
WACC 13% 13% 13%
EVA 7 7.91 8.75
terminal Growth Rate 5%
Correct Value of the Company
Year 0 1 2 3 4 5
OIC 100 113 125 135
ROIC 20% 20% 20% 20% 20% 20%
NOPAT 20 22.6 25 27
Net Investment 13 12 10 6.75
Free Cash Flow 7 10.6 15 20.25
WACC 13% 13% 13% 13%
EVA 7 7.91 8.75 9.45
terminal Growth Rate 5%
PV(EVA) 6.19469 6.19469 6.064189 81.86655
Value-EVA
PV(FCF) 6.19469 8.301355 10.39575 175.4283
Value-FCF
200.3201199
200.3201199
GROWTH AND VALUE
Growth Rate of ABC Limited
• OIC as on 31 March 2010 = Rs.100m
• ROIC = 20%
• Investment rate = 25%
NOPAT
Investment Net
IR Rate Investment
_
) ( _ =
Growth Rate = ROIC * Investment Rate
Growth and Value
• OIC = 500
• ROIC = 10%
• WACC = 15%
• Growth rate = 0%
• Growth rate = 5%
Growth and Value
• OIC = 500
• ROIC = 15%
• WACC = 15%
• Growth rate = 0%
• Growth rate = 5%
Growth and Value
• OIC = 500
• ROIC = 20%
• WACC = 15%
• Growth Rate = 0%
• Growth rate = 5%
Where to Invest?
Company A Company B Company C
OIC 100 100 100
ROIC 20% 15% 10%
WACC 15% 15% 15%
Growth
Rate
5% 5% 5%
doc_276099587.pptx