DES Chapter 13 1

Chapter 13

The Valuation of an Actual

Company: Home Depot

DES Chapter 13 2

The valuation spreadsheet has seven interrelated worksheets, each of which performs an essential function:

(1) Proj & Val(2) Inputs(3) WACC(4) Hist Analys(5) Condensed(6) Comprehensive(7) Actual

Steps to estimate value using the Corporate Valuation Spreadsheet

DES Chapter 13 3

Horizon Value Methods

Recall what the “Proj & Val” sheet does:

This sheet automatically forecasts the future Pro Forma financial statements, based on data in the Inputs Sheet.

It automatically calculates future expected Free Cash Flows (FCF) from the Pro Formas.

It then calculates Present Value (PV) of future expected FCF and finds estimated price per share.

(continued)

DES Chapter 13 4

Horizon Value Methods (continued)

The value of a company is the present value of all future free cash flows

A realistic approach to valuation involves:

analysts only forecast a finite number of years (20 years is more than adequate)

the last year in the forecast is called the horizon (i.e., it begins the steady state, period of constant growth)

(continued)

DES Chapter 13 5

Horizon Value Methods (continued)

The discounting of the future free cash flows involves three steps:

find the value of all free cash flows beyond the horizon, discounted back to the horizon.

find the present value of the firm’s horizon value and all of its forecasted free cash flows for the years up to the horizon.

add the two components of value together

(continued)

DES Chapter 13 6

Horizon Value Methods (continued)

There are four ways to calculate the horizon value:

1) continuing value method

2) book value method

3) convergence value method

4) general value method

(continued)

DES Chapter 13 7

Horizon Value Methods (continued)

1) The Continuing Value Horizon Formula:Suppose the WACC=10%, and ROIC for the last year in the forecast is 15%.

Q: can the company earn a return in excess of its cost of capital indefinitely?

Are barriers protecting this company from the forces of competition?

Will future competition in the period after our last forecasted year fail to drive down the company’s ROIC? (continued)

DES Chapter 13 8

Horizon Value Methods (continued)

If you think the answers to these questions are “Yes”, then use the Continuing Value Horizon Formula:

Where HVT is the horizon value at year T.

gWACC

)g1(TFCFTHV

−+

=

(continued)

DES Chapter 13 9

Horizon Value Methods (continued)

2) The Book Value Horizon Formula:Suppose that immediately after the horizon year, competition will force the ROIC on existing capital and on new investment to the WACC. As of that time, the NPV of all the firm’s assets and future investment is zero, and the horizon value equals book value of capital as of the beginning of the horizon:

TCapitalTHV =(continued)

DES Chapter 13 10

3) The Convergence Value Horizon Formula:Suppose ROIC on existing capital can be maintained, but competition will force ROIC on new capital (after the horizon) to equal the WACC. Then horizon value is just the value of the free cash flows from existing capital.*

*Eventually the ROIC of the firm converges the WACC.

Horizon Value Methods (continued)

( )gWACC

g1TNOPATTHV

−+

=

(continued)

DES Chapter 13 11

Horizon Value Methods (continued)

4) The General Value Horizon FormulaCompetition will result in a gradual reduction of the return on new capital, forcing the ROIC on new capital to fall from ROICT to some long-term sustainable ROICL, which may be greater than the

WACC.

€

HVT =ROIC

L− g( )Capital

TWACC −g

⎡

⎣

⎢ ⎢

⎤

⎦

⎥ ⎥+

ROICT

− ROICL( )Capital

TWACC

⎡

⎣

⎢ ⎢

⎤

⎦

⎥ ⎥

DES Chapter 13 12

Valuing Operations: Home Depot

Recursive Calculation of Value:The Val & Proj worksheet starts (in cell W97) with the horizon value as the value at year T (2023) of free cash flow beyond year T. This is

V2023 = HV2023

The value at T-1 (2022) is the free cash flow during year T and subsequent years:

V2022=(FCF2022+V2023)/(1+WACC)

And so on, back to year 2003.(continued)

DES Chapter 13 13

Valuing Operations: Home Depot, 2021 and beyond

This is the horizon year

Note hiddencolumns

DES Chapter 13 14

The Half-Year Adjustment

Cash flows occur throughout the year and not just on the last day of the year. The estimate of the value of operations based upon year-end cash collection understates the true value of operations. The half-year adjustment treats the total yearly cash flow as if it occurs at mid-year:

VAfter Adjustment=VBefore Adjustment(1+WACC)0.5.

(continued)

DES Chapter 13 15

This is the horizon year

Note hiddencolumns

The Half-Year Adjustment for Home Depot

DES Chapter 13 16

Target Valuation Date

Cells in the “Calculating Value” section of the worksheet give the valuation calculations as of the end of the most recent fiscal year.

It’s usually desirable to calculate value as of the current date, or some other “target date”, usually the date on which the valuation estimate is completed.

(continued)

DES Chapter 13 17

Target Valuation Date (continued)

Cells in the “Price per share on target date” section adjust value of operations for the elapsed time from last FYR date to the target date by compounding at the WACC:

Vtarget date = VFYR date (1 + WACC)#days/365

(continued)

DES Chapter 13 18

Target Valuation Date (continued)

Target date adjustments for Investments and nonequity claims use linear interpolation between FYR ends:

Xtarget date = XFYR date + Adj,

Where:

Adj= [XFYR date+ 1 year - XFYR date](#days/365)].

(X stands for either investments or nonequity claims.)

(continued)

DES Chapter 13 19

Target Valuation Date Adjustments for Home Depot

DES Chapter 13 20

Valuation of Home Depot

Once satisfied that the projected financials are plausible, look closely at the projected ROIC:

actual ROIC for 2003 was 19.2%

declines gradually to 16.2% by 2023

assumed long-term ROIC is 10%, compared to WACC of 8.51%

(continued)

DES Chapter 13 21

Valuation of Home Depot (continued)

Summary of valuation (worksheet row numbers in parentheses):

(Row 97) the present value of all forecasted future free cash flows as of 2/2/2003 is about $75.0 billion

(Row 98) the half-year adjustment give the value of operations on the target date of 5/21/03 at about $78.2 billion

(continued)

DES Chapter 13 22

Valuation of Home Depot (continued)

Summary of valuation (continued):

(Row 99) add nonoperating investments, which are less than $0.1 billion

(Row 101) subtracting nonequity claims of $1.8 billion

(continued)

DES Chapter 13 23

Valuation of Home Depot (continued)

Summary of valuation (continued):

(Row 102) total value of equity of $76.4 billion

(Row 104) dividing by shares outstanding gives intrinsic value for the most recent fiscal year-end, 2/02/2003, of $32.71 per share

(continued)

DES Chapter 13 24

Valuation of Home Depot (continued)

Summary of valuation (continued):

(Row 117) Finally, making the adjustments for target date valuation results in a target dated estimated share value of $33.45.

(continued)

DES Chapter 13 25

Valuation of Home Depot (continued)

Perspective on value:

To gain some perspective on the valuation result, put the intrinsic value estimate in the context of recent stock prices for Home Depot. As of this writing, there are almost five months of hindsight on the 5/21/2003 value estimate:

(continued)

DES Chapter 13 26

Source: marketguide.com (http://www.multexinvestor.com/Home.aspx)

Home Depot stock prices: October 2002-October 2003

Intrinsic value estimate for 5/21/2003: $33.45

Actual HD stock prices

DES Chapter 13 27

Other Financial Measures

(Row 120) Economic profit - “profit” that the company generated during the year in excess of the “profit” that investors required at the beginning of the year:

EP = NOPAT – Capital charges

= NOPAT – WACC(Op. capital at the beg. of the year).

(continued)

DES Chapter 13 28

Other Financial Measures (continued)

(Row 121) Market value added (MVA) - the estimated value of operations minus the total operating capital (at current book value):

MVA = Value of operations – Operating capital

(continued)

DES Chapter 13 29

Other Financial Measures (continued)

(Rows 122-125) Comparative valuation approaches:

P/E (or just PE) ratio

market to book ratio

Value/Sales ratio

Value/EBITDA ratio (EBITDA is earnings before interest, taxes,

depreciation,and amortization.)

(continued)

DES Chapter 13 30

Other Financial Measures (continued)

(Rows 126-127) Capital structure:

market-based percent of the firm that is financed with debt

times-interest-earned ratio

(continued)

DES Chapter 13 31

Other Financial Measures (continued)

(Rows 149-157) Net cash flow from financing activities:

short-term borrowing/ short-term investments

long-term borrowing

DES Chapter 13 32

Reverse Engineering

What if intrinsic value estimates are substantially different from current market price?

Reverse engineering is the process of discovering what changes in the analyst’s input choices would give an intrinsic value estimate that equals the market’s price.

(continued)

DES Chapter 13 33

Reverse Engineering (continued)

Is the market price reasonable?

If you only have to make small changes in the inputs that reflected your best judgment to get the model’s price equal to the market’s price, then the stock is probably fairly priced.

(continued)

DES Chapter 13 34

Reverse Engineering (continued)

Is the market price reasonable? (continued)

If not, then the market may be wrong. Perform sensitivity analysis to identify critical inputs, and determine how your valuation “holds up” under plausible variation in those inputs.

(continued)

DES Chapter 13 35

Scenario Analysis: Assessing the Impact of Managerial Decisions

The FCF model is very useful in assessing the impact that operating decisions or external events have on the firm’s value.Change sales growthChange profitability (margin)Change working capital requirementsChange fixed asset requirements

(continued)

DES Chapter 13 36

Scenario Analysis (continued)

The financial projections from the free cash flow model may be used to facilitate long-term financial planning.Change in dividend policyChange in financial structureStock repurchases