The FTE model
Valuation with the FTE model: An example
The APV model
Valuation with the APV model: An example
Additional issues
The big picture
Excel section
Challenge section
I
n theory, given the company and the point in time, all discounted cash flow (DCF) models should yield the same intrinsic value. In practice, however, that is frequently not the case. And implementing one version of the DCF model is often easier than implementing another. That’s why in this chapter we’ll discuss the flows-to-equity (FTE) and the adjusted present value (APV) models, two versions of the DCF model that, although less widely used than the WACC model, may be easier to apply in some circumstances. (In order to fully understand the issues discussed in this chapter it is essential that you’re familiar with the issues discussed in Chapter 14.)The FTE model
You may recall from our discussion in the previous chapter that the weighted- average cost of capital (WACC) model discounts capital free cash flows at the cost of capital. The present value calculated is therefore the intrinsic value of debt and equity. This implies that in order to find the value of the company’s equity, we need to subtract from the present value calculated the market value of long-term debt.
The flows-to-equity (FTE) model is simpler than the WACC model on two counts. First, it estimates the value of the equity directly, so there is no need for the additional step of subtracting the long-term debt. Second, the discount rate is easier to estimate simply because it is just one component of the company’s cost of capital.
Before we formally define the FTE model it is important to recall the difference between the equityfree cash flow (EFCF), which is given by
EFCF = Net income + Depreciation and amortization – Net capital expense – Increase in net working capital , (15.1)
and the capitalfree cash flow (CFCF), which is given by
CFCF = Net income + Depreciation and amortization – Net capital expense – Increase in net working capital + After-tax interest (15.2)
As you may recall from the previous chapter, the former is the cash available to shareholders after the company has paid interest to debt holders and made the necessary investments in fixed assets and working capital. The latter, on the other hand, is the cash available to all the providers of capital, again after the company has made the necessary investments in fixed assets and working capital. You may also recall that the CFCF, unlike the EFCF, is independent of the company’s capital structure.
Note that EFCFs belong to shareholders, who are the ones bearing the risk.
The appropriate discount rate for these cash flows, then, is the required return on the company’s equity. Therefore, the FTE model discounts EFCFs at the cost of equity and can be formally expressed as
(15.3)
where E denotes the value of the company’s equity, E(EFCFt) the expected equity free cash flow in period t, RE the required return on equity, TV the terminal value, and Tthe number of periods for which cash flows are forecasted.
The required return on equity, sometimes called the cost of equity, is usually (but not exclusively) estimated with the CAPM (discussed at length in Chapter 7).
As we discussed in the previous chapter, the terminal value can be estimated in different ways, the two most widely used alternatives being a growing perpetuity or a multiple of some fundamental variable. In the first case, it is important to keep in mind that it is not plausible to assume a long-term growth rate larger than that of the economy, which limits the long-term growth of cash flows to not more than 6% or so a year.
Note that in the way it is usually implemented, the FTE model yields the value of the company’s equity. Therefore, in order to estimate the intrinsic value of a share, the estimate resulting from equation (15.3) must be divided by the number of shares outstanding.
Valuation with the FTE model: An example
Let’s apply the FTE model to the valuation of Dell at the beginning of the year 2004 using all the information we discussed in the previous chapter. Recall that in the year 2003, Dell delivered a profit of $2.6 billion on revenues of $41.4
E= E(EFCF1)
+ E(EFCF2)
+ . . . + E(EFCFT) + TV (1 + RE) (1 + RE)2 (1 + RE)T
billion. On January 30, 2004, when Dell’s fiscal year 2003 concluded, the company’s market cap was $85.5 billion and its stock price $33.44. At the same time, Dell’s earnings per share (EPS) and price/earnings (P/E) ratio were $1.01 and 33, respectively.
In Table 14.4 of the previous chapter we had estimated that Dell delivered an EFCF of $3,341 million in fiscal year 2003. Let’s assume that over the next five years (2004 to 2008) Dell’s EFCFs will increase at the annual rate of 17%, which is the rate at which analysts expect the company to increase its earnings during the same period. Let’s also assume that over the following five years (2009 to 2013) Dell’s EFCFs will slow down and increase at the annual rate of 10%. And let’s finally assume that, from that point on, Dell’s EFCFs will grow along with the economy at the annual rate of 6%. (As you may have noticed, these are the same assumptions we made for the expected growth of the CFCFs in the previous chapter.) The expected EFCFs that follow from these assumptions are displayed in Table 15.1.
TABLE 15.1
Year EFCF Year EFCF
($m) ($m)
2004 3,909 2010 8,863
2005 4,573 2011 9,750
2006 5,351 2012 10,724
2007 6,261 2013 11,797
2008 7,325 TV 160,021
2009 8,057
Note that the last number in the table, roughly $160 billion, is the terminal value and is calculated as the present value of EFCFs growing at 6% in perpetuity from 2013 on. Importantly, note also that these EFCFs are very similar to the CFCFs displayed in Table 14.5 simply because Dell is a company almost fully financed by equity. This means that its interest payments are very small, and therefore so is the difference between CFCFs and EFCFs.
Using the CAPM, we estimated in the previous chapter that Dell’s cost of equity was 13.8%. Therefore, putting together this discount rate with the expected EFCFs in Table 15.1, we can obtain the intrinsic value of Dell’s equity at the end of January 2004, which was