# Valuation Measuring and managing the value ofpanies - Koller T.

ISBN 0-471-36190-9

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flow value (percent) factor of cash flow

($ million) (percent) at WACC

(S million)

1999 331 13.3 7.52 0.930 308

2000 349 12.3 7.54 0.865 302

2001 364 10,2 7.1)9 0.804 293

2002 379 12.7 7.53 0.748 283

2003 395 10.6 7.58 0.695 274

2004 412 13.2 7.52 0.646 2?Ki

2005 429 11.1 7.57 0.601 258

2006 447 13,3 7.52 0.559 250

2007 466 11.2 7.56 0.520 242

2008 485 13.1 7.52 0.483 234

Continuing value 14,416 13.1 7.52 0.483 6,965

9,675

Mid-year adjustment 1.037

Value of operations 10,032

Value of non-operating investments 450

Enterprise value 10,482

Debt 1,282

WACC equity value 9,200

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Exhibit 8.16 Hershey Foods—Equity DCF Valuation Summary

/-------------------------------------------------------------------------------------------------------------i

Year Equity cash flow Discount factor Present value of

{S million) at 8.1% ks cash flow at k$

($ million)

1999 245 0.925 227

2000 137 0.856 118

2001 644 0.792 512

2002 149 0.733 1(19

2003 708 0.678 481

2004 162 0.628 102

2005 723 0.581 420

2006 176 0.537 95

2007 738 0.497 367

2008 193 0.460 8'J

Continuing value 12,895 0.460 5,934

Discounted equity cash flow 8,454

Mid-year discount adjustment 357

Value of non-operating investments 450

Equity value 9,261

and WACC for each period, we get an equity value of $9,200 million, identical to that given by the APV model (Exhibit 8.15).3

The APV model is easier to use than the enterprise DCF model when the capital structure is changing significantly over the projection period. For this reason it is particularly helpful for leveraged buyouts and distressed company valuations. It is also useful when a company has significant tax loss carry-forwards that are difficult to factor into the WACC.

The Equity DCF Model

The equity DCF model is the simplest model in theory, but is actually difficult to carry out in practice. The equity DCF model discounts the cash flows to the equity owners of the company at the cost of equity. Exhibit 8.16 shows the equity DCF valuation for Hershey using the 8.1 percent cost of equity as the discount rate that we derived earlier in this chapter. The value is $9,261 million, or less than 1 percent off of the APV model value. This is because, once again, we have not adjusted for the changing capital structure. To

3 To be technically correct when using the enterprise DCF model, you should assume that the unlevered cost of equity is constant and the levered cost of equity and WACC change each year to reflect the capital structure for that year. You can do this by working back from the future and iterating a solution. Starting with the last year, you solve iteratively for a capital structure and WACC, which results in values for debt and equity consistent with the capital structure. Next, work back one year at a time until you get to your starting point.

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adjust for the changing capital structure, we need to recalculate the cost of equity every period. Use the following formula or one of the approaches discussed in Appendix A.

Where ks = levered cost of equity

Once we adjusted the cost of equity, the value using the equity DCF approach is $9,200 million (Exhibit 8.17), the same as the APV approach and the enterprise DCF model with WACC adjusted every period.

While the equity DCF model is intuitively the most straightforward valuation technique, it is not as useful as the enterprise model, except for financial institutions (as described in Chapters 21 and 22). Discounting equity cash flow provides less information about the sources of value creation and is not as useful for identifying value-creation opportunities. Furthermore, it requires careful adjustments to ensure that changes in projected financing do not incorrectly affect the company's value.

A common error in discounted equity valuations is an inconsistency between the company's dividend policy and the discount rate used. Suppose you construct a valuation that results in a value of, say, $15 a share. Next, you

Exhibit 8.17 Hershey Foods—Adjusted Equity DCF Valuation Summary

r-------------------------------------------------------------------------------------------------------------------%

Year Equity1 Debt/total Levered Discount Present value of

cash flow value ks factor cash flow at kc

($ million) (percent) (percent) ($ million)

1999 245 13.3 816 0.925 227

2000 137 12.3 3.13 0.855 117

2001 646 10.2 a.07 0.791 511

2002 149 12.7 8.14 0.732 109

2003 709 10.6 s.oa 0.677 480

2004 162 13.2 8.16 0.626 101

2005 723 11.1 8.09 0.579 410

2006 177 13.3 8.16 0.535 95

2007 738 11.2 8.09 0.495 366

2008 193 13.1 3.15 0.458 88

Continuing value2 12,838 13.1 8.15 0.458 5,880

Discounted equity cash flows 8,393

Mid year discounting adjustment3 357

Value of non-operating investments 450

Equity value 9.200

1 Dividends plus share repurchases; excludes proceeds from sale of business in 1999 (4450), which are added separately below.

2 Assumes 2009 net income 580.9 (before goodwill); 4% growth and incremental ROr of 41.44% (ROIC of 21.27% from WACC approach adjusted for leverage).

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