∑ ∞ FCF WACC
PPG, FINANCIAL MODEL, 2001-2005
4.7 Free Cash Flows and Valuation
We haven’t yet determined the cost of capital of this company (we do so in sections 4.10–4.12). Suppose it’s 10 percent. Then here’s a valuation:
48
ASSETS 2000 2001 2002 2003 2004 2005
Cash and short-term investments 111 111 111 111 111 111
Receivables 1,563 1,639 1,702 1,769 1,837 1,909
Inventories - total 1,121 1,097 1,140 1,184 1,230 1,278
Other current assets 298 287 299 310 322 335
Total current assets 3,093 3,134 3,252 3,374 3,501 3,633
Property, plant, and equipment, gross 7,089 7,669 8,291 8,958 9,674 10,441 Depreciation, depletion, and amortization
(accumulated) 4,148 4,613 5,116 5,660 6,248 6,882
Property, plant, and equipment, net 2,941 3,055 3,174 3,298 3,426 3,559
Investments and advances 320 320 320 320 320 320
Intangibles 1,700 1,700 1,700 1,700 1,700 1,700
Other assets 1,071 1,156 1,248 1,347 1,454 1,569
TOTAL ASSETS 9,125 9,366 9,694 10,039 10,401 10,781
LIABILITIES 2000 2001 2002 2003 2004 2005
Accounts payable 764 762 791 822 854 887
Accrued expense 606 650 675 701 728 757
Other current liabilities 12 12 12 12 12 12
Debt 2,971 2,997 3,102 3,212 3,328 3,450
Deferred taxes 543 564 586 609 633 657
Minority interest 128 128 128 128 128 128
Other liabilities 1,004 1,130 1,271 1,431 1,610 1,812
EQUITY
Common stock 484 484 484 484 484 484
Capital surplus 102 102 102 102 102 102
Retained earnings 6,019 6,440 6,867 7,297 7,730 8,165
Less: treasury stock 3,508 3,903 4,325 4,760 5,209 5,673
Total stockholders equit
G
y 3,097 3,124 3,128 3,124 3,107 3,078
TOTAL LIABILITIES AND EQUITY 9,125 9,366 9,694 10,039 10,401 10,781
Following are some comments on our valuation.
4.7.1 Terminal Value
As discussed in Chapter 3, we’ve used a perpetuity model to arrive at the fi rm’s terminal value:
Terminal value Long-term growth rate) Long-ter
m growth rate
The estimate of the long-term growth rate (5% in this example) and the estimate of the difference between this long-term growth and the WACC (also 5% in our example) is critical for the valuation. Our 5 percent estimate for long-term growth is based on the assumption that in mature markets, such as those in which PPG operates, growth will be approxi-mated by real growth of the economy (∼2% per year) plus infl ation (∼2–
4% per year). A small change in the long-term growth assumption can
83
FREE CASH FLOW (FCF) 2001 2002 2003 2004 2005
Profit after tax 709 726 742 757 773
Add back depreciation 465 503 544 587 634
Change in net working capital
Increase in operating current assets -41 -118 -122 -127 -132
Add increase in operating current liabilities 41 55 57 59 62
Subtract capital expenditures -580 -622 -667 -716 -767
Subtract increase in other assets -85 -92 -99 -107 -115
Add back after-tax interest 127 130 135 140 145
FCF 636 583 589 594 598
Valuing PPG
WACC 10.00%
Long-term free cash flow growth rate 5%
Year 2001 2002 2003 2004 2005
FCF 636 583 589 594 598
Terminal 12,565 <-- =G100*(1+B97)/(B96-B97)
Total 636 583 589 594 13,163
Discounted value 10,574 <-- =NPV(B96,C102:I102)*(1+B96)^0.5
Add back initial cash 111
Firm value 10,685
Subtract total debt value, Dec.00 4,646 <-- =SUM(B69:B72) -- this is controversial!
Implied equity value 6,039
Number of shares outstanding, Dec.00 168.22 Implied value per share 35.90
Market price per share, Dec. 00 46.31
PPG over or under-valued? overvalued <-- =IF(B111>B113*1.1,"undervalued",IF(B111<B113/1.1,"overvalued","ok"))
lead to signifi cant differences in the valuation; for example, if we assume that long-term growth is equal to 6 percent, our valuation of PPG’s stock increases to $48.64, which leads us to conclude that the current market valuation is “ok.” (In the spreadsheet cell B114 we’ve defi ned an “ok”
valuation as one that is within 10% of the current market price. Other-wise the stock is either over- or undervalued.)
95
Long-term free cash flow growth rate 6%
Year 2001 2002 2003 2004 2005
FCF 636 583 589 594 598
Terminal 15,856 <-- =G100*(1+B97)/(B96-B97)
Total 636 583 589 594 16,454
Discounted value 12,717 <-- =NPV(B96,C102:I102)*(1+B96)^0.5
Add back initial cash 111
Firm value 12,828
Subtract total debt value, Dec.00 4,646 <-- =SUM(B69:B72) -- this is controversial!
Implied equity value 8,182
Number of shares outstanding, Dec.00 168.22 Implied value per share 48.64
Market price per share, Dec. 00 46.31
PPG over- or undervalued? ok <-- =IF(B111>B113*1.1,"undervalued",IF(B111<B113/1.1,"overvalued","ok"))
4.7.2 Midyear Discounting
As discussed in Chapter 3, we assume that the FCFs and the terminal value occur throughout the year and not at year-end. As an approxima-tion, we assume that they occur in midyear. This assumption requires that the Excel NPV formula in cell B104 be adjusted by a factor of (1 + WACC)0.5.
4.7.3 Dealing with Initial Cash and Debt
In principle, the valuation format is as follows:
Valuation Schematic
Item Why?
Enterprise value = PV of future FCFs and terminal value.
The enterprise value is the discounted value of the fi rm’s future anticipated business cash fl ows, represented here by the free cash fl ow (FCF).
Add in initial cash. The cash on the fi rm’s balance sheet at end-year 2000 is assumed not to be needed for its business activities.
Subtract the current value of the fi rm’s fi nancial obligations.
Enterprise value + Initial cash = Firm’s current market value. This value is split between its shareholders and its debt holders. In our model we approximate the market value of the fi rm’s debt by the book value of the debt.
Note that the fi rm’s operating current liabilities are not included in the debt for valuation purposes—they’ve already been netted out of the FCF.
= Equity valuation of the fi rm.
This value has to be divided by the number of shares outstanding to arrive at a per-share valuation.
The implementation of this schematic is problematic, especially as it regards the fi rm’s debt. The question is, Which of the liability items on the balance sheet are regarded by the market as fi nancial obligations of the fi rm? In the preceding valuation we’ve chosen to include all of the following items as “fi nancial debts” of PPG:
69 70 71 72
B A
Debt 2,971
Deferred taxes 543
Minority interest 128
Other liabilities 1,004
Many Wall Street analysts would consider this approach too conserva-tive. They often argue that deferred taxes are not a fi nancial obligation of the fi rm, and they might even take issue with our listing of other liabili-ties among the debts of PPG. Obviously, the fewer debts we list, the higher our valuation of PPG’s equity.
4.7.4 Is PPG Overvalued? Undervalued?
In cell B114, we’ve used a “10 percent” rule: If PPG’s computed stock price falls within a ±10% range of the current stock price of $46.31, we call our valuation “ok.” The formula we use is =IF(B111>B113*1.1,
“undervalued”,IF(B111<B113/1.1,“overvalued”,“ok”)).