*Traduced from Intervalue*

A company, is an asset formed by different assets such as buildings, intellectual property, brands, accounts receivables and other, some of which can be founded in the balance sheet[1]. In this sense, a company is just a complex type of cash generating asset.

Therefore, as any other asset, each company has a financial intrinsic value, defined as the current value of future cash flows, adjusted by the associated risk. Thus, the value of a company is:

Where EV is the Enterprise value, CF_{t }is the cash Flow generated in year t and k is the discount rate.

However, the cash flow generated by the company should remunerate all the financing sources, that is, the shareholders and the debtholders. Thus, we can distinguish between equity value[2], known as E, and debt value (D). So that, the Enterprise value is equal to:

Therefore, the value of a company is equal to the sum of the equity and debt values, which is equal to the current value of future expected cash flows.

Once we have reached this point, the great challenge of firm valuation emerges. The Free Cash Flow is not an accounting measure, so it is always necessary to calculate it from available accounting data. To achieve the FCF, it is necessary to consider all revenues and expenses effectively payed or received, so that, the formula is as follows:

Where EBIT (Earnings Before Interests and Taxes) is the operating profit, T is the effective tax rate, WC is non-cash Working Capital defined as WC = Inventory + Accounts Receivable – Accounts Payable.

The Free Cash Flow could be considered as the money that enters in the company as a result of its operations and investments, independently of the financing sources and equity or debt emissions. That is the reason why the valuation of the firm is done through the free cash flow.

So that, we have:

Once we have obtained the FCF, we should obtain the other variable of the equation: the discount rate (k). This rate is the weighted average cost of capital, known as WACC. This measure can be understood as the average opportunity cost for investors. As it is a weighted average, it is necessary to consider the capital structure of the company, that is, the relationship between E (Equity) and D (Debt), at market values. Moreover, it must be considered that the debt is tax deductible, so the cost of debt should be after-tax. So, we have that:

Where E/(E+D) and D/(E+D) are the weights of equity and debt, K_{E }is the required rate by shareholders, K_{D }is the required return by debtholders and T is the marginal tax rate for the company.

From this formula, arises another problem. The required return by shareholders is not observable and, even though there are some theories, there is no consensus about that. The most generally accepted measure, in spite of its numerous theoretical and empirical problems, is the CAPM, which states that the cost of equity is equal to the risk-free rate plus the risk of the market adjusted by the individual risk of the company with respect to the market. With this model we have:

Where R_{F} is the risk-free rate, MRP is the Market Risk Premium and β is the beta coefficient, that measures the risk of the company.

Thus, with equations (4) and (5), the WACC is equal to:

So that, we have the valuation formula defined and explained, that arises as a result of combining equations (3) and (4):

Frequently, what interests in the valuation is the value of Equity, as it is the part of the capital structure corresponding with the ownership of the company. In order to have this value, the valuation must be adjusted, combining equations (2) and (7), so we have the value of the shareholders.

In the second part of this article, it will be introduced the multiples approach to valuation, also known as relative valuation. Additionally, an example of a valuation with these two methods will be included.

[1] However, not all the assets of a company appear in the Balance Sheet, which is just financial statement that shows the static situation of a company according to the accounting standards. A typical example of an asset that doesn’t appear in the balance sheet is a brand, since its accounting value is almost zero, even financially it is not the case.

[2] Usually, the Enterprise value and the equity value are . For example, it is normal to listen to the sentence “the company X is worth 10 billion in the stock market”, when the precise sentence would be “the equity value of the company X is worth 10 billion”.

Pingback: Viscofan: An Example of Value Creation | Market Inefficiencies