Calculate The Intrinsic Value Of The Company By Conducting A

Calculate The Intrinsic Value Of The Company By Conducting A Two Stage

Calculate the intrinsic value of the company by conducting a two-stage DCF company-level valuation analysis, compare your results to the current market capitalization of the company, and perform sensitivity analysis. The requirements involve calculating the intrinsic value using the two-stage Discounted Cash Flow (DCF) model, estimating free cash flows (FCF) from recent fiscal year data, specifying the WACC, calculating high-growth and terminal values, and comparing these to the market capitalization. Additionally, the analysis includes a sensitivity analysis on key inputs and, optionally, an industry comparable valuation.

Paper For Above instruction

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Introduction

Valuation is a critical component of financial analysis, enabling investors and managers to estimate a company's intrinsic worth based on its financial performance and prospects. Among various valuation methodologies, the Discounted Cash Flow (DCF) model is widely regarded for its reliance on fundamental cash flow projections rather than market sentiment or comparable firms alone. This paper applies a two-stage DCF model to derive the intrinsic value of a specific company, compares this value to its market capitalization, and examines the sensitivity of the valuation to key assumptions. Additionally, an optional industry comparable analysis is discussed to contextualize the valuation.

Calculating Free Cash Flows

The first step involves calculating the free cash flow (FCF) to the firm for the most recent fiscal year. FCF represents the cash available to all providers of capital (both debt and equity) after accounting for operating expenses and capital investments. The formula used is:

\[ \text{FCF} = \text{Cash Flow from Operations} - \text{Capital Expenditures} + \text{Interest} \times (1 - \text{Tax Rate}) \]

Data for Cash Flow from Operations and Capital Expenditures can be obtained from Yahoo! Finance’s Statement of Cash Flows. The interest expense is found in the income statement, while the tax rate is calculated as:

\[ \text{Tax Rate} = \frac{\text{Tax Expense}}{\text{Net Income}} \]

This approach ensures an accurate reflection of the effective tax shield on interest payments, aligning with standard valuation practice.

Determining the Discount Rate: WACC

The Weighted Average Cost of Capital (WACC) serves as the discount rate, representing the average expected return required by both debt and equity investors. Ideally, the WACC used should reflect the company's capital structure and risk profile. It can be derived from prior analysis or obtained via financial data sources or valuation tools. For this analysis, suppose the WACC is 7.5%, either previously calculated or retrieved from financial databases.

Two-Stage Valuation: High-Growth and Terminal Phases

The core of the model involves projecting FCFs over two periods: a high-growth phase (Years 1-3) and a perpetuity phase.

- High-Growth Phase: Assume FCFs grow at 8% annually for the first three years. The projected FCFs for Years 1-3 are:

\[ \text{FCF}_1 = \text{FCF}_0 \times (1 + 8\%) \]

\[ \text{FCF}_2 = \text{FCF}_1 \times (1 + 8\%) \]

\[ \text{FCF}_3 = \text{FCF}_2 \times (1 + 8\%) \]

- Terminal Value: Beyond Year 3, FCFs grow at a stable rate of 2.5%. The terminal value at the end of Year 3 is calculated using the Gordon Growth Model:

\[ \text{TV}_3 = \frac{\text{FCF}_4}{\text{WACC} - g_{\text{terminal}}} \]

where

\[ \text{FCF}_4 = \text{FCF}_3 \times (1 + g_{\text{terminal}}) \]

- Present Value Calculations: Discount the projected FCFs and terminal value back to the present using the WACC:

\[ \text{PV of FCF}_t = \frac{\text{FCF}_t}{(1 + \text{WACC})^t} \]

\[ \text{PV of Terminal Value} = \frac{\text{TV}_3}{(1 + \text{WACC})^3} \]

Adding the present values yields the total enterprise value (EV). Subtracting net debt gives the equity value, which can be compared to the market capitalization.

Comparison to Market Capitalization

From Yahoo! Finance’s Key Statistics page, the market capitalization (market cap) is identified, representing the total value of all outstanding shares at current market prices. This market cap reflects collective market expectations and investor sentiment. To compare with the intrinsic value, the firm's net debt is subtracted from the enterprise value:

\[ \text{Equity Value} = \text{Enterprise Value} - \text{Debt} \]

This adjusted intrinsic value, divided by the number of outstanding shares, provides a per-share intrinsic valuation.

Discrepancies between intrinsic value and market cap may occur due to market optimism or pessimism, differing assumptions, or unaccounted risks. Market prices incorporate expectations about future growth, macroeconomic factors, or company-specific events, which may cause deviations from fundamentally derived valuations.

Sensitivity Analysis

Following the initial valuation, a sensitivity analysis explores how key assumptions influence the intrinsic value. Variations include:

- FCF Alteration: Increasing and decreasing FCF by 10% to observe the impact on valuation.

- Terminal Growth Rate: Adjusting the terminal growth rate from 1.5% to 3.5% to assess long-term growth assumptions.

- WACC Changes: Modifying WACC by ±2 percentage points (e.g., from 7.5% to 5.5% and 9.5%) to understand the impact of perceived risk and capital costs.

These analyses demonstrate the model’s sensitivity to inputs, highlighting that terminal growth assumptions and discount rates are critical determinants of valuation. A higher terminal growth rate and lower WACC inflate the intrinsic value, emphasizing the importance of accurate estimations.

Industry Comparable Valuation (Optional)

An industry comparable or "relative valuation" involves selecting similar firms within the same sector. Key multiples such as Price-to-Earnings (P/E), Price-to-Book (P/B), or Enterprise Value-to-EBITDA (EV/EBITDA) are used to estimate the target company's value relative to its peers.

By calculating these multiples for two comparable companies and applying the average or median multiple to the target company's financial metrics, an alternative valuation emerges. Comparing this "market multiple" approach with the DCF-derived intrinsic value provides insight into market consensus and valuation robustness.

Conclusion

This comprehensive valuation exercise, combining the two-stage DCF model, market comparison, and sensitivity analyses, offers a detailed view of the company's intrinsic worth. While the DCF provides a fundamental perspective based on cash flow projections and assumptions, the comparison with market capitalization reveals market perceptions. The sensitivity analysis underscores the importance of assumptions—particularly terminal growth and WACC—in valuation accuracy, guiding investors in understanding the risk-return profile.

References

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