business-haroun/mba/ch60.org

#+title: Section 11 | Lesson 60 - How to value public firms the easy way
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* Links
- [[./../mba-main.org][TOC | Business]]
- [[https://www.udemy.com/course/an-entire-mba-in-1-courseaward-winning-business-school-prof/learn/lecture/4310022#overview][S11:L60 course video]]
- file:../_data/section_11/microsoft_valuation.numbers
- file:../_data/section_11/course_notes.pdf

* notes

** final cash flow explanation

The "final cash flow" refers to the cash flow in the **last year of your explicit forecast** — typically Year 10 in a 10-year DCF model.

It is used as the base to calculate the **terminal value**, which estimates all future cash flows from Year 11 to infinity.

*** How to Determine the Expected Cash Flow

This is the process to forecast expected cash flow for a future year:

**** 1. Start with Historical Financials
- Gather at least 3–5 years of historical data
- Use sources like: Yahoo Finance, Google Finance, EDGAR (SEC), or company filings


**** 2. Choose the Right Cash Flow Metric
Use either:
- **Free Cash Flow (FCF)** = Operating Cash Flow – Capital Expenditures
- Or estimate **Free Cash Flow to Firm (FCFF)** with:
  #+BEGIN_SRC text
  FCFF = EBIT × (1 - Tax Rate) + Depreciation - CapEx - ΔWorking Capital
  #+END_SRC

***** What the Components Mean

- EBIT (Earnings Before Interest and Taxes) :: Profit from the company’s core operations before interest and taxes are deducted.

- Depreciation (Non-cash expense) :: A way to spread out the cost of physical assets over their useful life; it reduces taxable income but doesn't reduce actual cash.

- CapEx (Capital Expenditures) :: Cash spent to buy or upgrade physical assets like equipment, property, or infrastructure.

- Working Capital (Current Assets - Current Liabilities) :: Measures short-term liquidity; changes in it reflect how much cash is tied up in day-to-day operations.

**** 3. Project Revenue Growth
- Estimate growth rate based on:
  - Past performance
  - Industry benchmarks
  - Market conditions
  - Company guidance

**** 4. Forecast Expenses
- Express expenses as a **percentage of revenue** (e.g., COGS, SG&A)
- Estimate EBIT, taxes, CapEx, depreciation, and working capital changes

**** 5. Project for 5–10 Years
- Do this for each year individually
- The last year's result is your **final cash flow**

*** Example Forecast

| Year | Revenue | EBIT Margin | EBIT   | Taxes (20%) | FCFF    |
|------|---------|-------------|--------|-------------|---------|
| 2024 | 100000  | 20%         | 20000  | 4000        | 16000   |
| 2025 | 110000  | 21%         | 23100  | 4620        | 18480   |
| 2026 | 120000  | 22%         | 26400  | 5280        | 21120   |

🧠 The FCFF in the final projected year (e.g., $21,120 in 2026) is what you use in the **terminal value formula**.

*** Summary

- The final cash flow is not the end of the business; it’s the **bridge** to estimating future value
- It should reflect the company’s stable, mature cash-generating potential
- Accuracy here has a **big impact** on the total DCF valuation


** how to calculate the beta

Beta measures a stock's volatility relative to the market (typically the S&P 500). A beta of:

- **1.0** → moves in line with the market
- **>1.0** → more volatile than the market
- **<1.0** → less volatile than the market

Here’s how to find or calculate it:

*** 1. Google Finance (Quick and Easy)

1. Go to https://www.google.com/finance
2. Search for the company (e.g., Microsoft)
3. Scroll to the "Performance" section
4. Look for **"Beta"**

🧠 Example: Microsoft’s beta may be listed as **0.78**, meaning it is 22% less volatile than the market.

*** 2. Yahoo Finance

1. Go to https://finance.yahoo.com
2. Search for the company (e.g., MSFT)
3. Click on **"Statistics"**
4. Under "Stock Price History", find **"Beta (5Y Monthly)"**

*** 3. Bloomberg Terminal / Paid Services

These are professional tools, often used in finance:

- Bloomberg: `MSFT <Equity> FA`
- Also available via: Morningstar, Reuters, FactSet

*** 4. Manual Calculation (Advanced)

If you want to calculate beta yourself:

Formula:
#+BEGIN_SRC text
Beta = Covariance(Stock Return, Market Return) / Variance(Market Return)
#+END_SRC

Steps:
1. Get historical prices for the stock and a market index (e.g., S&P 500)
2. Calculate periodic returns (daily, weekly, or monthly)
3. Compute covariance and variance
4. Apply the formula

You can do this using:
- Excel (with `COVARIANCE.P()` and `VAR.P()` functions)
- Python (e.g., using pandas and NumPy)

*** Summary

- Use Google Finance or Yahoo Finance for quick lookups
- Use Bloomberg or Morningstar for professional-level data
- Calculate manually only if you're customizing the analysis


** Cost of Equity Calculation

The cost of equity is the return investors expect for owning a company's stock. It's calculated using the Capital Asset Pricing Model (CAPM):

Formula:
#+BEGIN_SRC text
Cost of Equity = Risk-free rate + Beta × Market Risk Premium
               = 1% + 0.78 × 11% = 9.58%
#+END_SRC

- **1%**: Risk-free rate (e.g., U.S. Treasury yield)
- **0.78**: Microsoft's beta (measures volatility relative to market)
- **11%**: Market risk premium (extra return expected above risk-free rate)

🧠 Interpretation:
Investors expect a 9.58% annual return to compensate for the risk of owning Microsoft stock.

** Discounted Cash Flow (DCF) Basics

DCF tells us how much a company is worth today, based on future expected profits.

Steps:
1. Forecast future cash flows (e.g., next 10 years)
2. Discount each cash flow using the cost of equity (e.g., 9.58%)
3. Sum the discounted values

Formula:
#+BEGIN_SRC text
Present Value = Cash Flow / (1 + r)^n
#+END_SRC

Example:
- Year 1: $100 / (1 + 0.0958)^1 ≈ $91.27
- Year 2: $100 / (1 + 0.0958)^2 ≈ $83.33
- Year 3: $100 / (1 + 0.0958)^3 ≈ $76.07
- Total Present Value ≈ $250.67

🧠 Interpretation:
A dollar in the future is worth less today. DCF converts all future profits into today’s dollars.

** Terminal Value and Growth Limits

What happens after the 10-year forecast? Use the Terminal Value to estimate value from Year 11 to infinity.

Formula (Gordon Growth Model):
#+BEGIN_SRC text
Terminal Value = Final Year Cash Flow × (1 + g) / (r - g)
#+END_SRC

Assumptions:
- Final Year Cash Flow = $20 billion
- g = 1% (long-term growth rate)
- r = 9.58% (discount rate)

Example:
#+BEGIN_SRC text
TV = 20 × (1 + 0.01) / (0.0958 - 0.01) ≈ 235.41 billion
#+END_SRC

🧠 Interpretation:
- This is the present value (as of Year 10) of all future profits beyond that year.
- We assume **low, steady growth** because no company can grow faster than the economy forever.
- This value must then be discounted back to today just like the other cash flows.

** NPV in Excel

You can calculate all the present values quickly using Excel’s `=NPV()` function.

Steps:
1. Enter your forecasted cash flows into cells (e.g., B2:B6)
2. Add terminal value to the last cash flow (e.g., B6 = 14,000 + 150,000)
3. In an empty cell, enter:
#+BEGIN_SRC excel
=NPV(0.0958, B2:B6)
#+END_SRC

🧠 Notes:
- Excel assumes cash flows happen at the end of each period.
- If you receive a cash flow today (Year 0), add it manually:
#+BEGIN_SRC excel
=InitialCashFlow + NPV(0.0958, B2:B6)
#+END_SRC

🧠 Interpretation:
Excel returns the total **present value** of all the future income streams — meaning how much they are worth today, assuming a 9.58% expected return.

** What "Present Value of Future Income Streams" Means

"Present value of future income streams" means:

- You're estimating how much a set of future cash payments is worth today.
- This accounts for risk, time, and opportunity cost.
- Future money is discounted using a rate (like 9.58%) to reflect these factors.

🧠 Analogy:
If someone promises to pay you $10k every year for 5 years, that’s not worth $50k **today** — because of inflation and risk. You discount those payments to find out their **real value now**.

🧠 Summary:
- It’s the foundation of DCF
- It gives you today’s value of tomorrow’s profits
- Helps investors decide if an investment is worthwhile