business-haroun/mba/ch60.org

Section 11 | Lesson 60 - How to value public firms the easy way

• Links
• notes
  • final cash flow explanation
    • How to Determine the Expected Cash Flow
      • 1. Start with Historical Financials
      • 2. Choose the Right Cash Flow Metric
        • What the Components Mean
      • 3. Project Revenue Growth
      • 4. Forecast Expenses
      • 5. Project for 5–10 Years
    • Example Forecast
    • Summary
  • how to calculate the beta
    • 1. Google Finance (Quick and Easy)
    • 2. Yahoo Finance
    • 3. Bloomberg Terminal / Paid Services
    • 4. Manual Calculation (Advanced)
    • Summary
  • Cost of Equity Calculation
  • Discounted Cash Flow (DCF) Basics
  • Terminal Value and Growth Limits
  • NPV in Excel
  • What "Present Value of Future Income Streams" Means

Links

• TOC | Business
• 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:

  FCFF = EBIT × (1 - Tax Rate) + Depreciation - CapEx - ΔWorking Capital

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:

Beta = Covariance(Stock Return, Market Return) / Variance(Market Return)

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:

Cost of Equity = Risk-free rate + Beta × Market Risk Premium
               = 1% + 0.78 × 11% = 9.58%

• 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:

Present Value = Cash Flow / (1 + r)^n

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):

Terminal Value = Final Year Cash Flow × (1 + g) / (r - g)

Assumptions:

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

Example:

TV = 20 × (1 + 0.01) / (0.0958 - 0.01) ≈ 235.41 billion

🧠 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:

=NPV(0.0958, B2:B6)

🧠 Notes:

• Excel assumes cash flows happen at the end of each period.
• If you receive a cash flow today (Year 0), add it manually:

=InitialCashFlow + NPV(0.0958, B2:B6)

🧠 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