Practical Equity Valuation: A Simple Approach
27 Pages Posted: 26 Jul 2000
Date Written: June 2000
Abstract
In a typical market-based valuation, the standard procedure is to discount the expected free cash flow (EFCF) at the weighted average cost of capital (WACC) and the effect of financing is taken into account by adjusting the WACC. However, in many cases, it may be difficult to capture the various impacts of financing by simply adjusting the WACC. In other cases, as a component of the analysis, the construction of the cash flows to the equity holder may be necessary. In this paper, I present a simple spreadsheet model for the direct valuation of the cash flows to the equity holder without the usual simplifying assumptions.
In particular, I specify the following flexible conditions:
a. Multiperiod investments and reinvestments, b. Finite cash flows, with variable growth rates, c. Variable debt-equity ratios, d. Losses carried forward.
With the inclusion of these conditions, the analysis is more realistic. In the model, the present value of the tax shield is discounted at rho, the required return with all-equity financing. In addition, the impacts of inflation are directly incorporated into the analysis. In particular, the model shows that the NPV of the free cash flow (including the tax savings from debt financing), discounted at the WACC is equal to the NPV of the free cash flow to the equity holder, discounted at the annually adjusted return to equity. The general approach presented here can be easily modified to take into account the varied circumstances and special complexities that are often encountered by practitioners.
Keywords: Multiperiod WACC, Equity Valuation, Cost of Capital
JEL Classification: G12, G31
Suggested Citation: Suggested Citation
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