Calculation loop (year-by-year forecasting)

Though we do not set any assumptions on how long the company we are valuating will be in existence, and, therefore, imply that its operations will continue forever, the calculation loop cannot be indefinite. Thus, merely for practicality considerations, we put some reasonable time horizon (say, 50 years) for our forecast.

The time horizon is also the number of times we go through the calculation algorithms that forecasts key financial data, with each passage through the loop corresponding to a separate year in the future.

Below is a brief description of each step of the calculation and the appropriate formulae.

  1. Revenue growth rate
  2. The calculation loop starts with forecasting revenue growth rate for a particular year. For the first forecasted year following the base year, it is set to be equal to its input value. For all subsequent years it is calculated using the following formula:
    Revenue growth rate = Terminal revenue growth rate +(Revenue growth rate at previous year -Terminal revenue growth rate) x Revenue decline factor
    REVGR = TERMREVGR + (REVGRprev - TERMREVGR) x REVDECL

  3. Revenue
    Revenue = Previous year revenue x (1+ Revenue growth rate)
    REVENUE = REVENUEprev x (1 + REVGR)
  4. Variable costs
    Variable costs = Revenue x Variable cost factor+ Goodwill / Years goodwill amortizes
    Note: the second addend exists only in years when Goodwill is greater than zero (i.e. when it is not fully amortized).
    VARCOSTS = REVENUE x VARCOSTF + GOODWILL / GWAMORT
  5. Production assets or base (average for the year)
    Production assets = Revenue x Production assets to revenue
    PRASSETS= REVENUE x PRASSREV
  6. New CAPEX
    Here we calculate the amount of capital expenditures needed to expand the production base to the level commeasurable with the current level of revenue. We assume that all new capital expenditures are made at the very beginning of the year and, therefore, the benefits of this new CAPEX also fully accrue in the current year. Definitely, this is an oversimplification, but the one that greatly reduces complexity of the model.
    New CAPEX = Production assets - Previous year production assets
    NEWCAPEX = PRASSETS - PRASSETSprev
  7. Maintenance CAPEX
    Maintenance CAPEX, as it is used here, is different from maintenance expenses. Rather, in accounting terms it could be described as the current-year depreciation expense (estimated here on the straight line basis) on the previous-year production assets. We consciously used the word ‘maintenance’ to describe these capital expenditures, as, in essence, this is the CAPEX that is needed to keep existing production assets at their current production capacity.
    Maintenance CAPEX = Previous year production assets / Depreciationlife of production assets
    MAINTCAPEX = PRASSETSprev / DLIFE
  8. Depreciation expense of new CAPEX
    As mentioned above, we assume that all new capital expenditures are made at the very beginning of the current year. Therefore, we must also account for depreciation of the new CAPEX already in the current year. Depreciation is calculated on the straight line basis.
    Depreciation expense on new CAPEX = New CAPEX / Depreciation life of production assets
    DEPRNEWC = NEWCAPEX / DLIFE
  9. Total depreciation
    Total depreciation = Depreciation expense on new CAPEX + Maintenance CAPEX + Goodwill / Years goodwill amortizes
    Note: the third addend exists only in years when Goodwill is greater than zero (i.e. when it is not fully amortized).
    DEPREC = DEPRNEWC + MAINTCAPEX + GOODWILL / GWAMORT
  10. Fixed operating expenses
    Fixed operating expenses = Previous year fixed operating expenses x (1+Inflation rate)
    FIXCOSTS = FIXCOSTSprev x (1 + INFLATION)
  11. EBIT(Operating Income)
    EBIT = Revenue - Variable costs - Fixed operating expenses
    EBIT = REVENUE - VARCOSTS - FIXCOSTS
  12. EBITDA
    EBITDA = EBIT + Total depreciation
    EBITDA = EBIT + DEPREC
  13. Interest expense (on net debt)
    Interest expense = Previous year total net debt x Interest rate on debt
    INTCOSTS = NETDEBTprev x INTRATE
  14. Earnings before tax
    Earnings before tax = EBIT - Interest expense
    EBT = EBIT - INTCOSTS
  15. Tax expense
    Tax expense = Earnings before tax x Corporate tax rate
    Note: only if Earnings before tax are positive
    TAXES = EBT x TAXRATE
  16. Net income
    Net income = Earnings before tax - Tax expense
    NETINCOME = EBT - TAXES
  17. Funds from operations (FFO)
    Funds from operations = Net income + Total depreciation
    FFO = NETINCOME + DEPREC
  18. Working capital
    Working capital = Revenue x Working capital to revenue
    WC = REVENUE x WCREV
  19. Change in working capital
    Change in working capital = Working capital  - Previous year working capital
    WCCHG = NFWC - NFWCprev
  20. Cash from operations (CFO)
    Cash from operations = Funds from operations - Change in working capital
    CFO = FFO - WCCHG
  21. Free cash flow (FCF)
    Free cash flow = Cash from operations - New CAPEX - Maintenance CAPEX
    FCF = CFO - NEWCAPEX - MAINTCAPEX
  22. Adjusted total assets
    Adjusted total assets = Revenue /Production assets to revenue
    ADJASSETS = REVENUE / PRASSREV
  23. Equity
    Equity = Adjusted assets * Adjusted equity ratio
    EQUITY = ADJASSETS * EQRATIO
  24. Change in equity
    Change in equity = Equity - Previousyear equity
    EQUITYCHG = EQUITY - EQUITYprev
  25. Adjusted total liabilities
    Adjusted total liabilities = Adjusted total assets -Equity
    ADJLIABIL = ADJASSETS - EQUITY
  26. Change in liabilities
    Change in liabilities = Adjusted total liabilities - Previous year adjusted total liabilities
    LIABILCHG = ADJLIABIL - ADJLIABILprev
  27. Issuance of new debt
    Issuance of new debt = Change in liabilities
    NEWDEBT = LIABILCHG
  28. Total cash flow
    Total cash flow = Free cash flow + Issuance of new debt
    TOTALCF = FCF + NEWDEBT
  29. Cash flow adjustment (for real cost of stock options, for example)
    This is the entry for any cash flow adjustments, such as for the real cost of stock option compensation plan used by the company, for example.
    Cash flow adjustment = Revenue x Cash flow adjustment to revenue
    CFADJ = REVENUE x CFADJREV
  30. Adjusted total cash flow
    Adjusted total cash flow = Total cash flow + Cash flow adjustment
    ADJTOTALCF = TOTALCF + CFADJ
  31. Cash for distribution 1
    Before cash could be distributed to shareholders, it is used, if needed, for equity increase - see the change in equity calculation above. Conversely, if the change in equity is negative, such change could be distributed to shareholders, too.
    Cash for distribution 1 = Adjusted total cash flow - Change in equity
    CFD1 = ADJTOTALCF - EQUITYCHG
  32. Issuance of new equity
    If Cash for distribution 1 calculated above is negative, then the company needs to issue new equity (i.e. sell its shares to shareholders).
    If CFD1 is negative:
    Issuance of new equity= -CFD1
    NEWEQUITY = -CFD1
    If CFD1 is non-negative:
    Issuance of new equity = 0
         NEWEQUITY = 0
  33. Cash for distribution 2
    Cash for distribution 2 = Cash for distribution 1 - Issuance of new equity
    CFD2 = CFD1 - NEWEQUITY
  34. Proportional claim of current shareholders on cash flows
    If new equity is issued (i.e. if new shares are sold by the company to investors), the stake of the current shareholders on the company’s assets and cash flows is diluted (assuming that they do not purchase newly-issued shares).
    Proportional claim of current shareholders on cash flows = Previous year proportional claim of current shareholders on cash flows x (Equity - Issuance of new equity) / Equity
    PORTION = PORTIONprev x (EQUITY - NEWEQUITY) / EQUITY
  35. Cash for distribution 3
    Cash for distribution 3= Cash for distribution 2 x Proportional claim of current shareholders on cash flows
    CFD3 = CFD2 x PORTION
  36. Present value (PV) of cash for distribution
    PV of cash for distribution = Cash for distribution 3/(1+Discount rate) ^ Year
    PVCFD = CFD3 / (1+ DR) ^ Year
  37. Next year’s discount rate
    Next year’s discount rate = Discount rate x Discount rate multiplier
    DRnext = DR x DRMULT

Calculation of intrinsic value

The intrinsic value of the company is calculated by summing up the present values of the cash flows available for distribution in each of the future years that were estimated in the calculation loop. We impose a restriction on the lower magnitude of the intrinsic value: it cannot be less than the company’s Tangible net worth.

By dividing the company’s intrinsic value by the number of outstanding shares, we find the intrinsic value per share. The latter is compared with the current market share price to estimate the company’s stock upside or downside potential.

 

 

Valuation algorithm

1. Introduction

2. Model input parameters

3. Calculation of intrinsic value

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