[ Music ] >> Okay, now in a series of videos, let's discuss the income approach or discounted cash flow technique to valuation. And in this particular video, let's just provide an overview of doing discounted cash flows and then in subsequent videos, we can you know, kind of delve deeper in the discount rate component, and the cash flow component. So, when we're using the income approach to valuing our firm, we're using the textbook definition. What the value of any asset should be, is just the cash flows from that asset, discounted to express those future cash flows in today's dollars. Okay? So add up the cash flows generated from the asset, to get the asset's value. You know, kind of the strength of this approach as it directly relies up on actual benefits that investors care about. The weakness, and this is kind of you know, kind of true for anything is you know, it's kind of going to rely heavily on projections. Just like when they look at market, you know, kind of multiples, you know, kind of a weakness -- a strength and weakness with that too. You know, with income approach, the strength and weakness. Strength you know, the textbook definition of valuation. Weakness, we rely, you know, heavily on these assumptions about short term cash flows, long term growth rates, long term discount rates. That's why you know, stock prices move around a lot. People's you know, views on these assumptions, differ you know, kind of day to day, week to week. Okay, and also, very important to remember, garbage in, garbage out. So you can always get a very precise answer at the end of the day, given the inputs that go into the valuation exercise, but just because your answer is expressed to the you know, hundredth of a decimal point, doesn't mean it's, you know, good. Okay? What matters is whether the quality of the assumptions that are going into this valuation, that's you know, kind of very important to think about. If your assumptions are bad, your end product, your valuation's going to be bad as well. Of course, this isn't just you know, specific to the income approach to valuation. If you have a bad comparable for your market multiple technique, you're going to get bad estimates of firm value as well. Like General Motors is probably not a good comparable firm to use with Tesla. Probably a better comparable firm to use with Ford, for example. Different approaches, to the, you know, doing the income valuation that are you know, kind of discussed. Capital cash flows, equity cash flows, free cash flows, okay? Kind of the good news is, all three of these methods are going to arrive at the same answer if done correctly. In this course, we're going to focus on the free cash flow technique. That's you know, kind of very popular, covered in a lot of you know, kind of corporate finance textbooks and view this as kind of a classic way to value the firm. But I just wanted you to be aware of like there's other cash flow income approaches and different cash flow income approaches to value the firm. I just want to talk about them briefly, for we're going to be focusing then all our time on the free cash flow technique. So the Capital Cash Flow Method, value cash flow available to both equity holder and bond holders, just like the Free Cash Flow Method. A difference between the Capital Cash Flow Method and the Free Cash Flow Method is the discount rate for the Capital Cash Flow Method, reflects the risks of the cash flows to all security holders of the firm, without taking into account the deductibility of interest on debt. So the key thing is for the capital cash flow, deductibility of interest on debt is taken into account with an adjustment to the cash flows, to the numerator. It's not taken into account by an adjustment to the discount rate. When we do the Free Cash Flow Methodology, the deductibility of interest for borrowing, is taken into account in the discount rate, not in the cash flow. That's the key difference. And at least in the U.S., when firms borrow money, the interest they pay on that debt is tax deductible. So thus, that you know, kind of issue that has to be dealt with when you're doing evaluation. Equity Cash Flow Method. So just value the cash flows available to equity holders, after payments to the bond holders have been deducted. The discount rate for the Equity Cash Flow Method is just simply the discount rate you would use for the firm's stock. And then the Free Cash Flow Method. As I mentioned, you know, this is very popular. We'll be using this, you know, from this point on throughout you know, this Module 4, used in a lot of you know, kind of corporate finance classes and textbook. So for the Free Cash Flow Method like the Capital Cash Flow Method, values the cash flow available to both stockholders and bond holders. The discount rate reflects a riskiness of the cash flows to all security holders of the firm, okay, therefore, the deductibility of interest is not taken into account in the cash flows. The deductibility of interest instead is taken into account by in the discount rate which is called the Weighted Average Cost of Capital or WACC. So free cash flow technique, we're valuing the cash flows to all the security holders of the firm, bond holders, and stock holders. So therefore the discount rate should reflect the riskiness of this cash flow, generated by the firm's assets as a whole. They go to all the security holders of the firm. But we make one adjustment to the discount rate. We take into account the deductibility of interest from the firm perspective when it borrows money. This discount rate that we use to discount these future free cash flows of the firm, goes by the name Weighted Average Cost of Capital or WACC. So let's think about these you know, kind of different discount rates across these different you know, kind of valuation methodologies here, and in particular, which cash flow discount rate would you expect to be the largest? The one used in the Equity Cash Flow Method, or the Weighted Average Cost of Capital? Okay? So which discount rate would you expect to be the largest? The one basically used for the firm as a whole, the Weighted Average Cost of Capital, or the discount rate just used applying to the cash flows that go to the equity holders? Okay? What do you think about this? You know, kind of think of -- you know, kind of your intuition here. Then you know, come back and I'll give you my response. Alright, welcome back. So which cash flow discount rate would you expect to be larger? The one for equity or the one for the firm as a whole, the Weight Average Cost of Capital? Well actually, the answer is, you know, the one for equity, you'd expect to be the higher, you know, kind of discount rate. Why is that? Well, as stockholders of the firm, you're the residual claimant. So you get whatever cash flows are left over after paying the bond holders, okay? So what does that mean? It means this residual amount, that amount is going to be most sensitive to the state of the economy. So when times are very bad, dividends get cut, capital gains are poorer or probably negative, so returns to the stockholders are you know, kind of low. When times are good, this residual income draws a lot. Higher capital gains, higher dividends. So you'd expect the income to the stockholders to be much more sensitive to the economy than the overall cash flows of the firms, which includes you know, money going to both stockholders and bond holders. You can kind of show this graphically. Let's say there's you know, two cash flows of the firm. There's a good state and a bad state. So let's draw this. This is you know, bad state of the world. This is good. Okay, and these arrows here represent the total cash flows generated by the firm. And let's say of these cash flows, there's a certain amount that's going to debt, a certain amount of income that's going to the bond holders, to the debt holders. That's interest on the debt. That's a fixed amount, fixed interest rate, that the firm has to pay to the bond holders whether the times are good or bad. So that's a component that goes to the bond holders. That's fixed across it too. The remainder, goes to the stockholders. So in bad times, they just get a little bit. In good times, they get much more. So what do you see here? You know, kind of beta of the equity is going to be you know, kind of greater than the beta of the bond holders. The bond holders are getting the same payment regardless of the state of the economy. The residual income that goes to the stockholders, that's much more sensitive to the state of the economy. Another way to look at this, like the total cash flows of the firm, when they go from the bad state to the good state, maybe the cash flows are about 50% higher, judging how I drew these two arrows here. As you go from bad state of the world, to good state of the world. So cash flows maybe go up 50%. If you look up to the cash flows for just the equity holders, they probably go up, instead of a factor or 1.5, going up 50%, it looks like they go up a factor of 5. They increase dramatically so the cash flows to the stockholders, more sensitive to the state of the economy than the cash flows going to all the security holders. Or the cash flow is generated by the firm as a whole, so the discount rate tied to the discount rate for the equity, should be higher than a discount rate that represents a riskiness of the firm's cash flows as a whole. Okay, so when we're valuing firms, using a, you know, the discounted Free Cash Flow technique here, we're going to follow this you know, kind of playbook here. So, if you go back to textbook, you know, the value of the firm is a discounted stream of future cash flows, in Year 1, Year 2, cash flow in Year 3, in Year 37, in Year 48, in Year 85, you know, so on and so forth, appropriately discounted to get a value today. Okay? But that's a little bit you know, kind of too much to think about coming up with estimates for cash flow for each year forever. Okay, so when we do a firm valuation, we're going to break it into a couple parts. The -- okay, and we define here the left hand side's the value -- value of the firm. So good to start out here on solid ground. Then the parts that go into the valuation, the first part will be the present value of the total Free Cash Flows from Operations, through a forced forecast period end at Year T. So when we're doing this firm valuation where we're willing to forecast short term cash flows, maybe for the first five years or may up to the first ten years. So T being 5 or 10. The first part of the firm value are just these first 5 or 10 cash flows, that we forecast individually. The second part, is the present value of the firm at the end of Year T, at the end of Year 5 or the end of Year 10. So you could think of this, you know, present value of the terminal value is representing the discounted stream of all cash flows after Year T. Okay? So let's say our forecast period is five years. Out terminal point is at five years. So in this case, when we're doing our valuation exercise, it's going to be the sum of the two components. The first component here will be the discounted value of the first five cash flows. The second component will be the discounted terminal value or future value of the firm at the end of five years, discounted back to a value today where this value of the firm at the end of five years, will assume as a perpetuity, where we get our first cash flow in Year 6. Then you know, divided by R minus G. So you can think, "Well, what's the justification for stopping, doing cash flows, after five years or ten years, and then just going to this perpetuity formula?" Well one is, you know, maybe the firm is actually after a short five or ten year period, is in some long run equilibrium with like a constant growth rated cash flows. So using the perpetuity formula makes sense. Or, it could just simply represent, "Hey, we don't have enough confidence in our estimates, you know, going out 5 or 10 years, yet along going out 20, 30, 40 years. So this is really just kind of a practical convenience. At some point, let's just -- you know, make some assumptions about discount rate, growth rates, come up with this terminal value because it doesn't make sense to try and estimate specific individual cash flows beyond some short term horizon like five or ten years. Then finally, there's this third term to the value of the firm. This is a market value of non-operating assets. This is usually very small or you know, not even you know, kind of you know, a big part of the [inaudible] at all in terms of the ultimate valuation of the firm. The value of the firm is simply the discounted stream of cash flows generated from the assets. The value of the assets or the cash they yield. What if you have some assets that are non-operating assets that don't kind of yield any cash for the firm, but they do have some value, like you know, strange example. A caterpillar happens to have some real estate in Hollywood and it's not -- you know, making use of the real estate or running it out or anything. So it's not getting any income from that asset, but that asset certainly has value. If you have a weird example like that, that you know, value of the real estate in Hollywood, would go in this you know, non-operating asset category. But usually, this is you know, kind of not sizeable or not even you know, something that's considered when people are doing like the firm valuation exercises. So once we have this total value of the firm, it's the sum of the value of all the claims against the cash flow. So we've calculated this total value of the firm. Now we can think. The total value of the firm, the cash flow is generated by all the assets, that's the same as saying that the total value of the firm, it's the sum of the value that claims against those cash flows. You know, the value of the firm is the value of the debt, and the value of the equity. Okay? So for example, if you've calculated the value of firm by doing this discounted free cash flow technique, you know the amount of debt owed, then you can back out. "Oh, what's the value of the equity of the firm from the simple fact that hey, assets, equals debt plus equity." So if we calculate the cash flows generated from the assets of the firm, that gives us a market value of those assets. The value of the assets is just the value of the securities that have claims on those assets. Assets equals debt plus equity. Calculate the value of the firm. Subtract the value of the debt. That gives us the value of the equity. Okay? So, that might be something that we make use of when we do the, you know, kind of free cash flow technique, later on in this module to convert total firm value to equity value. For a lot of high tech companies, the amount of debt claims against the firm is very small, so the value of the cash flows generated from the firm as a whole is very close to the value of the firm's equities or the claim of the equity holders. Okay, if there's both common and preferred stock, you'd want to subtract out from the value of the firm, not only the value of the debt, but the value of the preferred stock claims, to get finally to the value of the common stock. Okay, so we talked kind of generally about discounted cash flows and in particular, the Free Cash Flow Method. Two components are going into the Free Cash Flow Valuation. Cash flows to investors, the free cash flows, and the discount rate, the Weight Average Cost of Capital. So now let's you know, kind of look at a couple videos that deal with each of these, starting with the discount rate or Weighted Average Cost of Capital. [ Silence ]
