Nov 26, 2014 The Art of Valuation Jujitsu : Part 5
As we saw in Part 4, there are four inputs to an absolute value model: cash flow from existing assets, the expected growth in those assets over the explicit forecast period, the terminal value at the end of the forecast period, and the cost of financing the assets.
When forecasting future cash flows, there are a few key drivers that must be scrutinized. These include revenue growth, which is typically estimated by taking the total market for a product or service and the company’s expected share of that market over the forecast period. You must also consider how the operating margin (OM) is going to trend over time. To do so, look at the margins for the industry. Profit margins tend to converge to the industry average over time. Revenue is then multiplied by the operating margin to arrive at earnings before interest and taxes (EBIT).
Provided below is a free cash flow forecast that I compiled in September 2013. As you can see, it includes all the components we discussed in Part 4. In this case, the explicit forecast period is 20132019 with FCF growing from $5,090 to $7,825 million. The terminal value of $83,409 million was calculated using my 2019 FCF estimate of $7,825 million, expected terminal growth in FCF of 0.5%, and cost of capital of 8.8%.

2013E 
2014E 
2015E 
2016E 
2017E 
2018E 
2019E 
EBIT 
6,392 
7,415 
7,940 
8,397 
8,957 
9,034 
9,534 
Minus: taxes 
(1,471) 
(1,581) 
(1,633) 
(1,727) 
(1,842) 
(1,858) 
(1,961) 
Plus: depreciation & amortization 
402 
408 
411 
409 
405 
401 
405 
Minus: change in working capital 
93 
53 
21 
(9) 
(18) 
(20) 
20 
Minus: deferred taxes 
(150) 
(150) 
(150) 
(150) 
(100) 
(50) 
0 
Minus: capital expenditures 
(175) 
(194) 
(206) 
(207) 
(174) 
(172) 
(174) 
Unlevered free cash flow 
5,090 
5,951 
6,383 
6,713 
7,228 
7,334 
7,825 
Free cash flow growth 
1.9% 
16.9% 
7.3% 
5.2% 
7.7% 
1.5% 
6.7% 








Discount period months 
(8) 
4 
16 
28 
40 
52 
64 
Discount period years 
(0.7) 
0.3 
1.3 
2.3 
3.3 
4.3 
5.3 
Discount factor 
1.060 
0.974 
0.895 
0.822 
0.756 
0.694 
0.638 
Present value of annual cash flows 
5,396 
5,796 
5,712 
5,520 
5,461 
5,092 
4,991 








Terminal value 






83,409 
Next, the FCF estimates over the explicit forecast period (201319) and the terminal value were discounted back to the present at the company’s cost of capital of 8.8% (assumed). The sum of the present value of future cash flows was $91,173 million. We refer to this as the enterprise value. Since we are trying to estimate the equity value (not the enterprise value of the firm), we need to deduct net debt from enterprise value. In this case, ESRX had net debt of $13,925 million. Netting the two figures, the estimated equity value per share was $94.65. When compared to the current price of $62, my intrinsic value estimate implied 52% upside.
Valuation 

Present value of cash flows 
37,969 
Present value of terminal value 
53,204 
Enterprise value 
91,173 
Minus: net debt 
(13,925) 
Equity value 
77,248 
Equity value per diluted share 
$94.65 
Current share price 
62.05 
Upside/(downside) potential 
+52.5% 


Valuation assumptions 

Residual growth rate 
0.5% 
Shares – diluted 
816 
Tax rate 
20.6% 


WACC calculation 

Cost of equity (CAPM) 
10.8% 
Beta 
1.09 
Equity risk premium 
8.0% 
Risk free rate 
2.8% 
Cost of debt 
2.4% 
Taxadjusted cost of debt 
1.9% 
% equity 
77.9% 
% debt 
22.1% 
WACC 
8.8% 


Returns 

ROIC 
13.2% 
IRR 
18.9% 
The valuation model will include your assumptions, which I have recapped above. Two key assumptions are the company’s cost of capital and the terminal growth rate. The cost of capital in a free cash flow to the firm model is the company’s weighted average cost of capital or WACC. It is calculated as the weighted average of debt and equity capital used to finance the company’s assets. The cost of capital will change over time with changes in interest rates, tax rates, and the volatility of the company’s stock. In this case, the cost of capital was ~9%.
The terminal growth rate used in a DCF analysis typically ranges from 2% to +5%. In this case, I have assumed that free cash flow will decline by 0.5% annually beginning in 2020. The terminal growth rate conservatively assumes that sales growth continues to be pressured and that the company’s opportunities for margin improvement dry up post 2019.
When considering the terminal growth rate for a company, I find it instructive to ask: What does the current stock price imply about the company’s future growth rate? To answer that question, we use the cash flows we estimated above, along with the current stock price, to back into the implied terminal growth rate. In this case, the current price was implying a terminal growth rate of 7%! This seemed too draconian for a company that is expected to grow at a midpoint of +15% for the foreseeable future based on management’s estimates.
Reverse DCF 

Present value of cash flows 
37,969 
Present value of terminal value 
29,315 
Implied terminal growth rate 
7.0% 
Enterprise value 
67,284 
Minus: net debt 
(13,925) 
Equity value 
53,359 
Equity value per diluted share 
65 
Current share price 
62 
Like the analysis above, the implied growth rate suggested the company was undervalued and provided me with confidence to purchase the stock.
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