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P.V. VISWANATH
FOR A FIRST COURSE IN VALUATION
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 Different kinds of Valuation Models
 Free cashflow depends on reinvestment strategies,
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which in turn affects Operating cashflows – hence
there is a joint computation problem
Starting from the Zen equation, how we do we get
the inputs?
How to look at historical performance to generate
inputs
Defining competitors
Different Issues with Liabilities and Asset Headings
Coming up with the Stock Price Forecast
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 DCF Models
 Enterprise DCF
 Discounted Economic Profit (EVA)
 Adjusted Present Value (APV)
 Free Cashflow to Equity
 Advantages of Enterprise DCF
 Relies solely on the flow of cash in and out of the company, rather than on
accounting-based earnings, which could be misleading
 Closely related to economic theory and competitive strategy
 Advantages of Discounted Economic Profit
 Highlights whether a company is earning its cost of capital in a given year
 Useful for crafting compensation strategies for firm executives
 APV methods work when capital structure is expected to change
 Free Cashflow to Equity
 Focuses on Value to Shareholders
 It doesn’t require the analyst to make assumptions regarding the value of debt.
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 Value company’s operations by discounting free cashflow from
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operations at the WACC.
Forecast free Cashflow for as long as it is reasonable to make
explicit forecasts. Past that period, assume that the growth rate will
be stable and compute a terminal value.
Value non-operating assets such as excess marketable securities,
nonconsolidated subsidiaries, and other equity investments.
Combining the value of operating and non-operating assets leads to
enterprise value.
Identify and value all non-equity financial claims against the
company’s assets. Non-equity financial claims include fixed- and
floating-rate debt, pension shortfalls, employee options and
preferred stock.
Subtract the value of non-equity financial claims from enterprise
value to determine the value of common stock.
Divide enterprise value by number of shares outstanding to
determine share price.
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 The value of operations is the discounted value of forecasted
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future free cashflow from operations.
As we have already seen, Free Cashflow from operations
equals the cashflow generated by the company’s operations
less reinvestment required to maintain the forecasted
cashflow.
Hence there are different possible firm values, with
reinvestment being in each case chosen to be consistent with
cashflow forecasts.
Free Cashflow is the cashflow available to all investors and is
independent of leverage.
This is discounted using the WACC, which is an average of the
returns required by the firm’s capital contributors.
We then choose the reinvestment strategy that maximizes
firm value.
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 In order to forecast future cashflows, we have to
understand the business well; in particular, we need
to know where and how value is being created.
 For this we need to look at key drivers of value –
ROIC, NOPLAT and g, as is evident from the Zen
value equation:
Valuet = NOPLATt+1(1-g/ROIC)/(WACC-g)
 The first step is to look at the past to see if and how
the company has created value, whether and how it
has grown and how it compares with competitors.
Excludes operating leases in Invested Capital
10/1/2008
5/1/2008
12/1/2007
7/1/2007
2/1/2007
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4/1/2006
11/1/2005
6/1/2005
1/1/2005
8/1/2004
3/1/2004
10/1/2003
5/1/2003
12/1/2002
7/1/2002
2/1/2002
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4/1/2001
11/1/2000
6/1/2000
1/1/2000
8/1/1999
3/1/1999
10/1/1998
5/1/1998
12/1/1997
7/1/1997
2/1/1997
9/1/1996
4/1/1996
11/1/1995
6/1/1995
1/1/1995
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ROIC
0.9
0.8
0.7
0.6
0.5
0.4
ROIC
0.3
0.2
0.1
0
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 We see that ROIC, which was as high as 80% in 1995 has
dropped to less than 10% in 2008!
 Since the cost of capital probably hasn’t fluctuated to this
extent and since inflation hasn’t changed so much over time,
there is probably only one conclusion:
 The level of competition has increased over time.
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(NetAdvantage) Industry publication Nation's Restaurant News reports
that for the 12 months ended September 2008, the number of restaurant
locations fell slightly, marking the first decline since 2000. However,
segments of the industry and types of operators fared quite differently.
Locations operated by independent operators declined 0.8%, while
chains grew 0.8% in total. About 11% of fine dining restaurants operated
by independents closed during the period. Among chains, family dining
operators with 50 to 99 locations shrank by 8.9%, while those with fewer
than 50 units were down 2.5%. Among all types of restaurants, only large
chains with more than 100 restaurants expanded.
1/1/1995
Operating Margin = Income from Operations/Revenue
10/1/2008
5/1/2008
12/1/2007
7/1/2007
2/1/2007
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4/1/2006
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6/1/2005
1/1/2005
8/1/2004
3/1/2004
10/1/2003
5/1/2003
12/1/2002
7/1/2002
2/1/2002
9/1/2001
4/1/2001
11/1/2000
6/1/2000
1/1/2000
8/1/1999
3/1/1999
10/1/1998
5/1/1998
12/1/1997
7/1/1997
2/1/1997
9/1/1996
4/1/1996
11/1/1995
6/1/1995
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Operating Margin
0.12
0.1
0.08
0.06
Operating Margin
0.04
0.02
0
Capital Efficiency = Revenues/Invested Capital
7/1/2008
1/1/2008
7/1/2007
1/1/2007
7/1/2006
1/1/2006
7/1/2005
1/1/2005
7/1/2004
1/1/2004
7/1/2003
1/1/2003
7/1/2002
1/1/2002
7/1/2001
1/1/2001
7/1/2000
1/1/2000
7/1/1999
1/1/1999
7/1/1998
1/1/1998
7/1/1997
1/1/1997
7/1/1996
1/1/1996
7/1/1995
1/1/1995
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Capital Efficiency
30
25
20
15
Capital Efficiency
10
5
0
11/1/2008
6/1/2008
1/1/2008
8/1/2007
3/1/2007
10/1/2006
5/1/2006
12/1/2005
7/1/2005
2/1/2005
9/1/2004
4/1/2004
11/1/2003
6/1/2003
1/1/2003
8/1/2002
3/1/2002
10/1/2001
5/1/2001
12/1/2000
7/1/2000
2/1/2000
9/1/1999
4/1/1999
11/1/1998
6/1/1998
1/1/1998
8/1/1997
3/1/1997
10/1/1996
5/1/1996
12/1/1995
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Revenue Growth
40.00%
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
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 Operating Margin hasn’t dropped as much over time
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as ROIC has.
What could be the reason?
Invested Capital must have grown in a way not
reflected in the expenses.
We see that Capital Efficiency has dropped over
time, and so has revenue growth.
All of this probably reflects the same or related
phenomena of increased capital needs coupled with
decreased market share in the entertainment dollar.
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 We now need to look at competitors before we can figure out
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how to forecast the relevant quantities for CAKE.
This is necessary because the prognosis for CAKE depends on
our analysis of the competitive situation.
To do this, we have to first figure out who are CAKE’s
competitors.
We have already discussed Dupont Analysis and seen that
Dupont Analysis gives us a good idea of the operating and
financial strategies of a firm.
Now a firm might compete with different sorts of firms in its
industry broadly defined, where each firm might use different
strategies. Still, the closest competitors are those who are using
similar strategies.
There are many companies that are identified as competitors to
CAKE in the sense of being in the same industry, viz.
restaurants. Mergent lists 18 such firms that are publicly traded.
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DineEquity Inc (DIN)
Landry's Restaurants, Inc. (LNY)
Ruby Tuesday, Inc. (RT)
Steak n Shake Co. (The) (SNS)
Bob Evans Farms, Inc. (BOBE)
Texas Roadhouse Inc (TXRH)
O'Charley's Inc. (CHUX)
Chipotle Mexican Grill Inc (CMG)
Darden Restaurants, Inc. (DRI)
Carrols Corp. (CRLL)
California Pizza Kitchen Inc (CPKI)
Cracker Barrel Old Country Store, Inc. (CBRL)
P.F. Chang's China Bistro, Inc. (PFCB)
Panera Bread Co. (PNRA)
Brinker International Inc. (EAT)
Buffalo Wild Wings Inc (BWLD)
Denny's Corp (DENN)
TravelCenters of America LLC (TA)
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Ticker
DIN
LNY
RT
SNS
CAKE
BOBE
TXRH
CHUX
CMG
DRI
CRLL
CPKI
CBRL
PFCB
PNRA
EAT
BWLD
DENN
TA
Total_Asset_Turnover EBITDA_Margin LTDebt_Equity
0.45
0.18
10.15
0.76
15.46
2.93
1.09
4.36
1.36
1.13
1.78
0.53
1.41
9.93
0.61
1.45
10.55
0.22
1.48
11.33
0.37
1.6
-5.57
0.74
1.72
13.51
0.01
1.75
12.61
1.2
1.79
9.4
35.76
1.85
7.78
0.42
1.85
8.68
8.4
1.86
9.92
0.61
1.86
13.68
1.88
6.29
1.52
1.92
14.15
?
2.05
11.28
7.09
0.06
0.26
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 If we sort the competitors according to each of the
three ratios and consider the firms that are closest to
the Cheesecake Factory (two firms with higher ratios
and two firms with lower ratios), we note the
following:
Total Asset
Turnover
RT
1.09
SNS
EBITDA
Margin
LT Debt/Equity
SNS
0.53
PFCB
0.61
CRLL
9.4
1.13
PFCB
9.92
CAKE
1.41
CAKE
9.93
CAKE
0.61
BOBE
1.45
BOBE
10.55
CHUX
0.74
TXRH
1.48
DENN
11.28
DRI
1.2
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 SNS (Steak n Shake) and BOBE (Bob Evans Farms) are represented on two of
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the three lists.
Of the three ratios, though, the first two represent strategic decisions that are
more related to the firms’ operations.
On that basis, it may make sense to add PFCB (PF Chang’s China Bistro) as
well since it has a EBITDA Margin close to CAKE’s.
SNS, while it has a total asset turnover ratio not too far from that of CAKE, has
an EBITDA Margin not at all close to that of CAKE.
What this points out is that we should get more information on what these
competitors do and in which sub-category of the industry they belong.
We note that firms such as DineEquity are in a completely different line of
business (moderately priced, family restaurants) or CBRL (specialty retail
outlets including restaurants) or CRLL (which has low-priced restaurants),
whereas firms such as CAKE, BOBE and SNS are all upscale restaurants that
are looking to provide a quality brand dining experience with a twist.
Although we could proceed further with this, let us pick SNS, BOBE, PFCB as
CAKE’s competitors.
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 To compute ROIC and FCF, we cannot use the
company’s financial statements directly because
these statements mix operating performance,
nonoperating performance and capital structure.
 Hence we need to reorganize the accountant’s
financial statements into new statements that
separate these three components.
 We will use the company’s financial statements to
compute ROIC and Invested Capital, which will
require computing Net Operating Assets and Net
Operating Liabilities.
 We start with operating working capital.
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 This is defined essentially as Current Assets less Current
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Liabilities
Includes all current assets necessary for the operation of
the business including working cash balances, trade
accounts receivable, inventory and prepaid expenses.
Excluded are excess cash and marketable securities (cash
greater than required for running the business)
Non-interest-bearing operating current liabilities include
liabilities related to the ongoing operations of a business.
Examples are liabilities related to suppliers (accounts
payable), employees (accrued salaries), customers
(deferred revenue) and the government (income taxes
payable).
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 R&D outlays is traditionally expensed. However, R&D is
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an asset in the sense that it generates future cashflows.
Hence, historical information on R&D outlays should be
used to capitalize and compute the R&D asset.
This will also have implications for NOPAT since not all
R&D outlays should be considered expenditures
chargeable to current income.
CAKE does not have any R&D so this is not as much of an
issue for this company.
We will now consider issues regarding firm operating
liabilities.
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 If a company runs a defined-benefit plan for its
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employees, it must fund the plan each year.
If it funds the plan faster than its pension expenses
dictate, it can recognize a portion of the excess assets on
the balance sheet.
However, this is properly considered a non-operating
asset and not part of invested capital.
However, this is part of what a stockholder owns and
must be computed separately.
On the other hand, if a plan is underfunded, it must
recognize a portion of this underfunding as a liability.
This is not an operating liability and must be reckoned
with separately.
Again, CAKE has no pension obligations.
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 The best way to take employee options into account
is to actually estimate their value and subtract from
the enterprise value.
 Alternatively, we can make assumptions regarding
the number of options that are likely to be exercised
and compute a sort of “present value” number of
those options.
 Adding this number to the number of shares
outstanding, we get the number of shares
outstanding on a diluted basis.
 This is then used to divide total stockholder wealth
and obtain estimated share price.
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 As mentioned before, Operating lease payments need
to be capitalized.
 Operating leases represent a set of obligations to
make payments in the future and must be included
in the firm’s liabilities.
 However, these payments also represent access to
future services and hence futures cashflows.
Therefore there is also a corresponding asset.
 Capitalization of operating leases will, thus, increase
Invested Capital.
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 This includes common stock, as well as additional
paid-in capital plus retained earnings.
 Accumulated other Comprehensive Income is also to
be included. This consists of currency adjustments
and aggregate unrealized gains and losses from
liquid assets whose value has changed but have not
been sold yet.
 Treasury stock should be deducted from total equity.
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 Deferred Taxes are noncash expenses that represent future
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costs.
For example, straight-line depreciation is used to determine
taxes reported in financial statements, while accelerated
depreciation can be used to compute actual taxes owed.
Hence the financial statements will show “taxes owed” or
deferred taxes. This will be offset in the future when more
depreciation will be recognized in the financial statements
and actual taxes paid will be greater than the taxes payable
according to reported income. Hence this “delay” in taxes is
temporary.
The best way to deal with this is to use actual taxes paid as
discussed below.
Deferred taxes could also derive from non-operating items
such as pensions. In such cases, they should be aggregated
with the corresponding non-operating item.
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 NOPLAT or Net Operating Profit Less Adjusted Taxes
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measures the dollar return on the firm’s operations.
This differs from Net Income in that NI is affected by the
firm’s financing, while NOPLAT is solely the result of the
firm’s operating side.
NOPLAT can then be evaluated relative to the Invested
Capital (IC) to see if the firm’s operations are profitable or
not, separate from its capital structure.
Furthermore, ROIC = NOPLAT/IC is more likely to be stable
and can be analyzed profitably.
FCF is NOPLAT adjusted for noncash operating expenses and
incremental investments in capital; as such, it can be lumpy
and vary widely from year to year. Consequently, it is not as
stable as NOPLAT and its year-to-year variations cannot be
treated as “deviations.”
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 We start out with Earnings before interest, taxes and
amortization of goodwill, which is essentially revenue less
operating expenses (e.g. COGS, selling costs, general and
administrative costs, depreciation).
 We exclude interest income, gains and losses from the firm’s
non-operating assets.
 Operating Leases are operating liabilities. Hence expenses
associated with these liabilities should be included, but not
other payments that are not operations related. Operating
lease payments included both financing payments and “rent”
for the leased asset. A firm’s financial statements include
both of these as expenses – obviously, the financing payments
have to be excluded from NOPLAT.
 R&D is an asset. R&D expenses that are attributable to the
current year should be included, but that part of R&D that is
actually an investment should be excluded.
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 Firms that are highly leveraged will pay lower taxes because of the tax
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deductibility of interest. In computing NOPLAT, this effect of debt on taxes
must be eliminated.
To compute operating taxes, we take reported taxes, subtract tax payments
on interest income and add back the tax shield on interest expense, as well
as on the operating lease interest expense.
The tax effects of each non-operating item can be computed by multiplying
each line item dollar amount by the company’s marginal tax rate (the
amount of tax saved if taxable income fell by a dollar).
This marginal tax rate is essentially the sum of the statutory tax rate on
federal and state income, and can be found in the firm’s 10-K statements.
The firm’s reported taxes can be different from the actual taxes paid because
firms are allowed to compute depreciation, provisions for liabilities etc.
differently for reporting and for tax computation purposes.
Hence we need to subtract from reported taxes, the change in deferred tax
liabilities to get the correct amount of cash taxes paid.
For NOPLAT computation, however, using the statutory tax rate should
resolve this issue as well.
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 Equals investment in PP&E less the book value of
any PP&E sold.
 Net Capex is estimated by taking the change in net
property, plant and equipment and adding in
depreciation; we can also use the number provided
in the Statement of Cash Flows.
 Capex should not be computed by taking the change
in gross PP&E because this quantity will drop when
companies retire assets (which has no cash
implications). Hence change in gross PP&E often
understates the actual amount of capital
expenditures.
-20,000,000
-40,000,000
-60,000,000
-80,000,000
-100,000,000
11/1/2008
6/1/2008
1/1/2008
8/1/2007
3/1/2007
10/1/2006
5/1/2006
12/1/2005
7/1/2005
2/1/2005
9/1/2004
4/1/2004
11/1/2003
6/1/2003
1/1/2003
8/1/2002
3/1/2002
10/1/2001
5/1/2001
12/1/2000
7/1/2000
2/1/2000
9/1/1999
4/1/1999
11/1/1998
6/1/1998
1/1/1998
8/1/1997
3/1/1997
10/1/1996
5/1/1996
12/1/1995
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FCF
60,000,000
40,000,000
20,000,000
0
FCF
11/1/2008
6/1/2008
1/1/2008
8/1/2007
3/1/2007
10/1/2006
5/1/2006
12/1/2005
7/1/2005
2/1/2005
9/1/2004
4/1/2004
11/1/2003
6/1/2003
1/1/2003
8/1/2002
3/1/2002
10/1/2001
5/1/2001
12/1/2000
7/1/2000
2/1/2000
9/1/1999
4/1/1999
11/1/1998
6/1/1998
1/1/1998
8/1/1997
3/1/1997
10/1/1996
5/1/1996
12/1/1995
31
Net Capex
160,000,000
140,000,000
120,000,000
100,000,000
80,000,000
60,000,000
Net Capex
40,000,000
20,000,000
0
11/1/2008
6/1/2008
1/1/2008
8/1/2007
3/1/2007
10/1/2006
5/1/2006
12/1/2005
7/1/2005
2/1/2005
9/1/2004
4/1/2004
11/1/2003
6/1/2003
1/1/2003
8/1/2002
3/1/2002
10/1/2001
5/1/2001
12/1/2000
7/1/2000
2/1/2000
9/1/1999
4/1/1999
11/1/1998
6/1/1998
1/1/1998
8/1/1997
3/1/1997
10/1/1996
5/1/1996
12/1/1995
32
Net Capex/Sales
0.14
0.12
0.1
0.08
0.06
Net Capex/Sales
0.04
0.02
0
-0.05
12/1/2008
8/1/2008
4/1/2008
12/1/2007
8/1/2007
4/1/2007
12/1/2006
8/1/2006
4/1/2006
12/1/2005
8/1/2005
4/1/2005
12/1/2004
8/1/2004
4/1/2004
12/1/2003
8/1/2003
4/1/2003
12/1/2002
8/1/2002
4/1/2002
12/1/2001
8/1/2001
4/1/2001
12/1/2000
8/1/2000
4/1/2000
12/1/1999
8/1/1999
4/1/1999
12/1/1998
8/1/1998
4/1/1998
12/1/1997
8/1/1997
4/1/1997
12/1/1996
8/1/1996
4/1/1996
12/1/1995
33
Working Capital/Revenues
0.3
0.25
0.2
0.15
0.1
0.05
0
1/1/1995
5/1/1995
9/1/1995
1/1/1996
5/1/1996
9/1/1996
1/1/1997
5/1/1997
9/1/1997
1/1/1998
5/1/1998
9/1/1998
1/1/1999
5/1/1999
9/1/1999
1/1/2000
5/1/2000
9/1/2000
1/1/2001
5/1/2001
9/1/2001
1/1/2002
5/1/2002
9/1/2002
1/1/2003
5/1/2003
9/1/2003
1/1/2004
5/1/2004
9/1/2004
1/1/2005
5/1/2005
9/1/2005
1/1/2006
5/1/2006
9/1/2006
1/1/2007
5/1/2007
9/1/2007
1/1/2008
5/1/2008
9/1/2008
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Other Operating Liabilities/Revenues
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
1/1/1995
5/1/1995
9/1/1995
1/1/1996
5/1/1996
9/1/1996
1/1/1997
5/1/1997
9/1/1997
1/1/1998
5/1/1998
9/1/1998
1/1/1999
5/1/1999
9/1/1999
1/1/2000
5/1/2000
9/1/2000
1/1/2001
5/1/2001
9/1/2001
1/1/2002
5/1/2002
9/1/2002
1/1/2003
5/1/2003
9/1/2003
1/1/2004
5/1/2004
9/1/2004
1/1/2005
5/1/2005
9/1/2005
1/1/2006
5/1/2006
9/1/2006
1/1/2007
5/1/2007
9/1/2007
1/1/2008
5/1/2008
9/1/2008
35
Other Assets/Revenues
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
36
 Valuet = NOPLATt+1(1-g/ROIC)/(WACC-g)
 Forecast long-term ROIC, growth rate and WACC.
 Forecast FCF components period-by-period for the
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forecastable future (5 years?)
Compute NOPLAT for the five years.
Compute IC for the five years.
Use growth rate estimate to get NOPLAT for the sixth
year and derive terminal value.
Get present value of firm.
Deduct value of debt and other liabilities to get equity
value.
Divide by number of shares outstanding to get stock
price.

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