Hlavní práce72019_lehd01.pdf, 1.2 MB Stáhnout

(1)

University of Economics, Prague

Master’s Thesis

2021 Dominik Lehocký

(2)

University of Economics, Prague Faculty of Business Administration

Master’s Field: International Management

Diploma Thesis Title:

Valuation of Farfetch Ltd

Author: Dominik Lehocký

Supervisor: Ing. Jaroslav Schönfeld, Ph.D.

(3)

D e c l a r a t i o n o f A u t h e n t i c i t y

I hereby declare that the Master’s Thesis presented herein is my own work, or fully and specifically acknowledged wherever adapted from other sources. This

work has not been published or submitted elsewhere fir the requirement of a degree program.

Prague, May 12, 2021 Dominik Lehocký

(4)

Title of the Master’s Thesis:

Valuation of Farfetch Ltd

Abstract:

This thesis aims to provide a valuation of Farfetch Ltd in order to validate the massive stock price increase followed by the news on its partnership with Alibaba and Richemont group.

Strategic analysis of the company and its environment preceding the valuation has hinted at the company’s favorable position in markets outside of China, where the position looks promising as well; however, it is unlikely the company will ever dominate the Chinese market in a way it has dominated the rest of the world. Following the analysis, key value drivers were estimated, and a valuation using the FCFF DCF model and EV/Revenue ratio followed.

The valuation results suggest that the closing price of USD 62.82 per share on December 31, 2020, was highly inflated relative to the estimates of USD 32.21 and USD 35.04 obtained using the DCF model and EV/Revenue model with multiple regression.

Key Words:

Farfetch, Valuation, Growth firms, DCF, EV/Revenue

(5)

Introduction

In August 2019, Farfetch announced its acquisition of New Guards Group, a group specializing in the development and production of luxury streetwear brands. Although the brands in its portfolio had been enjoying a very favorable position in the luxury fashion market, the acquisition was viewed rather negatively by many investors, and Farfetch’s stock tumbled to its all-time low following the news.

In November 2020, after a period of a meager COVID-19 induced rebound of the stock price, the company had announced its partnership with Alibaba and Richemont Group. The news about this partnership was followed by a massive upswing in Farfetch’s stock price, reaching the USD 70 mark at its peak. Although the news was undoubtedly a good sign of Farfetch’s future performance potential, the validity of this upswing should be questioned, as the stock price gained over 940% in the span of less than a year.

As an avid follower of the luxury fashion industry, the author has decided to validate the closing price of Farfetch’s stock on December 31, 2020, of USD 62.82 per share using the knowledge obtained during his studies, particularly in the fields of corporate finance and strategy.

In recent years, Farfetch has been at the forefront of the headlines in the luxury fashion space, as the company is perceived as the largest innovator in the market, a view underlined by its aggressive acquisition strategy and bold partnerships. Additionally, the company is still relatively young and unprofitable, making it a challenging company for valuation which further cements it as an attractive pick for the author.

To re-iterate, the goal of this master thesis is to analyze and value Farfetch Ltd as of December 31, 2020, in order to validate the expectations projected in the stock price gain seen in late 2020.

This thesis is structured into two major parts – the Theoretical Part and the Practical Part.

The Theoretical Part serves as the revision of the fundamental principles underlying valuation, and their subsequent extension in the context of multi-business multi-national corporations, as well as growth companies, as companies with these characteristics pose specific challenges when being valued.

The Practical Part contains a thorough strategic analysis, in which we first analyze the trends shaping the luxury fashion industry, then analyze the history and development of Farfetch, its product portfolio, and geographic footprint, and lastly, we conduct a similar analysis of its major rivals. Once we have a firm understanding of the company and its environment, we will estimate the key value drivers necessary for valuation and subsequently value the company using the DCF model and relative valuation. Once we estimate Farfetch’s value, a discussion will follow on the findings presented in this thesis to validate the stock price development of the company.

(9)

Theoretical Part

1 Introduction to Valuation

The following section will introduce the concept of value in corporate finance and then link it to the value of a company itself. Later we will describe commonly used valuation techniques in more detail, allowing us to understand their advantages and disadvantages when valuing companies.

1.1 Value and Commonly Used Methods in Valuation

1.1.1 Value creation in the context of corporate finance

Every business exists in an environment where countless many stakeholders are affected by its conduct and operations. However, in corporate finance, a corporation has only one purpose: to maximize shareholder value (Brealey, Myers, & Allen, 2014). The champion of this doctrine, Milton Friedman, has famously proclaimed in his essay that the only social responsibility of a corporation is to increase its profits (Friedman, 1970). In recent years, this notion has caused a lot of lively debate and controversy, prompting the creation of concepts such as Creating Shared Value (CSV) proposed by Porter & Kramer (2011), where the focus of corporations is not only to maximize shareholder value but also to create value for other stakeholders and communities affected by corporations’ conduct – an approach which they describe as the way to reinvent capitalism.

As Koller, Goedhart, & Wessels (2015) point out, many recent financial crises have resulted in a public outcry against the ubiquitous notion of shareholder value maximization and its impact on the wider society in an ever-more global world. They argue that the issue is not the notion of maximizing shareholder value itself but the pervasive short-term thinking that has proliferated the way companies have been managed in the past decades. In their book, they argue that in many cases, the maximization of shareholder value indeed requires satisfying the needs of other stakeholders along with adopting other long-term shareholder value maximization practices. The authors even mention results of a study that shows that in many cases undertaking corporate social responsibility (CSR) activities has a positive impact on the overall shareholder value, and they encourage managers to seek such opportunities. Investments in CSR activities that create positive externalities clearly come at a price that lowers profits, just as managing externalities that affect stakeholders other than shareholders negatively. These trade-offs, however, are necessary to be made to maximize long-term shareholder value (Koller, Goedhart, & Wessels, 2015) e.

No matter which side of the debate we decide to root for, a compelling case can be made that in either case, maximizing shareholder value is a clearly stated goal that, when executed properly, can benefit and create value for other stakeholders as well. At this point, a definition of what we understand by maximizing shareholder value seems appropriate. In essence,

(10)

companies that grow and earn a return on capital greater than their cost of capital create (Koller, Goedhart, & Wessels, 2015). Thus, by undertaking activities with the most value created, a corporation is thought to maximize shareholder value. In straightforward terms, in corporate finance, we look for the projects that offer the highest value creation potential, we consider how we can finance these projects, and then subsequently form dividend policies that distribute the value to shareholders (Damodaran, 2012). Then, the value of a company is the direct result of these decisions (Damodaran, 2012).

1.1.2 Deriving the value of a company

As previously stated, for a company to have value, it needs to create excess returns and deliver growth. For corporations to operate and create this value, they all need a variety of different assets (Brealey, Myers, & Allen, 2014). Every asset has its value, but despite our best ability, it is very improbable that we will ever learn what that true value of an asset is; however, we always can, and often should, try and estimate it (Damodaran, 2009).

Practitioners have developed several models that can be used to try and estimate the value of these assets, and subsequently the value of whole companies. These models can be relatively conveniently categorized into three distinct groups based on similarities among them to compare them, and ultimately decide which should be used in the context of a valued company (Damodaran, 2012). According to Damodaran (2012), the following three groups of models can be identified:

1. Discounted cash flow valuation 2. Relative valuation

3. Contingent claim valuation

Before we proceed with a more detailed description of the groups of methods mentioned above, there are a few considerations that need to be brought up. The growth criterion for value creation implies we are not only looking at the value created by a firm in the current period, but we also need to consider the returns generated in future periods as well. To deliver growth, companies must reinvest a portion of the returns they generate (Damodaran, 2012). That is why when valuing companies, we must not only consider the investments made (the assets in place), but we must consider the value of future investments (the growth assets) as well, resulting in a lot of uncertainty (Damodaran, 2009). Ultimately, the second criterion of value creation, the excess returns, or the returns exceeding the cost of capital, also requires us to understand and factor in a company’s financing mix and its cost of capital required to fund the investments being made (Damodaran, 2009).

(11)

1.2 Discounted Cash Flow Valuation

1.2.1 Fundamental principles of discounted cash flow valuation

According to Damodaran (2012), the discounted cash flow valuation attempts to estimate the value of a company, or in fact any asset, as the present value of all its expected future cash- flows. The discount rate used to obtain the present value of an asset should reflect the riskiness of the discounted cash flows (Damodaran, 2009). In Figure 1 we can find the mathematical notation of this definition.

Figure 1: Mathematical notation of DCF valuation 𝑉𝑎𝑙𝑢𝑒 = ∑ 𝐸(𝐶𝐹_𝑡)

(1 + 𝑟)^𝑡

𝑡=𝑛

𝑡=1

𝑛 = 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑎𝑛 𝑎𝑠𝑠𝑒𝑡

𝐶𝐹_𝑡= 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡

𝑟 = 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 𝑟𝑒𝑓𝑙𝑒𝑐𝑡𝑖𝑛𝑔 𝑟𝑖𝑠𝑘𝑖𝑛𝑒𝑠𝑠 Source: Damodaran (2009)

Theoretically speaking, when valuing a company, we also need to consider the possibility that it will generate cash flow for eternity (Damodaran, 2009). This phenomenon is called the going- concern principle, where we assume the company valued will continue its operations and will not become distressed (Frykman & Tolleryd, 2010). Since estimating cash flows forever is clearly impossible, DCF models that assume going concern generally estimate cash flows until a finite period. Then we estimate the terminal value that effectively estimates the value of all remaining cash flows past that period (Damodaran, 2009).

There are numerous approaches for terminal value estimation. However, according to Damodaran (2009), the one most harmonious with the principles of intrinsic valuation under the going concern assumption is to assume that cash flows beyond the finite period until which we project cash flows will continue to grow at a constant rate forever. In Figure 2 we can find the mathematical notation for this relationship.

Figure 2: Mathematical notation of DCF valuation with the terminal value component 𝑉𝑎𝑙𝑢𝑒 = ∑ 𝐸(𝐶𝐹_𝑡)

(1 + 𝑟)^𝑡

𝑡=𝑁

𝑡=1

+ 𝐸(𝐶𝐹_𝑁+1) (𝑟 − 𝑔_𝑛)(1 + 𝑟)^𝑁

𝑁 = 𝑙𝑎𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑓𝑜𝑟 𝑤ℎ𝑖𝑐ℎ 𝑤𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝐶𝐹_𝑡 = 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡

𝑟 = 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 𝑟𝑒𝑓𝑙𝑒𝑐𝑡𝑖𝑛𝑔 𝑟𝑖𝑠𝑘𝑖𝑛𝑒𝑠𝑠 𝑔_𝑛 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑛

Source: Damodaran (2009)

(12)

When we examine Figure 2, we can see the inputs required for the DCF model are cash flows generated by a company, growth rates, discount rates, and ultimately knowing when a firm achieves stable growth (Damodaran, 2009). We will discuss how to estimate these later in the following sections of this chapter.

According to Damodaran (2012), there are countless many different DCF models in existence.

He claims, however, that all these DCF models can only be differentiated across three distinct dimensions (Damodaran, 2012):

1. Equity valuation versus firm valuation

2. Cost of capital valuation versus adjusted present value (APV) approaches 3. Total cash flow versus excess cash flow valuation

Equity valuation versus firm valuation

When valuing companies, we can decide between two paths we can take – we can value the equity stake only, or we can value the entire firm, which, on top of equity, includes other claim holders in the firm, such as bondholders or preferred stockholders (Damodaran, 2012). In both cases, we discount expected cash flows; however, the cash flows we estimate and the discount rates we use are different (Damodaran, 2012).

To obtain the value of equity, we need to discount expected cash flows to equity, which, simply put, are all residual cash flows available after all expenses, reinvestment needs, tax obligations, and interest and principal payments are met (Damodaran, 2012). In other words, we need to calculate the free cash flow to equity (FCFE), which is the theoretical maximum of potential dividend payments available to the equity holders in a firm (Damodaran, 2009). The formula to obtain this value can be found in Figure 3.

Figure 3: Free cash flow to equity formula

𝐹𝐶𝐹𝐸 = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑛𝑒𝑒𝑑𝑠 − 𝐷𝑒𝑏𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠

𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑛𝑒𝑒𝑑𝑠 = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝛥𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 − 𝑁𝑒𝑤 𝑑𝑒𝑏𝑡 𝑖𝑠𝑠𝑢𝑒𝑑

Once we obtain free cash flows to equity, we discount them at the cost of equity, which is essentially the rate of return required by equity investors in the firm (Damodaran, 2012). To obtain the value of equity, we need to use the formula found in Figure 4.

(13)

Figure 4: Value of equity formula

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = ∑𝐸(𝐹𝐶𝐹𝐸_𝑡) (1 + 𝑘_𝑒)^𝑡

𝑡=𝑛

𝑡=1

𝐹𝐶𝐹𝐸_𝑡 = 𝑓𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡 𝑘_𝑒 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

If we decide to take the other approach, and we try and estimate the value of the firm, we need to discount cash flows to the firm, which in this case are all the residual cash flows available after all operating expenses, reinvestment needs, and taxes are met, but before any payments to either debt or equity holders (Damodaran, 2012). A corollary to the FCFE described in the previous section is the free cash flow to the firm (FCFF), which in essence represents the bulk of all cash distributions made by a firm to investors – dividends, stock buybacks, interest payments, and debt repayments all need to be made of these cash flows (Damodaran, 2009).

The formula to obtain this value can be found in Figure 5.

Figure 5: Free cash flow to firm formula

𝐹𝐶𝐹𝐹 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝐿𝑒𝑠𝑠 𝑇𝑎𝑥𝑒𝑠 − 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑁𝑒𝑒𝑑𝑠

𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑁𝑒𝑒𝑑𝑠 = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝛥𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 Source: Damodaran (2009)

Once we obtain the free cash flows to the firm, we discount them at the weighted average cost of capital (WACC), which can be understood as the cost of the different financing components weighted by their market value proportions (Damodaran, 2012). To obtain the value of the firm, we need to use the formula found in Figure 6.

Figure 6: Value of firm formula

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 = ∑ 𝐸(𝐹𝐶𝐹𝐹_𝑡) (1 + 𝑊𝐴𝐶𝐶)^𝑡

𝑡=𝑛

𝑡=1

𝐹𝐶𝐹𝐹_𝑡 = 𝑓𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝑓𝑖𝑟𝑚 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡 𝑊𝐴𝐶𝐶 = 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 Source: Damodaran (2009)

Despite using different cash flows and discount rates, both approaches will yield identical estimates of value if the assumptions made are consistent (Damodaran, 2012). Deciding which approach to use depends on a company being valued. Some of the decision criteria relevant to this thesis will be discussed in a later chapter of this thesis.

(14)

Cost of capital valuation versus adjusted present value (APV) approaches

A firm has two options for financing its operations – equity or debt (Damodaran, 2012). When companies decide on debt financing, it can have several effects on their value, most notably the tax-deductibility of interest payments resulting in a tax subsidy benefit to them, but on the other hand, debt tends to increase the likelihood that they will default on their obligations and will be forced into bankruptcy (Damodaran, 2012). In conclusion, the net effect of debt financing can go in any direction. In the cost of capital approach, the effects of debt are reflected in the discount rate we use (Damodaran, 2012). To avoid double-counting of the tax benefit, the cash flows discounted are pre-debt cash flows (Damodaran, 2012). To arrive at this discount rate, we need to calculate the weighted cost of capital (WACC). The formula for WACC can be found in Figure 7.

Figure 7: WACC formula

𝑊𝐴𝐶𝐶 = 𝑘_𝑒 𝐸

𝐸 + 𝐷+ (1 − 𝑇_𝑐)𝑘_𝑑 𝐷 𝐸 + 𝐷 𝑘_𝑒 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

𝑘_𝑑 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑝𝑟𝑖𝑜𝑟 𝑡𝑜 𝑡𝑎𝑥𝑒𝑠 𝑇_𝑐 = 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 𝐸 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝐷 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 Source: (Brealey, Myers, & Allen, 2014), adjusted by author

In adjusted present value models (APV), we isolate the debt financing effects on value from the value of a company's assets (Damodaran, 2012). In simple terms, we first establish the base- case, all equity financed value of a firm, and we discount it at the cost of equity (Brealey, Myers,

& Allen, 2014). Then we define and calculate the present value of each side effect of debt financing and add it to the base-case value of the firm (Brealey, Myers, & Allen, 2014).

Examples of side effects include any tax benefits, positive, or costs associated with potential bankruptcy, negative (Damodaran, 2012). However, it must be said that the fundamental flaw of the APV method lies in the difficulties in estimating the costs associated with potential bankruptcy (Damodaran, 2009). The mathematical notation of this approach can be found in Figure 8.

Figure 8: Mathematical notation of the adjusted present value approach

𝐴𝑃𝑉 = 𝑁𝑃𝑉 𝑏𝑎𝑠𝑒-𝑐𝑎𝑠𝑒 + ∑ 𝑃𝑉𝑠 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑠𝑖𝑑𝑒 𝑒𝑓𝑓𝑒𝑐𝑡𝑠

Source: (Brealey, Myers, & Allen, 2014)

Although the cost of capital and adjusted present value approaches take two different routes when assessing the value added or destroyed by debt, just as in the case of value to equity versus value to the firm case, as long as our assumptions about future cash flows and risk are consistent, they will ultimately provide the same estimate of value (Damodaran, 2012).

(15)

Total cash flow versus excess cash flow valuation

Up until now, we have always looked at the value of a company as the sum of the present value of all its future cash flows. This approach is called the total cash flow approach (Damodaran, 2012). The other alternative, called the excess return approach, is only considering the cash flows created in excess of the required return (Damodaran, 2012). To illustrate the difference, Damodaran (2012) suggests a simple example, in which we consider an asset in which we invested $100 million, and we expect it to generate $12 million in perpetuity. He then proposes to set the appropriate cost of capital at 10%. In Figure 9, we can find the proposed numbers plugged into the formula for perpetuity.

Figure 9: Example calculation using the perpetuity formula 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 = $12 𝑚𝑖𝑙.

10% = $120 𝑚𝑖𝑙.

Source: (Damodaran, 2012)

After calculating the value of the perpetuity, we arrive at the value of the asset of $120 million.

This calculation is consistent with the total cash flow approach. With an excess cash flow approach, we first need to calculate the excess return made on this asset. The appropriate calculation can be found in Figure 10.

Figure 10: Example excess return calculation

𝐸𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝐶𝐹 𝑒𝑎𝑟𝑛𝑒𝑑 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 × 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛 𝑎𝑠𝑠𝑒𝑡 𝐸𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 = $12 𝑚𝑖𝑙. −10% × $100 𝑚𝑖𝑙. = $2 𝑚𝑖𝑙.

To arrive at the final value of the asset, we then need to finish the calculation by calculating the present value of excess returns earned and add it to the book value of the asset we invested in (Damodaran, 2012). In Figure 11, we can see the asset value calculation for our example.

Figure 11: Example calculation using the excess return approach

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 = 𝑃𝑉 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 + 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 =$2 𝑚𝑖𝑙.

10% + $100 𝑚𝑖𝑙. = $120 𝑚𝑖𝑙.

Just as in the previous two dimensions as well as in the example we solved here, if we are consistent with our assumptions, the two approaches will yield the same value (Damodaran, 2012). According to Damodaran (2009), excess return models have their roots in capital budgeting, where it is necessary to consider the net present value of any investment to assess whether it adds or destroys value. In fact, he argues, if we make the assumption that the book value of assets in place is a good measure of capital invested in assets today, we can infer from

(16)

this approach that companies that trade at market values higher than their book values earn positive excess cash flows, whereas the companies that trade under their book value are more likely to earn negative excess cash flows (Damodaran, 2009).

1.2.2 Inputs required for DCF valuation

Earlier in this work, we introduced the DCF valuation formula with the terminal value component in Figure 2. In essence, four major parameters need to be estimated to successfully value a company using the DCF model presented in Figure 2. The parameters mentioned were:

1. Cash flows generated by a company 2. Growth rates

3. Discount rates

4. Achieving stable growth

1.2.3 Estimating cash flows generated by a company

When estimating cash flows generated by a company, it often makes sense to start analyzing its earnings (Damodaran, 2012). After all, as already stated in the previous sections, free cash flows to equity are based on the net income, whereas free cash flows to the firm are based on after- tax operating earnings.

Ideally, a company's financial statements should provide us with all the necessary data;

however, considering the way traditional financial statements are structured, it is hard to obtain reliable information directly from them without properly adjusting them first (Koller, Goedhart,

& Wessels, 2015). That is why first we will need to discuss the items that are often misclassified. Later, we will focus more deeply on how to turn accounting earnings into actual cash flows of a company. To do so, we need to consider the effects of taxation, and satisfying reinvestment needs to sustain growth (Damodaran, 2012).

Commonly misclassified financial statements items

This first stage of statements adjustment is described by Damodaran (2012) as the stage of understanding of how much cash flow is generated by the existing assets and investments.

Where applicable, it is advised to reclassify certain items to reflect their impact on a business better.

According to Damodaran (2012), the most commonly misclassified items are capital expenses treated as operating expenses such as R&D. In many cases, it could be argued that marketing expenses or sales expenses could also be capitalized. The supporting argument for this claim is that there are companies where the lifetime value of a customer is expected to be spread out over a longer period, whereas the acquisition costs of onboarding new customers in the early stages are high. Before doing this, however, we need to carefully consider if the argument of the expense delivering benefits over multiple periods is substantial (Damodaran, 2012).

Another category of expenses that is often misclassified are financing expenses (Damodaran,

(17)

companies do not need to record assets and liabilities tied to a leasing agreement in their balance sheet. As such, their asset intensity appears lower, which can distort their recorded performance reflected in inflated results when benchmarking with other companies or when calculating returns (Koller, Goedhart, & Wessels, 2015).

Effects of taxation

When dealing with taxation, there are three areas in which we need to pay extra attention (Damodaran, 2012):

1. Effective versus marginal tax rate 2. Firms with large losses carried forward 3. Capitalization of expenses

To arrive at the operating income after tax, we need to multiply the earnings before interest and taxes by an estimated tax rate (Damodaran, 2012). To do so, we can use the effective tax rate calculated as the taxes due divided by the taxable income as reported in the financial statement, or we can use the marginal tax rate, which is the tax rate the firm faces on its income dollar (Damodaran, 2012). These tax rates are often different for several reasons. According to Damodaran (2012) , the major reasons include the usage of different reporting standards for tax and reporting purposes, usage of tax credits by firms, deferring tax payments, and income generation for foreign domiciles with lower tax rates. When deciding which tax rate we should use, Damodaran (2012) advises preferring the marginal tax rate, especially if the same tax rate needs to be applied to earnings in each period, as none of the reasons for discrepancies in the section above can be sustained forever.

When valuing companies with large net operating losses carried from previous periods, or firms that are still recording operating losses, we need to acknowledge the potential for tax savings in the first few years when they become profitable (Damodaran, 2012). The first way we could do this is to set the tax rate equal to zero in the first few years when the losses carried over offset income, and then when the net operating losses decrease, the tax rates need to be increased toward the marginal tax rate (Damodaran, 2012). When calculating the after-tax cost of debt (see Figure 6), we need to keep in mind the zero-tax rate and its subsequent change in later years as well (Damodaran, 2012). Alternatively, we can ignore the tax savings, value the firm, and then add the expected tax savings from the net operating loss (Damodaran, 2012).

When adjusting certain operational expenses in the first phase, such as R&D, we often need to consider the tax implications (Damodaran, 2012). R&D expenses, unlike capital expenses, are fully tax-deductible, whereas, in the case of capital expenses, firms are only allowed to deduct the deprecation on them (Damodaran, 2012). Keeping this in mind is especially important if companies decide to capitalize their operating expenses for reporting purposes but expense them for tax purposes (Damodaran, 2012).

(18)

Effects of reinvestment

In this section, we will need to return to Figure 3 and Figure 5. In these figures, we introduced the term for reinvestment needs, which, in essence, is composed of the net capital expenditures (CAPEX) and the change in working capital.

To obtain the net capital expenditures, we need to take the amount invested in long-term assets in the last period and subtract the value of depreciation, as it is a non-cash expense, and therefore needs to be added back to the appropriate earnings term used for either FCFE or FCFF calculation (Damodaran, 2009). When forecasting capital expenditures, we need to be cautious about companies that make large irregular investments that take longer to depreciate, then we need to look out for the different accounting definitions and capitalization of operating expenses, and lastly, we need to be careful about the fact acquisitions are not classified as capital expenditures by accountants, which for firms that grow primarily through acquisitions will result in an understatement of capital expenditures (Damodaran, 2012).

Conversely, to arrive at the net working capital, we need to look at the short-term assets a firm purchased in the observed period. Net working capital is essentially the difference between short-term assets, such as inventories, raw materials, or accounts receivable, and short-term liabilities, such as accounts payable or deferred taxes (Brealey, Myers, & Allen, 2014). The inclusion of cash depends on the way it is being used. In companies where cash is converted into bonds or other low-risk securities, we do not consider it, as it is earning at least some return;

however, in companies that need a lot of cash for daily operations, it makes sense to include it in the calculation as well since the cash tied up in operations is not making any return (Damodaran, 2012). Debt, both short-term and long-term, should be excluded, as it is considered in the cost of capital calculation (Damodaran, 2012).

1.2.4 Estimating growth rates

When estimating growth rates, we first need to understand what item we are looking at, with revenues and earnings being the most probable answers to that question. For earnings estimation, we need to, just as in the case of cash flow estimation, differentiate between growth in equity earnings and growth in operating earnings (Damodaran, 2009).

According to Damodaran (2009), the largest factors we need to consider are the financial and operating leverage. Firms that are highly financially leveraged often use increasing amounts of debt to fund operations and can thus report net interest expense growth higher than their operating income growth. This, in turn, can cause a discrepancy in the operating income and net income growth rates. Similarly, the growth reported in operating income and revenues can be vastly different if the proportion of fixed operating costs is much higher than the proportion of variable operating costs (Damodaran, 2009).

Once we establish the growth rates we are interested in, we generally have two options for their estimation – we can either look at the historical and forecasted growth rates or look at the firm’s fundamentals (Damodaran, 2009).

(19)

Historical and forecasted growth rates

When estimating growth rates, we can look at businesses’ past performance or look for forecasts shared by equity analysts or company insiders (Damodaran, 2012). However, it needs to be said that studies consistently prove that both estimates tend to be poor predictors of future growth (Damodaran, 2009).

The major drawbacks associated with historical growth rates estimation, according to Damodaran (2009), are:

1. A weak relationship between past and future growth 2. Growth rate drops in maturing companies

3. The cyclical nature of many firms and industries

However, if we decide to take this route, special attention should be paid to the method we use for averaging, particularly whether we decide to use the simple average or the geometric average (Damodaran, 2012). Unlike with simple average, the geometric average accounts for the compounding effect and proves to be a more reasonable choice when estimating earnings, especially when dealing with high volatility in reported earnings in the past years (Damodaran, 2012).

Forecasts from equity analysts and insiders should be, in theory, better, as they are based on the assumption made by people who have been either following the companies for many years or, in fact, are part of them (Damodaran, 2009). The premise is that they should have disproportionately more information, which should yield more qualified estimates. Damodaran (2009) argues, though, that neither of these parties is objective, as managers are likely to overestimate their ability to generate growth, whereas analysts may have their own biases in either direction depending on their end-goal – both analysts and managers, however, have the tendency to overestimate growth in times of economic prosperity and conversely underestimate growth in times of economic decline. Interestingly, according to Koller, Goedhart & Wessels (2015), analysts tend to be overly optimistic and produce estimates off by often more than five percentage points and the one-year-out aggregate earnings growth of the S&P 500.

Fundamental growth rates

As we will discuss later, the relationship between growth and fundamentals depends on what growth rate we are trying to estimate. Despite the discrepancies in details, both approaches share some similarities. First, growth and reinvestment are linked, and second, the quality of growth can vary across firms, so it is essential to measure this quality in terms of the returns earned on a particular form of investment (Damodaran, 2012).

For firms to grow at high rates over long periods of time, they need to reinvest periodically and substantially to deliver this growth (Damodaran, 2012). Growth attributed to reinvestments can also be called the growth generated on new investments (Damodaran, 2009). When estimating growth from new investments in equity earnings, we need to focus on investments in equity and returns on equity, whereas when estimating growth in operating earnings, we need to focus on investments in capital and the returns on invested capital (Damodaran, 2009). Figures 12 and

(20)

13 illustrate the terms required for calculating corresponding earnings growths. It is also important to note that the return earned on new investments should, indeed, be measured as the return on the investments made in the measured period (Damodaran, 2009).

Figure 12: Terms for Operating income growth rates from new investments estimation 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 =𝐶𝐴𝑃𝐸𝑋 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝛥𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

𝐸𝐵𝐼𝑇(1 − 𝑡)

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑅𝑂𝐶) = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒_𝑖(1 − 𝑡) 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙_𝑖−1

𝑖 = 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡 = 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒

Figure 13: Terms for Net (equity) income growth rates from new investments estimation 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 =𝐶𝐴𝑃𝐸𝑋 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝛥𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 − 𝛥𝐷𝑒𝑏𝑡

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑅𝑂𝐸) = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒_𝑖

𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦_𝑖−1 𝑖 = 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

For many firms, the pool of growth opportunities available from new investments is relatively small, resulting in their need to focus on operational efficiency and growth attributable to these changes (Damodaran, 2009). Unlike with growth arising from new investments, efficiency growth has the benefit of not coming with substantial additional costs required to achieve it, meaning there is no negative effect to offset the efficiency growth (Damodaran, 2009).

Unfortunately, there is a natural ceiling, which comes in effect when a business operates at an optimal level, further efficiency improvements are not feasible (Damodaran, 2009). In Figures 14 and 15, we can find the terms relevant to our estimation.

Figure 14: Terms for Operating income growth rates from efficiency growth estimation 𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 𝑔𝑟𝑜𝑤𝑡ℎ =(𝑅𝑂𝐶_𝑡− 𝑅𝑂𝐶_𝑡−1)

𝑅𝑂𝐶_𝑡−1 𝑡 = 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 Source: (Damodaran, 2009)

(21)

Figure 15: Terms for Net (equity) income growth rates from efficiency growth estimation 𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 𝑔𝑟𝑜𝑤𝑡ℎ =(𝑅𝑂𝐶_𝑡− 𝑅𝑂𝐶_𝑡−1)

𝑅𝑂𝐶_𝑡−1 𝑡 = 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 Source: (Damodaran, 2009)

Before tying this all together, however, we first need to discuss the observations made by Koller, Goedhart & Wessels (2015). Let us assume we have a company with predicted cash flows of $100 in the first year, with a 9% cost of capital. In Figure 16, we can see a table in which the authors estimate value based on different values of RO(I)C and growth. In essence, fast growth with low ROIC can be detrimental to value creation, especially if ROIC is lower than the cost of capital. This dynamic can often be observed in growing companies, more of which will be discussed later. The important lesson here, however, is that increasing operating efficiency - improving ROIC - will always result in higher value creation, regardless of the growth in earnings.

Figure 16: Example value calculation under different combinations of growths and returns

Source: (Koller, Goedhart, & Wessels, 2015)

Ultimately, to arrive at the predicted growth, we need to combine the growth from new investments and the growth from increasing operating efficiency. For simplicity, we will define a general case for both types of earnings. The formula can be seen in Figure 17.

(22)

Figure 17: Estimating growth using fundamentals 𝐺𝑟𝑜𝑤𝑡ℎ = 𝑅𝑂𝐼_{𝑁𝑒𝑤,𝑡}× 𝛥𝐼

𝐸_𝑡−1+(𝑅𝑂𝐼_{𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔,𝑡}− 𝑅𝑂𝐼𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔,𝑡−1) 𝑅𝑂𝐼𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔,𝑡−1)

𝑡 = 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝐼 = 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐸 = 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠

𝐸 = 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Source: (Damodaran, 2009) 1.2.5 Estimating discount rates

In conventional DCF models, the discount rate essentially takes on the role of reflecting the riskiness of an asset being valued (Damodaran, 2009). Simply put, cash flows that are riskier should be assigned a lower value than stable cash flows and should therefore have a higher discount rate (Damodaran, 2009). In Figure 6, we introduced the formula for calculating the WACC, which in essence represents the weighted return to all investors in the company (Koller, Goedhart, & Wessels, 2015). To estimate the value of WACC, we first need to estimate the cost of its two primary components – equity and debt.

Estimating cost of equity

The notion of a marginal investor is central to estimating the cost of equity (Damodaran, 2009).

According to Damodaran (2009), the marginal investor in a publicly-traded company needs to, in theory, own enough stock to be able to make a difference and needs to be willing to trade on it. On top of that, he also needs to be diversified. These assumptions, then, allow us to consider the risk of an investment to be equal only to the risk added to his portfolio by making the said investment. In other words, only the proportion of risk that is attributable to the wider market and economy, and is non-diversifiable, should be considered when calculated expected returns (Damodaran, 2009).

For estimation of the cost of equity that subscribes to the notion of the marginal investor, we can generally use three options (Damodaran, 2009):

1. Capital asset pricing model (CAPM) 2. Arbitrage pricing and multifactor models 3. Proxy models

Thanks to its simplicity, the capital pricing model is the most commonly used in valuations (Damodaran, 2012). In essence, the model is based on the idea that the expected rate of return, or cost of capital, equals the risk-free rate plus the beta times the market risk premium (Koller, Goedhart, & Wessels, 2015).

(23)

Figure 18: Capital asset pricing model

𝐸(𝑅_𝑖) = 𝑟_𝑓+ 𝛽_𝑖× (𝐸(𝑅_𝑚) − 𝑟_𝑓)

𝐸(𝑅_𝑖) = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑎𝑛 𝑎𝑠𝑠𝑒𝑡 𝑖 𝑟_𝑓 = 𝑟𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒

𝛽_𝑖 = 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑖^′𝑠 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 𝑡𝑜 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝐸(𝑅_𝑚) = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 Source: (Koller, Goedhart, & Wessels, 2015)

In CAPM, the risk-free rate and the market premium are identical for all companies (Koller, Goedhart, & Wessels, 2015). The risk-free rate is equal to the expected return made on an investment with no default or reinvestment risk (Damodaran, 2012). The most suitable riskless rate for doing valuations, which are long-term analyses, is the interest rate on long-term government bonds (Damodaran, 2012). The risk premium, which is the return investors demand over investing in risk-less assets, can be estimated either by looking at past returns on stocks and government-issued securities or by looking at the current stock prices in the market (Damodaran, 2012).

Beta is the element that captures a stock’s incremental risk to the marginal investor (Koller, Goedhart, & Wessels, 2015). Beta is usually estimated by running a regression of returns on historical stock prices against returns on a market equity index (Damodaran, 2009). As a result, the more a stock follows the movement of a market equity index, the lower its incremental risk (Koller, Goedhart, & Wessels, 2015).

The arbitrage pricing and multifactor models allow for multiple sources of non-diversifiable risk with multiple betas (Damodaran, 2009). In fact, we can think of CAPM as a special case of arbitrage pricing and multifactor models with a single risk factor (Damodaran, 2012). In proxy models, we virtually give up on measuring risk directly, and instead, we analyze past values of different company characteristics to identify shared characteristics that can help us understand the risk profile of an asset (Damodaran, 2009).

Estimating cost of debt

Simply put, the cost of debt is the market rate at which a firm can borrow money to finance its projects and operations, adjusted for tax advantages, if applicable (Damodaran, 2012). The market rate is then essentially the sum of the riskless rate and the default spread, associated with the default risk of a company (Damodaran, 2012).

As we have already discussed the risk-less rate in the previous section, we will now focus on the default spread and tax advantage. The easiest setting for estimating the cost of debt is when a company has long-term bonds that are widely traded in the market (Damodaran, 2012). The market price, coupon, and the maturity of a bond can be used to calculate the yield that can be used as the cost of debt (Damodaran, 2012). If we are dealing with a company whose bonds are not traded, we can use its rating to estimate its default spread (Damodaran, 2012). There are still many companies, however, that are not rated. In this case, we can either look at their recent

(24)

borrowing history and use the spreads on the debt they have raised recently, or we can use synthetic ratings obtained by looking at various debt coverage ratios of the company (Damodaran, 2012).

Finally, we must consider the tax benefit associated with raising debt. If the interest expense is tax-deductible, as seen in Figure 6, we need to multiply the pre-tax cost of debt by 1 less the applicable tax rate. While there can be some discussion about which tax rate should be used, consistent with the discussion we previously had, it is better to apply the marginal tax rate (Damodaran, 2012). It is important to keep in mind that interest only creates a tax benefit if a firm has enough income to cover its interest expenses – firms that incur operating losses will not get a tax benefit from its operating losses in the year of loss (Damodaran, 2012).

Final notes on discount rates estimation

As soon as we obtain the cost of equity and debt, we also need to keep in mind the possibility of these figures changing over time (Damodaran, 2009). If we suspect this might be the case, we need to specify what we expect the change to be and how soon will it occur (Damodaran, 2009). It is not uncommon for companies financing mix to change over time, and the cost of capital should reflect this (Damodaran, 2009).

1.2.6 Estimating terminal value

As already discussed, the value of a firm is the present value of cash flows it is expected to generate over its lifetime. With publicly traded companies, it is often fair to assume they have the potential to generate cash flows until infinity. This idea is embodied in the going concern assumption mentioned in earlier chapters. For many risky firms, however, this assumption may not be valid. Therefore, when valuing companies, there are two routes we can take – we can take the going concern approach and assume perpetual cash flows, or we can take the liquidation approach and assume a shutdown and assets sell-off at some point in the future (Damodaran, 2012).

Liquidation approach

In the liquidation approach, we are assuming a company has a finite life, and at the end of its life, we simply sell the assets it has accumulated to the highest bidders (Damodaran, 2012). To arrive at the liquidation value of a company, we have two options.

The easier option is to look at the book value of a company's assets and adjust them for any inflation in the time we decide to sell them (Damodaran, 2012). This approach, however, does not reflect the earning potential of the assets.

Therefore, alternatively, we can decide to estimate the expected cash flows from the assets and then discount these cash flows to the present value using an appropriate discount rate (Damodaran, 2012).

(25)

Going concern approach

In the going concern approach, unlike in the liquidation approach, we assume that companies can reinvest some of the cash flows they generate to extend their lives (Damodaran, 2012). If we also assume that the firms will continue to grow at a stable rate forever, we can estimate the terminal value using the formula in Figure 19.

Figure 19: Terminal value estimation

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒_𝑡 = 𝐶𝐹_𝑡+1 𝑟 − 𝑔_𝑠

𝑡 = 𝑝𝑒𝑟𝑖𝑜𝑑 𝑖𝑛 𝑤ℎ𝑖𝑐ℎ 𝑠𝑡𝑎𝑏𝑙𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑖𝑠 𝑎𝑐ℎ𝑖𝑒𝑣𝑒𝑑 𝐶𝐹 = 𝑎𝑝𝑝𝑟𝑜𝑝𝑟𝑖𝑎𝑡𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

𝑟 = 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 𝑔_𝑠 = 𝑠𝑡𝑎𝑏𝑙𝑒 𝑔𝑟𝑜𝑤𝑡ℎ Source: (Damodaran, 2012)

The cash flow and discount rate we use clearly depend on whether we value the firm or equity (Damodaran, 2012). To determine the value of respective inputs, we need first to consider several factors.

When it comes to stable growth rates, even small changes can cause significant changes in the terminal value, with the magnitude of this discrepancy increases radically increasing as it approaches the discount rate used in a valuation (Damodaran, 2009). The assumption that the growth rate is perpetual, however, places significant constraints on its potential value. In the long run, it is highly improbable that a single firm will continue to grow at a rate higher than the growth rate of the economy in which it operates (Damodaran, 2012). It can, however, grow at a rate lower than the overall economic growth (Damodaran, 2012). This rule, in turn, ensures that the growth rate will remain lower than the discount rate because of the relationship between the riskless rate and the economy’s nominal growth rate (Damodaran, 2009).

Once we understand the limits of stable growth, we need to understand how long the period of high growth will be (Damodaran, 2012). In valuation, it is not a question of if, but rather when does the high growth halt. This happens for two simple reasons – first, a company’s increasing size makes it harder to sustain high growth rates, and second, the excess returns generated by a company will attract other competitors to the market over time and thus reduce the total potential earnings (Damodaran, 2012).

Because of the first reason, we can comfortably say that for smaller firms, sustaining higher growth rates for a longer period of time should be a lot easier, at least in terms of revenue (Damodaran, 2012). The consequence of the second reason is two-fold. First, developing a significant competitive advantage that is sustainable in the long run vastly increases a company’s growth generating potential, and second, the growth momentum is a factor that should not be underestimated, and we should therefore assume that the risks associated with new entrants will not cause a significant drop in growth rates immediately (Damodaran, 2012).

(26)

After establishing the period of high growth-rate, we need to model the companies in a way where we give them mature company characteristics. Mature companies pose less risk to their investors (Damodaran, 2009). This needs to be reflected in their beta estimates. According to Damodaran (2012), when estimating beta, a maximum value of 1.2 for stable growth companies seems the most appropriate. Stable companies also often take on more debt, which is another factor that needs to be considered in the calculation of both the cost of equity and the excepted cash flows (Damodaran, 2012). As companies mature, their perceived riskiness decreases, and their ratings and the cost of debt should decrease as well (Damodaran, 2012). The easiest way to estimate the target values is to look at other mature companies in the industry and consider their debt ratios and cost of debt (Damodaran, 2012).

Mature companies also often earn lower returns, compared to the periods of high growth, as we discussed in an earlier paragraph. When projecting these returns, it is reasonable to assume a firm’s returns will converge towards the industry averages (Damodaran, 2012). It is also a good practice to link the returns we project to reinvestment rates (Damodaran, 2009). Stable growth firms generally reinvest less than high growth firms; therefore, it is important we consider the effects of lower growth on reinvestment and make sure that the firm reinvests enough to sustain its terminal growth rate (Damodaran, 2009). To estimate the reinvestment rate, we can use the formulas in Figure 20.

Figure 20: Reinvestment rate estimation in stable growth 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 𝐹𝐶𝐹𝐸 = 𝑔_𝑠

𝑅𝑂𝐸_𝑠 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 𝐹𝐶𝐹𝐹 = 𝑔_𝑠

𝑅𝑂𝐶_𝑠 𝑔_𝑠 = 𝑠𝑡𝑎𝑏𝑙𝑒 𝑔𝑟𝑜𝑤𝑡ℎ Source: (Damodaran, 2009)

1.3 Relative Valuation

1.3.1 Fundamental principles of relative valuation

Unlike in discounted cash flow valuation, where the objective is to assign value to an asset using its cash flows, growth, and risk characteristics, in relative valuation, the objective is to value an asset based on how the market currently prices similar assets (Damodaran, 2009). To successfully value a company on relative basis, two major components need to be considered.

First, the prices need to be standardized, which usually takes on the form of multiples of some common variable that varies across assets such as earnings, book value, or revenues for publicly traded stocks (Damodaran, 2009). Second, the assets we compare should be as similar as possible (Damodaran, 2009). The latter component, however, often proves to be difficult to execute, as no assets are exactly identical (Damodaran, 2009).

(27)

Before we proceed with the introduction of particular methods, it is worth it to consider the following four points according to Damodaran (2012):

1. The multiples we use need to be defined consistently, and we need to ensure uniform measurement across the firms we compare.

2. We need to have an idea of how a particular multiple value varies across the industry, i.e., what the high, low, and typical value for said multiple is.

3. We need to identify the fundamentals that determine the value of each multiple and understand how changes in these fundamentals affect their value.

4. We need to find truly comparable firms and try and adjust for discrepancies between the firms in fundamental characteristics.

1.3.2 Earnings multiples

Earnings multiples are probably the most commonly used group of multiples in relative valuation; however, it is easy to misuse them as well (Damodaran, 2012). The idea behind them is fairly intuitive – we need to compare multiples of the earnings an asset generates (Damodaran, 2009).

Price to earnings ratio

The price-earnings (PE) ratio is probably the most widely used multiple, primarily due to its simplicity of calculation (Damodaran, 2012). Unfortunately, its relationship to fundamentals is often overlooked, which results in significant errors in applications (Damodaran, 2012). The formula for PE ratio can be found in Figure 21.

Figure 21: Price to earnings ratio

𝑃𝐸 =𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 Source: (Damodaran, 2012)

Usually, the biggest problem when working with PE ratios is the variations on earnings per share used in the calculation – earning measures such as current earnings, trailing earnings, forward earnings, fully diluted earnings, or primary earnings per share can be used (Damodaran, 2012).

The PEG ratio

It is not unusual for analysts to compare PE ratios to the expected growth rate of a company to identify undervalued or overvalued stocks (Damodaran, 2012). In general, the lower the PEG ratio, the more the firm is undervalued (Damodaran, 2012). The formula for this multiple can be found in Figure 22.

(28)

Figure 22: PEG ratio

𝑃𝐸𝐺 = 𝑃𝐸 𝑟𝑎𝑡𝑖𝑜

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 Source: (Damodaran, 2012)

Enterprise value (EV) to EBITDA ratio

This ratio enjoys particular popularity for a few reasons, mainly because many companies have positive EBITDA despite negative earnings, the fact that depreciation schedule does not impact the value, and finally, it also allows for easier comparisons of companies with different financial leverage (Damodaran, 2012). The formula for EV/EBITDA can be found in Figure 23.

Figure 23: EV/EBITDA ratio

𝐸𝑉/𝐸𝐵𝐼𝑇𝐷𝐴 =𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ 𝐸𝐵𝐼𝑇𝐷𝐴

Source: (Damodaran, 2012) 1.3.3 Book value multiples

When analyzing companies, we could argue that companies whose stock sells for less than the book value of equity are undervalued (Damodaran, 2012). This idea is the basis of book value multiples.

Price to book equity ratio

Financial markets provide an estimate of a value of a business that is often very different from the one recorded by the accountants, namely because the accounting standards mostly consider the original price of assets and liabilities, less some depreciations (Damodaran, 2009). As already mentioned earlier, investors often believe that the relationship between the price of a stock and the book value of equity is a good measure of how a company is over- or undervalued.

If we were to value a company using this method, we need to understand that this ratio can vary widely across industries, with the main factors we need to control for being the growth potential and the quality of investments that were made (Damodaran, 2009). The formula can be found in Figure 24.

Figure 24: Price to book equity ratio

𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝑏𝑜𝑜𝑘 𝑟𝑎𝑡𝑖𝑜 = 𝑃𝐵𝑉 = 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 Source: (Damodaran, 2012)

(29)

1.3.4 Revenue multiples and sector specific multiples

Many young firms often post negative earnings, making it impossible for analysts to value them using earnings multiples (Damodaran, 2012). That is why analysts have increasingly moved towards multiples based on revenues or multiples based on industry-specific metrics such as the number of subscribers or the number of website visitors (Damodaran, 2012).

Revenue multiples

There are two major advantages for using revenue multiples – they are less dependent on accounting standards, and even firms making a loss have positive revenues (Damodaran, 2009).

It is also worth noting that revenues and revenue multiples are usually not as volatile as earnings and earnings multiples; however, the big disadvantage is that we can easily highly value a company that earns high revenues at a high loss (Damodaran, 2012). As such, we need to be careful when using these and thoroughly examine whether the firm in question question has the capacity to become profitable over time. The most commonly used revenue ratio is the price to sales ratio, found in Figure 25.

Figure 25: Price to sales ratio

𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝑠𝑎𝑙𝑒𝑠 𝑟𝑎𝑡𝑖𝑜 =𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠

Source: (Damodaran, 2012) Sector specific multiples

According to Damodaran (2012), the use of sector-specific multiples stems from three reasons:

1. There is an apparent link between a firm’s value and operating details and output 2. They can be calculated without any accounting statements or measures

3. They can be used as a last resort if no other multiples are available

However, the biggest drawback is that the connection of these multiples to the fundamentals is very complicated, and therefore it is difficult to control for the differences when comparing the multiples (Damodaran, 2012). There are many sector-specific multiples; however, they generally revolve around the idea that we add the market values of debt and equity, subtract the cash and marketable securities, and divide this value by the number of relevant units of a product, customers, subscribers, or anything else that seems appropriate (Damodaran, 2012).

1.4 Contingent Claim Valuation

One of the more recent developments in valuation is the acceptance that the value of an asset may actually be greater than the present value of its cash flows if the cash flows are contingent on some events either occurring or not occurring (Damodaran, 2012). The premise rests on the idea that, unlike DCF, option pricing models are better equipped to value assets that are contingent on some event (Damodaran, 2012).

Hlavní práce72019_lehd01.pdf, 1.2 MB Stáhnout

University of Economics, Prague

Master’s Thesis

2021 Dominik Lehocký

University of Economics, Prague Faculty of Business Administration

Diploma Thesis Title:

Valuation of Farfetch Ltd

Author: Dominik Lehocký

Supervisor: Ing. Jaroslav Schönfeld, Ph.D.

D e c l a r a t i o n o f A u t h e n t i c i t y

I hereby declare that the Master’s Thesis presented herein is my own work, or fully and specifically acknowledged wherever adapted from other sources. This

work has not been published or submitted elsewhere fir the requirement of a degree program.

Prague, May 12, 2021 Dominik Lehocký

Title of the Master’s Thesis:

Valuation of Farfetch Ltd

Abstract:

Key Words:

Table of Contents

Introduction

Theoretical Part

1 Introduction to Valuation

1.1 Value and Commonly Used Methods in Valuation

1.2 Discounted Cash Flow Valuation

1.3 Relative Valuation

1.4 Contingent Claim Valuation