Equity Valuation Using Multiples: An Empirical Investigation

Theoretical foundations 25vestors of a firm: debt holders and equity holders. That is, FCF equals net operatingprofit after taxes (NOPAT) less the change in invested capital (i.e., the cumulativeamount a firm has invested in its core operations). Unlike operating cash flow(OCF) reported in the cash flow statement, FCF itself is independent of financingand therefore not affected by capital structure; even though capital structure mayaffect a firm’s discount rate, the weighted average cost of capital ( rwacc ) and thereforeits intrinsic value (Copeland, Koller & Murrin 2000, p. 167).tt( 1 )NOPAT = EBIT ⋅ −tax rate(3.3)The FCF can be calculated from information in financial statements. Koller,Goedhart & Wessels (2005) start with NOPAT calculated from the income statementusing equation (3.3), add back depreciation and amortization, deduct increasesin working capital, and deduct capital expenditures (CAPEX). Aboody (2006) presentsan alternative approach where FCF equals OCF less CAPEX plus interest netof income taxes. In this sense, FCF equals the amount of dividends, which a firmcould pay if it had no debt and a full payout (i.e., a dividend payout ratio of one).FCF = NOPAT −Δ invested capitalt t t= NOPAT + depreciation & amortization −Δworking capital −CAPEXt t t tt t t( 1 )= OCF − CAPEX + interest ⋅ −tax rate(3.4)In reality, firms use FCF to distribute dividends, pay debt holders, or simplyretain the cash. Consequently, the present value of future FCF represents the intrinsicvalue of common equity plus the market value of debt including preferred stockless cash & equivalents. We can also view future FCF as “firm dividends” and theirpresent value as the value of the firm as a whole or entity value respectively. Formally,ventityt=E( FCF )∞t t+i∑ (3.5)ii=1 1wacc( + r )