Weighted Average Cost of Capital and Terminal Growth in Valuation

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We have arrived close to the end of our exploration of the basic theory of valuation. Now, we will take a look at two essential components before transitioning in the following chapter to the application of a Discounted cash flow type model to our fundamental framework.

A quick recap of the last few chapters before we proceed –

Valuation techniques include relative, option-based and absolute. The former is referred to as the method of comparable; the latter relies on discounted cash flow analysis. Option-based valuation is dependent on an event.

We are looking into the DCF model, which is a stock-based valuation instead of an annual one.

By rearranging the equation of the balance sheet, we find that Fixed assets are equivalent to Net Debt plus Equity.

You can opt to assess the worth of the enterprise as a whole, known as ‘Enterprise valuation’, or just the equity section of it.

Valuation is determined by factors including the cashflow, its rate of growth, and the timing of when it is received.

To determine the free cash flow, begin with profit after tax and incorporate non-cash outlays, interest charges, and alterations in working capital.

To work out the value of the entire company, WACC is used as a blended rate. If you are just considering the equity, then the cost of capital can be taken as your expected return. We will be looking at this in more detail later on in this chapter.

The return anticipated by equity holders will typically exceed that of debt holders, and this can be determined using the CAPM model.

Finally, when factoring in the tax shield to PAT in the FCF calculation, we must make sure it is taken into account.

Over the past three chapters, we have discussed in detail the discounted cash flow model. If you are having difficulty understanding it, I suggest you revisit those chapters and post any questions you may have. In this instalment, we will wrap up our discussion of this topic.

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