Master Case: AMD: Valuation: Session IX
The most difficult part in valuing a business is the pro forma projections and the calculations of free cash flows. Most major errors in the valuation exercise are found in these two parts.
Valuation aims at seeing that if a business generates a certain amount of cash over the next two years and keeps on generating a stable amount of cash till infinity, what is the business worth today. It is a basic application of the present value principles.
Valuation can be broken down into a series of steps.
- Determining the appropriate cash flows
- Determining the appropriate discount rate
We have already calculated the required information for step one and two. The appropriate cash flows are the free cash flow numbers we have generated. The appropriate discount rate is the weighted average cost of capital (WACC), which is 12.4% for AMD.
- Determining the appropriate discount factors
The appropriate discount factors are the factors that will be used to discount the projections of the first to the fourth year. Using the discount rate of 12.4, the discount factors are
Valuation | 2000 | 2001 | 2002 | 2003 |
Discount Factor | 88% | 75% | 63% | 50% |
- Calculating the present value of cash flows till the terminal date
The Terminal Date is the date at which all components and growth factors for the balance sheet and income statements become stable. Our assumption is that beyond the terminal date, everything will remain stable at the percentage projected on the terminal date. So sales will keep on growing at 6% per year to infinity, research & development will stay at 18% per year to infinity, General, Marketing, and Administrative expenses will stay at 23% of sales per year until infinity and so on.
In our case, we set the terminal date as 2003. The calculation will now be done in two parts.
In Part One, we calculate the present value of cash flows up to, but not including, the terminal date, which means we will calculate the cash flows only up to 2002.
Free cash flows | -1,099,669 | -957,320 | -778,299 |
The present value of these cash flows, using the discount factors given above, is:
Valuation | 2000 | 2001 | 2002 |
Discount Factor | 88% | 75% | 63% |
Free cash flows | -1,099,669 | -957,320 | -778,299 |
PV of Cash Flows | -967,709 | -717,990 | -490,328 |
The cumulative value of these cash flows is also given
Cumulative Cash Flows | -967,709 | -1,685,699 | -2,176,027 |
We now know that the present value of cash flows till 2002 today is -2,176,027.
In Part Two, we try to calculate the terminal value of the business in 2003
An infinite sequence of cash flows, growing at a certain rate, can be valued by using the following formula.
Present Value = Cash Flows / (Discount Rate – Growth Rate)
For our case
The terminal cash flow is -2,241,511
The discount rate is 12.4%
The terminal growth rate is 6%
Putting these into the formula given above, we get
Terminal Value = -2,241,511 / (12.4% – 6%) = -35,023,609
We have now calculated the terminal value for the beginning of 2003. However, we still need to bring it back in terms of today’s value, which is the beginning of 1999. We can do this by multiplying the terminal value by the discount factor for 2003, which is .50.
This equals to 0.50 * -35.023,609 = -17,511,804
The total value of the business is the sum of the numbers in Part One and Two = -2,176,027 + -17,511,804 = -19,687,831
So, under our assumptions AMD is worth $-19,687,831 today. There are 311,490 shares outstanding. Dividing -19,687,831 by 311,490 million gives us the share price of $-63 per share. Remember that the final figure is in 000’s and that the shares are also in 000’s.
This case is almost closed, all you have to do now is test your models using extreme growth assumptions and see how sensitive the valuation is to certain factors. Well, we’ll leave the testing to you.
Valuation | 2000 | 2001 | 2002 |
Discount Factor | 88% | 75% | 63% |
Free cash flows | -1,099,669 | -957,320 | -778,299 |
PV of Cash Flows | -967,709 | -717,990 | -490328 |
Cumulative Cash Flows | -967,709 | -1,685,699 | -2,176,027 |
Terminal Cash Flow | |
Terminal Value | |
PV of Terminal Value | |
PV of Terminal Value and Cash Flows | |
Shares Outstanding | |
Price per share |