Lecture Notes: Basics of Intrinsic Value and Valuation

Introduction

• Focus on intrinsic value from Chapter 3 of the Little Book Evaluation.
• Practical valuation of Kraft Heinz Corp.
• Two approaches to valuation:
  • Valuing the entire business (debt + equity).
  • Valuing just the equity.

Valuation Approaches

• Full Business Valuation:

  • Consider cash flows to both debt and equity holders.
  • Discount using weighted average cost of capital (WACC).

• Equity Valuation:

  • Focus on cash flows to equity holders post-debt payments.
  • Discount using the cost of equity.

• Both methods should yield the same value for equity if done correctly, but differ in complexity.

Key Components of Valuation

• Cash Flows to Equity:

  • Dividends as a direct measure (Dividend Discount Model).
  • Augmented dividends: Dividends + stock buybacks.
  • Free cash flow to equity: potential dividends.

• Free Cash Flow to Equity Calculation:

  • Start with net income.
  • Adjust for reinvestment in long-term (net capex) and short-term (working capital) assets.
  • Adjust for net cash flow from debt.

Practical Example: Kraft Heinz Corp.

• Use historical financial data (2020-2022).
• Calculate net income, depreciation, amortization, capex, and working capital changes.
• Address the effect of debt payments on free cash flow to equity.

Valuing the Entire Business

• Free Cash Flow to the Firm:

  • Use operating income before interest.
  • Apply effective tax rate.
  • Subtract reinvestment (long/short-term assets).

• Notable Observations from Kraft Heinz:

  • Significant debt repayment affecting cash flows.
  • Importance of smoothing historical data for projections.
  • Reinvestment rate as a percentage of after-tax operating income.

Risk and Discount Rates

• Risk Measurement:

  • Three parameters: risk-free rate, beta, and equity risk premium.

• Risk-Free Rate:

  • Ideal: default-free government bonds.
  • Adjust for default risk in certain currencies.

• Equity Risk Premiums:

  • Reflect market balance between greed and fear.
  • Calculated using historical or implied methods.

• Beta Assessment:

  • Conventional regression vs. bottom-up approach using industry data.

Cost of Capital and Growth

• Cost of Debt:

  • Based on current borrowing rates, not historical.
  • Use ratings and interest coverage ratios to estimate default spreads.

• Cost of Capital Calculation:

  • Combine cost of equity and after-tax cost of debt.
  • For Kraft Heinz, calculated at 7.56%.

• Growth Projections:

  • Historical growth, analyst forecasts, or fundamental (reinvestment and return on capital) approaches.
  • For Kraft Heinz: low growth projection based on historical data and reinvestment behavior.

Terminal Value and Final Valuation

• Terminal Value Calculation:

  • Use perpetuity growth model post-year 10.
  • Adjust for reinvestment needs and maturity.

• Adjustments and Final Steps:

  • Include cash, subtract debt, account for options.
  • Final per-share value vs. market price assessment.

• Challenges in Valuation:

  • Potential errors in assumptions.
  • Market mispricing or divergent assumptions.

Conclusion

• Reflect on growth and profitability assumptions for Kraft Heinz.
• Evaluate based on future expectations and current market behavior.
• Encouragement to independently assess investments beyond market perceptions.