A Primer On Company Valuation

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Includes: AAPL
by: Michele Manganelli

Summary

What is NOPAT and how it can be used as a valuation tool.

Value creation principles and their use in company valuation.

Concrete application of the model to Apple Inc..

In this article I will share a way to think about company valuation in terms of the key fundamental value drivers and how they can be used to develop an effective model. I will then apply this model to value Apple Inc. (NASDAQ:AAPL) in order to understand its long-term potential value creation.

What is NOPAT and why is it useful

Net operating profit after tax (NOPAT) measures potential cash earnings if the company had no debt. The NOPAT approach has an evident advantage over net income, because it does not take in account tax savings from debt. We can define NOPAT as

Net operating profit after tax provides a measure of core efficiency without the influence of debt, helping investors to compare companies with different debt ratios.

Drivers of Value creation

The basic principle in corporate finance is that a company creates shareholders' value by gaining a return on its investments greater that its Weighted Average Cost of Capital. We can identify three main value drivers:

  1. Return on Invested Capital, ROIC
  2. Weighted Average Cost of Capital, WACC
  3. NOPAT growth rate, g

Value is created when ROIC > WACC.

In order to operate its business, a company has to invest capital to maintain or expand its operations. Invested capital represents the cumulative amount the company has invested in its core operations, and can be defined as:

From these investments, the company generates a certain NOPAT, depending on the efficiency of its operations. Return on Invested Capital is the return that the company earn on each dollar invested:

Finally a company must be able to grow its NOPAT at a sustainable rate. However, growth comes not for free, but it is determined by what portion of NOPAT the company is willing to reinvest in its business. The Investment Rate is a key component of value creation, as it represents the percentage of NOPAT invested back in the business:

Net Investment expresses the portion reinvested each year (should not be confused with Invested Capital) in the core operations (PP&E and Working Capital) and can be defined as:

The NOPAT growth rate that the company can sustain in a give year depends by two factors:

  1. ROIC
  2. Investment Rate

We can express the growth rate as:

Finally, to calculate the WACC we apply traditional CAPM for the Cost of Equity, while for the pre-tax Cost of Debt we use Interest Expenses over Book Value of Debt (ST Debt + LT Debt) as a proxy for the yields on traded Corporate Bonds.

Build a valuation model

The next step is to incorporate the key elements of value creation in the Intrinsic Value calculations. According to financial theory, the Enterprise Value is defined as

We can think about FCFF as the result from core operations minus the amount reinvested in the business.

By rewriting the Investment Rate as a function of NOPAT growth rate and ROIC, the Enterprise Value can be defined as:

From the formula above, we can observe that:

  • Value is clearly created when ROIC > WACC
  • When ROIC = WACC, the Enterprise Value is calculated as NOPAT/WACC

Free Cash Flow Dynamics

We can describe how FCFF evolve through time with the concept of fade: starting NOPAT growth rate will fade to a long-term sustainable rate, while the starting ROIC will fade to the WACC.

  • The starting NOPAT growth is calculated as a function of starting ROIC and Investment Rate. For the long-term sustainable growth rate we use the Risk Free Rate applied to the CAPM: this will help to maintain internal coherence by establishing a link between our growth rate and the discount rate.
  • The margin between ROIC and WACC determines how efficiently a company is operating. The fact that ROIC fades to the WACC determines a gradual reduction of this margin and reflects the typical reduction of overall profitability for a more mature company.

Under these assumptions we have the starting and ending values for both NOPAT growth and ROIC so the intermediate values can be calculated through interpolation, with a forecasting period of 10 years. We apply an Exponential Interpolation where each value is determined as:

where:

  • xi and xf are the initial and ending values of g or ROIC
  • tx is the time in which x(t) is calculated
  • ti and tf are the extremes of the forecasting period

How to calculate the Terminal Value

There are two main ways to calculate the EV Terminal Value:

  1. NOPAT exit multiple
  2. Gordon Growth Model

For this analysis we will use the second approach to calculate Enterprise Value in perpetuity. According to the model:

As I have explained in the section above, the model assumes a ROIC that reverts to the WACC at the end of the forecasting period. Under the assumption that ROIC = WACC, the Terminal Value can be simplified as:

Consequently, we can express the Enterprise Value as:

From Enterprise Value to Equity Value

The Enterprise Value is a measure that reflects the total market value of a business, being a sum of claims by both creditors and shareholders (common and preferred). We can define EV as:

+ Common Equity at market value

+ Interest-bearing liabilities

+ Minority interest

+ Preferred Equity

- Value of associate companies

- Cash & cash equivalents

In order to calculate the Intrinsic Value per share, we simply need to start from Enterprise Value and solve the equation to find the Common Equity at market value (Market Cap.). In the formula above, cash & cash equivalents are subtracted from the Equity Value because they reduce the overall net cost to a potential buyer.

Is Apple stock still a good buy?

As the company has recently released its 2016 Q4 results, I believe it is worth taking a look at the Cupertino tech giant in order to get a better understanding of its long-term value creation potential. I will analyze Apple Inc. only with a quantitative approach, applying the valuation model shown above, without taking in account any market noise such as news, EPS forecasts or short-term technical outlook. I think that developing a coherent model and applying it consistently to value different companies is a far better solution than taking decisions on news or on someone else's forecasts. I use Morningstar as my main reference for TTM values and Yahoo Finance for historical price data.

The company has registered a high TTM ROIC of 19,96%. In order to gain an understanding of its overall profitability we have to calculate the WACC. The first component, the Cost of Equity, is calculated according to the CAPM, applying the current 10 year U.S. Treasury Yield as the Risk Free Rate, and an average market return of 7.50% in order to find the Market Risk Premium. The stock Beta is calculated using 10 year worth of adjusted daily closes, and the S&P 500 index is used as a benchmark.

The Cost of Debt is calculated as Interest Expenses over Book Value of Debt. For the WACC we obtain the following value:

Apple registers a WACC of 6.62%, lower than its ROIC: this means that the company is able to generate positive returns beyond the cost necessary to finance its capital. The starting NOPAT growth rate is calculated as a function of the ROIC and Investment Rate:

According to the concept of fade, NOPAT growth rate will decrease to 2.486% (Risk Free Rate) while TTM ROIC will decrease to 6.62%, both following an exponential decay. With the above information, we get the following calculation:

According to the model, the Intrinsic Value for Apple Inc. is set at $168.87 per share, above the current market price.

The company registers an initial ROIC-WACC spread of 13.34%; with ROIC diminishing over time, the spread will fade to 0% in t+10.

To sum up, the company has positive long-term upside potential, driven by high Return on Invested Capital and high NOPAT growth, representing a profitable investment opportunity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.