Long-run measures of return 8 / 13

Long-run measures of return

Companies are trying to maximise the wealth of their shareholders by making a profit. 

However, for a company whose shares are traded on a stock market, the movement in the share price is important.

The value of shares depends on a company's future cash flow potential.

When valuing a share on the basis of future cash flows

Remember that ... money to be received in the future is worth less than money received today. 

This is because investors prefer to receive money sooner rather than later.

So, the value of a company's future cash Flows will need to be adjusted to reflect this time value of money

This process is called Discounting.

Discounting free cash flows to equity

Free cash flows to equity

The cash flows generated by a business in a particular year after interest and tax and investment spending.

Free cash flows to equity are available either to pay as a dividend or to keep within a business — either way this cash is a benefit to ordinary (equity) shareholders.

Illustration

Cow Co is predicted to generate the following free cash flows to equity.

Year 1 $150 million Year 2 $170 million Year 3 $200 million

There are 50 million shares and shareholder's required rate of return is 10%

This is to reflect the time value of money and indicates the rate at which future cash flows are to be discounted.

The discounted, or present, value of the cash flows is:

In year 1:  
$150m / 1.1 = $136.4m.

In year 2:
$170m /1.1 / 1.1 = $140.5m

In year 3:
$200m /1.1 / 1.1 / 1.1 = $150.3m

Total value = $136.4m + $140.5m + $150.3m = $427.2m

Price per share = $427.2m / 50m = $8.54

Discounting free cash flows to the firm

Free cash flows to the firm
The cash flows generated by a business in a particular year after tax and investment spending (but before interest).

The value of debt needs to be subtracted to obtain the value of equity.

Free cash flows to the firm are available to pay to all investors, whether shareholders or providers of debt finance.

Illustration

Cow Co (above) has a $30m three-year loan costing 10%. 

Repayments on this loan are:
$3m in year I, 
$3m in year 2 and 
$33m (capital plus interest) in year 3.

Cow is predicted to make the following free cash flows to the firm.

Year 1 $153 million Year 2 $173 million Year 3 $233 million

There are 50 million shares and the overall cost of capital is 10%.

The discounted, or present, value of the cash flows is:

In year 1:  
$153m / 1.1 = $139.1m.

In year 2: 
$173m /1.1 / 1.1 = $143m

In year 3: 
$233m /1.1 / 1.1 / 1.1 = $175.1m

Total value = $139.1m + $143m + $175.1m = $457.2m

This is the value of the cash flows to all investors (debt or equity); the value of debt therefore needs to be subtracted to obtain the value of equity.

Value of equity = $457.2m - $30m = $427.2m 
Price per share = $427.2m / 50m = $8.54 (the same as above)