From the forecast model to an equity value

What are the steps from statements to value?

The six-step valuation process runs from the historical statements to a value for the equity.

Six stepssome summaries merge steps 2 and 3, giving five

• 1. Gather historical statements
• 2. Forecast the income statement Memorize revenue, expenses, margins
• 3. Forecast the balance sheet Memorize assets and financing
• 4. Compute free cash flow to the firm (FCFF) and to equity (FCFE)
• 5. Estimate the terminal value constant growth or a multiple
• 6. Discount and subtract debt present value at WACC − market value of debt

Steps 2 and 3 are the heart of it. They produce every input to free cash flow, and the story they tell decides how the terminal value is estimated.

How do you read an assumption table?

Reading an assumption table means turning growth rates into two directions.

• Margin direction . Expenses growing faster than revenue mean margins fall. Expenses growing slower mean margins rise.
• Investment intensity . Assets growing faster than revenue mean more investment per unit of revenue and lower free cash flow now. Slower growth means less.

Take revenue growth of 6%, 6% and 5%, operating cost growth of 5%, 4% and 4%, and operating capital growth of 6%, 5% and 4%. Costs grow more slowly than revenue in all three years, so the operating margin rises (12.0% to 15.3%). Capital grows with revenue in year 1 and more slowly afterwards, so investment intensity eases.

How do you get FCFF and FCFE from the forecast?

Both free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) come straight out of the forecast. FCFF from forecast statements is net operating profit after taxes (NOPAT) minus net investment, as in lesson 1. FCFE from forecast statements is net income minus net investment plus net borrowing, as in lesson 4.

Choosing FCFF over FCFE makes sense when the financing assumptions are shaky, for example when debt is simply held flat. FCFF depends on profitability and investment, not on how the company is financed.

How do you estimate the terminal value?

There are two routes. The constant growth terminal value needs positive free cash flow and stable fundamentals at the horizon. The alternative is relative valuation: a peer multiple of final-year revenue, earnings before interest, taxes, depreciation and amortization (EBITDA), EBIT or earnings, which needs a sound peer group.

For constant growth, the sustainable growth rate of FCFF is the reinvestment rate times the return on capital . The reinvestment rate is the share of NOPAT that is not paid out as free cash flow. The return on capital is NOPAT divided by the book value of total capital at the start of the year.

$$FCFF\,SGR_{t+n} = \left(1 - \frac{FCFF_{t+n}}{NOPAT_{t+n}}\right) \times \frac{NOPAT_{t+n}}{\text{Book value of total capital}_{t+n-1}}$$

The terminal firm value then follows the constant growth pattern, with WACC as the discount rate.

$$\text{Firm value}_{t+n} = \frac{FCFF_{t+n} \times (1 + FCFF\,SGR_{t+n})}{WACC - FCFF\,SGR_{t+n}}$$

The terminal value is a firm value, so check it as a multiple of a firm-level measure such as EBIT, EBITDA or revenue. The implied terminal multiple for Halvard is 1,151.74 ÷ 90.19 = 12.8 times year-3 EBIT. If peers or the company’s own history sit around 9 to 11 times, the growth, return on capital or WACC assumptions deserve another look. Converting a terminal value into a multiple tests whether it is reasonable. It does not replace choosing a sound peer group.

$$\text{Implied multiple} = \frac{\text{Terminal firm value}}{EBIT_{t+n}}$$

Go deeper Why the growth rate equals the last year's capital growth here

When net investment is exactly the growth in operating capital, reinvestment rate × return on capital = net investment ÷ last year’s capital. Halvard’s capital grows 4% in year 3, and so does g. A terminal growth rate out of line with the final year’s investment is a sign the forecast has not reached a steady state.

How do you get from firm value to equity value?

Discount the free cash flow and the terminal value at WACC, not at the cost of equity. That is the present value at the weighted average cost of capital (WACC) , and it gives the firm value . Then subtract the market value of debt . Book value is a fair proxy when the two are close. The answer is the total equity value , to set beside market capitalization.

$$IV_t = \left[\sum_{i=1}^{n} \frac{FCFF_{t+i}}{(1 + WACC)^i} + \frac{E(P_{t+n})}{(1 + WACC)^n}\right] - MV_{Debt}$$

What if the company still burns cash?

For a young, fast-growing company with negative profits and free cash flow, base-year methods cannot work, so a disaggregated model is the only present value route.

The terminal value for a high-growth company comes from a multiple of final-year revenue or earnings, once the model shows the company reaching scale. A constant growth model does not fit while growth is still high and the fundamentals are unstable, and a multiple of next year’s earnings would be negative and would give a current value, not a terminal one.

Picture a recently listed delivery-software company growing revenue 40% a year, with margins turning positive in year 4 of a five-year model. Discount the negative early free cash flows, then value year 5 with a peer multiple of year-5 revenue or earnings.

Go deeper Firm value or equity value from FCFE?

FCFE discounted at the cost of equity gives equity value directly, with no debt to subtract. It is only as good as the borrowing assumptions in the model. With debt simply held flat, the FCFF route is safer.