Here is the Valuation 101 of how investment bankers determine if a share is currently undervalued or overvalued. We use a piece of financial economics called a discounted cash flow (DCF) model. This is a key part of corporate finance. Now value does not always equal price – but as the Benjamin Graham quote goes, “In the short-term the market is a voting machine and in the long-term a weighing machine”.

The DCF is the primary method in corporate finance theory for calculating value. In corporate finance – value is a DCF

The genius part of the DCF is that it only requires two inputs:

1. An estimate of cash flows (post-tax) that the business will generate into the future; and
2. A discount rate that reflects the variability of those cash flows (riskiness).

That sounds really simple – but there is a lot of work that goes into making assessments of each of those inputs. For example:

• Detailed estimates of the financial performance for the next three to five years.
• Assessment of future performance beyond the three to five year period.
• Calculation of the appropriate discount rate to apply to the business.

However, I am going to walk through a really simply example – a cartoon valuation. An investment banker would never use this level of simplification – but I am trying to illustrate the process.

We are going to use Telecom New Zealand [NZX: TEL] as our example. Telecom’s current share price as at 25 October 2013 is $2.32 – how do we get to an assessment of whether that is over or under-valued?

First – estimate the future post-tax cash flows of the business:

• Telecom generated $1.043 billion of profit in 2013 (at the EBITDA line). Let’s say, for simplicity that means Telecom will do $1.00 billion of EBITDA per year moving forward.
• Telecom spent $465 million on capital expenditure (CAPEX) in 2013. Let’s say that is $450 million of CAPEX per annum moving forward.
• Telecom paid $103 million in taxes in 2013. Let’s say $150 million a year of taxes per annum moving forward. Note: the IRD allow additional deductions from the EBITDA line – like depreciation and amortisation. The tax paid looks reasonable.

TABLE – EBITDA to Post-Tax Free Cash Flow

Yes these are a simplification – a cartoon valuation remember.

Second – estimate the post-tax discount rate:

• PwC calculates Telecom’s discount rate (Weighted Average Cost of Capital – WACC) at 10.5%. I am going to round that down to 10%.
• We need to also consider a nominal long-term growth rate. I am going to use 2%.

The calculation where PTFCF equals Post-Tax Free Cash Flows:

This gives an Enterprise Value (EV) of $5.0 billion. From the EV we deduct Net Debt [Long-term borrowings ($976 million) less Cash ($118 million)] of $858 million. EV less Net Debt gives us the value of the Equity in Telecom of $4.142 billion (equivalent of the market capitalisation). Then we divide the value of the equity by the number of shares on issue (1.822 billion) to get our calculation of the value of Telecom’s shares of $2.27 – very close to the current $2.32 share price.

TABLE – EV calculation to Share Price

In a really basic way – that is how investment bankers do a valuation.

Disclaimer: Intended for educational use only. See a financial advisor before making any investment decisions.