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its free cash flow to shareholders through dividends or share repurchases. When return on investment equals a company s WACC, investors are just compensated for the risk that they are taking in owning the company s stock and no additional value is created from new business investments. The stock price is still growing in value, but its growth does not exceed its risk-adjusted market expectation (or match investors hopes). At that point in time, the after-tax earnings of the company can be treated and valued as what is known as a cash flow perpetuity equal to the company s net operating profit after tax divided by its WACC (NOPAT/WACC). This number is discounted to the present also at the company s WACC. This discounted value is called the company s residual value a very important number, and generally represents 60 percent to 90 percent of the total value of the company. The residual value is very sensitive to projections of the company s NOPAT and its WACC, as described in the section that follows.
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What is our preferred excess return period This is a judgment call. We use the 1-5-7-10 Rule and suggest that you do likewise. We group companies into one of four general categories and excess return periods. We then value them using a 10-year excess return period to calculate what we consider to be their maximum value, and a more conservative 1-year, 5-year, or 7-year return period to calculate a reasonable or minimum value. Here are the criteria we use to determine the lower, more conservative excess return period: 1. Boring companies that operate in a highly competitive, low-margin industry in which they have nothing particular going for them a 1-year excess return period; 2. Decent companies that have a recognizable name and decent reputation and perhaps a regulatory benefit (e.g., a utility like Consolidated Edison), but don t control pricing or growth in their industry a 5-year excess return period; 3. Good companies with good brand names, large economies of scale, good marketing channels, and consumer identification (e.g., McDonald s) a 7-year excess return period; and
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4. Great companies with great growth potential, tremendous marketing power, brand names, and in-place benefits (e.g., Intel, Microsoft, Coca Cola and Disney) a 10-year excess return period. We do not believe in going out more than 10 years with an excess return period. Some fundamental stock valuation models, like the dividend discount model, incorporate earnings and dividend growth in excess of the company s WACC, out to an infinite time period. Cash flows in these models are discounted until the hereafter. We think that 10 years is a reasonable amount of time to incorporate the product cycles of today s markets. Does a corporation really lose its competitive advantage and the benefit of its excess return period For well-managed corporations, the answer is probably no. Most well-run companies will continue to innovate, reduce operating costs, increase efficiency, create new business strategies, and maintain their competitive advantage for a long time. Some will go bankrupt. Some will be acquired or merge. But the concept of an excess return period or forecast period is one that should result in a more conservative, less aggressive stock valuation. When we invest, we would rather err on the side of conservatism than overpay for a stock.
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In calculating corporate or enterprise value, the FCFF approach and the spreadsheet software divides corporate assets and liabilities and discounts cash flows into three categories and time periods: Cash Flow from Operations. First, during the excess return period, we calculate free cash flow to the firm. This is the difference between operating cash inflows and cash outflows. The free cash flows are then discounted. The discount factors are a function of the firm s WACC and the timing of the expected cash flows. Corporate Residual Value. Second, we find the corporation s residual value. This is the value calculated by taking the company s NOPAT at the end of the excess return period, dividing it by the company s WACC, and discounting it (also at the WACC) to today s value. At the end of the excess return period, we assume that the corporation is just receiving a return on investment equal to its WACC. Therefore, the net
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