In the previous
chapters we discussed various steps to make projections of free cash flow
and weighted average cost of capital (WACC). In this last window (Target price), we discuss further required
steps to calculate the share's target price and its respective growth
(upside) or decline potential.
This chapter is comprised of the topics listed below. Click on the desired topic to move automatically to its corresponding description.
The current year is partially accounted
Factors to be added or subtracted from the present value of the cash flow
The portion of the company that belongs to the shareholders
Projections must be generated again following share issuances
The current year is partially accounted : In calculating the present value of the cash flow projected in the period it is worth noting that the current year is accounted for on a prorata basis taking into consideration the remaining days of the year.
Example: Suppose that today is 20-Aug-05 and therefore 232 days have transpired and 133 days yet remain in the year. In this case the system would take into account the equivalent of 36.4% (=133/365) of the cash flow projected for 2005.
The discount rate would also be accounted for proportionally in the year.
WACCp = (1 + WACCt) ^ (133/365)
were:
WACCp is the cost of capital for the remainder of the year
WACCt is the projected cost of capital for the entire year
Factors to be added or subtracted from the present value of the cash flow : The present value of the cash flow is equivalent to the value of all the underlying assets comprising this cash flow. As the company may hold nonoperating assets, we need to add the respective values of such assets to the present value of the cash flow in order to obtain the target price of the company. Similarly, the company may hold nonoperating liablities which would need to be subtracted from the present value of the cash flow to obtain the target price of the company. The factors are:
- Investment in subsidiaries and others (+)
- Minority interests (-)
- Other adjustments (+)
The values of the first two factors are extracted automatically by the system from the most recent financial statement available. The third factor should be entered by the user should he consider any special adjustments need to be made.
The portion of the company that belongs to the shareholders : To obtain the value of the company that corresponds to the shareholders (fair market cap), we subtract the value of the net debt (=total debt minus cash and short-term investments) from the value of the company. These values are obtained from the company's most recent financial statement.
Finally, in order to determine the target price of the stock we divide the fair market cap by the total number of shares outstanding.
Projections must be made again following share issuances : When a company issues a significant number of new shares (IPO, acquisition of another company, etc.), the increase in the shares outstanding results in an artificial reduction of the target price.
To return to a target price that is again representative the user most re-do the projection of the cash flow so that it properly reflects the increase in operations expected from the share issuance.