Valuation is one of primary concerns in mergers and acquisitions. Unfortunately, valuation is not easy to conduct especially in foreign countries not only because accounting principles and tax systems may be different from acquirer but also because business environment including trends in business, inflation, regulations and so on may not be hardly fully understood by acquirer outside Japan.
This approach calculates the present value of projected cash flows using an estimated cost of capital as discount factor. While most companies have infinite lives, in reality valuing such a stream should be impossible. Therefore, typical forecast period is around five years, depending on type of business.
The present value of discounted cash flows will be the business enterprise value. In order to gain enterprize value, the value of non-core assets which will not be in use to generate projected cash flows is added to the value of business enterprize value. Then the enterprize value less debt provides the value of stock.
Business Enterprise Value
Free Cash Flow
Weighted Average Cost of Capital
|※Assuming that cash flows occur at the end of each fiscal years|
Typically, the terminal value after certain projected periods is calculated as the present value at a future point in time of all future cash flows using stable growth rate.
The weighted average cost of capital, known as WACC, is the rate that a company is expected to earn on average, using interest bearing debt and capital invested from shareholders.
In other words, the WACC is the minimum return that an entity have to earn on an existing asset base to satisfy its creditors, shareholders, and other providers of capital.