2.1.4 be created regarding the company’s long-term

2.1.4 Continuing Value

Considering that it is
impossible to forecast a company’s free cash flow forever, a CV formula that captures
the company’s value after the explicit forecast period is used (Rosenbaum and
Pearl, 2013). A careful estimate of CV is fundamental for any valuation because
it generally accounts for a large percentage of a company’s total value. 

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Damodaran (2012)
suggests two methods to calculate CV: through an estimation of liquidation
value or a going concern approach. The first assumes the company will cease
operations at a specific point in the future and sell its accumulated assets.
Nonetheless, it is more frequent to assume that the company will operate
forever, which is the case of the going concern approach. As such, an
assumption must be created regarding the company’s long-term sustainable growth
rate. Koller et al. (2015) suggest that the best estimate is “the expected
long-term rate of consumption growth for the industry’s products, plus
inflation”. Rosenbaum and Pearl (2013) and Damodaran (2012) suggest the
projected nominal GDP growth for the geography the company operates in. Koller
et al. (2015) suggest the key value driver formula:






in the first year after the explicit forecast period

            g = long-run growth in NOPLAT

            RONIC = expected rate of return on new invested capital


authors defend that this formula is “superior to alternative methodologies
because it is based on cash flows and links them directly to growth and ROIC”. The
authors also note that the company’s terminal year financial data represents a
steady-state level with stable revenue growth and operating margins since
perpetuity-based formulas rely on parameters that never change.

Damodaran (2012) and Rosenbaum and Pearl (2013) bring up the idea of a multiple
approach. This multiple is often based on current trading multiples for
comparable firms. However, this approach disregards the fact that this multiple
will change over the years (Koller et al., 2015). One is implicitly assuming
that the future multiple will be worth the same as today’s multiple,
overlooking changes in growth and return prospects. Damodaran (2012) even
states that using multiples to estimate CV “results in a dangerous mix of
relative and DCF valuation”.


2.1.5 Cost of Capital

To value a company using
enterprise-DCF, FCFF must be discounted at the WACC. The WACC represents the
returns that all investors in a firm, equity holders and debt holders, expect
to earn for investing their capital in a specific business as an alternative of
others with identical risk (Koller et al., 2015):





where D
= market value of debt

E = market value of

pretax cost of debt

cost of equity

marginal income tax rate


Hereupon, capital
structure enters valuation through the WACC since FCFF should be independent of
capital structure and nonoperating items. By removing the interest tax shield
from FCFF, an accurate picture of historical performance is obtained by solely
focusing on operations (Koller et al., 2015). The after-tax cost of debt is used to include the tax shield in
the WACC. Analysts refer to this as the tax deductibility of debt provided that
it reduces the amount of taxes paid, therefore impacting the cost of debt and
decreasing it by the value of the marginal tax rate. Cost of Equity

The cost of equity is
defined as “the rate of return investors require on an equity investment in a
firm” (Damodaran, 2012). In this dissertation, the capital asset pricing model
(CAPM) is used to estimate ATVI’s cost of equity.

The CAPM is simple and
widely accepted in the financial industry to compute a company’s cost equity (Brealey
et al., 2017 and Copeland et al., 2014). The cost of equity is determined by
“estimating the expect return on the market portfolio, adjusted for the risk of
the company being valued” (Koller et al., 2015). Company-specific risk is
adjusted through the use of beta, which is a measure of how the company’s share
price moves in conjunction with the overall market. The remaining risk, known
as idiosyncratic risk, can be diversified away by holding several securities.

 The CAPM postulates that the sum of the
risk-free rate (

) and the security’s beta (

) times the market risk premium

 equals the expected return on that security






Note that the expected return is
replaceable with the cost of equity since a firm’s investors will earn the cost
of equity if the firm meets expectations.
Risk-free Rate

an investment to be considered risk-free, two requirements must be fulfilled:
the inexistence of default and reinvestment risk (Damodaran, 1999). Fernández
(2004) denotes the importance of matching the maturity of a risk-free security
to each year’s cash flow in the explicit forecast period. However, since using multiple
rates can be troublesome, Koller et al. (2015) suggest the use of a single
yield to maturity (YTM) that best corresponds to the stream of cash flows being
valued. In practical terms, 10-year government bonds yields for U.S.-based firm
valuations are suggested.
Market Risk Premium

The reasoning behind the market risk premium
(MRP) is simple: investors require a compensation for bearing risk. Since
stocks are riskier than treasury bonds, they should compensate investors with
higher returns (Siegel and Thaler, 1997). Nonetheless, there is no general
agreement within the literature about the estimation of the MRP. Koller et al.
(2015) indicate that most practitioners use the historical MRP or a market
implied cost of equity. The first uses historical excess returns on the market
the company operates. The authors recommend adding today’s long-term government
bond rate to the historical average of past returns, since past returns are
heavily affected by the inflation rate prevalent during that period, to reach a
better estimate of MRP. The second approach computes the implied cost of equity
derived from the relationship between current stock prices and aggregate
fundamental performance of a large sample of companies. The authors advocate
that this method is reliable because it embodies up-to-date market prices. The
fundamental formula is derived from Formula 9, such that:





where Earnings = equity earnings

            g = expected growth in
real gross domestic product (GDP)

            ROE = expected return
on equity


 = cost of equity


Solving the equation for

, gives
the cost of equity. Subtracting the risk-free rate yields the MRP.

Additionally, Damodaran (2017) suggests that
companies with multinational operations are exposed to country risk, thus
making country risk an essential constituent in their valuation. The MRP is
then calculated as the sum of a mature market equity risk premium and an
additional country risk premium based upon the risk of the country in question.

Concluding, although there is no consensus in
estimating the MRP, the evidence suggests its value ranges around 5% (Koller et
al., 2015).

measures the tendency of a security’s returns to swings in the market. In order
to estimate the future beta of a company, Koller et al. (2015) suggest the use
of an industry peer median beta instead of relying on individual company’s
betas, since these can be largely influenced by nonrepeatable events. Firms in
the same industry confront the same business risks, so their betas should be
resembling. As a first step, the authors advise the use of the market model to
estimate the “raw” beta for each company in the peer group:





this model, the stock’s return (

) is regressed against the return on the
market portfolio (

). In practical terms, the market
portfolio should be a “value-weighted, well-diversified market portfolio” such
as the S&P 500 index. The use of at least five years of monthly returns is
also advised to reduce systemic biases. After gathering the “raw” betas for the
peer group, each company’s beta should be unlevered because beta is a function
of financial and operational risk. Therefore, to better compare the operational
risk across companies, the effect of leverage must be removed from their betas.
The following formula is used:





levered beta


unlevered beta

            D = market value of debt

            E = market value of equity


a median of the unlevered betas should be computed to ultimately relever the
industry beta to the company’s target capital structure using Formula 14.

a last note, some practitioners “smooth” the calculated betas towards the
overall average of all companies. Blume (1975) showed evidence of the fact that
betas are mean-reverting. Therefore, the following adjustment is proposed:


Fama-French three-factor Model

Fama and French (1992)
assert that stock’s returns are negatively correlated with the size of a
company (measured by market capitalization) and positively correlated with the
ratio of a firm’s book value to its market value of equity. The authors suggest
that stock’s excess returns

be explained by the excess market returns

, the difference between the returns of a
portfolio containing small stocks and another containing large stocks (SMB) and
the difference between the returns of a portfolio composed by high
book-to-market stocks and another by low book-to-market stocks (HML). The
following equation describes the model:






coefficient related to market excess return


coefficient related to size


coefficient related to value


Koller et al. (2015) advert that to best implement the CAPM, an industry beta
is used since “regression results are imprecise”. Since the Fama-French model
has three coefficients and that they are dependent on each other, the industry
beta cannot be generated in a clear way. Cost of Debt

The cost of debt
represents the marginal cost to the firm of issuing new debt. Koller et al.
(2015) present two approaches to estimate this value. The first states that if
the company has investment-grade debt, the YTM on “liquid, option-free,
long-term debt” should serve as a reasonable proxy for the cost of debt. The
second approach relates to credit ratings. For companies whose debt rarely
trades, or for nontraded debt, the YTM on a portfolio of long-term bonds with
the same credit rating as the company’s unsecured long-term debt should be used
as an approximation for the implied YTM on long-term debt. 


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