Enterprise Discounted Cash Flow Model  181 We use Costco throughout Part Two to demonstrate in greater detail various parts of the valuation process. To value GlobalCo, we forecast three years of cash flow. Cash flows gener- ated beyond year 3 are valued using the key value driver formula and reported as continuing value. Next, discount each year’s projected free cash flow and the continuing value by the company’s weighted average cost of capital.5 Sum the present values of the annual cash flows and discounted continuing value to determine the present value of operations. For simplicity, the first year’s projected cash flow is discounted by one full year, the second by two full years, and so on. For the purpose of clear exposi- tion, we assume cash flows occur in lump sums. In actuality, cash flows occur throughout the year, not as a lump sum. Therefore, adjust the discount rate as necessary to better match the timing of cash flows.6 The resulting present value is known as the value of operations, which equals $1 billion for Glo- balCo. To the value of operations, add nonoperating assets, such as excess cash and noncontrolling interests in other companies. Since GlobalCo has no non- operating assets, the value of operations equals enterprise value. To determine equity value, subtract the value of debt and other nonequity claims. GlobalCo has $110 million in short-term debt and $140 million in long-term debt, for a total debt of $250 million. The company has no unfunded pension obligations or noncontrolling interests held by other companies, but if it did, their value would be subtracted as well.7 Divide the resulting equity value of $750 mil- lion by the number of shares outstanding (12.5 million) to estimate a per-share intrinsic value of $60. Over the course of the next few sections, we dig deeper into the inputs and the valuation process. Although this chapter presents the enterprise DCF valuation sequentially, valuation is an iterative process. Valuing Operations The value of operations equals the discounted value of future free cash flow. Free cash flow equals the cash flow generated by the company’s operations, less any reinvestment back into the business. As defined at the beginning of this section, free cash flow is the cash flow available to all investors—equity holders, debt holders, and any other investors—so it is independent of how 5 To generate identical results across valuation methods, we have not adjusted figures to eliminate round- ing errors. Rounding errors occur in most exhibits. 6 If cash flow occurs smoothly throughout the year, lower each discount factor by half a year. If cash flow is heavily weighted toward the year end, as in retail, a smaller adjustment to the discount factor is required. For more on this issue and how to value a company in between fiscal years, see Chapter 16. 7 A noncontrolling interest arises when an outside investor owns a minority share of a subsidiary. Since this outside investor has a claim on cash flows, the claim’s value must be deducted from enterprise value to compute equity value. 182  Frameworks for Valuation EXHIBIT 10.5  GlobalCo: Income and Shareholders’ Equity Statements $ million Forecast Historical Year 1 Year 2 Year 3 Continuing value Revenue 200.0 250.0 287.5 301.9 308.5 Operating costs (120.0) (150.0) (172.5) (181.1) (185.1) Depreciation (20.0) (25.0) (28.8) (30.2) (30.9) Operating profit 60.0 75.0 86.3 90.6 92.6 Interest expense (9.0) (10.0) (10.8) (11.4) (11.8) Earnings before taxes 51.0 65.0 75.5 79.1 80.8   Income taxes (10.2) (13.0) (15.1) (15.8) (16.2) Net income 40.8 52.0 60.4 63.3 64.6 Statement of shareholders’ equity Equity, beginning of year 65.0 98.0 140.0 171.1 Net income 40.8 52.0 60.4 63.3 Dividends (7.8) (10.0) (14.3) (24.1) Share issuances (repurchases) – – (15.0) (30.0) Equity, end of year 98.0 140.0 171.1 180.3 the company is financed. Consistent with this definition, free cash flow must be discounted using the weighted average cost of capital, because the WACC represents rates of return required by the company’s debt and equity holders blended together. It is the company’s opportunity cost of funds. Reorganizing the Financial Statements  To begin the valuation process, collect the company’s historical financial statements. In Exhibit 10.5, we present the in- come statement and statement of shareholders’ equity for GlobalCo. Exhibit 10.6 presents the company’s balance sheet. For ease of exposition, we present only one historical year of financial statements. In practice, collect multiple years in order to better assess the long-run performance and future potential of the company. Although ROIC and free cash flow (FCF) are central to the valuation pro- cess, the two measures cannot be computed easily from a company’s financial statements, which commingle operating performance and capital structure. Therefore, to calculate ROIC and FCF, first reorganize the accounting financial statements into new statements that clearly separate operating items, nonop- erating items, and sources of financing. This reorganization leads to two new terms: invested capital and net operating profit after taxes (NOPAT). Invested capital represents the investor capital required to fund operations, without distinguishing how the capital is financed. NOPAT rep- resents the total after-tax operating income generated by the company’s invested capital, available to all investors. We briefly summarize the reorganization process next, but for a more detailed discussion using Costco, see Chapter 11.