Now we have to do something much more complex. That means we have to explore all the items related to the DCF methodology. That means to discover all the elements that quantify the formula we use to calculate the equity value. If you remember the formula, we have to start with the sum of cash flows where cash flows are taken by the business plan of the company. That means if you use three, four, five years we have to calculate three, four or five years of cash flow. What is the concept of cash flow? Cash flow is the difference between EBIT minus income taxes, plus the appreciation, minus increasing net working capital, minus capital expenditure that is sometimes named CapEx. This is the what we use to calculate cash flow, year by year. After cash flow we have to focus on the concept of WACC. WACC is the weighted average cost of capital, where the idea is to calculate what is the cost of the liabilities of the company. The formula of the WACC is relatively simple because WACC is equal to the net cost of debt multiplied by debt, divided by debt loss equity, plus the cost of equity, multiplied by equity divided by equity plus debt. That's the idea. where the concept is to calculate the cost of the debt, the cost of the equity, and we have to calculate what is the weighted average. Now the problem we have to face is to calculate both the cost of debt and the cost of equity, which is a bit more difficult. The concept of net cost of debt, is relatively easy, because the net cost of debt is equal to the cost of debt multiplied by one minus t, where t is the corporate tax. Why do we have to multiply the cost of debt by the difference between one minus that tax ratio rate? This is related to the fact, in all countries, corporates have an advantage in collecting debt because they pay a lower level of taxation. This effect is named tax shield. To calculate the cost of debt, typically we take numbers for the balance sheet of the company and we divide the amount of interest expenses by the amount of debt of the company. We can also be a bit more sophisticated calculating that liability per liability with these, the cost of every liability. But it's related to the fact that in a certain balance sheet, we do not have a huge number of liabilities, otherwise we calculate as I mentioned before, the net cost of debt. The concept of cost of equity is much more complicated than the cost of debts, because equity doesn't pay interest expenses. It is impossible to calculate the cost of equity using the balance sheet as we did for the cost of debt. For this reason we need a theory and the theory is named CAPM model. Where the idea is that the cost of equity is equal to the risk free rate plus beta, multiplied by the risk premium, minus the risk free again. And now we have to explain all the items. What is the risk-free? Risk-free is the interest rate that an investor can receive investing the money into an asset without any risk. And honestly today it's very hard to find an investment without any risk. And the best practices all around the world is to use the interest rate paid by triple A bonds. The idea for example if investing in Germany, is to use what is the interest rate of the Bund. Or if investing in United States the idea is to take the interest rate that investors receive investing their money into US Treasury Bonds. This is the idea to calculate the risk-free rate. What is the risk premium? Risk premium is the average return investors receive investing in a certain stock exchange. That means if we wanted to calculate the cost of equity on a US company, for the risk premium we have to calculate the average return coming from the investment in the US stock exchange. A bit more complex is the beta parameter. What is beta? Beta is the correlation between the price of a certain stock and the trend of the price of the entire stock exchange. If the correlation is bigger than one, it means that the volatility of our stock is bigger than the volatility of the stock exchange itself. If beta is lower than one, it means the volatility of our stock, of our share, is lower than the volatility of the stock exchange itself. In the case we invest in companies listed in the stock exchange, calculating beta is easier, but we are not investing in the stock exchange, we are investing as private equity and our target, our venture backed company, is not listed in the stock exchange. In this case, is not possible to calculate the beta, and the best practice is to use the betas of other companies, that means of other comparable companies listed in the stock exchange. This concept is honestly easy, and if we exclude some strange cases, it's quite normal to even define comparable companies in the stock exchange. The problem is that, in many cases, comparable companies have a liability structure which is completely different from the liability structure of our company, and this effect could affect the risk of the evaluation itself. For this reason we have to run a process, and the process is name unlever and relever of the beta. First of all we have to unlever the beta, that means to clean the betas of the comparable company from their liability structure. To calculate the beta unlever, we have to divide the betas of comparable companies by one plus one minus T, Where T is the taxation rate, multiplied by debt, divided by equity where debt to equity ratio is the debt to equity ratio of the comparable company. When we have calculated the beta unlever, we have to relever it using the debt-to-equity ratio of our company. To do that the formula is beta unlevered multiplied by one plus, one minus T, where T's again the taxation rate, multiplied by debt, divided by equity, where debt-to-equity ratio is that of our company. This is the entire process we have to use to calculate the cost of equity. To come to an end of the analysis of the enterprise value, we need the concept of terminal value. Terminal value is calculated in the last year of the business plan. That means if the valuation is run in four years, the terminal value is calculated in year four, for example. What is the formula of terminal value? Terminal value is equal to the cash flow calculated in year n, multiplied by one plus g, where g is the growth rate, divided by WACC minus g, all together divided by one plus WACC to the power n. The concept missing is the concept of g, the growth rate. What is growth rate? The idea of growth rate is to insert in the terminal value, what is the expectation of growth, of sales of the company, in the years after the end of the business plan. As you can imagine, it's a very difficult exercise. And for this reason we use best practices. The best practice is to use a g, ranging between zero and one if the expectation of growth is not aggressive. On the contrary, we use a a ranging between one and two when the expectation of growth is very aggressive. To come to the end of the formula of the equity value, we need three last items. Net financial position. Net financial position is the difference between the amount of debt of the company and the amount of cash. Minorities, even if minorities are a bit uncommon in private equity, minorities represent the amount of shares of the company in the end of minority investors, and lost surplus assets. Where surplus assets are assets belonging to the companies, but not relevant to generate operating profit for the company itself.
