Lecturer: 2012

VALUATION MODELS

VALUATION MODELS

Lecturer:

Lecturers name 2012

A. Discounted Dividend Valuation

Lecturer:

Lecturers name 2012

A. Discounted Dividend Valuation Discounted Cash Flow Valuation

An assets intrinsic value is the present value of its expected future cash flows

Very important concept!

5

A. Discounted Dividend Valuation Various Measures of Cash Flow in Valuation

Measures of cash flow
o Dividends = cash paid to shareholders, used in DDM o Free cash flow = cash available to pay shareholders, broader

scope
o Residual income = economic profit

Key point: Valuation metric (e.g., divs or FCF) must be

measurable and related to earnings power

A. Discounted Dividend Valuation Dividends

Advantages
o Less volatile than other cash flow measures o Theoretically justified dividends are what you receive when

you buy a stock

o Accounts for reinvested earnings to provide a basis for increased future dividends

A. Discounted Dividend Valuation Dividends

Disadvantages
o Non dividends paying firms o Dividends artificially small for tax reasons

o Dividends may not reflect the control perspective desired by the

investor

A. Discounted Dividend Valuation Dividends Suitability

Situations when appropriate
o Company has history of paying dividends o Board of directors has a dividend policy that has an

understandable and consistent relationship to profitability

o Minority shareholder takes a non-control perspective o Mature firms, profitable but not fast growth

A. Discounted Dividend Valuation Free Cash Flow (FCF)

FCF represents cash flow distributable to the providers of capital
o Free Cash Flow to the Firm (FCFF): Cash flow distributable to all providers of capital (i.e., debt and equity) o Free cash flow to equity (FCFE): Cash flow distributable to equity holders

Much more on this topic in Study Session 12

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A. Discounted Dividend Valuation Residual Income (RI)

Residual income: Earnings in excess of the investors required return on the beginning-of-period investment
o RI focuses on profitability in relation to all opportunity costs faced by the firm o Think: Economic profit.

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A. Discounted Dividend Valuation DDM: How To

Process: Discount the future dividends at the required rate of return:
o Step 1: Estimate future dividends o Step 2: Determine required return o Step 3: Value = PV (expected dividends)

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A. Discounted Dividend Valuation Dividend Discount Models

The Rule: Value is present value of all future dividends discounted at required return That is
The basic model

Problem: requires estimation of infinite stream of CFs

13

A. Discounted Dividend Valuation Single Period DDM

Single-period DDM is the present value of the future dividend and sales price

Notice that there are two cash flows in the final period!

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A. Discounted Dividend Valuation Single Period DDM

Example: Is WTC over- or under-valued?
o Current market price = $60 o Expected year-end dividend = $2

o Expected year-end stock price = $64

o Required return = 8%

15

A. Discounted Dividend Valuation Single Period DDM

undervalued!
Current market price $60 < intrinsic value $61.11, therefore a

buy decision

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A. Discounted Dividend Valuation Single Period DDM

Two period DDM: Extends single period model

oValue = PV two years of cash flows and the future sales price

Notice that in the final year, two cash flows occur

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A. Discounted Dividend Valuation Two-Period DDM

Example: Holzgraf Company shares sell for $50 today. Is Holzgraf over- or under-vaued?

oExpect Year 1 dividend = $1.25

oExpected Year 2 dividend = $1.50

oExpected price at the end of Year 2 = $65 oRequired return = 13%

18

A. Discounted Dividend Valuation Two-Period DDM

=
Current Price = $50; thus undervalued
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A. Discounted Dividend Valuation Multiple-Period DDM

Again the model takes the present value of all future cash flows

Note: If you can do 1 and 2 periods, you can do n periods!

20

A. Discounted Dividend Valuation Dividend Discount Models

Simplifying assumptions for future growth
1. Constant growth (Gordon model) 2. Two-stage growth 3. H-model

Know also 4. Other assumption (e.g., N-stage, spreadsheet)

Very important!

Nah

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A. Discounted Dividend Valuation Gordon Growth Model

where:
D = dividend g = sustainable growth rate

r = required return on equity

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A. Discounted Dividend Valuation DDM Constant Growth (Gordon)

Assumptions:
1. Dividend (D1) expected in one year
2. Dividends grow at constant rate (g) forever 3. Growth rate less than required return (r > g)

Situations in which model is useful:

1. Mature (late in life cycle )firms 2. Broad-based equity index 3. Terminal value in more complex models 4. International valuation 5. Can be used to calculate P/E ratio

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A. Discounted Dividend Valuation DDM Constant Growth (Gordon) - Example

Doug Inc.,: o Paid a dividend yesterday of $1.50 o Dividends are expected to grow at a long-term constant rate of 5% o Required return is 10% Calculate the intrinsic value

24

A. Discounted Dividend Valuation Gordon Growth Model Example

Correct answer Vo = ($1.50 x 1.05) / (0.10 0.05) = $31.50

Incorrect answer Vo = ($1.50) / (0.10 0.05) = $30.00

The numerator was not increased by 5%

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A. Discounted Dividend Valuation DDM: Implied Growth Rate Example

Assume: o Firm just paid $1.20 dividend per share o Required return is 13% o Market price is %15.75 Implied dividend growth rate is:

Requires some algebra!

=> g = 0.05 = 5.0%

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A. Discounted Dividend Valuation PV of Growth Opportunities

Equity value has two components: 1. Value of no growth firm (E1/ r) (i.e., assets/earnings currently in place) 2. Present value of future growth opportunities (PVGO)

Model :

Po = E1/ r + PVGO
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A. Discounted Dividend Valuation PV of Growth Opportunities

Example: ABV Inc., shares sell for $80. Next years expected EPS = $4.00. If the required return is 20%, compute the PVGO:

$80 = $4.00 0.20

+ PVGO

PVGO = $80 - $20 = $60

Point: Market assigns 75% of the price ($60/$80) to future growth

expensive

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A. Discounted Dividend Valuation PVGO Model Using Leading P/E1

Point: Morph PVGO model into a leading Po /E1 model o Just divide thru by E1

Po /E1 = 1/r + PVGO/ E1

Intuition: o 1/r = P/E1 ratio for a no growth company o PVGO/ E1 = P/E1 component related to growth

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A. Discounted Dividend Valuation Gordon and Justified P/Es

Point: The GGM can also be used to calculate a justified price multiple As shown in SS#12, rearrange GGM yields

Justified leading

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A. Discounted Dividend Valuation

Valuation of Non-Callable, Fixed Rate, Perpetual, Preferred Stock
Point: Perpetual cash flows can be valued Level 1 TVM topic: o Preferred stock value of a perpetuity
o No growth assets Formula: Po = Annual CF / Capitalization rate Example: o Annual Dividend = $12 o r = 10% Value = $12/0.10 = $120

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A. Discounted Dividend Valuation DDM: Constant Growth (Gordon)

Strengths: Use for mature, stable, dividend paying firms Used with broad market indexes Estimate g, r, and PVGO

Supplement to more complex models

Weaknesses: Value (Vo) very sensitive to estimates of r and g Difficult to use with non-dividend-paying stocks Model Selection: Minority perspective only Not useful for valuing M&A

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A. Discounted Dividend Valuation

Multi-Stage DDM Models

GGM assumption: Stable dividend growth rate forever

o Problem: Unrealistic for most firms

Solutions include: o Two-Stage

o H-Model, Three-Stage
o Spreadsheet modeling Growth can be expressed in three distinct phases

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A. Discounted Dividend Valuation

Phases of Growth
1. Initial growth phase use 3-stage model

o
o

Rapid EPS growth, negative FCF

ROE > r, no or low dividend payout

2. Transitional phase use 2-stage/H model

o
o

Sales and EPS growth slow, div increase

ROE approaching r, positive FCF

3. Mature phase use GGM

o
o

Growth at economy-wide rate, positive FCF

ROE = r, high competition, saturation

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A. Discounted Dividend Valuation

Terminal Value
o Terminal value = forecasted value at beginning of the final mature growth phase Also known as the future sales price Two estimation methods:

1. Applying trailing multiple (P/E) x forecasted EPSt in year t

2. Gordon Growth Model Dn / (r g)

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A. Discounted Dividend Valuation

Two-Stage DDM
Assume stages of growth: o First: Fixed period of supernormal growth o Then: Identify growth at normal level

o o

Useful in cases when growth rate expected to drop suddenly

Patent expiration Firm enters mature phase of life cycle after a rapid growth stage

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A. Discounted Dividend Valuation

Two-Stage DDM
Problem: GGM constant g assumption unrealistic Solution: Assume rapid growth for n years, then long-term sustainable growth 2-stage assumes a drop-off in growth

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A. Discounted Dividend Valuation

Application: The Two-Stage Model

Two stages of growth: 1. Initial high-growth phase 2. Perpetual stable-growth phase

Two approaches
1. Formula 2. Timeline

Suggestion: Use the timeline (or spreadsheet approach) it provides the flexibility to solve many types of problems
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A. Discounted Dividend Valuation

Application: The Two-Stage Model

Methodology: 1. Individual estimation of supernormal dividends, followed by 2. Calculation of a terminal value

Note: Very important concept

Vo = PV(dividends over 1st n year) + PV(terminal value)

From Gordon growth model or price multiple approach

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A. Discounted Dividend Valuation

Example: The Two-Stage Model

Time-line example o Dividends of $2.50 and $4.00 at the end of each of the next two years o Stage 2 constant growth = 4% o Required return = 12% Calculate the value today

40

A. Discounted Dividend Valuation

Solution: The Two-Stage Model

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A. Discounted Dividend Valuation The H-Model

Assumes a gradual decay in g as firm matures over a transition period

42

A. Discounted Dividend Valuation The H-Model

Problem: 2-stage model assumes high growth rate will suddenly drop The H-model: More realistic assumption o Firm will start with high growth rate o Growth declines linearly over a transition period T = 2H years Note: Only an approximation method; more accurate the shorter

the declining growth period

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A. Discounted Dividend Valuation The H-Model Formula

Most recent dividend
H = Transition Period/2 Short-term high growth rate

Required return

Long-term low growth rate

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A. Discounted Dividend Valuation Example: H-Model

Example BTeam Inc.,:
o Currently pays a dividend of $1.30 o Stage 1 growth rate is 25%

o Growth is expected to decay over five years

o Constant growth rate of 5% thereafter o Required return is 14%

Calculate the intrinsic value of BTeam stock using the H-Model

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A. Discounted Dividend Valuation Solution: H-Model (just memorized the formula)

= $22.39

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A. Discounted Dividend Valuation DDM: Multi-Stage Models

Three-stage model: Two approaches
1. Three distinct phases, simply add an additional growth stage to the 2-stage model

Growth, transition, and mature

2. High-growth phase + H-model pattern High followed by linearly declining followed by perpetual growth

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A. Discounted Dividend Valuation Example: Three-stage with H-model

Netweb Inc. o Current growth rate of 25% o Supernormal rate expected to last three years o After three years, growth decays linearly to a sustainable 3% over the following seven years o Last dividend was $0.30

o Required return is 10%

Calculate the value of Netwebs shares today
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A. Discounted Dividend Valuation Solution: Three-Stage With H-Model D1 = $0.30 x 1.251 = $0.375 D2 = $0.30 x 1.252 = $0.469 D3 = $0.30 x 1.253 = $0.586

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A. Discounted Dividend Valuation Solution: Three-Stage With H-Model

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A. Discounted Dividend Valuation

Evaluation
If the current market price of the stock is $15.00, determine if the stock is fairly valued/overvalued or overvalued by the market?

Since the market price ($15.00) exceeds the model price

($12.48), the stock is overvalued by the market

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A. Discounted Dividend Valuation

The Multi-Period Models

Strengths
o Ability to model many growth patterns
o Solve for V, g, and r

Weaknesses
Required high-quality inputs (GIGO) Value estimates sensitive to g and r

Model suitable very important

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A. Discounted Dividend Valuation

GGM and Required Return: r

Point: DDM can be used to find implied r o Drive model in reserve Solving GGM for r

Example: If expected dividends are $1.60 and the current price is $40 with expected growth of 9%

Then: Required return should be 13%

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A. Discounted Dividend Valuation

H-Model and Required Return: r

Point: Given market price, drive H-model in reserve to get required return o Dont fret o Example: Using our BTeam, Inc., data and a current market price of $30, we get:

= 11.7%
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A. Discounted Dividend Valuation

SGR: The Sustainable Growth Rate

SGR (g) = sustainable growth rate in earnings and dividends if we assume: o Growth uses internally generated equity o Capital structure remains unchanged o Several key ratios held constant Formula: g = retention rate (rr) x NI/SE g = rr x ROE

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A. Discounted Dividend Valuation

Calculate SGR
Example: Compute SGR for Green, Inc.,: o Payout ratio = 25% o EPS = $1.00 o BVPS is $10.00 o ROE of 10% SGR = Retention rate (rr) x (ROE) SGR = (1 DIV/EPS) x Net Inc/Equity SGR = (1 0.25) x 10% = 7.5%

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A. Discounted Dividend Valuation

SGR: The Sustainable Growth Rate

Three-Part DuPont ROE Decomposition:

Note: Always use beginning of year balance sheet numbers on exam (unless told otherwise) Point: SGR = retention x ROE o SGR = retention x NPM x Asset T/O x EQ mult

57

A. Discounted Dividend Valuation

SGR Value Drivers and Their Impact

1. Net income/Sales measures profitability, higher margins result in a higher ROE 2. Sales/total assets measures operational efficiency, higher

turns result in higher ROE

3. Assets/equity measures financial leverage via the equity multiplier based on the firms financing policies, higher leverage

higher ROE

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A. Discounted Dividend Valuation

Problem : DuPont and SGR

Revenues Net income Dividends Total assets SHs equity 2007 $12,000 $960 $280 $13,475 $6,100 2008 $13,100 $1,389 $300 $15,370 $7,189

Calculate sustainable growth rate for 2008

Calculate 3-component DuPont formula for 2008

Use beginning of period balance sheet values

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Discounted Dividend Valuation

Solution : DuPont and SGR

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Discounted Dividend Valuation

Solution : DuPont and SGR

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A. Discounted Dividend Valuation Spreadsheet Modeling

Allows more flexibility in forecasting cash flows Steps: o Establish base level cash flows o Forecast deviations for near future (e.g. supernormal growth for first four years) o Project normal growth beyond near future

o Discount all cash flows to PV

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KEYS TO THE EXAM Dividend Discount Models

Big reading this will be on the exam! Five competitive forces Calculating value with single-stage, constant growth, 2-stage DDM, and H-models Justify model selection; identify strengths and weaknesses Solve for growth and required return with GGM

Be able to calculate ROE and g

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 Solution: DuPont and SGR

rr = (1,389 300) / (1,389) = 0.784

ROE = 1,389 / 6,100 = 0.2277

SGR = 0.784 x 0.2277 = 17.85%

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 Solution: DuPont and SGR

NPM = 1,389 / 13,100 = 0.1060 TAT = 13,100 / 13,475 = 0.9722

LR = 13,475 / 6,100 = 2.2090

ROE = 0.1060 x 0.9722 x 2.2090 = 22.77%

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B. Free Cash Flow Valuation Introduction to Free Cash Flow

Dividends are the cash flows actually paid to stockholders Free cash flow is the cash flow available for distribution after fulfilling all obligations (operating expenses and taxes) and without impacting on the future growth plans of the company (working capital and fixed capital) Extends the DCF approach with a more comprehensive basis

for the valuation than dividends

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B. Free Cash Flow Valuation FCF Defined

FCFF (Free Cash Flow to the Firm)
o Cash available to shareholders and bondholders after taxes, capital investment, and WC investment ; pre-levered cash flow

FCFE (Free Cash Flow to Equity)

o Cash available to equity holders after payments to and inflows from bondholders; post-leverage cash flow o Not equal to dividends actually paid

67

B. Free Cash Flow Valuation Interpret FCF Strengths

Strengths o Used with firms that have no dividends o Functional model for assessing alternative financing policies o Rich framework provides additional detailed insights into company o Other measures EBIT, EBITDA, and CFO either double count

or omit important cash flows

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B. Free Cash Flow Valuation Interpret FCF Limitations

Limitations o If FCF < 0 due to large capital demands o Required detailed understanding of accounting and FSA o Information not readily available or published

69

B. Free Cash Flow Valuation FCFF vs. FCFE

Firm value = FCFF discounted at WACC Equity value = FCFE discounted at required return on equity r o Use FCFE when capital structure is stable o Use FCFF when high or changing debt levels, negative FCFE Equity value = firm value MV of debt

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B. Free Cash Flow Valuation Ownership Perspective

FCFE = control perspective o Ability to change dividend policy o Used in control perspective DDM = minority owner o No control o Used in valuing minority position in publicly traded shares

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B. Free Cash Flow Valuation Problem: Equity Value

Which of the following is the least accurate statement regarding valuation? a. Equity value equals firm value minus the market value of debt b. Equity value should be calculated using the weighted average cost of capital (WACC) as the discount rate

c. Free cash flow to equity can be used to calculate equity

value when a control perspective is appropriate

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B. Free Cash Flow Valuation FCF Formula References

NI = Net income to common shr/holders, after preferred div

but before common dividends

NCC = non-cash charges, depreciation, and amortization Int(1 t) = after tax interest expense FCInv = net fixed capital investment (proceeds from sales less Cap Ex)

WCInv = working capital investment

Net borrowings = new debt - repayments

73

B. Free Cash Flow Valuation Calculating FCF

Statement of Cash Flows Net income (NI) + Non-cash charges (NCC) - WCInv Cash flow operations (CFO) FCFE/FCFF Net income (NI) + Non-cash charges (NCC) - WCInv Cash flow operations (CFO) + Int(1 tax rate) - FCInv Free cash flows to firm (FCFF)

- FCInv

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B. Free Cash Flow Valuation Calculating FCF

Statement of Cash Flows FCFE/FCFF Free cash flow to firm (FCFF) + Net borrowing + Int(1 tax rate) Free cash flow to equity (FCFE) - Dividends +/- Stock issues/purch Net change in cash
75

+ Net borrowing

- Dividends +/- Stock issues/repurch Net change in cash

B. Free Cash Flow Valuation Non-Cash Charges (NCC)

Applies to both FCFE and FCFF Represent adjustments for non-cash decreases and increases in net income based on accrual accounting, but did not result in an outflow of cash o If non-cash charges decrease net income, add back to net income

o If non-cash charges increase net income, subtract from the

net income

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B. Free Cash Flow Valuation Non-Cash Charges

Adjustment to Net Income to Arrive at FCF Add
Subtract Add Add/(Subtract)

Non-Cash Items Depreciation & amort. Gain on asset sale Loss on asset sale Restructuring exp./(inc.)

Location I/S or CFO I/S I/S I/S

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B. Free Cash Flow Valuation Non-Cash Charges

Adjustment to Net Non-Cash Items Inc to Arrive at FCF Location Deferred tax Add if they are not CFO and liability expected to reserve in B/S future (FSA material)
Amortization Add discounts bond discounts & Subtract premiums premiums CFO

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B. Free Cash Flow Valuation Investment in Working Capital

Applies to both FCFE and FCFF Net investment in working capital for the purpose of calculating FCF excludes o Changes in cash/cash equivalents o Notes payable o Current portion of L.T. debt

The exclusions are considered financing activities, not operating

items, and therefore not included in WCInv

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B. Free Cash Flow Valuation Working Capital Adjustments

There is a inverse relationship between changes in assets and changes in cash flow An increase in an asset account is a use (negative/subtraction) of cash A decrease in an asset account is a source (addition/plus) of a cash

80

B. Free Cash Flow Valuation Working Capital Adjustments

There is a direct relationship between changes in liabilities and changes in cash flow An increase in a liability account is a source (addition/plus) of cash A decrease in a liability account is a use (negative/subtraction) of cash

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B. Free Cash Flow Valuation WCInv Adjustments

Increase in WCInv Decrease in WCInv

Decrease FCF
Increase in assets or decrease in liabilities Inventory Accounts receivable

Increase FCF
Decrease in assets or increase in liabilities Inventory Accounts receivable

Accounts payable Accrued taxes & expenses

Accounts payable
Accrued taxes & expenses
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B. Free Cash Flow Valuation Working Capital Adjustments

Account Inventory A/R 2009 50 25 2008 40 30 Change 10 (5) Source/use Use/Subtract WCInv = -10 Source/Add WCInv = + 5 Source/Add WCInv = +20 Use/Subtract WCInv = -15

A/P
Acc Exp

30
5

10
20

20
(15)

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B. Free Cash Flow Valuation

Net FCInv Adjustments
Investment in a fixed capital (FCInv) represent a cash out flow

necessary to support the companys current and future operations

Viewed as a capital expenditure (Cap Ex) that reduces both FCFE and FCFF Expenditures can include acquisition of intangible items such as trademarks Care should be used with non-recurring large acquisitions in forecasts

84

B. Free Cash Flow Valuation Net FCInv Adjustments

Asset Purchases and Sales o If given gross PP&E on the balance sheet, identify the additions (cap ex) by taking the year over year change in gross PP&E, only if there were no disposals during the period, to identify the capital expenditures for the period

85

B. Free Cash Flow Valuation Net FCInv Adjustments

Asset Purchases and Sales If given net PP&E, use the equation: Beginning net PP&E

- Depreciation
+ Assets purchased (solve) - Book value of assets sold Ending net PP&E

86

B. Free Cash Flow Valuation Net FCInv Adjustments

If a company receives cash in disposing/selling of a fixed asset, the analyst must deduct this cash in arriving at the net investment in PP&E (FCInv) o Gain/loss on asset sale = proceeds from sale book value of asset o Subtract gains on sales from FCF

o Add losses on sales to FCF

o Deduct the proceeds from sale in arriving at the net FCInv

87

B. Free Cash Flow Valuation Problem: FCInv

The income statement of Tykes Toys shows a $5M profit on disposal of fixed assets. Balance sheet data on disposed assets are shown below. Capital spending on new fixed assets during the year was $37M. Tykes investment in fixed capital (FCInv) is closest to what value?

a. 22 b. 37 c. 77

Balance Sheet ($M) Original Cost $40 Accum Depr. (30) Net Book Value $10
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B. Free Cash Flow Valuation Solution: FCInv

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B. Free Cash Flow Valuation Net Borrowing Adjustments

Net Borrowings only affect FCFE, they do not affect FCFF 1. Long-Term Debt (Three Stooges) o o Add debt issuances to net income to arrive at FCFE Subtract debt repurchases from net income to arrive at FCFE o Net Borrowings = + new debt issuances debt

repurchases

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B. Free Cash Flow Valuation Net Borrowings

2. Notes Payable o o Incr. in notes payable, add to FCFE Decr. In notes payable, subtract from FCFE

3. Current Portion of LT Debt o o Incr. in short-term debt, add to FCFE Decr. in short-term debt, subtract from FCFE

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B. Free Cash Flow Valuation

FCFF and FCFE Beginning with Net Income

FCFF = NI + NCC + Int(1 t) WCInv FCInv Subtracting after-tax interest and adding back net borrowing from the FCFF equations gives us the FCFE from NI

FCFE = NI + NCC WCInv FCInv + Net borrowing

FCFE = FCFF Int(1 t) + Net borrowing

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B. Free Cash Flow Valuation

FCFF and FCFE Beginning with CFO

Recall, CFO = NI + NCC WCInv CFO is an after-interest starting point

FCFF = CFO + Int(1 t) - FCInv

Subtracting after-tax interest and adding back net borrowing from the FCFF equations gives us the FCFE from CFO FCFE = CFO Inv(FC) + Net borrowing

93

B. Free Cash Flow Valuation

FCFF Beginning with EBIT

To show the relation between EBIT and FCFF, start with the FCFF equation and assume that the non-cash charge (NCC) is depreciation (Dep): o FCFF = NI + Dep + Int(1 t) - WCInv FCInv Net income (NI) can be expressed as: o NI = (EBIT Int)(1 t), rearranging

o NI = EBIT(1 t) Int(1 t)
o FCFF = EBIT(1 t) + Dep WCInv - FCInv

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B. Free Cash Flow Valuation

FCFE Beginning with EBIT

To get FCFE from EBIT, adjust EBIT for taxes by multiplying EBIT x (1 t), subtract Int(1 t), add back the non-cash charges, and then subtract the investments in working capital and fixed capital, and add the net borrowings

FCFE = EBIT(1 t) Int(1 t) + NCC WCInv FCInv + Net

Borrowings

95

Reading 10c: Free Cash Flow Valuation FCFF Beginning with EBITDA
To get FCFF from EBITDA, (Earnings before Interest, Taxes, Depreciation, and Amortization), use the formula for FCFF:

FCFF = EBITDA(1 t) + Depr(t) WCInv FCInv We add back the NNC (depr) times the tax because we capture the tax benefit from deducting the depreciation; it represents the

cash flow savings from the deduction

96

B. Free Cash Flow Valuation FCFE Beginning with EBITDA

To get FCFE from EBITDA, adjust EBITDA for taxes, subtract interest (1 t), add back Depr (t), subtract working capital and fixed capital, and add net borrowings

FCFE = EBITDA(1 t) Int (1 t) + NNC (t) WCInv FCInv + Net borrowings

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B. Free Cash Flow Valuation FCFF Formula Review

FCFF = NI + NNC + [Int (1 t)] WCInv FCInv FCFF = CFO + [Int (1 t)] FCInv FCFF = [EBIT(1 t)] + NNC WCInv FCInv FCFF = EBITDA(1 t ) + (NNC x t) WCInv FCInv Notice: No net borrowings!

98

B. Free Cash Flow Valuation FCFE Formula Review

FCFE = NI + NCC WCInv FCInv + Net borrowings FCFE = CFO FCInv + Net borrowings FCFE = EBIT(1 t) Int(1 t) + NCC WCInv FCInv + Net borrowings FCFE = EBITDA(1 t) Int (1 t) + NNC (t) WCInv FCInv + Net borrowings

FCFE = FCFF [Int(1 t)] + Net borrowings

99

B. Free Cash Flow Valuation Important Concept FCFF & FCFE

There is only one value for FCFF and only one value for FCFE The various equations are all different ways to get to the same value Use whichever equation is easiest with the data given in the problem

100

B. Free Cash Flow Valuation Soft Corp. Balance Sheet

Actual 20x6 $24.0 17.0 100.0 100.0 (30.0) $211.0 Projected 20x7 $26.0 24.0 150.0 125.0 (35.0) $290.0

Cash A/R Inventory PP & E (FCInv) Accumulated dep Total assets

101

B. Free Cash Flow Valuation Soft Corp. Balance Sheet

Actual 20x6 $91.0 20.0 80.0 20.0 $211.0 Projected 20x7 $101.0 40.0 90.0 59.0 $290.0

Accounts payable Long-time debt Common stock Retained earnings Total liab, and OE

102

B. Free Cash Flow Valuation Soft Corp. Income Statement

Actual 20x6 $80.0 38.0 $42.0 13.0 3.0 $16.0 Projected 20x7 $198.0 90.0 $108.0 30.0 5.0 $35.0

Sales COGS Gross profit SG & A Depreciation Operating expense

103

B. Free Cash Flow Valuation Soft Corp. Income Statement

Actual 20x6 Interest expense Pre-tax income Income tax expense Net income $4.0 22.0 (7.0) $15.0 Projected 20x7 $5.0 68.0 (25.0) $43.0

104

B. Free Cash Flow Valuation Soft Corp. FCFF and FCFE

FCInv = $125 - $100 = $25

Plant and Equip Opening NBV

$ 70

Plant and Equip. Opening cost

$ 100

NBV of disposals
Depreciation Additions Closing NBV

(0)
(5) 25 90

Cost of disposals
Additions Closing cost

0
25 125

105

B. Free Cash Flow Valuation Soft Corp. FCFF and FCFE

Accounts Receivable Inventory Accounts Payable

WC20x7 = ($24 + $150) ($101) = $73 WC20x6= ($17 + $100) ($91) = $26

WCInv = $73 - $26 = $47

Effective tax rate = $25 / $68 37% Net borrowing = $40 - $20 = $20

106

B. Free Cash Flow Valuation Soft Corp. FCFF from NI and CFO
FCFF = NI + NNC + [Int (1 t)] WCInv FCInv - 20.85 = 43 + 5 + 5(1 0.37) 47 25 FCFF = CFO + [Int (1 t)] FCInv - 20.85 = (43 + 5 47) + 5(1 0.37) 25

Recall, CFO = NI + NCC - WCInv

107

B. Free Cash Flow Valuation Soft Corp. FCFE from NI and CFO
FCFE = (NI + NCC WCInv) FCInv + Net borrowing - 4 = (43 + 5 47) 25 + 20 FCFE = CFO FCInv + Net borrowings - 4 = (43 + 5 47) 25 + 20

108

B. Free Cash Flow Valuation Soft Corp. FCFF and FCFE FCFE = FCFF [Int(1 t)] + Net borrowing -$4 = -$20.85 [$5(1 0.37)] + 20

109

B. Free Cash Flow Valuation FCFE from EBIT and EBITDA

FCFE = EBIT(1 t) Int(1 t) + NCC WCInv FCInv + Net borrowing + 20 - 4 = 73(1 0.37) 5(1 0.37) + 5 47 25

FCFE = EBITDA(1 t) Int (1 t) + NNC(t) WCInv FCInv +

Net borrowings - 4 = 78(1 0.37) 5(1 0.37) + 5(0.37) 47 25 + 20

110

B. Free Cash Flow Valuation FCFE from EBIT and EBITDA

FCFF = [EBIT(1 t)] + NNC WCInv FCInv - 20.85 = 73 (1 0.37) + 5 47 25

FCFF = EBITDA(1 t ) + NNC(t) WCInv FCInv - 20.85 = 78 (1 0.37) + 5(0.37) 47 25 Small differences due to tax effects in interest

111

B. Free Cash Flow Valuation Problem: FCFF, FCFE

Newday Ltd. Is an Edinburgh manufacturer of beauty supplies and personal care products. It provides the following financial statements. Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) for 2011 are closest to what values?

a. b. c.

FCFF 72.5 81.5 43.0

FCFE 85.0 85.0 31.5

112

B. Free Cash Flow Valuation Newday Balance Sheet

Actual 2010 18.0
18.0 14.0 202.0

Cash A/R Inventory PP&E (Net)

Projected 2011 66.0

20.0 10.0 228.0

Total assets

252.0

324.0

113

B. Free Cash Flow Valuation Newday Income Statement

Projected 2011
Sales COGS Gross profit Depreciation Operating expense 230.0 80.0 150.0

11.0
14.0

114

B. Free Cash Flow Valuation Newday Income Statement

Projected 2011
Interest expense Pre-tax income Income tax expense Net income

10.0
115.0 (40.0)

75.0

115

B. Free Cash Flow Valuation Newday FCFF and FCFE

FCInv = 228 202 + 14 depc = 40

WC2011 = 10 + 20 56 = - 26
WC2010 = 14 + 18 32 = 0 Wcinv = 26 0 = - 26 T = 40 / 115 35% Net borrowing = 70 60 = 10

116

B. Free Cash Flow Valuation Newday FCFF from NI and CFO

FCFF = NI + NNC + Int (1 t) WCInv FCInv - 81.5 = 75 + 14 + 10(1 0.35) (- 26) 40

FCFF = CFO + Int (1 t) FCInv - 81.5 = (75 + 14 (-26)) + 10(1 0.37) 40

Recall, CFO = NI + NCC WCInv

117

B. Free Cash Flow Valuation Newday FCFE from NI and CFO

FCFE = (NI + NCC WCInv) FCInv + Net borrowing 85 = (75 + 14 (- 26)) 40 + 10

FCFE = CFO FCInv + Net borrowings 85 = (75 + 14 (- 26)) 40 + 10

118

B. Free Cash Flow Valuation Two Approaches to Forecast FCF

Calculate historical FCF: Most common o Estimate FCF for current period o Apply growth rate FCF x (1 + g)n Forecast components of FCF o Forecast each underlying component of free cash flow: Net income, FCInv, NCC, and WCInv are tied to sales forecast

o Realistic and flexible but time consuming

119

B. Free Cash Flow Valuation Recognizing of Value Between FCFE and DDM
The general valuation models are the same but the numerator is different The share of common stock is the present value of dividend or FCFE, where FCFE could be either greater or less than dividends based on the adjustments to arrive at FCFE

120

B. Free Cash Flow Valuation Effect of Financing Decisions on FCF

FCFF Dividends Share repurchase Share issue Change in leverage None None None None FCFE None None None ST &LT effects partially offset*

Note: Share repurchase/issue is use of FCF; not determinant * e.g., if leverage increases, FCFE higher in current year (net borrowing) and lower in future years (interest expense)

121

B. Free Cash Flow Valuation NI is a Poor Proxy for FCFE

NI is an accrual concept not cash flow NI recognizes con-cash charges such as depreciation, amortization, and gains on sale of equipment, alternatively NI fails to recognize the cash flow impact of investments in working capital and net fixed assets, and net borrowings

122

B. Free Cash Flow Valuation EBITDA is a Poor Proxy for FCFF

EBITDA doesnt reflect taxes paid EBITDA ignores effect of depreciation tax shield [(Depr (tax)] EBITDA does not account for needed investments in working

capital and net fixed assets for going concern viability

123

B. Free Cash Flow Valuation

Problem: FCFF
Which of the following is most likely to affect Free Cash Flow to the Firm (FCFF)?

a. Dividends b. Share repurchases c. Sale of assets

124

B. Free Cash Flow Valuation

Problem: EBITDA
Which of the following is least likely to be considered a reason that EBITDA is an ineffective proxy for Free Cash Flow to the Firm (FCFF)? EBITDA does not account for:

a. working capital investment b. interest expense c. cash taxes paid

125

B. Free Cash Flow Valuation

Single-Stage FCFF Model

Point: Analogous to Gordon growth model
o Useful for stable firms in mature industries Two assumptions: 1. Constant growth rate g forever

2. Growth rate g is less than WACC

Firm value0 = FCFF1

= FCFF0 x (1 + g)

WACC g

WACC g

126

B. Free Cash Flow Valuation

Weighted Average Cost of Capital

Weighted average of rates of return required by capital suppliers (WACC)

Required returns

WACC = (We x re ) + [wd x rd x (1 t)]

MV weights OR target weights

127

B. Free Cash Flow Valuation

Single-Stage FCFE Model

Point: Similar to FCFF/GGM model
Often used with international firms, especially in high-inflation countries

FCFE1 Equity value = r g

FCFE0 x (1 + g) rg =

Required return on equity (CAPM, APT, Build-up)

128

B. Free Cash Flow Valuation

Multi-Stage Models
Four major variations:
1. FCFF or FCFE? 2. Two stages or three?

Base case: 2-stage, historical growth, FCFE with the GGM for terminal value

3. Total FCF or components or FCF?

4. Terminal value via GGM or P/E?

Note: All are very similar Always: Value = PV of future cash flows discounted at appropriate required return

129

B. Free Cash Flow Valuation

Selection of Appropriate Model

Single-stage model
o Income stock (slow, constant growth) o International setting or volatile inflation rates: Use real rates Two-stage and three-stage models

o Competitive advantage will disappear over time

Match growth pattern or company life cycle approach to the appropriate model

130

B. Free Cash Flow Valuation

Sensitivity Analysis
Apply sensitivity to each of the following variables:
o The base-year value for the FCFF or FCFE o Future growth rate o Risk factors beta, risk-free rate, and ERP

o Relationship between discount rate and the growth rate is critical

o Most sensitive: Beta and FCF growth rate

o Least sensitive: FCF and Rf

131

1B. Free Cash Flow Valuation

Terminal Value
Terminal value = forecasted value at beginning of normal
growth phase Apply average trailing multiple (P/E) to forecasted EPS = P/E x

EPSn
Or, use single stage (Gordon Growth) model Terminal value is added to the last period cash flow and then

discounted along with the prior period dividends or FCFs

132

B. Free Cash Flow Valuation

Problem: FCFF Valuation
Tykes Toys has a required return on equity of 15%, a WACC of 12% and a marginal tax rate of 40%. FCFF is expected to grow at a constant rate of 4% after three years. Using the data below, which figure is closest to the value of the firm?

Year 1
Cash flow from operations $400

Year 2
$500

Year 3
$600

WCInv
FCInv

$50
$200

$60
$250

$80
$300

Interest expense
a. b. c. $4,056 $3,502 $3,900

$15

$15

$20

133

B. Free Cash Flow Valuation Solution: FCFF Valuation

134

B. Free Cash Flow Valuation Problem: Terminal Value FCFE

Which is the least appropriate approach for FCFE Valuation calculating terminal value in a Free Cash Flow to Equity (FCFE) analysis?

a. Apply average trailing multiple (P/E) to forecasted EPS = P/E x EPSn b. Use Gordon growth model = Dividendn / (r g)

c. Add terminal value to the last period cash flow and then discount along with the prior period FCFEs

135

KEYS TO THE EXAM Free Cash Flow Valuation

Define FCFF and FCFE Calculate FCFF and FCFE Application of models in FCF framework

FCF vs. dividends and ownership perspective

Model selection criteria

136

VALUATION MODELS

Lecturer:

Lecturers name 2012

Price Multiples Method of Comparables

The method of comparables involves using a price multiple to evaluate whether an asset is relatively fairly valued, relatively undervalued, or relatively overvalued in relation to a benchmark value of the multiple Most widely used method by analysts The economic rationale for the method of comparables Law of

One Price

138

Price Multiples Method of Comparables

Price scaled by a measure of value such as sales, net income, book value, or CF Compare relative to a benchmark multiple Choices for the benchmark value of a multiple include the multiple of a closely matched individual stock or the average (or median value) for the stocks peer group of companies or industry

139

Price Multiples Method of Forecasted Fundamentals

Relates multiples to company fundamentals growth, risk, payout Based on discounted cash flow model Permits the analyst to explicitly examine how valuations differ across stocks and against a benchmark given different expectations for growth and risk

140

Price Multiples Price Multiple Fundamentals

Justified price multiple: What the price multiple should be if the stock is fairly valued Also warranted and intrinsic price multiple
o Actual = justified o Actual < justified o Actual > justified properly valued undervalued overvalued

141

Price Multiples What You Need To Know!

For relative valuation measures such as P/E, P/B, P/S, P/CF, and dividend yield, know the following for each ratio:
o Rationale for using ratio o Possible drawbacks of ratio o Calculation of ratio o Fundamental influences o Calculate justified ratio o Evaluate a stock with the ratio

142

Price Multiples Rationale for P/E Ratio

Rationale: o Earnings power (EPS) key to investment value o Focal point for Wall Street o Differences in P/Es may be related empirically to differences in long-run stock returns according to research o Ratio can be used as a proxy for risk and growth

143

Price Multiples Drawback for Using the P/E Ratio

Drawbacks: o Negative and very low earnings make P/E useless o Volatile or transitory earnings make interpretation difficult o Management discretion on accounting choices can distort earnings o Solely using the ratio avoids addressing the fundamentals

(growth, risk, and cash flows)

144

Price Multiples Market P/E Ratio

Trailing P/E0 : Uses EPS from last year P0 / E0 =

market price per share EPS last 12 months

Leading P/E1 (forward or prospective): Uses forecasted earnings for coming year P0 / E1=

market price per share forecast EPS next 12 months

145

Price Multiples Example: Trailing and Leading P/E

2001 earnings = $25 million Forecasted EPS over the next 12 months = $0.60 50 million shares outstanding

Market price = $16

Calculate trailing and leading P/E ratios

146

Price Multiples Solution: Trailing and Leading P/E

EPS2001 = Trailing P/E = Leading P/E =

147

Price Multiples Problems with Trailing P/E0

When calculating a P/E ratio using trailing earnings, care must be taken in determining the EPS number. The issues include: o Transitory, non-recurring components of earnings that are company-

specific
o Cyclicality components of earnings due to business or industry trends o Differences in accounting methods o Potential dilution of EPS

148

Price Multiples

Underlying Earnings
Goal: Analysts want to remove nonrecurring items from earnings for forecasting purposes Non-recurring items to remove include: o Gains/losses on asset sales o Asset write-downs impairment o Loss provisions o Changes in accounting estimates Result : Persistent, continuing, and core earnings

149

Price Multiples

Underlying Earnings
Example:

o 2008 EPS = $8
o Gain on asset sale = $1.40 o Gain from change in accounting estimate = $0.75 Underlying earnings o = $8.00 - $1.40 - $0.75 = $5.85

150

Price Multiples

Normalized Earnings
Adjust EPS to remove cyclical component of earnings and capture mid-cycle or an average of earnings under normal market conditions

Two normalization methods o Method of historical average EPS o Method of average ROE

151

Price Multiples

Example: Normalized Earnings

Year
EPS

2005
$4.00

2006
$3.80

2007
$5.25

2008
$4.50

BVPS ROE

$25.00 15%

$26.00 15%

$26.00 21%

$28.00 16%

152

Price Multiples

Solution: Normalized Earnings

Average EPS = $4.00 + $3.80 + $5.25 + $4.50 4

= $4.39

0.15 + 0.15 + 0.21 + 0.16 Average ROE = 4

= 0.1675

Average ROE x BVPS2008 = 0.1675 x $28.00 = $4.69

153

Price Multiples Solution: Normalized Earnings

If the current stock price was $60, then the normalized P/E ratios

approaches are:
Average EPS = $4.39 P/E = $60 / $4.39 = 13.7x

Average ROE method EPS = $4.69 P/E = $60 / $4.69 = 12.8x

Preferred method since it more accurately reflects the effect of growth and company size on EPS

154

Price Multiples

E/P: Earnings Yield

Problem: Negative earnings make P/E ratios meaningless Potential solution: Substitute E/P, simply the inverse of the P/E o Price is never negative

o High E/P suggests cheap security

o Low E/P suggests expensive security

155

Price Multiples

Example: Earnings Yield

Current Price ABC GHI PQR TUV $26.00 $19.20 $8.59 $8.07

Trailing EPS
$0.49 $(0.11) $(0.40) $(3.15)

Trailing P/E 53.06 NM NM NM

E/P Ratio
1.9% - 0.6% - 4.7% - 39.0%

156

Price Multiples

Justified Price Multiple

Recall : o Justified multiple = multiple if the stock is fairly valued Forecasted fundamentals:

o Justified multiple = the ratio of value from any DCF model to

earnings, book value, sales, or cash flow Typical CFA L2 case: Use the Gordon growth model (GGM) to

derive justified multiples and identify determinants

157

Price Multiples

Justified Leading P/E1

Justified leading P/E1 : Start with GGM

P0 =

D1 rg
Payout

justified leading Note: All derivations are just (1) substitution and (2) algebra. The relationships are exact

158

Price Multiples

Justified Trailing P/E1

Justified trailing P/Eo : Start with GGM P0 = Do (1 + g) rg
Payout x (1 + g)
justified leading

= (justified leading P/E) (1 + g)

159

Price Multiples

Justified P/E
Fundamental factors affecting justified P/E: P/E positively related to growth rate and payout, all else equal
o Assumes no interaction between g, payout, and ROE

o Recall: g = ROE x (1 Div/EPS)

P/E inversely related to required return, (real rate, inflation, and equity risk premium) all else equal

160

Price Multiples

Example: Justified P/E Based on Fundamentals

Example:
Payout ratio = 40% Required rate of return = 12%

Expected dividend growth rate = 4%

Calculate the trailing P/Eo and leading P/E1 multiple based on these forecasted fundamentals

161

Price Multiples

Solution: Justified P/E Based on Fundamentals

Trailing P/E =

Leading P/E =

162

Price Multiples

Predicted P/E from Regression

The P/E and company characteristics are measured cross sectionally The P/Es are regressed against the stock and company characteristics The estimated equation exhibits the relationship between the P/E and the stocks characteristics

o Positive coefficient with growth and payout

o Negative coefficient with beta

163

Price Multiples

Example: Predicted P/E from Regression

Predicted P/E regression:
Dividend payout ratio = 0.40 Beta = 0.60

Expected earnings growth rate = 3%

A regression on related public utility firms produces the following equation:
o Predicted P/E = 5 + (6 x dividend payout) + (10 x growth) (0.5 x beta)

Calculate the predicted P/E

164

Price Multiples

Solution: Predicted P/E from Regression

Predicted P/E =

Useful for large data sets

Infrequently used due to these limitations

o Changing relationships o Multicollinearity o Unknown predictive power

165

Price Multiples

Valuation Using Comparables

Select and calculate the comparative price multiple for the security Select the benchmark asset and calculate the mean of median P/E Compare the stocks P/E with the benchmarks P/E

Are observed differences between asset and benchmark P/E

explained by underlying determinants of P/E? If not, asset may be mispriced. Watch the fundamentals!

166

Price Multiples

Example: Method of Comparables

Are Alaska and Buffalo relatively over or undervalued? 5-Year Current P/E Consensus Growth

Stock

Beta

Alaska Inc.
Buffalo Inc. Industry average

20.2
16.3 22.7

15.4%
19.6% 19.4%

1.20
1.20 1.20

167

Price Multiples Solution: Method of Comparables

Buffalo: Undervalue

o Why?
Lower P/E than the industry Approximately same growth rate and risk Alaska: Cant determine o Why? Lower P/E than industry But, low P/E may result from lower growth forecast

168

Price Multiples

PEG Ratio
PEG ratio is a stocks P/E divided by the expected long-term earnings growth rate g P/E g Calculates a stocks P/E per unit of expected growth PEG = Lower PEG more attractive valuation, higher PEG less attractive valuation

169

Price Multiples

Example: PEG Ratio

SGS Inc., leading P/E = 15 Five-year consensus long-term earnings growth rate forecast = 21%

Median industry PEG = 0.90

Calculate PEG and explain whether the stock appears to be correctly valued, overvalued, or undervalue

170

Price Multiples

Solution: PEG Ratio

PEG = 15/21% = 0.71 Note do not make growth a decimal Comparable Industry PEG = 0.90

SGS PEG 0.71 < Industry PEG 0.90

Conclusion: SGS Inc., is undervalued o SGS Inc., has a lower multiple per unit of expected growth

171

Price Multiples

Problems with PEG Ratios

PEG ratio does not account for: Differences in firm risk attributes Differences in the duration of growth

Non linear relationship between growth and P/E ratio

172

Price Multiples

Terminal Value Estimation

Terminal value: Value projected at end of estimation horizon Terminal value = (trailing P/E) x (earnings forecast) Two methods:

1. Fundamentals: Requires estimates of g, r, and payout

2. Comparables: Uses market data to calculate benchmark

173

Price Multiples

Price to Book Ratio P/B0

Book value per share (BVPS) attempts to represent the investment that common shareholders have made in the company BVPS is calculated as common equity divided by number of shares outstanding There is only a current P0/B0 not a leading P/B

174

Price Multiples

P/B0 Ratio
Rationale:
Usually positive (even when EPS < 0) Less volatile, more stable than EPS

Good for firms with mostly liquid assets (e.g., financial firms)
Useful for distressed firms, liquidation Differences in P/B ratios explain differences in long-run average returns

175

Price Multiples P/B0 Ratio

Drawbacks: Does note reflect value of intangible assets, off-B/S assets (e.g., human capital) Misleading when comparing firms with significant differences in asset size Different accounting conventions obscure comparability (particularly international)

Inflation and technological change can cause big difference between BV

and MV

176

Price Multiples

Example: Market P/B0 Ratio

P/B ratio =

market value of equity book value of equity market price per = share book value per share

Market price = $80 Book value = $200 million Shares O/S = 4 million Compute P/B ratio

177

Price Multiples

Solution: Market Price to Book Value

BV per share = $200 million 4 million

= $50

P/B ratio = $80 $50

= 1.6

178

Price Multiples

Justified P0/B0 ratio

By using the Gordon growth model and using the expression g = b ROE for the sustainable growth rate, the expression for the justified P/B ratio based on the most recent book value (B0 ) is

179

Price Multiples

Justified P/B
Fundamental factor affecting P/B: o (ROE r) Larger spread = value creation = higher market value

Compare to residual income model

Intuition: Firms that earn ROE = r will have a P/B of 1

180

Price Multiples

Fundamental Factors - Influencing P0/B0 Ratio

Positive relationship o P/B increases as ROE increases o P/B increases as g increases

Inverse Relationship o P/B increases as r decreases (falling risk, interest rates, inflation, and beta)

181

Price Multiples

Justified P0/B0 Ratio Based on Fundamentals

Example: o Return on equity = 22% o Expected growth rate = 6%

o Required return = 17%

justified P/B0 ratio =

182

Price Multiples

Valuation Using Comparable P0/B0

Justified selection of Stock A or B

Stock A B Industry

3-Year Mean P/B 6.85 8.62

Current P/B 4.32 3.31 5.75

ROE Forecast 18.9% 19.6% 19.8

Beta 1.22 1.26

183

Price Multiples

Valuation Using Comparable P0/B0

B is more attractive investment o Why? B has lower P/B than A

Bs P/B < industry P/B, Bs ROE = industry ROE

PB undervalued

184

Price Multiples

Rationale for Using P0/S0

P/S useful for distressed firms Sales revenue is always positive Sales are generally more stable and less prone to distortion than

EPS, over time

P/S useful for mature, cyclical, and zero-income stocks Differences in P/S ratios may be related to difference in long-run

average returns

185

Price Multiples

Drawbacks Against Using P0/S0

High sales growth does not translate to operating profitability P/S ratio does not capture different cost structures between firms Revenue recognition methods can distort reported sales and forecasts

186

Price Multiples

Market P/S0 Ratio

P/S =

market value of equity total sales

= market price per share sales per share

187

Price Multiples

Justified P0/S0 Based on Fundamental Factors P0 = S0 (E0 / S0) x ( 1 b) x ( 1 + g) rg

Profit margin = E0 / S0 Payout = 1 b

Required return = r
Sustainable growth rate = g

188

Price Multiples

Justified P0/S0 Ratio Based on Fundamentals

Example:
Payout ratio (Div/EPS) = 40% Required return on equity = 15% Expected growth in earnings = 8% Current net profit margin (E0 / S0) = 12%

P0/S0 =
P0/S0 =

189

Price Multiples

Relationship of Fundamentals to the P0/S0 Ratio

P0/S0 increases as:
Current profit margin (E0/S0) improves Sustainable growth (g) increases Risk falls

P0/S0 decreases as:

The profit margin decreases Risk increases

Growth decreases

190

Price Multiples

Valuation Using Comparable P0/S0

Same method as P/E and P/B Low P/S undervalued Use trailing sales to calculate

In choosing comparables, control for:

o Profit margin o Expected growth o Risk o Quality of accounting data
191

Price Multiples

Rationales for Using P/CF0

More difficult to manipulate CF than EPS Cash flow is more stable than earnings Addresses quality of earnings problem Differences in P/CFs may explain differences in long-run average returns

192

Price Multiples

Drawbacks Against Using P/CF0

Earnings plus non-cash charges approach ignores some cash flows such as net fixed investments, working capital investment, and net borrowings FCFE is preferable to CFO, but FCFE more volatile and more difficult to compute FCFE can be negative with large CapEx

193

Price Multiples

Market P/CF Ratio

P/CF =

market value of equity total cash flow

= market price per share Cash flow per share

194

Price Multiples

What is cash flow?

1. Traditional cash flow: CF = net income + non-cash charges 2. CFO ( from statement of cash flows)

3. Adjusted CFO:
Adj. CFO = CFO + [interest x (1 t)] 4. EBITDA: (Also used for EV/EBITDA ratio) 5. FCFE: Theoretically superior (from this study session)

195

Price Multiples

Cash Flow Definitions

FCFE cash flow concept with the closest relationship to theory, although can be more volatile due to Cap Ex

EBITDA is a pre-tax, pre-interest, pre-investment in working capital and pre-investment in fixed assets o Appropriate for firm value, not equity

196

Price Multiples

Justified P/CF
Two step Process o Step 1: Calculate stock value using suitable DCF model

V0 =

FCFE0 (1 + g) r-g

o Step 2: Divide result by cash flow: Justified P/CF = V0/CF

197

Price Multiples

Fundamental Factors Affecting Justified P/CF

Justified P/CF will increase, all else equal, if: o Cash flow increases o Growth rate increases

o Required return decreases

o Same relationship as all other ratios

198

Price Multiples

Valuation Using Comparable P/CF

Same method as P/E, P/B, and P/S Low P/CF undervalued Control for:

o Return and risk

o Cash flow o Growth rate

199

Price Multiples

P/EBITDA or EV/EBITDA?
EBITDA is a earnings flow to both debt and equity holders A multiple using total company value: Enterprise Value (EV) in the numerator is logically more appropriate than equity market price (P) Because the numerator is enterprise value, EV/EBITDA is a valuation indicator for the overall company rather than common

stock

200

Price Multiples

EV / EBITDA Ratio
Enterprise Value (EV) or Firm Value
= MV of common stock + MV of debt + MV preferred cash and investments Divided by EBITDA = earnings before interest, taxes, depreciation, and

amortization
o Ratio provides an indication of company/firm value, not equity value
201

Price Multiples

Arguments For/Against EV/EBITDA

Arguments for: Comparing firms with different financial leverage since EBITDA is pre-interest Controls for dep/amort differences EBITDA usually positive when EPS is negative Arguments against:

Ignores changes in WC investments

FCFF (which controls for capex) is more closely tied to value

202

Price Multiples

Valuation Using EV/EBITDA

Firm EV/EBITDA < benchmark Undervalued

Firm EV/EBITDA > benchmark

Overvalued

203

Price Multiples

Arguments For Using D0/P0

Dividend yield is a component of total return Dividends are a less risky component of total return than capital appreciation

204

Price Multiples

Arguments Against D0/P0

Dividend yield is just one component of total return Dividends paid now displace earnings in all future periods (a concept known as the dividend displacement of earnings). Investors trade off future earnings growth to receive higher current dividends.

205

Price Multiples

Market Dividend Yield D/P

4 x most recent quarterly DIV market price per share

trailing D/P =

leading D/P = next 4 quarters forecasted DIVs market price per share For practical purposes, dividend yield, D/P is preferred over P/D (zero dividends are a problem)

206

Price Multiples

Justified Dividend Yield D0/P0

The justified dividend yield in a Gordon model is:

D0 rg = P0 1+g

207

Price Multiples

Example: Justified Dividend Yield D0/P0

Example: Required rate of return on equity = 10% Long term earnings growth = 5%

D0 = P0

rg 1+g

o D0/P0 = (0.10 0.05) / (1.05) o D0/P0 = 0.048 or 4.8%

208

Price Multiples

Fundamental Factors Affecting D0/P0

Dividend yield increases as: Required return increases (price falls) High growth rate decreases the firms payout and therefore the firm is

less able to pay dividends which results in a lower D/P ratio

High D/P strategy = value strategy

209

Price Multiples

Valuation Using Comparable D/P

Consensus Growth SW Utilities NE Utilities
SW Utilities preferred Lower risk; higher total expected return

Beta 0.71 0.74

D/P 8% 5%

9% 6%

210

Price Multiples

Problem: P/CF
The least accurate description of the advantages and disadvantages of using the price to cash flow ratio (P/CF) rather than the price to earnings ratio (P/E) is that the P/CF ratio has the:
a.

advantage of addressing the earnings quality issue

b. advantage that cash flow is generally harder to manipulate than earnings

c. disadvantage that cash flow is generally less stable than earnings

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Problem: Price/Sales
The price/sales ratio is most likely to decrease as:
a.

profit margin increases

b. inflation increases

c. risk decreases

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Problem: PEG
Which of the following is least likely to be considered a disadvantage of using the P/E to growth (PEG) ratio?
a.

The PEG ratio does not account for differences in the duration of growth between firms

b. The relationship between P/E and growth is non-linear c. The PEG ratio does not account for differences in risk attributes

between firms

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Problem: Dividend Yield

Dividend yield is least likely to increase as: a. required return increases b. growth rate increases

c. price decreases

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Cross Border Valuation Differences

Comparing companies across borders frequently involves accounting method differences, cultural differences, economic differences, and resulting differences in risk and growth opportunities For example, P/E ratios for individual companies in the same industry across borders have been found to vary widely

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Momentum Indicators
Momentum indicators based on price, such as the relative strength indicator, have also been referred to as technical indicators Unexpected earnings (also call earnings surprise) is the difference between reported earnings and expected earnings

UEt = EPSt - E(EPSt)

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Momentum Indicators
Another momentum indicator based on the relative change in earnings per share is called standardized unexpected earnings

SUEt =

EPSt - E(EPSt) [EPSt - E(EPSt)]

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Measuring Central Tendency in Multiples

Arithmetic mean
o Most affected by outliers

Harmonic mean
o Less affected by large, more by small, outliers

Weighted harmonic mean

o Effect of outliers depends on market value weight

Median
o Least affected by outliers

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(Simple) Harmonic Mean

Outliers:

o Reduces impact of large outliers

o May worsen impact of small outliers Small outliers bounded by zero, so less problematic

Weighting:
o Less weight on higher ratios o More weight on lower ratios Lower value than arithmetic mean (unless all observations are the same value) Used when marked weight information unavailable

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Weighted Harmonic Mean

Similar to simple harmonic mean except in weighting:

o Uses market value weights

o Major advantage: Corresponds to portfolio value (e.g., total price/total earnings)

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Stock Screens
Applies set of criteria to narrow possible investments to those meeting criteria May be used with: o Fundamental and/or valuation criteria Multiples Momentum indicators o Individual securities, industries, economic sectors

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Benefits/Limitations to Screening
Benefit: o Efficient means of narrowing investment universe Limitations: o Little control over calculation of inputs in most commercial screening software o Lack of qualitative factors

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KEYS TO THE EXAM

Price Multiples
Method of comparables vs. forecasted fundamentals Valuation multiples formulas: P/E, P/B, P/S, P/CF Advantages/disadvantages of different multiples

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KEYS TO THE EXAM

Price Multiples
Selection of valuation multiple (when to use P/E, etc.) PEG ratio P/E to estimate terminal value in the DDM two-stage framework

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