VALUATION

Five Categories of Valuation Methods 1. Discounted cash-flow 2. Market-based 3. Mixed models 4. Asset-based methods 5. Option-based methods

Discounted Cash-Flow Approach Estimated future cash flows are discounted back to present value based on the investor’s required rate of return Discounted dividend valuation Discounted operating cash-flow models

Discounted Dividend Valuation Most straightforward approach Explicit cash flows received by equity investors Dividends Terminal value when shares are sold Firm is expected to have an infinite life

Discounted Dividend Valuation Theoretical Model No-growth, constant dividend Dividends are growing at rate g

Discounted Dividend Valuation Required rate of return (r) r is the rate of return demanded on a specific investment Based on investor’s assessment of risk CAPM

CAPM -- Example r f, Risk-free (30-year Treasury bond) = 5% r m, Expected stock market return = 10% Risk premium = (r m – r f ) Beta = 1.5 r = 5% + 1.5(10%-5%) r = 12.5%

Discounted Dividend Valuation Required rate of return (r) For nonpublic companies, use a buildup model and historical sources for data Begin with risk-free rate + Equity risk premium + Small company premium + Company specific risk premium = Required rate of return

Discounted Dividend Valuation Growth rate (g) Top-Down analysis Begin with growth of economy Adjust for industry, sector and company factors Sustainable growth = ROE(1-Payout rate) ROE = Earnings/Average equity Payout rate: proportion of earnings used to pay dividends or repurchase shares

Company A Annual dividend = $0.16 Beta = 1.35 ROE = 13% Payout ratio = 20% Economic 20-year Treasury bond = 4.75% Historical market risk premium = 5.4% Discounted Dividend Valuation - example

r = (.054) =.120 g =.13(1-.20) =.104 Value = $11.04… Discounted Dividend Valuation - example

Discounted Dividend Valuation Assumes a single, constant growth rate (g) What if growth rates differ? Use a multi-stage model to calculate future dividends Calculate future stock value based on future dividend Calculate present value of stock and dividends

Discounted Operating Cash-Flow Models Most applicable in the event of a takeover Free cash flow (FCF) is operating cash flows less necessary investments in working capital and property, plant and equipment

FCFF or FCFE

Discount Rate FCFF Weighted Average Cost of Capital FCFE Cost of Equity (required rate of return)

Discounted Operating Cash-Flow Models Other considerations Growth Can use a multi-stage model to accommodate rate changes Forecasting cash flows requires judgment Begin with reported, historical cash flow and earnings Make company-appropriate adjustments

Special Issues Loss generating firm valuation Closed Firm Valuation Start-up companies

Valuation Of GAP Retail Stores

FCFF-Stable Growth

Market-based Models Compare subject company to other similar companies for which market prices are available Simple computations but require a great deal of professional judgment P/E Model P/B Method P/S Model

P/E Model Assumes a company is worth a certain multiple of its current earnings Assumes each share is worth the same multiple of EPS Derived from the dividend discount models Requires judgment regarding Peer firms and their prices Historical (average) data

P/E Model Firms with no internal growth prospects, paying out 100% of earnings Current P/E = 1/r Constant growth, Leading P/E P 0 /E 1 = (D 1 /E 1 )/(r-g) D = annual dividends, E = EPS

P/E Model - Example Consensus analyst forecast EPS = $0.46 P/E of 23 is appropriate Value = 23*$0.46 = $10.58 If the current price is $10.22, there is limited upside to this investment

Mixed Models Because the previous models are linked (discounted dividend model) a combined approach can be used May use discounted cash flow approach to forecast cash flows then use market multiple to derive terminal value Residual income approaches are linked to the dividend discount model

Asset-Based Models Used when a company is going to be liquidated Valuation is based on underlying assets Market value of balance sheet items Assets and liabilities Also called cost or adjusted book value approach

Options-Based Models Theoretically elegant but practical application is difficult Analyst must have information about opportunities (and their value) available to a firm Equity ownership is viewed as an option call on the firm Limited downside, unlimited upside

Selecting a Model Consider characteristics of the firm Dividend paying Growing Likely to be liquidated Consider data availability of data Publicly available or closely held