Chapter 6 Common Stock Valuation: Putting all the pieces together

6-2 Objectives We now have an understanding of the how to compute all the inputs for our models except the growth rate in cash flows and earnings. In this lecture, our objectives are to: –Understand methods of computing growth rates. –Put all the pieces together to estimate intrinsic value using the DCF and RI models. –Understand the differences and benefits of the models. –Understand the process of evaluating a company within an industry.

6-3 Estimating future growth: DCF model A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. In general, we can make one of two assumptions: –there is no high growth, in which case the firm is already in constant growth –there will be high growth for a period, at the end of which the growth rate will drop to the stable growth rate (2-stage). Some advocate a smoother drop in growth between the first and second stages. We need to determine the growth rates in each period as well as the length of the different periods if a 2- stage model is used.

6-4 Estimating growth rates: DCF model With the DCF model, if we assume a constant growth model, then a growth rate of 2.5 – 3.5% per year for FCFF should be used. This is the expected growth rate in the economy overall (in GDP). We would not expect a firm’s FCFF to grow much faster (or much slower) than the economy overall in the long run.

6-5 Estimating growth rates: DCF model With a 2-stage model, we use similar intuition to set the growth rate in this stage between 2.5 – 3.5%. When valuing firms in declining (growing) industries, we would use a growth rate toward the lower (upper) end of the range.

6-6 Estimating 1 st stage growth rates/FCFF With a 2-stage DCF model, we need to estimate growth rates during the first stage to calculate FCFF during this first stage. We can do this in a few different ways: –Use a historical growth rate in FCFF as a proxy for the growth rate over the next few years. –Use a “percentage of sales” method to forecast FCFF. –Use analysts estimate for growth rates.

6-7 Estimating 1 st stage growth rates: Historical growth rate Using historical growth rates: –Calculate the FCFF for the firm for the past few years (usually 5-10 years). –Calculate the geometric average growth rate: This approach would be appropriate if FCFF tended to grow at a constant rate and if historical relationships between free cash flow and fundamental factors were expected to be maintained.

6-8 Estimating 1 st stage growth rates: Percent of Sales Method With the percentage of sales method, we can compute 1 st stage FCFF directly. We need to first determine an appropriate growth rate in sales during the 1 st stage. With this method, we would forecast the individual components of FCFF. –EBIT: forecasted using an appropriate EBIT margin based on historical data and the current and expected economic environment. Forecasted EBIT = Sales forecast * EBIT margin

6-9 Estimating 1 st stage growth rates: Percent of Sales Method –FCInv: This represents the incremental capital expenditure required to meet the growth in sales. –It can be computed as: –The second component can be estimated using previous years’ ratios.

6-10 Estimating 1 st stage growth rates: Percent of Sales Method –WCInv: This represents the incremental working capital investment required to meet the growth in sales. –It can be computed as: –The second component can be estimated using previous years’ ratios. –Be sure to include other Non-Cash Charges in your forecasts.

6-11 Estimating 1 st stage growth rates: Analyst estimates There are numerous sources for obtaining estimates for growth rates (especially earnings growth). Some of these sources include: –S&P Net Advantage –Value Line Investment Survey –Yahoo Finance

6-12 Determinants of length of the 1 st stage Size of the firm –Success usually makes a firm larger. As firms become larger, it becomes much more difficult for them to maintain high growth rates Current growth rate –While past growth is not always a reliable indicator of future growth, there is a correlation between current growth and future growth. Thus, a firm growing at 30% currently probably has higher growth and a longer expected growth period than one growing 10% a year now.

6-13 Determinants of length of the 1 st stage Barriers to entry and differential advantages –Ultimately, high growth comes from high project returns, which, in turn, comes from barriers to entry and differential advantages. –The question of how long growth will last and how high it will be can therefore be framed as a question about what the barriers to entry are, how long they will stay up and how strong they will remain.

6-14 Determinants of length of the 1 st stage Questions to ask about firms: –What drives revenue growth? Can that be maintained? –What kinds of capital expenditure will be required to maintain free cash flow growth? –Can firms maintain their operating and gross margins? Standard 1 st stage lengths used are 5 years and 10 years.

6-15 Firm characteristics as growth changes VariableHigh Growth Firms Stable Growth Firms tend totend to Riskbe of above-average riskbe of average risk Dividend Payoutpay little or no dividendspay high dividends Net Cap Exhave high net cap exhave low net cap ex (just covering depreciation) ROCearn high ROEearn ROE closer to cost of equity Leveragehave little or no debthave higher leverage

6-16 Putting it all together: DCF Model The intrinsic value of the firm is calculated as the present value of all future FCFF. The intrinsic value of the equity of the firm is: The intrinsic value of equity per share then is:

6-17 Forecasting Residual Income: RIM With the RIM, we need to estimate future earnings (net income) or ROE, and dividends. The 2-stage RIM tends to be logically more appropriate for firms because a constant growth RIM assumes that ROE will be greater than k indefinitely. We can estimate future earnings using the same methods used to estimate future FCFFs: historical growth rate, analyst estimates, percent of sales method. Future dividends can be estimated by looking at historical relationship between earnings and dividends and at the industry average. Alternatively, we could estimate ROE in future years, and assume that it will decline to the cost of equity in the 2 nd stage.

6-18 Putting it all together: RIM The intrinsic value of equity is calculated as the current book value plus the present value of all future residual incomes. The intrinsic value of equity per share then is:

6-19 DCF and RIM vs. relative valuation DCF and RIM valuation assumes that markets make mistakes in estimating value (i.e., current price is not an accurate reflection of the value of the firm) and these mistakes tend to be corrected over time and can occur over entire sectors. Relative valuation assumes markets are correct on average (i.e., comparables on average are correctly priced)

6-20 Strengths of the RI model versus the DCF model Terminal value does not make up a large portion of the total value The model can be used for companies that do not pay dividends and/or firms that have near-term negative free cash flows The model can be used when cash flows are unpredictable or difficult to forecast. This can be particularly true for financial institutions.

6-21 Weaknesses of the RI model The model relies on accounting data that can be subject to manipulation When book value and ROE are unpredictable, the resulting estimate is less valid.

6-22 Readings Reserve Material