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Chapter 6 Common Stock Valuation: The Inputs

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6-2 Valuation Inputs Now that we have an understanding of the models used, we are going to focus on developing estimates for the inputs the models require.

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6-3 DCF Model: Cash Flow In the cash flow valuation models, there are three cash flows we can use to determine value: dividends, free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). Using dividends as the cash flow is restrictive because we would not be able to value non-dividend paying or low dividend paying firms. The cash flow that we will use is the Free Cash Flow to the Firm. This represents the cash flow available to ALL the investors of the firm, including equity holders and debt holders. Valuing the firm using FCFF and FCFE are equivalent.

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6-4 DCF Model: Calculating Current FCFF Free cash flow to the firm (FCFF) can be calculated in the following way: Where EBIT = Earnings Before Interest and taxes (Income statement) t = marginal tax rate (assumed to be 35%) NCC = non-cash charges (such as depreciation) (statement of cash flows) FCInv = Investment in fixed capital (statement of cash flows) WCInv = Investment in working capital (balance sheet)

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6-5 DCF Model: Calculating Current FCFF In general, working capital is defined as current assets minus current liabilities. However, for valuation purposes, working capital should exclude cash and cash equivalents and short term debt, which can be notes payable or the current portion of long-term debt. Our focus is on calculating a value for operating working capital. Investment in working capital in year t then is: WCInv = WC(t) – WC(t-1)

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6-6 DCF Model: Discount Rate The discount rate used in any valuation model should reflect the return required by the investors that are to receive the cash flows. In the DCF model, with FCFF, since the cash flow is to all investors of the firm, we have to determine the required return for the debt holders and equity holders. The weighted average of these required returns is referred to as the weighted average cost of capital (WACC)

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6-7 DCF Model: Discount Rate The WACC (k) is calculated as: Where k e = required rate of return for equity holders (cost of equity) k d = required rate of return for debt holders (cost of debt) MV e = market value of equity MV d = market value of debt t = marginal tax rate

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6-8 DCF Model: Discount Rate – Cost of Equity The cost of equity for a stock can be estimated using the capital asset pricing model (CAPM ). We will discuss the CAPM in a later chapter. However, we can estimate the discount rate for a stock using this formula: Cost of equity (k e ) = risk-free rate + risk premium = T-bond yield + (stock beta x stock market risk premium) T-bond yield:return on 30-yr U.S. T-bonds Stock Beta:risk relative to an average stock Stock Market Risk Premium: risk premium for an average stock (Long-term geometric average)

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6-9 DCF Model: Discount Rate – Cost of Debt Just like with equity, the cost of debt or the required rate of return for debt holders can be stated as: Cost of debt (k d ) = risk-free rate + risk premium The risk premium here represents the extra return that investors require to compensate them for the possibility that the firm may default on their debt obligation. The cost of debt (k d ) can be estimated in one of two ways: –Look for prices and yields of bonds outstanding –Estimate the cost of debt from the firm’s credit rating

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6-10 DCF Model: Discount Rate – Cost of Debt If the firm has bonds outstanding, and the bonds are traded, the yield to maturity (YTM) on a long-term, straight (no special features) bond can be used as the before tax cost of debt. The YTM incorporates the risk-free rate and firm-specific default risk. Sources: –Look at the Corporate Bond excerpt in the WSJ or other publications –Yahoo may also have this information k d = YTM * (1-t)

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6-11 DCF Model: Discount Rate – Cost of Debt Rating agencies, such as Standard and Poors and Moody’s provide ratings for company’s debt. This rating is an indication of the riskiness of the debt. Standard and Poors ratings can be found at: www.standardandpoors.com If the firm is rated, use the credit rating and a typical default spread on bonds with that rating to estimate the cost of debt. Default spreads represent the risk premium. Default spreads can be found at www.bondsonline.com (premium service) OR inferred from bond spreads of other bonds with the same ratingwww.bondsonline.com k d = (30-yr. T-bond yield + default spread) * (1-t)

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6-12 DCF Model: Discount Rate – Market Value of Equity The market value of equity (MV e ) is the market capitalization of the firm: Market Cap =Shares outstanding * current stock price

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6-13 DCF Model: Discount Rate – Market Value of Debt The market value of debt (MV d ) consists of two components: –The value of long-term debt –The value of operating leases (off-balance sheet) The market value of long-term debt can be approximated using the book value of long-term debt which can be found on the firm’s balance sheet.

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6-14 DCF Model: Discount Rate – Market Value of Debt Operating leases represent payments for things such as leasing a building, etc. These leases do not show up on the balance sheet. The “debt value” of leases is the present value of the lease payments, at a rate that reflects their risk. In general, this rate will be close to or equal to the rate at which the company can borrow, i.e., pre-tax cost of debt.

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6-15 RIM One of the very attractive properties of the RIM is that apart from the discount rate and the growth rate, all the other inputs can be taken directly from the firm’s financial statements. Book value of equity = Total shareholders equity – Preferred Stock ROE = Net Income / Book value of equity

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6-16 RIM – Discount Rate The “cash flows” used in the RIM is the earnings per share. This represents a cash flow to the equity holders only. Therefore, the discount rate should reflect a required rate of return to the equity holders. This rate is the cost of equity (k e ).

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6-17 Readings Reserve Material

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