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Valuation Chapter 10

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Ch 102 Valuation models –Discounted cash-flow –Market-based (multiples) –Residual income Model DCF and risidual income model are much more sophisticated valuation tools than the price multiples –Infinite forecast horizon –Risk and the time-value of money are taken into account (cost of capital)

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Ch 103 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

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Ch 104 Discounted Dividend Valuation Theoretical Model No-growth, constant dividend Dividends are growing at rate g

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Ch 105 Required rate of return (r) r f, Risk-free (30-year Treasury bond) = 5% r m, Expected stock market return = 10% –Risk premium = (r m – r f ) For example, if Beta = 1.5 r = 5% + 1.5(10%-5%) r = 12.5%

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Ch 106 Growth rate (g) Sustainable growth = ROE(1-Payout rate) –ROE = Earnings/Average equity –Payout rate: % of earnings used to pay dividends

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Ch 107 Motorola –Annual dividend = $0.16 –Beta = 1.35 –ROE = 13% –Payout ratio = 20% Economic –Yield on Treasury bills = 4.75% –Historical market risk premium = 5.4% Discounted Dividend Valuation Motorola example

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Ch 108 r =.0475+1.35(.054) =.120 g =.13(1-.20) =.104 Value = $11.04 Discounted Dividend Valuation Motorola example

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Ch 109 Discounted Operating Cash-Flow Models Value of the firm (EV) = Value of assets = Enterprise value = Value of debt +value of equity Typically, valuation of debt is relatively easy. Amount of debt reported in balance sheet is usually close to market value, i.e. value of debt is observable

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Ch 1010 Discounted Operating Cash-Flow Models Operating cash flow Plus: Interest Paid Times (1-tax rate) Less: Investments in Fixed Capital Free Cash Flow to the Firm (to all investors)

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Ch 1011 Discounted Operating Cash-Flow Models r = Weighted average cost of capital (WACC) –Required rate of return to all capital providers –For Motorola, 10.2% g = growth rate of FCFs –For Motorola, 9% If Motorola’s FCF = $314 million Firm value is $26,167 million [314/(.102-.09)] Shares outstanding is 2,299 Value per share (after debt $9,428) is $7.28

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Ch 1012 Discounted Operating Cash-Flow Models Growth –Can also 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 –Use financial analysts’ estimates

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Ch 1013 Market-based Models (multiples) Compare subject company to other similar companies for which market prices are available Simple but require a lot of professional judgment P/E Model P/B Method P/S Model

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Ch 1014 P/E Model Assumes a company is worth a certain multiple of its current earnings Assumes each stock is worth the same multiple of EPS Requires judgment regarding –Peer firms –Historical (average) P/E

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Ch 1015 P/E Model Firms with no internal growth prospects, paying out 100% of earnings –Current P/E = 1/r Constant growth, –P 0 /E 1 = (D 1 /E 1 )/(r-g) –D = annual dividends, E = EPS

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Ch 1016 P/E versus bond yields http://home.golden.net/~pjponzo/PE-BondRates.htm

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Ch 1017 Effect of the cost of equity and growth opportunities to P/E-ratio

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Ch 1018 P/E Model Motorola example Consensus analyst forecast EPS = $0.46 P/E of 23 is appropriate Value = 23*$0.46 = $10.58

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Ch 1019 Problems when using P/E-ratio in valuation It assumes that the benchmark is obtainable. P/E-ratios might differ accross firms or time at least for the following reasons: –growth opportunities may differ accross firms –riskiness of a firm may differ accorss firms –earnings for a given year may be temporary by nature

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Ch 1020 P/B-ratio, price/book–ratio No growth –P 0 /B = ROE/r Constant growth –P 0 /B = (ROE- g)/(r-g) P/B ratios for similar firms are compared with those of the subject firm to arrive at an appropriate multiple for use in valuation

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Ch 1021 Other Price multiples –enterprise value/EBIT–ratio –price/free cash flow–ratio –price/sales–ratio –Price/EBITDA Method used should be appropriate considering the specific circumstances of the subject company.

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Ch 1022 Residual Income Model PV = book value + excess earnings over time Perpetuity model

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Ch 1023

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Ch 1024 Valuation tools most used by analysts in Morgan Stanley European sector research teams

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