1. Equity Valuation and Analysis with eVal
Chapter 10
Valuation

2. Framework for Business Analysis and Valuation

3. Key Valuation Inputs Cost of Capital Forecast Financial Statements
Value of Contingent Equity Claims

4. Alternative Approaches to Valuation
Discounted Dividends
Discounted Free Cash Flow
Discounted Residual Income
Earnings Multiples and Related Heuristics

5. Dividend Discounting Model
where
P0 = equity value at the end of period 0
Divt = net cash distributions to equity at the end of period t
re = cost of equity capital

6. Problems With Discounting Dividends
Most growth companies pay no dividends, and may plan not to pay dividends for many years
Most companies reinvest a large proportion of their earnings rather than paying them out as dividends
Dividends measure wealth distribution rather than wealth creation

7. Traditional Discounted Free Cash Flow Model (to All Investors)
where
P0 = equity value at the end of period 0
FCFt = free cash flows to debt and equity holders during period t
rW = weighted average cost of capital
Debt0 = value of debt at the end of period 0

8. Discounting Free Cash Flows to Equity
where
P0 = equity value at the end of period 0
FCFEt = free cash flows to equity holders during period t
re = cost of equity capital

9. Problems With Discounting Free Cash Flows
Cash flows are difficult to forecast because they depend on the timing of events that do not have a big impact on value (e.g., timing of equipment/inventory purchases)
For growth companies, cash flows may be negative for many years to come
Cash flows provide a noisy and untimely measure of firm performance

10. Discounted Residual Income Model
where
P0 = equity value at the end of period 0
NIt = net income for period t
re = cost of equity capital
CEt = book value of common equity at the end of period t

11. Discounting Residual Income to All Investors (Debt and Equity)
where
P0 = equity value at the end of period 0
NOIt = net operating income (after taxes)
rW = weighted average cost of capital
NOAt = net operating assets at the end of period t
Debt0 = value of debt at the end of period 0

12. Two Stage Discounted Residual Income Model (used in eVal)
where
P0 = equity value at the end of period 0
NIt = net income for period t
re = cost of equity capital
CEt = book value of equity at the end of period t
g = constant terminal growth rate in residual income beyond period T+1

13. Advantages of Discounting Residual Income
Unlike dividends and cash flows, earnings provide a reasonably reliable and timely measure of firm performance
Accounting analysis and ratio analysis provides a framework for evaluating earnings performance
Most practicing investors seem to use earnings to evaluate equities

14. Discounted Residual Income Model Focuses on Key Value Drivers
This expression indicates that value is created by:
1. Generating a long-run ROE that exceeds the cost of capital (focus on profit margin and asset turnover)
2. Growing the size of the investment base on which the ROE is generated (focus on sales growth)

15. Subsequent Performance for Firms With Extreme Residual Income

16. Bottom Line on Valuation Models
Discounted dividends, discounted free cash flow and discounted residual income are all theoretically valid valuation models.
Your valuations should always be based on a complete and consistent set of forecast financial statements, in which case you will get the same value regardless of the valuation model used.
Your forecast horizon must extend out far enough that you reach a constant terminal growth rate in the flow that you are discounting – at which point you can make a terminal value computation.

17. Valuation Using Price Multiples
Examples include price-earnings, enterprise value-sales and market-book multiples.
A popular heuristic is the ‘PEG’ Ratio, which uses an earnings multiplier that equals the long-run expected growth rate in earnings.
The major problem with these approaches is that they implicitly make restrictive assumptions that are very often unrealistic.
We will explore determinants of common valuation multiples in session 19.

18. Contingent Claims on Equity
Value to Existing Equity Holders
= PV of FCF to Common Equity
Value of Contingent Claims on Common Equity
In building your free cash flow forecasts, assume that all future expenses are ultimately paid for in cash or stock and not with contingent equity claims.
Note that FAS123R essentially does this for employee stock options, in that it requires an expense equal to the estimated cash value of the options granted
but we don’t currently have similar accounting for convertible bonds

19. Valuation Example EnCom Corporation Stage 3
Illustrates equivalency of valuations using the DCF Model and the Residual Income Model
Illustrates how accounting distortions can change the sequence of residual income, but not the value of the firm.

20. Solution (double click to see computations)

21. Stage 3 Questions
2. In question 1 above, you should have arrived at the same valuation regardless of the accounting method employed. Provide a qualitative explanation as to why the different accounting methods have no impact on the valuation.
The accounting technique selected has no effect on cash flows or dividends, and hence has no impact on the valuation. Note that conservative accounting leads to low residual income in earlier years and high residual income in later years. Conversely, aggressive accounting leads to high residual income in earlier years and low residual income in later years.

22. Upcoming Cases Overstock.com E Evaluating Intel’s Earnings Torpedo
Critical evaluation of analyst valuation. What are the implicit assumptions and are they reasonable?
Conduct your own valuation of Overstock.com using eVal. Focus on sales growth and ROE as the key drivers of value.
Evaluating Intel’s Earnings Torpedo
Understand why a small reduction in earnings can lead to a large drop in price.
The Restaurant Industry in 2003
Understanding the determinants of common valuation ratios.
The AOL Time Warner Merger
Illustrates how value can be created and destroyed through financing transactions