Suggested Example Problems
Investment Valuation – Damodaran
Lecture 5 – Final Steps in DCF Analysis
Lecture 6 – Relative Valuation
In Lectures 3 and 4, we discussed measurement and forecasting of earnings and cash flows. In
Lecture 5, we will discuss the final steps in DCF valuation. Chapter 16 deals with final
adjustments that must be made in order to estimate equity value per share. This discussion
includes adjustments for holdings in other firms and for employee stock options. In Chapters 13
through 15, Damodaran provides numerous examples of valuations based on the dividend
discount model, the FCFE model, and the FCFF model. While there is little new material here,
the chapters and related problems should help to bring the whole valuation process together.
Lecture 6 deals with relative valuation. We will start with a basic discussion of multiples and
how to interpret them. This discussion is related to chapter 17 in the text and to the McKinsey
article on the use of multiples. We will then describe specific multiples in more detail focusing
on their definitions, their distributions, and the fundamental characteristics that drive variation in
the multiple across firms. Earnings multiples, such as P/E ratios, PEG ratios, and Value/EBITDA
ratios are described in chapter 18. Additional book value multiples and revenue multiples are
covered in chapters 19 and 20, but we will not have time to cover these chapters.
Homework (Turn In):
Complete the homework problems on the attached pages and turn in your solutions by the
assigned due date. Be prepared to discuss your solutions in class.
Additional Suggested Problems (Do Not Turn In):
The following suggested problems will give you a basic idea of the topics that I want to
emphasize from the text. The solutions to these problems are available on the class web site.
Chapter
Topic
Suggested Problems
16
From Firm Value to Equity Value per Share
1, 2, 6, 8
13
The Dividend Discount Model
1, 2, 3
14
The FCFE Model
1, 4, 7
15
The FCFF Model
1, 3
17
An Overview of Relative Valuation
1, 2, 3, 4
18
Earnings Multiples
6, 7
Homework Assignment - Lecture 5
1.
Using a FCFF model based on consolidated financials, you estimate that the present value of
operating cash flows for Conglomerate Inc. is $6.25 billion. The firm reports a 70% majority stake
in a subsidiary called ABC, which has a market value of $2.5 billion. Conglomerate Inc. has no debt,
but reports a liability of $375 million related to the minority interest in ABC. Conglomerate also has
excess cash and short-term investments worth $600 million. If Conglomerate Inc. has 200 million
shares outstanding, what is your estimate of the equity price per share?
2.
The current stock price of Acme Corp. is $79.00 per share. Using a DCF model, you estimate that
the total equity value for Acme Corp. is $110 billion. The firm has 1.4 billion shares outstanding.
However, the firm also has 145 million outstanding employee stock options with an average exercise
price of $62 per share (you can assume all options are vested and in-the-money). The options have a
Black-Scholes value of $17.10 each and the firm’s marginal tax rate is 38%.
a. What is the estimated equity price per share if you use the Treasury Stock method to incorporate
employee stock options?
b. What is the estimated equity price per share if you use the Black-Scholes method to incorporate
employee stock options?
Homework Assignment - Lecture 6
1.
Starting from the Gordon Growth Model (the Dividend Discount Model with constant growth), show
how the P/E ratio is related to the fundamentals of the firm.
2.
Based on your answer to (1), estimate the expected P/E ratio for a firm that has long-term expected
growth of 6%, an ROE of 13%, and a cost of equity of 8.5%. If the company has a current P/E ratio
of 19.5, would your analysis suggest that the company is over- or under-valued?