Valuation
Lecture 6 Valuation Models and Perspectives
Diem Nguyen
diem.nguyen@handels.gu.se
Spring 2020
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Valuation
Learning Objectives
Describe major approaches to valuation.
Use the dividend-discount model to compute the value of a
dividend-paying stock.
Use the discounted free cash ow model to calculate the value
of stock in a company with leverage.
Compare and contrast dierent valuation models.
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Valuation
Outline
1
2
Introduction to Valuation
Discounted Cash Flow Valuation
Dividend Discount Models
Free Cash Flow Models
The Inputs
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Valuation
Reading
Berk and DeMarzo, Corporate Finance (4th/5th edition)
Chapter 9 - Valuing stocks
Palepu, Healy and Peek, Business Analysis and Valuation:
IFRS edition, 5th edition
Chapter 7 - Prospective analysis: Valuation theory and
concepts
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Valuation
Introduction to Valuation
Outline
1
2
Introduction to Valuation
Discounted Cash Flow Valuation
Dividend Discount Models
Free Cash Flow Models
The Inputs
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Valuation
Introduction to Valuation
Firm Valuation vs. Equity Valuation
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Valuation
Introduction to Valuation
Value Concepts
Book value
Obtained from the balance sheet
Market value
Price of securities traded in liquid markets.
Intrinsic (fundamental) value
Present value of expected future cash ows discounted by
required rate of return.
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Valuation
Introduction to Valuation
Approaches to Valuation
1
Discounted Cash Flow (DCF) Valuation
Value of an asset = Present value of its expected future cash
ows.
n
Value =
X
t=1
CFt
(1 + r )t
(1)
r → discount rate reecting the riskiness of the estimated cash
ows.
2
Relative valuation
Value of an asset = market value for comparable assets.
Value = Multiple of comparables × Firm-specic variable.
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Valuation
Introduction to Valuation
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Valuation
Introduction to Valuation
Keep in mind
Corporate valuation is not an exact science.
Valuation models require assumptions or forecasts that are
often too uncertain to provide a denitive assessment of rm's
value.
Lots of things can go wrong
Hidden or distorted data
Badly interpreted data
The future doesn't meet the forecast
Prudence, caution and healthy skepticism
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Valuation
Introduction to Valuation
Infamous Valuation Stories
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Valuation
Introduction to Valuation
Infamous Valuation Stories
Autonomy acquisition by Hewlett-Packard (2011)
Oct 2011: HP purchased the British software rm Autonomy
at a price of $11 billion.
Nov 2012: HP wrote down $8.8 billion in relation to the
purchase
The majority of this impairment charge is linked to serious
accounting improprieties, disclosure failures and outright
misrepresentations at Autonomy Corporation plc that occurred
prior to HP's acquisition of Autonomy and the associated
impact of those improprieties, failures and misrepresentations
on the expected future nancial performance of the Autonomy
business over the long-term.
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Valuation
Introduction to Valuation
Infamous Valuation Stories
AOL acquisition of Time Warner (2001)
Jan 2001: AOL completed its $164bn acquisition of Time
Warner
2002: recorded goodwill impairment of $99 bn.
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Valuation
Discounted Cash Flow Valuation
Outline
1
2
Introduction to Valuation
Discounted Cash Flow Valuation
Dividend Discount Models
Free Cash Flow Models
The Inputs
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Valuation
Discounted Cash Flow Valuation
Dividend Discount Models
The Dividend-Discount Model: A One-Year Investor
Potential cash ows:
Dividend
Sale of stock
Timeline:
Today's value:
P0 =
rE →
Div1 + P1
1 + rE
(2)
equity cost of capital
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Valuation
Discounted Cash Flow Valuation
Dividend Discount Models
Illustration
3M just paid a dividend of $4.5 per share.
You expect the stock price to be $178.5 and the dividend to
increase by 5% in one year.
Investments with equivalent risk to 3M's stocks have an
expected return of 11%.
Question: What would you pay today for 3M stock?
P0 =
Div1 + P1
4.5 × 1.05 + 178.5
=
= 165.07
1 + rE
1 + 0.11
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Valuation
Discounted Cash Flow Valuation
Dividend Discount Models
The Dividend-Discount Model: A Multi-Year Investor
What is the price if we plan on holding the stock for 2 years?
P0 =
Div1
Div2 + P2
+
1 + rE
(1 + rE )2
(3)
Holding period = N years
P0 =
Div1
Div2
DivN + PN
+
+ ... +
2
1 + rE
(1 + rE )
(1 + rE )N
(4)
→ Stock Price = PV of expected future dividends
∞
P0 =
X Divn
Div1
Div2
Div3
+
+
+... =
(5)
2
3
1 + rE (1 + rE ) (1 + rE )
(1 + rE )n
n=1
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Valuation
Discounted Cash Flow Valuation
Dividend Discount Models
1
Zero growth:
Div1
rE
(6)
Div1
rE − g
(7)
P0 =
2
Constant growth:
P0 =
3
Multi-stage growth:
P0 =
Div1
Div2
DivN
1
DivN+1
+
+ ... +
+
2
N
N
1 + rE (1 + rE )
(1 + rE )
(1 + rE ) rE − g
(8)
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Valuation
Discounted Cash Flow Valuation
Dividend Discount Models
Illustration: 2-stage DDM
Small Fry, Inc., has just invented a potato chip that looks and
tastes like a french fry. Given the phenomenal market response
to this product, Small Fry is reinvesting all of its earnings to
expand its operations.
Earnings were $2 per share this past year and are expected to
grow at a rate of 20% per year until the end of year 4. At that
point, other companies are likely to bring out competing
products.
Analysts project that at the end of year 4, Small Fry will cut
investment and begin paying 60% of its earnings as dividends
and its growth will slow to a long-run rate of 4%.
Small Fry's equity cost of capital is 8%.
Question: What is the value of Small Fry's share today?
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Valuation
Discounted Cash Flow Valuation
Dividend Discount Models
DPS = EPS × Payout ratio
Forecast future earnings and dividends
From year 4 onward, dividends will grow at the expected
long-run rate of 4% per year
→ Estimate terminal value with constant growth model
2.49
Div4
=
= 62.25
P3 =
rE − g
0.08 − 0.04
Value of Small Fry's stock
Div1
Div2
Div3
P3
P0 =
+
+
+
2
3
1 + rE
(1 + rE )
(1 + rE )
(1 + rE )3
62.25
=
= 49.42
3
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Valuation
Discounted Cash Flow Valuation
Free Cash Flow Models
Free Cash Flow to Equity
Value of equity
V0 =
FCFE1
FCFE2
1
FCFEN+1
FCFEN
+
+
+...+
1 + rE (1 + rE )2
(1 + rE )N (1 + rE )N rE − g
(9)
Free cash ow to equity → cash ows left over after meeting
all nancial obligations, including debt payments, and after
covering capital expenditure and working capital needs.
FCFE = Net Income − Capital expenditures + Depreciation
−∆noncash working capital
+(New debt issued − Debt repayments)
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Valuation
Discounted Cash Flow Valuation
Free Cash Flow Models
Free Cash Flow to Equity
If the net capital expenditures and working capital changes are
nanced using a xed mix of debt and equity:
FCFE = Net Income
−(1 − DR)(Capital expenditures − Depreciation)
−(1 − DR)∆noncash working capital
where DR → debt-to-capital ratio
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Valuation
Discounted Cash Flow Valuation
Free Cash Flow Models
Free Cash Flows to Firm
Firm value
V0 =
FCFF1
FCFFN
1
FCFFN+1
+...+
+
N
N
1 + WACC
(1 + WACC )
(1 + WACC ) WACC − g
(10)
Free cash ow to the rm
FCFF = EBIT(1-tax rate) − Capital expenditures + Depreciation
−∆noncash working capital
WACC → rm's weighted average cost of capital = weighted
average of costs of equity and debt
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Valuation
Discounted Cash Flow Valuation
Free Cash Flow Models
Illustration: FCF
Footwear and apparel maker Kenneth Cole Productions, Inc.,
(KCP) had sales of $518 million in 2005.
Suppose you expect its sales to grow at a 9% rate in 2006, but
that this growth rate will slow by 1% per year to a long run
growth rate for the apparel industry of 4% by 2011.
Based on KCP's past protability and investment needs, you
expect EBIT to be 9% of sales, increases in net working
capital requirements to be 10% of any increase in sales, and
net investment (capital expenditures in excess of depreciation)
to be 8% of any increase in sales.
KCP has $100 million in cash, $3 million in debt, 21 million
shares outstanding, a tax rate of 37%, and a weighted average
cost of capital of 11%
Question: What is your estimate of the value of KCP's stock in
early 2006?
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Valuation
Discounted Cash Flow Valuation
Free Cash Flow Models
Estimate KCP's future FCF
Stable growth after 2011 → Terminal value
V2011 =
FCFF2012
37.6 × 1.04
=
= $558.6million
WACC − g
0.11 − 0.04
Enterprise value in early 2006
Value of KCP's stock
V0 + Cash0 − Debt0
424.8 + 100 − 3
P0 =
=
= $24.85
Shares oustanding
21
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Valuation
Discounted Cash Flow Valuation
The Inputs
Generic DCF Valuation Model
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Valuation
Discounted Cash Flow Valuation
The Inputs
Dividend-Discount Model
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Valuation
Discounted Cash Flow Valuation
The Inputs
Free Cash Flow to Equity
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Valuation
Discounted Cash Flow Valuation
The Inputs
Free Cash Flow to Firm
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Valuation
Discounted Cash Flow Valuation
The Inputs
Estimating the inputs
1
Estimate the discount rate(s) ← Lecture 7
Cost of equity (if doing equity valuation), or
WACC (if rm valuation)
2
Estimate the current earnings and cash ows, to either equity
investors (CF to equity) or to both debt and equity investors
(CF to rm)
3
Estimate the future earnings and cash ows, generally by
estimating an expected growth rate in earnings ← Lecture 8
4
Estimate when the rm will reach stable growth and its
terminal value ← Lecture 8
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