EC5321 Investment and Portfolio Management Valuation Principles and Techniques Lecture 4 What we plan to evaluate Firm’s Securities The firm’s value in total Firm’s Securities Firm Operating assets Real Option Preferred Stock Tangible assets Intangible assets A Hybrid Security Fixed Assets Current Assets Bonds Common Stock 2 What we plan to study Fundamentals of Investment Decisions The three steps analyzing process Expected Returns on Investment Evaluation Techniques Discounted Cash Flows (DCF) Techniques Relative Valuation Techniques Required Rate of Return 3 Today’s questions • • • • • What is the top-down (three-step) approach? How do you determine the value of bonds? How do you determine the value of preferred stock? What are the two primary approaches to the valuation of common stock? How can we apply the present value of the operating cash flow technique for the firm’s valuation? • How can we apply the present value of the free cash flow technique to the equity valuation? • What is the essence of the relative valuation approach, and what are the primary relative valuation ratios? Today’s readings 1. Security valuation principles: Reilly & Brown, Chapter 11 2. Financial statement analysis: Reilly & Brown, Chapter 10 (background reading) EC5321 Lecture 4 4 Agenda 1. 2. 3. 4. 5. 6. Fundamentals of the Investment Approach The Theory of Valuation Techniques The DCF Approach to Security Valuation The DCF Approach to Firm’s Valuation Relative Valuation Techniques Valuation inputs – – – Required Rate of Return, Expected Growth Rate, Return on Equity EC5321 Lecture 4 5 Fundamentals of the Investment Approach The three steps, top-down analyzing process Analysis of Alternative Economies and Security Markets Decide how to allocate investment funds among countries and within countries to bonds, stock and cash. Analysis of Alternative Industries Based upon the economics and market analysis, determine which industries will prosper and which industries will suffer on a global basis and within countries. EC5321 Lecture 4 Following the analysis of the industries, determine which companies within these industries will prosper and which stocks are undervalued. Analysis of Individual Companies and Stocks 6 The three steps, top-down process Step #1. Analyzing general economic issues: – Fiscal policy initiatives, such as tax credits or tax cuts, can encourage spending, while high taxes can discourage it – Monetary policy controls money supply growth and interest rate and affects all segments of an economy and that economy’s relationship with other economies. – Inflation (unexpected) changes the spending and savings behaviour of consumers and corporations. – Effects of extraordinary events (war, political upheavals, currency devaluations, etc.) 7 The three steps, top-down process Step #2. Exploring industry influences – Identifying global industries that will prosper or suffer in the long run or during the expected near-term economic environment – Different industries have different responses to the business cycle: • Pro-cyclical: Construction, airlines, autos, luxury goods • Acyclical: Retail food, primary household products • Counter-cyclical: Pawn shops, payday credit providers – Different industries are influenced differentially by demographic factors: • e.g., ageing population: pharmaceuticals up, childcare providers down 8 The three steps, top-down process Step #3. Analyzing companies: – The purpose of company analysis is to identify the best companies in a promising industry. – This involves examining a firm’s past performance, but more importantly, its prospects. – It needs to compare the estimated intrinsic value to the prevailing market price of the firm’s stock and decide whether its stock is a good investment. – The final goal is to select the best stock within a desirable industry and include it in your portfolio based on its correlation with all other assets in your portfolio. 9 The three steps, top-down process Does it work? • Studies indicate that most changes in an individual firm’s earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industry. • Studies have also found a relationship between aggregate stock prices and various economic issues such as employment, income, or production. • Most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock industry. 10 The Theory of Valuation Techniques Time Value of Money Phenomenon Return on Investment RETURN INVESTMENT Return of Investment Now 1 2 3 FUTURE VALUE PRESENT VALUE in n years DISCOUNTING • bringing future sums of money to the "now" point in time. • "cutting-off" of future earnings that can be generated through alternative investment of money now. FVn PV ο½ (1 ο« r ) n 11 The Theory of Valuation Techniques The Value of an Asset Present Value of its returns = A required Rate of Return on the investment A stream of expected returns ππ = π·1 (1+π)1 + π·2 (1+π)2 +…+ π·π (1+π)π . Value of an Asset Return on Investment CF1 CF2 1 2 CF3 3 CF5 CF4 4 5 Return of Investment The Value of an Assts? Value of Asset = πΆπΉ1 (1+π)1 πΆπΉ2 + (1+π)2 πΆπΉπ +…+ (1+π)π . 13 The Theory of Valuation Techniques Expected returns Form of returns: • Earnings • Cash flows • Dividends • Interest payments • Capital gains (increases in value) Time pattern and growth rate of returns: • When the returns occur • At what rate will the return grow The Theory of Valuation Techniques Required Rate of Return U N C E R T A I N T Y Required Rate of Return Risk-free Rate of Return Inflation Rate Risk Premium Country Risk Business Risk Financial Risk Liquidity Risk Exchange Rate Risk EC5321 Lecture 4 15 The Theory of Valuation Techniques Investment Decision Process Estimated Value Vs. Market Price Buy or Hold Estimated Value > Market Price Don’t Buy or Sell Estimated Value < Market Price EC5321 Lecture 4 16 Bond Valuation A bond typically promises: 1. Interest (coupon) payments every six months 2. The payment of the principal on the bond’s maturity date. Principal . . . . . Coupon Stream EC5321 Lecture 4 17 Bond Valuation Key characteristics of a bond: – Par value (face value or principal), π·π • The basis for interest calculation and the amount repaid at maturity. – Maturity, n • The time when the principal is repaid. – Coupon rate, c • The simple annual interest rate (paid on the par value) • The resulting annual coupon payment πͺ = π β π·π • Interest is actually paid twice a year for most bond. The Additional Factor needed to estimate a Bond’s Value: - Required Rate of Return (rr), usually market rate of return on similar securities EC5321 Lecture 4 18 Bond Valuation (semi-annual case) Principal . . . . . Coupon Stream ππ΅ = πΆ1 (1+π)1 where r = Equation in a closed form ππ 2 + πΆ2 (1+π)2 +…+ πΆ2π (1+π)2π + ππ (1+π)2π , = Required Rate of Return/2, πΆ = π β ππ /2 1 ο¦ οΆ ο§1ο 2n ο· 2 n (cP ) 2 Pp cPp ο§ (1 ο« rr 2) ο· Pp p V ο½ο₯ ο« ο½ ο« t 2n 2n ο§ ο· ( 1 ο« r 2 ) ( 1 ο« r 2 ) 2 r 2 ( 1 ο« r 2 ) t ο½1 r r r r ο§ ο· ο¨ οΈ EC5321 Lecture 4 19 Bond Valuation Some examples (Excel spreadsheets) Face Value of the Bond Time to Maturity (years) Coupon Rate of the Bond # of coupons pmt per year Coupon pmt Required Rate of Return PV of coupons PV of Principal Bond's Value 10,000.00 15 10% 2 500.00 10% 7,686.23 2,313.77 10,000.00 10 years to maturity Required Return = 10% (remains the same) 10,000.00 10 10% 2 500.00 10% 6,231.11 3,768.89 10,000.00 10 years to maturity Required Return =12 % 15 years to maturity Required Return =12 % Face Value of the Bond Time to Maturity (years) Coupon Rate of the Bond # of coupons pmt per year Coupon pmt Required Rate of Return PV of coupons PV of Principal Bond's Value Face Value of the Bond Time to Maturity (years) Coupon Rate of the Bond # of coupons pmt per year Coupon pmt Required Rate of Return PV of coupons PV of Principal Bond's Value 10,000.00 15 10% 2 500.00 12% 6,882.42 1,741.10 8,623.52 10 years to maturity Required Return = 12% EC5321 Lecture 4 Face Value of the Bond Time to Maturity (years) Coupon Rate of the Bond # of coupons pmt per year Coupon pmt Required Rate of Return PV of coupons PV of Principal Bond's Value 10,000.00 10 10% 2 500.00 12% 5,734.96 3,118.05 8,853.01 20 Preferred Stock Valuation Key characteristics of Preferred Stock: – Par value – No Maturity • Preferred stock is a perpetuity – Stated Dividend D The Additional Factor needed to estimate a Preferred Stock Value: - Required Rate of Return (kr), usually market rate of return on similar securities ππ = π· (1+ππ )1 + π· (1+ππ )2 +…+ π· (1+ππ )π EC5321 Lecture 4 + …= π· ππ . 21 Preferred Stock Valuation Some examples (Excel spreadsheets) Par Value # of dividends pmt per year Stated Dividend Required Rate of Return Preferred Stock Value 100.00 4 8.00 9% 88.89 10 years passed Required Return = 9 % 100.00 4 8.00 9% 88.89 10 years passed Required Return = 7 % Required Return =7 % Par Value # of dividends pmt per year Stated Dividend Required Rate of Return Preferred Stock Value Par Value # of dividends pmt per year Stated Dividend Required Rate of Return Preferred Stock Value 100.00 4 8.00 7% 114.29 10 years passed Required Return = 7 % EC5321 Lecture 4 Par Value # of dividends pmt per year Stated Dividend Required Rate of Return Preferred Stock Value 100.00 4 8.00 7% 114.29 22 Preferred Stock Valuation (changing Required Rate of Return) An investor expects that after m years the Required Return will change from ππ to ππ(πππ€) ππ = π· (1+ππ )1 Par Value # of dividends pmt per year Stated Dividend Required Rate of Return Year of changing Return Required Return after Preferred Stock Value + π· (1+ππ )2 +…+ 100.00 1 8.00 7% 2 7% 114.29 After two years Required Return = 9 % EC5321 Lecture 4 π·+π·/ππ(πππ€) (1+ππ )π . Par Value # of dividends pmt per year Stated Dividend Required Rate of Return Year of changing Return Required Return after Preferred Stock Value 100.00 1 8.00 7% 2 9% 92.10 23 Equity Valuation Common Stock Valuation Approaches to Equity Valuation • Present Value of Dividends (DDM) • Present Value of Operating Free Cash Flow • Present Value of Free Cash Flow to Equity • Price/Earnings Ratio (P/E) • Price/Cash Flow Ratio (P/CF) • Price/Book Value Ratio (P/BV ) • Price/Sales Ratio (P/S) Firm's Valuation EC5321 Lecture 4 24 Mathematics of Equity Valuation Technique ππΈ = πΆπΉ1 (1+ππ )1 + πΆπΉ2 (1+ππ )2 +…+ πΆπΉπ (1+ππ )π + …= ∞ πΆπΉπ‘ π‘ (1+π )π‘ . π Required Rate of Return Essential factors affected ππΈ ππ Dynamics (growth rate) of Returns πͺππ 25 The Dividend Discount Model (DDM) The value of a share of common stock is the present value of all future dividends ππ = π·1 (1+ππ )1 + π·2 (1+ππ )2 +…+ π·π (1+ππ )π + …= π·π‘ ∞ π‘ (1+π )π‘ . π where: VS = value of common stock Dt = dividend during time period t k = required rate of return on stock. 26 The Dividend Discount Model (DDM) • The N-period model – If the stock is held for only N periods and sold at the end of year N, the value would be ππ = π·1 (1+ππ )1 + π·2 π·π πππ +…+ +SPj 2 D D 2 π 1 2 (1+π V j ο½π ) ο« (1+ππ ) ο« (1+ππ )π (1 ο« k ) (1 ο« k ) 2 (1 ο« k ) 2 – SPN is the stock's expected selling price at the end of the year. SPN is crucial for estimation. – SP is often called a Terminal Value (TV) 27 The Dividend Discount Model (DDM) A special case of DDM – The Constant Growth Model – It assumes stock dividends grow at a constant rate g, so D Dt+1 =V(1+g) D1t, t = 0, 1, 2, … ο½ j ο gwill continue for an infinite period – The constant growth krate – The Required Rate of Return is greater than the infinite growth rate ππ = π·1 (1+ππ )1 + π·2 (1+ππ )2 Well-known GORDON’S formula +…+ π·∞ (1+ππ )∞ ππ = = π·0 . (ππ −π) π·0 . (ππ −π) 28 Firm’s Valuation: a DCF Technique Main Assumption : Free Cash Flow is the Expected Return on Investment • Free cash flow (FCF) is the total incremental Cash Flow attributable to the business. • FCF is all monetary flow to debt holders and equity holders. Investor’s Balance Sheet FCF = NOPAT + Depreciation − CAPEX − πNWC NOPAT = EBIT (1 – T) – Net Operating Profit After Taxes Depreciation - comprising of all noncash operating charges, such as depreciation, depletion, and amortization, that are deductible for tax reporting purposes. CAPEX – capital expenditures for fixed assets πNWC – a change in Net Working Capital (Current Assets less the Non-interest-bearing Current Liabilities) 29 Firm’s Valuation: a DCF Technique The value of a firm is determined by calculating the Present Value (PV) of all the Free Cash Flows (FCF) that are generated by the firm. g … FCF1 FCF2 FCF3 FCF4 FCF5 FCF6 TV Replaces all residual FCF TV ……………………. V Free Cash Flows Terminal Value FCF5 ο (1 ο« g ) TV ο½ kοg V ο½ PV ( FCF1 ) ο« PV ( FCF2 ) ο« ... ο« PV ( FCFN ) ο« PV (TV ) 30 Firm Valuation Vs. Equity Valuation Firm Valuation Equity Valuation FCF = OFCF Operating Free Cash Flows FCF = FCFE Free Cash Flows for Equity Discount Rate = Weighted Average Cost of Capital (WACC) Discount Rate = Cost of Equity 31 Firm’s Valuation: PV of FCF for Equity The Value of Equity is determined by discounting the Free Cash Flows attributable to equity (FCFE): n FCFEt TVE VE ο½ ο₯ ο« t n (1 ο« k E ) t ο½1 (1 ο« k E ) • FCFE is a balance after all expenses, reinvestments, tax liabilities, interest and principal payments, • FCFE is discounted at a rate equal to the cost of equity kE 32 Firm’s Valuation: PV of Operating FCF The Value of Equity is determined by discounting the Free Cash Flows attributable to equity (FCFE): n OFCFt TVO VO ο½ ο₯ ο« k n (1 ο« WACC ) t ο½1 (1 ο« WACC ) • OFCF is a balance after all expenses, reinvestments, and tax liabilities, but before any payments are made to the holders of liabilities, • OFCF is discounted at a rate equal to the Weighted Average Cost of Capital (WACC) 33 Firm’s Valuation: What is WACC Example. Let's say the bank grants a loan to the business on a ratio of $2 for every $1 of its own funds. The bank charges a 6% interest rate on the loan, and the shareholders' required rate of return is 12%. If the business requires $3,000, it must generate net cash income as follows: - $2,000 x 6% = $120 to fulfil the bank's requirements - $1,000 x 12% = $120 to meet the shareholders' claims - the company also benefits from savings on income tax at T=25%: $120 x 25% = $30 As a result, the cost of capital will amount to ($120 + $120 - $30) / $3,000 * 100% = 7%. In General WACC ο½ wD ο CD ο (1 ο T ) ο« wE ο CE , wD and wE – fractions of Debt and Equity CD and CE – Cost of Debt and Cost of Equity In the Example ππ΄πΆπΆ = 2 3 β 0,12 β 1 − 0,25 + 1 3 β 0,06 = 0,07 = 7% 34 Firm’s Valuation: Relative Valuation Techniques (RVT) The Fundamentals: Relative Valuation Techniques argue that it is possible to determine the value of an economic entity (such as a company) by comparing it to similar entities using various relative ratios (multipliers). 1. 2. 3. 4. Price/earnings (P/E), Price/cash flow (P/CF), Price/book value (P/BV) Price/sales (P/S) 35 Relative Valuation Techniques: Earnings Multiplier Model The basic concept Values the stock are estimated based on expected annual earnings πΈπππππππ ππ’ππ‘ππππππ = P/E = πΆπ’πππππ‘ ππππππ‘ πππππ πΈππ πΈπππππππ π€βπππ πΈππ = πΈπ₯ππππ‘ππ ππ€πππ£π ππππ‘β Investors must decide if they agree with the prevailing P/E ratio based on how it compares to the P/E ratio for the aggregate market, the firm’s industry, and similar firms and stocks. 36 Relative Valuation Techniques: Earnings Multiplier Model Over time, the aggregate stock market P/E ratio can vary from about six times earnings to about 30 times earnings. S&P Industrials Index S&P 500 Sectors & Industries Forward P/Es (monthly, weekly since 1997). 37 Relative Valuation Techniques: Earnings Multiplier Model Relation to the DCF Approach π·1 π π·1 πΈ π= → = π − π πΈ (π − π) The P/E ratio is determined by: 1) The expected dividend payout ratio (dividends divided by earnings) 2) The estimated required rate of return on the stock (k) 3) The expected growth rate of dividends for the stock (g) A sample dynamics in the key parameters a basic Dividend payout ratio (D/E) 0.5 Required rate of return (k) 12% Growth rate (g) 8% Price/Earning (P/E) = 12.50 an optimistic scenario a higher k Dividend payout ratio (D/E) Required rate of return (k) Growth rate (g) Price/Earning (P/E) = a higher g 0.5 14% 8% 8.33 Dividend payout ratio (D/E) 0.5 Required rate of return (k) 12% Growth rate (g) 9% Price/Earning (P/E) = 16.67 Dividend payout ratio (D/E) 0.6 Required rate of return (k) 11% Growth rate (g) 9% Price/Earning (P/E) = 30.00 a higher D/E Dividend payout ratio (D/E) 0.6 Required rate of return (k) 12% Growth rate (g) 8% Price/Earning (P/E) = 15.00 38 Relative Valuation Techniques: Price to Cash Flow Ration Why Price/Cash flow ratio: – Companies can manipulate earnings, but cash flow is less prone to manipulation – Cash flow is important for fundamental valuation and in credit analysis πΆππ β πΉπππ€ ππ’ππ‘ππππππ = P/CF = πΆπ’πππππ‘ ππππππ‘ πππππ πΈππ πΆππ β πΉπππ€ 39 Relative Valuation Techniques: Price to Sales Ration Why Price/Sales ratio: • Sales are subject to less manipulation than other financial data • Caveat: This ratio varies dramatically by industry Relative comparisons using the P/S ratio should be between firms in similar industries πππππ ππ’ππ‘ππππππ = P/S = πΆπ’πππππ‘ ππππππ‘ πππππ πΈππ πππππ 40 Firm’s Valuation: Relative Valuation Techniques Sample of statistics of different ratios based on the data collected on 17 May 2022* Key Characteristics/Ratios Enterprise Value (USD Billions) Net Operating Margin Price to Earnings Price to Casf Flow Price to Sales Google MacDonald's 1,400.00 226.44 30.50% 43.70% 21.1 25.8 24.4 25.6 6.2 7.7 * https://www.wallstreetoasis.com/resources/skills/valuation/relative-valuation-models 41 Relative Valuation Techniques: Price to Book Value Why Price/Book Value ratio • Widely used to measure bank values • The Special study* indicated an inverse relationship between P/BV ratios and excess return for a cross section of stocks π΅πππ ππππ’π ππ’ππ‘ππππππ = P/BV = = πΆπ’πππππ‘ ππππππ‘ πππππ πΈπ π‘ππππ‘ππ πππ−ππ−π¦πππ π΅πππ ππππ’π * Fama and French (1992) 42 Relative Valuation Techniques: Implementing The General Procedure Step 1: Compare a company's valuation ratio (e.g., P/E ratio) with the market, industry, and other stocks to determine if it is • similar, • at a premium, • at a discount. Step 2: Explain the relationship – Understand what factors determine the specific valuation ratio for the stock being valued – Compare these factors versus the same factors for the market, industry, and other stocks – May refer to a reference model, such as the DDM: • If the model’s predicted ratio justifies a high ratio, buy 43 Relative Valuation Techniques: P/E multiplier simple case Statistics of the recent sales of similar entities 1 2 3 4 5 EBITDA V Mio. GBP Mio. GBP. 3,68 22,08 5,35 42,1 10,44 52,64 5,98 29,88 7,78 52,68 Mean Value M M 6,00 7,87 5,04 5,00 6,77 6,14 Assume Π=6 Business Valuation ο§ Estimate EBITDA ο§ Estimate Business Value V=M x EBITDA For instance, EBITDA = 6,36 MM. V = 6 x 6,36 = 38,16 MM 44 Firm’s Valuation: Relative Valuation Techniques https://corporatefinanceinstitute.com/course/advanced-financial-modeling-valuation-amazon-dcf-new/ 45 Valuation Techniques: Estimating the Inputs The Key Reasons • Estimating Inputs is the foundation for making informed investment decisions and understanding an asset's potential worth. • Estimating inputs allows for evaluating the sensitivity of the valuation to changes in these inputs. Sensitivity analysis helps identify critical drivers of value and highlight potential areas of uncertainty or variability. • Estimating inputs aids in comparing different investment opportunities. This helps investors prioritize investment options and allocate resources effectively. • Estimating inputs provides transparency and credibility to the valuation process. Investors often rely on these valuations to make financial decisions. By using reliable input estimates, the evaluation process becomes more robust, transparent, and trustworthy. 46 Valuation Inputs: Required Rate of Return • The Required Rate of Return is used as the discount rate in the DCF valuation approach and also affects the relative valuation techniques. • The investor’s Required Rate of Return must be estimated regardless of the approach selected or technique applied. Required Rate of Return Real Risk-Free Rate (RRFR) Expected Rate of Inflation (I) Risk Premium (RP) 47 Valuation Inputs: The Economy’s Real Risk-Free Rate • RRFR is the absolute minimum rate that an investor should require. • It depends on the real growth rate of the investor’s home economy because capital invested should grow at least as fast as the economy. • This rate can be affected for short periods of time by temporary tightness or ease in the capital markets. Real Risk-Free Rate Real Growth Rate of Economy 48 Valuation Inputs: The Expected Rate of Inflation General Reasoning 1. An investor invests P at a Real Risk-Free Rate (RRFR), expecting to receive in a year: πΉ1 = π β (1 + π π πΉπ ) 2. If the Estimated Inflation Rate is E(I) per year, the future value F1 must be adjusted to Inflation πΉπ1 = π β (1 + π π πΉπ ) β 1 + πΈ(πΌ) 3. Nominal Risk-Free Return (NRFR) is : πΉπ1 = π β (1 + ππ πΉπ ) 4. Combining #2 and #3 we arrive to NRFR: ππ πΉπ = (1 + π π πΉπ ) β 1 + πΈ(πΌ) - 1 = π π πΉπ +πΈ πΌ +πΈ πΌ β π π πΉπ . ππ πΉπ − πΈ(πΌ) π π πΉπ = 1 + πΈ(πΌ) Example sampling Real Risk Free Rate of Return Inflation Rate Nominal Risk Free Return 6.00% 4.00% 10.24% Nominal Risk Free Return Inflation Rate Real Risk Free Rate of Return 16.00% 8.00% 7.41%49 Valuation Inputs: Nominal Risk-Free Return Estimates of the year 2011 NRFR for major countries Valuation Inputs: The Risk Premium The Risk Premium (RP) • Causes differences in required rates of return on alternative investments • Explains the difference in expected returns among securities • Changes over time, both in absolute yield spread and ratios of yields • Five key risks: business, financial, liquidity, exchange rate, country Required Rate of Return = Nominal Risk Free Return + Risk Premium 51 Valuation Inputs: Expected Growth Rate The Growth Rate of Dividends or Cash Flows is determined by • the growth rate of earnings and • the proportion of earnings paid out in dividends (the D/E Ratio). In the short run, dividends can grow differently than earnings if the firm changes its dividend policy. Expected Growth Rate (g) Therefore, how rapidly a firm’s earnings increase depends on: (1) the proportion of earnings it retains and reinvests in new assets and (2) the rate of return it earns on these new assets. Retention Rate (RR) Return on Equity 52 Valuation Inputs: Expected Growth Rate Fundamental Mathematics of Growth Rate πΊπππ€π‘β π ππ‘π = π ππ‘πππ‘πππ π ππ‘π β π ππ‘π’ππ ππ πΈππ’ππ‘π¦ Management Decision π ππ‘πππ‘πππ π ππ‘π = (1 − π·ππ£πππππ πππ¦ππ’π‘ π ππ‘ππ) A firm can increase its growth rate by • increasing its Retention Rate (reducing its payout ratio) and investing these added funds at its historic ROE, • maintaining its Retention Rate but increasing its ROE. It might provide both increasing RR and increasing ROE. Retention Rate Return on Equity Expected Growth Rate 0.50 10.00% 5.00% Retention Rate Return on Equity Expected Growth Rate 0.75 10.00% 7.50% Retention Rate Return on Equity Expected Growth Rate 0.50 15.00% 7.50% 53 Valuation Inputs: Breakdown of ROE Changes in the firm’s ROE result from changes in its operating performance or its financial leverage. πππ‘ πΌπππππ πππππ πππ‘ππ π΄π π ππ‘π π ππΈ = × × πππππ πππ‘ππ π΄π π ππ‘π πΈππ’ππ‘π¦ ROE = Net Profit Margin x Total Assets Turnover reflect operating performance x Financial Leverage indicates a firm’s financing decision 54 ROE = Net Profit Margin x Total Assets Turnover x Financial Leverage Valuation Inputs: Breakdown of ROE • It changes over time for some companies and is highly sensitive to the business cycle. • For growth companies, it declines because the increased competition increases the supply of goods or services and forces price cutting. • During recessions, profit margins decline because of price cutting or because of higher percentages of fixed costs due to lower sales. • It is the ultimate indicator of operating efficiency and reflects the asset and capital requirements of the business. • Although this ratio varies dramatically by industry, within an industry, it is an excellent indicator of management’s operating efficiency. • It indicates how management has decided to finance the firm. • In turn, this management decision can contribute to a higher ROE, but it also has financial risk implications for the stockholder. 55 Valuation Inputs: Breakdown of ROE Example Sampling No Financial Leverage Company ROE Net Profit Margin Assets Turnover Financial Leverage 15.00% 6.00% 2.50 1.00 The company uses Financial Leverage ROE Net Profit Margin Assets Turnover Financial Leverage 16.80% 5.60% 2.50 1.20 The company with a higher Profit Margin ROE Net Profit Margin Assets Turnover Financial Leverage 14.10% 9.40% 1.25 1.20 56 Valuation Inputs: Impact of Financial Leverage 57 The Real World: an invitation for discussion • A valuation is not a subjective exploration for a definitive value. • There are no exact valuations. • All valuations are influenced. The only questions are how much and in which way. • The extent and significance of the influence in your valuation depend directly on who compensates you and the amount of compensation. • It is a misconception that the more quantitative a model is, the superior the valuation. • Simpler valuation models outperform complex ones. EC5321 Lecture 4 58
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