Valuation
DISCOUNTED CASH FLOW MODEL, DIVIDEND
DISCOUNT MODELS, & MULTIPLES
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Discounted Cash Flow (DCF)
Model
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4-Step Process
1) Project Free Cash Flow
2) Discount Free Cash Flows
3) Calculate Perpetuity Value
4) Put it all together
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Step 1: Project Free Cash Flows
 Free Cash Flow = EBIT(1-Tax Rate) + Depreciation &
Amortization - Change in Net Working Capital Capital Expenditure
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Step 2: Discount Free Cash Flows
 Discount Rate is usually equal to or near the
company’s WACC, but can be adjusted based on
other risk factors
 Discounted Free Cash Flow = Free Cash Flow
/(1+discount rate or WACC)^# years
For example: If the discount rate is 10% and in the 3rd
year the predicted free cash flow is $20,000, the
discounted cash flow for that year will be:
$20,000/(1.1)^3= $15,026.30
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Step 3: Calculate Perpetuity Value
 Most DCFs only project 5 or 10 years into the future
and then use a perpetuity value to account for the
rest of the time
 Perpetuity values are usually between 1-3%
 Perpetuity Value = (final free cash flow * (1 +
perpetuity rate) / (discount rate – perpetuity rate)
For example: If the 10th year’s free cash flow was
$300, with a discount rate of 8% and a perpetuity rate
of 2%, then the perpetuity value would be:
($300*1.02) / (8%-2%) = $5,100
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Step 4: Put it all together
 1) Add together discounted cash flows
 2) Discount perpetuity value
 3) Add discounted cash flows to discounted
perpetuity value
 4) Divide that sum by # shares outstanding to find
the per share value of the company
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DCF Equations
 Free Cash Flow = EBIT(1-Tax Rate) + Depreciation &
Amortization - Change in Net Working Capital Capital Expenditure
 Discounted Free Cash Flow = Free Cash Flow /
(1+discount rate)^# years
 Perpetuity Value = (final free cash flow * (1 +
perpetuity rate)) / (discount rate – perpetuity rate)
 Discounted Perpetuity Value = Perpetuity Value / (1
+ discount rate) ^ # year
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Dividend Discount Models
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Dividend Discount Models
Stable Dividend Discount
Two-Stage Model
 Use for firms with long
 Use for firms going
term stable growth
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through a period of
high growth and then
expect long term stable
growth
Stable Dividend Discount Model
 DPS(1): Total Annual Dividends per Share expected
one year forward
 K: Discount Rate (or Required Rate of Return)
 g: Dividend Growth Rate
 Value of Stock = DPS(1) / (K – g)
For example, if DPS in one year is expected to be
$1.20, the discount rate is 9%, and growth is 6%, the
value of the stock = $1.20/ (9%-6%) = $40.00
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Two-Stage Model
 Like a DCF using DPS instead of Free Cash Flow
 Stage 1: Project future dividends
 DPS * (1+high growth rate)
 Discount Projected Dividends
 Stage 2: Find Perpetuity Value
 DPS(final) / (discount rate – long-term growth rate)
 Discount Perpetuity Value
 Add Discounted Projected Dividends and Discounted
Perpetuity Values together to arrive at the Value of the Stock
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Two-Stage Model Example
 DPS(0)= $1.00; Discount Rate = 12%; High-Growth
Rate = 30%; Long-Term Growth Rate = 6%; HighGrowth Period = 4 years
Stage 1:
DPS(1) = $1.00 * 1.3= $1.30 / (1.12)^1 = $1.16
DPS(2) = $1.00 * 1.3= $1.69 / (1.12)^2 = $1.35
DPS(3) = $1.00 * 1.3= $2.20 / (1.12)^3 = $1.56
DPS(4) = $1.00 * 1.3= $2.86 / (1.12)^4 = $1.82
Sum of Projected Discounted Dividends = $5.89
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Two-Stage Model Example
 DPS(0)= $1.00; Discount Rate = 12%; High-Growth
Rate = 30%; Long-Term Growth Rate = 6%; HighGrowth Period = 4 years; DPS(4) = $2.86
Stage 2:
DPS(4) = $2.86 / (12%-6%) = $47.67 Perpetuity Value
Discounted = $47.67 / (1.12)^4 =$30.30
Value of Stock =$30.30 + $5.89 = $36.19
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Multiples
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Price to Earnings (P/E)
 Price of a share of stock to the most recent annual
earnings per share
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Historical P/E: based on an average of historical P/E
Competitor P/E: based on a market cap weighted average of
competitor P/E
Forward P/E: what some analyst thinks the P/E will be in the
future based on his stock price and earnings estimates
 Generally used to predict the future price of the stock
based off of projected earnings per share
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Price to Book
 Price of a share of stock to book value per share of
stock
 Book value is the difference between the book value
of assets and the book value of liabilities, so is
heavily dependent on accounting practices
 Commonly used when valuing financial institutions
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Example of How Multiples Work
 To use a multiple, simply multiply the multiple by
expected EPS, expected free cash flow per share,
expected sales, book value per share, or whatever
else the multiple is measuring
For example, if expected EPS is $1.15 and the P/E
multiple that is most fitting is 9.57, the expected
future value of the stock will be $1.15 * 9.57 = $11.01.
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Enterprise Value
 Enterprise Value (EV) is the theoretical price a
company could be acquired for by buying all the
outstanding equity and paying off debts
 EV = Equity Value + Net Debt + Noncontrolling
(Minority) Interests + Preferred Stock + Capital
Leases


Equity Value: calculated as current stock price multiplied by
diluted shares outstanding
Net Debt: total debt minus cash and cash equivalents
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EV/EBITDA
 To use an EV/EBITDA multiple, you essentially
reverse engineer the way the multiple is calculated.
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
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Determine appropriate model based on historical or
competitor averages
Multiply EV/EBITDA multiple by the forecasted EBITDA for
desired year
Subtract estimated values of capital leases, minority interests,
preferred stock, and net debt to arrive at a new Equity Value
Divide the new Equity Value by diluted shares outstanding to
arrive at the price per share
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For More Information:
 DCF:
http://news.morningstar.com/classroom2/course.asp?docId=145102&
page=1&CN=COM
 Dividend Discount:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/dd
m.htm
 Multiples:
http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch8.pd
f
 EV/EBITDA: http://macabacus.com/valuation/enterprise-value
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