More on firm valuation
Objective
Discuss in detail several valuation techniques
Company Analysis and Stock Valuation
After analyzing the economy and stock markets for several
countries, you have decided to invest some portion of your portfolio
in common stocks
After analyzing various industries, you have identified those
industries that appear to offer above-average risk-adjusted
performance over your investment horizon
Which are the best companies?
Are they overpriced?
Company Analysis and Stock Valuation
• Industry competitive environment
• SWOT analysis
• Present value of cash flows
• Relative valuation ratio techniques
Firm Competitive Strategies
• Current rivalry
• Threat of new entrants
• Potential substitutes
• Bargaining power of suppliers
• Bargaining power of buyers
Firm Competitive Strategies
Defensive strategy involves positioning firm so that it its capabilities
provide the best means to deflect the effect of competitive forces in
the industry
Offensive strategy involves using the company’s strength to affect
the competitive industry forces, thus improving the firm’s relative
industry position
Porter suggests two major strategies: low-cost leadership and
differentiation
SWOT Analysis
Examination of a firm’s:
Strengths
Weaknesses
Opportunities
Threats
Outline
Introduction: A question of value
DCF techniques
•
•
•
•
The dividend model
APV
FTE
WACC
Relative valuation
A question of firm value
Liquidation value:
What claimholders receive from selling all the assets of the firm
Going concern value:
The present value of the future cash flow generated by the firm
Valuation & Selection
DCF techniques
Calculate on your own intrinsic value and compare it to price to
determine if buying
Relative techniques
Compare stocks based on their market valuation & determine the
best buy
DCF techniques
The dividend model
•
One or multiple stage growth
Total market value of firm:
•
Use three alternative DCF methods
The dividend model
P = D/(r-g)
Can’t use it with firms no dividend paying stocks
You have to use CAPM in order to estimate the discount rate
Formula breaks down when g > r; use multi-stage growth
Three alternative DCF methods
Adjusted Present Value (APV):
PV UCF (at the unlevered cost of equity) + debt tax shield
Flow to equity (FTE):
PV LCF (at the levered cost of equity) + market value of debt
Weighted Average Cost of Capital (WACC):
PV UCF (at the WACC)
Clarification
Unlevered CF = Total CF = CF from assets
Levered CF = CF to equity = CF to shareholders
Calculating cash flows
In any given year:
CF from assets = CF to creditors + CF to shareholders
where:
CF to creditors = Interest paid +/- Net new debt raised
CF to shareholders = Dividends paid +/- Net new equity raised
CF from assets = OCF +/- NCS +/- Additions to NWC
where:
Operating CF = EBIT + Depr. - Taxes = UNI + Depr
NCS = Ending Fixed Assets - (Beginning Fixed Assets - Depr.)
Additions to NWC = NWCt - NWCt-1
Levered vs. un-levered NI
Sales
(Costs)
(Depreciation)
EBIT
(Interest)
EBT
(Tax)
Levered NI
Sales
(Costs)
(Depreciation)
EBIT = EBT
(Tax)
Un-Levered NI
Cash flow to equity (to shareholders)
CF to S/H = NI + Depr. +/- NCS +/- Additions to NWC +/- Net new debt
NI = levered net income
Note that
Dividends = CF to S/H +/- Net new equity
Exemplification
Assume a company, with perpetual cash flows. Ignore depreciation, net
capital spending, and additions to NWC.
Annual sales: $500,000
Annual costs: $360,000
Corporate tax: 40%
Market value of debt: $116,667
Unlevered cost of equity: 20%
Levered cost of equity :22%
Weighted average cost of capital : 18%
Interest rate:10%
Total cash flow calculation
(aka cash flow from assets)
Unlevered Cash Flow = Sales - Costs - Tax
UCF = $ 500,000- $ 360,000- $ 56,000 = $ 84,000
Levered CF = Sales - Costs - Interest -Tax
LCF = $ 500,000 - $ 360,000 - $ 11,666.7 - $ 51,333.3 = $77,000
APV
PV =
Σ[(UCF) /(1 + uke) ] + PV(debt tax shield)
t
t
Assuming constant growth:
PV = (UCF)/(uke – g) + PV(debt tax shield)
PV = $ 84,000/(0.2) + $ 116,667(0.4) = $ 466,667.8
FTE
PV = (levered CF)/(levered cost of equity) + market value of debt
PV =
Σ[(LCF) /(1 + Lke) ] + market value of debt
t
t
Assuming constant growth:
PV = (LCF)/(Lke - g) + market value of debt
PV = $ 77,000/(0.22) + $116,667.8 = $ 466,667.8
WACC
PV = (unlevered CF)/average cost of capital
PV =
Σ[(UCF) /(1 +wacc) ]
t
t
Assuming constant growth:
PV = (UCF)/(wacc– g)
PV = $ 84,000/(0.18) = $ 466,667.8
Recap
We can calculate firm's present value in three ways:
 Discount net income pretending the company is all-equity, and
then add the PV of the tax shield (and any other net influences
of debt).
 Find out the market value of equity by discounting the levered
cash flow using the levered cost of equity. Add the market value
of the outstanding debt.
 Discount net income pretending the company is all-equity at an
average rate (wacc) that has been adjusted to reflect the tax
savings of debt.
When to use APV, FTE, and WACC methods?
Use WACC or FTE if the firm’s debt-to-equity ratio will remain
constant in the future.
Use APV if the project’s level of debt is likely to remain constant in
the future.
Final step: Estimating intrinsic value per share
Market value of equity = Total firm value - Market value of debt
Intrinsic value per share = Market value of equity/No. of shares
Relative valuation
Works well when:
•
The stocks under comparison are similar in size, industry, and
risk
•
The market is not bubbling or in a crunch
Relative valuation
Most popular market ratios:
•
•
•
•
P/E aka Earnings multiplier
P/CF
P/S
P/BV
The earnings multiplier
Higher P/E indicate higher expected growth opportunities, caeteris
paribus.
P/E = Payout/(r-g)
where
g = (Ret)ROE
P/E is also a measure of cheapness
The earnings multiplier: How to use it
• Naïve approach
• Dynamic P/E
• Growth duration
• Other
Naïve approach
Basic idea: Compare the P/E between two firms, or between one firm
and the industry/market; determine whether differences in P/E are
justified in terms of expected earnings growth.
(P/E)i / (P/E)b = (1-Ret)i(r-g)b / (1-Ret)b(r-g)a
Example: Firm ABC inc. has an industry beta of 0.98 and its ROE is
expected to remain close to the industry average. Its earnings
multiple is at 25, while the industry earnings multiple hovers around
15.
Implication: Unless the retention ratio of ABC, and expected ROE are
significantly higher than the industry average than the ABC is
overpriced compared to the industry.
Dynamic P/E
Basic idea: Project P/E and earnings into the future in order to infer
changes in share price
Exemplification: The industry is expected to produce an average ROE of
12% over the next five years or more. The industry retention ratio is 25%, its
market beta is 1.2 . It is believed that the market risk premium is about 10%. The
current earnings multiple for the industry is 8. the risk-free rate is 2%.
Company ABC Inc. projects its EPS at $0.8/shares for next year. Its current
earnings multiple is 10. In addition a times series regression yielded the following
result:
Chg(P/E)ABC = 0.02 + (0.5)Chg(P/E)b
Required returnb = 2% + (1.2)(10%) = 14%
gb = (0.25)(0.12) = 0.03
Forecasted (P/E)b = (0.75)/(0.14 – 0.03) = 6.82 (-14.75% change)
Forecasted change in (P/E)ABC = 0.02 + (0.5)(-0.1475) = -0.0938 (-9.38%)
(P/E)ABC = 9.06  expected P = $7.25
Growth Duration
Basic idea: How long must earnings grow at g, in order to justify the
difference in P/E?
If P/E reflects growth expectation, then:
(P/E)stock/(P/E)b = [ (1 + divyield + g)stock / (1 + divyield + g)b ]T
A = BT
T = ln(A)/ln(B)
Exemplification:
Dividend yieldstock = 5%
Dividend yieldb = 6%
Earnings growthstock = 15%
Earniongs growthb = 4%
P/Estock = 19
P/Eb = 7
T = ln(19/7) / ln(1.20/1.10) = 0.9985/0.087 = 11.48 years
Firm’s earnings must grow at 15% for at least 11.48 years in order to justify the P/E differential
P/CF
Not as prone to accounting manipulation as P/E
P/S
Leibowitz:
Strong earnings are preceded by strong sales.
Recommendation
Buy low P/S stocks
However, one has to account for industry profit margin.
P/BV
Fama & French found that low P/BV stocks outperform the market
Tenets of Warren Buffet
Business Tenets
Management Tenets
Financial Tenets
Market Tenets
Business Tenets
Is the business simple and understandable?
Does the business have a consistent operating history?
Does the business have favorable long-term prospects?
Management Tenets
Is management rational?
Is management candid with its shareholders?
Financial Tenets
Focus on return on equity, not earnings per share
Look for companies with high profit margins
For every dollar retained, make sure the company has created at
least one dollar of market value
Market Tenets
What is the value of the business?
Can the business be purchased at a significant discount to its
fundamental intrinsic value?
Some Lessons from Peter Lynch
(ran Fidelity's Magellan Fund)
Favorable Attributes of Firms:
1. Firm’s product should not be faddish
2. Firm should have some long-run comparative advantage over its
rivals
3. Firm’s industry or product has market stability
4. Firm can benefit from cost reductions
5. Firms that buy back shares show there are putting money into
the firm
Summary
DCF & relative valuation techniques should be used together