Valuation
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Valuation Overview
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Valuation
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Discounted cash flow models
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DDM
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FCFE
Relative valuation
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 over time across assets at a given time relative to comparables relative to the market
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General Thoughts on
Valuation
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We will be using quantitative models.
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But one size does not fit all.
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Obviously, a DDM won’t work for a company that doesn’t pay dividends.
Estimating growth for a cyclical company is problematic.
Sometimes, it’s easier to compare ratios with comparables.
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But this comparison should be both across comparables and across time.
Use more than one valuation metric
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The more metrics that produce the same answer, the better.
Sensitivity analysis is vital .
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Valuation Models
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Discounted Cash Flow
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DDM
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FCFE
Relative Valuation
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P/E
P/B
Other ratios (some predict better than others for different industries.
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Valuation Methods
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Valuation Versus Own History
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Is it relatively cheap now?
Valuation Versus Peer Group
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Is it undervalues relative to peers now?
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How has that relationship evolved over time?
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If a company a reason.
always sells at a discount, there’s probably
Valuation Versus Market
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Is it undervalued relative to the market now?
How has that relationship evolved over time?
Absolute Valuation
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What you may find
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Companies that look cheap, and always have.
Firms that look good in industries that look bad.
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That is, the industry currently looks expensive but the firm is the cheapest thing in the industry.
Industries that look good with firms that are average for the industry.
How can you tell?
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DCF
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DDM’s
FCFE
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The holy grail: the numerator should be the cash flows that can be distributed to shareholders while retaining enough cash to support the assumed growth rate
The holy grail 2: your discount rate should match your numerator type
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Basic Dividend Discount Model
P= D
1
(r-g)
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Two Stage DDM

Pо=∑ D
1
_____+ ___P n
___
(1+K hg
)† (1+K hg
)ⁿ
Where P n
=DPS n+1
(K st
-G n
)
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Citigroup: Gordon Growth
DDM
Dividend
R growth
P=D/(R-g)
Citigroup Dividend Discount Model
1.6
1.6
1.6
1.6
$
9.00%
4.00%
32.00
$
9.00%
5.00%
40.00
$
9.00%
6.00%
53.33
$
9.00%
7.00%
80.00
$
$47.00
1.6
9.00%
8.00%
160.00
Dividend
R growth
P=D/(R-g)
$ 1.60
$ 1.60
$ 1.60
$ 1.60
$ 1.60
10.00% 10.00% 10.00% 10.00% 10.00%
5.00% 6.00% 7.00% 8.00% 9.00%
$ 32.00
$ 40.00
$ 53.33
$ 80.00
$ 160.00
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DDM Challenges
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Certainty and Growth Rate of Dividends
Appropriate Discount Rates
Length of Growth Period(s)
Normal growth is what???
Small Changes in Assumptions Lead to
Widely Disparate Values
Outliers Most likely to be Mis-specified
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Growth Failure: Companies
Maintaining 20% Growth
%
10
9
8
7
6
5
4
3
2
1
0
5 Years 10 Years 15 Years
% Companies w/20% Growth
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Growth Failure: Persistence of
Excessive Growth
First Year
-15.00%
Seventh Year -0.30%
-0.20%
-1.00%
-0.90%
-1.80%
-1.70%
-3.30%
-9.90%
-10.00% -5.00% 0.00%
0.90%
1.70%
1.00%
1.30%
1.10%
1.90%
3.70%
5.00%
8.60%
10.00%
Low PE
High PE
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Discount Model Applications
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Testing of Assumptions: Solve for Implied Values.
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Take P as given, pick R and solve for g.
Must have Stable Growth and Leverage Companies
Cross Sectional, Time Series Analysis
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DDM may produce low values for a particular industry.
Prefers Low PE/High Dividend Payers over High PE
Cash Retainers
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The high P/E cash retainers can perhaps be better valued by
FCF.
FCF is often a good Alternative to Dividends
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Free Cash Flow Valuation
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Simple Definition:
FCF=
Operating Earnings+Depreciation
-Capital Expenditure-∆Working Capital
You may be able to do better, but this is useful for forecasting.
Why Could This Be More Effective than DDM?
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Relative Valuation
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Measure Comparable Assets with a
Common Measure
Evaluate Price vs. Fundamental Factors
(P/E, P/FCF, P/S, P/Bk, EV/EBITDA)
Look at Time Series Data
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Relative Valuation
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Commonly Used against Company
Historical Range, Peers, or Market
Easy to Access, Easy to Misuse
Yields Different Answers Than DCF
If it Looks Too Good to be True it
Probably is…Too Good to Be True
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What are Comparable Assets?
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Comparable Assets
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Similar Cash Flow, Growth and Risk
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Generally in Similar Industries
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Complicating Issues: Size, Business Mix,
Leverage, Profitability
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Understand Implicit Assumptions
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Comparable Assets 2004?
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GE ($33.75)
2004 estimate $1.57
LTG estimate 9.4%
PTax Margin 15.12%
Mkt Cap $356bn
ROE 21%
Debt/Tot Cap 43.6%
2004 PE 21.4x
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C ($47.00)
2004 estimate $4.01
LTG estimate 11.36%
PTax Margin 27.8%
Mkt Cap $243bn
ROE 19.52%
Debt/Tot Cap 23.3%
2004 PE 11.7x
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Comparable Assets 9/03
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GE ($31.79)
2003 estimate $1.56
LTG estimate 11.3%
Op Margin 14.14%
Mkt Cap $318bn
ROE 23.8%
Debt/Equity 214%
2003 PE 23x
Price 9/13/04 $33.75
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UTX ($79.48)
2003 estimate $4.64
LTG estimate 11.6%
Op Margin 12.26%
Mkt Cap $37.2bn
ROE 26.6%
Debt/Equity 51%
2003 PE 18x
Price 9/13/04 $94.64
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When to use what?
3.
4.
1.
2.
5.
6.
P/E
P/FCF
P/B
P/Sales
EV/EBITDA
Other measures???
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1. PE Ratio
Sensitive to Volatility, Growth, Profitability
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P/E = 1/r + PVGO/E
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Affected by Accounting Issues
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Multiple Definitions (Operating Eps,
Historic, Forward, Pro-forma, Fully Diluted vs Basic)
Affected by leverage
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2. Free Cash Flow Yield
(instead of earnings)
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Operating Earnings+Depreciation Expense-
Cap Ex-∆Working CAP
Cash Available for Distribution to
Shareholders
Strips Back Some Accounting Artifice
Incorporates Info from Balance Sheet
Note that we are still stuck with perpetual growth assumption
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3. Price to Book Value
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Useful in Distressed Situations
Useful in Lower Growth Industries
(Energy, Utilities, Financials)
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3. Price to Book Value
Liquidation Value
Going Concern Value
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3. Price to Book Value
Liquidation Value
Going Concern Value
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3. Price to Book Value
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Useful in Financials Where Reserves can be Manipulated
Influenced by ROE and Cost of Equity
Significant Accounting Issues
(Buybacks, Restructuring)
Can be Useful in Mean Reverting
Mature Industries (Energy, Utilities)
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4. Price to Sales
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Tougher to Manipulate
Revenues Tend to be Positive!
Useful in Absence of Profitability (Highly
Cyclical Situations)
Enterprise Value to Sales (MV of
Equity+MV of Debt-Cash)/Sales
Corrects for Companies with Different
Leverage
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5. Enterprise Value to Ebitda
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(Market Value of Equity+Debt-
Cash)/(Earnings Before Interest, Taxes,
Depreciation, and Amortization)
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Used in the Absence of Profits
Used Where EBITDA is Free Cash
Corrects For Varying Leverage
But Ignores Depreciation as Real Expense
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6. Alternative Measures?
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PE to Growth Ratio
Market Value per Subscriber
Market Value per Home Passed
Market Value per Member
Market value per Pet
HOLD ON TO YOUR WALLET!
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Why Are Comparables/Relative
Value So Important?
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Arbitrage
Relies on “close substitutes”
Be careful of stocks “obviously” cheaper than comparables
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Why Use Multiples Analysis?
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Used prevalently in practice
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Research reports full of multiples
Rules of thumb based on multiples
Quick – can evaluate large #s of stocks
Understandable/sellable/defensible
Current market data
DCF relies on multiples in the end
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Terminal value
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Problem with Multiples
Analysis
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Quick can be too quick – and dirty
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Issues When Using Multiples
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Definitions
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What are “earnings”?
Consistency
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Equity versus Firm (enterprise)
Uniform
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Over time
Cross-section (across firms)
Scaling
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Common sizing is useful
Range/Distribution
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Mean versus median outliers
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