Valuation Chapter 10 Robinson, Munter, Grant. Grant, Munter & Robinson Chapter 102 Learning Objectives Compare and contrast valuation models –Discounted

Valuation

Chapter 10

Robinson, Munter, Grant

Grant, Munter & Robinson

Chapter 10 2

Learning Objectives

• Compare and contrast valuation models– Discounted cash-flow– Market-based– Asset- or Option-based– Others

• Identify circumstances in which each model is most appropriate


Chapter 10 3

Five Categories of Valuation Methods

1. Discounted cash-flow

2. Market-based

3. Mixed models

4. Asset-based methods

5. Option-based methods


Chapter 10 4

Discounted Cash-Flow Approach

• Estimated future cash flows are discounted back to present value based on the investor’s required rate of return

• Discounted dividend valuation

• Discounted operating cash-flow models


Chapter 10 5

Discounted Dividend Valuation

• Most straightforward approach

• Explicit cash flows received by equity investors

– Dividends– Terminal value when shares are sold

• Firm is expected to have an infinite life


Chapter 10 6

Discounted Dividend ValuationTheoretical Model

• No-growth, constant dividend

• Dividends are growing at rate g

r

D0P

gr

g)(D

gr

DP

10

0

1


Chapter 10 7

Discounted Dividend ValuationRequired rate of return (r)

• r is the rate of return demanded on a specific investment

– Based on investor’s assessment of risk

• CAPM

)( fmf rrrr


Chapter 10 8

CAPM -- Example

• rf, Risk-free (30-year Treasury bond) = 5%

• rm, Expected stock market return = 10%– Risk premium = (rm – rf)

• Beta = 1.5

• r = 5% + 1.5(10%-5%)

• r = 12.5%


Chapter 10 9

Discounted Dividend ValuationRequired rate of return (r)

• For nonpublic companies, use a buildup model and historical sources for data

• Begin with risk-free rate

• + Equity risk premium

• + Small company premium

• + Company specific risk premium

• = Required rate of return


Chapter 10 10

Discounted Dividend ValuationGrowth rate (g)

• Top-Down analysis– Begin with growth of economy– Adjust for industry, sector and company factors

• Sustainable growth = ROE(1-Payout rate)– ROE = Earnings/Average equity– Payout rate: proportion of earnings used to pay

dividends or repurchase shares


Chapter 10 11

• Motorola– Annual dividend = $0.16– Beta = 1.35– ROE = 13%– Payout ratio = 20%

• Economic– 20-year Treasury bond = 4.75%– Historical market risk premium = 5.4%

Discounted Dividend ValuationMotorola example


Chapter 10 12

• r = .0475+1.35(.054) = .120

• g = .13(1-.20) = .104

• Value = $11.04…

Discounted Dividend ValuationMotorola example

104.120.

)104.1(16.0$


Chapter 10 13

Discounted Dividend Valuation

• Assumes a single, constant growth rate (g)• What if growth rates differ?• Use a multi-stage model to calculate future

dividends– Calculate future stock value based on future

dividend– Calculate present value of stock and dividends

• H model: for growth rates that decay over time


Chapter 10 14

Discounted Operating Cash-Flow Models

• Most applicable in the event of a takeover

• Free cash flow (FCF) is operating cash flows less necessary investments in working capital and property, plant and equipment

gr

FCFV

1

0


Chapter 10 15

Discounted Operating Cash-Flow Models

• r = Weighted average cost of capital (WACC)– Required rate of return to all capital providers– For Motorola, 10.2%

• g = growth rate of FCFs– For Motorola, 9%

• If Motorola’s FCF = $314 million

• Firm value is $26,167 million [314/(.102-.09)]

• Value per share (after debt) is $7.28


Chapter 10 16

Discounted Operating Cash-Flow ModelsOther considerations

• Growth– Can use a multi-stage model to accommodate rate

changes– Is only beneficial if it leads to increased positive

cash flows in the future

• Forecasting cash flows requires judgment– Begin with reported, historical cash flow and

earnings– Make company-appropriate adjustments


Chapter 10 17

Market-based Models

• Compare subject company to other similar companies for which market prices are available

• Simple computations but require a great deal of professional judgment

• P/E Model• P/B Method• P/S Model


Chapter 10 18

P/E Model

• Assumes a company is worth a certain multiple of its current earnings

• Assumes each share is worth the same multiple of EPS

• Derived from the dividend discount models

• Requires judgment regarding– Peer firms and their prices– Historical (average) data


Chapter 10 19

P/E Model

• Firms with no internal growth prospects, paying out 100% of earnings– Current P/E = 1/r

• Constant growth, Leading P/E– P0/E1 = (D1/E1)/(r-g)– D = annual dividends, E = EPS

• Constant growth, Trailing P/E– P0/E0 = [(D0/E0)(1+g)]/(r-g)


Chapter 10 20

P/E Model

• Motorola example

• Consensus analyst forecast EPS = $0.46

• P/E of 23 is appropriate

• Value = 23*$0.46 = $10.58

• If the current price is $10.22, there is limited upside to this investment


Chapter 10 21

P/B Method

• Book value (B)– Total stockholder’s equity– Less sensitive to short-term events than is earnings

• P/B is a function of profitability, growth and risk

• Is linked to the dividend discount model


Chapter 10 22

P/B Method

• No growth– P0/B = ROE/r

• Constant growth– P0/B = (ROE- g)/(r-g)

• P/B ratios for similar firms are compared with those of the subject firm to arrive at an appropriate multiple for use in valuation


Chapter 10 23

P/S Model

• Insert sales (S) into the dividend discount model

• E/S = Π

• P0/S = Π/r

• P0/S1 = (Π*Payout)/(r-g)

• Often used to value start-up firms, caution should be used


Chapter 10 24

Other Multiples

• Cash-flow-based multiples are common

• Price/operating cash flow

• Price/EBITDA

• Price/free cash flow

• Dividend yield (D/P)

• Method used should be appropriate considering the specific circumstances of the subject company


Chapter 10 25

Mixed Models

• Because the previous models are linked (discounted dividend model) a combined approach can be used

• May use discounted cash flow approach to forecast cash flows then use market multiple to derive terminal value

• Residual income approaches are linked to the dividend discount model


Chapter 10 26

Residual Income

• PV = book value + excess earnings over time

• Perpetuity model

1

100 )1(t

ttt

r

rBEBP

Bgr

ROEBP

10


Chapter 10 27

Asset-Based Models

• Used when a company is going to be liquidated

• Valuation is based on underlying assets– Market value of balance sheet items– Assets and liabilities

• Also called cost or adjusted book value approach


Chapter 10 28

Options-Based Models

• Theoretically elegant but practical application is difficult– Analyst must have information about

opportunities (and their value) available to a firm

• Equity ownership is viewed as an option call on the firm– Limited downside, unlimited upside


Chapter 10 29

Selecting a Model

• Consider characteristics of the firm– Dividend paying– Growing– Likely to be liquidated

• Consider data availability of data– Publicly available or closely held– Special opportunities available to certain firms


Chapter 10 30

Summary

• Determine value using five categories of valuation models

• How these models are similar to and different from each other

• Circumstances in which each is most appropriate

Documents

Valuation Chapter 10 Robinson, Munter, Grant. Grant, Munter & Robinson Chapter 102 Learning Objectives Compare and contrast valuation models –Discounted