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### Valuation

Discounted Cash Flow Model, Dividend discount models, & Multiples

MU Investment Club Spring 2013

Discounted Cash Flow (DCF) Model

MU Investment Club Spring 2013

4-Step Process

Project Free Cash Flow

Discount Free Cash Flows

Calculate Perpetuity Value

Put it all together

MU Investment Club Spring 2013

Step 1: Project Free Cash Flows

Free Cash Flow = EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

MU Investment Club Spring 2013

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

MU Investment Club Spring 2013

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

MU Investment Club Spring 2013

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

MU Investment Club Spring 2013

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

MU Investment Club Spring 2013

Dividend Discount Models

MU Investment Club Spring 2013

Dividend Discount Models

Stable Dividend Discount

Two-Stage Model

MU Investment Club Spring 2013

Use for firms with long term stable growth

Use for firms going 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

MU Investment Club Spring 2013

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

MU Investment Club Spring 2013

Two-Stage Model Example

DPS(0)= $1.00; Discount Rate = 12%; High-Growth Rate = 30%; Long-Term Growth Rate = 6%; High-Growth 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

MU Investment Club Spring 2013

Two-Stage Model Example

DPS(0)= $1.00; Discount Rate = 12%; High-Growth Rate = 30%; Long-Term Growth Rate = 6%; High-Growth 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

MU Investment Club Spring 2013

Multiples

MU Investment Club Spring 2013

Price to Earnings (P/E)

- Price of a share of stock to the most recent annual earnings per share
- 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

MU Investment Club Spring 2013

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

MU Investment Club Spring 2013

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.

MU Investment Club Spring 2013

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

MU Investment Club Spring 2013

EV/EBITDA

- To use an EV/EBITDA multiple, you essentially reverse engineer the way the multiple is calculated.
- 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

MU Investment Club Spring 2013

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/ddm.htm

Multiples: http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch8.pdf

EV/EBITDA: http://macabacus.com/valuation/enterprise-value

MU Investment Club Spring 2013

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