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Valuation. Curriculum designed for use with the Iowa Electronic Markets by Roger Ignatius Thomas A. Rietz. Valuation: Lecture Outline. Principles of Valuation Discounted Dividend Models Constant Dividend Model Constant Growth Model Discounted Cash flow Model Market Multiple Models

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Valuation l.jpg

Valuation

Curriculum designed for use with the Iowa Electronic Markets

by

Roger Ignatius

Thomas A. Rietz


Valuation lecture outline l.jpg

Valuation: Lecture Outline

  • Principles of Valuation

  • Discounted Dividend Models

    • Constant Dividend Model

    • Constant Growth Model

  • Discounted Cash flow Model

  • Market Multiple Models

    • P/E versus Past and Peers

    • P/S versus Past and Peers

    • P/CF versus Past and Peers

  • Summary


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Principles of Valuation

  • Book Value

    • Depreciated value of assets minus outstanding liabilities

  • Liquidation Value

    • Amount that would be raised if all assets were sold independently

  • Market Value (P)

    • Value according to market price of outstanding stock

  • Intrinsic Value (V)

    • NPV of future cash flows (discounted at investors’ required rate of return)


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Intrinsic Valuation Procedure

  • Asset Characteristics

    • Size of Future Cash flows

    • Time of Future Cash flows

    • Risk of Future Cash flows

  • Investor Characteristics

    • Assessment of Cash flow Riskiness

    • Risk Preferences

Investors’ Required Rate of Return (k)


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Where Does the Discount Rate (k) Come From?

  • CAPM: k = rf + bxRP

  • Beta (b) is estimated using historical data and is available from many sources

  • The risk free rate (rf) is the current Treasury rate

    • Typically the 3-mo rate, but other are sometimes used

  • The risk premium (RP) is a historical average relative to the rf used


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Example: Estimating k for Wal-Mart (WMT) on 4/27/01

  • Inputs

    • Three month Treasury rate: 3.75%

    • Historical average RP (1926-1996): 8.74%

    • Beta for Dell (from MoneyCentral): 0.9

  • Computing k:

    • CAPM: k = 0.0375 + 0.9x0.0874 = 11.62%


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Sensitivity to CAPM Inputs

Initial values:

Rf = 3.75%

RP = 8.47%

Beta = 1.5


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Discounted Dividend Models

  • Dividends will be

    • Forecast directly

    • Assumed to be constant

    • Assumed to grow at a constant rate or

    • Some combination of the above

  • Stock pricing relationship:


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Constant Dividend (Zero Growth Model) Model

  • If Dt is constant, then it is an ordinary perpetuity:

  • Stock pricing relationship:


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Example: Wal-Mart (4/27/01)

  • The price of Wal-Mart was actually $52.83

  • Can you explain the difference?

  • The current (annual) dividend is: $0.28

  • According to the constant dividend (zero growth) model:


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Sensitivity to Constant Dividend Model Inputs

Initial values:

D0 = $0.50

k = 12%


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Why do a firm’s dividends grow?

  • Because earnings grow. Why?

  • Because of reinvested funds

    • Used to expand or to undertake new projects

    • Used in positive NPV projects

  • Leads to

    • Earnings growth

    • Investments growth and

    • Dividend growth


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Constant Growth Model

  • If Dt grows at a constant rate, g, then it is a growth perpetuity:

  • Stock pricing relationship:


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How do You Estimate Growth (g)?

  • NOTE: Must have g<k in the long run!

  • Historical average

  • Average analyst forecast

  • Sustainable growth

    • g = (1-Payout Ratio)xROE

  • Required return versus dividend yield:


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Estimating g for Wal-Mart (4/27/01)

  • What should it be?

    • 1st 3 are too high b/c long run must have g<k

    • Guess: 11%?

  • 5 year historical average: 19.72%

  • Average 5-year analyst forecast: 14.4%

  • Sustainable growth

    • g = (1-0.17)x0.22 = 18.26%

  • Required return versus dividend yield:


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Example: Wal-Mart (4/27/01)

  • The price of Wal-Mart was actually $52.83

  • Notes:

    • Must have g<k in long run

    • As gk, the price increases without bound

  • Current (annual) dividend is: $0.28

  • If we use estimated growth of 11%:


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Sensitivity to Constant Growth Model Inputs

Initial values:

D0 = $0.50

k = 12%

g = 6%


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Summary of Dividend Discount Models

  • Represents the value of dividends received by shareholders

  • Requires

    • A discount rate (k)

    • Dividends (D)

    • Steady or zero growth (g, with g<k)

  • Trouble valuing

    • Companies with D=0

    • Fast growing companies with g>k


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Discounted Cash Flow Model

  • Shareholders receive or “own”:

    • Dividends

    • Re-invested earnings

    • The effects of re-invested earnings are captured in dividend growth if a firm pays dividends and growth can be estimated

  • An alternative valuation comes from valuing cash flows available to stockholders directly

    • Useful for companies that pay no dividends


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What Constitutes Cash flows?

  • There is some debate over exactly what constitutes cash flows

  • The GAAP cash flow statement:

    • CF = NI + depreciation – preferred stock dividends

    • This should represent CFs that are either

      • Paid out in common stock dividends or

      • Re-invested


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What Discount Rate Should be used?

  • It depends on the definition of CFs

    • If CFs are defined as those available to all investors, WACC should be used

    • If CFs are defined as those available to common stockholders, k from CAPM should be used

  • We will use the latter


Example estimating k for k mart k on 4 27 01 l.jpg

Example: Estimating k for K-Mart (K) on 4/27/01

  • Inputs

    • Three month Treasury rate: 3.75%

    • Historical average RP (1926-1996): 8.74%

    • Beta for K-Mart (from MoneyCentral): 1

  • Computing k:

    • CAPM: k = 0.0375 + 1x0.0874 = 12.49%


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How do You Estimate Growth (g)?

  • CFs will also grow

  • Use methods similar to dividend growth, but

    • Analysts forecasts are typically unavailable

    • For many companies, dividend yield cannot be used b/c there is no dividend

  • Often, earnings or sales growth are used

    • Expenses and re-investment need to be relatively constant percentages of sales

  • NOTE: Must have g<k in the long run!


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Estimating g for K-Mart (4/27/01)

  • 5 year sales growth: 2.35%

  • Analysts’ 5 year earnings forecast: 10.3%

  • Suppose, you believe K-Mart will not grow at all!

  • From the historical income statement:


Example k mart 4 27 01 l.jpg

Example: K-Mart (4/27/01)

  • The price of K-Mart was actually $9.82

  • What must the market be expecting for K-Mart’s growth in the future?

  • According to the last statements:

    • CF = $1,216 million

    • Shares = 486.5 million

       CF/Share = $2.50

  • If we use estimated growth of 0.0%:


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Sensitivity to Constant Growth Cash flow Model Inputs

Initial values:

CF0 = $0.50

k = 12%

g = 6%


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Summary of Discounted Cash flow Models

  • Represents the value of cash flows available to shareholders

  • Requires

    • A discount rate (k)

    • A reasonable measure of cash flows

      • IMPORTANT: How much depreciation MUST be replaced ? Model assumes zero.

    • Steady or zero growth (g, with g<k)

  • Trouble valuing

    • Companies with CF<0

    • Fast growing companies with g>k

    • Companies with necessary replacement of depreciated assets


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Market Multiples

  • Valuations are derived by:

    • Forecasting earnings, sales or cash flows

    • Applying the company’s historical P/E, P/S or P/CF to forecast

    • Applying industry average P/E, P/S or P/CF to current inputs


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Why do P/E Ratios Make Sense?

  • A company with a payout less than 1 will grow and be valued at:

  • A company with a payout ratio of 1 will not grow and be valued at:


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Logic of Market Multiple Models

  • Sales, earnings and cash flow drive profits, growth and value

  • P/S, P/E & P/CF ratios show the relationship between price and these value drivers

  • Firms within an industry have similar sales, profit and cash flow patterns and similar required returns

  • Therefore, a reasonable value for a firm is its sales, earnings or cash flows times the respective industry ratio


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P/E Ratio Valuation

  • If company “j” is “valued at industry ratios” relative to earnings:

  • If company “j” is “valued at historical ratios” relative to earnings:


Example wal mart 4 27 0132 l.jpg

Example: Wal-Mart (4/27/01)

  • Valued at historical P/E ratio:

    • Analysts forecast next year’s earnings for WMT at $1.58

    • WMT’s recent P/E was 37.7

    • Then: P = $1.58x37.7 = $59.57

  • Valued at industry average P/E ratio:

    • This year, earnings for WMT were $1.40

    • The industry average P/E was 36.0

    • Then: P = $1.40x36.0 = $50.40

  • The price of Wal-Mart was actually $52.83


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Sensitivity to P/E Multiple Model Inputs

Initial values:

E1 = $1.50

P/E = 35


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P/S Ratio Valuation

  • Using current sales, a company “j” is “valued at industry ratios” relative to sales:

  • For companies w/o earnings, P/S is sometimes used

  • If you have a sales forecast, company “j” is “valued at historical ratios” relative to sales:


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Example: Amazon (4/27/01)

  • For the year ending 12/00

    • Sales = 2,762 million (income statement)

    • Shares = 357.1 million (balance sheet)

      Sales/Share = 2762/357.1 = 7.73

  • Industry average P/S = 3.46

  • So, using industry P/S Amazon should be priced at: 3.46x7.73 = $26.76

  • The price of Amazon was actually $15.27


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Sensitivity to P/S Multiple Model Inputs

Initial values:

S1 = $3.00

P/S = 15


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P/CF Ratio Valuation

  • Using current cash flow, company “j” is “valued at industry ratios” relative to cash flows:

  • For companies w/o dividends, P/CF is sometimes used

  • If you have a cash flow forecast, company “j” is “valued at historical ratios” relative to cash flows:


Example k mart 4 27 0138 l.jpg

Example: K-Mart (4/27/01)

  • For the year ending 12/00

    • CF = 1,216 million (discussed previously)

    • Shares = 486.5 million (balance sheet)

      CF/Share = 1216/486.51 = 2.50

  • Industry average P/CF = 21.3

  • Using industry P/CF K-Mart should be priced at: 21.3x2.50 = $53.24

  • The price of K-Mart was actually $9.82

  • Is K-Mart undervalued or in serious trouble?


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Sensitivity to P/CF Multiple Model Inputs

Initial values:

CF = $1.00

P/S = 30


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Summary of Market Multiples Models

  • Valuations using historical and industry ratios

    • Provide useful benchmarks

    • Useful when dividends and cash flows cannot be discounted directly

    • Can be compared to current ratios as a measure of market sentiment

  • Weaknesses

    • Misleading for firms that are changing rapidly or do not resemble the industry


Summary l.jpg

Discounted Dividend

w/ dividends and constant expected (possibly zero) growth in dividends

Discounted Cash flow

w/o dividends and constant expected (possibly zero) growth in cash flows

P/E, P/S and P/CF ratios

Comparison with past or industry

Why several methods?

Each has strengths and weaknesses

Different methods useful in different situations

Each gives a different “take” on the value of the company’s stock

Provides a range of valuations instead of point estimates

Summary


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