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# VALUATION - PowerPoint PPT Presentation

VALUATION. Five Categories of Valuation Methods. Discounted cash-flow Market-based Mixed models Asset-based methods Option-based methods. Discounted Cash-Flow Approach. Estimated future cash flows are discounted back to present value based on the investor’s required rate of return

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### VALUATION

• Discounted cash-flow

• Market-based

• Mixed models

• Asset-based methods

• Option-based methods

• 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

• 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

Discounted Dividend ValuationTheoretical Model

• No-growth, constant dividend

• Dividends are growing at rate g

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

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%

Discounted Dividend ValuationRequired rate of return (r)

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

• Begin with risk-free rate

• + Company specific risk premium

• = Required rate of return

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

Discounted Dividend Valuation- example

• Company A

• 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 Valuation- example

• r = .0475+1.35(.054) = .120

• g = .13(1-.20) = .104

• Value = \$11.04…

• 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

• 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

• FCFF

• Weighted Average Cost of Capital

• FCFE

• Cost of Equity (required rate of return)

Discounted Operating Cash-Flow ModelsOther considerations

• Growth

• Can use a multi-stage model to accommodate rate changes

• Forecasting cash flows requires judgment

• Begin with reported, historical cash flow and earnings

• Loss generating firm valuation

• Closed Firm Valuation

• Start-up companies

• 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

• 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

• Firms with no internal growth prospects, paying out 100% of earnings

• Current P/E = 1/r

• P0/E1 = (D1/E1)/(r-g)

• D = annual dividends, E = EPS

P/E Model - 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

• 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

• 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

• 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

• Consider characteristics of the firm

• Dividend paying

• Growing

• Likely to be liquidated

• Consider data availability of data

• Publicly available or closely held