Valuation
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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

VALUATION


Five categories of valuation methods

Five Categories of Valuation Methods

  • Discounted cash-flow

  • Market-based

  • Mixed models

  • Asset-based methods

  • Option-based methods


Discounted cash flow approach

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


Discounted dividend valuation

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


Discounted dividend valuation theoretical model

Discounted Dividend ValuationTheoretical Model

  • No-growth, constant dividend

  • Dividends are growing at rate g


Discounted dividend valuation required rate of return r

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

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 valuation required rate of return r1

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


Discounted dividend valuation growth rate g

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


Valuation

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%


Valuation

Discounted Dividend Valuation- example

  • r = .0475+1.35(.054) = .120

  • g = .13(1-.20) = .104

  • Value = $11.04…


Discounted dividend valuation1

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


Discounted operating cash flow models

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


Fcff or fcfe

FCFF or FCFE


Discount rate

Discount Rate

  • FCFF

    • Weighted Average Cost of Capital

  • FCFE

    • Cost of Equity (required rate of return)


Discounted operating cash flow models other considerations

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

    • Make company-appropriate adjustments


Special issues

Special Issues

  • Loss generating firm valuation

  • Closed Firm Valuation

  • Start-up companies


Valuation of gap retail stores

Valuation Of GAP Retail Stores


Fcff stable growth

FCFF-Stable Growth


Market based models

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


P e model

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


P e model1

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


P e model example

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


Mixed models

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


Asset based models

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


Options based models

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


Selecting a model

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


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