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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

Valuation

Curriculum designed for use with the Iowa Electronic Markets

by

Roger Ignatius

Thomas A. Rietz

valuation lecture outline
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
principles of valuation
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)
intrinsic valuation procedure
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)

where does the discount rate k come from
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
example estimating k for wal mart wmt on 4 27 01
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%
sensitivity to capm inputs
Sensitivity to CAPM Inputs

Initial values:

Rf = 3.75%

RP = 8.47%

Beta = 1.5

discounted dividend models
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:
constant dividend zero growth model model
Constant Dividend (Zero Growth Model) Model
  • If Dt is constant, then it is an ordinary perpetuity:
  • Stock pricing relationship:
example wal mart 4 27 01
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:
sensitivity to constant dividend model inputs
Sensitivity to Constant Dividend Model Inputs

Initial values:

D0 = $0.50

k = 12%

why do a firm s dividends grow
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
constant growth model
Constant Growth Model
  • If Dt grows at a constant rate, g, then it is a growth perpetuity:
  • Stock pricing relationship:
how do you estimate growth g
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:
estimating g for wal mart 4 27 01
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:
example wal mart 4 27 011
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%:
sensitivity to constant growth model inputs
Sensitivity to Constant Growth Model Inputs

Initial values:

D0 = $0.50

k = 12%

g = 6%

summary of dividend discount models
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
discounted cash flow model
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
what constitutes cash flows
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
what discount rate should be used
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
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%
how do you estimate growth g1
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!
estimating g for k mart 4 27 01
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
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%:
sensitivity to constant growth cash flow model inputs
Sensitivity to Constant Growth Cash flow Model Inputs

Initial values:

CF0 = $0.50

k = 12%

g = 6%

summary of discounted cash flow models
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
market multiples
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
why do p e ratios make sense
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:
logic of market multiple models
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
p e ratio valuation
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 27 012
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
sensitivity to p e multiple model inputs
Sensitivity to P/E Multiple Model Inputs

Initial values:

E1 = $1.50

P/E = 35

p s ratio valuation
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:
example amazon 4 27 01
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
sensitivity to p s multiple model inputs
Sensitivity to P/S Multiple Model Inputs

Initial values:

S1 = $3.00

P/S = 15

p cf ratio valuation
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 27 011
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?
sensitivity to p cf multiple model inputs
Sensitivity to P/CF Multiple Model Inputs

Initial values:

CF = $1.00

P/S = 30

summary of market multiples models
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
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