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Corporate Finance by ROAoRY4

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									       Asset Valuation


         P.V. Viswanath




Class Notes for Corporate Finance and
      Mergers and Acquisitions
         Discounted Cashflow Valuation

                           t = n CF
                    Value =          t
                                        t
                            t =1 (1 + r)


where,
      n = life of the asset
      CFt = cashflow in period t
      r = discount rate reflecting the riskiness of the
      estimated cashflows




                           P.V. Viswanath                  2
       Two Measures of Discount Rates

 Cost of Equity: This is the rate of return required
  by equity investors on an investment. It will
  incorporate a premium for equity risk -the greater
  the risk, the greater the premium. This is used to
  value equity.
 Cost of capital: This is a composite cost of all of
  the capital invested in an asset or business. It will
  be a weighted average of the cost of equity and the
  after-tax cost of borrowing. This is used to value
  the entire firm.


                       P.V. Viswanath                     3
                               Equity Valuation

                             Figure 5.5: Equity Valuation
                      Assets                                       Liabilities

                             Assets in Place              Debt
Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth                                             Discount rate reflects only the
                                                                     cost of raising equity financing
                             Growth Assets                Equity




                    Present value is value of just the equity claims on the firm



Free Cash Flow to Equity = Net Income – Net Reinvestment (capex as well as
     change in working capital) – Net Debt Paid (or + Net Debt Issued)

                                        P.V. Viswanath                                              4
                                   Firm Valuation
                                 Figure 5.6: Firm Valuation
                        Assets                                        Liabilities

                               Assets in Place              Debt
 Cash flows considered are
 cashflows from assets,
                                                                        Discount rate reflects the cost
 prior to any debt payments                                             of raising both debt and equity
 but after firm has                                                     financing, in proportion to their
 reinvested to create growth
 assets                                                                 use
                               Growth Assets                Equity




                      Present value is value of the entire firm, and reflects the value of
                      all claims on the firm.

Free Cash Flow to the Firm = Earnings before Interest and Taxes (1-tax rate) – Net
Reinvestment
Net Reinvestment is defined as actual expenditures on short-term and long-term assets less
depreciation.
The tax benefits of debt are not included in FCFF because they are taken into account in the firm’s
cost of capital.
                                          P.V. Viswanath                                               5
                      Valuation with Infinite Life
                                  DISCOUNTED CASHFLOW VALUATION


                                                                Expe cte d Growth
                      Cash flows                                Firm: Growth in
                      Firm: Pre-debt cash                       Operating Earnings
                      flow                                      Equity: Growth in
                      Equity: After debt                        Net Income/EPS             Firm is in stable growth:
                      cash flows                                                           Grows at con stant rate
                                                                                           forever


                                                                                                 Terminal Value
                               CF1          CF2      CF3        CF4           CF5          CFn
Value                                                                               .........
Firm: Value of Firm                                                                                           Fore ver
Equity: Value of Equity
                                             Le ngth of Pe riod of High Growth


                                                     Disc ount Rate
                                                     Firm:Cost of Capital

                                                     Equity: Cost of Equity




                                             P.V. Viswanath                                                              6
         Valuing the Home Depot’s Equity

 Assume that we expect the free cash flows to equity at
  Home Depot to grow for the next 10 years at rates much
  higher than the growth rate for the economy. To estimate the
  free cash flows to equity for the next 10 years, we make the
  following assumptions:
      The net income of $1,614 million will grow 15% a year each year
       for the next 10 years.
      The firm will reinvest 75% of the net income back into new
       investments each year, and its net debt issued each year will be 10%
       of the reinvestment.
      To estimate the terminal price, we assume that net income will grow
       6% a year forever after year 10. Since lower growth will require less
       reinvestment, we will assume that the reinvestment rate after year 10
       will be 40% of net income; net debt issued will remain 10% of
       reinvestment.
                               P.V. Viswanath                             7
Estimating cash flows to equity: The
           Home Depot

Year   Net Income   Reinvestment Needs Net Debt Paid        FCFE      PV of FCFE
  1    $   1,856       $    1,392        $      (139)   $      603    $        549
 2     $   2,135       $    1,601        $      (160)   $      694    $        576
 3     $   2,455       $    1,841        $      (184)   $      798    $        603
 4     $   2,823       $    2,117        $      (212)   $       917   $        632
 5     $   3,246       $    2,435       $       (243)   $    1,055    $        662
 6     $   3,733       $    2,800       $       (280)   $    1,213    $        693
 7     $   4,293       $    3,220       $       (322)   $    1,395    $        726
 8     $   4,937       $    3,703       $       (370)   $    1,605    $        761
 9     $   5,678       $    4,258       $       (426)   $    1,845    $        797
 10    $   6,530       $    4,897       $       (490)   $    2,122    $        835
                       Sum of PV of FCFE =                                $6,833




                               P.V. Viswanath                                        8
      Terminal Value and Value of Equity
                    today
 FCFE11 = Net Income11 – Reinvestment11 – Net Debt Paid
  (Issued)11
     = $6,530 (1.06) – $6,530 (1.06) (0.40) – (-277) = $ 4,430 million
 Terminal Price10 = FCFE11/(ke – g)
   = $ 4,430 / (.0978 - .06) = $117,186 million
 The value per share today can be computed as the sum of the
  present values of the free cash flows to equity during the
  next 10 years and the present value of the terminal value at
  the end of the 10th year.
Value of the Stock today = $ 6,833 million + $
  117,186/(1.0978)10
                       = $52,927 million

                              P.V. Viswanath                             9
            Valuing Boeing as a firm

 Assume that you are valuing Boeing as a firm, and
  that Boeing has cash flows before debt payments
  but after reinvestment needs and taxes of $ 850
  million in the current year.
 Assume that these cash flows will grow at 15% a
  year for the next 5 years and at 5% thereafter.
 Boeing has a cost of capital of 9.17%.




                     P.V. Viswanath                   10
    Expected Cash Flows and Firm Value

 Terminal Value = $ 1710 (1.05)/(.0917-.05) = $ 43,049
  million
       Year      Cash Flow          Terminal     Present
                                     Value        Value
         1          $978                          $895
         2          $1,124                         $943
         3          $1,293                         $994
         4          $1,487                        $1,047
         5          $1,710       $43,049         $28,864
          Value of Boeing as a firm =          $32,743
                        P.V. Viswanath                     11
                What discount rate to use?

 Since financial resources are finite, there is a hurdle that
  projects have to cross before being deemed acceptable.
 This hurdle will be higher for riskier projects than for safer
  projects.
 A simple representation of the hurdle rate is as follows:
    Hurdle rate = Return for postponing consumption +
                                         Return for bearing risk
    Hurdle rate = Riskless Rate + Risk Premium
 The two basic questions that every risk and return model in
  finance tries to answer are:
      How do you measure risk?
      How do you translate this risk measure into a risk premium?


                              P.V. Viswanath                         12
         The Capital Asset Pricing Model

 Uses variance as a measure of risk
 Specifies that a portion of variance can be diversified away,
  and that is only the non-diversifiable portion that is
  rewarded.
 Measures the non-diversifiable risk with beta, which is
  standardized around one.
 Relates beta to hurdle rate or the required rate of return:
       Reqd. ROR = Riskfree rate + b (Risk Premium)
 Works as well as the next best alternative in most cases.



                          P.V. Viswanath                      13
        Inputs required to use the CAPM

 According to the CAPM, the required rate of return on an
   asset will be:
               Required ROR = Rf + b (E(Rm) - Rf)
 The inputs required to estimate the required ROR are:
(a) the current risk-free rate
(b) the expected market risk premium (the premium expected
   for investing in risky assets over the riskless asset)
(c) the beta of the asset being analyzed.




                        P.V. Viswanath                       14
                          The Riskfree Rate

 For an investment to be riskfree, i.e., to have an actual return be
  equal to the expected return, there must be:
      No default risk; this usually means a government-issued security; but, not
       all governments are default free.
      No uncertainty about reinvestment rates.
 In practice, the riskfree rate is the rate on a zero coupon
  government bond matching the time horizon of the cash flow
  being analyzed.
 Using a long term government rate (even on a coupon bond) as
  the riskfree rate on all of the cash flows in a long term analysis
  will yield a close approximation of the true value.



                                 P.V. Viswanath                              15
         Measurement of the risk premium

 The risk premium is the premium that investors
  demand for investing in an average risk investment,
  relative to the riskfree rate.
 As a general proposition, this premium should be
      greater than zero
      increase with the risk aversion of the investors in that
       market
      increase with the riskiness of the “average” risk
       investment




                            P.V. Viswanath                        16
         The Historical Premium Approach

 This is the default approach used by most to arrive at the
  premium to use in the model
 In most cases, this approach does the following
       it defines a time period for the estimation (1926-Present, 1962-
        Present....)
       it calculates average returns on a stock index during the period
        it calculates average returns on a riskless security over the period
                    it calculates the difference between the two
                      and uses it as a premium looking forward

 The limitations of this approach are:
      it assumes that the risk aversion of investors has not changed in a
       systematic way across time. (The risk aversion may change from
       year to year, but it reverts back to historical averages)
      it assumes that the riskiness of the “risky” portfolio (stock index) has
       not changed in a systematic way across time.
                                P.V. Viswanath                                  17
   Historical Average Premiums for the
               United States


Historical period Stocks - T.Bills      Stocks - T.Bonds
                  Arith      Geom       Arith      Geom
1926-1999             9.41%       8.14%     7.64%     6.60%
1962-1999             7.07%       6.46%     5.96%     5.74%
1981-1999            13.24%     11.62%     16.08%    14.17%


Considering that market rates of return since 1999 have been
lower, it is probably more appropriate to use a market risk
premium, which is somewhat lower, such as 5.5%


                         P.V. Viswanath                        18
                       Estimating Beta

 The standard procedure for estimating betas is to
  regress stock returns (Rj) against market returns
  (Rm) -
                     Rj = a + b Rm
      where a is the intercept and b is the slope of the
       regression.
 The slope of the regression corresponds to the beta
  of the stock, and measures the riskiness of the
  stock.



                            P.V. Viswanath                  19
                   Setting up for the Estimation

 Decide on an estimation period
      Services use periods ranging from 2 to 5 years for the regression
           Longer estimation period provides more data, but firms change.
           Shorter periods can be affected more easily by significant firm-specific
            event that occurred during the period
      Decide on a return interval - daily, weekly, monthly
           Shorter intervals yield more observations, but suffer from more noise.
      Noise is created by stocks not trading and biases all betas towards one.
 Estimate returns (including dividends) on stock
      Return = (PriceEnd - PriceBeginning + DividendsPeriod)/ PriceBeginning
      Included dividends only in ex-dividend month
 Choose a market index, and estimate returns (inclusive of
  dividends) on the index for each interval for the period.

                                      P.V. Viswanath                                   20
           Choosing the Parameters: Boeing

   Period used: 5 years
   Return Interval = Monthly
   Market Index: S&P 500 Index.
   For instance, to calculate returns on Boeing in May 1995,
       Price for Boeing at end of April= $ 27.50
       Price for Boeing at end of May = $ 29.44
       Dividends during month = $0.125 (It was an ex-dividend month)
       Return =($29.44 - $ 27.50 + $ 0.125)/$27.50= 7.50%
 To estimate returns on the index in the same month
       Index level (including dividends) at end of April = 514.7
       Index level (including dividends) at end of May = 533.4
       Dividends on the Index in May = 1.84
       Return =(533.4-514.7+1.84)/ 514.7 = 3.99%
                                P.V. Viswanath                          21
                               Boeing’s Historical Beta

                                                                        Boeing versus S&P 500: 10/93-9/98

                                                                                           10.00%



                                                                                                                                          Regression
                                                                                            5.00%                                         line

Returns on Boeing



                                                                                            0.00%
                    -25.00%   -20.00%         -15.00%            -10.00%          -5.00%         0.00%          5.00%   10.00%   15.00%         20.00%



                                                                                            -5.00%
                                           Beta is slope of this line




                                                                                           -10.00%




                                                                                           -15.00%

                                        Each point represents a month
                                        of data.

                                                                                           -20.00%




                                                                                           Returns on S&P 500




                                                                        P.V. Viswanath                                                                   22
                The Regression Output

   ReturnsBoeing = -0.09% + 0.96 ReturnsS & P 500
   R squared=29.57%
   Intercept = -0.09%
   Slope = 0.96




                        P.V. Viswanath               23
        Estimating Expected Returns:
             December 31, 1998
 Boeing’s Beta = 0.96
 Riskfree Rate = 5.00% (Long term Government
  Bond rate)
 Risk Premium = 5.50% (Approximate historical
  premium)
 Expected Return = 5.00% + 0.96 (5.50%) = 10.31%




                    P.V. Viswanath              24
      Fundamental Determinants of Betas

 Type of Business: Firms in more cyclical businesses or that
  sell products that are more discretionary to their customers
  will have higher betas than firms that are in non-cyclical
  businesses or sell products that are necessities or staples.
 Operating Leverage: Firms with greater fixed costs (as a
  proportion of total costs) will have higher betas than firms
  will lower fixed costs (as a proportion of total costs)
 Financial Leverage: Firms that borrow more (higher debt,
  relative to equity) will have higher equity betas than firms
  that borrow less.




                         P.V. Viswanath                      25
            Determinant 1: Product Type

 Industry Effects: The beta value for a firm
  depends upon the sensitivity of the demand for its
  products and services and of its costs to
  macroeconomic factors that affect the overall
  market.
      Cyclical companies have higher betas than non-cyclical
       firms
      Firms which sell more discretionary products will have
       higher betas than firms that sell less discretionary
       products



                          P.V. Viswanath                        26
      Determinant 2: Operating Leverage
                   Effects
 Operating leverage refers to the proportion of the
  total costs of the firm that are fixed.
 Other things remaining equal, higher operating
  leverage results in greater earnings variability
  which in turn results in higher betas.




                      P.V. Viswanath                   27
      Determinant 3: Financial Leverage

 As firms borrow, they create fixed costs (interest
  payments) that make their earnings to equity
  investors more volatile.
 This increased earnings volatility which increases
  the equity beta




                      P.V. Viswanath                   28
              Equity Betas and Leverage

 The beta of equity alone can be written as a function of the
  unlevered beta and the debt-equity ratio
                    bL = bu (1+ ((1-t)D/E)
where
   bL = Levered or Equity Beta
   bu = Unlevered Beta
   t = Corporate marginal tax rate
   D = Market Value of Debt
   E = Market Value of Equity
 The unlevered beta measures the riskiness of the business
  that a firm is in and is often called an asset beta.


                              P.V. Viswanath                     29
      Effects of leverage on betas: Boeing

 The regression beta for Boeing is 0.96. This beta is a levered
  beta (because it is based on stock prices, which reflect
  leverage) and the leverage implicit in the beta estimate is the
  average market debt equity ratio during the period of the
  regression (1993 to 1998)
 The average debt equity ratio during this period was
  17.88%.
 The unlevered beta for Boeing can then be estimated:(using
  a marginal tax rate of 35%)
   = Current Beta / (1 + (1 - tax rate) (Average Debt/Equity))
   = 0.96 / ( 1 + (1 - 0.35) (0.1788)) = 0.86



                              P.V. Viswanath                     30
             Betas are weighted Averages

 The beta of a portfolio is always the market-value
  weighted average of the betas of the individual
  investments in that portfolio.
 Thus,
      the beta of a mutual fund is the weighted average of the
       betas of the stocks and other investment in that portfolio
      the beta of a firm after a merger is the market-value
       weighted average of the betas of the companies involved
       in the merger.



                           P.V. Viswanath                       31
      The Boeing/McDonnell Douglas
                 Merger
Company      Beta Debt             Equity   Firm Value

Boeing       0.95 $ 3,980 $ 32,438    $
  36,418
McDonnell Douglas 0.90    $ 2,143 $ 12,555 $
  14,698




                  P.V. Viswanath                         32
              Beta Estimation: Step 1

 Calculate the unlevered betas for both firms
  Boeing = 0.95/(1+0.65*(3980/32438)) = 0.88
  McDonnell Douglas = 0.90/(1+0.65*(2143/12555))
  = 0.81
 Calculate the unlevered beta for the combined firm
   Unlevered Beta for combined firm
   = 0.88 (36,418/51,116) + 0.81 (14,698/51,116)
   = 0.86



                        P.V. Viswanath             33
              Beta Estimation: Step 2

 Boeing’s acquisition of McDonnell Douglas was
  accomplished by issuing new stock in Boeing to cover the
  value of McDonnell Douglas’s equity of $12,555 million.
  Debt = McDonnell Douglas Old Debt + Boeing’s Old Debt
      = $3,980 + $2,143 = $6,123 million
  Equity = Boeing’s Old Equity + New Equity used for
  Acquisition
      = $ 32,438 + $ 12,555 = $44,993 million
  D/E Ratio = $ 6,123/44,993 = 13.61%
  New Beta = 0.86 (1 + 0.65 (.1361)) = 0.94



                       P.V. Viswanath                   34
         The Home Depot’s Comparable Firms

Co mpan y Name             Be ta Marke t Ca p $ (Mi l)     De bt Du e 1 -Yr Out    Lo ng-Te rm Deb t
Bu il di ng Materi al s     1.05                 $1 36                       $1                $1 13
Ca tal i na Li gh ti ng         1                  $1 6                      $7                   $1 9
Co nt'l Materi al s Corp    0.55                   $3 2                      $2                     $7
Ea gle Hardware             0.95                 $6 12                       $6                $1 46
Emco Li mited               0.65                 $1 87                      $3 9               $1 19
Fa stena l Co .             1.25              $1 ,1 57                      $1 6    $        -
Ho me Base Inc.              1.1                 $2 27                                         $1 16
Hu ghes Supp ly                 1                $6 10                       $1                $3 35
Lo we's Co s.                1.2             $1 2,554                     $1 11              $1 ,0 46
Waxman Indu stri es         1.25                   $1 8                      $6                $1 21
Westb urne Inc.             0.65                 $6 07                       $9                   $3 4
Wol oh an Lumb er           0.55                   $7 6                      $2                   $2 0
            Su m                             $1 6,232                     $2 00              $2 ,0 76
          Average           0.93




                                          P.V. Viswanath                                            35
        Estimating The Home Depot’s
               Bottom-up Beta
 Average Beta of comparable firms = 0.93
 D/E ratio of comparable firms =
  (200+2076)/16,232 = 14.01%
 Unlevered Beta for comparable firms =
  0.93/(1+(1-.35)(.1401)) = 0.86
 If the Home Depot’s D/E ratio is 20%, our bottom-
  up estimate of Home Depot’s beta is
  0.86[1+(1-.35)(.2)] = 0.9718


                     P.V. Viswanath               36
    From Cost of Equity to Cost of Capital

 The cost of capital is a composite cost to the firm of
  raising financing to fund its projects.
 In addition to equity, firms can raise capital from
  debt




                       P.V. Viswanath                 37
               Estimating the Cost of Debt

 If the firm has bonds outstanding, and the bonds are traded,
  the yield to maturity on a long-term, straight (no special
  features) bond can be used as the interest rate.
 If the firm is rated, use the rating and a typical default spread
  on bonds with that rating to estimate the cost of debt.
 If the firm is not rated,
      and it has recently borrowed long term from a bank, use the interest
       rate on the borrowing or
      estimate a synthetic rating for the company, and use the synthetic
       rating to arrive at a default spread and a cost of debt
 The cost of debt has to be estimated in the same currency as
  the cost of equity and the cash flows in the valuation.


                               P.V. Viswanath                             38
              Estimating Synthetic Ratings

 The rating for a firm can be estimated using the financial
  characteristics of the firm. In its simplest form, the rating
  can be estimated from the interest coverage ratio
      Interest Coverage Ratio = EBIT / Interest Expenses
 Consider InfoSoft, a firm with EBIT of $2000 million and
  interest expenses of $ 315 million
           Interest Coverage Ratio = 2,000/315= 6.15
      Based upon the relationship between interest coverage ratios and
       ratings, we would estimate a rating of A for the firm.




                               P.V. Viswanath                             39
         Interest Coverage Ratios, Ratings and
                    Default Spreads
Interest Coverage Ratio   Rating               Default Spread
> 12.5                    AAA                  0.20%
9.50 - 12.50              AA                   0.50%
7.50 – 9.50               A+                   0.80%
6.00 – 7.50               A                    1.00%
4.50 – 6.00               A-                   1.25%
3.50 – 4.50               BBB                  1.50%
3.00 – 3.50               BB                   2.00%
2.50 – 3.00               B+                   2.50%
2.00 - 2.50               B                    3.25%
1.50 – 2.00               B-                   4.25%
1.25 – 1.50               CCC                  5.00%
0.80 – 1.25               CC                   6.00%
0.50 – 0.80               C                    7.50%
< 0.65                    D                    10.00%
                              P.V. Viswanath                    40
             Estimating Market Value Weights

 Market Value of Equity should include the following
      Market Value of Shares outstanding
      Market Value of Warrants outstanding
      Market Value of Conversion Option in Convertible Bonds
 Market Value of Debt is more difficult to estimate because few
  firms have only publicly traded debt. There are two solutions:
      Assume book value of debt is equal to market value
      Estimate the market value of debt from the book value; for Boeing, the
       book value of debt is $6,972 million, the interest expense on the debt is $
       453 million, the average maturity of the debt is 13.76 years and the pre-tax
       cost of debt is 5.50%.
                                                       1       
                                               (1 
                                                         13.76 
                                                    (1.055)            6, 972
   Estimated MV of Boeing Debt =           453                                $7, 631
                                                    .055        (1.055 )13.76
                                              
                                                               
                                                                 

                                   P.V. Viswanath                                             41
        Estimating Cost of Capital: Boeing

 Equity
      Cost of Equity = 5% + 1.01 (5.5%) = 10.58%
      Market Value of Equity =            $32.60 Billion
      Equity/(Debt+Equity ) =             82%
 Debt
      After-tax Cost of debt =        5.50% (1-.35) = 3.58%
      Market Value of Debt =                          $ 8.2 Billion
      Debt/(Debt +Equity) =                           18%
 Cost of Capital = 10.58%(.80)+3.58%(.20) = 9.17%




                                  P.V. Viswanath                       42
       Estimating the Expected Growth Rate
                                     Expected Growth


                 Net Income                                Operating Income


Rete ntion Ra tio=       Retu rn on Equity             Reinvestment           Retu rn on Capital =
1 - Dividends/Net    X   Net Income/Book Value of      Rate = (Net Ca p   X   EBIT(1-t)/Book Value of
Income                   Equity                        Ex + Chg in            Capital
                                                       WC/EBIT(1-t)




                                          P.V. Viswanath                                                43
            Expected Growth in EPS

  gEPS = (Retained Earningst-1/ NIt-1) * ROE
       = Retention Ratio * ROE
       = b * ROE
• ROE = (Net Income)/ (BV: Common Equity)
• This is the right growth rate for FCFE
• Proposition: The expected growth rate in earnings
  for a company cannot exceed its return on equity in
  the long term.



                     P.V. Viswanath                44
          Expected Growth in EBIT And
                 Fundamentals
 Reinvestment Rate and Return on Capital
  gEBIT = (Net Capex + Change in WC)/EBIT(1-t) * ROC
        = Reinvestment Rate * ROC
 Return on Capital =
  (EBIT(1-tax rate)) / (BV: Debt + BV: Equity)

 This is the right growth rate for FCFF
 Proposition: No firm can expect its operating income to
  grow over time without reinvesting some of the operating
  income in net capital expenditures and/or working capital.



                         P.V. Viswanath                        45
          Getting Closure in Valuation

 A publicly traded firm potentially has an infinite
  life. The value is therefore the present value of cash
                                    t =  CFt
  flows forever.            Value = 
                                     t = 1 (1+ r)
                                                 t

 Since we cannot estimate cash flows forever, we
  estimate cash flows for a “growth period” and then
  estimate a terminal value, to capture the value at the
  end of the period: Value = t =N CFt t  Terminal Value
                             t = 1 (1 + r)   (1 + r)N




                       P.V. Viswanath                   46
       Stable Growth and Terminal Value

 When a firm’s cash flows grow at a “constant” rate forever,
  the present value of those cash flows can be written as:
   Value = (Expected Cash Flow Next Period) / (r - g) where,
     r = Discount rate (Cost of Equity or Cost of Capital)
     g = Expected growth rate
 This “constant” growth rate is called a stable growth rate
  and cannot be higher than the growth rate of the economy in
  which the firm operates.
 While companies can maintain high growth rates for
  extended periods, they will all approach “stable growth” at
  some point in time.
 When they do approach stable growth, the valuation formula
  above can be used to estimate the “terminal value” of all
  cash flows beyond.
                             P.V. Viswanath                    47
            Estimating Stable Growth Inputs

 Start with the fundamentals:
      Profitability measures such as return on equity and capital, in stable
       growth, can be estimated by looking at
           industry averages for these measure, in which case we assume that this
            firm in stable growth will look like the average firm in the industry
           cost of equity and capital, in which case we assume that the firm will
            stop earning excess returns on its projects as a result of competition.
      Leverage is a tougher call. While industry averages can be used here
       as well, it depends upon how entrenched current management is and
       whether they are stubborn about their policy on leverage (If they are,
       use current leverage; if they are not; use industry averages)
 Use the relationship between growth and fundamentals to
  estimate payout and net capital expenditures.


                                   P.V. Viswanath                                     48
        Estimating Stable Period Net Cap Ex

gEBIT   = (Net Capex + Change in WC)/EBIT(1-t) * ROC
        = Reinvestment Rate * ROC
Therefore, Reinvestment Rate = gEBIT / Return on Capital
 For instance, assume that Disney in stable growth will grow
  5% and that its return on capital in stable growth will be
  16%. The reinvestment rate will then be:
  Reinvestment Rate for Disney in Stable Growth = 5/16 =
  31.25%
 In other words,
       the net capital expenditures and working capital investment each
        year during the stable growth period will be 31.25% of after-tax
        operating income.


                                P.V. Viswanath                             49
                        Relative Valuation

 In relative valuation, the value of an asset is derived from
  the pricing of 'comparable' assets, standardized using a
  common variable such as earnings, cashflows, book value or
  revenues. Examples include --
   • Price/Earnings (P/E) ratios
         and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples)
   • Price/Book (P/BV) ratios
         and variants (Tobin's Q)
   • Price/Sales ratios




                                 P.V. Viswanath                             50
            Multiples and DCF Valuation

 Gordon Growth Model: P  rDPS  g         0
                                                      1
                                                      n

 Dividing both sides by the earnings,
                     P0         Payout Ratio* (1  g n )
                          PE =
                    EPS0                r-gn


 Dividing both sides by the book value of equity,
                   P0          ROE * Payout Ratio* (1  g n )
                        PBV =
                  BV 0                   r-g      n

 If the return on equity is written in terms of the retention
  ratio and the expected growth rate
                            P0          ROE - gn
                                 PBV =
                           BV 0           r-gn

 Dividing by the Sales per share,
                   P0            Profit Margin* Payout Ratio* (1  g n )
                           PS =
                  Sales 0                        r-g      n




                                   P.V. Viswanath                          51

								
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