Sample DCF firm valuation by broverya76

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									More on firm valuation

Discuss in detail several valuation techniques
        Company Analysis and Stock Valuation

After analyzing the economy and stock markets for several
countries, you have decided to invest some portion of your portfolio
in common stocks

After analyzing various industries, you have identified those
industries that appear to offer above-average risk-adjusted
performance over your investment horizon

Which are the best companies?

Are they overpriced?
      Company Analysis and Stock Valuation

• Industry competitive environment

• SWOT analysis

• Present value of cash flows

• Relative valuation ratio techniques
          Firm Competitive Strategies

• Current rivalry

• Threat of new entrants

• Potential substitutes

• Bargaining power of suppliers

• Bargaining power of buyers
             Firm Competitive Strategies

Defensive strategy involves positioning firm so that it its capabilities
provide the best means to deflect the effect of competitive forces in
the industry

Offensive strategy involves using the company’s strength to affect
the competitive industry forces, thus improving the firm’s relative
industry position

Porter suggests two major strategies: low-cost leadership and
                      SWOT Analysis

Examination of a firm’s:


Introduction: A question of value

DCF techniques
•   The dividend model
•   APV
•   FTE
•   WACC

Relative valuation
                  A question of firm value

Liquidation value:
What claimholders receive from selling all the assets of the firm

Going concern value:
The present value of the future cash flow generated by the firm
                   Valuation & Selection

DCF techniques
Calculate on your own intrinsic value and compare it to price to
determine if buying

Relative techniques
Compare stocks based on their market valuation & determine the
best buy
                                   DCF techniques

The dividend model
•   One or multiple stage growth

Total market value of firm:
•   Use three alternative DCF methods
                 The dividend model

                         P = D/(r-g)

      Can’t use it with firms no dividend paying stocks

You have to use CAPM in order to estimate the discount rate

 Formula breaks down when g > r; use multi-stage growth
             Three alternative DCF methods

Adjusted Present Value (APV):
PV UCF (at the unlevered cost of equity) + debt tax shield

Flow to equity (FTE):
PV LCF (at the levered cost of equity) + market value of debt

Weighted Average Cost of Capital (WACC):
PV UCF (at the WACC)

  Unlevered CF = Total CF = CF from assets

Levered CF = CF to equity = CF to shareholders
                            Calculating cash flows

In any given year:

CF from assets = CF to creditors + CF to shareholders
CF to creditors = Interest paid +/- Net new debt raised

CF to shareholders = Dividends paid +/- Net new equity raised

CF from assets = OCF +/- NCS +/- Additions to NWC
Operating CF = EBIT + Depr. - Taxes = UNI + Depr
NCS = Ending Fixed Assets - (Beginning Fixed Assets - Depr.)
Additions to NWC = NWCt - NWCt-1
 Levered vs. un-levered NI

     Sales           Sales
    (Costs)         (Costs)
(Depreciation)   (Depreciation)
      EBIT        EBIT = EBT
      (Tax)          (Tax)
  Levered NI     Un-Levered NI
            Cash flow to equity (to shareholders)

CF to S/H = NI + Depr. +/- NCS +/- Additions to NWC +/- Net new debt

NI = levered net income

Note that
Dividends = CF to S/H +/- Net new equity

Assume a company, with perpetual cash flows. Ignore depreciation, net
capital spending, and additions to NWC.

Annual sales: $500,000
Annual costs: $360,000
Corporate tax: 40%
Market value of debt: $116,667
Unlevered cost of equity: 20%
Levered cost of equity :22%
Weighted average cost of capital : 18%

Interest rate:10%
                Total cash flow calculation
               (aka cash flow from assets)

Unlevered Cash Flow = Sales - Costs - Tax
UCF = $ 500,000- $ 360,000- $ 56,000 = $ 84,000

Levered CF = Sales - Costs - Interest -Tax
LCF = $ 500,000 - $ 360,000 - $ 11,666.7 - $ 51,333.3 = $77,000

PV =   Σ[(UCF) /(1 + uke) ] + PV(debt tax shield)

Assuming constant growth:
PV = (UCF)/(uke – g) + PV(debt tax shield)

PV = $ 84,000/(0.2) + $ 116,667(0.4) = $ 466,667.8

PV = (levered CF)/(levered cost of equity) + market value of debt

PV =   Σ[(LCF) /(1 + Lke) ] + market value of debt

Assuming constant growth:
PV = (LCF)/(Lke - g) + market value of debt

PV = $ 77,000/(0.22) + $116,667.8 = $ 466,667.8

PV = (unlevered CF)/average cost of capital

PV =   Σ[(UCF) /(1 +wacc) ]

Assuming constant growth:
PV = (UCF)/(wacc– g)

PV = $ 84,000/(0.18) = $ 466,667.8

We can calculate firm's present value in three ways:
 Discount net income pretending the company is all-equity, and
  then add the PV of the tax shield (and any other net influences
  of debt).
 Find out the market value of equity by discounting the levered
  cash flow using the levered cost of equity. Add the market value
  of the outstanding debt.
 Discount net income pretending the company is all-equity at an
  average rate (wacc) that has been adjusted to reflect the tax
  savings of debt.
    When to use APV, FTE, and WACC methods?

Use WACC or FTE if the firm’s debt-to-equity ratio will remain
constant in the future.

Use APV if the project’s level of debt is likely to remain constant in
the future.
   Final step: Estimating intrinsic value per share

Market value of equity = Total firm value - Market value of debt

Intrinsic value per share = Market value of equity/No. of shares
                      Relative valuation

Works well when:

•   The stocks under comparison are similar in size, industry, and

•   The market is not bubbling or in a crunch
                       Relative valuation

Most popular market ratios:

•   P/E aka Earnings multiplier
•   P/CF
•   P/S
•   P/BV
                     The earnings multiplier

Higher P/E indicate higher expected growth opportunities, caeteris

P/E = Payout/(r-g)

g = (Ret)ROE

P/E is also a measure of cheapness
          The earnings multiplier: How to use it

• Naïve approach

• Dynamic P/E

• Growth duration

• Other
                            Naïve approach
Basic idea: Compare the P/E between two firms, or between one firm
and the industry/market; determine whether differences in P/E are
justified in terms of expected earnings growth.

(P/E)i / (P/E)b = (1-Ret)i(r-g)b / (1-Ret)b(r-g)a

Example: Firm ABC inc. has an industry beta of 0.98 and its ROE is
expected to remain close to the industry average. Its earnings
multiple is at 25, while the industry earnings multiple hovers around

Implication: Unless the retention ratio of ABC, and expected ROE are
significantly higher than the industry average than the ABC is
overpriced compared to the industry.
                                Dynamic P/E
Basic idea: Project P/E and earnings into the future in order to infer
changes in share price
Exemplification: The industry is expected to produce an average ROE of
12% over the next five years or more. The industry retention ratio is 25%, its
market beta is 1.2 . It is believed that the market risk premium is about 10%. The
current earnings multiple for the industry is 8. the risk-free rate is 2%.

Company ABC Inc. projects its EPS at $0.8/shares for next year. Its current
earnings multiple is 10. In addition a times series regression yielded the following
result:   Chg(P/E)ABC = 0.02 + (0.5)Chg(P/E)b

Required returnb = 2% + (1.2)(10%) = 14%
gb = (0.25)(0.12) = 0.03
Forecasted (P/E)b = (0.75)/(0.14 – 0.03) = 6.82 (-14.75% change)
Forecasted change in (P/E)ABC = 0.02 + (0.5)(-0.1475) = -0.0938 (-9.38%)
(P/E)ABC = 9.06  expected P = $7.25
                                       Growth Duration
Basic idea: How long must earnings grow at g, in order to justify the
difference in P/E?

If P/E reflects growth expectation, then:
(P/E)stock/(P/E)b = [ (1 + divyield + g)stock / (1 + divyield + g)b ]T
A = BT
T = ln(A)/ln(B)

Dividend yieldstock = 5%
Dividend yieldb = 6%
Earnings growthstock = 15%
Earniongs growthb = 4%
P/Estock = 19
P/Eb = 7
T = ln(19/7) / ln(1.20/1.10) = 0.9985/0.087 = 11.48 years
Firm’s earnings must grow at 15% for at least 11.48 years in order to justify the P/E differential

Not as prone to accounting manipulation as P/E

Strong earnings are preceded by strong sales.

Buy low P/S stocks

However, one has to account for industry profit margin.

Fama & French found that low P/BV stocks outperform the market
Tenets of Warren Buffet

     Business Tenets

   Management Tenets

     Financial Tenets

      Market Tenets
                      Business Tenets

Is the business simple and understandable?

Does the business have a consistent operating history?

Does the business have favorable long-term prospects?
                   Management Tenets

Is management rational?

Is management candid with its shareholders?
                      Financial Tenets

Focus on return on equity, not earnings per share

Look for companies with high profit margins

For every dollar retained, make sure the company has created at
least one dollar of market value
                        Market Tenets

What is the value of the business?

Can the business be purchased at a significant discount to its
  fundamental intrinsic value?
            Some Lessons from Peter Lynch
                      (ran Fidelity's Magellan Fund)

Favorable Attributes of Firms:

1. Firm’s product should not be faddish
2. Firm should have some long-run comparative advantage over its
3. Firm’s industry or product has market stability
4. Firm can benefit from cost reductions
5. Firms that buy back shares show there are putting money into
   the firm

DCF & relative valuation techniques should be used together

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