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```					Valuation

Chapter 10
Valuation models

– Discounted cash-flow
– Market-based (multiples)
– Residual income Model

DCF and risidual income model are much more
sophisticated valuation tools than the price multiples
– Infinite forecast horizon
– Risk and the time-value of money are taken into
account (cost of capital)

Ch 10                         2
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

Ch 10                     3
Discounted Dividend Valuation
Theoretical Model
•   No-growth, constant dividend
D
P0 
r
•   Dividends are growing at rate g
D1           D 0( 1  g)
P0           
rg             rg

Ch 10           4
Required rate of return (r)
r  rf   (rm  rf )

• rf, Risk-free (30-year Treasury bond) = 5%
• rm, Expected stock market return = 10%
– Risk premium = (rm – rf)
• For example, if Beta = 1.5
• r = 5% + 1.5(10%-5%)
• r = 12.5%

Ch 10               5
Growth rate (g)

• Sustainable growth = ROE(1-Payout rate)
– ROE = Earnings/Average equity
– Payout rate: % of earnings used to pay
dividends

Ch 10                 6
Discounted Dividend Valuation
Motorola example
• Motorola
–   Annual dividend = \$0.16
–   Beta = 1.35
–   ROE = 13%
–   Payout ratio = 20%
• Economic
– Yield on Treasury bills = 4.75%
– Historical market risk premium = 5.4%
Ch 10               7
Discounted Dividend Valuation
Motorola example
• r = .0475+1.35(.054) = .120
• g = .13(1-.20) = .104
• Value = \$11.04

\$0.16(1  .104)
.120  .104
Ch 10        8
Discounted Operating Cash-Flow Models

• Value of the firm (EV) = Value of assets
= Enterprise value
= Value of debt +value of equity

• Typically, valuation of debt is relatively easy.
Amount of debt reported in balance sheet is
usually close to market value, i.e. value of debt
is observable

Ch 10                        9
Discounted Operating Cash-Flow Models

• Operating cash flow
Plus: Interest Paid Times (1-tax rate)
Less: Investments in Fixed Capital
Free Cash Flow to the Firm (to all investors)
FCF 1
V0 
rg
Ch 10                      10
Discounted Operating Cash-Flow Models

• r = Weighted average cost of capital (WACC)
– For Motorola, 10.2%
• g = growth rate of FCFs
– For Motorola, 9%
•   If Motorola’s FCF = \$314 million
•   Firm value is \$26,167 million [314/(.102-.09)]
•   Shares outstanding is 2,299
•   Value per share (after debt \$9,428) is \$7.28
Ch 10                       11
Discounted Operating Cash-Flow Models

• Growth
– Can also use a multi-stage model to accommodate
rate changes
• Forecasting cash flows requires judgment
– Begin with reported, historical cash flow and
earnings
– Use financial analysts’ estimates

Ch 10                     12
Market-based Models (multiples)
• Compare subject company to other similar
companies for which market prices are available
• Simple but require a lot of professional judgment

• P/E Model
• P/B Method
• P/S Model

Ch 10                   13
P/E Model

• Assumes a company is worth a certain multiple
of its current earnings
• Assumes each stock is worth the same multiple
of EPS
• Requires judgment regarding
– Peer firms
– Historical (average) P/E

Ch 10               14
P/E Model

• Firms with no internal growth prospects,
paying out 100% of earnings
– Current P/E = 1/r
• Constant growth,
– P0/E1 = (D1/E1)/(r-g)
– D = annual dividends, E = EPS

Ch 10                15
P/E versus bond yields

http://home.golden.net/~pjponzo/PE-BondRates.htm

Ch 10                         16
Effect of the cost of equity and
growth opportunities to P/E-ratio
Cost      Expected annual growth rate of earnings (%)
of
Equity (%)     0       1     2       3      4      5        6
8,5        11,8   13,3   15,4    18,2   22,2   28,6     40,0
9,0        11,1   12,5   14,3    16,7   20,0   25,0     33,3
9,5        10,5   11,8   13,3    15,4   18,2   22,2     28,6
10,0       10,0   11,1   12,5    14,3   16,7   20,0     25,0
10,5       9,5    10,5   11,8    13,3   15,4   18,2     22,2
11,0       9,1    10,0   11,1    12,5   14,3   16,7     20,0
11,5       8,7     9,5   10,5    11,8   13,3   15,4     18,2
12,0       8,3     9,1   10,0    11,1   12,5   14,3     16,7

Ch 10                            17
P/E Model

•   Motorola example
•   Consensus analyst forecast EPS = \$0.46
•   P/E of 23 is appropriate
•   Value = 23*\$0.46 = \$10.58

Ch 10                18
Problems when using P/E-ratio in valuation
• It assumes that the benchmark is obtainable.
• P/E-ratios might differ accross firms or time
at least for the following reasons:
– growth opportunities may differ accross firms
– riskiness of a firm may differ accorss firms
– earnings for a given year may be temporary by
nature

Ch 10                        19
P/B-ratio, price/book–ratio

• No growth
– P0/B = ROE/r
• Constant growth
– P0/B = (ROE- g)/(r-g)
• P/B ratios for similar firms are compared with
those of the subject firm to arrive at an
appropriate multiple for use in valuation

Ch 10              20
Other Price multiples
–   enterprise value/EBIT–ratio
–   price/free cash flow–ratio
–   price/sales–ratio
–   Price/EBITDA
Method used should be appropriate
considering the specific circumstances of
the subject company.

Ch 10                21
Residual Income Model

• PV = book value + excess earnings over time

E t  rBt 1
P0  B0  
t 1 (1  r )
t

• Perpetuity model
 ROE  r 
P0  B            B
 rg 

Ch 10                 22
Ch 10   23
Valuation tools most used by analysts in
Morgan Stanley European sector research teams

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Ch 10                               24

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