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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)
    – Required rate of return to all capital providers
    – 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
  – Make company-appropriate adjustments
  – 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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