Application: Equity Valuation

based on: INVESTMENTS | BODIE, KANE, MARCUS

 Motivation

• Fundamental analysis values tries to identify the

fundamental (or intrinsic) value of a stock
– The purpose of fundamental analysis is to identify
mispriced stocks relative to some measure of “true” value
derived from financial data
– If we could find a stock with fundamental value > or <
market price, we could generate alpha!
• Valuing common stock is, in theory, no different
from valuing any other stream of risky cash flows:
─ determine the cash flows
─ discount them to the present value
• We will review three different methods for valuing
stock, each with its advantages and drawbacks.
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 Recall: Present Value

• The concept of present value is based on the

commonsense notion that a dollar of cash flow paid
to you one year from now is less valuable to you
than a dollar paid to you today.
• This notion is true because you could invest the
dollar in a savings account that earns interest and
have more than a dollar in one year.
• The term present value (PV) can be extended to
mean the PV of a single cash flow or the sum of a
sequence or group of cash flows.

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 Bond Valuation

• It’s straightforward to use present value

concepts to value bonds!
– The idea is simple: You are willing to pay exactly
the PV for a debt contract;
– Thus, the price in equilibrium is exactly the PV of
the future cash flow streams!
• We know the future cash flow generated by
the bond quite well
• But: What is the discount rate i? We come
back to that ...

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 Bond Valuation

• Assume a Coupon Bond with coupon rate = 10%

•

• We normally know C and F from the bond contract;

but what is i?
– i should reflect the riskiness of the bond
• Default risk, liquidity risk, inflation risk, ...
– i is determined by the market / investors!
– We can observe P for traded bonds and solve for i to see
the market’s i!

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 Equity Valuation

• Valuing common stock is, in theory, no different

from valuing any other stream of risky cash flows
─ determine the cash flows
─ discount them to the present value
• By and large, we can differentiate three
models/approaches:
– Dividend discount model
– Free cash flow method
– Multiples valuation
• Book value of equity is not too helpful
– based on historical cost, not actual market values
• However, this is often no exact science in practice!

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 Dividend Discount Model

• Basic Idea
– Over an infinite time horizon, all profits are paid out as
dividends
– Firm value is today’s PV of future dividends
• What is the right discount factor?
– The discount factor should reflect the riskiness of cash flows
– For equity, we can use the cost of equity as discount rate!
• Cost of equity is nothing else than the expected
return for the security
– If a security is more risky, inventors will demand a higher expected return
– For risky securities, the discount rate is thus higher, reflecting greater un-
certainty about the future and higher demand of investors for compensation
– The CAPM tells us that only systematic risk matters:
k = rf    E (rM )  rf 
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 Dividend Discount Model: The
One-Period Model
• Simplest model, just using the expected dividend
and price over the next year.

• What is the price for a stock with an expected

dividend and price next year of $0.16 and $60,
respectively? Use a 12% discount rate

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 Dividend Discount Model: The
Generalized Model
• However, we normally don’t know the price in t=1
• Thus, the general model extends this to n periods:

• The Gordon Growth Model additionally assumes

that the dividend grows over time
–
– So we get:
∞ 𝐷𝑖𝑣𝑡 𝐷𝑖𝑣0 (1+𝑔) 𝐷𝑖𝑣1
– 𝑃𝑟𝑖𝑐𝑒 = 𝑡=1 (1+𝑘 )𝑡 = =
𝑒 (𝑘𝑒 −𝑔) (𝑘𝑒 −𝑔)

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 Dividend Discount Model: The
Generalized Model - Example
• Basic information
– Assume that a firm pays a dividend of $1 now
– We expect the dividend to grow by 5% each year
– Cost of equity 𝑘𝑒 for this firm are 10%
– What is the current equilibrium stock price?
𝐷𝑖𝑣1 1∗1.05
• 𝑃𝑟𝑖𝑐𝑒 = = = $21
(𝑘𝑒 −𝑔) 0.10−0.05
• However, assume that it turns out that this firm is riskier than
originally expected: 𝑘𝑒 goes up to 15%
𝐷𝑖𝑣1 1∗1.05
• 𝑃𝑟𝑖𝑐𝑒 = = = $10.5
(𝑘𝑒 −𝑔) 0.15−0.05
• Now assume that dividend growth drops to 3%
𝐷𝑖𝑣1 1∗1.03
• 𝑃𝑟𝑖𝑐𝑒 = = = $8.58
(𝑘𝑒 −𝑔) 0.15−0.03

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 Dividend Discount Model:
Multistage Growth Model
• Firms typically pass through life cycles

Early Years Later Years

• Ample opportunities for profitable • Attractive opportunities for reinvestment

reinvestment in the company may become harder to find.

• Competitors may have not entered • Competitors enter the market

the market.

• Payout ratios are low • Payout ratios are high

• Growth is correspondingly rapid. • Dividend growth slows because the

company has fewer investment
opportunities.

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 Dividend Discount Model:
Multistage Growth Model
• We can also use detailed dividend forecasts for the next years
and apply the constant growth assumption thereafter
• Suppose D0 = 2.00 and ke = 13%. We assume supernormal
dividend growth of 30% for 3 years, then a long-run constant
g = 6%. What is the current stock price (after payment of D0)?
•

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 Dividend Discount Model:
Multistage Growth Model
• Is the stock price based on short-term growth in this model?
– The current stock price is $54.11.
– The PV of dividends beyond year 3 is $46.11 (P3 discounted back to t=0).
– The percentage of stock price due to “long-term” dividends is:
$46.11 / $54.11 = 85.2%
– This also means that small changes in the growth expectations and/or
discount rate can have a huge impact on today’s price!
• If most of a stock’s value is due to long-term cash flows, why
do so many managers focus on quarterly earnings?
– Changes in quarterly earnings can be a signal of future changes in cash
flows. This would affect the current stock price.
– If market expects a long run growth rate of g, then current dividend
earnings growth directly transfers into higher valuation!
– Sometimes managers have bonuses tied to quarterly earnings.

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 Dividend Discount Model

The model is useful, with the following assumptions:

• Dividends do, indeed, grow at a constant rate forever
• The growth rate of dividends, g, is less than the required
return on the equity, ke.
• Still, determining the correct discount rate ke is not
straightforward
– We can use the Capital Asset Pricing Model (CAPM) to calculate a
firm’s cost of equity!
• Of course, determining the correct growth rate of dividends is
also challenging!
– In fact, this requires estimating a firm’s growth over the next n
years!

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 Free Cash Flow Valuation

• Also called DCF (discounted cash flow) method

• Basic idea is to discount all future free cash flows to
today’s value; this equals the value of the firm

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 Free Cash Flow Valuation

• Most firms are finance by both debt and equity

• Their discount factor is given by the weighted
average cost of capital (WACC)
𝑉𝑑 𝑉𝑒
– 𝑊𝐴𝐶𝐶 = 𝑟 ∗ 1−𝑇 + 𝑟
𝑉𝑑 +𝑉𝑒 𝑑,𝐵𝑇 𝑉𝑑 +𝑉𝑒 𝑒
– 𝑉𝑑 is the (target) value of debt, 𝑉𝑒 of equity, 𝑟𝑑,𝐵𝑇 the before
tax cost of debt, 𝑟𝑒 cost of equity, and T the corporate tax
rate
• Cost of debt reflect the riskiness of debt and can be estimated by
bond yields or loans
• Cost of equity can be obtained by CAPM
– Interest payments are tax deductible; thus, corporate
taxes reduce the effective cost of debt

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 Free Cash Flow Valuation

• Free cash flow is the amount of cash available from

operations for distribution to all investors (including
stockholders and debtholders) after making the
necessary investments to support operations.
• We can use simple discounting to obtain the firm
value once we know the expected future FCFs
∞ 𝐹𝐶𝐹𝑡
𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = 𝑡=0 𝑡
(1+𝑊𝐴𝐶𝐶)
• Based on the firm value, we can easily calculate
equity value and value per share
• Requires detailed forecasts, thus often challenging
in practice

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 Free Cash Flow Valuation

• Free cash flow (simplified):

Sales
- Cost
- Depreciation
= Earnings before Interest and Taxes (EBIT)
- Taxes (EBIT * Tax Rate)
= Net Operating Profit less adjusted Taxes (NOPLAT)
+ Depreciation
= Net Operating Cash Flow
- Investment (fixed assets)
± Change of Net Operating Working Capital
(- investments/+ divestments in operating current
assets ± change of short-term liabilities)
= Free Cash flow (Entity Approach)

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 Free Cash Flow Valuation -
Example
• Consider a project (or firm) which buys assets in
t=0
– Cost for assets: $200,000 + $10,000 shipping + $30,000
installation
– Depreciable cost $240,000
– Economic life = 4 years
– MACRS 3-year class depreciation method [ special
method applies to project, high tax deduction early in the
projects live]
• The firm stops all operations and sells all assets for
their book value after year 4
– Salvage value = $0

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 Free Cash Flow Valuation -
Example
• In years one to four, the firm sells products
– Annual unit sales = 1,250.
– Unit sales price = $200.
– Unit costs = $100.
– Net operating working capital (NOWC) = 12% of (next
years) sales.
• Other important information
– Tax rate = 40%.
– WACC = 10%.
– Inflation is expected to be 3%
• Unit cost and prices rise with inflation!

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 Free Cash Flow Valuation -
Example
• Depreciation
– Basis = Cost + Shipping + Installation = $240,000
– Annual Depreciation Expense [MACRS 3-year] (000s)
Year % x Basis = Depr.
1 33 $ 79.2
2 45 $240 108.0
3 15 36.0
4 7 16.8

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 Free Cash Flow Valuation -
Example
• Unit sales and cost

Year 1 Year 2 Year 3 Year 4

Units 1250 1250 1250 1250

Unit price $200 $206 $212.18 $218.55

Sales $250,000 $257,500 $265,225 $273,188

Unit cost $100 $103 $106.09 $109.27

Costs $125,000 $128,750 $132,613 $136,588

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 Free Cash Flow Valuation -
Example
• Operating cash flow
Year 1 Year 2 Year 3 Year 4
Sales $250,000 $257,500 $265,225 $273,188
- Costs $125,000 $128,750 $132,613 $136,588
- Depr. $79,200 $108,000 $36,000 $16,800
= EBIT $45,800 $20,750 $96,612 $119,800
- Taxes (40%) $18,320 $8,300 $38,645 $47,920
= NOPLAT $27,480 $12,450 $57,967 $71,880
+ Depr. $79,200 $108,000 $36,000 $16,800
= Net Op. CF $106,680 $120,450 $93,967 $88,680

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 Free Cash Flow Valuation -
Example
• Cash Flows due to Investments in Net Operating
Working Capital (NOWC)

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 Free Cash Flow Valuation -
Example
• Free Cash Flows for Years 0-4

Year 0 Year 1 Year 2 Year 3 Year 4

Investment -$240,000 0 0 0 0

+ Net. Op. CF 0 $106,680 $120,450 $93,967 $88,680

+ NOWC CF -$30,000 -$900 -$927 -$956 $32,783

Free CF -$270,000 $105,780 $119,523 $93,011 $121,463

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 Free Cash Flow Valuation -
Example
• Net present value of future Free Cash Flows
0 1 2 3 4

(270,000) 105,780 119,523 93,011 121,463

∞ 𝐹𝐶𝐹𝑡 4 𝐹𝐶𝐹𝑡
– 𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = 𝑡=0 (1+𝑊𝐴𝐶𝐶)𝑡 = 𝑡=0 (1+0.1)𝑡 = $77,784

• Assuming
– no debt and
– 1,000 shares
 Share price equals $77,784/1000 = $77.78

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 Multiples Valuation

• Definition: a multiple is a financial figure that

relates the value of an asset to a (financial)
performance measure

• Application in corporate valuation:

– Idea: Estimate corporate value via comparison against
prices/values of „comparable” companies;
 Similar assets should sell at similar prices

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Multiples Valuation

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 Multiples Valuation - PE

• Price-to-earnings (P/E) ratio is the current market

value of the firm’s equity divided by the earnings
that belong to the owners.
• Typically, future earnings are used, such as the net
income expected for the next year.
• This is one of the most important multiples used in
practice because data on price and earnings is
readily available.
• However, there are problems with this multiple. For
example, it cannot be used if earnings are
negative.

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 Multiples Valuation – PE Example

• Assume that the industry average PE ratio is

16
• What is the value of a firm with earnings of
$1.13 / share?
• Answer:

Price = 16  $1.13 = $18.08

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 Multiples Valuation – Other
Multiples
• There are many different multiples
– Popular ones are P/E, Price-to-Book, or Firm value-to-EBIT
– Overview:

Source: www.cxoadvisory.com

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Multiples over Industries

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Multiples over Time

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 Multiples Valuation – Practice

• We need to identify comparable firms (peer group)

– In general, we only use firms within the same industry
– Although it would be preferable to use only firms within the
same country, this is often not practicable
– Although there are no generally accepted rules, a peer
group should at least include five to ten firms
– It is very important to select comparable firms carefully
and to make sure that they are really comparable!
• We need to decide which multiple to use
– Which ones to use also depends on data availability
– In practice, we will often use several multiples and
calculate the average valuation outcome

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 Multiples Valuation – Practice

• Frequently used multiples:

Source: Aswath Damodaran

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