Session 04

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Bachelor of Business Administration

Semester VII

Business Valuations (FIN 4239)

Intrinsic Value
(Session 04)
SENANI THENUWARA
DEPARTMENT OF FINANCE
FACULTY OF MANAGEMENT AND FINANCE
UNIVERSITY OF COLOMBO
Intrinsic Value
The intrinsic value approach states;

Value of a business = ∫ ( CFs, growth and risk)

Value of equity
Value of a business
Value of the entire
firm

Designed for Cashflow generating assets.


Value = expected value of CFs
Assets are required to generate some positive expected CFs over its life time
Financial balance Sheet

Growth Assets
Equity

Debt Investments
Principles of Valuation
1. Consistency Principle

Discount rate should be matched with the CFs.

CFs to equity - Discounted with WACC x - upward biased estimate of value of equity
CFs to firm - Discounted at Ke x - downward biased estimate of value of equity
Principles of Valuation
2. Nominal Vs Real value

If nominal – currency matters


Dividend Discount Model – Recap
Constant Growth model
Dividends are expected to grow at a constant rate forever.

D1 = Dividend paid at t1

𝑫𝟏 G = constant growth rate


◦V =
(𝑲𝒆−𝒈)
Ke = Required rate of return on equity

Example:
Stock A has an expected growth rate of 7%. Each share has just received an annual Rs.2.50 dividend per
share. The required rate of return is 12%. Determine the value of the common stock?
Dividend Discount Model – Recap
Zero Growth model

The constant growth dividend model calls for an expected dividend growth rate, g, of zero.

𝑫𝟏 D1 = Dividend paid at t1
V=
𝑲𝒆
Ke = Required rate of return on equity

Example:

Stock Z has an expected growth rate of 0%. Each share of stock just received an annual Rs. 2.50 dividend per share.
The appropriate discount rate is 10%. What is the value of the common stock?
Dividend Discount Model – Recap
Growth Phase Model
This assumes that dividends will grow at different phases (two or more) at different growth rates

According to the above;


Phase 01 : Dividend will grow at g1 until period n
Phase 02 : Dividend will grow at a constant rate of g2

Example:
A Stock has an expected growth rate of 12% for the first 3 years and 10% thereafter. Each share of
stock just received an annual Rs.3.50 dividend per share. The appropriate discount rate is 15%. What
is the value of the common stock under this scenario?
Dividend Discount Model – Recap


0 1 2 3 4
Consider two
separate time
lines in the
valuation.
D1 D2 D3 D4

Grow at 12% for three years Grow at 10% until infinity


Dividend Discount Model – Recap
Steps to be followed;
▪Calculate dividends for the first four years
▪Apply constant dividend growth model to Y4 cashflow to derive value of dividend until infinity
▪Discount the cashflows using appropriate discount factors
▪Sum up cash flows of the two timelines to derive the value
FREE CASH FLOW BASED
VALUATION
Free Cashflows to Equity (FCFE)
Measure of how much cash is available to be paid for equity shareholders after meeting
reinvestment needs.

Starting point is the net income.

Net income is converted in to cashflow by adjusting for reinvestment needs of the firm.
Free Cashflows to Equity (FCFE)
Adjusting net capital expenditure

net capital expenditure= Capital expenditure – depreciation

Adjusting for working capital (non-cash WC)

WC Cash available for equity holders

Cash available for equity holders


WC
Free Cashflows to Equity (FCFE)
Adjusting changes in the level of debt

Net effect of repayment of old debts against the issue of new debts

Net income adjusted for net capital expenditure, WC changes and net change of debt will result
in Free Cash Flows to Equity.
Free Cashflows to Equity (FCFE)
Free Cashflows to Equity = Net income – (Capital expenditure-Depreciation) – Change in WC
+ ( New debt issue- Repayments)
Equity Reinvestments
Equity Reinvestments = Capital expenditure-Depreciation + Change in WC - New debt issue + Repayments

Equity Reinvestments rate


Measures percentage of net income invested back in the firm.

Equity Reinvestments rate = (Capital expenditure-Depreciation + Change in WC - New debt issue + Repayments)
Net Income
FCFE Growth Estimations
Expected growth rate = Retention ratio * Return on equity

Replace with Replace with


Equity reinvestment rate Non cash ROE

Equity Reinvestments = (Capital expenditure-Depreciation + Change in WC Non cash ROE= Net Income – after tax income from cash and marketable securities
Rate -New debt issue + Repayments) / Net Income Book value of equity - cash and marketable securities

Expected growth rate in FCFE = Equity reinvestment rate * Non cash ROE
Dividends to FCFE
Conventional measure – Dividend payout ratio

Dividend payout ratio = Dividend / Earnings

Can modify with the concept of FCF

Cash to stakeholders to FCFE ratio = (Dividend + share buybacks) /FCFE


Why firms pay less than what is available?
▪ Stability

▪Future investments

▪Taxation

▪Signaling effect

▪Managerial interests
FCFE Valuation Models
Assumptions

1. No future cash buildups by the firm in future

2. Expected growth rate will include growth in income generated from operating assets but not
the income growth stems from increase in marketable securities.
Constant growth model
Value of equity is a function of expected FCFE under a stable growth rate discounted at required rate of return.
Constant growth model
There are two conditions to be met in using this model in valuation
1. Growth rate should be less than or equal to economic growth rate

( if nominal COC – nominal economic growth rate / real COC – real economic growth rate)

2. Characteristics of the firm t be consistence with the stable growth rate assumptions.
Two Stage FCFE Model
Value of the stock – present value of FCFE for an extraordinary growth period plus the present
value of the terminal price at the end of the period

Terminal value based on perpetual growth rate model;


E Model- Three Stage FCFE Model
For firms that are expected to pass three stages of growth;
◦ Initial phase - high growth
◦ Transitional period- decline in growth rates
◦ Steady state period – stable growth
Growth phase vs net capital Expenditure
FCFE Valuation Vs Dividend Discount Model Valuation
DDM FCFE Model
Assumption Only dividend paid FCFE are paid to the shareholder.
Remaining earning reinvested in Remaining earning reinvested only in
operating assets, cash and marketable operating assets
securities.

Expected growth Income growth from operating and Growth in income from operating
cash assets are considered assets

Adjustments for cash and marketable Built in to earnings. No special Include income from cash and
securities adjustments needed. marketable securities to income
projections and equity value estimation

Or

Ignore income from cash and


marketable securities and add them to
the equity value.

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