Intrinsic

valuation
 The essence of intrinsic valuation

• Value an asset based upon its intrinsic characteristics

• Discounted cash flow valuation is a tool for estimating intrinsic value – the expected value
of an assets is written as the present value of the expected cash flows on the asset, with
either the cash flows or the discount rate adjusted to reflect the risk
• For cashflow generating assets:
• The intrinsic value will be a function of the magnitude of the expected cash flows on the asset over its
lifetime and the uncertainty about receiving those cash flows.
Discounted cash flow valuation

Value of
an asset
The two faces of discounted
cash flow valuation
The two faces of discounted cash flow
valuation
• 1. The value of a risky asset can be estimated by discounting the expected cash flows on
the asset over its life at a risk-adjusted discount rate:

𝑬(𝐶𝐹1) 𝑬(𝐶𝐹2) 𝑬(𝐶𝐹𝑛)

𝑉alue 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 = + + ……+
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)𝑛
Where the asset has a n-year life:
• E(CFt): the expected cash flow in period t
• r : a discount rate that reflect the risk of the cash flows
The two faces of discounted cash flow
valuation
• 2. Replace the expected cash flows with the guaranteed cash flows, we would have
accepted as an alternative (certainty equivalents) & discount these at the risk free rate:

𝑪𝑬(𝐶𝐹1) 𝑪𝑬(𝐶𝐹2) 𝑪𝑬(𝐶𝐹𝑛)

𝑉alue 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 = + + ……+
(1 + 𝑟𝑓) (1 + 𝑟𝑓) 2 (1 + 𝑟𝑓)𝑛

• Where :
• CE(CFt): the certainty equivalent of E(CFt)
• rf : the risk free rate
Risk adjusted value
𝐸(𝐶𝐹1) 𝐸(𝐶𝐹2) 𝐸 𝐶𝐹𝑛
𝑉alue 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 = + + ……+
(1 + 𝑟) (1 + 𝑟)2 1+𝑟 𝑛

𝑪𝑬(𝐶𝐹1) 𝑪𝑬(𝐶𝐹2) 𝑪𝑬(𝐶𝐹𝑛)

𝑉alue 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 = + + ……+
(1 + 𝑟𝑓) (1 + 𝒓𝒇) 2 (1 + 𝒓𝒇)𝑛
Risk adjusted value:
Two basic propositions
• Proposition 1: For an asset to have value, the
expected cash flows have to be positive some time
over the life of the asset
• Proposition 2: Assets that generate cash flows
early in their life will be worth more than assets
that generate cash flows later
• The latter may however have greater growth
and higher cash flows to compensate
DCF choices: Equity valuation versus firm
valuation
Equity
valuation
Firm valuation
Discounted cashflow valuation
First principle of
valuation
• Consistency principle: Your discount rate should
match up to your cash flows
• Avoid mismatch cashflows and discount rates:
• Discounting cashflows to equity at the
weighted average cost of capital will lead to an
upwardly biased estimate of the value of
equity.
• Discounting cashflows to the firm at the cost of
equity will yield a downward biased estimate
of the value of the firm
DISCOUNT
RATE
DISCOUNT RATE

• Consistency principle
• Cash flow to equity -> Cost of equity
• Cash flow to firm -> Cost of capital (WACC)
Cost of Equity
• The cost of equity should be higher for riskier investments and lower
for safer investments.
• How to measure risk?
• Measure risk in term of statistical measures: standard error,
variance, volatility.
• Use stock prices instead of accounting earnings.
Risk
• Marginal investors are investors who can set the prices for
that stock
• They have two characteristics:
• They own a lot of shares Institutional Investors
• They often trade those shares
• Risk and return models in finance assume that the risk that should
be rewarded in valuation should be the risk perceived by the
marginal investor in the investment = Diversified Investors
• The risk in a company is the risk that it adds to a diversified
portfolio
Competing Risk and Return models
Capital asset pricing model (CAPM)
• The risk of an investment is the risk that it adds to the market
portfolio
• That risk is captured in Beta
Capital asset pricing model (CAPM)
Competing Risk and Return models
Arbirage pricing model (APM) and Multi-factor
model
• Rather than capture market risk with one Beta, they allow for multiple sources of market
risk (have multiple Beta).

APM Multi-factor model

It leaves the market risk

factors as unnamed factors
Competing Risk and Return models
Proxy model
• They give up measuring risk and let something else stand in for
it.
• Two widely used proxies for risk:
• Size of the business (Market cap)
• Small companies seem to earn higher return than large companies
• Small companies are riskier than larger companies
• Price to book
• Stock of market value of equity is well below the book value of equity
tend to have higher return than companies with high price to book ratio.
RISK FREE RATE
The essence of intrinsicvalue
• Nominal versus Real:
• If the cashflows being discounted are nominal cash
flows (i.e., reflect expected inflation), the discount
rate should be nominal
• Currency for your cash flow
• When you pick the currency to estimate the
cashflows, your discount rate has to be for the
same currency
Competing Risk and Returnmodels
A risk freerate
• For an investment to be risk free, it has to have
• No default risk
• No reinvestment risk
• Time horizon matter – If your cash flows stretch out over the
long term, your risk free rate has to be a long term risk free
rate.
• Not all government securities are risk free.
• Currencies matter: A risk free rate is currency-specific and
can be very different for differentcurrencies.
A risk freerate
• Examples:
• Determine a US dollar risk-freerate
• US Treasury issues 3 months T-bond
• US Treasury issues 6 months T-bond
• Five-year government bond
• Ten-year government bond
• Thirty-year government bond
• TIP rate
• Determine a Euros risk-free rate
A risk free rate inEuros
A risk freerate
• Examples:
• Determine a US dollar risk-freerate
• Determine a Euros risk-free rate
• Determine a Brazilian Reai risk-free rate
• Brazil’s 10 year-government bond denominate in Reai is 9%
• Default spread for Brazilian government is 1.77%
• -> Brazilian Reai risk-free rate = 9%-1.77% = 7.23%
• The key number to convert a government bond rate into
risk free rate is a default spread to the government or
sovereign default spread
Sovereign Default Spread: the firstway

• Sovereign dollar or euro denominated bonds: Find sovereign bonds

denominated in US dollars, issued by an emerging sovereign.
Default spread = Emerging Govt Bond Rate (in US $) – US Treasury Bond rate with same maturity.
• Example:
 Example: If
Sovereign Default Spread: the secondway

• CDS spreads: Obtain the traded value for a sovereign Credit Default Swap (CDS) for the emerging
government.
Default spread = Sovereign CDS spread (with perhaps an adjustment for CDS market
frictions).
• The CDS market is constantly updated -> It gives you an updated measure of market default spread for
this country right now.
• Example:
CDS Spread – Jan 2016
Sovereign Default Spread: the thirdway
Example: If

• Sovereign-rating based spread: For countries which don’t issue dollar

denominated bonds or have a CDS spread, you have to use the average
spread for other countries with the same sovereign rating.
 Average
Default
Spreads:
January 2016
EQUITY RISK
PREMIUM
(ERP)
The equity risk premiums: Intuition
• You have 2 choices:
Risky assets
Guaranteed assets (e.g Shares/stocks
(e.g Government bond = 2% ) on equity market)

Equity risk premium (ERP)

(2%+ ERP = Rate of return on equity)

Historical premium Forward looking premium

The equity risk premiums: Intuition
• The equity risk premium is the return that equity investors
demand over the risk-free rate for investing in risky assets.

Expected rate of - Risk free rate

Equity risk premium = return on equity

• For lack of a better description, it is the price of bearing a unit of

equity risk
• Determinant factors:
You are born with
• Investors’ attitute to risk : How risk–averse you are? Depend on your age
• Overall equity market risk Your perception of
macroeconomic risk
• ERP is a number should change over time.
 The ubiquitous historical risk premium
• The historical premium is the premium that stocks have historically earned
over riskless securities
Historical Equity Rate of return on - Risk free rate
risk premium
= equity in the past
• Example: For the last 50 years, you’d made 12%/year investing in stock, but
you would have made only 4% if investing in Treasury bond over the same
period. What is the historical equity risk premium?
• While the users of historical risk premiums act as if it is a fact (rather than an
estimate), it is sensitive to:
• How far back you go in history
• Whether you use T.Bill rates or T.Bond rates
• Whether you use geometric or arithmethic averages
 The perils of trusting the past

• Noisy estimates:
• Historical ERP is a statistical estimate and it comes with standard error. (E.g
5.88% as ERP)
• Historical premium is the estimates with some noise.
• Data with the shorter period of time tends to have a larger standard error than a
longer one
• Survivorship bias: Using historical data from the U.S equity markets over the twentieth
century does create a sampling bias.
• The Us economy and equity markets were among the most successful of the
global economies that you could have invested in early in the century
• Better measure historical premium is: Average out the premium across multiple
The perils of trusting the past
• Historical premium is a flawed way of thinking about equity
risk
• It is backward looking and assume everything revert back to historic
norms.
Forward-looking equity risk premium
• Forward looking return on equity can be estimated in the same way
as bond return
An updated equity risk premium for US
market
Equity Risk Premiums in the US: 1960-2012
Estimating a risk premium for an emerging market.

• Approach 1: Built off a mature market premium

• Emerging market’s risk premium is estimated on the basis of Mature
market’s risk premium
Emerging market’s risk Mature market’s risk Country risk premium for
= + Emerging market (CRP)
premium premium
• Example:Brazil’s default spread, based on its rating, in September,
2011 was 1.75%. If the US’s equity risk premium is 5.8%, then:
• Equity Risk Premium for Brazil = 5.8% + 1.75% = 7.55%
• In this approach, the country default risk is set equal
to the default spread of the bond issued by the
country’s government.
 Estimating a risk premium for an emerging market.

• Approach 2: Adusted for equity risk

• The country equity risk premium is based upon the volatility of
the equity market relative to the government bond rate.
• Default spread on Brazilian Bond = 1.75%
• Standard Deviation in Bovespa = 21%
• Standard Deviation in Brazilian government bond = 14%
• Total equity risk premium for Brazil = 5.8% + 1.75%(21/14) =
8.43%
Implied Equity Risk Premium - Brazil
 From Country Equity Risk Premiums to
Corporate Equity Risk premiums
• Approach 1: Assume that every company in the country is equally exposed to
country risk.
Cost of equity = E(Return) = Riskfree Rate + Beta *(Mature ERP) + CRP
• Approach 2: Assume that a company’s exposure to country risk is similar to its
exposure to other market risk.
E(Return) = Riskfree Rate + Beta *(Mature ERP+ CRP)
• Approach 3: Treat country risk as a separate risk factor and allow firms to have
different exposures to country risk (perhaps based upon the proportion of their
revenues come from non-domestic sales)
• E(Return)=Riskfree Rate+ 𝐵*(Mature ERP) + 𝜆*(CRP)
• In which:
• Mature ERP = Mature market Equity Risk Premium
• CRP = Country risk premium
Approaches 1&2: Estimating country risk
premium exposure
• Location based CRP: The standard approach in valuation is to attach a country risk
premium to a company based upon its country of incorporation. A developed market
company is assumed to bed un exposed to emerging market risk
• Operation-based CRP: There is a more reasonable modified version. The country risk
premium for a company can be computed as a weighted average of the country risk
preium of the countries that it does business in, with the weights based upon revenues
or operating income. If a coumpany is expose to risk in dozens of countries, you can take
a weighted average of the risk premiums by region.
• Single emerging market: Embraer, in 2004, reported that it dervied 3%
of its revenues in Brazil and the balance from mature markets. The
mature market ERP in 2004 was 5% and Brazil’s CRP was 7.89%

• Multiple emerging markets: Ambev, the Brazilian-based beverage

company, reported revenues from the following countries during 2011.
Extending to multinational: Regional
breakdown. Coca Cola’s revenue breakdown and
ERP in 2012
Estimating Lambdas: The revenue Approach
• Approach 3: Treat country risk as a separate risk factor and allow
firms to have different exposures to country risk (perhaps based upon
the proportion of their revenues come from non-domestic sales)
• E(Return)=Riskfree Rate+ 𝐵*(Mature ERP) + 𝜆*(CRP)
• The easiest and most accesible data is on revenues. Most companies
break their revenues down by region.
Cash flows
Defining Cashflow
The basic ingredients for free cash flows
• Estimate the current earnings ofthe firm
• If looking at cash flows to equity, look at earning after interest expenses – i.e
net income.
• If looking at cash flows to firm, look at operating earning after taxes
• Consider how much the firm invested to create future growth
• If the investment is not expensed, it will be categorized as capital
expenditures. To the extent that depreciation provides a cash flow, it will
cover some of these expenditures
• Increasing working capital needs are also investments for future growth
• If looking at cash flows to equity, consider the cash flows from net
debt issues (debt issued, debt repaid)
Step1: Get your earnings “right”
Step 2: Consider the effect of taxes
• Your earnings and cash flows should be after corporate taxes
• When you do free cash flow to the firm, you are computing your cash
flows “as if you had no debt”. That is why it is called an unlevered
cash flow.
• Consequently, you have to compute the tax you would have paid on
your operating income, as if it were taxable income
• For the short term, you can use the effective tax rate, since it is a tax
rate you paid on average on your taxable income
• Over time, though, you would expext this tax rate to climb towartds
your marginal tax rate.
Step 3: Define reinvestment broadly for long
term assets
• Research and development expenses, one they have been re-
categorized as capital expenses. The adjusted net cap ex will be:
• Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s
R&D expenses – Amortization of Research Asset
• Acquisitions of other firms, sicnce there are like capital expenditures.
The adjusted net cap ex will be:
• Adusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms –
Amortization of such acquisitions
• Two caveats:
• Most firm do not do acquistion every year. Hence, a normalized measure of acquisitions
(looking at an average over time) should be used
• The best place to find acquisitions in the statement of cash flows, usually categorized
under other investment activities.
Step 4: To get from FCFF to FCFE, consider debt
cash flows
• In the strictest sense, the only cash flow that an investor will receive from an equity investment in
a publicly traded firm is the dividend that will be paid on the stock
• Actual dividends, however, are set by the managers of the firm and may be much lower than the
potential dividends (that could have been paid out)
• Managers are conservative and try to smooth out dividends
• Managers like to hold on to cash to meet unforseen future contingencies and investment opportunities
• The potential dividends of a firm are the cash flows left over after the firm has mad any
“investments”, it needs to make to create future growth and net debt repayments (debt
repayments – new debt issues)
• Net income
• - (Capital Expenditures – Depreciation)
• - Change in non-cash Working Capital
• - (Principal Repayments – New Debt issues)
• = Free Cash flow to Equity
Cost of debts
What is debt?

• For an item to be classified as debt, it has to meet

three criteria:
• It has to give rights to a contractual
commitment, that has to be met in good times
or bad
• That commitment usually is tax deductible
• Failure to make that commitment can cost you
the control over the business
What is a debt?

Credit term 1/5 net 55

Estimating the Cost of Debt
• The cost of debt is the rate at which you can borrow long term today.
It will reflect not only your default risk but alse the level of interest
rates in the market
Estimating the Cost of Debt
• The two most widely used approaches to estimating the cost of debt
are:
• Looking up the yield to maturity on a straight bond outstanding from the firm
• Looking up the rating for the firm and estimating a default spread based upon
the rating.
Estimating Synthetic Ratings
• The rating for a firm can be estimated using the financial
characteristics of the firm. In its simplest form, the rating can be
estimated form the interest coverage ratio.
Interest Coverage Ratio = EBIT/Interest Expenses
• For Embraer’s interest coverage ratio, we used the interest expenses
from 2003 and the average EBIT from 2001 to 2003 (The aircraft
business was badly affected by 9/11 and its aftermath). In 2002 and
2003, Embraer reported significant drop in operating income
Interest Coverage Ratio = 462.1/129.70 = 3.56
Interest Coverage Ratios, Ratings and Default
Spreads: 2003 &2004
 Cost of Debt Computations

• The cost of debt for a company is then the sum of the risk free rate and the default spread:
Pre-tax
default risk, especially if theycost of debtor=have
are smaller Riskall
free rate +revenues
of their Defaultwithin
spreadthe country. Larger
• The
companies
default that derive
spread cana besignificant
estimatedportfrom
of their
therevenues
rating orinfrom
globalamarkets may beissued
traded bond less exposed
by
to country default risk. In other
the company or even a company CDS words, they may be able to borrow at a rate lower than the
government
• •Companies
The syntheticin rating
countries with low
for Embraer ratings
is A-. Usingand
the high
2004default risk might
default spread bear we
of 1.00%, theestimate
burden aofcost
country
of debt of 9.29% (using a risk free rate of 4.29% and adding in two thirds of the country default
spread of 6.01%:
Cost of debt = Risk free rate + 2/3 (Brazil country default spread) + Company default spread
= 4.29% + 4% + 1% = 9.29%
Wights for the Cost of Capital
• The general rule for computing weights for debt and equity is that
you use market value weights
• That is not because the market is right but because that is what it
would cost you to buy the company in the market today, even if you
think that the price is wrong.
Estimating Cost of Capital: Embraer in 2004
• Equity
• Cost of Equity = 4.29% +1.07(4%) + 0.27(7.89%) = 10.70%
• Market Value of Equity = 11,042 million BR ( or $ 3,781 million)
• Debt
• Cost of Debt = 4.29% + 4% + 1% = 9.29%
• Market Value of Debt = 2,083 million BR ($713 million)
• Cost of Capital
• Cost of capital = 10.70%(.84) + 9.29(1-.34)(0.16) = 9.97%
• The book value of equity at Embraer is 3,350 million BR
• The book value of debt at Embraer is 1,953 million BR, Interest expense is 222 mil BR.
Average maturity of debt = 4 years
• Estimated market value of debt
• = 222 million (PV of annuity, 4 year, 9,29%) + $1,953 million/1.092994 = 2,083 million BR
Deal with Hybrids and Preferred Stock
• When dealing with hybrids (convertiable bonds, for instance), break
the security down into debt and equity and allocate the amounts
accordingly
• When dealing with preferred stock, it is better to keep it as a separate
component. The cost of preferred stock is the preferred dividend yield
• As a rule of thumb, if the preferred stock is less than 5% of the outstanding
market value of the firm, lumping it in with debt will make no significant
impact on your valuation.
Recapping the Cost of Capital
Terminal
value
Getting Closure in Valuation: 3 approaches

TERMINAL VALUE

LIQUIDATION VALUE GOING CONCERN VALUE

MULTIPLE APPROACH
(SALVAGE VALUE)

Simple but not correct Assume the company will keep going
This approach is suitable
for private companies. forever. Terminal value = PV of a
growing perpetuity

E.g: P/E = 10 -> P= 10 x EPS

 GOING CONCERN VALUE
• If a company has an infinity cash flows, the firm value = PV (high growth CF) + Terminal
value

∞
High growing period Constant growing period
TV = PV( CFs in the constant growing period)

• Terminal value = PV ( CFs in constant growing period) = PV (constant growing perpetuity)

%&
• T𝑒𝑟𝑚𝑖𝑛𝑎𝑙𝑣
𝑎𝑒=
𝑙𝑢 ∑!$" # ! " $# = CFn+1/(r-gs)
(()*)

%&$
• 𝑉𝑎𝑙𝑢𝑒𝑜𝑓𝑎𝑓𝑖𝑟𝑚= ∑!," ( + -./01234 5346.
(()*) $ (()*)%
Stable Growth and TerminalValue
• When a firm’s cash flow grows at a constant rate forever, the present value of those cash
flows can be written as:
Value = Expected Cash Flow Next Period/(r-g)
Where:
• r = Discount rate (Cost of Equity or Cost of Caital)
• g = Expected growth rate
• This constant growth rate is called a stable growth rate and cannot be higher than the
growth rate of the economy in which the firm operates
How highcan the stable growth rate be?

• The stable growth rate cannot exceed the growth rate

of the economy but it can be set lower
• One simple proxy for the nominal growth rate of the
economy is the risk freerate
• Risk free rate = Expected inflation + Expected Real
Interest Rate
• Nominal growth rate in economy = Expected
inflation + Expected Real Growth Rate
When will the firm reach stablegrowth?

• Size: As firms become larger, it becomes much more difficult

for them to maintain high growth rates
• Current growth rate in sales: There is a correlation between
curren growth and future growth
• Barrier to entry and differential advantages
• High growth come from high project returns comes form
barriers to entry and differential advantages
• What, how long and how strong they will remain