Sum of Parts Valuation (SOTP)The sum-of-the-parts analysis is used to value a company with

business segments in different industries that have different valuation characteristics.

It is a useful methodology to gain a quick overview of a company by providing a detailed breakdown of each business segment's contribution to earnings, cash flow, and value.

Many companies can be viewed as a candidate for break-up valuation.

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Conglomerate DiscountSometimes a SOTP valuation does not equal the value of the whole company. This is called

the conglomerate discount. The conglomerate discount occurs because investors can achieve diversification on their own. As a result, the whole is often worth less than the sum of its parts. Investors often point to

the conglomerate discount as a market inefficiency and view the discount as a way to buy undervalued stocks.

The conglomerate discount is the reason why many conglomerates spin off or divest subsidiary holdings.

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Characteristics of a Good ModelAnalysts can often choose between a range of valuation models when undertaking

valuation of a particular stock.A good valuation should:

Fit the characteristics of the company like dividend payout, earnings growth estimate, intangible assets of the company.

Fit the quality and availability of data. Fit the purpose of analysis Should be selected after evaluation multiple models

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Different Return Concepts1. Holding Period Return2. Realized and Expected Holding Period Return3. Required Returns4. Price Convergence5. Discount Rate and the Internal Rate of Return (IRR)

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Types of Return Concepts1. Holding Period Return - is the increase in price of an asset plus any cash

flow received from that asset, divided by the initial price. - measurement of a holding period can be a day, month or even a year.

- cash flow is usually received at the end of period

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2. Realized and Expected Holding Period Return - A realized return is a historical return s a historical return based on past observed prices and cash flows

- Expected returns are based on forecasts of future prices and cash flows.

3. Required Returns - assets required return is the minimum return an

investor requires given the assets risk. - can also be seen as the opportunity cost for investing in the asset.

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4. Price Convergence - If the expected return is not equal to the required

return, investors can generate a return from convergence of price to intrinsic value.

5. Discount Rate and the Internal Rate of Return (IRR) - The discount rate is the rate used to find the present

value of an investment. - The IRR is a market determined rate of return that

equates the present value of discounted cash flows to the current price of the security.

- If markets are efficient, then IRR represents the required return.

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Preliminary Steps in Estimating the Historical Equity Risk Premium

• Select an equity index• Select a time period• Calculate the mean return of an index• Select a proxy for risk free rate

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• The historical equity risk premium is the difference between the historical mean return of a broad based equity market index and the risk free rate over a given time period. • Objective and simple, it will be unbiased if the investors were rational. • Assumes that mean and variance will be constant over time (assumes stationarity). However the equity risk premium is actually counter cyclical (ie low during good times and high during bad times).

Historical Estimate of Equity Risk Premium

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• The equity risk premium is susceptible to survivorship bias. If stocks with depressed stock prices (and hence high equity risk premiums) drop out of the index, the returns from the index may be artificially high, hence artificially boosting the equity risk premium. • The equity risk premium is lower if the geometric average mean is used instead of a historical mean.• If the yield curve is upward sloping, the use of longer term bonds rather than shorter term bonds to estimate the risk free rate will cause the estimated risk premium to be smaller.

Historical Estimate of Equity Risk Premium (cont.)

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• Forward looking estimates of the equity risk premium use current information and expectations concerning economic and financial variables.• The forward looking equity risk premium does not assume stationarity and are less susceptible to survivorship bias.

Forward Looking Estimates

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1. Gordon Growth - estimates risk premium as expected dividend yield plus expected growth rate minus current long term government bond yield

2. Supply side estimate - (macroeconomic model): estimates equity risk premium based on relations between macroeconomic variables and financial variables3. Survey estimates - use the consensus of opinions from a

sample of people

Three Types of Forward Looking Estimates

Capital Asset Pricing Model CAPM

Multifactor Models

(Has greater explanatory power than CAPM.) Fama Fench Model

(The Fama and French Model is a multifactor model that attempts to account for higher returns generally associated with small cap stocks.)

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Methods Used to Estimate the Required of Return

Pastor Stambaugh Model The Pastor Stambaugh Model adds a liquidity factor to the Fama French Model. The baseline factor for the liquidity factor beta is zero. Less liquid assets should have

a positive beta while more liquid assets should have a negative beta. Therefore, investors in less liquid assets require compensation via higher returns.

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Methods Used to Estimate the Required of Return (Continuation)

Macroeconomic Multifactor Models Macroeconomic multifactor models use factors associated with economic variables that can reasonably

be believed to affect cash flows and appropriate discount rates. The model by Burmeister Roll and Ross incorporates the following factors: confidence risk, time horizon

risk, inflation risk, business cycle risk and market timing risk.

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Methods Used to Estimate the Required of Return (Continuation)

Built Up Method

(Similar to risk premium approach)

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Methods Used to Estimate the Required of Return (Continuation)

Preliminary Steps in Estimating Beta for Public CompaniesSelect an equity index (popular choice being S&P 500 and NYSE composite)Select the length and frequency of sample data (popular choice being 2 weeks of data)Adjusted Beta for Public CompaniesBeta is often adjusted for beta drift which refers to the observed tendency of beta to revert to a value of 1.0 over time. Adjusted beta = (2/3 * regression beta) +(1/3*1.0) 

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Beta Estimates for Thinly Traded Stocks and Nonpublic Companies Identify a publicly traded benchmark company Estimate the beta of the benchmark company Unlever the beta using the relationship unlever beta = beta / (1+debt/equity) Lever the beta using the same relationship as above but different weights of debt and equity

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Typically Trade Offs Between the Different Models Used to Estimate Required Returns Capital Asset Pricing Model (CAPM) simple as it uses only one factor however it may not be simple selecting that one factor (for e.g. the stock may trade in more than one market thus making the

choice of one index particularly difficult). it also tends to have low explanatory power.

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Typically Trade Offs Between the Different Models Used to Estimate Required Returns Multifactor Modelshave higher explanatory power they are more complex and expensive

• Built Up Models simple and can be applied to closely held companies use historical estimates and may not be relevant to current markets.

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Exchange Rate RisksInternational investments expose investors to exchange rate risks if not hedged. To compensate for anticipated changes in exchange rates, an analyst should

compute the required return in home currency and then adjust it using forecasts for changes in the relevant exchange rates.

Two Methods for Building Risk Premia Into Required Returns   Country spread model: use a developed market as a benchmark and add premium

for emerging markets. Country risk rating model: estimate a regression equation using the equity

risk premium for developed countries as dependent variable and risk ratings for those countries as independent variables.

 

they are more complex and expensiveStudy Session 10, Reading 31

Weighted Average Cost of Capital (WACC)WACC is defined as:

Tax rate is the marginal tax rate, which better reflects the cost of raising funds.

WACC is appropriate for valuing a total firm.Which Discount Rate When?The discount rate needs to correspond to the type of cash flow being

discounted. Cash flows to the entire firm should be discounted by the WACC. Cash flows in excess of debt service costs should be treated as cash

flows to equity and discounted at the required return to equity.Nominal cash flows should be discounted at nominal discount rate and

real cash flows should be discounted at real discount rates.

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Porter’s Five ForcesThreat of new entrants in the industry: likelihood of new entrants

emerging to alter the competitive landscape in a way that reduces the share of value added realized by a firm

Threat of substitutes: do currently available alternative products put a ceiling on the price buyers are willing to pay for industry’s current products.

Bargaining power of buyers: how strong is the negotiating power of the buyers of the firm or industry’s output

Bargaining power of suppliers: how strong is the negotiating power of the suppliers of the industry

Rivalry among existing competitors: will existing firms compete away the value added component

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Factors Affecting the Threat of New EntrantsEconomies of scale make it difficult for new entrants to achieve critical

mass. Product differences and brand identity may deter customers from

switching to new brands without costly inducements. Switching costs that the product user will incur if they decide to use

new entrants.Capital requirements to construct facilities and other infrastructure

requirements.Access to distribution channels may be difficult for new entrants. Government policy may require licensing or other approvals to enter

the industry. Cost and quality advantages for incumbent firms that may not be

realized by new entrants.

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Factors Affecting the Threat of Substitutes Relative price performance of substitutes. Buyer’s propensity to substitute. Switching costs incurred by the buyers. Factors Affecting Bargaining Power of BuyersLow switching costs and readily available substitutes give the buyers

leverage. Buyers price sensitivity depending upon qualitative factors such as

brand identity, product differences, quality and performance.

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Factors Affecting Bargaining Power of SuppliersDifferentiation of inputs that are acceptable to the industry. Presence of substitute inputs. Smaller number of suppliers increases supplier power. The more the volume sought by the employer, the harder they will

work to maintain this volume and lower their bargaining power. Threat of forward integration. The greater the switching costs, the greater the supplier power.

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Factors Affecting the Degree of Rivalry Among existing competitorsThe more competitors, the greater the potential for rivalry. Industry growth means less competition between existing players. High degree of operating and financial leverage. Greater the participants commitment to business, the greater the

likelihood of competitive behaviour. Product differences make it more difficult to compete directly on price. The shorter the shelf life, the greater the potential for price

competition. Existence of exit barriers will increase the potential for competition.

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Factors That Shape Industry Structure Short Term FactorsHigh industry growth diminishes rivalry but does not assure

profitability if other forces are detrimental to profits. Improved technology can improve profitability but not if there is

increased competition. Some low tech sectors can be profitable if other forces are favourable.

Government policies can be good or bad and are prone to changes through time.

Complementary products can be used in conjunction with firms products.

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Typical Reasons for Changes in Industry StructureChanges in the threat of new entrants can typically be due to the

expansion of capacity by distributors. Changes in the bargaining powers of buyers or suppliers can be due

to consolidation in the number of buyers or suppliers in the industry. Changes in technology may cause substitutes to become more or less

viable. Changes in the number of competitors or changes in the leverage of

an industry may make the rivalry in an industry more or less intense.

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Three Types of StrategyAltering the firm’s existing position: intentionally create changes

in the five forces. Capitalizing the changes in the industry: whether the firm is able

to capitalize on a change depends on its current positioning. Creating changes in the industry structure: either by enhancing

overall value or by redistributing the value added in favour of industry participants.

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Three Prominent Categories of Future Cash Flows Dividends These direct cash payments are a key component of an investor’s returns. Dividends are typically more stable than earnings; small individual

shareholders cannot influence dividends, so dividend based valuation may be most appropriate from their perspective.

Lot of companies do not pay dividends, but opt to reinvest 100% of earnings; different countries have different dividend cultures and dividend tax policies, so dividend valuation presents some inconsistencies in an international context.

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Three Prominent Categories of Future Cash Flows Free Cash Flows Free cash flows are appropriate when the company pays no dividend, pays

an unsustainable dividend, cash flows track company profits, and/or the investor is large and has the ability to perform a controlling interest.

There are two types of free cash flows for valuation: free cash flow to the firm and free cash flow to equity.

Residual Income Residual income attempts to capture the extra value that an investor can

receive beyond the opportunity cost.

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Value of a Common Stock Using the Dividend Discount Model (DDM)One Period DDM To determine the value of a stock using the DDM, we must estimate the

dividend to be received during the period (D1), the expected sale price at the end of the holding period (P1), and the investor's required rate of return (r).

Multi Period DDM If you anticipate holding the stock for several years and then selling it,

the valuation estimate is more difficult. You must forecast several future dividend payments and estimate the

sale price of the stock several years in the future.

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Value of a Common Stock Using the Dividend Discount Model (DDM)

• Terminal Value in DDM The terminal value can be estimated by liquidation of the firm’s

assets in the terminal year and estimate what others would pay for the assets that the firm has accumulated at that point.

Multiples to earnings, revenues or book value can also be used to estimate the value in the terminal year.

Another method is to assume a stable growth rate and then the terminal value can be estimated using a perpetual growth model.

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Calculating the Value of Common Shares Using H Model

The H-Model is a modification of the Two Stage DDM.Unlike other two-stage models where the growth rate is

assumed to be a constant, the H-Model assumes that the growth starts at a higher rate, and then gradually declines until it becomes normal stable growth rate.

“H” represents half-life of the high growth period.

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Estimating Required Returns Based on the DDMAssuming that markets are efficient, DDM models can be used

for the calculation of the expected rate of return on a stock.Other models such as the general two-stage DDM, three-

stage DDM and more complicated spreadsheet models can be solved for the effective rate of return only by iteration. > Change the discount rate until the present value of

dividends and the terminal value is equal to the market price.

> If we believe that the market price differs from the intrinsic value of a stock, we need to adjust the expected required rate of return accordingly.

> This is the same approach that is used for the calculation of IRR in corporate finance.

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Evaluating a Stock Based on a DDM Estimate of the ValueIf the market price of a company's stock does not equal its

intrinsic value, the expected holding-period return will differ from the required rate of return.

This difference is called alpha or expected abnormal return. Investors look for positive alphas (expected holding period

return minus required rate of return), since these investments earn more than other assets with similar risk.

Spreadsheet Modeling in Forecasting Dividends and Valuing Common Shares

Estimating future dividends can be done through spreadsheet modelling.

Two period or multiple period DDMs can be more easily facilitated through the use of spreadsheets.

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Assumptions of GGMThe future dividend stream will grow at a constant rate (g) for an

infinite period.Required rate of return on equity is greater than growth rate of

future dividendsValuation using GGM To determine the value of the stock using the GGM, use the

following formula: The formula does not work for companies with dividend growth

in excess of the required rate of return. For such "growth companies", analysts employ two-stage or

three-stage models. Usually companies eligible for evaluation using the GGM grow at a rate close to the expected long-term growth of gross domestic product (which consists of real growth and expected inflation).

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Present Value of Growth Opportunities (PVGO)• The PVGO allows analysts to calculate how much growth

opportunities contribute to a company’s current share price:

As a company generates positive earnings and retains these earnings, its book value of equity increases. However, in order for the positive retained earnings to create wealth for investors, the company’s return on equity must exceed its cost of equity.

Percentage of a leading P/E related to PVGO = (PVGO/E1)/Leading P/E = (PVGO/E1)/(P0/E1)

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Justified Leading and Trailing P/EThere are two types of price-to-earnings ratios: A stock's trailing P/E (current P/E) is its current market price divided

by the most recent four quarters' EPS. The P/E published in financial newspapers' stock listings is the trailing

P/E. The leading P/E (forward P/E or prospective P/E) is a stock's current price divided by next year's expected earnings.

The Gordon Growth Model allows analysts to estimate the fundamentals-based value of the P/E ratio.

The trailing ratio is calculated as:

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Value of Non-callable Fixed-Rate Perpetual Preferred StockFixed-rate perpetual preferred stock is a senior claim on a

company's assets compared to its current stock.It entitles stockholders for a level stream of dividends into

perpetuity. Payments of fixed-rate perpetual preferred dividends are made only after the firm pays its bond interest.

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Strengths of the Gordon Growth ModelThe GGM very clearly and simplistically defines the relationships

among value and growth, required rate of return and the payout ratio.It allows us to more easily perform valuation of stable-growth,

dividend-paying companies.It can be used for valuation of broad-based equity market indexes.It is useful for estimation of a terminal value in multiple-stage models.

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Limitations of the Gordon Growth ModelGGM is highly sensitive to growth rate and required rate of

return inputs. Very small variations in estimation of these inputs can lead to significantly different estimates of intrinsic value.

It cannot be used to value non-dividend paying stocks.It cannot be used to value companies with unstable growth

rates.

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Maturity Phases of a BusinessGrowth Phase During the growth phrase, companies enjoy supernormal growth which

cannot be sustained in the long run. Free cash flows are often negative because companies invest heavily in

expanding operations. Very low or zero dividend payments may occur when a majority of earnings

are retained to finance growth.

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Maturity Phases of a BusinessTransitional Phase Sales growth, prices and profit margins are declining as a result of

intensifying competition in the industry. Earnings growth rates may be still above average but declining towards the growth rate for the overall economy.

Capital requirements typically decline often resulting in positive free cash flows and increasing dividend payout ratios.

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Maturity Phases of a BusinessMature Phase Profit margins have fallen to the average profitability of the economy. Companies invest in projects that earn the cost of capital. Growth is commensurate with the general economic growth. It is called

the mature growth rate. Dividend payout is significant.

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Estimating the Sustainable Growth Rate using DuPoint Analysis

• Sustainable Growth rate A growth rate is sustainable in the long run. A company can grow at this

rate indefinitely in the future without changing the capital structure. The sustainable growth rate can be estimated using the following

formula:

• Du Pont Model A system of analysis has been developed that focuses the attention on all

three critical elements of the financial condition of a company: the operating management, management of assets and the capital structure. This analysis technique is called the "DuPont Formula".

The ROE can be estimated using the Du Pont formula which is:

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Two Measures of Cash Flows

• Free Cash Flow to Firm Measures the cash produced for the debt and equity holders of

the firm. It starts with CFO. Interest payments for the year are added back as they are

available to the firm’s stakeholders. Net capital expenditures are taken away as cash spent on them

is not available to the firm’s stakeholders.

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Two Measures of Cash Flows

• Free Cash Flow to Equity Measures the cash which remains for stockholders. It also starts with CFO, but doesn’t add in the interest payments as they are paid

only to debtholders, and are thus not available to stockholders. If the firm has to use cash to pay back debtholders it is money the stockholders

don’t have. Equally if the firm issues new debt, then the stockholders have in theory more cash.

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FCFE Approach vs Dividend Discount ApproachFCFE assumes a control perspective. That is, all the cash flows are available to the stock owners. The Dividend Discount Model assumes that the valuation is done from a minority

shareholders perspective. It assumes that only the dividends are available to the stock owners.

The Dividend Discount Model assumes that a relatively large component of the present value would be realized later in the future (which means that terminal value will be a large component of the total present value).

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Approaches for Forecasting FCFF and FCFEThe simplest method is to assume a constant growth rate that is based on historical

trends.To get a more precise forecast, analysts need to forecast the components of free cash flow

by evaluating and capturing the complex relationships among the components of free cash flow.

Often, analysts start with the sales forecast. After that they analyze historical operating profit margin and two ratios:

o Net investment in new fixed assets / sales increase, ando Investment in working capital / sales increase.

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Effect of Dividends, Share Repurchases and Issues, and Leverage on FCFF and FCFE Dividends, share repurchases and share issues have no effect on FCFF and FCFE. This is because these transactions are uses of free cash flows, but FCFF and FCFE are the cash flows available to

investors or shareholders. When calculating FCFF and FCFE we only consider how these cash flows are generated, and not how they are

used. Transactions between the company and its shareholders (through dividends, share repurchases, and share issuances) do not affect free cash flow.

Changes in leverage have both a short-term and long-term effect on FCFE. In the year of change, net borrowing increases FCFE. In the long-run, assuming more debt means higher interest payments, partly compensated by an increase in the

interest tax shield. Therefore, the long-run effect of higher leverage is the decrease in FCFE.

o

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Net Income (NI) as a Proxy for Cash FlowNet Income (NI) includes non-cash charges like depreciation.These charges should be added back to arrive at FCFE.NI ignores investments in working capital and fixed assets.They should be subtracted to arrive at FCFE. NI ignores net borrowing which is a part of cash flow available to

shareholders, but not a part of NI.

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Using EBITDA as a Proxy for Cash FlowEBITDA is a before-tax measure and doesn't reflect taxes paid. The discount rate applied to EBITDA would need to be a

before-tax rate. The WACC used to discount FCFF is an after-tax rate. EBITDA is a measure of operating activities only. It ignores investments a company makes in working capital and fixed

assets. Depreciation tax shield (the depreciation charge times the tax rate) is ignored by the EBITDA measure.

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Single-Stage, Two-Stage and Three-Stage FCFF and FCFE ModelsSingle stage FCF models are similar to single stage Gordon Growth Models.In multi stage models (two or three stage) we have the option of forecasting either the growth rate of either FCFF

(or FCFE) or specific components of FCFF (or FCFE).Company Valuation using Free Cash flow ModelsIf a stocks model price is lower than the market price, the stock is considered undervalued in the market.

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