VALUATION

Five Categories of Valuation Methods

1. Discounted cash-flow2. Market-based3. Mixed models4. Asset-based methods5. Option-based methods

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

Discounted Dividend Valuation

Most straightforward approach Explicit cash flows received by

equity investors Dividends Terminal value when shares are sold

Firm is expected to have an infinite life

Discounted Dividend ValuationTheoretical Model

No-growth, constant dividend

Dividends are growing at rate g

r

D0P

gr

g)(D

gr

DP

10

0

1

Discounted Dividend ValuationRequired rate of return (r)

r is the rate of return demanded on a specific investment

Based on investor’s assessment of risk

CAPM )( fmf rrrr

Discounted Operating Cash-Flow Models

Most applicable in the event of a takeover

Free cash flow (FCF) is operating cash flows less necessary investments in working capital and property, plant and equipment

gr

FCFV

1

0

FCFF or FCFENet IncomePlus: Depreciation and amortizationLess: Increase in Working CapitalOperating Cash FlowPlus: Interest Expense*(1-tax rate)Less: Increase in Fixed CapitalFree Cash Flows to the Firm (FCFF)Less: Interest Expense*(1-tax rate)Plus: New debt borrowingLess: Debt RepaymentFree Cash Flows to the Equity (FCFE)

Discount Rate FCFF

Weighted Average Cost of Capital FCFE

Cost of Equity (required rate of return)

Market-based Models

Compare subject company to other similar companies for which market prices are available

Simple computations but require a great deal of professional judgment

P/E Model P/B Method P/S Model

P/E Model

Assumes a company is worth a certain multiple of its current earnings

Assumes each share is worth the same multiple of EPS

Requires judgment regarding Peer firms and their prices Historical (average) data

P/E Model - Example

Consensus analyst forecast EPS = $0.46

P/E of 23 is appropriate Value = 23*$0.46 = $10.58 If the current price is $10.22, there is

limited upside to this investment

Asset-Based Models Used when a company is going to

be liquidated Valuation is based on underlying

assets Market value of balance sheet items Assets and liabilities

Also called cost or adjusted book value approach

Options-Based Models Theoretically elegant but practical

application is difficult Analyst must have information about

opportunities (and their value) available to a firm

Equity ownership is viewed as an option call on the firm Limited downside, unlimited upside

Selecting a Model Consider characteristics of the firm

Dividend paying Growing Likely to be liquidated

Consider data availability of data Publicly available or closely held

Dividend Discount Model o The company is dividend paying o The company’s dividend policy has a consistent relationship with earnings. o The investor takes a non-control perspective

Discounted cash Flow Model

The company does not pay a dividend or dividends do not exhibit a consistent relationship with earnings Free cash flow align with profitability and can be forecast The investor takes a control perspective

Market Based Models Publicly traded peer companies exist A proxy of value such as earnings is positive and has a consistent relationship with the value of the firm The analyst is confident about the valuation in the market and the peers

Asset Based Models The company is not viewed as a going concern The liquidation value of assets and liabilities can be determined

Option Based Models The analyst has information about opportunities or projects that are available to the firm Sufficient data is available to value those opportunities in an option framework