Valuation - Basics

Equity Valuation I:

Basics

Objectives

A. Understand the relationship between intrinsic value and market valueB. Understand the various types of valuation models, including balance sheet, dividend discount , free cash flow, relative value and PE modelsC. Understand other key metrics used in valuing securities

A. The Relationship between Intrinsic Value and Market Value

What is intrinsic value?The present value of a firm’s cash flows discounted

by the firm’s required rate of return What is the firm’s market value (or price)?

The total value of a firm’s outstanding shares times its market price

In an efficient market, what should this relationship be? In a truly efficient market, the intrinsic value should

equal its market value What happens if it doesn’t?

Intrinsic Value (continued)

How do you identify mis-priced securities?• Determine the intrinsic or fair value of the security.

This can be done by many methods:

• Models, i.e. CAPM, APT (E(rs) = rf + s [E(rM) - rf ])

• Fundamental analysis

• Balance sheet methods

• Dividend Discount Models (DDMs)

• Then you compare the fair value to the current price


Do all analysts look at companies the same way?

• No. If you have 30 analysts, you will generally have more than 60 sets of intrinsic values.

How much is intrinsic value used in the real world?

• It is used a lot in terms of equity valuation and financial analysis. These have a more solid foundation and are not as affected by key assumptions

• It is not used as much with DDM’s and PV models, as slight changes in assumptions can have large changes in a company’s intrinsic value. Also these models assume a longer time frame generally.


If DD and PV models are not used as much in the real world, why do we include them in our analysis?• The concepts are critical to understanding

investments and finance

• They can add value with specific industries and companies

• They can be used to support your recommendations from other models if assumptions are stated clearly


How do you determine Intrinsic Value?• It is a value assigned by the analyst

• It is based on specific theories and assumptions

• Analysts use specific models for estimation

• Lots of models exist

• Remember, these models are proxies for reality – they are not reality


What happens if the calculated intrinsic value is greater than the market price?• Intrinsic Value > Market Price

• Buy• Intrinsic Value < Market Price

• Sell or Short Sell• Intrinsic Value = Market Price

• Hold or Fairly Priced or valued• In this class, we use a 10% estimation factor. If the

IV > (<) MP by greater (less) than 10%, then buy (sell)

• These models are not as accurate as most students would like. Valuation is much more an art than a science!

Questions

Do you understand the relationship between intrinsic value and market value or price?

B. Understand Various Types of Equity Valuation Models

Fundamental Stock Analysis: Models of Equity Valuation

• Basic Types of Models

• 1. Balance Sheet Models

• 2. Dividend Discount Models

• 3. Discount Models, i.e. Free Cash Flow

• 4. Working Capital Models

• 5. Relative Valuation Models

• 6. Price/Earning Ratios

1. Balance Sheet Models

• Balance sheet models assume that the intrinsic value of the firm is the value of its assets.• What is the value of the firms assets?

• Is it the value on the books?

• Is it the value we could really get for the assets (liquidation value)?

• Is it the value we could get to replace the assets?

• What are the main types of models?

• Book Value, Liquidation Value, Replacement Cost, and Tobin’s Q

Balance Sheet Models (continued)

Book Value (per share)• The Book Value is Equity / shares outstanding

• Example: FordAssets 243,283 millionLiabilities 219,736 “Owners Equity 23,547 “Shares Outstanding 1,169 “

• What is the Book Value per share?$23,547/1,169 = Book value of $20.14 per share

• Logic: the value of the assets should be equal to their value on the books.

• Caution: Be careful as book value does not tell you depreciation methods or the true value of the assets (they may actually be worthless)


Liquidation Value (per share)• Liquidation value is the value realized by breaking up

the firm, selling off assets and repaying debt• Company A has a market value of $250 mn with $50

mn in debt, cash of $150 mn and other assets likely worth $200 mn if sold today.

• What is the liquidation value?• Liquidation value is the cash on hand and what they

could liquidate the other assets for• Logic: if price falls below liquidation value, the firm

becomes a takeover target as investors buy the company and sell it in pieces

• Caution: Can they realize the value of the assets?


Replacement Cost (per share)• Replace cost is the money necessary to replace the

tangible and intangible assets of a company• Company B is a trucking company valued at $25

mn. Since Company C takes 60% of the company’s business and is planning to expand, you know that its CEO could replicate the trucking company for $20 million and build her own trucking division.

• What is the replacement cost? $20 million• Logic: If the value gets too high above the

replacement cost, competitors would replicate the firm and competition would drive down value of all firms.

• Concerns: Are all parts of the firm replicable?


Tobin’s Q• Tobin’s Q is the ratio of a firm’s price to its

estimated replacement cost

• In the long run, the market price to replacement cost will tend toward 1 as investors correctly value the replacement cost of the assets

• Logic: Investors will be willing to purchase the company as long as the company’s market price is below the replacement cost. As soon as its price is greater than the replacement cost, competition will come in, dropping the price to close to its replacement cost.

• Concerns: Differences may remain over time

Challenges of Balance Sheet Models

- What are the major challenges of Balance Sheet Models?- It may be difficult to determine the real value of the

assets, i.e. depreciated cost versus real value

- It is uncertain how long it will take for replacement cost to move toward unity. The time factor is a real concern

- It may be difficult to determine the value of intangible assets, which may be significant in some companies

2. Dividend Discount Models

These are models which take into account discounting expected future cash flows to gain a reference for the value of a company• These are the oldest and simplest present value

approach to valuing a stock

• Primary Dividend Discount ModelsGeneral ModelConstant Growth Model

Dividend Discount Models (continued)

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General Dividend Discount ModelVo= Sum [(Dt+ Pt) /(1+k)t ]

V0 = Value of Stock

Dt = Dividend at time t

Pt = Expected Price at time t

k = Required return on the stock

The value of a company is the discounted value of dividends and the eventual sale of the company stock

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Constant (or Gordon) Growth Rate Model

Vo = Do * (1+g) (k - g)

• This is for stocks that are growing at a constant growth rate (this rate is assumed in perpetuity)

g = constant perpetual growth rate b = plowback or retention ratio (rr)

• Note: take out the g and the formula becomes the no growth model

E1 = $5.00 b = 40% k = 15%

(1-b) = 60% D1 = $3.00 g = 8%

V0 = 3.00 / (.15 - .08) = $42.86


Estimating Dividend Growth Rates

g = ROE x b• g = growth rate in dividends

• ROE = Return on Equity for the firm

• b = plowback or retention percentage rate

• (1- dividend payout percentage rate)

• Internal Growth Rate (ROE x (1-payout))

• This is the rate that the company can continue to grow without any additional external financing

• Note: if the firm distributes all its earnings as dividends, there is nothing to allow the firm to continue to grow


More Changes to the DDM• What about growth opportunities?

• Do those impact the value of the company?

• Does the DDM only look at dividends?

• What about earnings on specific projects?

• Can we fix the DDM to look at the value of new projects?

• There are a number of different DDM models that can handle each of these situations

Challenges of Dividend Discount Models

- Major challenges to DDMs include:- A slight change in the discount rate can have a huge

change in the result

- It is difficult to determine the terminal value of the stock

- A small change in the termination value (i.e., the PE multiple) can have a large change in the result

- Not all firms have dividends

3. Discounting Models

Discounting models assume the intrinsic value of the company is the present value of the firms’ expected future cash flows. It is useful when:• The company does not pay dividends

• Dividends paid differs from what the firm could pay

• Free cash flows align with profitability within a specific forecast period

• The investor takes a control perspective

Discounting Models (continued)

Free Cash Flow to the Firm (FCFF)• FCFF is the cash flow available to the suppliers of

capital after all operating expenses (including taxes) are paid and working and fixed capital investments are made (i.e. less capital expenditures)

• FCFF = cash prior to the payment of interest to the debt holders

FCFF = EBIT - taxes + depreciation (non-cash costs) – capital spending – increase in net working capital – change in other assets + terminal value

• Discount this at the firm’s WACC- Firm Value = Operating free cash flow

WACC – growth OFCF


Free Cash Flows to Equity (FCFE)• FCFE is the cash flow available after all operating

expenses, interest, and principle repayments have been made and necessary investments in working capital and fixed capital have been made

• FCFE = Adjusts operating cash flows for debt repayments

• FCFE = EBIT – interest - taxes + depreciation (non-cash costs) – capital expenditures – increase in net working capital – principal debt repayments + new debt issues + terminal value. Discount at k = required return on equity

• Firm Value = Free CF to Equity/(k – growth FCFE)


Calculation Methodology for Discounting:• Determine the appropriate discount rate

• Set up each of the individual cash flows

• Discount each of the individual cash flows

• Discount the final cash flow assuming a constant growth rate = cash flow / (k – g)

• The question remains whether the final cash flow representative of all future cash flows

• Sum all the discounted cash flows

• Make adjustments as required

Challenges of Discounting Models

- Major challenges of Discounting Models include:- A slight change in the discount rate can have a huge

change in the result

- A small change in the terminal growth rate can have a large change in the result

- You must be very careful of your choice of discount rates and capitalization rates

4. Working Capital Models

These models, based on historical experience, state that most companies are worth some multiple of EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization). • Calculate their EBITDA for the past year, multiply

EBITDA by multiples of 6 and 9, and divide by diluted shares outstanding

• Calculate working capital, subtract out long-term debt, and divide by diluted shares outstanding

• Add EBITDA per share and working capital per share to get a value for the firm

Working Capital Models

Benefits• Easy to calculate

• Works for many different types of companies

Challenges• Not all companies are worth a 7.5x EBITDA

multiple

5. Relative Value Models

Relative value models assume that companies have a fair-value trading range versus the market and versus their respective indices• Companies that trade within their fair-value ranges

are correctly valued by the market

• When companies are outside their fair value ranges, this gives information that the company should be looked at, either to buy or sell

• The fair trading PE range times EPS times the market PE gives the price per share.

Relative Value Models

Benefits• Easy to calculate• Identifies when stock appreciation is due to general

market movement versus the benchmark• Works for many different types of companies• Can be compared to the market and industry

benchmarks Challenges

• Not all companies trade versus the market index in the same way

• May not be useful if the market is at extreme valuation levels

6. Price Earnings Ratios

P/E Ratios are a function of two factors• Required Rates of Return (k)

• Expected growth in Dividends

Uses• Valuation of new companies

• Relative valuation versus market and industry

• Note: this is used extensively in the industry. Research has found that low PE stocks have given a higher return to Investors than high PE stocks over the last 70 years

Price Earnings Ratios (continued)

Price Earnings Key Terms• Price Earnings = Price per share/Average Common

diluted Earnings Per Share

• Forward or Prospective PE = Current Price / Forward EPS

• Historic PE = Year-end Price/Year-end EPS

• Normalized PE = Current Price/normalized earnings (earnings adjusted to take into account the cycles in the economy)

• Earnings Yield (E/P) = 1 / Price Earnings

Challenges of Price Earnings Models

• Benefits

• Used extensively in the industry

• Generally low PE firms outperform high PE firms• Pitfalls

• Earnings are accounting earnings, which can be manipulated through depreciation, inventory, etc.

• Earnings can fluctuate widely around a trend

• You cannot know if the PE is high or low unless you compare it to a trend, to long-run growth prospects, to an industry, or to the market

1. Price/Earnings (PE=P/EPS)

PE Ratio• The most common measures of a firm’s stock price

relative to its earnings--what you are paying for $1 of earnings.

How is it analyzed?• Versus its historical average

• If lower that than its history, it may indicate it is moving into more attractive territory, i.e., growth is increasing

• Versus the market. • Gives a historical view. If it is trading at a lower

relative PE, it may be becoming more attractive. • Versus the industry

• If the relative PE versus the Industry is declining, it may indicate the stock is becoming more attractive.

2. Price/Book (PB=P/BVS)

P/BV or PB or Market to Book Gives the relationship between the stock price and

the book value of the firm (i.e. owners equity). How it is analyzed?

If the PB ratio is high when compared to peer firms, the stock may be overvalued, all else being equal.

If the PB is negative, the firm is in serious trouble.Remember that owners’ equity is based on

accounting depreciation and may not have relevance to the actual value of the assets of the company.

Generally, the higher the P/BV (or the lower its inverse, Book to Price) the more expensive the company.

3. Price/Sales (PS=P/SPS)

Price to Sales Sales multiples are indicator of growth in sales and

hence a future indicator of growth in profits. How it is analyzed?

Can be positive or negativeNote that growth in sales translates into growth

in profits only if the other drivers of profits are sustained, i.e. profit margins, turnover, etc.

New companies New companies like PS ratios when they don’t

have any earnings. But if earnings fail to materialize, then PS ratios are irrelevant.

Generally, the lower the PS ratio, the more attractive the company, all else being equal

4. Dividend Yield (DY=DPS/P)

Dividend Yield Certain companies are known for their high

dividend payouts Historically we have seen an overall decline in the

market’s dividend yield as firms decided that they could use dividend payouts more effectively in their own firms

How is it analyzed? DY assesses the amount of dividend an investor

will receive for his dollar if invested at the current share price.

A high dividend yield can be perceived as both positive and negative. Positively, as you have a return of capital; negatively, as the company has no better use for the funds

5. Price/Operating Cash Flow (POCF=P/OCFS)

Price to Operating Cash Flow P/OCF is an important measure of a firm’s health

It gives an assessment of the firm’s power to generate operating cash flow on a price per share basis

How is it analyzed? Firms that are generating a high amount of cash are

perceived to be more attractive than firms which are not generating cashGenerally, the lower the P/OCF the more

attractive the firm

6. Price/EBIT (PEBIT=P/EBITS)

Price to Earnings before Interest and Taxes In evaluating firms which are potential takeover

targets or which are not making earnings, analysts often use Price/EBIT, which they would use instead of Price Earnings (as there are no earnings).

This gives the relevant ratio assuming the firm had no other expenses, i.e. debts, taxes, etc. This was used in valuing the high-flying tech firms

How is it analyzed? Generally the lower the ratio, the more attractive the

company Be careful as this ratio says nothing about overall

profits, but only operating earnings.

7. Price/EBITDA (PEBITDA=P/EBITDAS)

Price to Earnings Before Interest and Taxes and Depreciation and Amortization Used to put a price on firms which have no

earnings but are generating cash and which may be attractive as acquisition candidates

P/EBITDA is similar to the Price/EBIT, except that it includes depreciation and amortization, which are non-cash charges

How is it analyzed? Takeover firms are concerned with the amount of

cash firms are generating assuming no other charges and taxes. Generally the lower the ratio, the more attractive the company

8. PE to IGR (PE/Internal Growth Rate or g)

PE to Internal Growth Rate (which is a proxy for a firm’s sustainable growth rate) Used to relate a company’s PE to its sustainable

growth rate How is it analyzed?

A low PE stock with a high internal growth rate will have a low ratio, while a high PE stock with a low IGR will have a high ratio.

Generally the lower the ratio, the more attractive the company.

9. PE to Earnings Growth (PE/EPS Growth)

Price Earnings to Earnings Growth Another takeoff on the PE to growth ratio

Sometimes used this as a screening device, only looking at companies whose PE divided by Earnings growth rates are 1 or less

How is it analyzed? Generally, companies are more attractive when this

ratio is lower, as they have not only higher earnings, but those earnings are expected to growth in the near future.

Can be very volatile due to the volatility of earnings per share growthDue to volatility, some investors prefer the PE to

IGR above

DDM: GORDON GROWTH MODEL

What to do if DDM method doesn’t do well?• If value from this model is lower than expected,

– it may be because the firm’s dividend payout ratio may be low for a stable firms • Try using the FCFE Model

– the beta is high for a stable firm• Use a beta closer to one

• If value is too high, it is because– the expected growth rate is too high for a stable firm

• Use a growth rate closer to economy growth

What to do if DDM method doesn’t do well?• If value from this model is lower than expected,

– it may be because the firm’s dividend payout ratio may be low for a stable firms • Try using the FCFE Model

– the beta is high for a stable firm• Use a beta closer to one

• If value is too high, it is because– the expected growth rate is too high for a stable firm

• Use a growth rate closer to economy growth

Discounted cash flow:FCFE

• In FCFE modelValue of Stock = FCFE1

(Ke - g)– Where FCFE1 is free cash flow to equity after one year

• In FCFE modelValue of Stock = FCFE1

(Ke - g)– Where FCFE1 is free cash flow to equity after one year

Discounted cash flow:FCFE

• Cash flows to Equity for a Levered Firm

Revenues - Operating Expenses = Earnings before interest, taxes and depreciation (EBITDA) - Depreciation & Amortization = Earnings before interest and taxes (EBIT) - Interest Expenses = Earnings before taxes – Taxes = Net Income + Depreciation & Amortization = Cash flows from Operations - Preferred Dividends- Capital Expenditures - Working Capital Needs - Principal Repayments of debt + Proceeds from New Debt Issues

= Free Cash flow to Equity

• Cash flows to Equity for a Levered Firm

Revenues - Operating Expenses = Earnings before interest, taxes and depreciation (EBITDA) - Depreciation & Amortization = Earnings before interest and taxes (EBIT) - Interest Expenses = Earnings before taxes – Taxes = Net Income + Depreciation & Amortization = Cash flows from Operations - Preferred Dividends- Capital Expenditures - Working Capital Needs - Principal Repayments of debt + Proceeds from New Debt Issues

= Free Cash flow to Equity

Growth rate

Growth i.e. g= b*ROE• Where b= retention ratio• ROE=return on equity

or g=b* [ROA+D/E{ROA-i(1-t)}]

Where ROA is return on assets.

D/E is debt equity ratio.Real growth rate=(1+Nominal growth rate)(1+inflation rate)-1

Growth i.e. g= b*ROE• Where b= retention ratio• ROE=return on equity

or g=b* [ROA+D/E{ROA-i(1-t)}]

Where ROA is return on assets.

D/E is debt equity ratio.Real growth rate=(1+Nominal growth rate)(1+inflation rate)-1

What growth model should be used?

• stable growth model, if – the firm is growing at a rate which is below or close to the

growth rate of the economy

• two-stage growth model, if – the firm is growing at a moderate rate fore some period

and then cool down to stable rate.

• three-stage growth model, if – the firm is growing at a very high rate

• stable growth model, if – the firm is growing at a rate which is below or close to the

growth rate of the economy

• two-stage growth model, if – the firm is growing at a moderate rate fore some period

and then cool down to stable rate.

• three-stage growth model, if – the firm is growing at a very high rate

Discounted Cash flow: Firm

• The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses, reinvestment needs and taxes, but prior to any payments to either debt or equity holders.

t=nValue of Firm =∑ CF to Firm t t=1 (1+WACC)t

• The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses, reinvestment needs and taxes, but prior to any payments to either debt or equity holders.

t=nValue of Firm =∑ CF to Firm t t=1 (1+WACC)t

Free cash flow to firm

• CASH FLOWS TO THE FIRM

EBIT ( 1 - tax rate) + Depreciation - Capital Spending - Change in Working Capital = Cash flow to the firm

• CASH FLOWS TO THE FIRM

EBIT ( 1 - tax rate) + Depreciation - Capital Spending - Change in Working Capital = Cash flow to the firm

Relative Valuation approach

• In Relative Valuation approach, firm’s performance is compared by the market or with comparable standards from the market.

• So for valuation under this method, – first identify comparable assets and obtain market

values for these assets. – convert these market values into standardized

values.(standardization can be done using common variables such as earnings, cash flows, book value or revenues.

– compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset.

• In Relative Valuation approach, firm’s performance is compared by the market or with comparable standards from the market.

• So for valuation under this method, – first identify comparable assets and obtain market

values for these assets. – convert these market values into standardized

values.(standardization can be done using common variables such as earnings, cash flows, book value or revenues.

– compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset.

Relative Valuation approach

Different Ratios for relative valuation approach.

• Price/Earnings Ratio (PE)/ (PEG)

• Price/Book Value(of Equity) (PBV)

• Price/Sales per Share (PS)

Different Ratios for relative valuation approach.

• Price/Earnings Ratio (PE)/ (PEG)

• Price/Book Value(of Equity) (PBV)

• Price/Sales per Share (PS)

Relative valuation: brand name

• In general, the value of a brand name can be written as:

Value of brand name ={(V/S)b-(V/S)g }* Sales

(V/S)b = Value of Firm/Sales ratio of the firm with the benefit of the brand name

(V/S)g = Value of Firm/Sales ratio of the firm without the brand name.

• In general, the value of a brand name can be written as:

Value of brand name ={(V/S)b-(V/S)g }* Sales

(V/S)b = Value of Firm/Sales ratio of the firm with the benefit of the brand name

(V/S)g = Value of Firm/Sales ratio of the firm without the brand name.

Valuation in acquisition analysis

• Synergy are of two types

– Operating

Economies of scale, backward/forward integration, better pricing power

– Financial

• tax benefits, high debt capacity, better cash utilisation.

• Synergy are of two types

– Operating

Economies of scale, backward/forward integration, better pricing power

– Financial

• tax benefits, high debt capacity, better cash utilisation.

Which model to be chosen

• In the asset based valuation method– Liquidation cost method

– Replacement cost method

• Generally assets which are separable and marketable are being valued as per this method like real estate companies.

• In the asset based valuation method– Liquidation cost method

– Replacement cost method

• Generally assets which are separable and marketable are being valued as per this method like real estate companies.


• Based on the cash flow generation capacity– If company is generating the cash flow or going to

generate in near future then DCF method can be followed.

– If cash could not be generated at all like paintings then relative valuation method can be followed

• Based on the cash flow generation capacity– If company is generating the cash flow or going to

generate in near future then DCF method can be followed.

– If cash could not be generated at all like paintings then relative valuation method can be followed


• Assets based (liquidity) valuation approach value the assets considering the current situation only.

• DCF method value the business considering firm as going concern till infinity (generally)

• Option pricing or relative valuation method follow a limited time consideration approach.

• Assets based (liquidity) valuation approach value the assets considering the current situation only.

• DCF method value the business considering firm as going concern till infinity (generally)

• Option pricing or relative valuation method follow a limited time consideration approach.


In DCF• If cash flow can be predicted

– If leverage is stable

• FCFE

– If leverage unstable

• FCFF

• If cash flow can’t be predicted– Dividend growth model

In DCF• If cash flow can be predicted

– If leverage is stable

• FCFE

– If leverage unstable

• FCFF

• If cash flow can’t be predicted– Dividend growth model


In relative valuation• High growth firm

– P/E to growth• High growth/negative earning

– Price to sales• Retails business

– Price/sales• Real estate

– Price to cash flow• Financial Services

– Price to book value

In relative valuation• High growth firm

– P/E to growth• High growth/negative earning

– Price to sales• Retails business

– Price/sales• Real estate

– Price to cash flow• Financial Services

– Price to book value

The journey beginsWishing You all the best for the Mid Term

Valuation - Basics

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