Lecture 12 Valuation Approaches Investment Analysis

Free Cash Flow Model Free Cash Flows: Free cash flow to the firm (FCFF) is defined as the cash flow generated by the firm’s operations that is in excess of the capital investment required to sustain the firms current productive capacity. Free cash flow to equity (FCFE) is the cash available to stockholders after funding capital requirements and expenses associated with debt financing. One advantage of free cash flow models is that they can be applied to many firms, regardless of dividend policies or capital structures. The ability to influence the distribution and application of a firm’s free cash flow makes these models more pertinent to a firm’s controlling shareholder. Free cash flow is also useful to minority shareholders because the firm may be acquired for a market price equal to a value to the controlling party. However, there are cases in which the application of a free cash flow model may be very difficult. Firms that have significant capital requirements may have negative free cash flow for many years in the future. This can be caused by a technological revolution in an industry that requires greater investment to remain competitive or by rapid expansion into untapped markets. This negative free cash flow complicates the cash flow forecast and makes the estimates less reliable. Investment Analysis

When to Use FCFs? Free cash flow models are most appropriate: For firms that do not have a dividend payment history or have a dividend payment history that is not clearly and appropriately related to earnings. For firms with free cash flow that correspond with their profitability. When the valuation perspective is that of controlling shareholder. Investment Analysis

Residual Income Model Residual Income: Residual income is the amount of earnings during the period that exceeds the investor’s required return. The theoretical basis for this approach is that the required return is the opportunity cost to the suppliers of capital, and the residual income is the amount that the firm is able to generate in excess of this return. The residual income approach can be applied to firms with negative free cash flow and to dividend and non-dividend paying firms. Residual income models can be more difficult to apply, however, because they require in-depth analysis of the firm’s accounting accruals. Management discretion in establishing accruals for both income and expense may obscure the true results for a period. If the accounting is not transparent or if the quality of the firm’s reporting is poor, the accurate estimation of residual incense is likely to be difficult. Investment Analysis

When to Use Residual Income? The residual income approach is most appropriate for: Firms that do not share dividend histories. Firms that have negative free cash flow for the foreseeable future (usually due to capital demands). Firms with transparent financial reporting and high quality earnings. Investment Analysis

Dividend Discount Model (DDM) In the strictest sense, the only cash flow you receive from a firm when you buy publicly traded stock is dividend. The simplest model for valuing equity is DDM and it makes the perfect sense for valuing a stock because it calculate the value of a share as the present value of expected dividends on it. Investment Analysis

One Period DDM We can rearrange the holding period formula to solve for the value today of the stock given the expected dividend, the expected price in one year and the required return: (P 1 – P 0 ) + D 1 P 1 + D 1 P 0 P 1 + D 1 r = = r = P 0 P 0 P 0 P 0 P 1 + D 1 P 0 = V 0 = 1 + r Where: V 0 = P 0 =Fundamental value D 1 =Dividends expected to be received at the end of year 1 P 1 =Price expected upon sales at the end of year 1 r=Required return on equity Investment Analysis

Assignment (Question 1) Calculating value for a one period DDM Buy Best shares are expected to pay a dividend at the end of the year €1.25. The analyst estimates the required return to be 8% and the expected price at the end of the year to be € The current price is € Calculate the value of the shares today and determine whether Buy Best is overvalued, undervalued or properly valued. Investment Analysis

Two Period DDM The value of a share of stock using the two-period DDM is the present value of the dividends in years 1 and 2, plus the present value of the expected price in year 2: D 1 D 2 + P 2 V 0 = + (1 + r) 1 (1 + r) 2 Where: V 0 =Fundamental value D 1 =Dividends expected to be received at the end of year 1 D 2 =Dividends expected to be received at the end of year 2 P 2 =Price expected upon sale at the end of year 2 r=Required return on equity Investment Analysis

Assignment (Question 2) Machines Unlimited shares are expected to pay dividends of Canadian Dollars (C$) 1.55 and C$1.72 at the end of each of the next two years, respectively. The investor expects the price of the shares at the end of this 2 year holding period to be C$ The investor’s required rate of return is 14%. Calculate the current value of Machines Unlimited shares. Investment Analysis

Multi Period DDM DDM can be easily adapted to any number of holding periods by adjusting the discount factor to math the time to receipt of each expected return. With this, the present value becomes the sum of the properly discounted values of all expected cash flows (dividends and terminal/fundamental value): D 1 D 2 D n + P n V 0 = + + …….. + (1 + r) 1 (1 + r) 2 (1 + r) n Where: V 0 =Fundamental value D n =Dividends expected to be received at the end of year n P n =Price expected upon sale at the end of year n r=Required return on equity Investment Analysis

Assignment (Question 3) Reliable Motors shares are expected to pay dividends $1.50, $1.60 and $1.75 at the end of each of the next 3 years, respectively. The investor expects the price of the shares at the end of the 3 rd year holding period to be $ The investor’s required rate of return is 15%. Calculate the current value of Reliable Motors shares. Investment Analysis

The General Dividend Discount Model If we extend the holding period to infinity, the value simply becomes the present value of an infinite streams of dividends, represented by John Burt Williams (1938) original DDM formula: ∞ D t V0 = ∑ t = 1 (1 + r) t While the DDM is theoretically correct, applying it in practice requires the analyst to accurately forecast dividends for many periods, a task for which we rarely can expect to have sufficient information. We can use one of several growth models, including the: – Gordon constant growth model – Two-stage growth model – H-model – Three stage growth model With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method such as a multiple of book value or earnings. Choosing the appropriate model is essential to accurate forecasts. Investment Analysis