Principles of Finance with Excel, 2 nd edition Instructor materials Chapter 16 Valuing stocks

Four approaches to stock valuation  Valuation method 1: Efficient markets approach  Valuation method 2: Discounting future free cash flows (FCF)  Valuation method 3: Discounting future equity payouts  Valuation method 4: Valuation with multiples 2

Excel in this chapter  Sum  NPV  If  Data table 3

Valuation method 1: Efficient markets approach  Efficient markets says: The market knows best  Means: Current stock price is the right price! 4

Page MESSAGE: There’s a lot of evidence showing that you can’t outguess markets! MEANING: Before you do complicated stock valuations—consider the possibility that the market price is correct:  Market price represents sum total of thinking about the stock  The price may subsequently go up or down, but there’s no easy way to tell …

Another example 6

Valuation method 2: Stock price based on PV(FCF)  Reminder: Free cash flow (FCF) is the cash produced by the business activities of the firm (Chapter 6/7)  FCF = Profit after taxes + Depreciation - Increase in Current Assets + Increase in Current Liabilities - Capital expenditures + After-tax interest 7

8 The DCF valuation steps:  Value the enterprise value by taking the PV of future FCFs  Add back initial cash and marketable securities  Subtract out debt  = Equity valuation

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DCF example: Arnold Corp.  Current FCF = $2 million  Growth rate of FCF = 8% annually  WACC = 15%  1,000,000 shares  $10 million debt  $ 1 million cash 10

Valuing Arnold Corporation 11

Valuation method 3: Share price = PV of future anticipated equity cash flows discounted at cost of equity r E  This method is more direct  Equity cash flow=Dividends + stock repurchases  r E = cost of equity  Compute by using Gordon dividend model (Chapter 6)  Compute by using SML (Chapter 13) 12

Using equity payouts 13

Why finance professionals shun direct equity valuation  Equity payouts are even less predictable than FCFs  The WACC is probably more stable than the cost of equity 14

Valuation method 4: Using multiples  Most common:  Price-earnings ratio * Earnings  EBITDA ratio * EBITDA  See separate multiple valuation PPT on instructor website 15