Valuation Chapter 10

Ch 102 Valuation models –Discounted cash-flow –Market-based (multiples) –Residual income Model DCF and risidual income model are much more sophisticated valuation tools than the price multiples –Infinite forecast horizon –Risk and the time-value of money are taken into account (cost of capital)

Ch 103 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

Ch 104 Discounted Dividend Valuation Theoretical Model No-growth, constant dividend Dividends are growing at rate g

Ch 105 Required rate of return (r) r f, Risk-free (30-year Treasury bond) = 5% r m, Expected stock market return = 10% –Risk premium = (r m – r f ) For example, if Beta = 1.5 r = 5% + 1.5(10%-5%) r = 12.5%

Ch 106 Growth rate (g) Sustainable growth = ROE(1-Payout rate) –ROE = Earnings/Average equity –Payout rate: % of earnings used to pay dividends

Ch 107 Motorola –Annual dividend = $0.16 –Beta = 1.35 –ROE = 13% –Payout ratio = 20% Economic –Yield on Treasury bills = 4.75% –Historical market risk premium = 5.4% Discounted Dividend Valuation Motorola example

Ch 108 r = (.054) =.120 g =.13(1-.20) =.104 Value = $11.04 Discounted Dividend Valuation Motorola example

Ch 109 Discounted Operating Cash-Flow Models Value of the firm (EV) = Value of assets = Enterprise value = Value of debt +value of equity Typically, valuation of debt is relatively easy. Amount of debt reported in balance sheet is usually close to market value, i.e. value of debt is observable

Ch 1010 Discounted Operating Cash-Flow Models Operating cash flow Plus: Interest Paid Times (1-tax rate) Less: Investments in Fixed Capital Free Cash Flow to the Firm (to all investors)

Ch 1011 Discounted Operating Cash-Flow Models r = Weighted average cost of capital (WACC) –Required rate of return to all capital providers –For Motorola, 10.2% g = growth rate of FCFs –For Motorola, 9% If Motorola’s FCF = $314 million Firm value is $26,167 million [314/( )] Shares outstanding is 2,299 Value per share (after debt $9,428) is $7.28

Ch 1012 Discounted Operating Cash-Flow Models Growth –Can also use a multi-stage model to accommodate rate changes Forecasting cash flows requires judgment –Begin with reported, historical cash flow and earnings –Make company-appropriate adjustments –Use financial analysts’ estimates

Ch 1013 Market-based Models (multiples) Compare subject company to other similar companies for which market prices are available Simple but require a lot of professional judgment P/E Model P/B Method P/S Model

Ch 1014 P/E Model Assumes a company is worth a certain multiple of its current earnings Assumes each stock is worth the same multiple of EPS Requires judgment regarding –Peer firms –Historical (average) P/E

Ch 1015 P/E Model Firms with no internal growth prospects, paying out 100% of earnings –Current P/E = 1/r Constant growth, –P 0 /E 1 = (D 1 /E 1 )/(r-g) –D = annual dividends, E = EPS

Ch 1016 P/E versus bond yields

Ch 1017 Effect of the cost of equity and growth opportunities to P/E-ratio

Ch 1018 P/E Model Motorola example Consensus analyst forecast EPS = $0.46 P/E of 23 is appropriate Value = 23*$0.46 = $10.58

Ch 1019 Problems when using P/E-ratio in valuation It assumes that the benchmark is obtainable. P/E-ratios might differ accross firms or time at least for the following reasons: –growth opportunities may differ accross firms –riskiness of a firm may differ accorss firms –earnings for a given year may be temporary by nature

Ch 1020 P/B-ratio, price/book–ratio No growth –P 0 /B = ROE/r Constant growth –P 0 /B = (ROE- g)/(r-g) P/B ratios for similar firms are compared with those of the subject firm to arrive at an appropriate multiple for use in valuation

Ch 1021 Other Price multiples –enterprise value/EBIT–ratio –price/free cash flow–ratio –price/sales–ratio –Price/EBITDA Method used should be appropriate considering the specific circumstances of the subject company.

Ch 1022 Residual Income Model PV = book value + excess earnings over time Perpetuity model

Ch 1023

Ch 1024 Valuation tools most used by analysts in Morgan Stanley European sector research teams