Valuation Chapter 10 Robinson, Munter, Grant

Grant, Munter & Robinson Chapter 102 Learning Objectives Compare and contrast valuation models –Discounted cash-flow –Market-based –Asset- or Option-based –Others Identify circumstances in which each model is most appropriate

Grant, Munter & Robinson Chapter 103 Five Categories of Valuation Methods 1.Discounted cash-flow 2.Market-based 3.Mixed models 4.Asset-based methods 5.Option-based methods

Grant, Munter & Robinson Chapter 104 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

Grant, Munter & Robinson Chapter 105 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

Grant, Munter & Robinson Chapter 106 Discounted Dividend Valuation Theoretical Model No-growth, constant dividend Dividends are growing at rate g

Grant, Munter & Robinson Chapter 107 Discounted Dividend Valuation Required rate of return (r) r is the rate of return demanded on a specific investment –Based on investor’s assessment of risk CAPM

Grant, Munter & Robinson Chapter 108 CAPM -- Example r f, Risk-free (30-year Treasury bond) = 5% r m, Expected stock market return = 10% –Risk premium = (r m – r f ) Beta = 1.5 r = 5% + 1.5(10%-5%) r = 12.5%

Grant, Munter & Robinson Chapter 109 Discounted Dividend Valuation Required rate of return (r) For nonpublic companies, use a buildup model and historical sources for data Begin with risk-free rate + Equity risk premium + Small company premium + Company specific risk premium = Required rate of return

Grant, Munter & Robinson Chapter 1010 Discounted Dividend Valuation Growth rate (g) Top-Down analysis –Begin with growth of economy –Adjust for industry, sector and company factors Sustainable growth = ROE(1-Payout rate) –ROE = Earnings/Average equity –Payout rate: proportion of earnings used to pay dividends or repurchase shares

Grant, Munter & Robinson Chapter 1011 Motorola –Annual dividend = $0.16 –Beta = 1.35 –ROE = 13% –Payout ratio = 20% Economic –20-year Treasury bond = 4.75% –Historical market risk premium = 5.4% Discounted Dividend Valuation Motorola example

Grant, Munter & Robinson Chapter 1012 r = (.054) =.120 g =.13(1-.20) =.104 Value = $11.04… Discounted Dividend Valuation Motorola example

Grant, Munter & Robinson Chapter 1013 Discounted Dividend Valuation Assumes a single, constant growth rate (g) What if growth rates differ? Use a multi-stage model to calculate future dividends –Calculate future stock value based on future dividend –Calculate present value of stock and dividends H model: for growth rates that decay over time

Grant, Munter & Robinson Chapter 1014 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

Grant, Munter & Robinson Chapter 1015 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/( )] Value per share (after debt) is $7.28

Grant, Munter & Robinson Chapter 1016 Discounted Operating Cash-Flow Models Other considerations Growth –Can use a multi-stage model to accommodate rate changes –Is only beneficial if it leads to increased positive cash flows in the future Forecasting cash flows requires judgment –Begin with reported, historical cash flow and earnings –Make company-appropriate adjustments

Grant, Munter & Robinson Chapter 1017 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

Grant, Munter & Robinson Chapter 1018 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 Derived from the dividend discount models Requires judgment regarding –Peer firms and their prices –Historical (average) data

Grant, Munter & Robinson Chapter 1019 P/E Model Firms with no internal growth prospects, paying out 100% of earnings –Current P/E = 1/r Constant growth, Leading P/E –P 0 /E 1 = (D 1 /E 1 )/(r-g) –D = annual dividends, E = EPS Constant growth, Trailing P/E –P 0 /E 0 = [(D 0 /E 0 )(1+g)]/(r-g)

Grant, Munter & Robinson Chapter 1020 P/E Model Motorola 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

Grant, Munter & Robinson Chapter 1021 P/B Method Book value (B) –Total stockholder’s equity –Less sensitive to short-term events than is earnings P/B is a function of profitability, growth and risk Is linked to the dividend discount model

Grant, Munter & Robinson Chapter 1022 P/B Method 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

Grant, Munter & Robinson Chapter 1023 P/S Model Insert sales (S) into the dividend discount model E/S = Π P 0 /S = Π/r P 0 /S 1 = (Π*Payout)/(r-g) Often used to value start-up firms, caution should be used

Grant, Munter & Robinson Chapter 1024 Other Multiples Cash-flow-based multiples are common Price/operating cash flow Price/EBITDA Price/free cash flow Dividend yield (D/P) Method used should be appropriate considering the specific circumstances of the subject company

Grant, Munter & Robinson Chapter 1025 Mixed Models Because the previous models are linked (discounted dividend model) a combined approach can be used May use discounted cash flow approach to forecast cash flows then use market multiple to derive terminal value Residual income approaches are linked to the dividend discount model

Grant, Munter & Robinson Chapter 1026 Residual Income PV = book value + excess earnings over time Perpetuity model

Grant, Munter & Robinson Chapter 1027 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

Grant, Munter & Robinson Chapter 1028 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

Grant, Munter & Robinson Chapter 1029 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 –Special opportunities available to certain firms

Grant, Munter & Robinson Chapter 1030 Summary Determine value using five categories of valuation models How these models are similar to and different from each other Circumstances in which each is most appropriate