1. Lecture 7
Valuation (part 1)

2. The steps involved in Business Analysis
Step 4 – Prospective analysis: Valuation
RIM
Alternatives
Sensitivity
Step 5 – Application
for example:
Outside Investor
Compare Value with Price to BUY, SELL, or HOLD
Inside Investor
Compare Value with Cost to ACCEPT or REJECT Strategy
Step 3 – Prospective analysis: Forecasting
Profit and Loss
Balance Sheet
Cash Flow
Step 1 – Understanding the Business
e.g.:
The Product market
The Competition
The Regulatory Constraints
Business strategies
Step 2 - Analyzing Information – Accounting Analysis and Financial Analysis
Quality of Accounting information?
Re-formatting to uncover business activities
Ratio and cash flow analysis
Strategy

3. Introduction So far all information analysed has been historical.
Management consulting, equity analysis & valuation is forward looking – concerned with planning and future performance
Prospective analysis consists of 2 steps – forecasting (last lecture) and valuation (this and next lecture)

4. Learning Objectives
At the conclusion of this lecture you should understand:
Basic approaches to the valuation of investments
Price multiples
Discounted dividend model

5. Why the concern with firm value?
Value is the question everyone wants answered
Equity investors
Management
Creditors
Employees
Value is a function of returns

6. What is the valuation process?
Returns from investments include:
The cash received while investment it is held (e.g. dividends)
The cash received when the investment is realised
Returns have to be discounted having regard to the required return (Cost of Capital)
Cost of capital should reflect
The time value of money
Investment Risk
Cost of capital = r (and r=1+r)

7. Valuation overview
The process of converting forecast returns into ‘value’
Can focus on
Assets
Returns
Assets and returns
Can be
Outwardly simple such as the use of multiples
More complex and use discounting

8. Valuation Is the process of converting the forecast into some value
Lots of different methods, including:
Price multiples
Discounted dividends
Discounted abnormal earnings
Discounted abnormal operating earnings
Discounted cash flow
Can use to either value the equity or assets in the firm

9. Valuation of terminal investments: Bonds
A Bond: 1 2 3 4 5
Periodic cash coupon
Cash at redemption
Purchase price
Time, t
100
(1080)
1000
Cash flows for a $1,000, 5 year 10% pa coupon bond
Issue: calculating the discount rate (cost of capital for debt)

10. Valuation of terminal investments: Bonds

11. Valuation of terminal Investments: Lottery
You have won the million dollars lottery, and will be paid $100,000 per year for the next 10 years
What is the “real” value of your winnings?

12. Valuation of terminal investments: Lottery
year
discount rate
present value
1.06 1
100,000
94,339.62 2
1.12
88,999.64 3
1.19
83,961.93 4
1.26
79,209.37 5
1.33
74,725.82 6
1.41
70,496.05 7
1.50
66,505.71 8
1.59
62,741.24 9
1.68
59,189.85 10
1.79
55,839.48
total
736,008.71

13. Valuation – Why bonds are easy
Bonds are relatively easy to value as they have
Fixed predetermined cash flows
Finite terms
Equity investments are more complicated to value as have
Variable cash flows
Infinite time horizon
We will look at 2 methods this week:
Price multiples
Dividend discount

14. Valuation with multiples
Outwardly a very simple approach
Steps involved:
Select the measure on which the multiple valuation will be based (e.g., OE, Sales, NI, Div, ………………..)
Estimate the price multiple to be used (e.g., 10)
Apply the multiple to the measure (e.g., NI=1.23 per share, P=1.23*10=$12.30

15. Valuation with multiples
Which measure?
What price multiple?
If based on other firms,
Are firm business models comparable?
Are firm financing structures comparable?

16. Valuation with multiples: Penman (2001), Pages 40,41

17. Valuation with multiples: Penman (2001), Pages 40,41

18. Price multiples: example

19. Valuation with Discounted Dividend Model
Dividends are the returns to shareholders, so
Equity valuation
Equity discount rate (re)

20. Valuation with Discounted Dividend Model
Value of equity = PV of expected dividends summed to infinity:

21. Valuation with Discounted Dividend Model
Remember, r=1+r

22. Valuation with Discounted Dividend Model
A TV to replace sum to infinity
Truncated series + terminal value
Future Ret = 0
Future Ret = K
Future Ret = growth

23. Valuation with Discounted Dividend Model
Lecture 7 Terminal value assumptions.xlsx

24. Valuation with Discounted Dividend Model
Dividend Discount Model
Dividends as the future returns
Equity valuation
Cost of equity
Future Ret = 0
Future Ret = K
Future Ret = growth

25. Valuation with Discounted Dividend Model
Issues
Valuation is particularly sensitive to growth
Dividend policy irrelevance (i.e., M&M)

26. Valuation with Discounted Dividend Model
DDM:
Forecast dividends
Estimate cost of capital for equity
Calculate forecast dividend growth patterns to estimate TV calculation method (0, perpetuity or perpetuity with growth)
Calculate TV at time T (where growth pattern stabilises)
Discount forecast dividends to TV year and the TV, add together for total value

27. Valuation with Discounted Dividend Model
Forecasts for Anna's Company
Value
Forecast
2014
2015
2016
2017
2018
2019
1.Forecast Div
1,365.00
1,611.70
1,852.31
2,130.15
2,449.67
2. Estimate re
16%
1.16
1.34
1.56
1.81
2.10
3. Calculate forecast dividend growth patterns (g)
18%
15%
TV pattern - perpetuity with growth of 15% (TV3)
4. Calculate TV = Div (t+1) / (re-g)
213,015.08
5. Discount dividend stream to TV year
1,176.72
1,197.01
1,186.69
Discount TV
136,469.74
Equity value
140,030.17

28. Valuation with Discounted Dividend Model
Forecasts for Peter's company
Value
Forecast
1904
1905
1906
1907
1908
1909
1910
1.Forecast Div
1,800
1,900
2,000
2,130
2. Estimate re
12%
1.12
1.25
1.40
1.57
1.76
1.97
Required: estimate the value of Peter’s company using DDM

29. Valuation with Discounted Dividend Model
Forecasts for Peter's company
Value
Forecast
1905
1906
1907
1908
1909
1910
1.Forecast Div
1,800
1,900
2,000
2,130
2. Estimate re
1.12
1.25
1.40
1.57
1.76
1.97
3. Calculate forecast dividend growth patterns (g) 6% 5% 7% 0%
TV pattern - perpetuity with 0% growth (TV2)
4. Calculate TV = Div (t+1) / (re)
17,750
5. Discount dividend stream to TV year
1,607.14
1,514.67
1,423.56
1,353.65
1,208.62
Discount TV
10,071.83
Equity value
17,179.47

30. Valuation with Discounted Dividend Model
Forecasts for Charles' company
Value
Forecast
2014
2015
2016
2017
2018
2019
2020
1.Forecast net dividend payout
240,000
267,000
289,000
312,120
337,089.60
364,056.77
2. estimate cost of capital for equity
12%
1.12
1.25
1.40
1.57
1.76
1.97
Required: estimate the value of Charles’ company using DDM

31. Valuation with Discounted Dividend Model
Forecasts for Charles' company
Value
Forecast
2015
2016
2017
2018
2019
2020
1.Forecast Div
240,000
267,000
289,000
312,120
337,089.60
364,056.77
2. Estimate re
1.12
1.25
1.40
1.57
1.76
1.97
3. Calculate forecast dividend growth patterns (g)
11.3%
8.2%
8.0%
TV pattern - perpetuity with growth of 8% (TV3)
4. Calculate TV = Div (t+1) / (re-g)
8,427,240
5. Discount dividend stream to TV year
214,285.71
212,850.77
205,704.49
198,357.90
Discount TV
5,355,663.37
Equity value
6,186,862.24

32. Valuation with Dividend Discount Model: Issues
Theoretical
Dividend policy can be arbitrary and not linked to value added
Focuses on wealth distribution not creation
Practical
Horizon
Growth??????????????????

33. Conclusion This week Introduction to valuation Next week
Multiples – simple, but….
Discounted dividend model
Firms not paying dividends
Growth
Next week
Valuation continued
Models derived from DDM
RIM
RoIM
FCF