1. 1 Valuation Curriculum designed for use with the Iowa Electronic Markets by Roger Ignatius Thomas A. Rietz

2. 2 Valuation: Lecture Outline l Principles of Valuation l Discounted Dividend Models  Constant Dividend Model  Constant Growth Model l Discounted Cash flow Model l Market Multiple Models  P/E versus Past and Peers  P/S versus Past and Peers  P/CF versus Past and Peers l Summary

3. 3 Principles of Valuation l Book Value  Depreciated value of assets minus outstanding liabilities l Liquidation Value  Amount that would be raised if all assets were sold independently l Market Value (P)  Value according to market price of outstanding stock l Intrinsic Value (V)  NPV of future cash flows (discounted at investors’ required rate of return)

4. Intrinsic Valuation Procedure Asset Characteristics Size of Future Cash flows Time of Future Cash flows Risk of Future Cash flows Investor Characteristics Assessment of Cash flow Riskiness Risk Preferences Investors’ Required Rate of Return (k)

5. 5 Where Does the Discount Rate (k) Come From? CAPM: k = r f +  xRP Beta (  ) is estimated using historical data and is available from many sources l The risk free rate (r f ) is the current Treasury rate  Typically the 3-mo rate, but other are sometimes used l The risk premium (RP) is a historical average relative to the r f used

6. 6 Example: Estimating k for Wal-Mart (WMT) on 4/27/01 l Inputs  Three month Treasury rate: 3.75%  Historical average RP (1926-1996): 8.74%  Beta for Dell (from MoneyCentral): 0.9 l Computing k:  CAPM: k = 0.0375 + 0.9x0.0874 = 11.62%

7. 7 Sensitivity to CAPM Inputs Initial values: R f = 3.75% RP = 8.47% Beta = 1.5

8. 8 Discounted Dividend Models l Dividends will be  Forecast directly  Assumed to be constant  Assumed to grow at a constant rate or  Some combination of the above l l Stock pricing relationship:

9. 9 Constant Dividend (Zero Growth Model) Model l If D t is constant, then it is an ordinary perpetuity: l l Stock pricing relationship:

10. 10 Example: Wal-Mart (4/27/01) l The price of Wal-Mart was actually $52.83 l Can you explain the difference? l l The current (annual) dividend is: $0.28 l l According to the constant dividend (zero growth) model:

11. 11 Sensitivity to Constant Dividend Model Inputs Initial values: D 0 = $0.50 k = 12%

12. Why do a firm’s dividends grow? l Because earnings grow. Why? l Because of reinvested funds  Used to expand or to undertake new projects  Used in positive NPV projects l Leads to  Earnings growth  Investments growth and  Dividend growth

13. 13 Constant Growth Model l If D t grows at a constant rate, g, then it is a growth perpetuity: l l Stock pricing relationship:

14. 14 How do You Estimate Growth (g)? l NOTE: Must have g<k in the long run! l l Historical average l l Average analyst forecast l l Sustainable growth   g = (1-Payout Ratio)xROE l l Required return versus dividend yield:

15. 15 Estimating g for Wal-Mart (4/27/01) l What should it be?  1 st 3 are too high b/c long run must have g<k  Guess: 11%? l l 5 year historical average: 19.72% l l Average 5-year analyst forecast: 14.4% l l Sustainable growth   g = (1-0.17)x0.22 = 18.26% l l Required return versus dividend yield:

16. 16 Example: Wal-Mart (4/27/01) l The price of Wal-Mart was actually $52.83 l Notes:  Must have g<k in long run  As g  k, the price increases without bound l l Current (annual) dividend is: $0.28 l l If we use estimated growth of 11%:

17. 17 Sensitivity to Constant Growth Model Inputs Initial values: D 0 = $0.50 k = 12% g = 6%

18. 18 Summary of Dividend Discount Models l Represents the value of dividends received by shareholders l Requires  A discount rate (k)  Dividends (D)  Steady or zero growth (g, with g<k) l Trouble valuing  Companies with D=0  Fast growing companies with g>k

19. 19 Discounted Cash Flow Model l Shareholders receive or “own”: 1. Dividends 2. Re-invested earnings  The effects of re-invested earnings are captured in dividend growth if a firm pays dividends and growth can be estimated l An alternative valuation comes from valuing cash flows available to stockholders directly  Useful for companies that pay no dividends

20. 20 What Constitutes Cash flows? l There is some debate over exactly what constitutes cash flows l The GAAP cash flow statement:  CF = NI + depreciation – preferred stock dividends  This should represent CFs that are either 1.Paid out in common stock dividends or 2.Re-invested

21. 21 What Discount Rate Should be used? l It depends on the definition of CFs  If CFs are defined as those available to all investors, WACC should be used  If CFs are defined as those available to common stockholders, k from CAPM should be used l We will use the latter

22. 22 Example: Estimating k for K- Mart (K) on 4/27/01 l Inputs  Three month Treasury rate: 3.75%  Historical average RP (1926-1996): 8.74%  Beta for K-Mart (from MoneyCentral): 1 l Computing k:  CAPM: k = 0.0375 + 1x0.0874 = 12.49%

23. 23 How do You Estimate Growth (g)? l CFs will also grow l Use methods similar to dividend growth, but  Analysts forecasts are typically unavailable  For many companies, dividend yield cannot be used b/c there is no dividend l Often, earnings or sales growth are used  Expenses and re-investment need to be relatively constant percentages of sales l NOTE: Must have g<k in the long run!

24. 24 Estimating g for K-Mart (4/27/01) l 5 year sales growth: 2.35% l Analysts’ 5 year earnings forecast: 10.3% l Suppose, you believe K-Mart will not grow at all! l l From the historical income statement:

25. 25 Example: K-Mart (4/27/01) l The price of K-Mart was actually $9.82 l What must the market be expecting for K- Mart’s growth in the future? l l According to the last statements:   CF = $1,216 million   Shares = 486.5 million  CF/Share = $2.50 l l If we use estimated growth of 0.0%:

26. 26 Sensitivity to Constant Growth Cash flow Model Inputs Initial values: CF 0 = $0.50 k = 12% g = 6%

27. 27 Summary of Discounted Cash flow Models l Represents the value of cash flows available to shareholders l Requires  A discount rate (k)  A reasonable measure of cash flows o IMPORTANT: How much depreciation MUST be replaced ? Model assumes zero.  Steady or zero growth (g, with g<k) l Trouble valuing  Companies with CF<0  Fast growing companies with g>k  Companies with necessary replacement of depreciated assets

28. Market Multiples l Valuations are derived by: 1. Forecasting earnings, sales or cash flows 2. Applying the company’s historical P/E, P/S or P/CF to forecast 3. Applying industry average P/E, P/S or P/CF to current inputs

29. 29 Why do P/E Ratios Make Sense? l A company with a payout less than 1 will grow and be valued at: l l A company with a payout ratio of 1 will not grow and be valued at:

30. 30 Logic of Market Multiple Models l Sales, earnings and cash flow drive profits, growth and value l P/S, P/E & P/CF ratios show the relationship between price and these value drivers l Firms within an industry have similar sales, profit and cash flow patterns and similar required returns l Therefore, a reasonable value for a firm is its sales, earnings or cash flows times the respective industry ratio

31. 31 P/E Ratio Valuation l If company “j” is “valued at industry ratios” relative to earnings: l l If company “j” is “valued at historical ratios” relative to earnings:

32. 32 Example: Wal-Mart (4/27/01) l Valued at historical P/E ratio:  Analysts forecast next year’s earnings for WMT at $1.58  WMT’s recent P/E was 37.7  Then: P = $1.58x37.7 = $59.57 l Valued at industry average P/E ratio:  This year, earnings for WMT were $1.40  The industry average P/E was 36.0  Then: P = $1.40x36.0 = $50.40 l The price of Wal-Mart was actually $52.83

33. 33 Sensitivity to P/E Multiple Model Inputs Initial values: E 1 = $1.50 P/E = 35

34. 34 P/S Ratio Valuation l Using current sales, a company “j” is “valued at industry ratios” relative to sales: l l For companies w/o earnings, P/S is sometimes used l l If you have a sales forecast, company “j” is “valued at historical ratios” relative to sales:

35. 35 Example: Amazon (4/27/01) l For the year ending 12/00  Sales = 2,762 million (income statement)  Shares = 357.1 million (balance sheet)  Sales/Share = 2762/357.1 = 7.73 l Industry average P/S = 3.46 l So, using industry P/S Amazon should be priced at: 3.46x7.73 = $26.76 l The price of Amazon was actually $15.27

36. 36 Sensitivity to P/S Multiple Model Inputs Initial values: S 1 = $3.00 P/S = 15

37. 37 P/CF Ratio Valuation Using current cash flow, company “j” is “valued at industry ratios” relative to cash flows: For companies w/o dividends, P/CF is sometimes used If you have a cash flow forecast, company “j” is “valued at historical ratios” relative to cash flows:

38. 38 Example: K-Mart (4/27/01) l For the year ending 12/00  CF = 1,216 million (discussed previously)  Shares = 486.5 million (balance sheet)  CF/Share = 1216/486.51 = 2.50 l Industry average P/CF = 21.3 l Using industry P/CF K-Mart should be priced at: 21.3x2.50 = $53.24 l The price of K-Mart was actually $9.82 l Is K-Mart undervalued or in serious trouble?

39. 39 Sensitivity to P/CF Multiple Model Inputs Initial values: CF = $1.00 P/S = 30

40. 40 Summary of Market Multiples Models l Valuations using historical and industry ratios  Provide useful benchmarks  Useful when dividends and cash flows cannot be discounted directly  Can be compared to current ratios as a measure of market sentiment l Weaknesses  Misleading for firms that are changing rapidly or do not resemble the industry

41. 41 Summary Discounted Dividend  w/ dividends and constant expected (possibly zero) growth in dividends Discounted Cash flow  w/o dividends and constant expected (possibly zero) growth in cash flows P/E, P/S and P/CF ratios  Comparison with past or industry Why several methods?  Each has strengths and weaknesses  Different methods useful in different situations  Each gives a different “take” on the value of the company’s stock  Provides a range of valuations instead of point estimates