1. 1 Valuation of Cash Flow Streams: Company Valuation Global Financial Management Campbell R. Harvey Fuqua School of Business Duke University charvey@mail.duke.edu http://www.duke.edu/~charvey

2. 2 Overview l Stocks and stock markets l Valuation: »Use present value formula l Dividend growth models »Applications »Extensions l Financial ratios »Dividend yields »P/E multiples l Discounted cash flow models (DCF)

3. 3 Common Stock l Stockholders are owners of the firm. l Stockholders are residual claimants. l Stockholders have the right to: »vote at company meetings »dividends and other distributions »sell their shares l Stockholders benefit in two ways: »dividends »capital gains l Stock is issued by public corporations to finance investments. l Stock is initially issued in the primary market (IPOs and secondary offerings). l Stock is traded in the secondary market on organized exchanges.

4. 4 World Stock Markets l New York l Tokyo l London l Frankfurt l Paris l Johannesburg l Sydney l Stockholm l Amsterdam l Switzerland l Mexico l Canada l Brussels l Hong Kong l Singapore

5. 5 International Stock Market Indices Value on January 17, 1997, Change relative to previous day

6. 6 U. S. Stock Markets Major U. S. Stock Exchanges l New York Stock Exchange (NYSE) l American Stock Exchange (AMEX) l Over-The-Counter (OTC) »National Association of Securities Dealers (NASDAQ) U. S. Stock Market Other Indices l NYSE Composite l Russell 2000 l Wilshire 5000 l Value Line

7. 7 Transactions Involving Stocks l Buy  Savings motive  Expect stock to appreciate in value  Long position l Sell  Liquidity needs  Expect stock to decline in value l Short Sell  Sell stock without first owning it.  Borrow stock from your broker with the promise to repay it at some later date.  Sell the borrowed stock.  Repurchase it at a later date to repay your broker.  Responsible for all dividends and other distributions while short the stock.

8. 8 Stock Valuation l The price an investor is willing to pay for a share of stock depends upon: »Magnitude and timing of expected future dividends. »Risk of the stock. l The stock ’ s discount rate, r e, is the rate of return investors can expect to earn on securities with similar risk.

9. 9 Shareholders require a rate of return r e for buying a share. They buy for P 0 and sell after one year for P 1 and receive dividends D 1 : The next buyer also sells after one year: The same holds for P 2. Continuing gives: Share price = PV of dividends Why short-termists are long-termists

10. 10 Assumption: Dividends grow at a constant rate g for ever: Then: l Issues: »constant growth »g < r e. »Is this a real or a nominal calculation? The “ Constant Growth ” Formula

11. 11 Simplifying the Dividend Discount Model l Constant Dividends Then the pricing relation simplifies to: »Stock similar to perpetual bond l If dividends are constant, then we have that: Required return on equity = Dividend yield

12. 12 Constant Dividends: An Example l Consider a company that pays a dividend of: $3 per share in bad years (Probability = 50%) $15 per sharein good years (Probability = 50%) »Required rate of return is 18% »What is the share price?

13. 13 Constant Dividends: RJR Nabisco Preferred Stock l RJR Nabisco has a preferred stock outstanding »annual dividend of $2.50 per share. »Securities with similar risk are expected to return 9.6% – what is the price of the preferred stock?

14. 14 Constant Growth: Duke Power Common Stock l Duke Power currently pays a dividend of $2.04 per share. »Demand for electric power is growing at 4% per year, »Inflation averages 3% per year, »Duke Power expects its profits and dividends to grow at about 7% per year. »Stockholders require a 12% rate of return –what is the market price of Duke Power ’ s common stock?

15. 15 Valuation with Growing Dividends An Example: Valuation of GM l Generally, companies have growing dividends on stocks, hence apply general formula: l Consider data for GM: »Number of shares:855,820 »Market capitalization$42.051bn »Historic dividend$1.50 per share »Your forecast:$1.60 –What valuation do you obtain for GM, depending on g and r?

16. 16 Valuation of GM l Alternative valuations: Example: 855,820,000*$1.60=$1.37bn

17. 17 Valuing a Business A Hybrid Approach l Sometimes equity analysts have knowledge about the immediate, but not the distant future »Dividend forecasts for immediate future (2-5 years) »Assume constant growth for distant future (>5 years) »How do you change the model? Dividends Value

18. 18 Modify the Growth Model l The formula for a T-year horizon can be written as: Apply the growth model to the price in T: Then the current value of the share is:

19. 19 Valuing a Business l Consider a company with cash flows from operations of $1 million for the most recent year. l The company ’ s cash flows are expected to grow at a rate of 10% for the next 5 years and at a constant rate of 5% thereafter. l To generate this increase in cash flows, the company is required to reinvest 50% of its cash flows for the first 5 years and 25% of its cash flows thereafter. l Given the risk of the business, the required rate of return is 15%. l What is the value of the business?

20. 20 Valuing a Business (cont.) Present value= CF(1)+...+CF(5)=0.48+0.45+0.43+0.42+0.40=2.18 Year 1Year 2Year 3Year 4Year 5 Operating Cash Flows 1.101.211.331.461.61 New Capital Investment -0.55-0.61-0.67-0.73-0.81 Net Cash Flow (Div) 0.550.600.660.730.80 Present Value 0.480.450.430.420.40

21. 21 Valuing a Business l Value of dividends over the first 5 years is $2.18. l Value of business at the end of the 5th year: l Value of the Business:

22. 22 Another Application: Estimating the required return on equity l Holders of stock receive returns in two forms: »Dividend payouts »Capital gains (stock appreciation P 1 -P 0 ) l Note: »The required rate of return is not equal to the dividend yield »The expression is in terms of the prospective yield, not the historic yield

23. 23 Required Returns and the Growth Model l Use the growth model formula to solve for the required rate of return to give: l Hence, the required rate of return is equal to the prospective dividend yield plus the growth rate. l Note that you can synthesize the previous results: l If dividends grow at a constant rate, then: »share prices grow at the same rate »yield stay constant

24. 24 Next year ’ s EPS:E 1 Payout ratio: P/E-ratio:P 0 /E 1 Earnings yield:E 1 /P 0 The we obtain the following results: »Which assumptions do you have to make in order to argue that stocks with a low P/E multiple are undervalued? Another view: P/E-ratios

25. 25 P/E Ratios and Growth l You can use the expression for the historic yield to infer the growth rate: Consider auto industry:

26. 26 Growth rate in the Auto Industry l Infer growth rate in the auto industry Example:

27. 27 Summary l Stocks and equity securities can be valued by using present value techniques »The discounting horizon does not depend on the investment horizon of individual investors in the stock market l Investors are compensated through cash dividends and through capital gains »Required returns on equity are generally not equal to the dividend yield, but to the dividend yield plus the growth rate l P/E-ratios should be used with caution: »Depends on simplifying assumptions

28. 28 Issues in Capital Budgeting: Investment l How should capital be allocated? »Do I invest / launch a product / buy a building / scrap / outsource... »Should I acquire / sell / accept offer for company or division? »How should the capital budgeting process be organized? l Which choices should I make? »make or buy »which distribution channel

29. 29 Issues in Capital Budgeting: Financing l Choose between financing alternatives »How should I finance this deal? »Should I change my capital structure? »Lease or buy? l Risk Management »Hedging »Taking a view

30. 30 Discounted Cash Flows A Tool For Rational Decision Making l What can be an object of capital budgeting procedures? »There must be a choice - choose a base case and an alternative. (Do nothing/status quo) l Identify incremental cash flows from project »Treat as incremental cash flows to shareholder l Calculate the value of the project. »Taking into account timing and risk »Aggregate cash flows into one single number l Show that doing all and only projects which have positive net present value maximizes the value of the firm.

31. 31 Estimating Relevant Cash Flows l The relevant cash flows for evaluating a new investment project are the incremental cash flows contributed by the project. Incremental = Firm ’ s CFs - Firm ’ s CFs Cash Flows with Project without Project l Only Incremental Cash Flows are Relevant. »Include all incidental effects, including project interactions. »Don ’ t forget to include investment in working capital. »Forget about sunk costs. »Include all opportunity costs (e.g., land used to construct a new plant). »Beware of allocated overhead expenses.

32. 32 Estimating Relevant Cash Flows: Basic Principles l Discount Cash Flows, Not Accounting Profits. »For capital budgeting purposes, the point of recognition is when the money is actually received or spent. »Don ’ t forget the effect of taxes. l Separate Investment and Financing Decisions »Ignore all financing costs, even if the project is partially financed with debt. »Treat the project as if it were all-equity financed. »Financing side effects will be considered later.

33. 33 Depreciation l Depreciation is a non-cash expense that only affects cash flows through its tax effect. l Assets are depreciated down to their estimated salvage values. l Any removal costs associated with old equipment are expensed immediately. l Sales tax, delivery costs, and installation are regarded as part of the cost of the new asset for depreciation purposes. l Removal costs of the old asset are not regarded as part of the cost of the new asset and are expensed immediately. l If an asset is later sold for an amount above (below) its book value, the excess is taxable (deductible).

34. 34 Example: Estimating Cash Flows l A new machine costs $60,000 »installation costs of $2,000. »generates revenues of $155,000 and »expenses of $100,000 annually. »depreciated to its estimated salvage value over of $6,000 over its seven year life. –What are the relevant cash flows?

35. 35 Compute Cash Flows Step 1: Compute Tax cash flows Step 2: Compute Cash Flows

36. 36 Cash Flow and Accounting Numbers: How to Value a Company l The value of the firm is the present discounted value of all net cash flows accruing to all security holders (debt and equity). l Define: The capital cash flow of period t CCF(t) is the net cash flow received by all security holders of the firm combined: CCF=EBIT -(EBIT - Interest)*T -Depreciation & Amortization -Change in working capital -Capital Expenditure +Asset Sales

37. 37 Since Net Income = (1 - T)*(EBIT - Interest) we have the alternative definition: CCF=Net Income + Interest - Depreciation & Amortization - Change in working capital - Capital Expenditure + Asset Sales Then we can value a company as: where r is the company ’ s cost of capital. Capital Cash Flows

38. 38 Summary and Preview l Most investment and financing problems can be analyzed as capital budgeting problems l Focus is on cash flows, not accounting numbers »Use accounting numbers, remove non-cash flow charges like depreciation –However, depreciation has tax consequences –Taxes are cash flows l Capital budgeting always focuses on decisions, hence »Include all cash flow consequences affected by a decision On the agenda: l Take into account the time value of money l Use single criterion to evaluate project »NPV, compare with IRR, payback l Account for risk, inflation, and taxes