1. Three Approaches to Value There are three general approaches that we use to value any asset. –Discounted Cash Flow Valuation –Relative Valuation –Contingent Claim Valuation Each methods has its purpose and its limitations.

2. Discounted Cash Flow The value of any asset depends on the discounted value of the assets’ cashflow How much would you pay for bond if the bond would pay you 1000 in 1 year and nothing else? Further assume that the payoff is 100% certain and you know inflation will be 4%. How much would you pay for piece of rental property if the expected rents are $6000 next year and it will cost $1000 to keep the place up next year? Further assume that the rent and costs grow at 4%, an investment of similar risk returns 10% and with the 1000 in up keep the income is a perpetuity.

3. Discounted Cash Flow We are willing to pay = or < the value of the future cash flow The value of a share of stock is the value of the company less any proceeds that must be paid to other security holders divided by the number of shares outstanding. There are two commonly used methods of implementing discounted cash flows to valuing companies:

4. Sequential Valuation 1.In Sequential Valuation, we first value the entire firm using the firm’s cash flows. 2.We then subtract from that firm value the proceeds “owed” to other security holders or the value of other securities (ex. Debt, Preferred Stock, Warrants, etc….) 3.The final step is to divide the value left for equityholders by the number of shares outstanding to get the estimated value per share. Thus, you value each type of security sequentially.

5. Sequential Valuation To value a firm, you must project the firm’s cash flow FOREVER. –This is typically done by dividing the firm’s life into two periods: a non-constant and terminal value (often a constant growth period). Hemp Rope and Paper makes fabric products from the hemp plant. The firm is a small operation, but expects to have high growth for the next 10 years as the US rediscovers the benefits of their product. The firm had free cash flow of only $500 last year. However it plans to double that next year and grow at 50% for two more years. It further expects to continue growing for 15 more years at 12% growth. It plans to stabilize after 16 years at a modes 6% growth. If the firm’s cost of capital is 15%, and the firm has 5,000 shares of stock and $10,000 in debt outstanding, what is the one share of stock?

6. Hemp Rope and Paper Value

7. Rules to Discounted Cash Flow Valuation Non-constant growth calculation –Estimate Cash flow for all years –Discount cash flow –Note: growth annuity calculation may be helpful but can only use if r > g! Terminal Value –Two ways typically calculated 1.If can estimate constant growth rate, use perpetuity equation. –Timing is essential here. –You use the cash flow after one year of the constant growth rate. –This gives the value at the point when growth became constant, so the value must be discounted to t=0. 2.If you are unable to estimate constant growth, you can use an exit multiple. (to be discussed later)

8. Direct Valuation Sequential Valuation values the entire firm and then uses this firm value to get to an equity value. Direct Valuation Values the cash flows to the equity holders. –Cash flows to equity holders are the free cash flow of the firm less any annual payment to other security holders. –Since you value equity cash flow, you must use the cost of equity not the firm cost of capital

9. Direct Valuation: Hemp Co. Hemp Rope and Paper has $10,000 of debt. Let’s assume that the firm must make payments of $1,500 on this debt forever. Further, assume that the firm’s cost of capital is the same as its cost of equity and its cost of debt. What is the value of a share of stock in Hemp?

10. Direct vs. Sequential Valuation In the previous example, we saw that Direct and Sequential valuation provide the same value per share. The difference is the implementation. –In sequential, you need The firm cash flows and cost of capital. The value of each all securities. The number of shares of stock –In direct, you need The firm cash flows The cash flow and required return for each all securities. The number of shares of stock –It is easier to calculate the value than the cash flow and return to some types of securities.

11. Alternative Direct Valuations Alternatively, you can use dividends instead of the cashflow to equityholders. However, –Dividends may not equal free cash flow to equity holders –Firms distribute funds by methods other than regular dividend We will focus on sequential rather than direct valuation in this class.

12. Relative or Multiples Valuation –Compare the value of an asset to the values assessed by the market for similar or comparable assets. Steps: –Choose comparable firms –Choose bases for multiples: Examples: P/E ratio and M/B ratio –Average (or get the median) of the industry or comparable firms –Project bases for valued firm (i.e. if using P/E ratio, project the firm’s earnings)

13. Relative Valuation Example Seafood Inc. is expected to have Earnings per Share of 1.43 for the 2000 fiscal year. The firm is a seafood wholesaler operates in the wholesale meat products industry. This industry has a P/E ratio of 20. What is the value of a share of stock in Seafood Inc. using relative valuation?

14. Relative or Multiples Valuation Problems: –How do you identify comparable firms? –Is everything that determines value the same for the firms? –Often used to “avoid making assumptions about the firm,” but make lots of assumptions (i.e. assume everything is the same) –Is is better to make several individual (hopefully informed) assumptions or one general assumption. Why do people use multiples? –Simple to compute –Intuitively appealing –Not concerned with over simplification and willing to sacrifice accuracy. –Other people do it, so….

15. Contingent Claims Valuation –A contingent claim or an option is an asset that pays off only under certain contingencies. Example – Stock options (call options) or warrants payoff only if the stock price is above a certain threshold. There are option pricing models such as the Black-Scholes Formula to value options or assets with option like features. –Other corporate assets are also contingent claims such as patent or investments in R&D. These are referred to as real options. –Valuing these assets is beyond the scope of this class.