VALUATION Five Categories of Valuation Methods 1 2
- Slides: 29
VALUATION
Five Categories of Valuation Methods 1. 2. 3. 4. 5. Discounted cash-flow Market-based Mixed models Asset-based methods Option-based methods
Discounted Cash-Flow Approach n n n 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
Discounted Dividend Valuation Most straightforward approach Explicit cash flows received by equity investors n n n Dividends Terminal value when shares are sold Firm is expected to have an infinite life
Discounted Dividend Valuation Theoretical Model n No-growth, constant dividend n Dividends are growing at rate g
Discounted Dividend Valuation Required rate of return (r) r is the rate of return demanded on a n specific investment n n Based on investor’s assessment of risk CAPM
CAPM -- Example n n rf, Risk-free (30 -year Treasury bond) = 5% rm, Expected stock market return = 10% n n Risk premium = (rm – rf) Beta = 1. 5 r = 5% + 1. 5(10%-5%) r = 12. 5%
Discounted Dividend Valuation Required rate of return (r) n For nonpublic companies, use a buildup model and historical sources for data n n n Begin with risk-free rate + Equity risk premium + Small company premium + Company specific risk premium = Required rate of return
Discounted Dividend Valuation Growth rate (g) n Top-Down analysis n n n Begin with growth of economy Adjust for industry, sector and company factors Sustainable growth = ROE(1 -Payout rate) n n ROE = Earnings/Average equity Payout rate: proportion of earnings used to pay dividends or repurchase shares
Discounted Dividend Valuation - example n Company A n n n Annual dividend = $0. 16 Beta = 1. 35 ROE = 13% Payout ratio = 20% Economic n n 20 -year Treasury bond = 4. 75% Historical market risk premium = 5. 4%
Discounted Dividend Valuation - example n r =. 0475+1. 35(. 054) =. 120 g =. 13(1 -. 20) =. 104 n Value = $11. 04… n
Discounted Dividend Valuation n Assumes a single, constant growth rate (g) What if growth rates differ? Use a multi-stage model to calculate future dividends n n Calculate future stock value based on future dividend Calculate present value of stock and dividends
Discounted Operating Cash-Flow Models n n 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
FCFF or FCFE
Discount Rate n FCFF n n Weighted Average Cost of Capital FCFE n Cost of Equity (required rate of return)
Discounted Operating Cash-Flow Models Other considerations n Growth n n Can use a multi-stage model to accommodate rate changes Forecasting cash flows requires judgment n n Begin with reported, historical cash flow and earnings Make company-appropriate adjustments
Special Issues n n n Loss generating firm valuation Closed Firm Valuation Start-up companies
Valuation Of GAP Retail Stores
FCFF-Stable Growth
Market-based Models n n n 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
P/E Model n n 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 n n Peer firms and their prices Historical (average) data
P/E Model n Firms with no internal growth prospects, paying out 100% of earnings n n Current P/E = 1/r Constant growth, Leading P/E n P 0/E 1 = (D 1/E 1)/(r-g) n D = annual dividends, E = EPS
P/E Model - Example n n 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
Mixed Models n n n 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
Asset-Based Models n n Used when a company is going to be liquidated Valuation is based on underlying assets n n n Market value of balance sheet items Assets and liabilities Also called cost or adjusted book value approach
Options-Based Models n Theoretically elegant but practical application is difficult n n Analyst must have information about opportunities (and their value) available to a firm Equity ownership is viewed as an option call on the firm n Limited downside, unlimited upside
Selecting a Model n Consider characteristics of the firm n n Dividend paying Growing Likely to be liquidated Consider data availability of data n Publicly available or closely held
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