Chapter 11

AN INTRODUCTION TO VALUATION

Chapter 11 Questions

• • • • When valuing an asset, what are the required inputs?

After we have valued an asset, what is the investment decision process?

What are the tow major approaches to the investment decision process?

What are the specifics and logic of the top-down, three-step approach?

Chapter 11 Questions

• • • • • How do we determine the value of bonds?

What causes a change in the value of a bond?

How do we determine the value of preferred stock?

What are the two primary approaches to the valuation of common stock?

Under what conditions is it best to use the present value of cash flow approach for valuing a company’s equity?

Chapter 11 Questions

• • • • What conditions make it appropriate to use the relative valuation techniques for valuing a company’s equity?

What are the major discounted cash flow valuation techniques?

What is the dividend discount model (DDM), and what is its logic?

What is the effect of the assumptions of the DDM when valuing a growth company?

Chapter 11 Questions

• • • • • How do we apply the DDM to the valuation of a firm that is expected to experience temporary supernormal growth?

How do we apply the present value of operating cash flow technique?

How do we apply the present value of free cash flow to equity technique?

How do we apply the relative valuation approach?

What are the major relative valuation ratios?

Chapter 11 Questions

• • • What does the DDM imply are the factors that determine a stock’s P/E ratio?

What two general variables need to be estimated in any valuation approach?

How do we estimate the major inputs to the stock valuation models: (1) the required rate of return and (2) the expected growth rate of earnings, cash flows, and dividends?

What determines the value of an asset?

• The value of a financial asset is the present value of expected future cash flows received from the asset • Required inputs: – A discount rate used to calculate the present value of the cash flows – The stream of expected future cash flows

Discount Rate

Determined by: 1. The real risk-free rate of return (to compensate for the time for which funds are invested), plus 2. The expected rate of inflation, plus 3. A risk premium to compensate for the uncertainty of returns • Sources of uncertainty, and therefore risk premiums, vary by the type of investment

Stream of Expected Cash Flows

• • Types of cash flows Depending on the investment, cash flows can be in the form of: – Dividends – Interest payments – Capital gains Cash flows are sometimes easy to estimate (E.g. Government bonds) but can also be very difficult to estimate (E.g. Growth stocks)

Investment Decision Process

• Once expected (intrinsic) value is calculated, the investment decision is rather straightforward and intuitive: – If Estimated Value > Market Price, buy – If Estimated Value < Market Price, do not buy • The particulars of the valuation process vary by type of investment

The Valuation Process

• Two basic approaches: – Top-down, three-step approach – Bottom-up, stock-picking approach

• •

General Approaches to Security Analysis

Top-Down Approach (Our focus) 1. Review the macro-economy 2. Analyze different industries and sectors 3. Determine buy/sell candidates Bottom-up Approach – Focus primarily on the firm-specific factors that will lead to finding undervalued companies, regardless of industry or macroeconomic factors

A Three-Step Process

• • Within the three-step process of the top-down approach, all steps are crucial General economic influences – Government policies strongly influence the economic environment, leading to profound effects on industries – We can see the influence of changes in the overall economy on various classes of investments

A Three-Step Process

• • Industry Influences – We seek to determine which industries will likely do better than others in the expected economic environment – Also, changing demographic factors have different effects across industries Company Analysis – Individual investments will either make or break portfolio performance – Once well-positioned industries are determined, find well-positioned firms within those industries

A Three-Step Process

• There is academic support for this top-down approach – Most changes in individual companies’ earnings related to changes in aggregate earnings and changes in a firm’s industry – There is a relationship between stock and bond prices and macroeconomic variables – Rates of return for individual stocks can be explained by the aggregate stock market and the firm’s industry

A Three-Step Process

Three cheers for the three-step process!

Review of Valuation Components

• The value of a financial asset is the present value of its expected future cash flows • Two components: – The required rate of return on the investment – The stream of expected future returns, or cash flows

Required Rate of Return

• • Determined by the risk of an investment and available returns in the market Determined by: 1. The real risk-free rate of return, plus 2. The expected rate of inflation, plus 3. A risk premium to compensate for the uncertainty of returns • Sources of uncertainty, and therefore risk premiums, vary by the type of investment

Stream of Expected Returns (Cash Flows)

• From of returns Depending on the investment, returns can be in the form of: – Earnings – Dividends – Interest payments – Return of principal • Time period and growth rate of returns When will the cash flows be received from the investment?

Valuation of Alternative Investments

• • • We will consider the valuation of three important types of investments: The valuation of bonds The valuation of preferred stock The valuation of common stock

Valuation of Bonds

• • • What are the cash flows?

Bond cash flows (typically fixed) – Interest payments every six months equal to one half of: (Coupon rate x Face value) – The payment of principal (Face or par value) at maturity Discount at the required rate of return to find the bond’s value Process made relatively easy with a financial calculator or spreadsheet software

Bond Valuation Principles

• • The value of a bond moves in the opposite direction of the discount rate For a given change in the discount rate, the change in value will differ depending on the characteristics of the bond – More on this in Chapter 12

Valuation of Preferred Stock

• What are the cash flows?

– Preferred stock cash flows • Stated, usually fixed, dividends for an infinite period • Since there is no maturity, the payments represent a perpetuity

Valuation of Preferred Stock

• • The discount rate on preferred stock – Payment by the firm does not carry the same legal obligation as with bond cash flows, so preferred is more risk indicating the discount rate should be higher than the bonds of the same corporation – Preferred dividends have a tax advantage over interest income from bonds for some investors, indicating a lower required rate of return The yield on preferred is generally lower than the yield on high quality bonds

Valuation of Preferred Stock

• Present value of a perpetuity: V = PMT/Discount rate • Value of Preferred Stock: • V = Dividend/k P • k P = Required Return on Preferred Yield on Preferred Stock: k P = Dividend/Price

• •

Approaches to Common Stock Valuation

Discounted Cash Flow Techniques – Present value of Dividends (DDM) – Present value of Operating Cash Flow – Present value of Free Cash Flow Relative valuation techniques – Price-earnings ratio (P/E) – Price-cash flow ratios (P/CF) – Price-book value ratios (P/BV) – Price-sales ratio (P/S)

•

When to Use Discounted Cash Flow Valuation

What is the measure of cash flow?

– Dividends • These cash flows that go straight to the investor, and would be discounted at the required return on the stock • Difficult to apply to firms that pay low or no dividends because of growth opportunities • Most applicable to stable, mature firms where the assumption of relatively constant growth for the long term is appropriate

When to Use Discounted Cash Flow Valuation

• What is the measure of cash flow?

– Free cash flow to equity • Measure of cash flows available to equity holders, including those retained by the firm, would be discounted at the firm’s cost of equity – Operating free cash flow • Measure of cash flows available to all suppliers of capital to a firm, would be discounted the firm’s weighted average cost of capital

• • •

When to Use Discounted Cash Flow Valuation

Potential difficulty is that estimates of value are highly dependent on two important inputs: – The growth rates of cash flows – The estimate of the appropriate discount rate Small changes can be drastic differences GIGO

When to Use Relative Valuation

• Relative valuation focuses on how the market is currently valuing financial assets – This does not necessarily imply that current valuations are appropriate – The overall market or a particular industry can become seriously overvalued or undervalued for a period of time

When to Use Relative Valuation

• Appropriate to use under two conditions: – You have a good set of comparable entities • Similar size, risk, etc.

– The aggregate market or the relevant industry is not at a valuation extreme • It is fairly valued

Which approach to use?

• • No need to choose!

The best approach is to use both approaches to come up with the best valuation estimate possible.

Discounted Cash Flow Techniques

• • Based on the basic valuation model: the value of a financial asset is the present value of its expected future cash flows V j = S CF t /(1+k) t The different discounted cash flow techniques consider different cash flows and also different appropriate discount rates

Dividend Discount Models

• Simplifying assumptions help in estimating present value of future dividends V j = S D t /(1+k) t Can also assume various dividends for a finite period of time with a reselling price, and simply calculate the combined present value of the dividends

Dividend Discount Models

• Infinite Period DDM Constant Growth Model: – Assumes dividends started at D 0 (last year’s dividend) and will grow at a constant growth rate – Growth will continue for an infinite period of time – The required return (k) is greater than the constant rate of growth (g) V = D 1 /(k-g) where D 1 = D 0 (1+g)

Dividend Discount Models

• Constant Growth Model – Growth rate • Can be estimated from past growth in earnings and dividends • Can be estimated using the sustainable growth model – Discount rate • The required rate of return on the stock

Dividend Discount Models

• Valuation with Temporary Supernormal Growth – If you expect a company to experience rapid growth for some period of time 1. Find the present value of each dividend during the supernormal growth period separately 2. Find the present value of the remaining dividends as of the beginning of the period when constant growth starts.

3. Find the present value of the remaining dividends by finding the present value of the estimate obtained in step 2.

Present Value of Operating Cash Flows

• Another discounted cash flow approach is to discount operating cash flows – Operating cash flows are pre-interest cash flows, so the required rate of return would be adjusted to incorporate the required returns of all investors (use the WACC) V Fj = S OCF t /(1+WACC j ) t

Present Value of Operating Cash Flows

• If we further assume a growth rate of g OCF for operating cash flows, we can value the firm as: V Fj = OCF t /(WACC j – g OCF )

Present Value of Free Cash Flow to Equity

• • A third discounted cash flow technique is to consider the free cash flows of a firm available to equity as the cash flow stream to be discounted.

Since this is an equity stream, the appropriate discount rate is the required return on equity V Sj = S FCF t /(1+k j ) t

Present Value of Free Cash Flow to Equity

• Once again, if we constant growth in free cash flows, this expression reduces to the following V Sj = FCF t /(k j – g FCF )

Relative Valuation Techniques

• • • • These techniques assume that prices should have stable and consistent relationships to various firm variables across groups of firms Price-Earnings Ratio Price-Cash Flow Ratio Price-Book Value Ratio Price-Sales Ratio

Relative Valuation Techniques

• Price Earnings Ratio – Earnings Multiplier Model – Affected by two variables:

P

/

E

1 

D

1

k

 /

E

1

g

1. Required rate of return on its equity (k) 2. Expected growth rate of dividends (g)

Price-Earnings Ratio

• • Look at the relationship between the current market price and expected earnings per share over the next year – The ratio is the earnings multiplier, and is a measure of the prevailing attitude of investors regarding a stock’s value P/E factors – Expected growth in dividends and earnings – Required rate of return on the stock

Price-Earnings Ratio

• 1.

2.

3.

Using the P/E approach to valuation: Estimate earnings for next year Estimate the P/E ratio (Earnings Multiplier) Multiply expected earnings by the expected P/E ratio to get expected price V =E 1 x(P/E)

Price-Cash Flow Ratio

• Cash flows can also be used in this approach, and are often considered less susceptible to manipulation by management.

• The steps are similar to using the P/E ratio V =CF 1 x(P/CF)

Price-Book Value Ratio

• • Book values can also be used as a measure of relative value The steps to obtaining valuation estimates are again similar to using the P/E ratio V =BV 1 x(P/BV)

Price-Sales Ratio

• • Finally, sales can be used in relation to stock price. – Some drawbacks, in that sales do not necessarily produce profit and positive cash flows – Advantage is that sales are also less susceptible to manipulation The steps are similar to using the P/E ratio V =S 1 x(P/S)

Implementing the Relative Valuation Technique

1.

Compare the valuation ratio for the company to the comparable ratio for the market, industry, and other firms 2.

• • Explain the relationship Why is the ratio similar or different?

Do fundamental factors justify a difference in relative valuation?

Estimating the Inputs

• Two critical inputs common on most valuation models: – The Required Rate of Return – Expected Growth Rates

The Required Rate of Return

• Three influences: – The economy’s real risk-free rate (RRFR) – The expected rate of inflation E(I) – A risk premium • The first two influences collectively determine the nominal risk-free rate (NRFR): NRFR = [1 + RRFR] [1 + E(I)] – 1

The Required Rate of Return

• • The risk premium varies between different securities, due to differences in: – Business risk, financial risk, liquidity risk – Additionally, exchange rate risk, political risk for international investments Risk premiums change over time as investors attitudes toward risk and expectations of the future change

Expected Growth Rates

• • • Often need growth rates to estimate future values for cash flows Estimating growth from fundamentals g = (Retention Rate) x (Return on Equity) Growth is a function of earnings retention, profitability, asset turnover, the use of leverage (Modified DuPont) ROE = NPM x TAT x FLM

Estimating Growth Rates

• Estimating growth based on history – Can look at historic averages in growth • Geometric or arithmetic means – Can use various models • Linear regression: EPS

t

• Log-linear regression: = a + b

t

ln (EPS

t

) = a + b

t