Transcript Firm Value 06/05/2008 Ch. 12 What is a firm worth?  Firm Value is the future cash flow to each of the claimants (Cash.

Firm Value
06/05/2008
Ch. 12
What is a firm worth?
 Firm Value is the future cash flow to each of the
claimants (Cash is King)



Shareholders
Debt holders
Government
 When we talk of value of an asset…it is the price two
independent agents are willing to exchange the asset
at an arm’s length




Neither are forced to complete the transaction
The price reflects the value to the two parties
For a real asset it is the characteristics of the asset
For a financial asset it is simply the cash flows or the
rights to the cash flows
2
Firm Valuation
 Determining the cash flow to the owner…
 Four Methods
 Efficient Market Approach, take trading price of the
share x number of outstanding shares
 Discounted Cash Flow Approach I
 CF to Equity discounted at cost of equity (FCFE)

Discounted Cash Flow Approach II
 CF to Firm discounted by WACC (FCFF)

Relative Value
 Use financial ratios to determine value
 In Theory all four methods should give same value
3
Firm Value in an Efficient Market
 From the perspective of the owner


Value of the firm is the price of the shares
times the outstanding shares
Example, 3M



Current price per share is $76.51 (as of close of
business 6-4-2008)
Shares outstanding 704,290,000 (as of close of
business 6-4-2008)
Value = $53,779,580,000
 Is the market right (value to equity holders)?
4
Firm Value DCF Approach l
 Discount all future cash flows to equity
holders
Method A – Dividends are all future cash flow
 Method B – Find Free Cash Flow to Equity
(FCFE)
 Assumption of models…
 Growth rate is needed
 Growth rate may be different over time
 High Growth Period
 Stable Growth Period

5
Quick Review of Dividend Model
 Gordon’s Dividend Growth Model




No-growth, infinite horizon (g=0, n=∞)
No-growth, finite horizon (g=0, n<∞)
Constant growth, infinite horizon (g>0, n=∞)
Constant growth, finite horizon (g>0,n<∞)
E Div  1  g    1  g 
P0 
x 1  

r  g 
  1  r 
n



6
Different Growth Periods
 High Growth Period
 Start-up or time when firm is still expanding
 Transition Growth Period
 Moving to Stable or Constant Growth
 Stable or Steady or Constant Growth Period
 Mature Business – will continue at this rate forever
 Means that the firm is growing at the risk-free rate
 Find the PV of the dividends (of FCFE or FCFF) for
each of these periods
 Assumption today…transition is immediate
 High Growth Period + Stable Growth Period = Value
7
3M and Discounting Dividends
 Dividend (annual for 2007…$0.48 x 4 = $1.92)
 Dividend growth rate past ten years
1996 $1.06
 2007 $1.92
 Growth rate 6.12%
Required Return on Equity
 Beta 0.82
 Risk-free rate 3%
 Expected return on the market 12%
 R = 3% + 0.82 (9%) = 10.38%
If 3M at steady growth…
Price = $1.92 x (1.0612) / (0.1038 – 0.0612) = $47.83
Market has overpriced 3M unless…





8
Fixing the Dividend Model
 3M is still in its growth period and will move to
stable in 20 years…
 Need to have estimate for years 1 to 20 at the
current rates
 Need to estimate 21 to infinity with infinite
model but need to change…


Growth rate to 3% (risk-free rate)
Beta to 1.0
 P = $47.83 x (0.5448) + $36.70 / (1.1038)20
 P = $31.15
9
Finding Numbers that Work
 If we believe the market is efficient…
 Then our estimates of beta may be off
 Growth rate may be off
 Risk-free rate may be off
 Expected return on the market may be off
 Finding values that work for $76.50
 At a steady growth and infinite horizon
 If beta is 0.64256 all else held constant…
 Price = $1.92 x (1.0612) / (0.0878 – 0.612) = $76.50
 Which variable needs adjusting?
10
DCF Approach l
 Same concept except now we find the FCFE
and plug into the dividend model with a
growth rate and required return on equity
 FCFE = Net Income + Depreciation – Capital
Expenditures - Working Capital – Principal
Repayments on Debt + New Debt Issued
 We also need growth in FCFE
 Required return on equity (from SML)
11
After-Tax Cash Flow of Dividends
 FCFE (3M)
 2005 -- $2,480,000
 2006 -- $4,793,000
 2007 -- $5,053,000
 Growth rates
 2006 – 93.3%
 2007 – 5.4%
 Cost of Equity…10.38% or 12.0% or 15.2%
 $5,053 x (1.054) / (.153 - .054) = $53,780 Million
 Implies a beta of 1.367
12
DCF Approach ll
 Free Cash Flow to Firm and then divide by WACC
 FCFF = EBIT x (1 - t) (1 – Reinvestment Rate)
 Where
Reinvestment rate:
(Capital Expenditures – Depreciation + Working Cap.)
EBIT ( 1 – tax rate)
 Again we can look a 3M and estimate this number
 FCFF = $4,029 (million)
 Estimate of growth rate of FCFF 6.19%
 WACC estimate…11.37%
 Firm Value = $4,029 x (1.0619) / (0.1137 – 0.0619)
 Firm Value = $82,594
 Equity Value = $82,594 – $7,585 = $75,009

13
Adjustments to DCF ll
 Fix WACC to find equity value of $54,139
 IF we choose a WACC of 13.12%
 $4,029 x (1.0619) / (0.1316 – 0.0619) = 61,365
 Equity Value = $61,365 - $7,585 = $53,780
 What beta does this imply?




If book D/E is $7,585 / $11,747 = 0.6457
Keep cost of debt at 8% and tax rate at 32%
Cost of Equity must be 18.13%
Beta must be 1.68
14
Method Four – Relative Value
 Standardize the assets



Relative to earnings
Relative to book value or replacement value of
the assets
Relative to revenues
 Sensitivity Analysis also needed to adjust the
numbers for differences across firms
 Find comparable firms…

Similar risk, cash flow, and growth potential
15
Relative Value Continued
 Price to Earnings Ratio
 Here we assume that the market has properly priced
the cash flow of a firm
 P/E is price per share divided by earnings per share
 Backward looking vs. Forward looking
 Price = $76.50 and Earnings = $6.03
 Forward P/E = 12.68656716
 Net Income is $4,096
 Equity Value = $4,096 x 12.69 = $51,964
 If 3M P/E looks out of line with other large
manufacturing firms…substitute the industry average
16
Relative Value Continued
 Price to Book-Value




Return on Equity x Payout Ratio x (1+g)
(Cost of equity – g)
Return on Equity = 37.74%
Payout Ratio = 34%
Growth rate = 6%
Cost of Equity = 10% (mature firm beta = 0.82)
 P to B-V = 3.3760
 How does this compare?
17
Relative Value
 Price to Sales
 From the “book” regression…
 P to S = 0.04 x g + 0.011 payout ratio + 0.549 beta +
0.234 net margin
 For 3M
 g = 6%
 Payout ratio is 34%
 Beta is 0.82
 Net margin (profit margin) 16.74%
 P to S = 0.04 (0.06) + 0.011 (0.34) + 0.549 (0.82) +
0.234 (0.1674) = 0.4933 or 49.33%
 P to S for 3M is revenue / price = $34.055 / $76.51=
0.4451
18
What is the true value of a Company?
 What you can sell it for…
 If you believe efficient markets and the
markets are liquid…
 Share price is the true value
 Some caveats
 Share price is for a small portion of ownership
 What if you wanted to buy the whole company
in a short period of time?
 Takeover prices higher than current share
price – must climb the “ask” ladder
19
Questions?
 Review for exam
 Last minute questions on projects
 Other
20