Transcript day 10 - 0209.ppt

Chapter
6
Common Stock
Valuation: Putting all
the pieces together
Objectives
• We now have an understanding of the how to compute all
the inputs for our models except the growth rate in cash
flows and earnings.
• In this lecture, our objectives are to:
– Understand methods of computing growth rates.
– Put all the pieces together to estimate intrinsic value using the
DCF and RI models.
– Understand the differences and benefits of the models.
– Understand the process of evaluating a company within an
industry.
6-2
Estimating future growth: DCF model
• A key assumption in all discounted cash flow models is
the period of high growth, and the pattern of growth
during that period. In general, we can make one of two
assumptions:
– there is no high growth, in which case the firm is already in
constant growth
– there will be high growth for a period, at the end of which the
growth rate will drop to the stable growth rate (2-stage). Some
advocate a smoother drop in growth between the first and second
stages.
• We need to determine the growth rates in each period
as well as the length of the different periods if a 2stage model is used.
6-3
Estimating growth rates: DCF model
• With the DCF model, if we assume a constant growth
model, then a growth rate of 2.5 – 3.5% per year for
FCFF should be used. This is the expected growth rate in
the economy overall (in GDP).
• We would not expect a firm’s FCFF to grow much faster
(or much slower) than the economy overall in the long
run.
6-4
Estimating growth rates: DCF model
• With a 2-stage model, we use similar intuition to set the
growth rate in this stage between 2.5 – 3.5%.
• When valuing firms in declining (growing) industries, we
would use a growth rate toward the lower (upper) end of
the range.
6-5
Estimating 1st stage growth rates/FCFF
• With a 2-stage DCF model, we need to estimate growth
rates during the first stage to calculate FCFF during this
first stage. We can do this in a few different ways:
– Use a historical growth rate in FCFF as a proxy for the growth
rate over the next few years.
– Use a “percentage of sales” method to forecast FCFF.
– Use analysts estimate for growth rates.
6-6
Estimating 1st stage growth rates: Historical growth rate
• Using historical growth rates:
– Calculate the FCFF for the firm for the past few years
(usually 5-10 years).
– Calculate the geometric average growth rate:
 FCFF ( N ) 
g

 FCFF (0) 
1/( N 1)
1
• This approach would be appropriate if FCFF tended to
grow at a constant rate and if historical relationships
between free cash flow and fundamental factors were
expected to be maintained.
6-7
Estimating 1st stage growth rates: Percent of Sales Method
• With the percentage of sales method, we can compute
1st stage FCFF directly.
• We need to first determine an appropriate growth rate
in sales during the 1st stage.
• With this method, we would forecast the individual
components of FCFF.
– EBIT: forecasted using an appropriate EBIT margin based on
historical data and the current and expected economic
environment.
Forecasted EBIT = Sales forecast * EBIT margin
6-8
Estimating 1st stage growth rates: Percent of Sales Method
– FCInv: This represents the incremental capital expenditure
required to meet the growth in sales.
– It can be computed as:
FCInv  Sales growth ($) *
Capital expenditur e - depreciati on
Sales growth ($)
– The second component can be estimated using previous years’
ratios.
6-9
Estimating 1st stage growth rates: Percent of Sales Method
– WCInv: This represents the incremental working capital
investment required to meet the growth in sales.
– It can be computed as:
WCInv  Sales growth ($) *
Increase in working capital
Sales growth ($)
– The second component can be estimated using previous years’
ratios.
– Be sure to include other Non-Cash Charges in your
forecasts.
6-10
Estimating 1st stage growth rates: Analyst estimates
• There are numerous sources for obtaining estimates for
growth rates (especially earnings growth). Some of
these sources include:
– S&P Net Advantage
– Value Line Investment Survey
– Yahoo Finance
6-11
Determinants of length of the 1st stage
• Size of the firm
– Success usually makes a firm larger. As firms become larger, it
becomes much more difficult for them to maintain high growth
rates
• Current growth rate
– While past growth is not always a reliable indicator of future
growth, there is a correlation between current growth and future
growth. Thus, a firm growing at 30% currently probably has
higher growth and a longer expected growth period than one
growing 10% a year now.
6-12
Determinants of length of the 1st stage
• Barriers to entry and differential advantages
– Ultimately, high growth comes from high project returns, which,
in turn, comes from barriers to entry and differential advantages.
– The question of how long growth will last and how high it will be
can therefore be framed as a question about what the barriers to
entry are, how long they will stay up and how strong they will
remain.
6-13
Determinants of length of the 1st stage
• Questions to ask about firms:
– What drives revenue growth? Can that be maintained?
– What kinds of capital expenditure will be required to maintain free
cash flow growth?
– Can firms maintain their operating and gross margins?
• Standard 1st stage lengths used are 5 years and 10 years.
6-14
Firm characteristics as growth changes
Variable
High Growth Firms
Firms tend to
Stable Growth
tend to
Risk
Dividend Payout
Net Cap Ex
be of above-average risk
pay little or no dividends
have high net cap ex
ROC
earn high ROE
Leverage
have little or no debt
be of average risk
pay high dividends
have low net cap ex
(just covering depreciation)
earn ROE closer to cost of
equity
have higher leverage
6-15
Putting it all together: DCF Model
• The intrinsic value of the firm is calculated as the present value of
all future FCFF.
• The intrinsic value of the equity of the firm is:
Value of equity  intrinsic value of firm - market val ue of debt
• The intrinsic value of equity per share then is:
intrinsic value of equity
Value of equity / share 
shares outstandin g
6-16
Forecasting Residual Income: RIM
• With the RIM, we need to estimate future earnings (net income) or
ROE, and dividends.
• The 2-stage RIM tends to be logically more appropriate for firms
because a constant growth RIM assumes that ROE will be greater
than k indefinitely.
• We can estimate future earnings using the same methods used to
estimate future FCFFs: historical growth rate, analyst estimates,
percent of sales method.
• Future dividends can be estimated by looking at historical
relationship between earnings and dividends and at the industry
average.
• Alternatively, we could estimate ROE in future years, and assume
that it will decline to the cost of equity in the 2nd stage.
6-17
Putting it all together: RIM
• The intrinsic value of equity is calculated as the current book value
plus the present value of all future residual incomes.
• The intrinsic value of equity per share then is:
Value of equity / share 
intrinsic value of equity
shares outstandin g
6-18
DCF and RIM vs. relative valuation
• DCF and RIM valuation assumes that markets make
mistakes in estimating value (i.e., current price is not an
accurate reflection of the value of the firm) and these
mistakes tend to be corrected over time and can occur
over entire sectors.
• Relative valuation assumes markets are correct on
average (i.e., comparables on average are correctly
priced)
6-19
Strengths of the RI model versus the DCF model
• Terminal value does not make up a large portion of the
total value
• The model can be used for companies that do not pay
dividends and/or firms that have near-term negative free
cash flows
• The model can be used when cash flows are
unpredictable or difficult to forecast. This can be
particularly true for financial institutions.
6-20
Weaknesses of the RI model
• The model relies on accounting data that can be subject
to manipulation
• When book value and ROE are unpredictable, the
resulting estimate is less valid.
6-21
Readings
• Reserve Material
6-22