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Firm Value

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

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Firm Value

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  1. Firm Value 06/05/2008 Ch. 12

  2. 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

  3. 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

  4. 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)?

  5. 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

  6. 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<∞)

  7. 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

  8. 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…

  9. 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

  10. 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?

  11. 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)

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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?

  18. 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

  19. 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

  20. Questions? • Review for exam • Last minute questions on projects • Other

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