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VALUATION

VALUATION. Five Categories of Valuation Methods. Discounted cash-flow Market-based Mixed models Asset-based methods Option-based methods. Discounted Cash-Flow Approach. Estimated future cash flows are discounted back to present value based on the investor’s required rate of return

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VALUATION

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  1. VALUATION

  2. Five Categories of Valuation Methods • Discounted cash-flow • Market-based • Mixed models • Asset-based methods • Option-based methods

  3. Discounted Cash-Flow Approach • 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

  4. Discounted Dividend Valuation • Most straightforward approach • Explicit cash flows received by equity investors • Dividends • Terminal value when shares are sold • Firm is expected to have an infinite life

  5. Discounted Dividend ValuationTheoretical Model • No-growth, constant dividend • Dividends are growing at rate g

  6. Discounted Dividend ValuationRequired rate of return (r) • r is the rate of return demanded on a specific investment • Based on investor’s assessment of risk • CAPM

  7. CAPM -- Example • rf, Risk-free (30-year Treasury bond) = 5% • rm, Expected stock market return = 10% • Risk premium = (rm – rf) • Beta = 1.5 • r = 5% + 1.5(10%-5%) • r = 12.5%

  8. Discounted Dividend ValuationRequired rate of return (r) • For nonpublic companies, use a buildup model and historical sources for data • Begin with risk-free rate • + Equity risk premium • + Small company premium • + Company specific risk premium • = Required rate of return

  9. Discounted Dividend ValuationGrowth rate (g) • Top-Down analysis • Begin with growth of economy • Adjust for industry, sector and company factors • Sustainable growth = ROE(1-Payout rate) • ROE = Earnings/Average equity • Payout rate: proportion of earnings used to pay dividends or repurchase shares

  10. Discounted Dividend Valuation- example • Company A • Annual dividend = $0.16 • Beta = 1.35 • ROE = 13% • Payout ratio = 20% • Economic • 20-year Treasury bond = 4.75% • Historical market risk premium = 5.4%

  11. Discounted Dividend Valuation- example • r = .0475+1.35(.054) = .120 • g = .13(1-.20) = .104 • Value = $11.04…

  12. Discounted Dividend Valuation • Assumes a single, constant growth rate (g) • What if growth rates differ? • Use a multi-stage model to calculate future dividends • Calculate future stock value based on future dividend • Calculate present value of stock and dividends

  13. Discounted Operating Cash-Flow Models • 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

  14. FCFF or FCFE

  15. Discount Rate • FCFF • Weighted Average Cost of Capital • FCFE • Cost of Equity (required rate of return)

  16. Discounted Operating Cash-Flow ModelsOther considerations • Growth • Can use a multi-stage model to accommodate rate changes • Forecasting cash flows requires judgment • Begin with reported, historical cash flow and earnings • Make company-appropriate adjustments

  17. Special Issues • Loss generating firm valuation • Closed Firm Valuation • Start-up companies

  18. Valuation Of GAP Retail Stores

  19. FCFF-Stable Growth

  20. Market-based Models • 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

  21. P/E Model • 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 • Peer firms and their prices • Historical (average) data

  22. P/E Model • Firms with no internal growth prospects, paying out 100% of earnings • Current P/E = 1/r • Constant growth, Leading P/E • P0/E1 = (D1/E1)/(r-g) • D = annual dividends, E = EPS

  23. P/E Model - Example • 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

  24. Mixed Models • 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

  25. Asset-Based Models • Used when a company is going to be liquidated • Valuation is based on underlying assets • Market value of balance sheet items • Assets and liabilities • Also called cost or adjusted book value approach

  26. Options-Based Models • Theoretically elegant but practical application is difficult • Analyst must have information about opportunities (and their value) available to a firm • Equity ownership is viewed as an option call on the firm • Limited downside, unlimited upside

  27. Selecting a Model • Consider characteristics of the firm • Dividend paying • Growing • Likely to be liquidated • Consider data availability of data • Publicly available or closely held

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