chapter 10: equity valuation & analysis

7/21/2019 Chapter 10: Equity Valuation & Analysis

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Equity Valuation and Analysis witheVal

Chapter 10

Valuation



Framework for Business Analysis

and Valuation

STEP 1Understanding the Past

1. Information

Collection

2. Understanding theBusiness

3. Accounting Analysis

. !inancial "atioAnalysis

#. Cash !lo$ Analysis

STEP 2!orecasting the !uture

1. Structured

!orecasting

2. Income Statement!orecasts

3. Balance SheetForecasts

. Cash Flow Forecasts

STEP 3%aluation

1. Cost of Capital

2. Valuation Models "esidual Income&Based

%aluation

Cash !lo$&Based

%aluation

3. Valuation Ratios

. Complications 'egati(e %alues

%alue Creation and

)estruction though

!inancing Transactions



Key Valuation Inputs

Cost of Capital

Forecast Financial Statements

Value of Contingent !uity Claims



Alternative Approaches to Valuation

"iscounted "i#idends

"iscounted Free Cash Flow

"iscounted $esidual Income

arnings %ultiples and $elated &euristics



Dividend Discounting Model

∑

∞

= +=1t

t

e

t0

)r (1

Div

P

where

'0 ( e!uity #alue at the end of period 0

"i#t ( net cash distri)utions to e!uity at the end of period t

r e ( cost of e!uity capital



Problems With Discounting

Dividends

%ost growth companies pay no di#idends*

and may plan not to pay di#idends for manyyears

%ost companies rein#est a large proportion of

their earnings rather than paying them out as

di#idends"i#idends measure wealth distri)ution rather

than wealth creation



Traditional Discounted Free ash

Flow Model !to All "nvestors#

0

1t tW

t0 Debt

)r (1

FCFP −

+

=∑∞

=

where


FCFt

( free cash flows to de)t and e!uity holders duringperiod t

r + ( weighted a#erage cost of capital

"e)t0 ( #alue of de)t at the end of period 0



Discounting Free ash Flows to

Equity

where


FCFt ( free cash flows to e!uity holders during period t

r e ( cost of e!uity capital

∑∞

= +

=1t

t

e

t0

)r (1

FCFEP



Problems With Discounting Free

ash Flows

Cash flows are difficult to forecast )ecause

they depend on the timing of e#ents that do

not ha#e a )ig impact on #alue ,e-g-* timing of

e!uipment.in#entory purchases/

For growth companies* cash flows may )e

negati#e for many years to comeCash flows pro#ide a noisy and untimely

measure of firm performance



Discounted $esidual "ncome Model

∑

+

−+=

∞

=

−

1tt

e

1tet00

)r (1

CE*r NICEP

where


It ( net income for period tr e ( cost of e!uity capital

Ct ( )ook #alue of common e!uity at the end of period t



Discounting $esidual "ncome to All

"nvestors !Debt and Equity#

where


It ( net operating income ,after ta2es/

r + ( weighted a#erage cost of capital

At ( net operating assets at the end of period t

"e)t0 ( #alue of de)t at the end of period 0

0

1tt

W

1tWt00 Debt

)r (1

NOA*r NOI NOAP −∑

+

−+=

∞

=

−



Two %tage Discounted $esidual

"ncome Model !used in eVal#

Tee

Te1TT

1tt

e

1tet00

)r (1)g(r

CE*r NI

)r (1

CE*r NICEP

+−

−+∑

+

−+= +

=

−

where


It ( net income for period t

r e ( cost of e!uity capitalCt ( )ook #alue of e!uity at the end of period t

g ( constant terminal growth rate in residual income )eyond period341



Ad#antages of "iscounting $esidual

Income

5nlike di#idends and cash flows* earnings

pro#ide a reasona)ly relia)le and timely

measure of firm performance

Accounting analysis and ratio analysis

pro#ides a framework for e#aluating earnings

performance%ost practicing in#estors seem to use

earnings to e#aluate e!uities



Discounted $esidual "ncome Model

Focuses on &ey Value Drivers

∑+

−

+=∞

=

−

−

1tt

e

0

1t

e1t

t

0

0

)r (1CE

CE*)r

CE

NI(

1CEP

3his e2pression indicates that #alue is created )y6

1- 7enerating a long8run $ that e2ceeds the cost of

capital ,focus on profit margin and asset turno#er/

9- 7rowing the si:e of the in#estment )ase on which the

$ is generated ,focus on sales growth/



Su)se!uent 'erformance for Firms

+ith 2treme $esidual Income

'()*+

'()*

'(),+

'(),

'()-+

'()-

'()(+

(

()(+

()-

( - , * .

*ears Since Portfolio !ormation

" e s i d u a l I n c o



/ottom 0ine on Valuation Models

"iscounted di#idends* discounted free cash flow anddiscounted residual income are all theoretically #alid

#aluation models- ;our #aluations should always )e )ased on a complete

and consistent set of forecast financial statements* inwhich case you will get the same #alue regardless ofthe #aluation model used-

;our forecast hori:on must e2tend out far enough thatyou reach a constant terminal growth rate in the flowthat you are discounting < at which point you can makea terminal #alue computation-



Valuation 1sing Price Multiples

2amples include price8earnings* enterprise #alue8

sales and market8)ook multiples-

A popular heuristic is the ='7> $atio* which uses an

earnings multiplier that e!uals the long8run e2pected

growth rate in earnings-

3he ma?or pro)lem with these approaches is that they

implicitly make restricti#e assumptions that are #eryoften unrealistic-

+e will e2plore determinants of common #aluation

multiples in session 1@-



ontingent laims on Equity

Value to 2isting !uity &olders

( 'V of FCF to Common !uity

8 Value of Contingent Claims on Common !uity

In )uilding your free cash flow forecasts* assume that

all future e2penses are ultimately paid for in cash orstock and not with contingent e!uity claims- < ote that FAS19$ essentially does this for employee stock options* in that it

re!uires an e2pense e!ual to the estimated cash #alue of the options granted

< )ut we don>t currently ha#e similar accounting for con#erti)le )onds



Valuation E2ample

nCom Corporation Stage <

Illustrates e!ui#alency of #aluations using the "CF%odel and the $esidual Income %odel

< Illustrates how accounting distortions can change

the se!uence of residual income* )ut not the #alue

of the firm-



%olution !double clic3 to see computations#

0 1 9 A B C D

$esidual "ncome Valuation !e2pense mar3eting costs as incurred#

$esidual Income 8B9 91E 9AE 10E 19E 8D0

"iscounted $esidual Income 8AE-1E 1E0-1F 1FE-E1 FA-FF F@-BE 8AA-EF

$esidual "ncome Valuation ,4-5()-6

0 1 9 D

$esidual "ncome Valuation !amorti7ing mar3eting costs over * years#

$esidual Income 1E @E 19E 10E 19E 8D0

"iscounted $esidual Income 1-D E0-@@ @D-1 - @-E 8-E

$esidual "ncome Valuation ,4-5()-6



%tage * 8uestions

9- In !uestion 1 a)o#e* you should ha#e arri#ed at the same#aluation regardless of the accounting method employed-

'ro#ide a !ualitati#e e2planation as to why the differentaccounting methods ha#e no impact on the #aluation-

3he accounting techni!ue selected has no effect on cashflows or di#idends* and hence has no impact on the#aluation- ote that conser#ati#e accounting leads to low

residual income in earlier years and high residual incomein later years- Con#ersely* aggressi#e accounting leads tohigh residual income in earlier years and low residualincome in later years-



1pcoming ases

9verstoc3)com E < Critical e#aluation of analyst #aluation- +hat are the implicit

assumptions and are they reasona)leG < Conduct your own #aluation of #erstock-com using eVal- Focus on

sales growth and $ as the key dri#ers of #alue- Evaluating "ntel:s Earnings Torpedo

< 5nderstand why a small reduction in earnings can lead to a large dropin price-

The $estaurant "ndustry in ,((* < 5nderstanding the determinants of common #aluation ratios-

The A90 Time Warner Merger < Illustrates how #alue can )e created and destroyed through financing

transactions

chapter 10: equity valuation & analysis

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