ppt1 (corp valun)

8/7/2019 PPT1 (Corp Valun)

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2

Valuation: Lecture OutlineValuation: Lecture Outline

q Principles of Valuationq Discounted Dividend Models

♦ Constant Dividend Model

♦ Constant Growth Model

q Discounted Cash flow Modelq Market Multiple Models

♦ P/E versus Past and Peers

♦ P/S versus Past and Peers

♦ P/CF versus Past and Peers

q Summary



3

Principles of ValuationPrinciples of Valuation

q Book Value♦ Depreciated value of assets minus outstanding

liabilities

q Liquidation Value♦ Amount that would be raised if all assets were sold

independentlyq Market Value (P)

♦ Value according to market price of outstanding

stockq Intrinsic Value (V)

♦ NPV of future cash flows (discounted at investors’required rate of return)



Intrinsic Valuation ProcedureIntrinsic Valuation ProcedureAsset Characteristics

• Size of Future Cash flows•

Time of Future Cash flows• Risk of Future Cash flows

Investor Characteristics• Assessment of Cash flow

Riskiness• Risk Preferences

Investors’ Required Rateof Return (k)



5

Where Does the DiscountWhere Does the Discount

Rate (k) Come From?Rate (k) Come From?q CAPM: k = r

f + β xRP

q Beta (β ) is estimated using historical

data and is available from many sourcesq The risk free rate (r

f ) is the current

Treasury rate♦ Typically the 3-mo rate, but other are

sometimes usedq The risk premium (RP) is a historical

average relative to the r f used



6

Example: Estimating k for Example: Estimating k for

Wal-Mart (WMT) on 4/27/01Wal-Mart (WMT) on 4/27/01q Inputs♦Three month Treasury rate: 3.75%

♦Historical average RP (1926-1996):8.74%

♦Beta for Dell (from MoneyCentral): 0.9

q

Computing k:♦CAPM: k = 0.0375 + 0.9x0.0874 =

11.62%



7

6%

8%

10%

12%

14%

16%

18%

20%

22%

24%

26%

-0.05

-0.04

-0.03

-0.02

-0.01

0.00

0.01

0.02

0.03

0.04

0.05

Change in Input

R

equired Return (k) from CAP Change in Risk Free

Rate

Change in RiskPremium

Change in Beta(Scale ShowsChange / 10)

Sensitivity to CAPM InputsSensitivity to CAPM Inputs

Initial values:Rf = 3.75%

RP = 8.47%

Beta = 1.5



8

Discounted Dividend ModelsDiscounted Dividend Models

q Dividends will be♦Forecast directly

♦Assumed to be constant♦Assumed to grow at a constant rate or ♦Some combination of the above

q Stock pricing relationship:



9

Constant Dividend (ZeroConstant Dividend (Zero

Growth Model) ModelGrowth Model) Model

q If Dtis constant, then it is an

ordinary perpetuity:




10

Example: Wal-Mart (4/27/01)Example: Wal-Mart (4/27/01)

q

The price of Wal-Mart was actually $52.83q Can you explain the difference?

41.2$1162.0

28.0$0

==WMT

P

q The current (annual) dividend is: $0.28q According to the constant dividend (zero

growth) model:



11

$0

$1

$2

$3

$4

$5

$6

$7

$8

$9

-0.05

-0.04

-0.03

-0.02

-0.01

0.00

0.01

0.02

0.03

0.04

0.05

Change in Input

Stock Price from

Constan

Growth Model

Change in Dividend(Scale showsChange / 10)

Change in Discount

Rate

Sensitivity to ConstantSensitivity to Constant

Dividend Model InputsDividend Model Inputs

Initial values:D

0= $0.50

k = 12%



Why do a firm’s dividendsWhy do a firm’s dividends

grow?grow?q Because earnings grow. Why?q Because of reinvested funds

♦ Used to expand or to undertake new projects♦ Used in positive NPV projects

q Leads to♦ Earnings growth

♦ Investments growth and

♦ Dividend growth



13

Constant Growth ModelConstant Growth Model

q If Dtgrows at a constant rate, g, then

it is a growth perpetuity:

g k

g D

g k

D

k

DP

t t −

+=

−=

+= ∑

∞

=

)1(

)1(01

1

10




14

How do You Estimate GrowthHow do You Estimate Growth

(g)?(g)?

q NOTE: Must have g<k in the long run!0

0

0

0

0

0

0

1

1

)1(

P D

P

D

k g g P

g Dg P

Dk +

−=⇒++=+=

q Historical averageq Average analyst forecast

q Sustainable growth♦ g = (1-Payout Ratio)xROE

q Required return versus dividend yield:



15

Estimating g for Wal-MartEstimating g for Wal-Mart

(4/27/01)(4/27/01)

q What should it be?♦ 1st 3 are too high b/c long run must have g<k♦

Guess: 11%?

%03.11

83.52$28.0$1

83.52$28.0$1162.0

=+

−=g

q 5 year historical average: 19.72%q Average 5-year analyst forecast: 14.4%q Sustainable growth

♦ g = (1-0.17)x0.22 = 18.26%q Required return versus dividend yield:



16


q The price of Wal-Mart was actually $52.83q

Notes:♦ Must have g<k in long run

♦ As gk, the price increases without bound

13.50$11.01162.011.128.0$

0 =

−

×=P

q Current (annual) dividend is: $0.28q If we use estimated growth of 11%:



17

$0

$10

$20

$30

$40

$50

$60

-0.05

-0.04

-0.03

-0.02

-0.01

0.00

0.01

0.02

0.03

0.04

0.05

Change in Input

Stock Price from Constan

Growth M

odel

Change in Dividend(Scale showsChange / 10)

Change in DiscountRate

Growth Rate

Sensitivity to Constant GrowthSensitivity to Constant Growth

Model InputsModel Inputs

Initial values:D

0= $0.50

k = 12%

g = 6%



18

Summary of DividendSummary of Dividend

Discount ModelsDiscount Modelsq Represents the value of dividends

received by shareholdersq

Requires♦A discount rate (k)

♦Dividends (D)

♦Steady or zero growth (g, with g<k)

q Trouble valuing♦Companies with D=0

♦Fast growing companies with g>k



19

Discounted Cash Flow ModelDiscounted Cash Flow Modelq Shareholders receive or “own”:

1. Dividends2. Re-invested earnings♦

The effects of re-invested earnings arecaptured in dividend growth if a firm paysdividends and growth can be estimated

q An alternative valuation comes fromvaluing cash flows available to

stockholders directly♦ Useful for companies that pay no

dividends



20

What Constitutes Cash flows?What Constitutes Cash flows?

q There is some debate over exactlywhat constitutes cash flows

q

The GAAP cash flow statement:♦ CF = NI + depreciation – preferred

stock dividends

♦ This should represent CFs that areeither

1. Paid out in common stock dividends or

2. Re-invested



21

What Discount Rate ShouldWhat Discount Rate Should

be used?be used?q It depends on the definition of CFs♦ If CFs are defined as those available to

all investors, WACC should be used♦ If CFs are defined as those available to

common stockholders, k from CAPMshould be used

q We will use the latter



22

Example: Estimating k for K-Example: Estimating k for K-

Mart (K) on 4/27/01Mart (K) on 4/27/01q Inputs♦Three month Treasury rate: 3.75%

♦Historical average RP (1926-1996):8.74%

♦Beta for K-Mart (from MoneyCentral): 1

q

Computing k:♦CAPM: k = 0.0375 + 1x0.0874 = 12.49%



23

How do You Estimate GrowthHow do You Estimate Growth

(g)?(g)?q CFs will also growq Use methods similar to dividend growth, but

♦ Analysts forecasts are typically unavailable

♦ For many companies, dividend yield cannot beused b/c there is no dividend

q Often, earnings or sales growth are used♦

Expenses and re-investment need to be relativelyconstant percentages of sales

q NOTE: Must have g<k in the long run!



24

Estimating g for K-MartEstimating g for K-Mart

(4/27/01)(4/27/01)

q 5 year sales growth: 2.35%q Analysts’ 5 year earnings forecast: 10.3%q Suppose, you believe K-Mart will not grow at all!

Dec-00 Dec-99 Dec-98 Dec-97 Dec-96

Net Income $ (244.00) $ 403.00 $ 518.00 $ 249.00 $ (220.00)

Dep & Amort $1,460.00 $2,070.00 $1,762.00 $1,555.00 $1,427.00

Pref Div -$ -$ -$ -$ -$

Cashflow 1,216.00$ 2,473.00$ 2,280.00$ 1,804.00$ 1,207.00$

Growth -50.83% 8.46% 26.39% 49.46%

Avg Growth: 8.37%

q From the historical income statement:



25

Example: K-Mart (4/27/01)Example: K-Mart (4/27/01)

q The price of K-Mart was actually $9.82q What must the market be expecting for K-Mart’s growth in

the future?

01.20$00.01249.0

00.150.2$

0

=−

×=P

q According to the last statements:♦ CF = $1,216 million

♦

Shares = 486.5 million CF/Share = $2.50

q If we use estimated growth of 0.0%:



26

$0

$10

$20

$30

$40

$50

$60

-0.05

-0.04

-0.03

-0.02

-0.01

0.00

0.01

0.02

0.03

0.04

0.05

Change in Input

Stock Price from Constan

Growth M

odel

Change in Cashflow(Scale showsChange / 10)

Change in DiscountRate

Growth Rate

Sensitivity to Constant GrowthSensitivity to Constant Growth

Cash flow Model InputsCash flow Model Inputs

Initial values:CF

0= $0.50

k = 12%

g = 6%



27

Summary of Discounted CashSummary of Discounted Cash

flow Modelsflow Modelsq Represents the value of cash flows available to

shareholdersq Requires

♦

A discount rate (k)♦ A reasonable measure of cash flows

o IMPORTANT: How much depreciation MUST be replaced ?Model assumes zero.

♦ Steady or zero growth (g, with g<k)q Trouble valuing

♦ Companies with CF<0♦ Fast growing companies with g>k♦ Companies with necessary replacement of

depreciated assets



Market MultiplesMarket Multiples

q Valuations are derived by:

1. Forecasting earnings, sales or cash

flows2. Applying the company’s historical

P/E, P/S or P/CF to forecast

3. Applying industry average P/E, P/S or P/CF to current inputs



29

Why do P/E Ratios MakeWhy do P/E Ratios Make

Sense?Sense?

q A company with a payout less than 1 will grow and be valued at:

r E P

r

E

r

DP 1110

1

0 =⇒==

1

1

1

1E

PVGO

r E

P PVGO

r

E P +=⇒+=

q A company with a payout ratio of 1 will not grow and be valued at:



30

Logic of Market MultipleLogic of Market Multiple

ModelsModelsq Sales, earnings and cash flow drive profits,

growth and valueq P/S, P/E & P/CF ratios show the relationship

between price and these value driversq Firms within an industry have similar sales,

profit and cash flow patterns and similar required returns

q Therefore, a reasonable value for a firm is itssales, earnings or cash flows times therespective industry ratio



31

P/E Ratio ValuationP/E Ratio Valuation

q If company “j” is “valued at industry

ratios” relative to earnings:

×=

j

j j j

E P E P

0

011

×=

i

i

Industry

j j

E

P Avg E P

0

000

q If company “j” is “valued at historicalratios” relative to earnings:



32


q Valued at historical P/E ratio:♦ Analysts forecast next year’s earnings for WMT at

$1.58

♦ WMT’s recent P/E was 37.7

♦ Then: P = $1.58x37.7 = $59.57

q Valued at industry average P/E ratio:♦ This year, earnings for WMT were $1.40

♦ The industry average P/E was 36.0

♦ Then: P = $1.40x36.0 = $50.40

q The price of Wal-Mart was actually $52.83



33

$0

$10

$20

$30

$40

$50

$60

$70

-0.50

-0.40

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

Change in Input

Stock Price fro

m Consta

Growth M

odel

Change in Earnings

Change Benchmark

P/E Ratio (Scaleshows Change / 10)

Sensitivity to P/E MultipleSensitivity to P/E Multiple


Initial values:E

1= $1.50

P/E = 35



34

P/S Ratio ValuationP/S Ratio Valuation

q Using current sales, a company “j” is“valued at industry ratios” relative to sales:

×=

j

j j j

S

P S P

0

011

×=

i

i

Industry

j j

S

P Avg S P

0

000

q For companies w/o earnings, P/S is sometimesused

q If you have a sales forecast, company “j” is“valued at historical ratios” relative to sales:



35

Example: Amazon (4/27/01)Example: Amazon (4/27/01)

q For the year ending 12/00♦ Sales = 2,762 million (income statement)

♦

Shares = 357.1 million (balance sheet)Sales/Share = 2762/357.1 = 7.73

q Industry average P/S = 3.46q So, using industry P/S Amazon should be

priced at: 3.46x7.73 = $26.76q The price of Amazon was actually $15.27



36

$0

$10

$20

$30

$40

$50

$60

$70

-0.50

-0.40

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

Change in Input

Stock Price fro

m Consta

Growth M

odel

Change in Sales

Change BenchmarkP/S Ratio (Scaleshows Change / 10)

Sensitivity to P/S MultipleSensitivity to P/S Multiple


Initial values:S

1= $3.00

P/S = 15



37

P/CF Ratio ValuationP/CF Ratio Valuation

• Using current cash flow, company “j” is “valuedat industry ratios” relative to cash flows:

×=

j

j j j

CF

P CF P

0

011

×=

i

i

Industry

j j

CF

P Avg CF P

0

000

• For companies w/o dividends, P/CF is sometimesused

• If you have a cash flow forecast, company “j” is

“valued at historical ratios” relative to cash flows:



38

Example: K-Mart (4/27/01)Example: K-Mart (4/27/01)

q For the year ending 12/00♦ CF = 1,216 million (discussed previously)

♦ Shares = 486.5 million (balance sheet)

CF/Share = 1216/486.51 = 2.50

q Industry average P/CF = 21.3q Using industry P/CF K-Mart should be priced

at: 21.3x2.50 = $53.24q The price of K-Mart was actually $9.82q Is K-Mart undervalued or in serious trouble?



39

$0

$10

$20

$30

$40

$50

$60

$70

-0.50

-0.40

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

Change in Input

Stock Price fro

m Consta

Growth M

odel

Change in Cashflow

Change BenchmarkP/CF Ratio (Scaleshows Change / 10)

Sensitivity to P/CF MultipleSensitivity to P/CF Multiple


Initial values:CF = $1.00

P/S = 30



40

Summary of Market MultiplesSummary of Market Multiples

ModelsModelsq Valuations using historical and industry

ratios♦ Provide useful benchmarks

♦ Useful when dividends and cash flows cannotbe discounted directly

♦ Can be compared to current ratios as ameasure of market sentiment

q Weaknesses♦ Misleading for firms that are changing rapidly

or do not resemble the industry



SummarySummary

• Discounted Dividend♦w/ dividends and

constant expected(possibly zero) growth

in dividends• Discounted Cash flow♦w/o dividends and

constant expected(possibly zero) growthin cash flows

• P/E, P/S and P/CFratios♦Comparison with past

or industry

• Why severalmethods?♦ Each has strengths

and weaknesses♦ Different methods

useful in differentsituations

♦ Each gives a different“take” on the value of the company’s stock

♦ Provides a range of valuations instead of point estimates

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