Chapter 7: Corporate Valuation and Stock Valuation

Question 1

“Sell-side” analysts

Answer 1

security analysts that work for investment banks and brokerages

reports distributed to investors

Question 2

“Buy-side” analyst

Answer 2

work for mutual funds, hedge funds, pension funds, and other institutional investors

Question 3

analyst primary objective

Answer 3

to predict corporate earnings, dividends, and free-cash flow (and thus, stock prices)

Question 4

Value of operations

Answer 4

(also intrinsic value)

present value of expected free cash flows discounted by weighted average cost of capital

Question 5

stock value calculation

Answer 5

in some circumstances can be done by discounting the dividends (expected cash flow to stockholders) at rate of return required by stockholders

Question 6

widely- used valuation models

Answer 6

Free-cash-flow model
dividend growth model

Question 7

legal rights and privileges of common stock holders

Answer 7

• right to elect directors (who elect management)
• Preemptive right (right to maintain proportionate share if new shares are issued)

Question 8

cumulative voting

Answer 8

common stockholders get 1 vote per share. in cumulative voting stockholders get 1 vote per share per position and can cast them all to a single candidate if desired (increases minority control)

Question 9

proxy fight

Answer 9

an attempt to take over a company in which an outside group solicits existing shareholder’s proxies (authorizations to vote shares in a meeting) in an effort to overthrown management and take control of the business

Question 10

Purpose of preemptive right

Answer 10

allows current stockholders to maintain control

prevents transfer of wealth from current stockholder to new stockholders (say if corp issued new shares at a low price and took control that way)

Question 11

Classified stock

Answer 11

stock with different rights (determined by classification) to meet special needs and circumstances

if only two classes: dual class shares

rights specified may include rights to dividends and voting rights

voting stock typically sells higher than nonvoting stock

different share classes becoming less common

Question 12

founder’s shares

Answer 12

classified stock restricted to ownership by the firm’s founders, usually has sole voting rights but restricted dividends (for a specified number of years)

Question 13

tracking stock

Answer 13

aka target stock

classes of stock with dividends tied to a particular part of the company. an attempt to allow separate valuations for separate divisions

not very popular anymore

Question 14

stock prices on ticker

Answer 14

during trading hours may be current ask or bid quote. otherwise reported price is last price at which stock traded (closing price)

may show % change from previous day’s price

Question 15

ttm

Answer 15

trailing twelve months

Question 16

Free cash flow valuation model

Answer 16

defines the total value of a company as the present value of its expected free cash flows discounted at the weighted average cost of capital (value of operations) plus the value of non-operating assets

since managerial choices affect free cash flows and risk they can be judged by how the affect the model

Question 17

entity value

Answer 17

total value of a company

Question 18

Primary sources of entity value

Answer 18

value of operations (free cash flow discounted at weighted average cost of capital) can be influenced by the company

value of non-operating assets (financial assets: short term + long term investments) determined by market forces

Question 19

Claims on entity value

Answer 19

debt: 1st claim

preferred stock: 2nd claim

common stock: residual claim

Question 20

perpetuity

Answer 20

a constant and equal cash flow stream

Question 21

present value of a perpetuity

Answer 21

Free cash flow / weighted average cost of capital

Question 22

total intrinsic value

Answer 22

= value of operations (FCF/WACC) + short term investments

Question 23

entity valuation model

Answer 23

estimates the total value of a corporation rather than just the values of its debt and stock

Question 24

intrinsic value of equity

Answer 24

remaining value after subtracting the claims of debtholders and preferred stockholders

= total intrinsic value - all debt - preferred stock

Question 25

Intrinsic stock price

Answer 25

= intrinsic value of equity / number of shares

Question 26

long-term constant growth rate

Answer 26

a long-term rate of FCF growth that is approximately equal to the sum of population growth (# of units to be sold under market saturation) and inflation (growth in prices/ profits) reached when competition reaches market saturation and competition has limited the ability to increase market share without losing profits

Question 27

Calculating cash flows at constant growth rate

Answer 27

Free cash flow for year t = (Free cash flow year t-1) *( 1+ growth rate) alternately Free cash flow for year t = (free cash flow year 1) * (1+growth rate) to the power of (t-1)

Question 28

value of operations if free cash flow grows at a constant rate

Answer 28

= Free cash flow year 1 / (weighted average cost of capital - growth rate)

Question 29

constant growth model

Answer 29

formula for the present value of an infinite stream of cash flows growing at a constant rate = FCF year 1 / (Weighted average cost of capital - growth rate) can only be used once growth rate has leveled off to a value LESS THAN weighted average cost of capital valid when have an actual or estimated first cash flow and constant growth begins thereafter

Question 30

value of operations if growth begins immediately

Answer 30

= (FCF time 0 * (1+gl)) / (WACC - gl) (uses FCF 0 to estimate FCF 1, FCF 0 still not included in value of future cash flows) only use this if constant growth begins IMMEDIATELY

Question 31

rules for the constant growth model

Answer 31

- use ONLY when growth rate is constant and less than weighted average cost of capital - use to calculate flows from t=1 to infinity (not t=0 to infinity) t=0 is in the past and inherently not include in present value of future cash flows

Question 32

multi-stage valuation model

Answer 32

used when short-term growth rates are not constant 1) Forecast expected FCFs and annual growth rates for each year until growth rate is expected to become consistent 2) Apply the constant growth model to the value of operations at the horizon year (= horizon value, value of all FCFs past the horizon discounted back to the horizon) 3) create time line with free cash flows up to the horizon date. will have two values at horizon date: FCF for that year + horizon value 4) discount cash flows in the timeline back to year 0 using weighted average cost of capital 5) add the present value of all free cash flows to the present value of the horizon value to get the current value of operations result = estimated value of operations at t= 0

Question 33

horizon value

Answer 33

Present value of all free cash flows beyond the horizon date (to infinity) discounted back to the horizon date The value of operations at the horizon date aka terminal value aka continuing value

Question 34

Forecast horizon

Answer 34

aka horizon date aka terminal date the last year in a cash flow forecast - the year after which cash flows are expected to grow at a constant rate even if grew unevenly before

Question 35

formula for horizon value

Answer 35

for a horizon of year t the present value = (FCF t * (1+growth rate)) / (Weighted average cost of capital - growth rate)

Question 36

current value of operations

Answer 36

= (sum of all (FCF period t) / (1+WACC) to the power of t) + Horizon value at period t / ((1+WACC) to the power of t)

Question 37

value of operations at year 0

Answer 37

= sum of the present value of the horizon value + the present value of the free cash flows

Question 38

Signals that forecast horizon has been reached

Answer 38

FCF grows at same rate of sales Operating profit and capital utilization have not change in the two previous years

Question 39

Projected annual value

Answer 39

Can start with horizon value and work backwards to get each year's annual value value of operations for year 5 = horizon value discounted to year t Value operations year t-1 = (FCF t + value operations (t))/ (1+ WACC)

Question 40

total intrinsic value of a company

Answer 40

= value of operations + value of short-term investments (assumes no other non-operating investments)

Question 41

Estimated intrinsic value of equity

Answer 41

Remaining value of company after subtracting the claims of the debtholders and preferred stockholders = total intrinsic value - all debt - preferred stock

Question 42

Estimated intrinsic stock price

Answer 42

= intrinsic value of equity / number of shares

Question 43

Causes of differences between intrinsic stock price and market rice

Answer 43

Standard deviation in stock returns Investors expectations of future performance

Question 44

Percent of Present value due to long term cash flows beyond horizon

Answer 44

= present value of cash flows beyond horizon / total value of operations

Question 45

Do stock values reflect long term or short term cash flows

Answer 45

Long term Managers can affect a stock's value more by working to increase long-term cash flow than by increasing short term flows

Question 46

Key inputs to free cash flow valuation model

Answer 46

- Most recent level of sales - Most recent level of total net operating capital - projected sales growth rate - projected operating profitability ratios - projected capital requirement ratis - weighted average cost of capital

Question 47

Value drivers

Answer 47

Inputs to the free cash flow valuation model that manager are able to influence though strategic choices and execution of business plans Include: Operating profitability ratio Capital requirement ratio Weighted average cost of capital Growth rates Past information never value driver because cannot be changed

Question 48

Value based management

Answer 48

The systematic use of the free cash flow valuation model to identify value drivers and to guide managerial and strategic decisions Done by estimating how the value driver inputs affect the value of operations and intrinsic stock price

Question 49

Effect on horizon value: Increase in ROIC

Answer 49

May be from improvement in operating profitability (OP) or in capital utilization Positive effect on horizon value (or current value)

Question 50

Affect on horizon value: reduction in the cost of caputal

Answer 50

Always have a positive effect on the horizon value and current value of operations

Question 51

Affect on horizon value: increase in growth rate

Answer 51

May be positive or negative If ROIC is sufficiently less than WACC then horizon value will be less than investment in operating capital (return isn't sufficient to compensate investors) Essential: don't implement growth strategies if return on invested capital is too low. OP or capital utilization must be improved before pursuing growth

Question 52

Average stock's standard deviation

Answer 52

Approx 30%

Question 53

Why are stock prices so volatile

Answer 53

Small changes in value drivers can cause large changes in intrinsic stock price. So if investors expectations of value drivers change with new information received there are large changes in stock price. If no changes in stock price probably no new information coming

Question 54

Dividends per share

Answer 54

Cash flows that go directly to the owner of common shares Can be an easier way to find intrinsic price per share (dividends discounted at required rate of return)

Question 55

Dividend yield

Answer 55

Expected rate of return during the coming year due to dividends either: End-of-period dividend / beginning-of-period price or Ration of the current dividend to the current price (for valuation formulas use 1st definition)

Question 56

Expected capital gains yield

Answer 56

expected rate of return due to expected change in the stock price at the end of the coming year = (expected price at the end of the year - price today) / price today

Question 57

Expected rate of return

Answer 57

= expected dividend yield + expected capital gains yield

Question 58

stock's value to purchaser

Answer 58

= present value of the dividends during the year + present value of the stock's share price at the end of the year

Question 59

Equation for value of stock

Answer 59

= PV of expected future dividends = sum of all (expected dividends for period t / (1+ required rate of return) to the power of t))

Question 60

long-term growth rate in dividends for a company in the constant growth phase

Answer 60

same as overall rate of long-term growth in free cash flow g[L]

Question 61

constant dividend growth model

Answer 61

formula for the present value of an infinite stream of constantly growing dividends (also dividend growth model or Gordon model) Valid as long as constant growth rate is LESS than the rate of return required by common shareholders (if gl is not less than required rate of return the company is not in its constant growth phase) = (expected dividend for period 1 / (required rate of return - long term growth rate))

Question 62

Expected rate of return on a constant growth stock

Answer 62

= (dividend year 1 / market price of stock today) + growth rate

Question 63

why must dividend growth rate eventually level off at a constant growth rate?

Answer 63

- market saturation - competition from companies in the same industry

Question 64

Horizon value for stock

Answer 64

aka continuing value or terminal value intrinsic value of a stock at time T (time beyond which dividends are supposed to grow at a constant rate) =(Dividend the stockholder expects at end of year T * (1+ long-term growth rate))/ (required rate of return - long term growth rate)

Question 65

stock's estimated value at time 0

Answer 65

(stock's estimated value today) Present value of the dividends during the non-constant growth period plus the present value of the horizon value

Question 66

multiple market method

Answer 66

used to estimate the value of a company 1) identify a sample of comparable firms 2) calculate the ratio of observed market value to some chosen metric for each firm (must be a single metric that can be applied to target firm and comparable firms) = market multiple 3) calculate the average ratio from the sample 4) multiply the result by the metric of the target firm = target firm's estimated value

Question 67

Market multiple

Answer 67

for estimating a target company's value ratio of observed market value to a given metric may be: net income, eps, sales, book value, number of subscribers, etc...as long as the metric can be applied to target and comparable firms collected for comparable firms and then averaged and multiplied by the target firm's target metric to get target firm's value

Question 68

EBITDA multiple

Answer 68

total value of a company (aka market value of equity + debt) / EBITDA an entity multiple (covers equity and debt value)

Question 69

Entity multiple

Answer 69

for a group of comparable firms, the average ratio of the observed market entity value to a particular metric that applies to the whole firm (sales, EBITDA, subscribers) can be used to estimate firm's total value

Question 70

Finding intrinsic value from full value

Answer 70

total value - debt - preferred stock = intrinsic value

Question 71

FCF valuation vs Dividend growth valuation vs market multiple models

Answer 71

FCF and dividend growth should give same estimated stock price if assumptions re: capital structure are consistent mature company in steady growth phase: dividend mode efficient company in high growth stage, pays dividends: FCF valuation requires fewer steps Company that doesn't pay dividends: FCF or corporate valuation model

Question 72

Shortcomings of market multiple model

Answer 72

- hard to find companies that are truly comparable (comparable based on *what*) - fails to help identify the value drivers or determine why intrinsic value is high or low best only for ballpark estimates or situations where FCF requires too much guesswork many banks use constant growth model + market multiple to estimate horizon value

Question 73

preferred stock

Answer 73

a hybrid security similar to bonds in that: preferred dividends are fixed amounts and usually must be paid before common stock dividends can be paid similar to common stock in that: no dividends are required to be declared. if company lacks funds it doesn't have an obligation to pay

Question 74

Value of preferred stock

Answer 74

a perpetuity if scheduled to go on indefinitely = Dividends on preferred stock / required rate of return on preferred stock (constant growth dividend model with growth rate of 0 because dividends are fixed)

Question 75

nominal rate of return

Answer 75

coupon rate. r[nom]

Question 76

Conversion from nominal rate to effective rate

Answer 76

= ((1 + (nominal rate / M)) to the power of M) -1 where M is the number of interest payments per year

Question 77

comparing return on bonds to return on preferred stock

Answer 77

convert nominal rates on each security to effective rates and then compare these equivalents