Chapter 7: Corporate Valuation and Stock Valuation Flashcards
“Sell-side” analysts
security analysts that work for investment banks and brokerages
reports distributed to investors
“Buy-side” analyst
work for mutual funds, hedge funds, pension funds, and other institutional investors
analyst primary objective
to predict corporate earnings, dividends, and free-cash flow (and thus, stock prices)
Value of operations
(also intrinsic value)
present value of expected free cash flows discounted by weighted average cost of capital
stock value calculation
in some circumstances can be done by discounting the dividends (expected cash flow to stockholders) at rate of return required by stockholders
widely- used valuation models
Free-cash-flow model
dividend growth model
legal rights and privileges of common stock holders
- right to elect directors (who elect management)
- Preemptive right (right to maintain proportionate share if new shares are issued)
cumulative voting
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)
proxy fight
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
Purpose of preemptive right
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)
Classified stock
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
founder’s shares
classified stock restricted to ownership by the firm’s founders, usually has sole voting rights but restricted dividends (for a specified number of years)
tracking stock
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
stock prices on ticker
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
ttm
trailing twelve months
Free cash flow valuation model
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
entity value
total value of a company
Primary sources of entity value
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
Claims on entity value
debt: 1st claim
preferred stock: 2nd claim
common stock: residual claim
perpetuity
a constant and equal cash flow stream
present value of a perpetuity
Free cash flow / weighted average cost of capital
total intrinsic value
= value of operations (FCF/WACC) + short term investments
entity valuation model
estimates the total value of a corporation rather than just the values of its debt and stock
intrinsic value of equity
remaining value after subtracting the claims of debtholders and preferred stockholders
= total intrinsic value - all debt - preferred stock
Intrinsic stock price
= intrinsic value of equity / number of shares
long-term constant growth rate
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
Calculating cash flows at constant growth rate
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)
value of operations if free cash flow grows at a constant rate
= Free cash flow year 1 / (weighted average cost of capital - growth rate)
constant growth model
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
value of operations if growth begins immediately
= (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
rules for the constant growth model
- 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
multi-stage valuation model
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
horizon value
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
Forecast horizon
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
formula for horizon value
for a horizon of year t the present value =
(FCF t * (1+growth rate)) / (Weighted average cost of capital - growth rate)
current value of operations
= (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)
value of operations at year 0
= sum of the present value of the horizon value + the present value of the free cash flows
Signals that forecast horizon has been reached
FCF grows at same rate of sales
Operating profit and capital utilization have not change in the two previous years
Projected annual value
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)
total intrinsic value of a company
= value of operations + value of short-term investments
(assumes no other non-operating investments)
Estimated intrinsic value of equity
Remaining value of company after subtracting the claims of the debtholders and preferred stockholders
= total intrinsic value - all debt - preferred stock
Estimated intrinsic stock price
= intrinsic value of equity / number of shares
Causes of differences between intrinsic stock price and market rice
Standard deviation in stock returns
Investors expectations of future performance
Percent of Present value due to long term cash flows beyond horizon
= present value of cash flows beyond horizon / total value of operations
Do stock values reflect long term or short term cash flows
Long term
Managers can affect a stock’s value more by working to increase long-term cash flow than by increasing short term flows
Key inputs to free cash flow valuation model
- 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
Value drivers
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
Value based management
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
Effect on horizon value: Increase in ROIC
May be from improvement in operating profitability (OP) or in capital utilization
Positive effect on horizon value (or current value)
Affect on horizon value: reduction in the cost of caputal
Always have a positive effect on the horizon value and current value of operations
Affect on horizon value: increase in growth rate
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
Average stock’s standard deviation
Approx 30%
Why are stock prices so volatile
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
Dividends per share
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)
Dividend yield
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)
Expected capital gains yield
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
Expected rate of return
= expected dividend yield + expected capital gains yield
stock’s value to purchaser
= present value of the dividends during the year + present value of the stock’s share price at the end of the year
Equation for value of stock
= PV of expected future dividends
= sum of all (expected dividends for period t / (1+ required rate of return) to the power of t))
long-term growth rate in dividends for a company in the constant growth phase
same as overall rate of long-term growth in free cash flow g[L]
constant dividend growth model
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))
Expected rate of return on a constant growth stock
= (dividend year 1 / market price of stock today) + growth rate
why must dividend growth rate eventually level off at a constant growth rate?
- market saturation
- competition from companies in the same industry
Horizon value for stock
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)
stock’s estimated value at time 0
(stock’s estimated value today)
Present value of the dividends during the non-constant growth period plus the present value of the horizon value
multiple market method
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
Market multiple
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
EBITDA multiple
total value of a company (aka market value of equity + debt) / EBITDA
an entity multiple (covers equity and debt value)
Entity multiple
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
Finding intrinsic value from full value
total value - debt - preferred stock = intrinsic value
FCF valuation vs Dividend growth valuation vs market multiple models
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
Shortcomings of market multiple model
- 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
preferred stock
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
Value of preferred stock
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)
nominal rate of return
coupon rate. r[nom]
Conversion from nominal rate to effective rate
= ((1 + (nominal rate / M)) to the power of M) -1
where M is the number of interest payments per year
comparing return on bonds to return on preferred stock
convert nominal rates on each security to effective rates and then compare these equivalents
