chapter 9 - from slides Flashcards
what’s the role of valuation
- merger decision dependson teh estimated fair value of the target company
- the share price of an initial public offering depends on the business valuation by the issuer + potential investors
- identifying stocks or bonds that re over or undervalued
define cost of capital and future payoffs
cost of capital = discount rate to value the future payoffs and reflects the return the investor expects
future payoffs = dividends, free cash flows, residual earnings
what can we use valuation techniques for
compare stock price estimate to the observed trading price and then decide whether to buy, sell or hold the stock
set a share price in an initial public offering
determine the current price of a bond or other financial instruments
what are valuations useful in addressing?
deciding whether a plant or division should be expanded or closed
determining how much should be paid in a merger or acquisition
evaluating an offer to acquire the company
what are the payoffs from equity and debt intruments
equity = dividends and cash form selling the stock in the future
debt = interest payments and repayment of principal when the bond matures
what’s the valuation model formula
valuation = sum of (projected future payoffs)/(1+disount rate)^t
what’s the components of discount rate
time value of money - forgone interest from investing in an instrument with future payoffs - risk-free component
cost of risk - investor’s compensation for bearing the risk associated with the uncertainty of the payoff - risk-premium component
what determines the risk premium
a company’s perceived level of risk by lenders - short term liquidity and long-term solvency
what’s the pretax borrowing rate for interest-bearing debt
pretax borrowing rate for debt = interest expense/average interest-bearing debt
what’s the cost of debt capital (after tax)
rate = pretax borrowing rate for debt x (1 - tax rate)
what’s the income tax rate
tax savings due to interest reducing taxes
what’s included in the interest bearing debt
current portion of debt + finance lease
dent + finance lease, net of current portion
pretty much total leases
what’s the percentage of the cost of debt/equity
cost of debt = how much the debt investors ask for: time value (risk free rate) + debt risk premium
cost of equity = how much equity investors ask for: time value (risk free rate) + equity risk premium
how have researchers estimate expected returns
capital assets pricing model
what’s the component of CAPM
re = rf + [B x (rm-rf)]
re = expected return - expected return for security e
rf = commonly based on the return on 10-year US treasury bills
market risk premium = difference between the expected market return (rm) and the expected risk free rate
market beta (B) = sensitivity of the asset’s return to the overall market
what are the criticisms of CAPM
variation in beta should track changes in systematic risk of firm - whereas in practice time period and methodology used in estimate have big effects
market portfolio should include all assets in the economy not just publicly traded equities
market risk premium changes over time and these changes are difficult to capture - no consensus on what it is and how to measure it
what’s the formula for WACC
WACC = ((IVdebt/IVfirm) x cost of debt) + (cost of equity x (IVequity/IVfirm))
IVfirm = intrinsic value of the company
IVdebt = intrinsic value of company liabilities
IVequity = intrinsic value of company equity
what’s wrong with the WACC
there’s a circularity problem in estimating WACC as we are using the market value as the intrinsic value of equity to find the intrinsic value of equity
if the purpose is to value equity, we do not need to estimate WACC
what’s an alternative to WACC
match the cost of equity with the future payoffs to equity holders
cost of debt vs cost of equity
COE = very difficult to estimate, should be higher than cost of debt - can adjust estimates based on understanding of the firm’s past
what are the 2 camps of equity valuation models
fundamental firm-specific data; dividends, cash flows, residual income
market multiples; earnings, book value
what’s the process of using market multiples
select relevant summary performance measure for a target company
identify companies that are comparable to the target company
compute the ratio of market value to the selected summary performance measure
average of ratios = market multiple
value of target company = summary of performance measure x market multiple
how to select a equity or company value with market multiple
depends on the performance measure selected to get the value of either equity or company value
if an equity performance measure is selected - output will be an equity value (earnings, book value)
if a company performance measure is selected = output will be an enterprise value (sales, EBIT, EBITDA, NOPAT, NOA)
what’s the limitations of using industry based multiples
multiple focuses on sales rather than profitability
e.g retail industry sales per square foot of selling space is common
airline industry focuses on revenue, expenses or profits per mile