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
what are the key assumptions of market multiples-based valuation
- the performance measure chosen = summary statistic of intrinsic value
- the comparable firms we choose re truly comparable for valuation purpose, similar growth, risk, profitability, etc
- comparable firms are efficiently priced
what are the weaknesses of multiples-based valuation
- no right measure to use - bc company value depends on future performance
- no right companies to use for comparison - as different companies can be very different in critical ways, could be over or under valued
- no right way to combine comparable company data to produce a multiple - median, equal-weighted average, value-weighted average or other average
- despite deficiencies in valuing companies using market multiples, it’s commonly applied in practice - wide discretion might also help with its popularity
what’s the dividend discount model
DDM equates the value of company equity with the present value of all future dividends - using cost of equity capital to discount
2 methods to forecast future dividends - perpetuity or constant growth method
what’s the DDM with constant perpetuity
dividends stabilize at some point in the future and remain constant thereafter
perpetuity: ordinary annuity with an infinite horizon
PV of constant perpetuity - IV = D1/re??
what’s the DDM of increasing perpetuity
dividends grow at some constant rate in the future - present value of an increasingly perpetuity
IV = D1/ (re-g)
where long term growth must be less than cost of equity
issues with DDM
lots of companies don’t issue dividends
some companies have high dividend payouts given their profit levels - sustaining may not be possible
difficult to find analysts’ forecasts of dividends to use in the model
tell me about the DCF
DCF model focuses on company’s operating and investing activities - ability to generate cash - makes the model more practical than DDM
DCF model estimates the value of the company (enterprise value) as the PV of the expected free cash flows then subtracts teh company’s debt to determine the equity value (the shareholders’ portion of the enterprise value)
FCFF vs FCFE
FCFF - free cash flows for all capital providers - use to value asset acquisition if objective is to value net operating assets
FCFE - free cash flows for common equity holders only after all operating expense and necessary investment in working capital and fixed capital and borrowing costs (principal + interest) - use to value common equity/equity shares, FCFE = OCF - CapEx + Change in borrowing
what the formulas to finding FCFF why are there different formulas
FCFF = NOPAT - increase in NOA
FCFF = OCF - Capex
FCFF = OCF - Capex + int(1-tax rate)
if there’s positive FCF - funds = available for distributions to creditors/shareholders
if there’s negative free cash flows - firms requires additional funds from creditors
FCFF = OCF - CAPEX vs FCFF = NOPAT - increase in NOA
net cash flow from operations uses net income which comingles both operating and nonoperating components (selling + interest expense)
- income tax includes the effect of the interest tax shield
- net cash flow from operating activities includes nonoperating items in working capital such as interest + dividends payable - NOA focuses only on operating activities
- CAPEX doesn’t include increases in long-term operating assets acquired via mergers + acquisitions
steps in DCF model
- forecast + discount FCFF for the horizon period
- forecast + discount FCFF for terminal period
- sum the present values for the horizon and terminal periods to yield firm (enterprise value)
- to determine equity value subtract; net nonoperating obligations (NNO), preferred stock, noncontrolling interest (NCI)
- divide firm equity value by the number of share outstanding to yield stock value per share
note: if NNO is negative, we still subtract it, but bc NNO is negative the equity value will be greater than enterprise value
types of sensitivity analysis on DCF model
horizon period - forecast growth longer than 5 years but it’s difficult to accurately project growth, more exact value estimate when an analyst can effectively use economic insights
sales growth rate - alter sales growth over horizon + terminal periods
terminal growth rate - valuations are sensitive to variations in terminal growth rate, the forecast horizon is sufficiently long to allow steady state to be achieved, terminal growth rate can be positive or negative but not exceeding WACC*
DCF model strengths + weaknesses
strengths: focuses on free cash flows (more economically meaningful than earnings?), based on analyst’s projections of future operating, investing and financing decision, widely used in practice
weaknesses: “penalizes” firms for investing while FCF might be small or negative for good reasons, treats new debt as increasing value but it’s only true if proceeds are invested in projects that provide a return that’s greater than the cost of debt, relies in large part on speculation, and is very sensitive to change sin estimates and errors
multiples-based model strengths vs weaknesse
strength: quick + efficient, implicitly incorporates market assumption about cost of capital and growth rates that may be difficult to estimate directly and incorporate into formal models
weakness: competitors may differ significantly in key wats, identifying appropriate competitor firms can be challenging
how does stock-based compensation affect valuation
can treat SBC as cash expense if there’s a lot - as SBC is a combination of operating activity (paying cash to employees) and financing activity (issuing stocks to employees)
is SBC is a one-time deal, will need to be reflected in forecasts of future FCFE - more cash expense would be needed for compensation
if SBC is continuously being issued, will need to account for future dilution effect - forecast the increased shares outstanding every year cause by dilution which is complicated
