Corporate Valuation Flashcards
Value or Theoretical Price
Sum of discounted expected future cash flows
Corporate Valuation Approach
Substance Valuation
Discounted Flows
Valuation Multiples
Substance Valuation
Assets - Liabilities = SE
Pros and cons of substance valuation
Pros:
Simple - little input and easy to calc
Easy to communicated
good link to dcf models
Cons:
Insufficient for companies where balance sheet doesn’t show the full picture
Discounted flows approach
Make a detailed scenario a few years ahead and calculate the terminal value
- Dividends
- Residual Income
- Free cash flows
Pros and cons of Discounted flows approach
Pros:
can capture detailed scenarios
shows value drivers
Shows assumptions
Cons:
A lot of work
difficult to make forecasts
high risks for mistakes
Multiple Valuation Approach
P/E Multiples -> make use of comp firms
Other multiple: EV/EBIT etc
Pros and Cons of multiple approach
Pros:
Simple easy to input and calculate
Easy to communicate
eaily applied to PE firms
Cons:
difficult to find comps
- Hard for high growth /profitability firms
-> how do u know if its valued properly
Indirect Equity Valuation
- Focus on flows from operations.
- Estimate the value of the company’s operations: V(CE).
- Estimate the value of the company’s debt: V(D).
V(CE) − V(D) = V(E)
Direct Equity Valuation
- Focus on flows to stock owners.
- Estimate value of the company’s equity: V(E).
Discounted Dividends
Direct valuation of Shareholder’s equity
The required rate of return for shareholders equity rE
DCF
Indirect valuation of shareholders equity
Requited rate of return for operating net assets rW ACC
Book value of equity + discounted residual income RI
Direct valuation
Required rate of return for shareholders equity rE
Present value formula
PV= FV \ (1+r)^t
Present Values Annuity
An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income stream for retirees.
PV = (E[CF] / r ) x (1 − 1 /(1 + r)^T)
E(CF) = each annuity payment T = number of periods r = interest rate / discount rat e
Present Value Perpetuity
PV = E(CF) / r
if growth
PV = FV / (r-g)
Required rate of return
rF + Compensation for risk
Rf
Nominal risk free interest rate
= treasury bond yield - inflation
= real risk free interest rate + expected inflation rate premium
Re
Required rate of return on equity
or expected total return of shareholders
= Rf + risk premium
= Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return)
Cash flows shareholders can obtain from owning stock
Dividends and Capital Gains
Explain rE formula
The expected total return of a shareholder is equal to the expected retrn of other investments available in the market with equivalent risk
The firm must pay SHs a return equivalent for the return they can earn elsewhere
Dividend Discount Model concept
The value of equity or theoretical current price (P0) is equal to the present value of the expected future dividends it will pay.
DDM with perpetual growth
PV of future dividendds = Price per share = D/ r-g
D = estimated value of next years dividends per share
r = cost of capital equity
g= constant growth rate for dividends
DDM When is a stock undervalued
When the PV of future dividends > current market value of the stock
Divt as a function of eps
Earnings/Shares outstanding x payout ratio
Div t = EPSt x Payout Ratiot
relationship between retention, plowback, and payout ratio
retention ratio = plowback ratio = 1- payout ratio
DDM growth formula at steady state
gss = ROE x Plowback ratio gss = ROE x (1 - payout ratio)
Plowback ratio
=(Net income - dividends) // Net income
Dividends under clean surplus
Div1 = E0 x ROE x payout ratio
DDM Terminal value
(Divf + 1) / (rE-g)
/ (1+rE)^F
Multiple Ratios
Market based measure / Accounting based measure
Forward P/E
when you buy a stock, you are buying the rights to the firms future earnings
= P0 / EPS1
= Div1/EPS1 / (rE - g)
= Payout ratio / (rE - g)
Trailing P/E
P0/EPS0
Pros of DDM
- Theoretically justified (dividends are cash flows to shareholders).
- Less volatile than other measures (if a firm stops paying dividends it can be a very bad signal).
- Closely connected to growth financials and easy to use on the basis of accounting data.
Cons of DDM
- Not all firms pay dividends.
- Expectation of future dividends bears uncertainty.
- Puts more weight on the steady state.
- Takes the perspective of a minority investor who cannot control the dividend policy (say on dividend).
Pros of multiples advantage
- easy to use and apply
- makes less assumption than other models
Cons of multiples
- Relies on comparable groups
- If the market is efficient for the comparable companies, why is it not for our target company?
- Interpretations of very “high” multiples can lead to ambiguous conclusions.
Market to book ratio
- approximation of growth oppertunities of a company
- Indicates short and long term profitability and the prudence of how valuable a stock is
=Mk Val E / Book Val E
= 1 + (ROEss - rE)/(rE - gss)
Permanent Measurement Bias
Book value of equity is underestimated and less than theoretical value of equity (V) based on accounting rules so the accounting long run ROE will be greater than actual rE
qT=Vt / Et - 1
PMB ROE Formula
ROEss = rE + qT ×(rE −gss)
Steady state ROE
rE + qt x (rE - gss)
Residual Income Valuation model
- Expresses the future cash flows to equity in terms of accounting measures of capital (e.g., book value of equity) and performance (e.g., return on equity).
- Residual income is the income a company generates after accounting for the cost of capital.
- Substituting future dividend payments for future residual earnings.
- looks at the economic profitability of a firm rather than just its accounting profitability.
Residual Income Formulas
Residual Income
= NI - Charge For Equity
= Net Income - (Equity(t-1) * Cost of Equity)
= (ROEt−rE)×Et−1
Equity Growth for residual income
= ROE - % of equity paid in dividend
RIV formulas
V0 =E0 + {NIt −rE * Et−1 / (1 + rE)^t}
=E0 + {RIt /(1 + rE )t}
=E0 + {(ROEt −rE) ×Et−1 /
(1 + rE)^t}
Factors that can influence residual income
- Competitive advantage in product markets.
- Management efficiencies (e.g., Profit Margin, Asset Turnover).
- Efficiency of financial decisions (e.g., Gain in ROE from financial
leverage) .
RIV Steady State
Vo
= Eo + [(ROEss – rE) x Eo] / [rE – Gss)
Steady State Payout Ratio
1 - gss/ROEss
Pros of RIV
▶ Puts less weight on the terminal value.
▶ Uses available accounting data.
▶ Is useful for firms without or unpredictable free cash flows.
Cons of RIV
▶ Relies on the clean surplus relation.
▶ May require adjustments of accounting data.
Book Value of Equity
book value of equity = total equity – non-controlling interests
