Corporate Valuation Flashcards
Equity versus Enterprise Value
When completely financed by equity. Value of equity = value of assets
If partially financed with equity and debt, sum of value of liabilities and equity = value of assets
Dividend Discount Model (DDM)
From a stock investment, stockholders can expect all future dividends and the price when selling the stock.
It is difficult to estimate stock prices in this framework, since estimating future dividends and the appropriate discount rate is needed
Gordon Growth Model (GGM)
It’s a special case of the DDM. The equity value is determined by dividend payments (D) to shareholders, assuming a constant dividend growth (g) and r>g.
The valuation formula is often used for simplicity but implies a constant dividend growth rate to infinity.
Constant-growth DDM is useful but very simplifying. Firms have life cycles with different dividend profiles.
GGM and growth opportunities
The difference in stock value before and after deciding to plowback is called the present value of growth opportunities (PVGO).
The value of a growth stock is much higher than the value of a non-growth stock. A growth firm needs to have profitable projects to invest in.
PVGO is the net present value of a firm’s future investments.
A sustainable growth rate is most desired, it is the highest growth rate that the firm can maintain without increasing its financial leverage.
Payout Ratio and questions
It’s the proportion of income that is paid out to shareholders.
- How much cash should the corporation pay out to its shareholders
- How should the cash be distributed, by paying cash dividends or repurchasing shares?
Dividend policy: high vs low payout ratio
High payout ratio: high dividend yield today, but limited growth implies lower dividend payments in the future
Low payout ratio: low dividend yield today, but strong growth implies higher dividend payments in the future.
Problems of DDM & GGM
DDM is intuitive and straightforward, but young and high-growth firms don’t pay dividends
Dividends are the strictest/ narrowest measure of cash flow to equity and many firms don’t pay dividends.
More firms buy back shares to return cash to shareholders.
Concentrating on dividends would result in an erroneous valuation.
Buybacks often spike in contrast to dividends, which are smoothed - buybacks should be normalized using averages over longer time periods. When using augmented dividends, we hope managers to pay cash to shareholders, but they don’t do so
Discounted Cash Flow Model (DCF)
Calculating FCF to firm, CF needs to be adjusted for reinvestment needs.
Reinvestment:
1. reinvestment in long-lived assets: the difference between CAPEX and depreciation.
2. reinvestment in short-lived assets: change in WC, increases in inventory, and accounts receivable represent cash tied up in assets that generate no return, supplier credit that accounts payable mute the effect on CF
Estimating horizon values
The final payment at H is the terminal or horizon value
To determine the horizon value PV, it is often assumed that the FCF at the end of the detailed planning period grow uniformly at a constant rate g
DCF advantages
DCF method considers CF, which was generated from business activities in one year. (less affected by accounting standards than earnings)
Amortization policy and different accounting rules have a significant influence on profits, but not on CF. Hence, DCF is independent of profit considerations and accounting policies. (also independent of market fluctuations and control premium)
DCF is independent of dividend payments, which primarily reflect a decision on the distribution of profits.
DCF pitfalls
Transparency: what level of budgeting/ amount of CAPEX has been chosen (and why)?
Material correctness: Are the CF forecasts realistic based on both the company’s profile and the economic outlook for the industry and the economy at large?
Insufficient consideration of the flexibility of operations, the synergy effect, and control premium.
Results are very sensitive to the assumption of the cost of capital, growth expectations, and forecasted CF
Multiple Valuation
It is more informative to compare the relative value of different firms, so market expectations can be included in the valuation.
How to:
1. determine peer group
2. choose one financial ratio (select multiple)
3. calculate ratios for both the firm and the peers
4. calculate the mean or median of the peer group as a benchmark
5. multiply the resulting ratio by the value driver of the evaluated company
Multiple valuations - primary fields of application
equity valuation (used as additional valuation method, sometimes as primary valuation method)
investment decisions (primary decision tool for style investing, frequently used for stock screening, aggregate of such valuation ratios is often used as a measure of market valuation and investor sentiment)
Multiple valuation pros
- few assumptions
- easy to calculate and interpret
- reflects current market mood; comparison between firms at the same time is not affected
- allows easy comparison between firms and industries
empirically, multiple valuations provide similar accuracy as the DCF method. Multiple valuations based on forecasted value driver improves accuracy.
multiple valuation cons
- neglect of risk
- limited forward-looking
- bubble effect
- lack of transparency (choice of peer group, multiples, and the calculation)
