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BE352 - Financial Reporting/Markets > L4-5: Corporate Valuation > Flashcards

L4-5: Corporate Valuation Flashcards

1
Q

What is economic value based on?

A

Preferences of individuals. Simplified logic: individuals value useful things, tends to involve consumption of goods, services and events; cash is needed in order to consume; value is based on cash and cash flow.

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2
Q

Valuation theory suggests that the value of an investment is determined on the basis of…

A

The future cash flows expected to be received by the investor. (Expectations → Estimation → Errors)

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3
Q

What is value (theoretical price)?

A

Sum of the discounted expected future cash flows.

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4
Q

What is the observed price?

A

The amount at which a buyer and a seller have agreed to make a transaction. Supply and demand is key!

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5
Q

Why may we do corporate valuation?

A
  • Stock investments
  • Portfolio choice
  • Merger and acquisitions
  • General successions
  • Hostile takeovers
  • Spin-offs
  • Initial public offerings
  • Stock issues
  • Stock analyses
  • Tax purposes (transaction between closely related parties)
  • Management tools (value based management)
  • Compensation (stock options)
  • Privatisations
  • Impairment tests
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6
Q

What are 3 corporate valuation approaches?

A
  1. Substance valuation (asset by asset, won’t go into detail)
  2. Discounted flows
  3. Valuation multiples
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7
Q

What is the substance valuation approach and what are its pros and cons?

A

Assets - Liabilities = Shareholders’ equity

(Book values, Liquidation values, Market values)

Pros:
- Simple (little input and easy to calculate)
- Easy to communicate
- Good link to discounted flow models.

Cons:
- Insufficient approach for companies where the balance sheet is a limited description of the company’s resources.

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8
Q

What is the discounted flows valuation approach?

A
  • Make a detailed scenario a few years ahead and then calculate a terminal value at the horizon.
  • Valuation attribute? Dividends, residual income, free cash flows.
  • Chosen valuation attribute and risk level are decisive for the choice of required rate of return.
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9
Q

What are pros and cons of the discounted flows valuation approach?

A

Pros:
- Can capture detailed scenarios
- Show value drivers
- Show assumptions

Cons:
- Much work
- Difficult to make forecasts
- High risks for mistakes

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10
Q

What is the multiples valuation approach?

A

P/E multiple. Make use of comparable firms (peer group).

  • Other multiples: Price or enterprise value (EV) compared to EBIT, EBITDA, Net sales, Employees, subscribers, number of clicks/views, etc.
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11
Q

What are pros and cons of multiples valuation approach?

A

Pros:
- Simple (little input and easy to calculate)
- Easy to communicate
- More easily applied to private firms

Cons:
- Difficult to find comparable firms
- Particularly difficult if the company has high growth and high profitability. Are the firms you compare with “correctly” valued?

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12
Q

What is indirect valuation?

A
  • Focus on flows from operations.
  • Estimate value of the company’s operations: V(CE).
  • Estimate value of the company’s debt V(D).
  • V(CE) - V(D) = V(E)
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13
Q

What is direct valuation?

A
  • Focus on flows to stock owners.
  • Estimate value of the company’s equity: V(E).
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14
Q

What are 3 discounted flow valuation approaches?

A

Discounted dividends (DIV):
- Direct valuation of shareholders’ equity
- Required rate of return for shareholders’ equity (rE)

Discounted free cash flows (FCF):
- Indirect valuation of shareholders’ equity
- Required rate of return for operating net assets (rWACC)

Book value of equity + Discounted residual income (RI):
- Direct valuation of shareholders’ equity
- Required rate of return for shareholders’ equity (rE)

With consistent assumptions, all 3 models will give the same equity value. This course: DDM and RIV.

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15
Q

What is time value of money?

A

The principle that states that the purchasing power of money can vary over time: “A dollar today is preferable to a dollar tomorrow”.

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16
Q

Why does money possess a time value?

A
  • Individuals prefer present consumption to future consumption. Would have to be offered more in future to give up present consumption.
  • Monetary inflation decreases the value of currency over time.
  • A promised cash flow might not be delivered for a number of reasons: any uncertainty associated with the cash-flow in the future reduces the value of it.
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17
Q

Why may we expect market values of corporations to exceed book values?

A
  1. Accounting values are often based on past transactions (acquisition cost), not PV of future CFs.
  2. Accounting typically values each asset individually: the going concern element is not recognized and measured.
  3. Prudence emphasis: some individual assets not recognized and measured on the balance sheet (internally generated intangible assets like R&D-related assets, market investments, training).
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18
Q

What are some aspects to consider about market values exceeding book values?

A
  • Will all industries be the same?
  • Does it matter whether the corporation grows organically or by acquisitions?
  • What about loss-making firms?
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19
Q

What is the risk-free rate compensation for?

A
  • Real risk-free interest rate (comp. for waiting)
  • Compensation for expected inflation
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20
Q

What is the risk premium?

A

Compensation for risk.

r(E) - rf

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21
Q

What are the cash flows shareholders obtain from owning stocks?

A
  • Dividends
  • Capital gains
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22
Q

What is rE?

A

The expected total return of a shareholder (rE) is equal to the expected return of other investments available in the market with equivalent risk.

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23
Q

What is the foundational idea for DDM valuation?

A

The fundamental value of equity or theoretical current price (P0) is equal to the present value of the expected future dividends it will pay.

24
Q

What should managers do to maximise share prices?

A

Increase next dividend, and the growth rate for future dividends (but rE > g)

However, there is a tradeoff since more dividends imply less cash to use to finance necessary investment to support the increasing growth rate

25
Q

How can you increase the dividend?

A
  • Increase earnings
  • Increase payout ratio
  • Decrease number of shares outstanding
26
Q

What do we assume is a necessary condition for growth in earnings and dividends?

A

Reinvestment is needed to support growth

27
Q

What is the sustainable growth rate?

A

The rate at which the firm can grow using only its retained earnings

28
Q

How do we know if we should increase dividends or save money to invest in growth?

A

Depends on the profitability from the investment supported by the retained earnings; is the ROEt larger, smaller or equal to the required return from shareholders (rE).

29
Q

What can be said about different growth rates in different company stages?

A

Growth rates depend on business cycle stage.

  • Younger firms have more growth opportunities (a larger set of NPV-positive projects) and therefore these firms payout less and reinvest most of their earnings.
  • Mature firms do not have a large set of NPV-positive projects, so they do not require large investments. At that point, their earnings exceed their investment needs and they should begin to pay dividends.

–> Forecast div during growth period, then assume steady state and calculate terminal value

30
Q

What are the 3 categories of the three-stage DDM?

A

Three categories of projected growth in earnings:

  1. Growth years (assumed to span 3-9 years), during which the company earns abnormal earnings (ROEgy > rE).
  2. Transition years (assumed to span 8-14 years), during which profitability gradually declines towards an average for the industry.
  3. Maturity years (beyond 11-17 years), during which profitability is at the industry average (ROEmy = ROEindustry)
31
Q

What is a multiple?

A

A ratio that relates a market based measure to an observable accounting (or non-accounting) based measure.

Multiple = market measure / accounting measure

32
Q

How can we estimate the market-based measure for the stock we want to value with a multiple?

A

Market measure(firm) = Multiple * Accounting measure(firm)

Normally use a comparable based measure for the multiple: industry mean or median (peers)

33
Q

What is the intuition behind the P/E ratio?

A

When you buy a stock, you are in a sense buying the rights to the firm’s future earnings. We can estimate the value of a firm’s share by multiplying its current earnings per share by the average/median P/E ratio of comparable firms

34
Q

What does the forward P/E imply?

A
  • If two stocks have the same payout ratios and earnings growth rates, as well as equivalent risk (same rE), then they should have the same P/E.
  • Firms and industries with high growth rates, and that generate earnings well in excess of their investment needs (ROE > rE) so that they can maintain high payout rates, should have high P/E multiples.
35
Q

What are the advantages of DDM?

A
  • 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) - normally sticky.
  • Closely connected to growth financials and easy to use on the basis of accounting data.
36
Q

What are the disadvantages of DDM?

A
  • Not all firms pay dividends
  • Expectation of future dividends bears uncertainty
  • Puts more weight on the steady state - terminal value requires strong assumptions, which makes the model sensitive.
  • Taking the perspective of a minority investor who cannot control the dividend policy (“say on dividend”), large shareholders (family owners) may however have a say.
37
Q

What are the advantages of using multiples valuation?

A
  • Easy to use and apply.
  • Makes less assumptions than other models.
38
Q

What are the disadvantages of using multiples valuation?

A
  • Relies heavily on a comparable group of firms.
  • 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.
39
Q

What is the market-to-book ratio?

A

An approximation of the “growth opportunities” of a company.

V0 / E0

40
Q

What can a high MTB be interpreted as?

A
  • High short-term and long-term profitability.
  • It may also indicate a prudent (conservative) valuation of the book value of equity.
41
Q

What industries tend to have relatively high and low MTBs?

A

High:
- Drugs
- Medical equipment
- Healthcare

Low:
- Banking
- Insurance
- Real estate

42
Q

What may prudent accounting principles result in?

A

Understated book value of equity.

–> ROE based on accounting numbers higher than cost of equity (rE, market), just because of “accounting measurement bias”

43
Q

What can the permanent measurement bias help us with?

A

Calculate the steady state (long-run) ROE, ROE(ss)

44
Q

What is the idea behind the RIV model?

A

It expresses the future CFs to equity in terms of accounting measures of capital (e.g. book value of equity) and performance (e.g. return on equity).

Implementation requires forecasting the amount of expected future “economic profits” which depends on how business strategy plays out in the context of industry competitive dynamics, effective management of financial capital, and governance.

45
Q

What is residual income?

A

Reflects the abnormal returns generated by managers with equity holders’ investment (like alpha, excess of required return)

46
Q

What is the equity charge?

A

What shareholders require for their initial investment, in monetary terms (Risk is reflected in this)

47
Q

How can we interpret the terms of the RIV model?

A
  • E0: the accountant’s estimate of a minimum value of the future cash flow equity investors should receive. Rests on the idea that accounting is conservative in nature.
  • The second term: PV of economic value added by managers (function of the expected managerial ability)
48
Q

How can RIV be linked with strategy and financing decisions?

A
  • Helps link intrinsic value to its strategic and financial levers.

Managers can improve intrinsic value by increasing future RI, which depends on:
- firm’s ability to compete in the industry
- efficiency with which management deploys assets and resources
- efficiency of management’s financial decisions.

For example, the DuPont decomposition of ROE can help managers and investors understand how different operating or financial decisions are linked to value.

49
Q

What are some factors that can influence residual incomes?

A
  • 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).

But: need to consider full effects, may be spillover effects of decisions

50
Q

What are the assumptions of the steady state RIV model?

A

Revenues, net income and book value of equity grows at constant rate g(ss) (i.e. the “sustainable growth rate”) so that ROE(ss) remains constant every period

51
Q

What is an appeal of the steady state RIV model?

A

It shifts part of the burden of terminal value estimation to the book value of equity. In essence, part of the expected future free cash flows is already incorporated in the current book value.

52
Q

What does the terminal value forecast of abnormal profitability in RIV depend on?

A

The forecaster’s view of industry competition and the extent of the company’s sustainable competitive advantage.

53
Q

What levers of value creation are highlighted in the RIV?

A

A combination of profitability, growth, and the ability to sustain both drive value.

Growth is a useful lever for creating value when firm profitability is above the cost of equity; growth adds value when firms have (and invest in) positive NPV projects.

When a firm’s long-term profitability is low, then improving profitability is the most important lever for improving value

54
Q

What are the advantages of the RIV model?

A
  • Puts less weight on the terminal value
  • Uses available accounting data
  • Is useful for firms without or unpredictable free cash flows
55
Q

What are the disadvantages of the RIV model?

A
  • Relies on the clean surplus relation
  • May require adjustments of accounting data

BE352 - Financial Reporting/Markets (6 decks)

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