Lecture 2/3 - Discounted Cash Flow Valuation

Question 1

What is terminal value of stock TVt?

Answer 1

The price payoff Pt when the share is sold

Question 2

Valuation issues:

Answer 2

• the forecast target: dividends, cash flow, earnings?
• the time horizon: T=5 , 10, 15?
• the terminal value
• the discount rate

Question 3

What is the dividend irrelevancy concept?

Answer 3

• Dividend policy can be arbitrary and not linked to value added
• Dividends paid before T reduce Pt to leave present value unaffected

Question 4

What is the dividend conundrum?

Answer 4

Equity value is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this value

Question 5

dividend discount analysis advantages:

Answer 5

• Easy concept as dividends are what shareholders get, so can be forecasted
• Element of predictability as dividends are usually fairly stable in the short run so dividends are easy to forecast

Question 6

dividend discount analysis disadvantages:

Answer 6

• Sometimes irrelevant as dividends payout is not related to value added, at least in short run
• Further, dividend forecasts ignore the capital gain component of payoffs
• The horizon usually requires forecasts for long periods, terminal values for shorter periods are hard to calculate with any reliability

Question 7

When does dividend discount analysis work best?

Answer 7

When the payout is permanently tied to the value generation in the firm

E.g. fixed payout ratio (dividends/earnings)

Question 8

Free cash flow:

Answer 8

cash flow from operations that results from investments minus cash used to make investments

Question 9

Steps for a DCF Valuation

Answer 9

1) Forecast free cash flow to a horizon
2) Discount the free cash flow to present value
3) Calculate a continuing value at the horizon with an estimated growth rate
4) Discount the continuing value to the present
5) Add 2 + 4
6) Subtract net debt

Question 10

DCF analysis advantages

Answer 10

• Easy concept as cash flows are real and easy to think about, and not affected by accounting rules
• Is straight application of familiar net present value techniques

Question 11

DCF analysis disadvantages

Answer 11

• free cash flow does not measure value added in the short run; value gained is not matched with value given. up
• free cash flow fails to recognise value generated that does not involve cash flows
• investment is treated as a loss of value
• can require long forecast horizons to recognise cash inflows from investments
• not aligned with what analysts forecast: analysts forecast earnings, not free cash flow

Question 12

When does DCF work best?

Answer 12

when the investment pattern is such to produce constant free cash flow or free cash flow growing at a constant rate

Question 13

The most uncertain (speculative) part of a valuation is?

Answer 13

The continuing value. Thus, valuation techniques are preferred if they result in a smaller amount of the value attributable to the continuing value.

DCF techniques can result in more than 100% of the valuation in the continuing value

Question 14

Why is free cash flow not a value-added concept?

Answer 14

Cash flow from operations (value added) is reduced by investments (which also adds value) - but investments are treated as value losses.

Thus, value received is not matched against value surrendered to generate value.

Question 15

cash flow from operations =

Answer 15

reported cash flow from operations + after-tax net interest payments

Question 16

after-tax net interest =

Answer 16

net interest x (1 - tax rate)

Question 17

net interest =

Answer 17

interest payments - interest receipts

Question 18

reported cash flow from operations is sometimes referred to as:

Answer 18

levered cash flow from operations

Question 19

Reported cash flow in investing activities is incorrect because:

Answer 19

reported cash investments include net investments in interesting bearing financial assets (excess cash) which is a financing flow

Question 20

cash investment in operations =

Answer 20

reported cash flow from investing - net investment in interest-bearing securities

Question 21

Value =

Answer 21

Anchor + Extra value

• Anchor is book value

Question 22

Residual earnings1 =

Answer 22

Earnings1 - (required return * investing0)

Question 23

Residual earnings is sometimes referred to as:

Answer 23

abnormal earnings or excess profit

Question 24

Valuing a savings account =

Answer 24

Book value + PV of residual earnings

Question 25

Normal P/B =

Answer 25

1.0

(Price = book value)

Normal P/B firm earns an expected rate of return on its book value equal to the required return

Normal P/B firm earns expected residual earnings of zero

Question 26

Lessons from the savings account:

Answer 26

1) An asset is worth a premium or discount to its book value only if the book value is expected to earn non-zero residual earnings
2) Residual earnings techniques recognise that earnings growth does not add value if that growth comes from investment earning at the required return
3) Even though an asset does not pay dividends, it can be valued from its book value and earnings forecast
4) The valuation of the savings account does not depend on the dividend payout. The two scenarios have different expected dividends, but the same value.
5) The valuation of a savings account is unrelated to free cash flows: the two accounts have the same value but different free cash flow.

Question 27

Anchoring principle - if one forecasts that an asset will earn a return on its book value equal to the required return, it must be worth its:

Answer 27

book value

Question 28

Residual earnings =

Answer 28

Comprehensive earnings - (required return on equity x initial book value)

Question 29

For finite horizon forecasts need three ingredients, besides the cost of capital:

Answer 29

1) The current book value
2) Forecasts of residual earning to horizon
3) Forecasted premium at the horizon

Question 30

ROCE =

Answer 30

Comprehensive earnings to common / book value

Question 31

Residual earnings is the rate of return on equity expressed as a:

Answer 31

dollar excess return on equity rather than a ratio

Question 32

Two drivers of residual earnings:

Answer 32

1. ROCE

2. Growth in book value

Question 33

Steps for applying the model:

Answer 33

1. Identify the book value in the most recent balance sheet
2. Forecast earnings and dividends up to a forecast horizon
3. Forecast future book values from current book values and your forecasts of earnings and dividends
4. Calculate future residual earnings from the forecasts of earnings and book values
5. Discount the residual earnings to present value
6. Calculate a continuing value at the forecast horizon
7. Discount the continuing value to the present value.
8. Add 1, 5, and 7

Question 34

Advantages of the residual earnings model

Answer 34

• Focuses on value drivers: profitability of investment and growth in investment
• Incorporates the financial statements
• Uses accrual accounting
• Can be used with a wide variety of accounting principles
• Aligned with what analysts forecast (earnings)
• Protects from paying too much for growth
• Relies less on uncertain continuing values and uncertain long-term growth rates

Question 35

Disadvantages of the residual earnings model

Answer 35

• Requires an understanding of how accrual accounting works

- Relies on accounting numbers that can be suspect