Session 3 Flashcards
Valuation process
- Understanding the business
- Forecasting
- Selecting your valuation model(s)
- converting your forecasts to a valuation
- Making the decision/recommendation
Absolute valuation
Just looking at the current market value of stock to give absolute valuation
E.g. present value models
-market value and/or
-relative value model
Relative valuation model
Look at other influential factors - similar houses in that area e.g. price multiples
-sensitivity analysis
Absolute valuation models overview
All models provide an estimate of equity value
DDM (dividend discount model)
DCF (discounted cash flow)
EVA (economic value added)
DDM
Dividend discount model:
Equity value = present value of expected future dividend
DCF
Discounted cash flow:
Equity value
= PV of expected future cash flows to equity
= PV of expected future cash flows to the firm
Market value of debt
EVA
Economic value added:
Equity value = book value of equity
+ PV of expected future abnormal earnings
Market value of debt
2 stage discount dividend model
Initial (higher growth) phase
Stable,steady state growth phase - terminal value
Considered when thinking about high growth companies - may be a high growth rate and offering shareholders substantial payout
H-model
Very similar to 2-stage ddm
It differs as it attempts to smooth out growth rate over time, rather than abruptly changing from high to stable growth period
Three stage model
- Initial period growth
- Period of incremental increase/decrease
- eventually stabilising at more moderate growth rate for rest of company
Ex: tesla, amazin
When to apply DDM
A company has prior history of dividend payments and profitability - allowing for future profits & payout ratios forecasts
A company has stated a clear dividend policy
A company has an implicit dividend policy
When NOT to apply DDM
Company doesn’t pay dividends
The company viability as a going concern is in doubt
No clearly stated dividend policy
Dividends differ from free cash flow/earnings
When to apply DCF
Discounted cash flow
- When an investor is valuing the firm from the perspective of a potential/actual controlling shareholder
- Free cash flows are expected to align with profits within a reasonable period
- When the company’s actual dividends differ from its ability to pay dividends
4 step DCF
- Forecast free cash flow to
-debt and equity or
-equity
(Over a finite forecast horizon -5/10yrs)
2.forecast free cash flow beyond the terminal yr based on some simplifying assumption
3.discount at the WACC or retained earnings - For WACC deduct market value of debt to get market value of equity
Net interest expense after tax
(Interest expense - interest income) x (1-tax rate)
NOPAT
Net operating profit after tax Net profit (/income) + net interest expense after tax
Net operating working capital
Current assets - (current liabs - short-term debt and current portion of long-term debt)
Net long-term assets
Total long-term assets - non-interest bearing long-term liabs
Net assets
Net operating working capital + net long term assets
Debt
Total interest - bearing liabilities
Net capital
Debt + shareholders equity
Return on assets
NOPAT / net assets
NOPAT of year and divide by net assets for YEAR BEFORE (year end figure)
Terminal value
Need an appropriate assumption for terminal years onwards
E.g. Competitive equilibrium assumptions
Competitive forces drives down returns to normal level
Projects earn the cost of capital e.g. zero NPV projects
So growth beyond terminal year can be ignored
EXISTING ASSETS CONTINUE TO EARN ABNORMAL RETURNS
