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)
