Valuation

Question 0

What discount rate should you use?

Answer 0

Cost of equity vs Cost of capital (WACC)

if discounting cash flows (dividends) to equity use Cost of equity from CAPM (basis: the riskier the investment is the greater is the cost of equity)

if discounting cash flows (FCF) to the firm use the Cost of capital (WACC)
WACC=ke•(E/(E+D))+kd•(D/(E+D))
Where
kd=current borrowing rate •(1-t)
E and D are market value of equity and debt

Question 1

What should you use for calculating market value (V) ? And for market capital (P) ?

Answer 1

V goes with EBIT(1-t), FCF, ROIC, BV of NOA and WACC

P goes with NI, ECF, ROE, BV of equity, r-cost of equity

Question 2

When should you use a stable growth model (single stage)?

Answer 2

If the firm is
Large and growing at a rate of below or close (within 1-2%) to the growth rate of economy or
Is constrained by regulation from growing at a rate faster than the economy or
Has the characteristics of the stable firm ( ie average risk, average reinvestment)

Question 3

When should you use 2-stage growth model?

Answer 3

If the firm is
• Large and growing at a moderate rate equal or less than +10% or
• has the single product and barriers to entry for finite life (ie patents)

Use 2-stage growth model

Question 4

When should you use 3-stage growth model?

Answer 4

If the firm is
• small and growing at a very high rate ie greater than +10% or
• has significant barriers to entry to the business or
• has firm characteristics that are very different from the norm

Use 3-stage growth model

Question 5

Why would you normalize values in your valuation model?

If required to normalize how do you normalize results?

Answer 5

It makes sense if firm’s last financial results are exceptionally good or bad (which is not to be sustainable)
And if firms were financially healthy but with the current problem which is viewed as temporary then normalizing would give valuation about the firm if they overcomes the problem next year

We are dealing below exceptionally bad resulted year where EBIT is negative

Rule 1. If firm is in trouble because of recession and its size HAS NOT changed significantly over time - use average EBIT over past period for the firm

Rule 2. If firm is in trouble because of recession an it’s size HAS been changed significantly over time - use average ROIC over an extended time period for the firm. That is
Normalized EBIT=current BV of invested capital • average ROIC of firm

Rule 3. If firm is in trouble because of firm-specific factors and the rest of the industry is healthy - use average ROIC for comparable firms
That is
Normalized EBIT=current BV of invested capital • average ROIC of comparable firms