Week 3: Fundamental Valuation Flashcards

1
Q

Terminal Value

A

Forecasting infinitely many future free cash flows is not feasible.
–> simplify this process
We explicitly forecast future free cash flows for a finite period (𝑁) and
future free cash flows beyond that period are captured in a “terminal value”.

We can determine the terminal value in three ways:
1) Liquidation value
2) Multiple approach
3) Stable growth model

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2
Q

Liquidation value: determining terminal value

A

Assume that the firm exists for a few more years and then at the end of the terminal year, it is liquidated.

The liquidation value is what others will pay for the assets of the firm at the end of the terminal year.

2 ways to estimate liquidation value:
1. MV of assets at end of terminal y
2. BV of assets at end of terminal y

(-) Assume that a firm will be liquidated in the terminal year is usually not reasonable!!

Example: Coal-fired power plant…
Due to the regulations the plant gets liquidated after a couple of years. The proceeds of assets after liquidation is included in the formula as FCF.

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3
Q

Multiple approach: determining terminal value

A

Determine the value of the firm at the end of the terminal year by applying a multiple to the firm‘s earnings or sales.

(+) simplicity
(-) Relative valuation: firm value will always be dependent on the multiple. Estimated on how firms trade TODAY.

see example calculation on slides- venture capitalists!

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4
Q

Stable growth model: determining terminal value

A

Determine the terminal value by assuming that future free cash flows beyond the terminal year 𝑁 grow at a constant rate forever.
–> growing perpetuity
! Most consistent fundamental valuation approach !

*The stable growth rate is a very important input parameter in fundamental valuation.
*Small changes in the stable growth rate can change the terminal value significantly and the terminal value typically accounts for a substantial fraction of the overall value of the firm.
(-)Analysts often use the stable growth rate to adjust the valuation in such a way that it reflects their biases.

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5
Q

2 constraints of stable growth rate

A
  1. Growth rate of economy
    *The stable growth rate of a firm cannot be higher than the overall growth rate of the economy in which it operates.
    *If a firm grew at a higher rate than the growth rate of the economy in which it operates, it would take over the entire economy at some point.
    *If young, growth firms have growth rates that are higher than the growth rate of the economy, more mature firms must have growth rates that are lower than the growth rate of the economy.
    *One often uses the risk-free rate as a lower bound for the long-term nominal growth rate of the economy.
  2. Reinvestment rate and return on capital
    –> g(EBIT)= reinvestment rate * return on capital
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6
Q

Extraordinary growth & stable growth

A

We often assume future free cash flows to grow at a high rate for a finite period and beyond that period we assume future free cash flows to grow at the lower stable growth
rate forever.
<2 parts in the formula>

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7
Q

Factors to determine length of extraordinary growth period.

A

1) Firm size
2) Past growth
3) Competitive advantage
etc.

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8
Q

Cost of Capital model (DCF-WACC)

A

Value of the firm is obtained by discounting the free cash flows to
the firm at the weighted average cost of capital (WACC) of the firm.

Determinants of value:
1. Cash flows:
What are the cash flows that will be generated by the existing investments of the company?
2. Growth:
How much value, if any, will be added by future growth?
3. Cost of capital:
How risky are the expected cash flows from both existing and growth investments, and what is the cost of funding them?
4. Terminal value: When will the firm become a stable growth firm, allowing us to estimate a terminal
value?

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9
Q

Sensitivity and scenario analysis

A

Because of the major uncertainty we are confronted with, point estimates are rarely meaningful in financial valuation. —> valuation ranges used.

How value changes if we change input parameters.
*Sensitivity analysis:
change one parameter.
*Scenario analysis:
change multiple parameters.

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10
Q

Minority holdings & minority interest

A

− Minority holdings are holdings in other companies that are not consolidated by the firm we are valuing.
− Minority interests are minority shareholders in other companies that are consolidated by the firm we are valuing.

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11
Q

APV model

A

We estimate the value of the firm in three steps:
1. We begin by estimating the value of the firm as if it was all equity financed.
2. We then add the value of the tax benefits resulting from debt.
3. Finally, we subtract the expected bankruptcy costs that debt creates

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12
Q

Probability of bankruptcy and bankruptcy costs

A

− The probability of bankruptcy is the probability that the firm will not be able to make the required payments on its debt obligation.
− The bankruptcy costs are the costs that will arise if the firm will not be able to make the required payments on its debt obligation.
*Direct bankruptcy costs (e.g., legal costs)
*Indirect bankruptcy costs (e.g., loss of trust of customers)

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13
Q

When to use DCF-WACC and when to use APV?

A

If we do not want to determine bankruptcy costs explicitly we go with DCF/WACC approach!

It can be very challenging to estimate bankruptcy costs, that is why mostly we go with DCF/WACC.

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14
Q

DDM (dividend discount model)

A

The equity value of the firm (per share) is the present value of all future dividends (per share), discounted at the cost of equity.

(+) past dividends are directly observable.
(-) firms often hold back cash that they could pay out to shareholders. Hence, dividends tend to underestimate the “true” free cash flow to equity. If this is the case, the dividend discount model results in an estimate of the equity value that is too conservative.

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15
Q

FCFE model

A

The equity value of the firm is the present value of future free cash flows to equity, discounted at the
cost of equity.

The free cash flow to equity model is a more general version of the dividend discount model. It replaces actual dividends with potential dividends. Consequently, it should yield a more realistic estimate of the equity value of a firm.

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16
Q

Why do we need the dividend discount model?

A

Has its downfalls but can be used under these circumstances:
1) Free cash flow to equity = dividends (e.g., mature firms with stable earnings)
2) Conservative estimate of the equity value (“lower bound of valuation range”)
3) Cash flow estimation difficult or impossible (e.g., financial services firms)

17
Q

Do different models lead to the same value?

A

− In theory, all approaches lead to the same value for a firm if we make consistent assumptions.
− However, getting the approaches to converge to the same value in practice can be very difficult.

18
Q

Consistency in cash flows and cost of capital

A

− In all valuation approaches, the cash flows and the cost of capital should be measured consistently.

For example: if the cash flows are measured in nominal U.S. dollars, the risk-free rate should be the
U.S. Treasury bond rate.

− Hence, it is not where a firm is headquartered that determines the choice of the risk-free rate, but
the currency in which the cash flows on the firm are estimated.

− Differences in risk-free (!) rates typically reflect differences in expected inflation.
− A low (high) cost of capital resulting from a low (high) risk-free rate will be exactly offset by a low (high) nominal growth rate of future free cash flows, leaving the valuation unchanged.

19
Q

Excess return models

A

*EVA (economic value added)
Value of assets in place and adds to it the present value of future economic value added.

*RIV (residual income valuation)
Initial book value of equity and add to it the present value of future residual income.

20
Q

Which fundamental valuation approach do analysts use?

A

Mostly DCF-WACC (or FCFE)
Then DDM
Then excess return models

21
Q

How does inflation impact valuation?

A

− 𝑟𝐸 : Nominal cost of equity
− 𝑔: Nominal stable (or constant or perpetual) growth rate in dividends per share
− A rise in inflation increases both the nominal discount rate and the nominal growth rate equally, leaving the equity value of a firm unaffected.

22
Q

Money illusion

A

− Money illusion refers to the tendency of people to confuse nominal and real values.
− When valuing companies, investors subject to money illusion adjust only the discount rate to rising inflation, but do not adjust the growth rate. This results in investors undervaluing firms in inflationary periods.