Post on 27-Dec-2015
Grant, Munter & Robinson
Chapter 10 2
Learning Objectives
• Compare and contrast valuation models– Discounted cash-flow– Market-based– Asset- or Option-based– Others
• Identify circumstances in which each model is most appropriate
Grant, Munter & Robinson
Chapter 10 3
Five Categories of Valuation Methods
1. Discounted cash-flow
2. Market-based
3. Mixed models
4. Asset-based methods
5. Option-based methods
Grant, Munter & Robinson
Chapter 10 4
Discounted Cash-Flow Approach
• Estimated future cash flows are discounted back to present value based on the investor’s required rate of return
• Discounted dividend valuation
• Discounted operating cash-flow models
Grant, Munter & Robinson
Chapter 10 5
Discounted Dividend Valuation
• Most straightforward approach
• Explicit cash flows received by equity investors
– Dividends– Terminal value when shares are sold
• Firm is expected to have an infinite life
Grant, Munter & Robinson
Chapter 10 6
Discounted Dividend ValuationTheoretical Model
• No-growth, constant dividend
• Dividends are growing at rate g
r
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gr
g)(D
gr
DP
10
0
1
Grant, Munter & Robinson
Chapter 10 7
Discounted Dividend ValuationRequired rate of return (r)
• r is the rate of return demanded on a specific investment
– Based on investor’s assessment of risk
• CAPM
)( fmf rrrr
Grant, Munter & Robinson
Chapter 10 8
CAPM -- Example
• rf, Risk-free (30-year Treasury bond) = 5%
• rm, Expected stock market return = 10%– Risk premium = (rm – rf)
• Beta = 1.5
• r = 5% + 1.5(10%-5%)
• r = 12.5%
Grant, Munter & Robinson
Chapter 10 9
Discounted Dividend ValuationRequired rate of return (r)
• For nonpublic companies, use a buildup model and historical sources for data
• Begin with risk-free rate
• + Equity risk premium
• + Small company premium
• + Company specific risk premium
• = Required rate of return
Grant, Munter & Robinson
Chapter 10 10
Discounted Dividend ValuationGrowth rate (g)
• Top-Down analysis– Begin with growth of economy– Adjust for industry, sector and company factors
• Sustainable growth = ROE(1-Payout rate)– ROE = Earnings/Average equity– Payout rate: proportion of earnings used to pay
dividends or repurchase shares
Grant, Munter & Robinson
Chapter 10 11
• Motorola– Annual dividend = $0.16– Beta = 1.35– ROE = 13%– Payout ratio = 20%
• Economic– 20-year Treasury bond = 4.75%– Historical market risk premium = 5.4%
Discounted Dividend ValuationMotorola example
Grant, Munter & Robinson
Chapter 10 12
• r = .0475+1.35(.054) = .120
• g = .13(1-.20) = .104
• Value = $11.04…
Discounted Dividend ValuationMotorola example
104.120.
)104.1(16.0$
Grant, Munter & Robinson
Chapter 10 13
Discounted Dividend Valuation
• Assumes a single, constant growth rate (g)• What if growth rates differ?• Use a multi-stage model to calculate future
dividends– Calculate future stock value based on future
dividend– Calculate present value of stock and dividends
• H model: for growth rates that decay over time
Grant, Munter & Robinson
Chapter 10 14
Discounted Operating Cash-Flow Models
• Most applicable in the event of a takeover
• Free cash flow (FCF) is operating cash flows less necessary investments in working capital and property, plant and equipment
gr
FCFV
1
0
Grant, Munter & Robinson
Chapter 10 15
Discounted Operating Cash-Flow Models
• r = Weighted average cost of capital (WACC)– Required rate of return to all capital providers– For Motorola, 10.2%
• g = growth rate of FCFs– For Motorola, 9%
• If Motorola’s FCF = $314 million
• Firm value is $26,167 million [314/(.102-.09)]
• Value per share (after debt) is $7.28
Grant, Munter & Robinson
Chapter 10 16
Discounted Operating Cash-Flow ModelsOther considerations
• Growth– Can use a multi-stage model to accommodate rate
changes– Is only beneficial if it leads to increased positive
cash flows in the future
• Forecasting cash flows requires judgment– Begin with reported, historical cash flow and
earnings– Make company-appropriate adjustments
Grant, Munter & Robinson
Chapter 10 17
Market-based Models
• Compare subject company to other similar companies for which market prices are available
• Simple computations but require a great deal of professional judgment
• P/E Model• P/B Method• P/S Model
Grant, Munter & Robinson
Chapter 10 18
P/E Model
• Assumes a company is worth a certain multiple of its current earnings
• Assumes each share is worth the same multiple of EPS
• Derived from the dividend discount models
• Requires judgment regarding– Peer firms and their prices– Historical (average) data
Grant, Munter & Robinson
Chapter 10 19
P/E Model
• Firms with no internal growth prospects, paying out 100% of earnings– Current P/E = 1/r
• Constant growth, Leading P/E– P0/E1 = (D1/E1)/(r-g)– D = annual dividends, E = EPS
• Constant growth, Trailing P/E– P0/E0 = [(D0/E0)(1+g)]/(r-g)
Grant, Munter & Robinson
Chapter 10 20
P/E Model
• Motorola example
• Consensus analyst forecast EPS = $0.46
• P/E of 23 is appropriate
• Value = 23*$0.46 = $10.58
• If the current price is $10.22, there is limited upside to this investment
Grant, Munter & Robinson
Chapter 10 21
P/B Method
• Book value (B)– Total stockholder’s equity– Less sensitive to short-term events than is earnings
• P/B is a function of profitability, growth and risk
• Is linked to the dividend discount model
Grant, Munter & Robinson
Chapter 10 22
P/B Method
• No growth– P0/B = ROE/r
• Constant growth– P0/B = (ROE- g)/(r-g)
• P/B ratios for similar firms are compared with those of the subject firm to arrive at an appropriate multiple for use in valuation
Grant, Munter & Robinson
Chapter 10 23
P/S Model
• Insert sales (S) into the dividend discount model
• E/S = Π
• P0/S = Π/r
• P0/S1 = (Π*Payout)/(r-g)
• Often used to value start-up firms, caution should be used
Grant, Munter & Robinson
Chapter 10 24
Other Multiples
• Cash-flow-based multiples are common
• Price/operating cash flow
• Price/EBITDA
• Price/free cash flow
• Dividend yield (D/P)
• Method used should be appropriate considering the specific circumstances of the subject company
Grant, Munter & Robinson
Chapter 10 25
Mixed Models
• Because the previous models are linked (discounted dividend model) a combined approach can be used
• May use discounted cash flow approach to forecast cash flows then use market multiple to derive terminal value
• Residual income approaches are linked to the dividend discount model
Grant, Munter & Robinson
Chapter 10 26
Residual Income
• PV = book value + excess earnings over time
• Perpetuity model
1
100 )1(t
ttt
r
rBEBP
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ROEBP
10
Grant, Munter & Robinson
Chapter 10 27
Asset-Based Models
• Used when a company is going to be liquidated
• Valuation is based on underlying assets– Market value of balance sheet items– Assets and liabilities
• Also called cost or adjusted book value approach
Grant, Munter & Robinson
Chapter 10 28
Options-Based Models
• Theoretically elegant but practical application is difficult– Analyst must have information about
opportunities (and their value) available to a firm
• Equity ownership is viewed as an option call on the firm– Limited downside, unlimited upside
Grant, Munter & Robinson
Chapter 10 29
Selecting a Model
• Consider characteristics of the firm– Dividend paying– Growing– Likely to be liquidated
• Consider data availability of data– Publicly available or closely held– Special opportunities available to certain firms