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## Valuation

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**Valuation**Chapter 10**Valuation models**• Discounted cash-flow • Market-based (multiples) • Residual income Model DCF and risidual income model are much more sophisticated valuation tools than the price multiples • Infinite forecast horizon • Risk and the time-value of money are taken into account (cost of capital) Ch 10**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 Ch 10**Discounted Dividend ValuationTheoretical Model**• No-growth, constant dividend • Dividends are growing at rate g Ch 10**Required rate of return (r)**• rf, Risk-free (30-year Treasury bond) = 5% • rm, Expected stock market return = 10% • Risk premium = (rm – rf) • For example, if Beta = 1.5 • r = 5% + 1.5(10%-5%) • r = 12.5% Ch 10**Growth rate (g)**• Sustainable growth = ROE(1-Payout rate) • ROE = Earnings/Average equity • Payout rate: % of earnings used to pay dividends Ch 10**Discounted Dividend ValuationMotorola example**• Motorola • Annual dividend = $0.16 • Beta = 1.35 • ROE = 13% • Payout ratio = 20% • Economic • Yield on Treasury bills = 4.75% • Historical market risk premium = 5.4% Ch 10**Discounted Dividend ValuationMotorola example**• r = .0475+1.35(.054) = .120 • g = .13(1-.20) = .104 • Value = $11.04 Ch 10**Discounted Operating Cash-Flow Models**• Value of the firm (EV) = Value of assets = Enterprise value = Value of debt +value of equity • Typically, valuation of debt is relatively easy. Amount of debt reported in balance sheet is usually close to market value, i.e. value of debt is observable Ch 10**Discounted Operating Cash-Flow Models**• Operating cash flow Plus: Interest Paid Times (1-tax rate) Less: Investments in Fixed Capital Free Cash Flow to the Firm(to all investors) Ch 10**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)] • Shares outstanding is 2,299 • Value per share (after debt $9,428) is $7.28 Ch 10**Discounted Operating Cash-Flow Models**• Growth • Can also use a multi-stage model to accommodate rate changes • Forecasting cash flows requires judgment • Begin with reported, historical cash flow and earnings • Make company-appropriate adjustments • Use financial analysts’ estimates Ch 10**Market-based Models (multiples)**• Compare subject company to other similar companies for which market prices are available • Simple but require a lot of professional judgment • P/E Model • P/B Method • P/S Model Ch 10**P/E Model**• Assumes a company is worth a certain multiple of its current earnings • Assumes each stock is worth the same multiple of EPS • Requires judgment regarding • Peer firms • Historical (average) P/E Ch 10**P/E Model**• Firms with no internal growth prospects, paying out 100% of earnings • Current P/E = 1/r • Constant growth, • P0/E1 = (D1/E1)/(r-g) • D = annual dividends, E = EPS Ch 10**P/E versus bond yields**http://home.golden.net/~pjponzo/PE-BondRates.htm Ch 10**Effect of the cost of equity and growth opportunities to**P/E-ratio Ch 10**P/E Model**• Motorola example • Consensus analyst forecast EPS = $0.46 • P/E of 23 is appropriate • Value = 23*$0.46 = $10.58 Ch 10**Problems when using P/E-ratio in valuation**• It assumes that the benchmark is obtainable. • P/E-ratios might differ accross firms or time at least for the following reasons: • growth opportunities may differ accross firms • riskiness of a firm may differ accorss firms • earnings for a given year may be temporary by nature Ch 10**P/B-ratio, price/book–ratio**• 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 Ch 10**Other Price multiples**• enterprise value/EBIT–ratio • price/free cash flow–ratio • price/sales–ratio • Price/EBITDA Method used should be appropriate considering the specific circumstances of the subject company. Ch 10**Residual Income Model**• PV = book value + excess earnings over time • Perpetuity model Ch 10**Valuation tools most used by analysts in Morgan Stanley**European sector research teams Ch 10