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VALUATION. Five Categories of Valuation Methods. Discounted cash-flow Market-based Mixed models Asset-based methods Option-based methods. Discounted Cash-Flow Approach. Estimated future cash flows are discounted back to present value based on the investor’s required rate of return

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## VALUATION

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**Five Categories of Valuation Methods**• Discounted cash-flow • Market-based • Mixed models • Asset-based methods • Option-based methods**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**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**Discounted Dividend ValuationTheoretical Model**• No-growth, constant dividend • Dividends are growing at rate g**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**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%**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**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**Discounted Dividend Valuation- example**• Company A • 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 Valuation- example**• r = .0475+1.35(.054) = .120 • g = .13(1-.20) = .104 • Value = $11.04…**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**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**Discount Rate**• FCFF • Weighted Average Cost of Capital • FCFE • Cost of Equity (required rate of return)**Discounted Operating Cash-Flow ModelsOther considerations**• Growth • Can 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**Special Issues**• Loss generating firm valuation • Closed Firm Valuation • Start-up companies**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**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**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**P/E Model - 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**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**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**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**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

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