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MBA 8480 - Valuation Principles

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MBA 8480 - Valuation Principles

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MBA 8480 - Valuation Principles

  1. 1. Valuation Principles Professor Mike Pagano michael.pagano@villanova.edu
  2. 2. The primary goal is shareholder wealth maximization, which translates to maximizing stock price. – Should firms behave ethically? YES! – Do firms have any responsibilities to society at large? YES! Shareholders are also members of society. 2 Goals of the Corporation
  3. 3. 3 Common Stock: Owners, Directors, and Managers Common Stock represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Since managers are “agents” of shareholders, their goal should be: Maximize stock price (as noted in prior slide!)
  4. 4. • Improved corporate focus on a common goal • More informed decisions • Greater knowledge of key drivers of corporate success • Better communication between departments / business units • Improved financial disclosures (e.g., SFAS 142) 4 Benefits of Value-based Decision-making
  5. 5. Magnitude of cash flows expected by shareholders Riskiness of the cash flows Timing of the cash flow stream 5 Key Factors that Affect Stock Price “M.R.T.”
  6. 6. Sales – Current level – Short-term growth rate in sales – Long-term sustainable growth rate in sales Operating Expenses Investments: Capital expenditures / R&D / Advertising / D Net Working Capital Operating Cash Flow (OCF) Net Invest. Oper. Capital 6 Three Key Determinants of Cash Flows 𝑭𝑪𝑭 = 𝑺 − 𝑪 ∙ 𝟏 − 𝑻 + 𝑫𝑬𝑷 − 𝑰𝑵𝑽 − ∆𝑵𝑾𝑪
  7. 7. Factors that Affect the Level and Risk of Cash Flows Decisions made internally by financial managers: – Investment decisions (product lines, production processes, geographic market, use of technology, marketing strategy) – Financing decisions (choice of debt policy and dividend policy) The External environment (e.g., credit crisis, government policies) 7
  8. 8. Value = + + ··· + FCF1 FCF2 FCF∞ (1 + WACC)1 (1 + WACC)∞(1 + WACC)2 Free cash flow (FCF) Market interest rates Firm’s business riskMarket risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Net operating profit after taxes Required investments in operating capital − = Determinants of Intrinsic Value: The Weighted Average Cost of Capital
  9. 9. 9 Cost of Capital components – Debt – Preferred Stock – Common Equity WACC = weighted average of these costs Opportunity costs Weighted Average Cost of Capital
  10. 10. 10 𝑾𝑨𝑪𝑪 = 𝑘=𝟏 𝑛 𝒘 𝒏 ∙ 𝒓 𝒏 𝑾𝑨𝑪𝑪 = 𝒘 𝒅 ∙ 𝒓 𝒅 ∙ (𝟏 − 𝑻) + 𝒘 𝒑𝒔∙ 𝒓 𝒑𝒔 + 𝒘 𝒔 ∙ 𝒓 𝒔 𝒓 𝒅 = return on long-term debt 𝑻 = marginal corporate tax rate 𝒓 𝒑𝒔 = return on preferred stock 𝒓 𝒔 = return on common stock Weighted Average Cost of Capital Equity LT Debt Pref. Stock
  11. 11. Capital Components Capital components are sources of funding that come from investors. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital. 11
  12. 12. Web resources for WACC: www.thatswacc.com 12
  13. 13. 13 Estimating the Cost of Debt Method 1: Ask an investment banker what the coupon rate would be on new debt. Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating. Method 3: Find the current market yield-to-maturity on the company’s debt, if it has any.
  14. 14. 14 A 15-year, 12% semi-annual bond sells for $1,153.72. What’s rd ? 60 60 + 1,00060 0 1 2 30 rd = ? -1,153.72 ... 30 -1153.72 60 1000 5.0% x 2 = rd = 10% N I/YR PV FVPMT INPUTS OUTPUT
  15. 15. 15 Component Cost of Debt Interest is tax deductible, so the after-tax (AT) cost of debt is: rd AT = rd BT x (1 – T) rd AT = 10% x (1 – 0.40) = 6.00%. Use nominal rate. Flotation costs small, so ignore.
  16. 16. 16 Cost of Preferred Stock: Pps = $116.95; 10%; Par = $100; F=5% Use this formula (with flotation cost of 5%): rps = Dps Pps (1 – F) = 0.1($100) $116.95(1 – 0.05) = $10 $111.10 = 0.090 = 9.0%
  17. 17. 17 Time Line of Preferred Stock 2.50 2.502.50 0 1 2 ∞ rps = ? -111.10 ... $111.10 = DQ rPer = $2.50 rPer rPer = $2.50 $111.10 = 2.25%; rps(Nom) = 2.25%(4) = 9%
  18. 18. 18 Notes: Flotation costs for preferred are significant, so they are reflected. Use net price. Preferred dividends are not deductible, so no tax adjustment. Just rps. Nominal rps is used.
  19. 19. 19 Why is there a cost for reinvested earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earning a return. Thus, there is an opportunity cost if earnings are reinvested.
  20. 20. 20 Three ways to determine the Cost of Equity: rs 1. CAPM: rs = rRF + (rM – rRF) x b = rRF + (RPM) x b 2. DCF: rs = D1/P0 + g 3. Own-Bond-Yield-Plus-Judgmental- Risk Premium: rs = rd + Bond RP
  21. 21. 21 CAPM Cost of Equity: rRF = 5.6%, RPM = 6%, b = 1.2 rs = rRF + (RPM )b = 5.6% + (6.0%)1.2 = 12.8%
  22. 22. 22 Issues in Using CAPM Most analysts use the rate on a long-term (10 to 20 years) government bond as an estimate of rRF. Most analysts use a rate of 3.5% to 6% for the market risk premium (RPM) Estimates of beta vary, and estimates are “noisy” (they have a wide confidence interval). (More…)
  23. 23. 23 DCF Cost of Equity: D0 = $3.26; P0 = $50; g = 5.8% rs = D1 P0 + g = D0(1 + g) P0 + g = $3.12(1.058) $50 + 0.058 = 6.6% + 5.8% = 12.4%
  24. 24. 24 Estimating the Growth Rate Use the historical growth rate if you believe the future will be like the past. Obtain analysts’ estimates: Value Line, Zacks, Yahoo!Finance. Use the earnings retention model, illustrated on next slide.
  25. 25. 25 Earnings Retention Model Suppose the company has been earning 15% on equity (ROE = 15%) and has been paying out 62% of its earnings. If this situation is expected to continue, what’s the expected future g?
  26. 26. 26 Earnings Retention Model (Cont.) Growth from earnings retention model: g = (Retention rate)(ROE) g = (1 – Payout rate)(ROE) g = (1 – 0.62)(15%) = 5.7% This is close to g = 5.8% given earlier.
  27. 27. 27 Could DCF methodology be applied if g is not constant? YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. But… calculations get complicated. See the Web 09A worksheet in the file Ch09Tool Kit.xls.
  28. 28. 28 The Own-Bond-Yield-Plus-Judgmental-Risk- Premium Method: rd = 10%, RP = 3.2% rs = rd + Judgmental risk premium rs = 10.0% + 3.2% = 13.2% This judgmental-risk premium  CAPM equity risk premium, RPM. Produces ballpark estimate of rs. Useful check.
  29. 29. 29 What’s a reasonable final estimate of rs? Method Estimate CAPM 12.8% DCF 12.4% rd + judgment 13.2% Average 12.8%
  30. 30. 30 Determining the Weights for the WACC The weights are the percentages of the firm that will be financed by each component. If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.
  31. 31. 31 Estimating Weights for the Capital Structure If you don’t know the targets, it is better to estimate the weights using current market values than current book values. If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term. (More…)
  32. 32. 32 Estimating Weights Suppose the stock price is $50, there are 3 million shares of stock, the firm has $25 million of preferred stock, and $75 million of debt. Vs = $50(3 million) = $150 million. Vps = $25 million. Vd = $75 million. Total Firm Value = $150 + $25 + $75 = $250 million.
  33. 33. 33 Estimating Weights (Continued) ws = $150/$250 = 0.60 wps = $25/$250 = 0.10 wd = $75/$250 = 0.30 The target weights for this company are the same as these market value weights, but often market weights temporarily deviate from targets due to changes in stock prices.
  34. 34. 34 What’s the WACC using the target weights? WACC = wdrd(1 – T) + wpsrps + wsrs WACC = 0.3(10%)(1 − 0.4) + 0.1(9%) + 0.6(12.8%) WACC = 10.38% ≈ 10.4%
  35. 35. 35 Four Mistakes to Avoid 1. Current vs. historical cost of debt 2. Mixing current and historical measures to estimate the market risk premium 3. Book weights vs. Market Weights 4. Incorrect cost of capital components (More…)
  36. 36. 36 Current vs. Historical Cost of Debt When estimating the cost of debt, don’t use the coupon rate on existing debt, which represents the cost of past debt. Use the current interest rate on new debt. (More…)
  37. 37. 37 Estimating the Market Risk Premium When estimating the risk premium for the CAPM approach, don’t subtract the current long-term T- bond rate from the historical average return on common stocks. For example, if the historical rM has been about 12.2% and inflation drives the current rRF up to 10%, the current market risk premium is not 12.2% – 10% = 2.2%!
  38. 38. 38 Estimating Weights Use the target capital structure to determine the weights. If you don’t know the target weights, then use the current market value of equity. If you don’t know the market value of debt, then the book value of debt often is a reasonable approximation, especially for short-term debt.
  39. 39. 39 Capital components are sources of funding that come from investors As noted earlier, accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the WACC. We do adjust for these items when calculating project cash flows, but not when calculating the WACC.
  40. 40. Divisional vs. Corporate Cost of Capital Rate of Return (%) WACC Project H Division H’s WACC Risk Project L Composite WACC for Firm A 13.0 7.0 10.0 11.0 9.0 Division L’s WACC 0 RiskL RiskAverage RiskH 40
  41. 41. Corporate Valuation methodology Stock Valuation Approaches 41 Fundamentals of Corporate Valuation & Stock Valuation
  42. 42. 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧𝐬 = FCF1 1 + WACC 1 + FCF2 1 + WACC 2 + ⋯ + FCF∞ 1 + WACC ∞ 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐒𝐭𝐨𝐜𝐤 = D1 1 + rs 1 + D2 1 + rs 2 + ⋯ + D∞ 1 + rs ∞ Free cash flow (FCF) Weighted average cost of capital (WACC) Firm’s debt/equity mix Cost of debt Cost of equity: The required return on stock Dividends (D) Corporate Valuation vs. Stock Valuation
  43. 43. Corporate Valuation: A company owns two types of assets Assets-in-place Financial, or non-operating, assets 43
  44. 44. Assets-in-Place Assets-in-place can be tangible, such as buildings, machines, inventory. Usually they are expected to grow (g). They generate free cash flows (FCF). The PV of their expected future free cash flows, discounted at the WACC, is the value of operations (Vop). 44
  45. 45. Value of Total Operations 45 Vop = ∑ ∞ t = 1 FCFt (1 + WACC)t
  46. 46. 0 1 2 3 4 How much Is the firm worth today? OCF1 - INV1 - D NWC1 FCF4 + Terminal Value at t=4 PV of FCF’s FCF1 FCF2 FCF3 FCF4 + TV4 Time Line Example for Discounted Cash Flow Analysis (DCF) 46 OCF2 - INV2 - D NWC2 OCF3 - INV3 - D NWC3
  47. 47. Non-operating Assets Marketable securities. Ownership of non-controlling interest in another company. Value of non-operating assets usually is close to figure that is reported on balance sheet (but not always, e.g., real estate purchased many years ago). Can be very valuable “hidden assets” that affect total market value. 47
  48. 48. Total Corporate Value Total corporate value is sum of: – Value of operations – Value of non-operating assets 48
  49. 49. Claims on Corporate Value Debtholders have first claim. Preferred stockholders have the next claim. Any remaining value belongs to stockholders (residual claim). 49
  50. 50. Applying the Corporate Valuation Model Calculate the projected free cash flows and then discount them at the firm’s WACC. Very Flexible Approach: Model can be applied to a company that does not pay dividends, a privately held company, or a division of a company, since FCF can be calculated for each of these situations. 50
  51. 51. Data for Valuation FCF0 = $20 million WACC = 10% g = 5% Marketable securities = $100 million Debt = $200 million Preferred stock = $50 million Book value of equity = $210 million Total common shares outstanding = 10 million shares 51
  52. 52. Value of Operations: Constant FCF Growth at Rate of g 52 Vop = ∑ ∞ t = 1 FCFt (1 + WACC)t = ∑ ∞ t = 1 FCF0(1+g)t (1 + WACC)t
  53. 53. Constant Growth Formula Notice that the term in parentheses is less than one and gets smaller as t gets larger. As t gets very large, term approaches zero. 53 Vop =∑ ∞ t = 1 FCF0 1 + WACC( 1+ g ) t
  54. 54. Constant Growth Formula cont’d The summation can be replaced by a single formula: 54 Vop = FCF1 (WACC - g) = FCF0(1+g) (WACC - g)
  55. 55. Find Value of Operations 55 Vop = FCF0 (1 + g) (WACC - g) Vop = 20(1+0.05) (0.10 – 0.05) = $420
  56. 56. Deriving the Value of Equity Sources of Corporate Value – Value of operations = $420 – Value of non-operating assets = $100 Claims on Corporate Value – Value of Debt = $200 – Value of Preferred Stock = $50 – Value of Equity = ? – Stock Price per Share = ? 56
  57. 57. Value of Equity Total corporate value = Vop + Mkt. Sec. = $420 + $100 = $520 million Value of equity = Total Value – Debt – Preferred Stock = $520 - $200 - $50 = $270 million To get Stock Price per Share, divide by Shares Outstanding: Stock Price = $270 million / 10 million Sh. = $27.00 / share 57
  58. 58. Another Example: Non-constant Growth Finance planned plant expansion by borrowing $40 million and halting dividends. Firm has no non-operating assets. Key Assumptions: – Year 1 FCF = -$5 million. – Year 2 FCF = $10 million. – Year 3 FCF = $20 million – FCF grows at constant rate of 6% after year 3. – The WACC, is 10%. – The company has 10 million shares of stock. 58
  59. 59. Horizon (or Terminal) Value Free cash flows are forecast for three years in this example, so the forecast horizon is three years. Growth in free cash flows is not constant during the forecast, so we can’t use the constant growth formula to find the value of operations at time 0. 59
  60. 60. Horizon / Terminal Value cont’d. Growth (g) is constant after the horizon (3 years), so we can modify the constant growth formula to find the value of all free cash flows beyond the horizon, discounted back to the horizon. Must make sure that long-term constant growth is less than or equal to the economy’s nominal GDP growth rate. Why? 60
  61. 61. Horizon / Terminal Value Formula Horizon value is also called Terminal Value, or continuing value. 61 Vops at time t = FCFt(1+g) (WACC - g) TV =
  62. 62. Value of operations is PV of FCF discounted by WACC 62 Vops at 3 0 -4.545 8.264 15.026 398.197 1 2 3 4rc=10% 416.942 = Vop g = 6% FCF= -5.00 10.00 20.00 21.2 $21.2 . .06 $530. 10 0    0
  63. 63. Find the price per share of common stock Value of equity = Value of operations - Value of debt = $416.94 - $40 = $376.94 million Stock Price per share = $376.94 /10 mil. = $37.69 63
  64. 64. 64 Other Approaches for Valuing Common Stock Alternatives to the Free Cash Flow model are: Dividend growth model (Dividend Discount Model): – Constant growth stocks – Nonconstant growth stocks Using the Market Multiples of comparable firms
  65. 65. 65 Stock value = PV of dividends discounted at required return on equity Conceptually correct, but how do you find the present value of an infinite stream? P0 = ^ (1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)∞ D1 D2 D3 D∞ + + + … +
  66. 66. 66 Constant Dividend Growth: PV of Dt if g < rs $ Years (t) Dt = D0(1 + g)t PV of Dt = D0(1 + g)t (1 + r)t g < r, D∞ → 0PV of D1 D1 1 2 D0 D2 PV of D2
  67. 67. Constant Dividend Growth: Cumulative Sum of PV of Dt if g < rs P0 = t=1 ∞ D0 1 + g 1 + rs t What happens to P0 as t gets bigger? Consider this: This sum converges to 1. Similarly, P0 converges. See next slide. 67 t 1 2 3 4 5 (1/2)t 1/2 1/4 1/8 1/16 1/32 Σ(1/2)t 1/2 3/4 7/8 15/16 Boring!!
  68. 68. Constant Dividend Growth Model (g < rs) If g is constant and less than rs, then D0 1+g 1+rs t converges to: P0 = D0 1+g rs−g = D1 rs−g 68
  69. 69. 69 Required rate of return: b = 1.2, rRF = 7%, & RPM = 5% rs = rRF + (RPM)bFirm = 7% + (5%)(1.2) = 13% Use the Security Market Line to calculate rs:
  70. 70. Estimated Intrinsic Stock Value: D0 = $2.00, rs = 13%, g = 6% D1 = D0(1+g) D1 = $2.00(1.06) = $2.12 P0 = D0 1+g rs−g = D1 rs−g P0 = $2.12 0.13−0.06 = $30.29 70
  71. 71. Expected Stock Price in 1 Year In general: Pt = Dt+1 rs − g D2 = D1(1+g) D1 = $2.12(1.06) = $2.2472 P𝟏 = D 𝟐 rs − g P0 = $2.2472 0.13−0.06 = $32.10 71
  72. 72. 72 Expected Dividend Yield and Capital Gains Yield (Year 1) Dividend yield = = = 7.0%. $2.12 $30.29 D1 P0 CG Yield = = P1 – P0 ^ P0 $32.10 – $30.29 $30.29 = 6.0%.
  73. 73. 73 Total Year 1 Return Total return = Dividend yield + Capital gains yield Total return = 7% + 6% = 13% Total return = 13% = rs. For constant growth stock CG Yield = g: – Capital gains yield = 6% = g.
  74. 74. 74 Re-arrange model to rate of return form: Then, rs = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13% ^ P0 = ^ D1 rs – g to: D1 P0 rs ^ = + g.
  75. 75. Suppose the stock price is $32.09. Is this price based mostly on short-term or long-term cash flows? Year (t) 0 1 2 3 Dt = D0 (1+g)t $2.1200 $2.2472 $2.3820 PV(Dt) = Dt/(1+rs)t $1.8761 $1.7599 $1.6509 Sum of PV(Divs.) $5.29 P0 $30.29 % of P0 due to 3 PV(Divs.) 17% % of P0 due to long-term divs. 83% 75
  76. 76. 76 Intrinsic Stock Value vs. Quarterly Earnings If most of a stock’s value is due to long-term cash flows, why do so many managers focus on quarterly earnings? – Changes in quarterly earnings can signal changes future in cash flows. This would affect the current stock price. – Managers often have bonuses tied to quarterly earnings, so they have incentive to manage earnings.
  77. 77. 77 Why are stock prices volatile? P0 = ^ D1 rs – g rs could change: rs = rRF + (RPM)bi – Interest rates (rRF) could change – Risk aversion (RPM) could change – Company risk (bi) could change g could change.
  78. 78. Stock Price Sensitivity: Changes in rs and g Growth Rate: g Required Return: rs 11.0% 12.0% 13.0% 14.0% 15.0% 5% $35.00 $30.00 $26.25 $23.33 $21.00 6% $42.40 $35.33 $30.29 $26.50 $23.56 7% $53.50 $42.80 $35.67 $30.57 $26.75 Small changes in g or rs can cause large changes in the estimated price. 78
  79. 79. 79 Are volatile stock prices consistent with rational pricing? (Yes!!) Small changes in expected g and rs cause large changes in stock prices. As new information arrives, investors continually update their estimates of g and rs. If stock prices aren’t volatile, then this means there isn’t a good flow of information.
  80. 80. Comparing the FCF Model & Dividend Growth Model Can apply FCF model in more situations (more flexible): – Privately held companies – Divisions of companies – Companies that pay zero (or very low) dividends FCF model requires forecasted financial statements to estimate FCF (but… needs more inputs and more work!) 80
  81. 81. 81 Relative Valuation Methods: Shortcut approach based on financial relativism. Many ratios available: P/E, P/CF, M/B, P/S, Dividend Yields. Using Comparables to determine Appropriate Multiples: – Analyst must choose companies that are as comparable as possible. – Select the relevant ratio and compare it for the chosen companies. – It does not determine the absolute value of the stocks (just identifies ranking). – Can use regression analysis to improve comparability
  82. 82. 82 Using Stock Price Multiples to Estimate Stock Price Analysts often use the P/E multiple (the stock price per share divided by the earnings per share). Example: – Estimate the average P/E ratio of comparable firms (SP / EPS). This is the P/E multiple. – Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price.
  83. 83. 83 Using Market Multiples The entity or “enterprise” value (V) is: – the market value of equity (# shares of stock multiplied by the price per share) – plus the value of debt. Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, Click-throughs, etc. Calculate the average entity ratio for a sample of comparable firms. For example, – V/EBITDA – V/Customers
  84. 84. 84 Using Entity Multiples (cont.) Find the entity value of the firm in question. For example, – Multiply the firm’s sales by the V/Sales multiple. – Multiply the firm’s # of customers by the V/Customers ratio The result is the firm’s total value. Subtract the firm’s debt to get the total value of its equity. Divide by the number of shares to calculate the price per share.
  85. 85. 85 Problems with Market Multiple Methods It is often hard to find comparable firms. The average ratio for the sample of comparable firms often has a wide range. – For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers?

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