ING - equity val.ppt

Equity Valuation
Prof. Ian Giddy
New York University
New York University
Stern School of Business

Copyright ©1998 Ian H. Giddy Equity Valuation 2
First Principles
 Invest in projects that yield a return
greater than the minimum acceptable
hurdle rate.
The hurdle rate should be higher for riskier
projects and reflect the financing mix used
- owners’ funds (equity) or borrowed
money (debt)
Returns on projects should be measured
based on cash flows generated and the
timing of these cash flows; they should also
consider both positive and negative side

Discounted Cashflow Valuation: Basis
for Approach
where,
 n = Life of the asset
 CFt = Cashflow in period t
 r = Discount rate reflecting the riskiness of
the estimated cashflows
Value =
CFt
(1+ r)t
t =1
t = n


Equity Valuation versus Firm Valuation
 value just the equity stake in the
business
 value the entire firm, which includes,
besides equity, the other claimholders in
the firm

I.Equity Valuation
 The value of equity is obtained by
discounting expected cashflows to
equity, i.e., the residual cashflows after
meeting all expenses, tax obligations
and interest and principal payments, at
the cost of equity, i.e., the rate of return
required by equity investors in the firm.
Value of Equity =
CF to Equityt
(1+ ke )t
t=1
t=n


II. Firm Valuation
 The value of the firm is obtained by
discounting expected cashflows to the
firm, i.e., the residual cashflows after
meeting all operating expenses and
taxes, but prior to debt payments, at the
weighted average cost of capital, which
is the cost of the different components
of financing used by the firm, weighted
by their market value proportions.
Value of Firm =
CF to Firmt
(1+ WACC)t
t=1
t=n


Equity versus Firm Valuation
 It is often argued that equity valuation
requires more assumptions than firm
valuation, because cash flows to equity
require explicit assumptions about
changes in leverage whereas cash
flows to the firm are pre-debt cash flows
and do not require assumptions about
leverage. Is this true?
 Yes
 No

First Principle of Valuation
 Never mix and match cash flows and
discount rates.
 The key error to avoid is mismatching
cashflows and discount rates, since
discounting cashflows to equity at the
weighted average cost of capital will
lead to an upwardly biased estimate of
the value of equity, while discounting
cashflows to the firm at the cost of
equity will yield a downward biased

Valuation: The Key Inputs
 A publicly traded firm potentially has an
infinite life. The value is therefore the
present value of cash flows forever.
 Since we cannot estimate cash flows
forever, we estimate cash flows for a
“growth period” and then estimate a
terminal value, to capture the value at
Value =
CF
t
(1+ r)t
t = 1
t = 

Value =
CF
t
(1 + r)t

TerminalValue
(1 + r)N
t = 1
t = N


Stable Growth and Terminal Value
 When a firm’s cash flows grow at a
“constant” rate forever, the present
value of those cash flows can be written
as:
Value = Expected Cash Flow Next Period / (r
- g)
where,
r = Discount rate (Cost of Equity or Cost of
Capital)
g = Expected growth rate

Growth Patterns
 A key assumption in all discounted cash
flow models is the period of high growth,
and the pattern of growth during that
period. In general, we can make one of
three assumptions:
there is no high growth, in which case the
firm is already in stable growth
there will be high growth for a period, at the
end of which the growth rate will drop to
the stable growth rate (2-stage)
there will be high growth for a period, at the

Length of High Growth Period
 Assume that you are analyzing two
firms, both of which are enjoying high
growth. The first firm is Earthlink
Network, an internet service provider,
which operates in an environment with
few barriers to entry and extraordinary
competition. The second firm is Biogen,
a bio-technology firm which is enjoying
growth from two drugs to which it owns
patents for the next decade. Assuming
that both firms are well managed, which

Choosing a Growth Pattern: Examples
Company Valuation in
Growth Period Stable
Growth
Disney Nominal U.S. $ 10 years
5%(long term Firm
(3-stage) nominal growth rate
in the U.S.
economy
Aracruz Real BR 5 years 5%: based
upon Equity: FCFE (2-

The Building Blocks of Valuation
Choose a
Cash Flow Dividends
Expected Dividends to
Stockholders
Cashflows to Equity
Net Income
- (1- ) (Capital Exp. - Deprec’n)
- (1- ) Change in Work. Capital
= Free Cash flow to Equity (FCFE)
[ = Debt Ratio]
Cashflows to Firm
EBIT (1- tax rate)
- (Capital Exp. - Deprec’n)
- Change in Work. Capital
= Free Cash flow to Firm (FCFF)
& A Discount Rate Cost of Equity
 Basis: The riskier the investment, the greater is the cost of equity.
 Models:
CAPM: Riskfree Rate + Beta (Risk Premium)
APM: Riskfree Rate + Betaj (Risk Premiumj): n factors
Cost of Capital
WACC = ke ( E/ (D+E))
+ kd ( D/(D+E))
kd = Current Borrowing Rate (1-t)
E,D: Mkt Val of Equity and Debt
& a growth pattern
t
g
Stable Growth
g
Two-Stage Growth
|
High Growth Stable
g
Three-StageGrowth
|
High Growth Stable
Transition

Value is Not Price
 What is Intrinsic Value?
 Self assigned Value
 Variety of models are used for estimation
 Market Price
 What stock can be sold for or bought at
 Trading Signal
 IV > MP Buy
 IV < MP Sell or Short Sell
 IV = MP Hold or Fairly Priced
More, less, or same as
market portfolio?

Fundamental Stock Analysis: Models
of Equity Valuation
 Basic Types of Models
Balance Sheet Models
Dividend Discount Models
Price/Earning Ratios
 Estimating Growth Rates and
Opportunities

Equity Valuation:
From the Balance Sheet
Value of Assets
 Book
 Liquidation
 Replacement
Value of
Liabilities
 Book
 Market
Value of Equity

Equity Valuation:
From the Balance Sheet
Value of Assets
 Book
 Liquidation
 Replacement
Value of
Liabilities
 Book
 Market
Value of Equity
Book Value
Liquidation
Value
Replacement
Value
Tobin’s Q:
Market/Replacement
tends to 1?

Dividend Discount Models:
General Model
V
D
k
o
t
t
t




( )
1
1
 V0 = Value of Stock
 Dt = Dividend
 k = required return

Specified Holding Period Model
0
1
1
2
2
1 1 1
V
D
k
D
k
D P
k
N N
N
  

  
( ) ( ) ( )
...
 PN = the expected sales price for the stock at
time N
 N = the specified number of years the stock is
expected to be held

No Growth Model
V
D
k
o 
 Stocks that have earnings and dividends that
are expected to remain constant
 Preferred Stock

No Growth Model: Example
E1 = D1 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33
V
D
k
o 

Constant Growth Model
Vo
D g
k g
o



( )
1
 g = constant perpetual growth rate

Constant Growth Model: Example
Vo
D g
k g
o



( )
1
E1 = $5.00 b = 40% k = 15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86

Estimating Dividend Growth Rates
g ROE b
 
 g = growth rate in dividends
 ROE = Return on Equity for the firm
 b = plowback or retention percentage rate
i.e.(1- dividend payout percentage rate)

Shifting Growth Rate Model
V D
g
k
D g
k g k
o o
t
t
t
T
T
T





 


( )
( )
( )
( )( )
1
1
1
1
1
1
2
2
 g1 = first growth rate
 g2 = second growth rate
 T = number of periods of growth at
g1

Shifting Growth Rate Model: Example
D0 = $2.00 g1 = 20% g2 = 5%
k = 15% T = 3 D1 = 2.40
D2 = 2.88 D3 = 3.46 D4 = 3.63
V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 +
D4 / (.15 - .05) ( (1.15)3
V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

Partitioning Value: Growth and No
Growth Components
V
E
k
PVGO
PVGO
D g
k g
E
k
o
o
 




1
1
1
( )
( )
 PVGO = Present Value of Growth
Opportunities
 E1 = Earnings Per Share for period 1

Partitioning Value: Example
 ROE = 20% d = 60% b = 40%
 E1 = $5.00 D1 = $3.00 k = 15%
 g = .20 x .40 = .08 or 8%

V
NGV
PVGO
o
o



 
  
3
15 08
86
5
15
33
86 33 52
(. . )
$42.
.
$33.
$42. $33. $9.
Partitioning Value: Example
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities

Price Earnings Ratios
 P/E Ratios are a function of two factors
Required Rates of Return (k)
Expected growth in Dividends
 Uses
Relative valuation
Extensive Use in industry

P/E Ratio: No expected growth
P
E
k
P
E k
0
1
0
1
1


 E1 - expected earnings for next year
 E1 is equal to D1 under no growth
 k - required rate of return

P/E Ratio with Constant Growth
P
D
k g
E b
k b ROE
P
E
b
k b ROE
0
1 1
0
1
1
1




 


 
( )
( )
( )
Where
 b = retention ratio
 ROE = Return on Equity

Numerical Example: No Growth
E0 = $2.50 g = 0 k = 12.5%
P0 = D/k = $2.50/.125 = $20.00
PE = 1/k = 1/.125 = 8

Numerical Example with Growth
b = 60% ROE = 15% (1-b) = 40%
E1 = $2.50 (1 + (.6)(.15)) = $2.73
D1 = $2.73 (1-.6) = $1.09
k = 12.5% g = 9%
P0 = 1.09/(.125-.09) = $31.14
PE = 31.14/2.73 = 11.4
PE = (1 - .60) / (.125 - .09) = 11.4

Valuation and M&A
Rationale: Firm A should merge with Firm B if
[Value of AB > Value of A + Value of B + Cost
of transaction]
 Synergy
 Gain market power
 Discipline
 Taxes
 Financing

Goals of Acquisitions
Rationale: Firm A should merge with Firm B if
[Value of AB > Value of A + Value of B + Cost of transaction]
 Synergy
 Eg Martell takeover by Seagrams to match name and inventory with
marketing capabilities
 Gain market power
 Eg Atlas merger with Varity. (Less important with open borders)
 Discipline
 Eg Telmex takeover by France Telecom & Southwestern Bell
(Privatization)
 Eg RJR/Nabisco takeover by KKR (Hostile LBO)
 Taxes
 Eg income smoothing, use accumulated tax losses, amortize goodwill
 Financing
 Eg Korean groups acquire firms to give them better access to within-group
financing than they might get in Korea's undeveloped capital market

Value Changes In An Acquisition
175
250
75
50
50
30 30
10
Final value of
combined company
Initial value
plus gains
Financial structure
improvements
Profit on sale
of assets
Synergies and/
or operating
improvements
Value of
acquired
company as
a separate
entity
Value of
acquiring
company
without
acquisition
Gain in
shareholder
value
Takeover premium & costs
Taxes on sale of assets
10

www.giddy.org

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