Lecture 7- Valuation methods

Standard valuation techniques include: [blank_start]book value[blank_end], [blank_start]dividend growth model[blank_end], [blank_start]earnings multiple[blank_end] & [blank_start]discounted cash flow[blank_end]

Book value assumes [blank_start]firm[blank_end] value is equal to [blank_start]book[blank_end] value of [blank_start]assets[blank_end]. It's [blank_start]widely[blank_end] used & accepted method due to certification by [blank_start]accountants[blank_end], while also being perhaps most [blank_start]flawed[blank_end]

One advantage of using book value as valuation method is it’s [blank_start]easy method[blank_end] to use

One disadvantage of using book value as valuation method is it's based on [blank_start]historic numbers[blank_end], ignores [blank_start]future[blank_end]

Another disadvantage of using book value as valuation method is it's based on [blank_start]accounting numbers[blank_end] that are potentially [blank_start]flawed[blank_end] & subject to [blank_start]manipulation[blank_end]

Third disadvantage of using book value as valuation method is it [blank_start]ignores risk[blank_end]

Fourth disadvantage of using book value as valuation method is it ignores [blank_start]intangibles[blank_end] which are difficult to [blank_start]measure[blank_end] & therefore not all [blank_start]included[blank_end] in balance sheet

Dividend growth model assumes [blank_start]equity[blank_end] value is equal to [blank_start]present[blank_end] value of [blank_start]dividend payments[blank_end]

One advantage of using dividend growth model as valuation method is it’s [blank_start]simple method[blank_end] to apply, especially if [blank_start]constant dividend growth[blank_end] model is assumed

One disadvantage of using dividend growth model as valuation method is [blank_start]dividends[blank_end] are based on [blank_start]accounting calculations[blank_end]

Another disadvantage of using dividend growth model as valuation method is it assumes [blank_start]dividends[blank_end] grow at [blank_start]constant rate[blank_end] which may not [blank_start]always[blank_end] be case

Third disadvantage of using dividend growth model as valuation method is it does not [blank_start]work[blank_end] for companies that do not [blank_start]pay dividends[blank_end]

Multiples method is very [blank_start]common method[blank_end] for valuing [blank_start]assets[blank_end]. It uses [blank_start]multiples[blank_end] from another [blank_start]comparable[blank_end] company (or average of group of companies) in [blank_start]conjunction[blank_end] with an [blank_start]earnings[blank_end] measure (or other return measures) of company for which [blank_start]value[blank_end] calculation is required

One advantage of using multiples method as valuation method is it’s [blank_start]easy method[blank_end] to use

Another advantage of using multiples method as valuation method is it makes [blank_start]intuitive sense[blank_end]

Third advantage of using multiples method as valuation method is if [blank_start]comparables[blank_end] are really [blank_start]comparable[blank_end] then it would work

One disadvantage of using multiples method as valuation method is [blank_start]earnings[blank_end] used in most methods are [blank_start]accounting figures[blank_end]

Another disadvantage of using multiples method as valuation method is [blank_start]earnings[blank_end] are subject to [blank_start]short-term fluctuations[blank_end]

Third disadvantage of using multiples method as valuation method is it often ignores [blank_start]growth potential[blank_end]

One widely used multiple is [blank_start]price-to-earnings[blank_end]. It is calculated as [blank_start]market price per share[blank_end] divided by [blank_start]earnings per share[blank_end]

Another widely used multiple is [blank_start]total asset value-to-EBIT[blank_end]. It is calculated as [blank_start]total asset value[blank_end] divided by [blank_start]EBIT[blank_end]

Third widely used multiple is [blank_start]market value[blank_end] of [blank_start]company[blank_end] to [blank_start]EBIT[blank_end]. It is calculated as [blank_start]market value of company[blank_end] divided by [blank_start]EBIT[blank_end]

Fourth widely used multiple is [blank_start]price-to-sales[blank_end]. It is calculated as [blank_start]current stock price[blank_end] divided by [blank_start]annual revenue per share[blank_end]

Fifth widely used multiple is [blank_start]price-to-book value[blank_end]. It is calculated as [blank_start]market value per share[blank_end] divided by [blank_start]book value per share of equity[blank_end]

First step of discounted cash flow valuation is forecast [blank_start]free cash flows[blank_end] up to some [blank_start]terminal date[blank_end]. Second step is to estimate [blank_start]terminal value[blank_end] (i.e. continuing [blank_start]value[blank_end]) which equals value after [blank_start]terminal date[blank_end]. Third step is to estimate [blank_start]cost of capital[blank_end] (i.e. [blank_start]discount[blank_end] rate). Fourth step is to [blank_start]discount[blank_end] to [blank_start]present[blank_end]

EBITDA = [blank_start]Revenue - Operating expenses[blank_end]

EBIT = [blank_start]EBITDA - Depreciation & amortisation[blank_end]

EBT = [blank_start]EBIT - Interest expenses[blank_end]

Net income or net earnings = [blank_start]EBT - Taxes[blank_end]

CFO or OCF = [blank_start]Net income + Depreciation & amortisation[blank_end]

Free cash flow to firm (FCFF)- Cash flow to [blank_start]common shareholders[blank_end], [blank_start]preferred shareholders[blank_end] & debtholders. If FCFF is used that belongs to both shareholders & bondholders use [blank_start]WACC[blank_end] as discount rate. Discounting FCFF at cost of equity will yield [blank_start]downward[blank_end] biased estimate of [blank_start]value[blank_end] of firm

Free cash flow to equity (FCFE)- FCFE is used that belong to shareholders use cost of equity only which can be [blank_start]measured[blank_end] using [blank_start]dividend[blank_end] model, [blank_start]risk & return[blank_end] model (such as [blank_start]capital asset pricing[blank_end] model & [blank_start]arbitrage pricing[blank_end] theory) & [blank_start]industry average[blank_end] model. Discounting FCFE using WACC will lead to an [blank_start]upwardly[blank_end] biased estimate of [blank_start]value[blank_end] of equity

When estimating firm’s terminal value, assume [blank_start]free cash flows[blank_end] grow at [blank_start]constant rate[blank_end] after [blank_start]forecast horizon[blank_end]

Ways of estimating earnings growth are: to look at [blank_start]past[blank_end] ([blank_start]historical[blank_end] growth in [blank_start]earnings per share[blank_end] is typical starting point), to look at what [blank_start]others[blank_end] are [blank_start]projecting[blank_end] (other [blank_start]analysts[blank_end] may be using [blank_start]information[blank_end] you do not have & it is often useful to know what their [blank_start]estimates[blank_end] are) & to look at [blank_start]fundamentals[blank_end] (how much are they [blank_start]investing[blank_end]? what is [blank_start]return[blank_end] on their [blank_start]investment[blank_end]?)

One advantage of using discounted cash flows as valuation method is it should be [blank_start]less exposed[blank_end] to market moods & perceptions if done [blank_start]right[blank_end] by being based upon an [blank_start]asset’s fundamentals[blank_end]

Another advantage of using discounted cash flows as valuation method is if investors buy [blank_start]businesses[blank_end], rather than [blank_start]stocks[blank_end], DCF valuation is [blank_start]right[blank_end] way to think about what you are getting when you buy an [blank_start]asset[blank_end]

Third advantage of using discounted cash flows as valuation method is DCF valuation forces you to think about [blank_start]underlying characteristics[blank_end] of firm & understand its [blank_start]business[blank_end]. It helps you [blank_start]question assumptions[blank_end] you have made

One disadvantage of using discounted cash flows as valuation method is it requires far more [blank_start]inputs[blank_end] & [blank_start]information[blank_end] than other valuation approaches as it attempts to [blank_start]estimate intrinsic value[blank_end] (perceived or calculated value)

Another disadvantage of using discounted cash flows as valuation method is [blank_start]inputs[blank_end] & [blank_start]information[blank_end] are difficult to [blank_start]estimate[blank_end] & can be [blank_start]manipulated[blank_end] by analyst to provide [blank_start]conclusion[blank_end] he or she wants

DCF valuation is easiest to use for assets (firms) whose cashflows are [blank_start]currently positive[blank_end], can be [blank_start]estimated[blank_end] with some [blank_start]reliability[blank_end] for [blank_start]future[blank_end] periods & where proxy for [blank_start]risk[blank_end] that can be used to obtain [blank_start]discount rates[blank_end] is available