StockValuation(continued)

FINC361 Fall2016
ProfessorMahdiMohseni

Stock valuation
Goal:
Determine fair market value for a stock (equity)
How?
Fair value= PV(Expected future cash flows)
Discounted Cash Flow (DCF) approach
Cash flows of stock: Dividends usually

Constant Dividend Growth Model

Assume dividends will grow at rate g forever!
Div1(1+g)
Div1(1+g)
Div1

Time 1

Time 2

Timeline

Constant Dividend growth model

Growing Perpetuity formula:

Div1
P0 =
rE g

Stock price evaluation:

Two Stage Growth Model
g: Initial fast growth rate
f: long term slower growth rate
CN=C(1+g)N-1

CN+1=[C(1+g)(N-1)]*(1+f)

C(1+g)
C(1+g)
C

Time 0

Time 1

Time 2

Time N

Time N+1

C: Could be dividends or sometimes EPS is used as substitute

Timeline

Two Stage Growth Model: 1st Stage

C(1+g)N-1
C(1+g)
C(1+g)
C

Time 0

Time 1

Time N

Time 2

Growing annuity formula:

PV0,Stage 1

1
= C
rg

1+ g N

1
1 + r

Timeline

Two Stage Growth Model: 2nd Stage

CN+1

CN+2=CN+1 (1+f)

CN+3=CN+1 (1+f)2

Time 0

Time N

Time N+1

Time N+2

Time N+3

Timeline

Growing perpetuity formula:

PVN , Stage 2

Brought back to time zero:

PV0, Stage 2

C N +1
=
r f
1
= PVN , Stage 2 *
N
(1
r)
+

Two Stage Growth Model:

Final Pricing formula
Combine:
PV(growing annuity) and PV(growing perpetuity)

PV0 = PV0, Stage1 + PV0, Stage 2

1

PV0 = C
rg

1 + g N C
1
+ N +1

1 + r r f

(1 + r) N

DCF methods: Elegant but

Three main issues:
1. Life expectancy is infinite
Sensitive to assumptions

In particular to the discount rate

Need good model for re (CAPM)

2. Growing cash flows

Growing perpetuityeven more sensitive!

Need good model for g

3. Distribution of dividends not guaranteed

Management has power to:

a)
b)

Retain (or worse waste) the generated cash flows

Distribute to shareholders

Prediction is very difficult,

especially if it's about the future.
Niels Bohr, Nobel Prize in Physics

Cap long-term growth to reasonable rate

1. Industry average
2. Growth rate of the economy

Perform sensitivity analysis!

Firm valuation
Goal: Find fair value of firms underlying business
Fundamental value = Intrinsic value = (Total) Enterprise value

More basically:

Estimate the size of the entire pie

The pie is to be shared among all capital providers
1.
2.
3.

Shareholders
Debtholders
(Preferred stockholders)

For simplicity we will assume no preferred stock on the balance sheet for now

Discounted Free Cash Flow approach

What is the purpose of valuation?

Initial Public Offerings (IPO)

Seasonal Public Offerings (SEO)

M&A

Advice for both acquirers and targets

Divestitures and restructurings
Recapitalizations and LBOs
Defense analysis
Vulnerable to hostile takeover?

Fairness opinions

Is the price offered fair?

Research

Buy-side and sell-side analysts

Enterprise value (V0)

By definition:

V0 = PV (Future free cash flows generated by business)

what you are willing to pay to own
the firm should be equal to what you get:
Market value of Equity + Debt = Enterprise Value (V0 ) + Cash

What you pay to acquire the firm!

What you get!

Steps
1. Need to determine the appropriate cash flows
Free cash flows

2. Need to determine the appropriate discount rate

Suppose we have a mix of debtholders and equityholders:
Weighted-average cost of capital (WACC)
Taken as given for now

Free cash flows

By definition:
Free Cash Flow = EBIT (1 - c )
+ Depreciation
Increases in Net Working Capital
Capital expenditures

Corresponds to:
Free cash generated by the business: Cash that can
be freely distributed between debtholders and
shareholders (your capital providers!)

Earnings Cash flows

Start with:
1.

EBIT x (1-)

After-tax operating income left for debtholders and shareholders

EBIT: Earnings before interest payments and taxes

1.
2.
3.

Interest payments what goes to debtholders

It seems we should use the following: Pre-tax income x (1-) + Interest expense
But we use: EBIT x (1-)
In doing so, we do not reflect the tax shield benefits of debt through tax deductible
interest payments! We will incorporate the tax shield benefit of debt in the WACC

Necessary adjustments:
1.
2.

Depreciation

Increase in Net Working capital (NWC)

3.

Non-cash expense
Add back

Recall, an increase in net working capital (e.g. increase in inventories) represents a cash
outflow not reflected in the income statement
Subtract

Capital expenditures

Investments necessary to generate future growth!

Cash outflow not in income statement
Subtract

Free cash flows: Interpretation

Free Cash Flow = EBIT (1 - c )
Investments in
short-term assets
(net of supplier
financing)

After-tax
Operating
Income

+ Depreciation
Increases in Net Working Capital
Capital Expenditures

Investments in long-term assets

(you should also take into account acquisitions)

Total Investments

Free Cash Flow = Oper. profit after investments left to distribute to

1.
2.

Debtholders
Shareholders

Modeling of Free Cash Flows (FCF)

FCFN+2=FCFN(1+ gFCF)2

FCF1

FCF2

FCFN

FCFN+1=FCFN(1+ gFCF)

FCF3

Time 1

Time 2

Time N

Forecast individual FCFs until year N

FCF1 to FCFN

Assume constant long-run growth rate gFCF for free

cash flows beyond year N
Growing perpetuity

Timeline

The math
Define: VN = Terminal value at time N

Place yourself at year N and use growing perpetuity

formula for value of all cash flows beyond year N

Hence:
=
V0

(1 + g FCF ) FCFN
FCFN +1
VN =
=
rwacc g FCF
rwacc g FCF

FCFN
VN
FCF1
FCF2
+
+ +
+
N
2
1 + rwacc
(1 + rwacc )
(1 + rwacc )
(1 + rwacc ) N
N first FCFs discounted back individually to time zero

Growing
perpetuity
discounted back
to time zero

First example:
Free Cash Flows given
Free cash flows of Heavy Metal Corp over next five years:

Year
FCF ($MM)

1
51.1

2
67.6

3
77.1

4
74.8

5
83.6

After first five years, it grows at industry average

of 4.2% a year
WACC = 14.7%
Estimate the enterprise value of Heavy Metal
Corp using the Discounted Free Cash Flow model

Solution
Formula:

FCFt
FCF6
1
+

V0 =
5
t
(1 + rwacc ) rwacc g
t =1 (1 + rwacc )

What is FCF at time 6?

FCF6 = FCF5 (1 + g )

Solve to get final answer:

V0 = $650.25MM

Forecasting Free Cash Flows:

Sales growth driven model
Two steps:
1. You forecast the top line (sales)
2. All other accounting numbers (COGS, SG&A, etc.) are
derived by defining them as a percentage of sales
Example:
FORECAST FOR 2012 (SALES DRIVEN)
Year
Sales
COGS
SG&A
Depreciation
EBIT
Less: Income Tax (EBIT*)
EBIT*(1-)
Add: Depreciation
Less: Incr. in NWC
Less: CAPEX
Free Cash Flow

2011
800

2012
1,000
500
120
80
300
90
210
80
40
100
150

Assumptions:
Assume 25% sales growth
50% of sales
12% of sales
8% of sales

30% corporate tax rate

20% of the dollar change in sales

10% of sales

The case of The GAP Inc.

After some number crunching, suppose you get the table below
You also assume:

To simplify, we forecast EBIT from sales by forecasting the operating margin

Incr. in NWC: 8% of dollar change in sales (not % of sales)

Long-term growth (after 2017): 1%

Discount rate (WACC): 7%

Alternative modeling: COGS, SG&A, etc. as a % of sales (see MyFinance Lab)

Why the different modeling of Incr. in NWC relative to the other items?
Alternative modeling: Forecast NWC each year (as % sales) then compute changes in NWC over time

Sales
Sales Growth
Operating Margin
Depr
Income Tax
Incr in NWC
Capex

2012
14526

2013

2014

2015

2016

2017

4.0%
10.7%
3.9%
35.0%
8.0%
5.0%

3.0%
10.7%
3.9%
40.0%
8.0%
5.0%

3.0%
10.7%
3.9%
40.0%
8.0%
5.0%

3.0%
10.7%
3.9%
40.0%
8.0%
5.0%

3.0%
10.7%
3.9%
40.0%
8.0%
5.0%

Solution
First five years:
Years
Sales
EBIT
Less Tax
EBIT(1-t)
Add Depr
Less NWC
Less Capex
FCF

2012
14,526.0

2013
15,107.0
1,616.5
(565.8)
1,050.7
589.2
(46.5)
(755.4)
838.0

2014
15,560.3
1,664.9
(666.0)
999.0
606.8
(36.3)
(778.0)
791.5

2015
16,027.1
1,714.9
(686.0)
1,028.9
625.1
(37.3)
(801.4)
815.3

2016
16,507.9
1,766.3
(706.5)
1,059.8
643.8
(38.5)
(825.4)
839.8

What about the terminal value (in 2017)?

Growing perpetuity
(1 + g FCF ) FCF5 (1 + .01) 864.9
=
= 14,559
V5 =
.07 .01
rwacc g FCF

2017
17,003.1
1,819.3
(727.7)
1,091.6
663.1
(39.6)
(850.2)
864.9

Enterprise value of The GAP

on Dec 31 2012
838
791
815
839
865
V0 =
+
+
+
+
2
3
4
1.07 (1 + .07) (1 + .07) (1 + .07) (1 + .07)5
14,559
+
(1 + .07) 5
= $13,778MM

From enterprise value to stock price

We just computed:
We know:

V0 = PV (Future Free Cash Flow of Firm)

Market value of Equity = Enterprise Value (V0 ) Debt + Cash

%y definition:
So:

Market value of Equity

Stock Price =
# Shares outstanding

Stock Price =

Enterprise Value (V0 ) Debt + Cash

# Shares outstanding

Second method to value a stock

We found what should be the stock value given

our fundamental analysis
Much more used on Wall Street than dividend model

Application to The GAP

# Shares outstanding: 694MM

Cash: $1,715MM
Debt/Lease: $1019MM
Recall: Enterprise Value: $13,778MM
Hence estimated stock price (on Dec 31 2012):
13,778 1019 + 1715
Stock Price =
= $20.85
694

Stock price of The GAP on that date: $31!

Is the market wrong or are we wrong?
Be careful before you rush to any conclusions

Quick recap: DCF approach

V0

FCFN
VN
FCF1
FCF2





1  rwacc
(1  rwacc ) 2
(1  rwacc ) N
(1  rwacc ) N

VN

FCFN 1
rwacc  g FCF

(1  g FCF ) FCFN
rwacc  g FCF

1. Need to model FCF1 to FCFN

Sales growth driven models

2. Choose conservative long-term growth rate (gFCF)

3. Find WACC
4. Plug and Play!

Relative valuation
Goal: Firm valuation
Approach
1.

Find similar firms to the one you want to value

1. Similar risk
2. Similar cash flows

2.

By Law of One Price:

If they have the same risk and cash flows
Must have same price today

Use wisdom of markets for valuation purposes

Relative valuation: Key questions

1. What is the best comparison firm to use?
A. Optimally
A firm with same risk and same cash flows

B. In practice
Think of the car analogy
No two firms are identicalneed dimensions along which to
compare them

1. Industry
2. Size

In 10-K, firms disclose who their competitors are: Very helpful!

2. What is the best benchmark to compare firms?

We need to define valuation multiples

Valuation Multiples
Definition of a multiple: It is simply a Ratio:
1. Numerator
Value: Enterprise value or stock/equity value

2. Denominator
Value driver: Size (Sales, etc.) or profitability (EPS, EBITDA, etc.)
Equity or enterprise value
(Value)
Financial statistic
(Value driver (profitability))

Multiple
(Value relationship)

Examples
1. P/E multiple: Stock price relative to EPS
2. EBIT multiple: Enterprise value relative to EBIT

Approach is straightforward
Step 1: Select group of peer firms
Typically firms in same industry
Hence the term Industry multiples

Step 2: Compute median/average for peer group

For the peer group: Average P/E ratio is 13
So, on average, P = 13* EPS

Step 3: Apply it to your firm

You want to value a private firm
It has EPS of $2
Comparables approach
Stock price of private firm should be = 13* $2 =$26

In Practice
Two big issues:
1. Wide dispersion within a given industry
2. Only relative valuation, what if entire industry is
sinking or overheating?

Solution
1. Use several valuation multiples
Get a range

2. Perform industry analysis

3. Perform fundamental valuation (DCF) approach

The case of Kenneth Cole

Kenneth Cole: Application with P/E ratio

Industry average P/E: 15.01
Range around this average: -42% to +51%

Kenneth Cole EPS number: $1.65

So, if stock price valued at industry average:
15.01*$1.65 = $24.76

The range (based on P/E):

1. Minimum: $24.76*(1-.42) = $14.36
2. Maximum: $24.76*(1+.51) = $37.38

Cloud computingsky high valuations!

The case of Workday
What is the P/E ratio of a
firm that is not expecting to
make a profit before 2016?
Classic alternative to P/E:
Price/Sales ratio
Con?

Comparables and Market efficiency

Be careful of language used!
Dangerous words:
1. Overvalued
2. Undervalued

Use instead the following:

1. Market is attributing a premium or a discount to this firm
2. This firm is more richly valued relative to its peers
3. Etc.

Then use fundamental analysis to determine whether

the discount or premium you find is justified!

The Classic case

March 2011: Bank of America has lowest price-to-book ratio

Undervalued or poor fundamentals?
News on March 24th 2011: FED denied dividend payout due to failed
stress-test
Lower relative valuation but justified by weaker fundamentals

The Final word on Valuation

No single technique provides a final answer
regarding a stocks true value
All approaches require assumptions or forecasts that
are too uncertain to provide a definitive assessment
of the firms value
1. Use a combination of these approaches

Gain confidence if results are consistent across methods

2. Stress-test the model to give a range of valuation

Sensitivity analysis