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The role of valuation models
An investor, analyst, or manager must be persuaded that she is using an
appropriate valuation model, for an analysis is only as good as the
valuation model on which it is based.
Valuation models are introduced with a caveat. Models guide our thinking.
And, with this thinking, they guide practice. It is practice that we are really
concerned about but sometimes models come with features that are
difficult to apply in practice.
It is most important to have good thinking, and a model gives this. But it is
important also to develop the art of applying a model, to smooth over
difficulties while remaining true to the concepts.
--Stephen Penman FSA textbook
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3
Economic Balance Sheet
Economic B/S
Market
value of
Invested
capital
Debt
Equity ?
The present value model
The value of a financial asset (such as a stock or a bond)
is theoretically equal to the sum of all future
payments from the asset, discounted to present
value at an appropriate rate of interest (the discount
rate, r). The rate of interest is supposed to reflect the
riskiness of the payment stream.
Shareholders equity value discount rate:
Cost of equity capital
4
Valuation of Definite-Life Investments
Bonds valuation:
5
Coupons $100 $100 $100 $100 $100
Cash at redemption $1,000
0 1 2 3 4 5
5 4 3 2
) 08 . 0 1 (
000 , 1 100
) 08 . 0 1 (
100
) 08 . 0 1 (
100
) 08 . 0 1 (
100
) 08 . 0 1 (
100
BondsValue
Bonds Value = Present value of future cash flows
Cost of capital (discount rate)- The only uncertain item, assume 8%
Price at time zero = $1,080
Going-concern assumption -> 2 additional complications:
1. Very long forecast horizon (theoretically forever?)
2. Future value added is very difficult to forecast.
Valuation of Infinite-Life Investments
6
Criteria for a good practical valuation model:
Finite forecast horizons: Forecast for just a few years ahead
and then summarize the long term with long-term growth
rate.
Validation: Forecasts should be observable afterwards.
Parsimony: The few pieces of information required, the
more parsimonious is the valuation.
7
Discounted Dividend Valuation:
The present value of future cash payments to shareholders
is the basis of the discounted dividends method.
This method is the basis for most theoretical approaches to
stock valuation, inducing the other methods discussed in
this chapter.
Where r
e
is the cost of equity capital
8
Discounted Dividends Valuation-Terminal Values
In reality, firms can not have an indefinite life. If firms go bankrupt or get
taken over, shareholders shall receive a terminating dividend on their
stock. The terminal value is the final year of the forecast and represents
the PV of future payoffs for the remainder of the firms life.
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Where TV
T
is estimated terminal value at time T.
T
e
T
T
e
T
e e e
r
TV
r
DIV
r
DIV
r
DIV
r
DIV
e EquityValu
) 1 ( ) 1 (
...
) 1 ( ) 1 ( ) 1 (
3
3
2
2 1
0
Discounted Dividends Valuation-Terminal Values
10
Terminal Value (at time T)=
If assume that the dividend at the forecast horizon will be the same
as DIV at the time T+1 forever afterward (perpetuity assumption) :
...
) 1 ( ) 1 ( ) 1 (
3
3
2
2 1
e
T
e
T
e
T
r
DIV
r
DIV
r
DIV
e
T
e e e
T
T
r
DIV
r r r
DIV TV
1
3 2
1
...)
) 1 (
1
) 1 (
1
) 1 (
1
(
Combined
T
e
e
T
T
e
T
e e e
r
r
DIV
r
DIV
r
DIV
r
DIV
r
DIV
e EquityValu
) 1 ( ) 1 (
...
) 1 ( ) 1 ( ) 1 (
1
3
3
2
2 1
0
Discounted Dividends Valuation-Terminal Values
But the perpetuity assumption is too bold. For example, if there is less than
full payout of earnings, one would expect dividends to grow as the
retained funds earn more in the firm.
If assume that the dividend at the forecast horizon will grow at a constant
rate of g
d
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If the constant growth starts in the first period, then
mathematically, it leads to:
T
e d e
T
T
e
T
e e e
r g r
DIV
r
DIV
r
DIV
r
DIV
r
DIV
e EquityValu
) 1 )( ( ) 1 (
...
) 1 ( ) 1 ( ) 1 (
1
3
3
2
2 1
0
) (
1
0
d e
g r
DIV
e EquityValu
Discounted Dividends: Advantages/Disadvantages
Advantages:
Easy concept: Dividends are what shareholders get.
Predictability: Dividends are usually fairly stable in the short run so
dividends are easy to forecast.
Disadvantages:
Relevance: Dividend payout is not related to value, at least in the short
run; the capital gain component of payoff is ignored.
Forecast horizon: Typical requirement is for forecasts for long periods;
terminal values for shorter periods are hard to calculate with any
reliability.
When it works the best:
When a firm has a fixed payout ratio (e.g. dividend/earnings)
12
Discounted Cash Flow Valuation: Rationale
The cash flows from a firms operating and investing activities
are eventually divided among the claimants: The debt
holders and the shareholders.
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Discounted Cash Flow Valuation: Rationale
Business activities include operating, investing, and financing.
Free Cash Flow to Debt and Equity
= Operating cash flow Capital outlays (Investing in W.C. and L.T. A.)
= Net cash flows to debt owners + Dividends
Rearrange the above equation:
Dividends (Free Cash Flow to Common Equity)
= Operating cash flow Capital outlays
+ Net cash flow fromdebt Owners
= NI Book Value of Assets + Book Value of Net Debt
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Discounted Cash Flow Valuation: Model
Derived from the discounted dividends model
Equity value = PV of free cash flows to equity claimants
Requires:
1. Forecasts of fee cash flows (usually 5 10 years)
2. Forecasts of fee cash flows beyond terminal year
3. Discounting free cash flows using the cost of equity
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Discounted Cash Flows: Advantage/Disadvantage
Advantages: Cash flows are real and easy to think about; unaffected
by accounting rules.
Disadvantage:
Free cash flows do not measure value added in the short run; value gained
is not matched with value given up.
Negative free cash flows may appear for firms of growing investments. Thus
a long forecast horizon is required.
Analysts forecast earnings, not free cash flows.
When it works best: A cashcow business.
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Discounted Abnormal Earnings Valuation:
Abnormal earnings (residual income) are those that differ from the
expected return:
Abnormal earnings = Net income (Expected return * Beg. Book equity)
or, in equation form: AE
t
= NI
t
r
e
* BVE
t-1
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How does a
company
create value?
Discounted Abnormal Earnings Valuation:
Abnormal earnings (residual income) are those that differ from the
expected return:
Abnormal earnings = Net income (Expected return * Beg. Book equity)
or, in equation form: AE
t
= NI
t
r
e
* BVE
t-1
How does a company create value? Earning more than the opportunity
cost (expected cost of capital).
The discounted dividends method can be modified to yield the
following relationship (see Appendix B):
Equity value
0
= BVE
0
+ PV expected future abnormal earnings
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Why terminal values in accounting-based valuation are
significantly lower than those for DCF valuation?
Accounting-based valuation includes BVE
0
that
captures the expected future normal values.
The terminal value captures only expected
future abnormal values.
DCF terminal value captures both normal
and abnormal values embedded in future
free cash flows.
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Accounting Methods and Discounted Abnormal Earnings
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How are AE estimates affected by managers choice of
accounting methods?
Provided analyst is aware of managers choice AE-
based valuations should be unaffected by variation in
accounting decisions. This is because:
Accounting choices affect both earnings and BV
Double-entry bookkeeping is self-correcting
Strategic and accounting analyses are important steps
to precede abnormal earnings valuation.
Discounted Abnormal Earnings: Advantage/Disadvantage
Advantages:
Focus on value drivers: profitability and growth of investment
Use accrual accounting
Forecast horizon can be shorter, depending on the quality of the
accrual accounting
Aligned with what analysts forecast
Disadvantage: Relies on understanding of accrual
accounting and accounting quality
When it works best: for a more general set of business.
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Price Multiples Valuation
Price multiple valuation methods are popular
because of their simplicity.
Three steps are involved:
1. Select base measure
2. Calculate price multiples for comparable firms
3. Apply comparable firm multiple to firm
analyzed
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Using Price Multiples
Selecting comparable firms
It may be difficult to identify comparable firms,
even within an industry
Industry averages may be used instead
Firms with poor performance
Marginal profitability or earnings shocks must be
considered
Adjustments for leverage
Take care to maintain consistency between
numerator and denominator
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Determinants of Value to Book Multiple
Value-to-book ratio is driven largely by:
Magnitude of future abnormal ROEs
Growth in book value
gbve r
BVE gbve BVE
BVE r ROE AE
Given
gbve r
r ROE
BVE
of AE V P
BVE
e EquityValu
e
t t
t e t t
e
e
1
1
0
0 0
0
*
) (
:
1
. .
1
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Determinants of Value to Earnings Multiple
If using discounted earnings model:
gear r
Given
gear r E
of E V P
E
e EquityValu
e
e
:
1 . .
0 0
0
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Determinants of Value to Earnings Multiple
Equity value-earnings can be derived from the
value-to-book formula:
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ROE, Equity Growth, Price-to-Book Ratio,
and Price-Earnings Ratio
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Shortcut Forms of Earnings-Based Valuation
Assumptions may be made to simplify
abnormal earnings and equity value-to-book
methods.
Abnormal earnings: random walk and
autoregressive models
ROE and Growth: ROE mean reversion, other
assumptions (e.g., decay)
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Shortcut Forms of Discounted AE
Assumptions may be made to simplify abnormal
earnings.
Abnormal earnings: random walk (perpetuity)
Abnormal earnings: autoregressive model
e
r
AE
BVE e EquityValu
0
0 0
) 1 (
0
0 0
0 1
e
r
AE
BVE e EquityValu
AE AE
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Summary on Valuation Models
Do these valuation models work? Do they all work equally well? Under what
circumstances?
The short answer to the first question is that they are often far from
perfect, but nevertheless useful.
The short answer to the second question is that in most cases no the
approximations and simplifications we tend to do in practice give these
models different properties. As a practical matter, one model may
therefore be preferable over another.
To understand why and how we need to understand the theory behind the
models.
Dont forget that we are dealing with accounting data: If the accounting
principles do not correspond to a models underlying assumptions, then
that model may be useless.
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ABOUT DISCOUNT RATE
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Computing a Discount Rate
The appropriate discount rate for asset
valuation is the WACC, which takes into
account debt and equity sources of financing
WACC = % debt financing
1
* After-tax cost of debt + %
equity financing * Cost of equity capital
1
Short- and long-term debts, not all liabilities
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Estimating the Costs of Debt and Equity
Cost of debt:
Should reflect the current interest rate(s)
Must be net of taxes because after-tax cash flows are being
discounted
Cost of equity:
The CAPM provides one approach
Three-Factor Model: CAPM may be combined with firm
size (SMB) and B/M ratio (HML)
Implied cost of capital
Amount of leverage affects risk
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CAPM model
CAPM based on historical information
What if risk has changed?
CAPM: E( R ) = R
f
+ Beta*(R
m
-R
f
)
Expected return is increasing in systematic risk.
What is Beta?
Cov( R
stock
,R
market
R
f
)/Var( R
market
R
f
)
Think of it as Co-wiggling.
According to this model, why does the systematic risk only
matter?
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Where do we get the information?
Where do we get Beta?
KEY ISSUE! This is an estimate from historical data
Estimation period is typically 60 months
Sources: Bloomberg, Analysts, Yahoo! Finance, or estimate it yourself!
Where do we get RF? Federal Reserve Bank of St. Louis:
research.stlouisfed.org/fred/data/irates.html
Estimating TJXs Cost of Equity
Assumptions:
Beta is 0.80
Treasury bond rate is 3.4%
Market risk premium 6.7%
Cost of equity = 8.8% (=3.4% + 0.8*6.7%)
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Is the CAPM correct?
Facts: Even after accounting for Beta risk:
Small stocks tend to have higher returns than big stocks.
Firms with high B/M ratios have higher returns.
Maybe the CAPM is a not perfect model:
Other sources of risk beyond single risk factor?
Maybe small stocks have greater systematic risk.
Maybe value stocks have greater systematic risk.
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Example of CAPM Calculation:
What is Equity Cost of Capital for Microsoft?
Beta = 1.49
R
f
= 4.87% (20 year treasury bond)
(R
m
R
f
) = 7.95%
E( R ) = R
f
+ Beta*(R
m
-R
f
)
=4.87% + 1.49*(7.95%) =16.7%
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The Fama-French 3-factor model
Origins:
Fama and French, 1993, Common Risk Factors in the
Returns on Stocks and Bonds, JFE.
An extension of the CAPM:
R
stock
=
R
f
+
*(
R
m
- R
f
) +
SIZE
*(
R
SMB
) +
HML
*(
R
HML
)
Every stock has different market ,
SIZE, and
HML
Where do we get (R
m
-R
f
), R
SMB
, R
HML
?
Homepage of Professor Ken French:
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/
data_library.html
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Fama-French Factor Returns
What are long-run average values of these
factors?
Long-run average (R
m
-R
f
) = 7.95% per year
Long-run average R
SMB
= 3.32% per year
Long-run average R
HML
= 5.05% per year
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Microsoft Cost of Capital: 3-Factor Model
Microsoft:
Market Beta = 0.9
Size Beta = -0.40 (!)
HML Beta = -1.24 (!)
R
stock
=
R
f
+
*(
R
m
-
R
f
) +
SIZE
*(
R
SMB
) +
HML
*(
R
HML
)
= 4.87%+0.98*7.95%
+(-0.40)*3.32%+ (-1.24)*5.05%
= 5.1%
Some Survey Data on Cost of Capital
Market Risk Premium used in 56 countries in 2011: a
survey with 6,014 answers
By Fernandaz et al 2011
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