Valuation Chapter 10 Valuation models Discounted cash-flow Market-based (multiples) Residual income Model DCF and risidual income model are much more sophisticated valuation tools than the price multiples Infinite forecast horizon Risk and the time-value of money are taken into account (cost of capital) Ch 10 2 Discounted Cash-Flow Approach

Estimated future cash flows are discounted back to present value based on the investors required rate of return Discounted dividend valuation Discounted operating cash-flow models Ch 10 3 Discounted Dividend Valuation Theoretical Model No-growth, constant dividend D P0

r Dividends are growing at rate g D1 P0 r g D 0( 1 g) r g Ch 10 4 Required rate of return (r)

r rf ( r m rf ) rf, Risk-free (30-year Treasury bond) = 5% rm, Expected stock market return = 10% Risk premium = (rm rf) For example, if Beta = 1.5 r = 5% + 1.5(10%-5%) r = 12.5% Ch 10 5 Growth rate (g) Sustainable growth = ROE(1-Payout rate) ROE = Earnings/Average equity

Payout rate: % of earnings used to pay dividends Ch 10 6 Discounted Dividend Valuation Motorola example Motorola Annual dividend = $0.16 Beta = 1.35

ROE = 13% Payout ratio = 20% Economic Yield on Treasury bills = 4.75% Historical market risk premium = 5.4% Ch 10 7 Discounted Dividend Valuation Motorola example r = .0475+1.35(.054) = .120 g = .13(1-.20) = .104 Value = $11.04 $0.16(1 .104)

.120 .104 Ch 10 8 Discounted Operating Cash-Flow Models Value of the firm (EV) = Value of assets = Enterprise value = Value of debt +value of equity Typically, valuation of debt is relatively easy. Amount of debt reported in balance sheet is usually close to market value, i.e. value of debt is observable Ch 10 9

Discounted Operating Cash-Flow Models Operating cash flow Plus: Interest Paid Times (1-tax rate) Less: Investments in Fixed Capital Free Cash Flow to the Firm (to all investors) FCF 1 V0 r g Ch 10 10 Discounted Operating Cash-Flow Models r = Weighted average cost of capital (WACC) Required rate of return to all capital providers For Motorola, 10.2%

g = growth rate of FCFs For Motorola, 9% If Motorolas FCF = $314 million Firm value is $26,167 million [314/(.102-.09)] Shares outstanding is 2,299 Value per share (after debt $9,428) is $7.28 Ch 10 11

Discounted Operating Cash-Flow Models Growth Can also use a multi-stage model to accommodate rate changes Forecasting cash flows requires judgment Begin with reported, historical cash flow and earnings Make company-appropriate adjustments Use financial analysts estimates Ch 10 12 Market-based Models (multiples) Compare subject company to other similar companies for which market prices are available

Simple but require a lot of professional judgment P/E Model P/B Method P/S Model Ch 10 13 P/E Model Assumes a company is worth a certain multiple of its current earnings Assumes each stock is worth the same multiple of EPS Requires judgment regarding Peer firms Historical (average) P/E

Ch 10 14 P/E Model Firms with no internal growth prospects, paying out 100% of earnings Current P/E = 1/r Constant growth, P0/E1 = (D1/E1)/(r-g) D = annual dividends, E = EPS Ch 10 15

P/E versus bond yields http://home.golden.net/~pjponzo/PE-BondRates.htm Ch 10 16 Effect of the cost of equity and growth opportunities to P/E-ratio Cost of Equity (%) 8,5 9,0 9,5 10,0

10,5 11,0 11,5 12,0 Expected annual growth rate of earnings (%) 0 11,8 11,1 10,5 10,0 9,5 9,1 8,7 8,3 1

13,3 12,5 11,8 11,1 10,5 10,0 9,5 9,1 2 15,4 14,3 13,3 12,5 11,8 11,1 10,5

10,0 Ch 10 3 18,2 16,7 15,4 14,3 13,3 12,5 11,8 11,1 4 22,2 20,0

18,2 16,7 15,4 14,3 13,3 12,5 5 28,6 25,0 22,2 20,0 18,2 16,7 15,4 14,3

6 40,0 33,3 28,6 25,0 22,2 20,0 18,2 16,7 17 P/E Model

Motorola example Consensus analyst forecast EPS = $0.46 P/E of 23 is appropriate Value = 23*$0.46 = $10.58 Ch 10 18 Problems when using P/E-ratio in valuation It assumes that the benchmark is obtainable. P/E-ratios might differ accross firms or time at least for the following reasons: growth opportunities may differ accross firms riskiness of a firm may differ accorss firms earnings for a given year may be temporary by

nature Ch 10 19 P/B-ratio, price/bookratio No growth P0/B = ROE/r Constant growth P0/B = (ROE- g)/(r-g) P/B ratios for similar firms are compared with those of the subject firm to arrive at an appropriate multiple for use in valuation

Ch 10 20 Other Price multiples enterprise value/EBITratio price/free cash flowratio price/salesratio Price/EBITDA Method used should be appropriate considering the specific circumstances of

the subject company. Ch 10 21 Residual Income Model PV = book value + excess earnings over time Et rBt 1 P0 B0 t ( 1 r ) t 1

Perpetuity model ROE r P0 B B r g Ch 10 22 Ch 10 23 Valuation tools most used by analysts in Morgan Stanley European sector research teams %

60 50 40 30 20 10 0 Ch 10 24