You are on page 1of 17

# VALUATION

## DISCOUNTED CASH FLOW VALUATION MODELS

The parameters that make up the DCF model Value= CFt+I / (1+r)I
Conceptually , cash flow are defined differently depending on whether the valuation objective is the firms equity or the value of the firms debt plus equity.

## Dividend base models

The value of a firms equity (p) equals to the present value of all

## future dividends paid by the firm to its equity holders:

po = D1/(1+r)+D2/(1+r)2.......... = Di/(1+r)I This formulation requires forecasting dividends to infinity , which is impossible .thus different pattern of future dividends must be assumed. No-Growth-constant Dividend Model Po= D1/r Constant Growth Model Po= Do(1+g)/r-g = D1/r-g

## Earning based model

Earning based models can be used to value either the equity of the firm the firm as whole , debt plus equity No- Growth Model Equity valuation p= E/r Value of the firm v = Net operating income/ WACC

CONT.
INCOME STATEMENT OPERATING REVENUE OPERATING EXPENSE ALL YEARS \$350 (150) \$200 DEPRECIATION EXPENSE OPERATING INCOME BEFORE TAX TAX@ 20% (50) \$150 (30)

## NET OPEARTING INCOME

INTEREST EXPENSE NET INCOME

\$120
(20) \$100

## P= 100/.10 = \$1000 V= \$120/.096 = \$1250

(ASSUME r= 10%) ( Debt to capital 20% and cost of debt is 8%(after tax))

## GROWTH MODEL - Equity Valuation and Earnings

INCOME Period STATEMENT Earnings OPERATING REVENUE OPERATING EXPENSE 0 Eo = 100 1 E = 104 DEPRECIATION EXPENSE1 OPERATING INCOME BEFORE 2 108.16TAX TAX@ 20% NET OPEARTING INCOME INTEREST EXPENSE ALL YEARS = dividends +

\$350
(150) \$200 (50) \$150 (30) \$120 0.8*Eo = 80 83.2 86.53

New Investments
.2*Eo = \$20 20.8 21.63

## g= r8(1-K) = (20) 0.2 * (1-0.8) = .04

NET INCOME \$100 Using the growth formula to find the value of the firm equity yields NEW INVESTMENT (EQUITY) 20 Po = KEO (1+g)/(r-g) = 0.8(104)/(.10-.04)= AVAILABLE FOR EQUITY HOLDERS \$80 \$ 1387

## GROWTH MODEL Value Of The Firm

INCOME STATEMENT OPERATING REVENUE OPERATING EXPENSE ALL YEARS \$350 (150) \$200 DEPRECIATION EXPENSE OPERATING INCOME BEFORE TAX TAX@ 20% (50) \$150 (30)

## NET OPEARTING INCOME NEW INVESTMENT

AVAILABLE FOR DEBT AND EQUITY HOLDERS

\$120 (30)
\$90

## Estimating Growth Rate

The firms growth rate can be estimated in one of the two ways : 1)Estimating the individual components , k and r* , that contribute to growth as g=(1 - k)r* 2)Extrapolating the historical growth rate to the future.

ESTIMATING r*
r*=actual return r= required rate of return when r*=r , growth model reduces to nogrowth case when r*>r , only then growth opportunities exist
Share holders wealth is not affected by firms dividend policy
Payout ratio k 0.75 0.50 0.25 Reinvested Income (1-k)E 25 50 75 Growth rate g=(1-k)r 0.025 0.050 0.075 Share Value P0=kE/(r-g) 75/(0.1-0.025)=\$1000 50/(0.1-0.050)=\$1000 25/(0.1-0.075)=\$1000

## Estimating k:The Dividend Payout Ratio

The current dividend payout ratio is often used to estimate k. This gives us an estimate of the firms earnings growth rate g=(1 k)X r* = (1 Dividend payout) X ROE

For stable growth companies , k and ROE are relatively constant and for cyclical companies they are not.
K= (Dividends + share repurchases new equity issued)/Earnings

## Dividend policy and EPS growth

Dividend policy has an important impact on earnings growth.
a firm with a low payout ratio grows faster than if it paid out most of its earnings , since reinvested earnings generate future earnings. a firm with low dividend payouts report faster EPS growth than firms with high payout policies , and using EPS growth rate to estimate g will lead to erroneous results.

## Earnings valuation & the rice/Earnings Ratio

The price/earnings ratio (P/E) is the best known investment valuation indicators. The P/E ratio has its imperfections, but it is the most widely reported and used valuation by investment professionals and the investing public. A stock with a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to the overall market, as investors are paying more for today's earnings in anticipation of future earnings growth. Price/Earnings ratio = (stock price per share/EPS)

## Growth , Risk and Valuation

The price/earnings ratios of a sample of firms to see whether growth and/or risk could explain differentials among firms. Initially some of the differences in P/E ratios are due to the earnings growth rate. Portfolios with high P/E ratios have higher earnings growth in the first few years P = [kE(1 + g)]/(r - g)

## Free cash flow approach to valuation

Free cash flow has been suggested as, when the valuation objective is the firm. Three of the most used valuation techniques are: (1) Valuing the cash flow to the invested capital (debt + equity), or free cash flow to the firm (FCFF); (2) Valuing the cash flow of the equity holders, or free cash flows to equity (FCFE); (3) Valuing EBITDA (Earnings before interest, taxes, depreciation and amortization).

Free cash flow:Net operating income before replacement of depreciated assets (-) replacement of depreciated assets (-) net investment = free cash flow

This is equivalent to:Adjusted CFO(net operating income plus adjustment) (-) cash from investment (new + replacement) =free cash flow

Note:- the adjusted CFO is not same as CFO reported in the statement of cash flow