Valuation

Curriculum designed for

use with the Iowa Electronic
Markets

by

Roger Ignatius
Thomas A. Rietz

1
Valuation: Lecture Outline
● Principles of Valuation
● Discounted Dividend Models
♦ Constant Dividend Model
♦ Constant Growth Model
● Discounted Cash flow Model
● Market Multiple Models
♦ P/E versus Past and Peers
♦ P/S versus Past and Peers
♦ P/CF versus Past and Peers
● Summary
2
Principles of Valuation
● Book Value
♦ Depreciated value of assets minus outstanding
liabilities
● Liquidation Value
♦ Amount that would be raised if all assets were sold
independently
● Market Value (P)
♦ Value according to market price of outstanding
stock
● Intrinsic Value (V)
♦ NPV of future cash flows (discounted at investors’
required rate of return)
3
Intrinsic Valuation Procedure
Asset Characteristics Investor Characteristics
• Size of Future Cash flows • Assessment of Cash
• Time of Future Cash flows flow Riskiness
• Risk of Future Cash flows • Risk Preferences

Investors’ Required Rate

of Return (k)
Where Does the Discount
Rate (k) Come From?
● CAPM: k = rf + β xRP
● Beta (β ) is estimated using historical
data and is available from many sources
● The risk free rate (rf) is the current
Treasury rate
♦ Typically the 3-mo rate, but other are
sometimes used
● The risk premium (RP) is a historical
average relative to the rf used
5
Example: Estimating k for
Wal-Mart (WMT) on 4/27/01
● Inputs
♦ Three month Treasury rate: 3.75%
♦ Historical average RP (1926-1996):
8.74%
♦ Beta for Dell (from MoneyCentral): 0.9
● Computing k:
♦ CAPM: k = 0.0375 + 0.9x0.0874 =
11.62%
6
 Sensitivity to CAPM Inputs
Required Return (k) from CAPM

Change in Risk Free

26%
Rate
24%
22% Change in Risk
20% Premium
18%
16% Change in Beta
14% (Scale Shows
Change / 10)
12%
10%
8%
6% Initial values:
-0.05

-0.04
-0.03

-0.02
-0.01

0.00
0.01

0.02
0.03

0.04
0.05
Rf = 3.75%
Change in Input RP = 8.47%
Beta = 1.5
7
Discounted Dividend Models
● Stock pricing relationship:

● Dividends will be
♦ Forecast directly
♦ Assumed to be constant
♦ Assumed to grow at a constant rate or
♦ Some combination of the above

8
Constant Dividend (Zero
Growth Model) Model
● Stock pricing relationship:

● If Dt is constant, then it is an
ordinary perpetuity:

9
Example: Wal-Mart (4/27/01)
● The current (annual) dividend is: $0.28
● According to the constant dividend (zero
growth) model:
$0.28
P0WMT
= = $2.41
0.1162
● The price of Wal-Mart was actually $52.83
● Can you explain the difference?

10
 Sensitivity to Constant
Dividend Model Inputs
$9
Change in Dividend
Stock Price from Constan

$8 (Scale shows
$7 Change / 10)
Growth Model

$6 Change in Discount
Rate
$5
$4
$3
$2
$1
$0 Initial values:
-0.05
-0.04
-0.03
-0.02
-0.01

0.05
0.00
0.01
0.02
0.03
0.04

D0 = $0.50
Change in Input k = 12%

11
Why do a firm’s dividends
grow?
● Because earnings grow. Why?
● Because of reinvested funds
♦ Used to expand or to undertake new projects
♦ Used in positive NPV projects
● Leads to
♦ Earnings growth
♦ Investments growth and
♦ Dividend growth
Constant Growth Model
● Stock pricing relationship:

● If Dt grows at a constant rate, g, then

it is a growth perpetuity:
∞
D1 D1 D0 (1 + g )
P0 = ∑ = =
t =1 (1 + k ) k −g k −g
t

13
How do You Estimate Growth
(g)?
● Historical average
● Average analyst forecast
● Sustainable growth
♦ g = (1-Payout Ratio)xROE
● Required return versus dividend yield:
D0
k−
D1 D0 (1 + g ) P0
k= +g = +g⇒g =
P0 P0 D0
1+
P0
● NOTE: Must have g<k in the long run!
14
Estimating g for Wal-Mart
(4/27/01)
● 5 year historical average: 19.72%
● Average 5-year analyst forecast: 14.4%
● Sustainable growth
♦ g = (1-0.17)x0.22 = 18.26%
● Required return versus dividend yield:
0.1162 − $0.28
g= $52.83 = 11.03%
1 + $0.28
$52.83
● What should it be?
♦ 1st 3 are too high b/c long run must have g<k
♦ Guess: 11%?
15
Example: Wal-Mart (4/27/01)
● Current (annual) dividend is: $0.28
● If we use estimated growth of 11%:
$0.28 × 1.11
P0 = = $50.13
0.1162 − 0.11
● The price of Wal-Mart was actually $52.83
● Notes:
♦ Must have g<k in long run
♦ As gk, the price increases without bound

16
 Sensitivity to Constant Growth
Model Inputs
Change in Dividend
$60
(Scale shows
Stock Price from Constan

Change / 10)
$50
Change in Discount
Growth Model

$40 Rate

$30 Growth Rate

$20

$10

$0 Initial values:
-0.05
-0.04
-0.03

-0.01
-0.02

0.02

0.04
0.00
0.01

0.03

0.05

D0 = $0.50
Change in Input k = 12%
g = 6%
17
Summary of Dividend
Discount Models
● Represents the value of dividends
received by shareholders
● Requires
♦ A discount rate (k)
♦ Dividends (D)
♦ Steady or zero growth (g, with g<k)
● Trouble valuing
♦ Companies with D=0
♦ Fast growing companies with g>k

18
Discounted Cash Flow Model
● Shareholders receive or “own”:
1. Dividends
2. Re-invested earnings
♦ The effects of re-invested earnings are
captured in dividend growth if a firm pays
dividends and growth can be estimated
● An alternative valuation comes from
valuing cash flows available to
stockholders directly
♦ Useful for companies that pay no
dividends

19
What Constitutes Cash flows?
● There is some debate over exactly
what constitutes cash flows
● The GAAP cash flow statement:
♦ CF = NI + depreciation – preferred
stock dividends
♦ This should represent CFs that are
either
1. Paid out in common stock dividends or
2. Re-invested
20
What Discount Rate Should
be used?
● It depends on the definition of CFs
♦ If CFs are defined as those available to
all investors, WACC should be used
♦ If CFs are defined as those available to
common stockholders, k from CAPM
should be used
● We will use the latter

21
Example: Estimating k for K-
Mart (K) on 4/27/01
● Inputs
♦ Three month Treasury rate: 3.75%
♦ Historical average RP (1926-1996):
8.74%
♦ Beta for K-Mart (from MoneyCentral): 1
● Computing k:
♦ CAPM: k = 0.0375 + 1x0.0874 = 12.49%

22
How do You Estimate Growth
(g)?
● CFs will also grow
● Use methods similar to dividend growth, but
♦ Analysts forecasts are typically unavailable
♦ For many companies, dividend yield cannot be
used b/c there is no dividend
● Often, earnings or sales growth are used
♦ Expenses and re-investment need to be relatively
constant percentages of sales
● NOTE: Must have g<k in the long run!

23
Estimating g for K-Mart
(4/27/01)
● From the historical income statement:
Dec-00 Dec-99 Dec-98 Dec-97 Dec-96
Net Income $ (244.00) $ 403.00 $ 518.00 $ 249.00 $ (220.00)
Dep & Amort $1,460.00 $2,070.00 $1,762.00 $1,555.00 $1,427.00
Pref Div $ - $ - $ - $ - $ -
Cashflow $ 1,216.00 $ 2,473.00 $ 2,280.00 $ 1,804.00 $ 1,207.00
Growth -50.83% 8.46% 26.39% 49.46%
Avg Growth: 8.37%

● 5 year sales growth: 2.35%

● Analysts’ 5 year earnings forecast: 10.3%
● Suppose, you believe K-Mart will not grow at all!

24
Example: K-Mart (4/27/01)
● According to the last statements:
♦ CF = $1,216 million
♦ Shares = 486.5 million
 CF/Share = $2.50
● If we use estimated growth of 0.0%:
$2.50 × 1.00
P0 = = $20.01
0.1249 − 0.00
● The price of K-Mart was actually $9.82
● What must the market be expecting for K-Mart’s growth in
the future?
25
 Sensitivity to Constant Growth
Cash flow Model Inputs
Change in Cashflow
$60
(Scale shows
Stock Price from Constan

Change / 10)
$50
Change in Discount
Growth Model

$40 Rate

$30 Growth Rate

$20

$10

$0 Initial values:
-0.05
-0.04
-0.03

-0.01
-0.02

0.02

0.04
0.00
0.01

0.03

0.05

CF0 = $0.50
Change in Input k = 12%
g = 6%
26
Summary of Discounted Cash
flow Models
● Represents the value of cash flows available to
shareholders
● Requires
♦ A discount rate (k)
♦ A reasonable measure of cash flows
o IMPORTANT: How much depreciation MUST be replaced ?
Model assumes zero.
♦ Steady or zero growth (g, with g<k)
● Trouble valuing
♦ Companies with CF<0
♦ Fast growing companies with g>k
♦ Companies with necessary replacement of
depreciated assets
27
Market Multiples
● Valuations are derived by:
1. Forecasting earnings, sales or cash
flows
2. Applying the company’s historical
P/E, P/S or P/CF to forecast
3. Applying industry average P/E, P/S or
P/CF to current inputs
Why do P/E Ratios Make
Sense?
● A company with a payout ratio of 1 will
not grow and be valued at:
D E P0 1
P = 1 = 1 ⇒ =
0 r r E1 r
● A company with a payout less than 1 will
grow and be valued at:
E P 1 PVGO
P= 1 + PVGO ⇒ = +
r E r E
1 1
29
Logic of Market Multiple
Models
● Sales, earnings and cash flow drive profits,
growth and value
● P/S, P/E & P/CF ratios show the relationship
between price and these value drivers
● Firms within an industry have similar sales,
profit and cash flow patterns and similar
required returns
● Therefore, a reasonable value for a firm is its
sales, earnings or cash flows times the
respective industry ratio

30
P/E Ratio Valuation
● If company “j” is “valued at historical
ratios” relative to earnings:
 P j

P1j = E1j ×  0j 
 E0 

● If company “j” is “valued at industry

ratios” relative to earnings:
 P i

P0 = E 0 × Avg  i 
j j 0

Industry  E 0 
31
Example: Wal-Mart (4/27/01)
● Valued at historical P/E ratio:
♦ Analysts forecast next year’s earnings for WMT at
$1.58
♦ WMT’s recent P/E was 37.7
♦ Then: P = $1.58x37.7 = $59.57
● Valued at industry average P/E ratio:
♦ This year, earnings for WMT were $1.40
♦ The industry average P/E was 36.0
♦ Then: P = $1.40x36.0 = $50.40
● The price of Wal-Mart was actually $52.83
32
 Sensitivity to P/E Multiple
Model Inputs
Stock Price from Constan

$70 Change in Earnings

$60
Growth Model

$50 Change Benchmark

P/E Ratio (Scale
$40 shows Change / 10)
$30
$20
$10
$0 Initial values:
-0.40
-0.30

-0.10
-0.50

-0.20

0.20

0.50
0.00
0.10

0.30
0.40

E1 = $1.50
Change in Input P/E = 35

33
P/S Ratio Valuation
● For companies w/o earnings, P/S is
sometimes used
● If you have a sales forecast, company “j” is
“valued at historical ratios” relative to
sales: j  P0 
P1j = S1j × j 
S 
 0 
● Using current sales, a company “j” is
“valued at industry ratios” relative to sales:
 P i

P0 = S0 × Avg  i 
j j 0

Industry  S0  34
Example: Amazon (4/27/01)
● For the year ending 12/00
♦ Sales = 2,762 million (income statement)
♦ Shares = 357.1 million (balance sheet)
Sales/Share = 2762/357.1 = 7.73
● Industry average P/S = 3.46
● So, using industry P/S Amazon should be
priced at: 3.46x7.73 = $26.76
● The price of Amazon was actually $15.27

35
 Sensitivity to P/S Multiple
Model Inputs
Stock Price from Constan

$70 Change in Sales

$60
Growth Model

$50 Change Benchmark

P/S Ratio (Scale
$40 shows Change / 10)
$30
$20
$10
$0 Initial values:
-0.40
-0.30

-0.10
-0.50

-0.20

0.20

0.50
0.00
0.10

0.30
0.40

S1 = $3.00
Change in Input P/S = 15

36
P/CF Ratio Valuation
• For companies w/o dividends, P/CF is
sometimes used
• If you have a cash flow forecast, company “j” is
“valued at historical ratios” relative to cash
flows:
 P j 
P1j = CF1j ×  0 j 
 CF 
 0 

• Using current cash flow, company “j” is “valued

at industry ratios” relative to cash flows:
 P i 
P0j = CF0j × Avg  0 i 

Industry  CF0


37
Example: K-Mart (4/27/01)
● For the year ending 12/00
♦ CF = 1,216 million (discussed previously)
♦ Shares = 486.5 million (balance sheet)
CF/Share = 1216/486.51 = 2.50
● Industry average P/CF = 21.3
● Using industry P/CF K-Mart should be priced
at: 21.3x2.50 = $53.24
● The price of K-Mart was actually $9.82
● Is K-Mart undervalued or in serious trouble?

38
 Sensitivity to P/CF Multiple
Model Inputs
Stock Price from Constan

$70 Change in Cashflow

$60
Growth Model

$50 Change Benchmark

P/CF Ratio (Scale
$40 shows Change / 10)
$30
$20
$10
$0 Initial values:
-0.40
-0.30

-0.10
-0.50

-0.20

0.20

0.50
0.00
0.10

0.30
0.40

CF = $1.00
Change in Input P/S = 30

39
Summary of Market Multiples
Models
● Valuations using historical and industry
ratios
♦ Provide useful benchmarks
♦ Useful when dividends and cash flows cannot
be discounted directly
♦ Can be compared to current ratios as a
measure of market sentiment
● Weaknesses
♦ Misleading for firms that are changing rapidly
or do not resemble the industry
40
Summary
• Discounted Dividend • Why several
♦w/ dividends and methods?
constant expected ♦ Each has strengths
(possibly zero) growth and weaknesses
in dividends ♦ Different methods
• Discounted Cash flow useful in different
♦w/o dividends and situations
constant expected ♦ Each gives a different
(possibly zero) growth “take” on the value of
in cash flows the company’s stock
• P/E, P/S and P/CF ♦ Provides a range of
ratios valuations instead of
point estimates
♦Comparison with past
or industry

41