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DCF Valuation Models

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Finding undervalued securities is not easy in efficient markets.

However, opportunities exist as markets not perfectly

efficient.

Fundamental analysis aims at determining fair market value of

a companys stock based on present and future profitability.

To identify mispriced securities, fundamental analysis looks at

some measure of true value derived from observable

financial data.

Alternative Measures of Value

Valuation by Comparables

Book Value

Liquidation Value

Replacement Cost

Tobins q

Intrinsic Value

Intrinsic Value

Intrinsic Value (V

0

) of a share is the present value of

all cash payments to the investor in the stock,

including dividends as well as the proceeds from the

ultimate sale of the stock, discounted at the

appropriate risk-adjusted interest rate, k.

Whenever the intrinsic value exceeds the market

price, the stock is considered undervalued and a

good investment.

The Valuation Process

Understand the business through macro-economic and

industry analysis.

Forecast company performance

Select the appropriate valuation model (absolute valuation

models such as DCF models or relative valuation models).

Convert a forecast to a valuation

Make investment recommendation.

Dividend Discount Models

The intrinsic value of common stock is viewed as the present value of its

expected future cash flows.

The most widely used definitions of cash flows associated with common

stock are dividends and free cash flows.

The dividend discount models define cash flows as dividends.

A discounted dividend approach is most suitable for dividend paying

stocks in which the companies have a discernible dividend policy that has

an understandable relationship to the companys profitability, and the

investor has a non-control (minority ownership) perspective.

These include seasoned profitable companies operating outside the

economys fastest growing subsectors.

Dividend Discount Models

When you buy stock in a publicly traded firm, the only cash

flow you receive directly from this investment is expected

dividends.

The DDM builds on this simple proposition and argues that

the value of a stock has to be the present value of expected

dividends over time.

1 2

0

2

(1)

(1 ) (1 ) (1 )

n

n

D D D

V

k k k

Dividend Discount Models

The DDM in the form of equation (1) showing the discounted

value of future dividends is not useful in valuing a stock

because it requires dividend forecasts for every year into the

indefinite future.

To make the model practical, it is assumed that dividends

trend upward at a stable growth rate g.

The equation for V

0

can be simplified as:

Equation (2) is called the constant growth DDM or the Gordon

Model.

1

0

(2)

D

V

k g

Growth comes from retention and reinvestment of profits. If b

denotes the retention ratio and r denotes the ROE, the growth

rate g =b*r

If the dividends are not expected to grow, then the dividend

stream will be a simple perpetuity and the valuation formula will

be V

0

= D

1

/k.

Since D

1

for a no growth company is E

1

, V

0

is also equal to E

1

/k.

In case of preferred stock, the constant growth rate of dividend

is zero. If a preferred stock pays a fixed dividend of Rs.10 per

share and the discount rate is 8%, the price will be Rs.10/0.08 =

Rs.125.

Implications of Constant Growth DDM

1. The model implies that a stocks value will be greater:

the larger the expected dividend per share

the lower the market capitalization rate, k.

the higher the expected growth rate of dividends.

2. The stock price is expected to grow at the same rate as

dividends.

Example

Expected dividend (D

1

) =4.00 k=0.10 g = 0.05

P

0

= 4/(0.10-0.05) = 80

D

2

= 4.20 P

1

= 4.20/(0.10-0.05) =84

The price has increased by 5%, the same rate as

growth rate of dividends.

Implications of Constant Growth DDM

From

When P

0

=V

0

, the market capitalization rate can be

calculated using the above relationship.

The constant growth dividend discount model cannot be

used when g >k

It is best suited for firms with well established dividend

payout policies and which are growing at a rate equal to

or lower than the growth in the economy

1

0

D

P

k g

1

0

(3)

D

k g

P

Two-Stage DDM

This model allows for two stages of growth-an initial phase

where the growth rate is not a stable growth rate and a

subsequent steady phase where the growth rate is stable and

is expected to remain so for the long-term.

The growth rate in the initial phase can be higher or lower

than the stable growth rate.

This model is best suited for firms that are in the high growth

and expect to maintain that growth rate for a specific period

after which the sources of high growth are expected to

disappear (expiry of patents, disappearance of barriers to

entry).

Two-Stage DDM

0

0

1

(1 ) (1 ) 1

(1 ) (1 )

t

n

s n c

t n

t

c

D g D g

V

k k g k

Where:

D

0

= Current Dividend

g

s

= Sub-normal or Super-normal Growth rate of Dividend

g

c

= Constant growth rate of Dividend

D

n

=Dividend at the end of the normal growth period

k = required rate of return

Example Two Stage DDM

Given D

0

= Rs.1.00, g

s

= 12%, g

c

=6%, n=3 and k=10%

V

0

=

= 1.02+1.04+1.05+27.97

= 31.08

2 3 3

2 3 3

1(1.12) 1(1.12) 1(1.12) 1(1.12) (1.06) 1

(1.10) (1.10) (1.10) (0.10 0.06) (1.10)

Two-Stage DDM

There are two major problems in applying the two-stage DDM

Defining the length of the extraordinary growth period. There

are three major considerations:

Size of the firm

Existing growth rate

Magnitude of sustainable competitive advantage

Deciding on the shift from high to stable rate. The two-stage

model is suited to firms with moderate growth only where the

shift will not be dramatic.

For firms with high growth rates, the transition should be

gradual and multi-stage growth models should be used.

Multistage Growth Models

These models allow dividends per share to grow at several different

rates as the firm matures.

They assume an initial period of high dividend growth, a final period

of sustainable growth and a transition period between the two

during which the initial high growth rate tapers off to the ultimate

sustainable rate.

These models are similar to the two-stage models but require a

larger number of inputs.

The three-stage DDM with declining growth in stage 2 has been

widely used. It has also been adopted by Bloomberg LP, a financial

services company that provides Bloomberg terminals to

professional investors and analysts.

Limitations of DDM

The models are extremely sensitive to the inputs for the

growth rate.

They can lead to misleading results as the growth rate

converges to the discount rate.

The focus on dividends can lead to skewed estimates of value

for firms that are not paying out what they can afford to in

dividends.

In particular, they will underestimate the value of firms that

accumulate cash and pay out too little in dividends.

Free Cash Flows

The second definition of stock returns used in DCF techniques of

stock valuation is free cash flows.

Whereas dividends are the cash flows actually paid to stockholders,

free cash flows are the cash flows available for distribution to

shareholders.

Analysts like to use free cash flow as the return whenever one or

more of the following conditions is present:

(1) The company does not pay dividends. (2) The company pays

dividends but does not have a discernible dividend policy that has

an understandable relationship to the companys profitability. (3)

Free cash flows align with profits within a reasonable forecast

period. (4) The investor has a control perspective.

FCFF and FCFE

There are two notions of free cash flows, free cash flow to the

firm (FCFF) and free cash flow to equity (FCFE).

FCFF is the cash flow available to companys suppliers of

capital after all operating expenses (including taxes) have

been paid and the necessary investments in working capital

(e.g., inventory) and fixed capital (e.g., equipment) have been

made.

FCFE is the cash flow available to the companys holders of

common equity after all operating expenses, interest and

principal payments have been made and necessary

investments in working and fixed capital have been made.

FCFF Approach

The free cash flow to the firm (FCFF) is the sum of the cash

flows to all claim holders in the firm including stockholders,

bondholders and preferred shareholders.

There are two ways of measuring FCFF:

1. FCFF =FCFE+ Interest expense (1-t) + Principal repayments

new debt issues + Preference dividend

2. FCFF = EBIT (1-t) + Depreciation- Capital expenditure

Changes in Working Capital

FCFF Approach

From the firm value, the value of the firms debt obligation is

deducted to arrive at the firms equity value.

FCFF models can also be constant growth, two stage or three-

stage models.

Under the constant growth FCFE model:

1

0

FCFF

FCFF

V

WACC g

Re Re ( )

FCFF

g investment Rate turnoninvested capital ROIC

Re

(1 )

Capex Depreciation WC

investment Rate

EBIT t

(1 ) EBIT t

ROIC

Total Capital

FCFE Approach

FCFE = Net income (capital expenditure-depreciation)-

(changes in non-cash working capital) + (new debt issued debt

repayments)

If it is assumed that the net capital expenditure and working

capital changes are financed using a fixed proportion ( ) of

debt, FCFE can be represented as:

FCFE = Net income (capital expenditure-depreciation)(1- ) -

(changes in non-cash working capital) (1- )

FCFE Approach

FCFE models can also be constant growth, two stage or three-

stage models.

Under the constant growth FCFE model:

Equity Reinvestment Rate =

1

0

e FCFE

FCFE

V

k g

FCFE

g Equity reinvestment rate ROE

Net capex WC Net debt issue

Net Income

Calculating Free Cash Flows

When finding the net increase in working capital for free cash

flow, we exclude cash and cash equivalents as well as notes

payable and the current portion of long-term debt.

Cash and cash equivalents are excluded because a change in

cash is what we are trying to explain.

Notes payable and the current portion of long-term debt are

excluded because these are liabilities with explicit interest

costs that make them financing items rather than operating

items.

Calculating Free Cash Flows

Changes in deferred tax liability should not be added back if

the liability is likely to reverse in the near future. The addition

may be done when a company is growing and has the ability

to indefinitely defer its tax liability.

Similarly changes in deferred tax asset should be subtracted

only when the company is expected to have this asset on a

continual basis.

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