Advanced Corporate Finance

AFIN353
Topic 1 DCF and Multiples
Valuation (Ch 4, 5, 7.1, 9.)

DCF and Multiples

Valuation

AFIN353
ADVANCED CORPORATE FINANCE
LEARNING OUTCOMES..TOPIC 1, WEEK 1
1. To refresh our understanding of the time value of money.
2. To understand the alternative approaches to valuation.
3. Use the dividend-discount model to compute the value of a dividendpaying companys stock and to calculate the total return of a stock,
given the dividend payment.
4. Discuss the determinants of future dividends and growth rate in
dividends, and the sensitivity of the stock price to estimates of those
two factors.
5. Assuming a firm has a long-term constant growth rate after time
N + 1, use the constant growth model to calculate the terminal value of
the stock at time N.
6. To apply the Multiples approach to valuation
7. Understand the limitations of each valuation model.

Overview
WEEK 1

DCF and MULTIPLES VALUATION

A. Introduction: Valuation
B. Toolbag Present Values
C. Toolbag Rates and Returns
D. Income, Capital and Total Returns
E. Valuing Shares and Firms
Dividend Discount Model
Relative Valuation/Valuation Multiples
Free Cash Flow to Firm [Next Week]

A. Intro: Valuation
Valuation is important to investment decision-making.
There are 3 ways to think about valuation. They are:
1.Discounted Cash Flow (DCF) valuation,
2.Multiples/Relative or Comparables valuation,
3.Contingent claims: Option valuation.
Arguably DCF is the most important.
DCF has 3 main parts: the formulas, the cash flows and
the required returns.
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Intro: DCF Valuation Overview

DCF is also called 'net present value' or 'discounted
expected value'.
Preferred when future cash flows are predictable and
the
required return (discount rate) can be easily calculated.
Widely used for valuing securities (eg. Bonds, shares),
assets (eg. real estate with stable rental income),
companies,
and for evaluating investment projects.
More of an absolute or intrinsic valuation technique,
as opposed to a relative valuation technique.

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Intro: Multiples Valuation

MULTIPLES VALUATION/RELATIVE VALUATION

Multiples Valuation is a relative valuation technique.

Prices assets using the prices of other, similar assets.
Many different types of multiples can be used.
e.g Price/Earnings, Price/Sales, Price/m2
Simple, intuitive, based on real-world prices.
Preferred when future cash flows are unpredictable,
and when there are many similar assets that are
frequently
traded at observable prices, such as stocks.
Real estate and stocks are suitable for multiples
valuation.

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B. Toolbag: Present Value

Formulas (Ch 4)
Discount a single cash flow:

Perpetuity: an infinite stream of equal cash flows received at

regular intervals over time.

A constant growth perpetuity also has

payments that never end, but the payments
increase at a constant rate over time.
True perpetuities are rare. Some cash flow streams can be
treated as a constant growth perpetuity, e.g dividends
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Toolbag: Present Value

Formulas (Ch 4)
Annuity: a series of identical cash flows occurring at
regular intervals through time for a specified number of
periods.

annuity with constant growth also has regular cash flows

y grow at rate of g each period.

NOTE: In the ordinary annuity and perpetuity formulae,

the first cash flow is at t=1 (If there is a cashflow at t=0,
we call it an annuity due, perpetuity due and need to
adjust the PV by C0).

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Toolbag: Present Value

Formulas (Ch 4)
To determine FV (future value), remember the future value
of a single cash flow is:

HINT: If you need the future value of an annuity or

perpetuity,
Find the PV and multiply the PV formula by (1+r)t.

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Calculation Examples: Perpetuity

Question 1: Ordinary Perpetuity: You want to create a fund

that will pay a scholarship of $30,000 each year in perpetuity
(forever) starting in one years time. The fund will earn
8%pa.
How much will you need to donate today (t=0)?
Answer:
t=0
1
2
3
4 ..
30,000

30,000

30,000

30,000

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Question 2: Perpetuity Due: What is the answer to Q1

if the first payment was to be made at t=0?
Answer:
t=0
30,000

1
30,000

30,000

4 ..
30,000

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Question 3: What is the answer to Q1 if the first payment

was made exactly 3 years from today (t=3)?
t=0

3
4 ..
30,000
30,000

Answer: Tricky! The PV perpetuity formula assumes the

first cash flow is one period into future. So, calculate the
value at one period prior the first cash flow, then discount
that back to t=0.
Value of perpetuity
at t=2

Discount Value t=2

to t=0

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Try this yourself!

Perpetuity with growth

Question 4: Perpetuity with growth:
What if the $30,000 scholarship in the
above example is to commence in exactly
3 years time (t=3) but will grow,
thereafter, at 4%pa. What is the donation
you will make today (t=0) to establish the
fund?
Answer:
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C. Toolbag: Rates & Returns

(Ch 5)
Lessons:
(1) When we use a particular discount rate in DCF,
we must match the discount rate period with the periodicity
of cash flows e.g. If cash flows are at 6 month intervals,
we must use the effective 6 month discount rate.
(2) Effective rates can be used to discount cash flows.
APR's cannot be used to discount cash flows,
they must be converted to effective rates first.

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Toolbag: Rates & Returns

(Ch 5)
Annual Percentage Rate (APR) simple rate of interest
for
one year without compounding.
Short term and money-market securities are often quoted
at APR.
The compounding period of an APR is usually not
explicitly
stated. But usually the compounding frequency of an
APR
is the
same
as the payment
e.g.
An APR
compounding
monthly frequency.
is equal to 12 multiplied by the
effective
To adjust APR to a rate per compounding period:
monthly rate. , =,12
Interest rate per compounding period=
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Toolbag: Rates & Returns

(Ch 5)
Effective Annual Rate (EAR) actual interest rate earned
at
end of year allowing for compounding.
To calculate EAR from APR with k compounding periods per
year:
To convert an EAR to n-year effective rate.
=(1+)1
n can be less than one (e.g. for 6 month rate n=
1/2)
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Toolbag: Rates & Returns

(Ch 5)
Example:
A credit card might advertise an interest rate of 12% pa.
This is an APR. Because credit cards are always paid off
monthly, the compounding frequency is per month.
Therefore
the interest rate is 12% pa compounding monthly and the
effective rate that you pay is greater than the
quoted APR.
EAR= (1+0.12/12)12-1=12.6825%
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Toolbag: Rates & Returns

(Ch 5)

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Toolbag: Rates & Returns

(Ch 5)
Continuously compounded returns: The more frequent
the
compounding period, the greater the EAR. When interest
compounds continuously (at intervals even less than a
second)
we call the interest rate the continuously compounded rate.
or converting back to EAR:
Alternatively,
Continuously compounded returns are used in certain option valuation models
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FACULTY
I DEPARTMENTin studying financial returns.
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and Iare
common

Toolbag: Rates & Returns

(Ch 5)
Rule:
If we discount nominal cash flows (not adjusted to reflect
changes in buying power of money) then we use the
nominal rate.
If cash flows are stated in real terms, use the real rate
of
return as discount rate.
The answer will be the same provided you stick to the rule.
Real versus Nominal rates of return
To turn a nominal return into a real return, use the Fisher
equation:
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Toolbag: Rates & Returns

(Ch 5)
Note that the rates used in the above equation should be effective
rates,
not APR's.
Be aware that Annualised Percentage Rates (APR's) are also
sometimes
called 'nominal rates' even though they have nothing to do with the
concept
of inflation.
This is very confusing. In these notes, when a 'nominal rate' is mentioned,
it means a rate that is not adjusted for inflation.

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Question 5:
Westpac advertises a 6 month term deposit with an interest rate of
5%pa (APR).
a) What is the effective interest rate per compounding period?
Answer:
APR/k periods = .05/2 =2.5%
The term deposit pays 2.5% on the amount of the deposit. This is the
effective 6mth rate.
b) What is the effective annual rate?
Answer:
This converts the 6mth rate to an annual rate, in essence assuming
funds are reinvested at same rate until year end.
=(1+/)1=(1.025)21=5.0625%
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Question 6: Your parents pay you $5,000 at the end of

every
3 mths for one year. The effective annual rate of interest is
10%. What is the present value of the cash you receive
over
the year?
Answer:
First, you must use the discount rate applicable to 3month
period. Convert the EAR of 10% to a quarterly rate.
3=(1+0.1)1/41=2.4114%
Next, discount the quarterly annuity at this rate:
==$18,850

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Try this yourself!

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Calculation Example: Inflation and Returns

Question 8: Fred bought an investment property for
$500,000. He sold it one year later for $550,000. Over that
year the Consumer Price Index (CPI) rose from 110 to
123.2.
What was the nominal return and real return on the
property?
Assume no rental income or costs, so the only cash flows
are the buy and sell amounts.
Also note that the $550,000 he sold it for is a nominal
amount.
Answer:
First let's find the nominal return on the property:
0=1/(1+)1

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This is an effective annual rate, and it is also a nominal rate

of return since it hasn't been reduced by inflation. To find the
real rate of return, 110=123.2/(1+)1
=123.2/1101=0.12 which is an effective annual rate.
Since the nominal return and inflation are both effective
annual rates we use the Fisher equation to find the real
return:
1+ =(1+ )/(1+)
Note that the real rate of return (-1.179%) is approximately
1+ equal
=1.1/1.12
to the
nominal rate minus inflation (-2% = 10% - 12%), but it is not
= 1.1/1.121=
0.017857143=1.179%
exact.
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D. Income, Capital and

Total Returns
Returns on stocks, bonds, real estate, and any asset can
be
broken into two parts, the income return and the capital
return.
Income return rate is the proportion of the asset's price
that is paid out in cash in a time period.
For a single period,
,=1/
Where 1 is the cash flow at t=1 and 0 is the price at t=0.
The cash flow income:
from equity is called dividends or drawings,
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from debt is called coupon or interest payments,

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Capital return rate is the rate of increase in the asset's

price
per time period.
,= ()/P
When a dividend is paid (actually on the ex-dividend date),
the stock price falls. So, all else equal, dividends (income
returns) come at the expense of price (capital returns).
Total return is the sum of the income and capital returns
(in this case for a single time period).
,=,+,
= ()/P + /P
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=( +)/P

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E. Valuing Stocks and Firms

(Ch 9 and 8)
ALTERNATIVE APPROACHES:
1. Dividend Discount Model (DDM):

Constant Growth
Multi-stage
2. Relative Valuation using Valuation Multiples
3. Free Cash Flow to Firm (FCFF) or Free Cash
Flow to
Equity (FCFE) [NEXT WEEK]
There are other methods (eg. valuing equity as a call option).
Each has limitations. The first and third both use discounted cash flows.
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E. Valuing Stocks and Firms

What are we valuing?

Assets

Liabilities and Equity

Assets
A

Debt
D
Equity
E

TOTAL

V= D + E

V TOTAL
V

We can value
equity (E) by
looking at the cash
flows that equity
holders receive
and discounting
them at a discount
rate that reflects
the risk of the
equity investment,
rE

The total value of the firms assets must equal the

value of the claims against those assets (by
debtholders and shareholders)
NOTE: We are interested in market values
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1. The Dividend Discount Model

A ONE-YEAR INVESTOR

Potential Cash Flows

Dividend
Sale of Stock
Timeline for One-Year Investor

Since the cash flows are risky, we must discount

them
at the equity cost of capital.

1. The Dividend Discount Model

A ONE-YEAR INVESTOR

Div1 P1
P0

E
If the current stock price were less than this
amount,
expect investors to rush in and buy it, driving up the
stocks
price.
If the stock price exceeded this amount, selling it
would
cause the stock price to quickly fall.

Dividend Yields, Capital Gains,

and Total Returns
rE

Div1 P1

1
P0

Div1
P
{0

Dividend Yield

P1 P0
P
{0

Capital Gain Rate

Total Return = Dividend Yield + Capital Gain Rate

The expected total return of the stock should equal the expected
return of other
investments available in the market with equivalent risk.

We have looked at the return to a shareholder assuming a

single period investment.
We can look at the value of a stock as the present value
of all expected cash flows from owning the stock
discounted at a rate that reflects the risk
of holding assets of similar risk; the cost of equity capital
or required rate of return on equity (more on this later).
If the firm is assumed to exist perpetuity and dividends are
expected to grow at a constant rate, we can use the
Constant Growth Dividend Discount Model
(DDM with constant growth).

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1. Dividend Discount Model

(Constant Growth)

The Constant Growth Dividend Discount Model (DDM)

Div1
P0
rE g

rE

Div1

g
P0

Rearranging, shows that the with constant dividend growth,

capital gain rate equals the growth rate in dividends.
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Constant Growth DDM

The DDM (or perpetuity with constant growth) has some
important assumptions that you need to be aware of:
The first dividend or cash flow in the formula occurs at
t=1,
not at t=0.
The constant dividend growth rate 'g' must occur in
perpetuity, that is, forever.
The growth in the dividend 'g' is also the capital growth
rate of the stock, also known as price growth or the capital
(return ().
The formula cannot be used if g > r.
(is the total required return of the stock ().
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Question 10. A start-up company is forecast to pay its

first
dividend of $1 per share in 5 years. From then on, this
annual dividend will grow by 2% pa. The required return
on
the stock is 10% pa. All rates are given as effective
annual
rates. What is the value of the stock?
Answer: This question is slightly trickier than simply
applying the DDM since the first cash flow is not 1 year
away, it is 5 years away.
What we will do is value the stock using the DDM which

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= $8.54

The stock price should be $8.54 now (t=o)

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Understand why we
discount back 4
periods but are
using D5

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Constant Growth DDM

UNDERSTANDING MORE ABOUT g

If the stock price grew by a rate less than the dividend in

perpetuity, then the dividend would eventually grow bigger
than the stock price which is impossible.
A SIMPLE GROWTH MODEL
Under the constant growth model, if growth in earnings
only arises from new investment, the growth rate can be
shown to be equal to:
=
=
= =
Where the retention rate, b, is the proportion of earnings
not paid out as dividends. In other words b= 1 payout
ratio.
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Constant Growth DDM

UNDERSTANDING MORE ABOUT g

In practice, book return on equity (ROE) is commonly used

as the return the firm earns on new investments.
A firms share price thus depends on a trade-off between
paying earnings out as dividends vs retaining earnings in
order to grow.
Increasing retention ratio and decreasing
dividend does not always increase share price.
Consider a no-growth firm which expects earnings to
be $6 next year (t=1) and pays all of this as a
dividend. If the required return on equityNoisgrowth
10% then
model
P0= $60.
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Suppose the company reduces the dividend to 75% (ie.

$4.5) and reinvests the rest at a return of 8% then g
becomes:
g= b x ROE
= 0.25 x 0.08=0.02.
The share price will decrease to $4.50/(0.10-.02)= $56.25.
This is because the reinvested funds earn ROE of 8%
which is less than investments of comparable risk ( i.e less
than r which is 10%).

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Constant growth DDM

UNDERTANDING MORE ABOUT g

A common mistake when applying the DDM is to use a

growth rate that is too high.
Remember that the DDMs dividend growth rate is
perpetual,
so it goes forever.
Also, the dividend growth rate is the capital return
(proportional price increase).
The perpetual growth rate cannot be greater than the
average GDP growth rate.
Otherwise, a corporation will get bigger than the average
firm forever. and dominate the world economy.
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Constant Growth DDM

LIMITATIONS

Future dividends are uncertain

Constant dividend growth assumption is likely unrealistic
Sensitivity to the dividend growth rate. Value of share
approaches infinity as g gets closer to r.
Value becomes highly sensitive to g.
Not good for high growth firms.
Stock repurchases (using excess cash to buy back shares
instead of paying a dividend) are not considered in the
model
(use Total Payout model instead of per share approach.
p283)
No good for non-dividend paying firms
No good if g > r.

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Changing Growth Rates

We cannot use the constant dividend growth
model to value a
stock if the growth rate is not constant.
For example, young firms often have very high
initial earnings
growth rates. During this period of high growth,
these firms often
retain 100% of their earnings to exploit profitable
investment
opportunities. As they mature, their growth slows.
At some point,
their earnings exceed their investment needs and
they begin to

Multi-Stage Growth Model

Question 11:
Dividends were $10 last year at t=0, and are forecast to
increase at a high rate of 7% pa for the first 3 years (t=0 to
3)
and then revert to a lower rate of 2% (inflation) forever after
that (t=3 to infinity).
The required return on equity is 10% pa.
What should be the share price?

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Answer:
The basic idea is to discount the high growth years
individually, then discount the 'terminal value' or horizon
value at the end of that period . In the finance industry, the
terminal value might be calculated using the DDM (or it
might be calculated using a multiples approach such as
using PE ratios, or even an average of the two.)

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Multi-Stage Growth Model

PN

DivN 1

rE g

PN is Estimate of terminal
value or horizon value or
continuation value at t =N

Dividend-Discount Model with Constant Long-Term

Growth
Div1
Div2
P0

L
2
1 rE
(1 rE )

DivN 1
DivN
1

N
(1 rE )
(1 rE ) N rE g

Multi-stage Growth Model

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Multi-stage Growth Model

At what point do we calculate Terminal Value?
The earliest point: Our cash flow one period ahead of terminal value
calculation
point is the one after which the perpetuity growth rate takes effect.
On the last slide, at t=2, the next periods dividend includes the effect of the
7% growth and thereafter the in perpetuity growth rate of 2% applies.
So, we can calculate the terminal value at t=2.
But, the above is equivalent to valuing first 3 years separately and calculating
terminal value at t=3:

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Textbook Example 9.5

Textbook Example 9.5 (cont'd)

Total Payout Models

SHARE REPURCHASES AND THE TOTAL PAYOUT MODEL

Share Repurchase - When the firm uses excess

cash to buy back
its own stock
Implications for the Dividend-Discount Model:
The more cash the firm uses to repurchase shares,
the less it has
available to pay dividends.
By repurchasing, the firm decreases the number
of shares
outstanding, which increases its earnings per and
dividends per

Total Payout Models (cont'd)

SHARE REPURCHASES AND THE TOTAL PAYOUT MODEL

Total Payout Model:

PV0

PV (Future Total Dividends and Repurchases)

Shares Outstanding 0

Values all of the firms equity, rather than a single

share. You
discount total dividends and share repurchases and
use the
growth rate of earnings (rather than earnings per
share) when
forecasting the growth of the firms total payouts.

2. Multiples Valuation

Multiples valuation is a common method to value stocks amongst

practitioners
In the finance industry. There are many different multiples that are used,
some of the most common are:
Share Price/Earnings ( PE) ratio,
Enterprise Value/EBITDA (EV/EBITDA) ratio
Book value of equity/Market value of equity (Book to market) ratio
Share Price/ Sales (Price to sales) ratio
(Share Price/Earnings)/Earnings growth (PEG) ratio
We will focus on the 'Price to Earnings' or PE ratio and Enterprise
Value/EBITDA.
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i. Price-Earnings Multiple
Price-Earnings ratio =
Earnings per share is reported in company financial reports.
It is the total earnings of the firm divided by the total number of shares.
= /
=/
=
/
Note that earnings are an American term for Net Income (NI) or
Net Profit After Tax (NPAT).
Trailing P/E : uses Trailing Earnings (Earnings over the last 12 months)
Forward P/E : uses Expected earnings over the next 12 months

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P/E Multiples (cont'd)

Substitute the DDM for P0:

P0
Div1 / EPS1
Dividend Payout Rate
Forward P/E

EPS1
rE g
rE g
Forward P/E =
Firms with high growth rates, and which
generate cash well in
excess of their investment needs so that they can
maintain
high payout rates, should have high P/E

P/E Multiples
RECONCILING P/E to DDM

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P/E Multiples (cont.)

HOW TO CALCULATE XYZs MARKET VALUE OF EQUITY

Make a list of similar firms from the same industry

as XYZ with
the same levels of risk and leverage (ratio of debt to
assets).
Calculate each similar firm's PE ratio by dividing its
current share
price by its earnings per share (historical EPS).
Calculate the average of all of the similar firms' PE
ratios.
Exclude firms with negative EPS or EPS close to zero.
Multiply XYZ's EPS last year by the average PE
ratio of similar
firms. This will give the share price of XYZ now.

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P/E Multiples (cont.)

In the above steps we valued our firm using

'backward looking' or
trailing PE ratios since we used last years EPS,
also known as
historical EPS.
This gives PE ratios which are accurate but stale
since they reflect
the past, not the future which is what we're
interested in.
Another way of doing PE ratio valuation is to use
'forward-looking
or leading PE ratios by using next year's expected

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Textbook Example 9.9

Textbook Example 9.9 (cont'd)

Price-Earnings Multiple

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Why firms have different P/E

There are many reasons why PE ratios vary between
firms:
Growth stocks tend to have high PE ratios.
This is because their earnings are low now but are
expected to grow.
Stocks with high systematic risk tend to have low PE
ratios.
This is because their required return is high so the
present
value of their cash flows (price) is low.
Illiquid stocks tend to have low PE ratios.
This is because their price is low due to the high cost of
selling the stock.

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Historical P/E

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ii. Enterprise Value/EBITDA

Multiple
Enterprise Value is the value of the firms underlying business.
Different to firm Value (V) only because it excludes the excess cash and
marketable securities not required to produce the Free Cash Flow to firm.
Remember to
Assets
Liabilities and Equity
think about what
Cash Assets
C Debt
we are valuing.
D
It affects the
cash flows we
(All Other assets)
Equity
consider and the
Enterprise Value
EV
E
discount rate.
TOTAL
V TOTAL
V
If we calculate Enterprise Value and need to determine the market value of
Total equity:

E= EV + Cash - Debt
.
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Enterprise Value/EBITDA

Enterprise Value Multiple:

We look at Free
Cash Flow ,FCF,
next week.

Why rWACC and

not Rvaluation
This
E?

multiple is higher for firms with

high growth rates
and low capital requirements (so that free cash flow
is high in
proportion to EBITDA).
EBITDA excludes affect of interest on debt so
useful for

Textbook Example 9.10

Textbook Example 9.10 (cont'd)

Valuation Multiples (cont'd)

OTHER MULTIPLES

Multiple of sales (eg hairdressing businesses

priced at
approximately 4 x sales revenue)
Price to book value of equity per share
Enterprise value per subscriber
(Used in cable TV industry)

Limitations of Multiples
Difficult to find true comparable firms.
When valuing a firm using multiples, there is no
clear guidance
about how to adjust for differences in expected
future growth
rates, risk, or differences in accounting policies.
Comparables only provide information regarding
the value of a
firm relative to other firms in the comparison set.
Using multiples will not help us determine if an
entire industry is
Overvalued.

Comparison with Discounted

Cash Flow Methods
Discounted cash flows methods have the
advantage that
they can incorporate specific information about the
firms
cost of capital or future growth.
The discounted cash flow methods have the
potential to be
more accurate than the use of a valuation multiple.

Table 9.1 Stock Prices and Multiples

for the Footwear Industry, January
2006