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Valuation Valuation
Business Knowledge Seminar
by
Rahul Gaddam - Analyst Investment Managers
Solutions
BNY Mellon IMS - GIA Outsourcing
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Valuation: Lecture Outline 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
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Principles of Valuation 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)
Intrinsic Valuation Procedure Intrinsic Valuation Procedure
Asset Characteristics
•Size of Future Cash flows
•Time of Future Cash flows
•Risk of Future Cash flows
Investor Characteristics
•Assessment of Cash flow Riskiness
•Risk Preferences
Investors’ Required Rate of Return (k)
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Where Does the Discount Where Does the Discount
Rate (k) Come From?
Rate (k) Come From?
CAPM: k = r
f+ xRP
Beta () is estimated using historical data and is available from many sources
The risk free rate (r
f) 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 r
fused
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Example: Estimating k for Example: Estimating k for
Wal-Mart (WMT) on 4/27/01 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%
7
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
26%
-0.05 -0.04 -0.03 -0.02 -0.01 0.00 0.01 0.02 0.03 0.04 0.05
Change in Input
Required Return (k) from CAPM Change in Risk Free Rate
Change in Risk Premium
Change in Beta (Scale Shows Change / 10)
Sensitivity to CAPM Inputs Sensitivity to CAPM Inputs
Initial values:
Rf = 3.75%
RP = 8.47%
Beta = 1.5
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Discounted Dividend Models Discounted Dividend Models
Dividends will be
Forecast directly
Assumed to be constant
Assumed to grow at a constant rate or
Some combination of the above
Stock pricing relationship:
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Constant Dividend (Zero Constant Dividend (Zero
Growth Model) Model Growth Model) Model
If D
tis constant, then it is an ordinary perpetuity:
Stock pricing relationship:
10
Example: Wal-Mart (4/27/01) Example: Wal-Mart (4/27/01)
The price of Wal-Mart was actually $52.83
Can you explain the difference?
41 . 2 1162 $
. 0
28 .
0
$
0WMT
P
The current (annual) dividend is: $0.28
According to the constant dividend (zero
growth) model:
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$0
$1
$2
$3
$4
$5
$6
$7
$8
$9
-0.05 -0.04 -0.03 -0.02 -0.01 0.00 0.01 0.02 0.03 0.04 0.05
Change in Input
Stock Price from Constan Growth Model
Change in Dividend (Scale shows
Change / 10)
Change in Discount Rate
Sensitivity to Constant Sensitivity to Constant
Dividend Model Inputs Dividend Model Inputs
Initial values:
D0 = $0.50 k = 12%
Why do a firm’s dividends Why do a firm’s dividends
grow?
grow?
Because earnings grow. Why?
Because of reinvested funds
Used to expand or to undertake new projects
Used in positive NPV projects
Leads to
Earnings growth
Investments growth and
Dividend growth
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Constant Growth Model Constant Growth Model
If D
tgrows at a constant rate, g, then it is a growth perpetuity:
g k
g D
g k
D k
P D
t t
) 1
( )
1 (
0 1
1
1 0
Stock pricing relationship:
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How do You Estimate Growth How do You Estimate Growth (g)? (g)?
NOTE: Must have g<k in the long run!
00
0 0
0 0
0 1
1 )
1 (
D P D P k
g P g
g g D
P k D
Historical average
Average analyst forecast
Sustainable growth
g = (1-Payout Ratio)xROE
Required return versus dividend yield:
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Estimating g for Wal-Mart Estimating g for Wal-Mart
(4/27/01) (4/27/01)
What should it be?
1st 3 are too high b/c long run must have g<k
Guess: 11%?
% 03 . 11 83
. 52 28$
. 0 1 $
83 . 52 28$
. 0 1162 $
.
0
g
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:
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Example: Wal-Mart (4/27/01) Example: Wal-Mart (4/27/01)
The price of Wal-Mart was actually $52.83
Notes:
Must have g<k in long run
As gk, the price increases without bound
13 . 50 11 $
. 0 1162
. 0
11 . 1 28
. 0
$
0
P
Current (annual) dividend is: $0.28
If we use estimated growth of 11%:
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$0
$10
$20
$30
$40
$50
$60
-0.05 -0.04 -0.03 -0.02 -0.01 0.00 0.01 0.02 0.03 0.04 0.05
Change in Input
Stock Price from Constan Growth Model
Change in Dividend (Scale shows
Change / 10)
Change in Discount Rate
Growth Rate
Sensitivity to Constant Growth Sensitivity to Constant Growth
Model Inputs Model Inputs
Initial values:
D0 = $0.50 k = 12%
g = 6%
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Summary of Dividend Summary of Dividend
Discount Models 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
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Discounted Cash Flow Model 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
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What Constitutes Cash flows?
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
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What Discount Rate Should What Discount Rate Should
be used?
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
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Example: Estimating k for K- Example: Estimating k for K-
Mart (K) on 4/27/01 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%
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How do You Estimate Growth How do You Estimate Growth (g)? (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!
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Estimating g for K-Mart Estimating g for K-Mart
(4/27/01) (4/27/01)
5 year sales growth: 2.35%
Analysts’ 5 year earnings forecast: 10.3%
Suppose, you believe K-Mart will not grow at all!
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%
From the historical income statement:
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Example: K-Mart (4/27/01) Example: K-Mart (4/27/01)
The price of K-Mart was actually $9.82
What must the market be expecting for K-Mart’s growth in the future?
01 . 20 00 $
. 0 1249
. 0
00 .
1 50
. 2
$
0
P
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%:
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$0
$10
$20
$30
$40
$50
$60
-0.05 -0.04 -0.03 -0.02 -0.01 0.00 0.01 0.02 0.03 0.04 0.05
Change in Input
Stock Price from Constan Growth Model
Change in Cashflow (Scale shows
Change / 10)
Change in Discount Rate
Growth Rate
Sensitivity to Constant Growth Sensitivity to Constant Growth
Cash flow Model Inputs Cash flow Model Inputs
Initial values:
CF0 = $0.50 k = 12%
g = 6%
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Summary of Discounted Cash Summary of Discounted Cash
flow Models 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
Market Multiples 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
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Why do P/E Ratios Make Why do P/E Ratios Make
Sense?
Sense?
A company with a payout less than 1 will grow and be valued at:
r E
P r
E r
P D1 1 1
0 1
0
1 1
1 1
E PVGO r
E PVGO P
r
P E
A company with a payout ratio of 1 will
not grow and be valued at:
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Logic of Market Multiple Logic of Market Multiple
Models 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
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P/E Ratio Valuation P/E Ratio Valuation
If company “j” is “valued at industry ratios” relative to earnings:
j jj
j
E E P
P
0 1 0
1
ii
Industry j
j
E Avg P
E P
0 0 0
0
If company “j” is “valued at historical
ratios” relative to earnings:
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Example: Wal-Mart (4/27/01) 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
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$0
$10
$20
$30
$40
$50
$60
$70
-0.50 -0.40 -0.30 -0.20 -0.10 0.00 0.10 0.20 0.30 0.40 0.50
Change in Input
Stock Price from Constan Growth Model
Change in Earnings
Change Benchmark P/E Ratio (Scale
shows Change / 10)
Sensitivity to P/E Multiple Sensitivity to P/E Multiple
Model Inputs Model Inputs
Initial values:
E1 = $1.50 P/E = 35
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P/S Ratio Valuation P/S Ratio Valuation
Using current sales, a company “j” is
“valued at industry ratios” relative to sales:
j
j j j
S S P
P
0 1 0
1
ii
Industry j
j
S Avg P
S P
0 0 0
0
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:
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Example: Amazon (4/27/01) 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
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$0
$10
$20
$30
$40
$50
$60
$70
-0.50 -0.40 -0.30 -0.20 -0.10 0.00 0.10 0.20 0.30 0.40 0.50
Change in Input
Stock Price from Constan Growth Model
Change in Sales
Change Benchmark P/S Ratio (Scale
shows Change / 10)
Sensitivity to P/S Multiple Sensitivity to P/S Multiple
Model Inputs Model Inputs
Initial values:
S1 = $3.00 P/S = 15
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P/CF Ratio Valuation P/CF Ratio Valuation
• Using current cash flow, company “j” is “valued at industry ratios” relative to cash flows:
j
j j j
CF CF P
P
0 1 0
1
ii
Industry j
j
CF Avg P
CF P
0 0 0
0
• 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:
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Example: K-Mart (4/27/01) 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?
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$0
$10
$20
$30
$40
$50
$60
$70
-0.50 -0.40 -0.30 -0.20 -0.10 0.00 0.10 0.20 0.30 0.40 0.50
Change in Input
Stock Price from Constan Growth Model
Change in Cashflow
Change Benchmark P/CF Ratio (Scale shows Change / 10)
Sensitivity to P/CF Multiple Sensitivity to P/CF Multiple
Model Inputs Model Inputs
Initial values:
CF = $1.00 P/S = 30
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Summary of Market Multiples Summary of Market Multiples
Models 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
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Summary Summary
• Discounted Dividend
w/ dividends and constant expected
(possibly zero) growth in dividends
• Discounted Cash flow
w/o dividends and constant expected
(possibly zero) growth in cash flows
• P/E, P/S and P/CF ratios
Comparison with past or industry
• Why several methods?
Each has strengths and weaknesses
Different methods useful in different situations
Each gives a different
“take” on the value of the company’s stock
Provides a range of valuations instead of point estimates
