Equity Training

Lecturer:
2012
VALUATION MODELS
VALUATION MODELS
Lecturer:
Lecturers name
2012
A. Discounted Dividend Valuation
Lecturer:
Lecturers name
2012

Discounted Cash Flow Valuation
An assets intrinsic value is the present value of its expected
future cash flows
Very important concept!

5

Various Measures of Cash Flow in Valuation
Measures of cash flow
o Dividends = cash paid to shareholders, used in DDM
o Free cash flow = cash available to pay shareholders, broader
scope
o Residual income = economic profit
Key point: Valuation metric (e.g., divs or FCF) must be
measurable and related to earnings power

Dividends
Advantages
o Less volatile than other cash flow measures
o Theoretically justified dividends are what you receive when
you buy a stock

o Accounts for reinvested earnings to provide a basis for
increased future dividends

Dividends
Disadvantages
o Non dividends paying firms
o Dividends artificially small for tax reasons
o Dividends may not reflect the control perspective desired by the

investor

Dividends Suitability
Situations when appropriate
o Company has history of paying dividends
o Board of directors has a dividend policy that has an
understandable and consistent relationship to profitability

o Minority shareholder takes a non-control perspective
o Mature firms, profitable but not fast growth

Free Cash Flow (FCF)
FCF represents cash flow distributable to the providers of
capital
o Free Cash Flow to the Firm (FCFF): Cash flow distributable to
all providers of capital (i.e., debt and equity)
o Free cash flow to equity (FCFE): Cash flow distributable to
equity holders
Much more on this topic in Study Session 12
10

Residual Income (RI)
Residual income: Earnings in excess of the investors
required return on the beginning-of-period investment
o RI focuses on profitability in relation to all opportunity costs
faced by the firm
o Think: Economic profit.
11

DDM: How To
Process: Discount the future dividends at the required rate of
return:
o Step 1: Estimate future dividends
o Step 2: Determine required return
o Step 3: Value = PV (expected dividends)
12

Dividend Discount Models
The Rule: Value is present value of all future dividends
discounted at required return
That is
The basic
model
Problem: requires estimation of infinite stream of CFs
13

Single Period DDM
Single-period DDM is the present value of the future dividend
and sales price
Notice that there are two cash flows in the final period!
14

Single Period DDM
Example: Is WTC over- or under-valued?
o Current market price = $60
o Expected year-end dividend = $2
o Expected year-end stock price = $64

o Required return = 8%
15

Single Period DDM
undervalued!
Current market price $60 < intrinsic value $61.11, therefore a
buy decision
16

Single Period DDM
Two period DDM: Extends single period model
oValue = PV two years of cash flows and the future sales

price
Notice that in the final year, two cash flows occur
17

Two-Period DDM
Example: Holzgraf Company shares sell for $50 today. Is
Holzgraf over- or under-vaued?
oExpect Year 1 dividend = $1.25
oExpected Year 2 dividend = $1.50

oExpected price at the end of Year 2 = $65
oRequired return = 13%
18

Two-Period DDM
=
Current Price = $50; thus undervalued
19

Multiple-Period DDM
Again the model takes the present value of all future cash flows
Note: If you can do 1 and 2 periods, you can do n periods!
20

Simplifying assumptions for future growth
1. Constant growth (Gordon model)
2. Two-stage growth
3. H-model
Very
important!
Know
alsoN-stage, spreadsheet)
4. Other assumption (e.g.,
Nah
21

Gordon Growth Model
where:
D = dividend
g = sustainable growth rate
r = required return on equity
22

DDM Constant Growth (Gordon)
Assumptions:
1. Dividend (D1) expected in one year
2. Dividends grow at constant rate (g) forever
3. Growth rate less than required return (r > g)
Situations in which model is useful:

1. Mature (late in life cycle )firms
2. Broad-based equity index
3. Terminal value in more complex models
4. International valuation
5. Can be used to calculate P/E ratio
23

DDM Constant Growth (Gordon) - Example
Doug Inc.,:
o Paid a dividend yesterday of $1.50
o Dividends are expected to grow at a long-term constant rate of
5%
o Required return is 10%
Calculate the intrinsic value
24

Gordon Growth Model Example
Correct answer
Vo = ($1.50 x 1.05) / (0.10 0.05) = $31.50
Incorrect answer
Vo = ($1.50) / (0.10 0.05) = $30.00
The numerator was not increased by 5%
25

DDM: Implied Growth Rate Example
Assume:
o Firm just paid $1.20 dividend per share
o Market price is %15.75
Implied dividend growth rate is:
Requires some
algebra!
=> g = 0.05 = 5.0%
26

PV of Growth Opportunities
Equity value has two components:
1. Value of no growth firm (E1/ r) (i.e., assets/earnings currently in
place)
2. Present value of future growth opportunities (PVGO)
Model :
Po = E1/ r + PVGO
27

PV of Growth Opportunities
Example: ABV Inc., shares sell for $80. Next years expected
EPS = $4.00. If the required return is 20%, compute the PVGO:
$80 = $4.00
0.20
+ PVGO
PVGO = $80 - $20 = $60

Point: Market assigns 75% of the price ($60/$80) to future growth
expensive
28

PVGO Model Using Leading P/E1
Point: Morph PVGO model into a leading Po /E1 model

o Just divide thru by E1
Po /E1 = 1/r + PVGO/ E1
Intuition:
o 1/r = P/E1 ratio for a no growth company
o PVGO/ E1 = P/E1 component related to growth
29

Gordon and Justified P/Es
Point: The GGM can also be used to calculate a justified price

multiple
As shown in SS#12, rearrange GGM yields
Justified leading
30

Valuation of Non-Callable, Fixed Rate, Perpetual, Preferred
Stock
Point: Perpetual cash flows can be valued

Level 1 TVM topic:
o Preferred stock
value of a perpetuity
o No growth assets
Formula: Po = Annual CF / Capitalization rate
Example:
o Annual Dividend = $12
o r = 10%
Value = $12/0.10 = $120
31

DDM: Constant Growth (Gordon)
Strengths:
Use for mature, stable, dividend paying firms
Used with broad market indexes
Estimate g, r, and PVGO
Supplement to more complex models

Weaknesses:
Value (Vo) very sensitive to estimates of r and g
Difficult to use with non-dividend-paying stocks
Model Selection: Minority perspective only
Not useful for valuing M&A
32
Multi-Stage DDM Models

GGM assumption: Stable dividend growth rate forever
o Problem: Unrealistic for most firms

Solutions include:
o Two-Stage
o H-Model, Three-Stage
o Spreadsheet modeling
Growth can be expressed in three distinct phases
33
Phases of Growth
1. Initial growth phase use 3-stage model
Rapid EPS growth, negative FCF
ROE > r, no or low dividend payout
2. Transitional phase use 2-stage/H model
Sales and EPS growth slow, div increase
ROE approaching r, positive FCF
3. Mature phase use GGM
Growth at economy-wide rate, positive FCF
ROE = r, high competition, saturation
34
Terminal Value
Terminal value = forecasted value at beginning of the final

mature growth phase
o
Also known as the future sales price

Two estimation methods:
1. Applying trailing multiple (P/E) x forecasted EPSt in year t

2. Gordon Growth Model Dn / (r g)
35
Two-Stage DDM
Assume stages of growth:

o First: Fixed period of supernormal growth
o Then: Identify growth at normal level
Useful in cases when growth rate expected to drop suddenly

o
Patent expiration
Firm enters mature phase of life cycle after a rapid growth

stage
36
Two-Stage DDM
Problem: GGM constant g assumption unrealistic
Solution: Assume rapid growth for n years, then long-term

sustainable growth
2-stage
assumes a
drop-off in
growth
37
Application: The Two-Stage Model
Two stages of growth:

1. Initial high-growth phase
2. Perpetual stable-growth phase
Two approaches
1. Formula
2. Timeline
Suggestion: Use the timeline (or spreadsheet approach) it

provides the flexibility to solve many types of problems
38
Application: The Two-Stage Model
Methodology:
1. Individual estimation of supernormal dividends, followed by
2. Calculation of a terminal value
Note: Very important concept
Vo = PV(dividends over 1st n year) + PV(terminal value)
From Gordon growth model

or price multiple approach
39
Example: The Two-Stage Model
Time-line example
o Dividends of $2.50 and $4.00 at the end of each of the next
two years
o Stage 2 constant growth = 4%
Calculate the value today
40
Solution: The Two-Stage Model
41

The H-Model
Assumes a gradual decay in g as firm matures over a transition
period
42

The H-Model
Problem: 2-stage model assumes high growth rate will suddenly
drop
The H-model: More realistic assumption
o Firm will start with high growth rate
o Growth declines linearly over a transition period T = 2H years
Note: Only an approximation method; more accurate the shorter
the declining growth period
43

The H-Model Formula
Most recent
dividend
Required return
Short-term high
growth rate
H = Transition Period/2
Long-term
low growth
rate
44

Example: H-Model
Example BTeam Inc.,:
o Currently pays a dividend of $1.30
o Stage 1 growth rate is 25%
o Growth is expected to decay over five years

o Constant growth rate of 5% thereafter
Calculate the intrinsic value of BTeam stock using the H-Model
45

Solution: H-Model (just memorized the formula)
= $22.39
46

DDM: Multi-Stage Models
Three-stage model: Two approaches
1. Three distinct phases, simply add an additional growth
stage to the 2-stage model
Growth, transition, and mature
2. High-growth phase + H-model pattern
High followed by linearly declining followed by

perpetual growth
47

Example: Three-stage with H-model
Netweb Inc.
o Current growth rate of 25%
o Supernormal rate expected to last three years
o After three years, growth decays linearly to a sustainable 3%
over the following seven years
o Last dividend was $0.30

Calculate the value of Netwebs shares today
48

Solution: Three-Stage With H-Model
D1 = $0.30 x 1.251 = $0.375
D2 = $0.30 x 1.252 = $0.469
D3 = $0.30 x 1.253 = $0.586
49

Solution: Three-Stage With H-Model
50
Evaluation
If the current market price of the stock is $15.00,
determine if the stock is fairly valued/overvalued or
overvalued by the market?
Since the market price ($15.00) exceeds the model price

($12.48), the stock is overvalued by the market
51
The Multi-Period Models

Strengths
o Ability to model many growth patterns
o Solve for V, g, and r
Weaknesses
Required high-quality inputs (GIGO)
Value estimates sensitive to g and r
Model suitable very important
52
GGM and Required Return: r

Point: DDM can be used to find implied r
o Drive model in reserve
Solving GGM for r
Example: If expected dividends are $1.60 and the current price is

$40 with expected growth of 9%
Then: Required return should be 13%
53
H-Model and Required Return: r

Point: Given market price, drive H-model in reserve to get
required return
o Dont fret
o Example: Using our BTeam, Inc., data and a current market
price of $30, we get:
= 11.7%
54
SGR: The Sustainable Growth Rate

SGR (g) = sustainable growth rate in earnings and dividends if we
assume:
o Growth uses internally generated equity
o Capital structure remains unchanged
o Several key ratios held constant
Formula:
g = retention rate (rr) x NI/SE
g = rr x ROE
55
Calculate SGR
Example: Compute SGR for Green, Inc.,:
o Payout ratio = 25%
o EPS = $1.00
o BVPS is $10.00
o ROE of 10%
SGR = Retention rate (rr) x (ROE)
SGR = (1 DIV/EPS) x Net Inc/Equity
SGR = (1 0.25) x 10% = 7.5%
56
SGR: The Sustainable Growth Rate

Three-Part DuPont ROE Decomposition:
Note: Always use beginning of year balance sheet numbers on

exam (unless told otherwise)
Point: SGR = retention x ROE
o SGR = retention x NPM x Asset T/O x EQ mult
57
SGR Value Drivers and Their Impact

1. Net income/Sales measures profitability, higher margins
result in a higher ROE
2. Sales/total assets measures operational efficiency, higher
turns result in higher ROE

3. Assets/equity measures financial leverage via the equity
multiplier based on the firms financing policies, higher leverage
higher ROE
58
Problem : DuPont and SGR

Revenues
Net income
Dividends
Total assets
SHs equity
2007
$12,000
$960
$280
$13,475
$6,100
2008
$13,100
$1,389
$300
$15,370
$7,189
Calculate sustainable growth rate for 2008
Calculate 3-component DuPont formula for 2008

Use beginning of period balance sheet values
59
Discounted Dividend Valuation
Solution : DuPont and SGR
60
Discounted Dividend Valuation
Solution : DuPont and SGR
61

Spreadsheet Modeling
Allows more flexibility in forecasting cash flows
Steps:
o Establish base level cash flows
o Forecast deviations for near future (e.g. supernormal growth for
first four years)
o Project normal growth beyond near future
o Discount all cash flows to PV
62
KEYS TO THE EXAM

Big reading this will be on the exam!
Five competitive forces
Calculating value with single-stage, constant growth, 2-stage
DDM, and H-models
Justify model selection; identify strengths and weaknesses
Solve for growth and required return with GGM
Be able to calculate ROE and g
63
Solution: DuPont and SGR
rr = (1,389 300) / (1,389) = 0.784
ROE = 1,389 / 6,100 = 0.2277
SGR = 0.784 x 0.2277 = 17.85%
64
Solution: DuPont and SGR
NPM = 1,389 / 13,100 = 0.1060

TAT = 13,100 / 13,475 = 0.9722
LR = 13,475 / 6,100 = 2.2090
ROE = 0.1060 x 0.9722 x 2.2090 = 22.77%
65
B. Free Cash Flow Valuation

Introduction to Free Cash Flow
Dividends are the cash flows actually paid to stockholders
Free cash flow is the cash flow available for distribution after
fulfilling all obligations (operating expenses and taxes) and
without impacting on the future growth plans of the company
(working capital and fixed capital)
Extends the DCF approach with a more comprehensive basis
for the valuation than dividends
66

FCF Defined
FCFF (Free Cash Flow to the Firm)
o Cash available to shareholders and bondholders after taxes, capital
investment, and WC investment ; pre-levered cash flow
FCFE (Free Cash Flow to Equity)

o Cash available to equity holders after payments to and inflows from
bondholders; post-leverage cash flow
o Not equal to dividends actually paid
67

Interpret FCF Strengths
Strengths
o Used with firms that have no dividends
o Functional model for assessing alternative financing policies
o Rich framework provides additional detailed insights into
company
o Other measures EBIT, EBITDA, and CFO either double count
or omit important cash flows
68

Interpret FCF Limitations
Limitations
o If FCF < 0 due to large capital demands
o Required detailed understanding of accounting and FSA
o Information not readily available or published
69

FCFF vs. FCFE
Firm value = FCFF discounted at WACC
Equity value = FCFE discounted at required return on equity r
o Use FCFE when capital structure is stable
o Use FCFF when high or changing debt levels, negative FCFE
Equity value = firm value MV of debt
70

Ownership Perspective
FCFE = control perspective
o Ability to change dividend policy
o Used in control perspective
DDM = minority owner
o No control
o Used in valuing minority position in publicly traded shares
71

Problem: Equity Value
Which of the following is the least accurate statement regarding
valuation?
a. Equity value equals firm value minus the market value of
debt
b. Equity value should be calculated using the weighted
average cost of capital (WACC) as the discount rate
c. Free cash flow to equity can be used to calculate equity

value when a control perspective is appropriate
72

FCF Formula References
NI = Net income to common shr/holders, after preferred div
but before common dividends

NCC = non-cash charges, depreciation, and amortization
Int(1 t) = after tax interest expense
FCInv = net fixed capital investment (proceeds from sales
less Cap Ex)
WCInv = working capital investment

Net borrowings = new debt - repayments
73

Calculating FCF
Statement of Cash Flows
Net income (NI)
+ Non-cash charges (NCC)
- WCInv
Cash flow operations (CFO)
- FCInv
FCFE/FCFF
Net income (NI)
+ Non-cash charges (NCC)
- WCInv
Cash flow operations (CFO)
+ Int(1 tax rate)
- FCInv
Free cash flows to firm
(FCFF)
74

Calculating FCF
Statement of Cash Flows
+ Net borrowing
- Dividends
+/- Stock issues/repurch
Net change in cash
FCFE/FCFF
Free cash flow to firm
(FCFF)
+ Net borrowing
+ Int(1 tax rate)
Free cash flow to equity
(FCFE)
- Dividends
+/- Stock issues/purch
Net change in cash
75

Non-Cash Charges (NCC)
Applies to both FCFE and FCFF
Represent adjustments for non-cash decreases and increases
in net income based on accrual accounting, but did not result in
an outflow of cash
o If non-cash charges decrease net income, add back to net
income
o If non-cash charges increase net income, subtract from the

net income
76

Non-Cash Charges
Adjustment to
Net Income to
Arrive at FCF
Add
Location
I/S or CFO
Subtract
I/S
Loss on asset sale
Add
I/S
Restructuring
exp./(inc.)
Add/(Subtract)
I/S
Non-Cash Items
Depreciation &
amort.
Gain on asset sale
77

Non-Cash Charges
Adjustment to Net
Non-Cash Items Inc to Arrive at FCF Location
Deferred tax
Add if they are not
CFO and
liability
expected to reserve in B/S
future (FSA material)
Amortization
Add discounts
bond discounts & Subtract premiums
premiums
CFO
78

Investment in Working Capital
Applies to both FCFE and FCFF
Net investment in working capital for the purpose of calculating
FCF excludes
o Changes in cash/cash equivalents
o Notes payable
o Current portion of L.T. debt
The exclusions are considered financing activities, not operating

items, and therefore not included in WCInv
79

Working Capital Adjustments
There is a inverse relationship between changes in assets
and changes in cash flow
An increase in an asset account is a use
(negative/subtraction) of cash
A decrease in an asset account is a source (addition/plus) of
a cash
80

There is a direct relationship between changes in liabilities
and changes in cash flow
An increase in a liability account is a source (addition/plus) of
cash
A decrease in a liability account is a use
(negative/subtraction) of cash
81

WCInv Adjustments
Increase in WCInv
Decrease in WCInv
Decrease FCF
Increase FCF
Increase in assets or decrease

in liabilities
Decrease in assets or
increase in liabilities
Inventory
Inventory
Accounts receivable
Accounts receivable
Accounts payable
Accounts payable
Accrued taxes & expenses
Accrued taxes &

expenses
82

Account
2009
2008
Change
Inventory
50
40
10
A/R
25
30
(5)
A/P
30
10
20
Acc Exp
20
(15)
Source/use
Use/Subtract
WCInv = -10
Source/Add
WCInv = + 5
Source/Add
WCInv = +20
Use/Subtract
WCInv = -15
83

Net FCInv Adjustments
Investment in a fixed capital (FCInv) represent a cash out flow
necessary to support the companys current and future operations

Viewed as a capital expenditure (Cap Ex) that reduces both FCFE
and FCFF
Expenditures can include acquisition of intangible items such as
trademarks
Care should be used with non-recurring large acquisitions in
forecasts
84

Asset Purchases and Sales
o If given gross PP&E on the balance sheet, identify the
additions (cap ex) by taking the year over year change in
gross PP&E, only if there were no disposals during the
period, to identify the capital expenditures for the period
85

Asset Purchases and Sales
If given net PP&E, use the equation:
Beginning net PP&E
- Depreciation
+ Assets purchased (solve)
- Book value of assets sold
Ending net PP&E
86

If a company receives cash in disposing/selling of a fixed asset,
the analyst must deduct this cash in arriving at the net
investment in PP&E (FCInv)
o Gain/loss on asset sale = proceeds from sale book value of
asset
o Subtract gains on sales from FCF
o Add losses on sales to FCF

o Deduct the proceeds from sale in arriving at the net FCInv
87

Problem: FCInv
The income statement of Tykes Toys shows a $5M profit on
disposal of fixed assets. Balance sheet data on disposed assets
are shown below. Capital spending on new fixed assets during the
year was $37M. Tykes investment in fixed capital (FCInv) is
closest to what value?
a. 22
b. 37
c. 77
Balance Sheet ($M)

Original Cost
$40
Accum Depr.
(30)
Net Book Value
$10
88

Solution: FCInv
89

Net Borrowing Adjustments
Net Borrowings only affect FCFE, they do not affect FCFF
1. Long-Term Debt (Three Stooges)
o
Add debt issuances to net income to arrive at FCFE
Subtract debt repurchases from net income to arrive at

FCFE
Net Borrowings = + new debt issuances debt
repurchases
90

Net Borrowings
2. Notes Payable
o
Incr. in notes payable, add to FCFE
Decr. In notes payable, subtract from FCFE
3. Current Portion of LT Debt

o
Incr. in short-term debt, add to FCFE
Decr. in short-term debt, subtract from FCFE
91
FCFF and FCFE Beginning with Net Income

FCFF = NI + NCC + Int(1 t) WCInv FCInv
Subtracting after-tax interest and adding back net borrowing
from the FCFF equations gives us the FCFE from NI
FCFE = NI + NCC WCInv FCInv + Net borrowing

FCFE = FCFF Int(1 t) + Net borrowing
92
FCFF and FCFE Beginning with CFO

Recall, CFO = NI + NCC WCInv
CFO is an after-interest starting point
FCFF = CFO + Int(1 t) - FCInv

Subtracting after-tax interest and adding back net borrowing
from the FCFF equations gives us the FCFE from CFO
FCFE = CFO Inv(FC) + Net borrowing
93
FCFF Beginning with EBIT

To show the relation between EBIT and FCFF, start with the
FCFF equation and assume that the non-cash charge (NCC)
is depreciation (Dep):
o FCFF = NI + Dep + Int(1 t) - WCInv FCInv
Net income (NI) can be expressed as:
o NI = (EBIT Int)(1 t), rearranging
o NI = EBIT(1 t) Int(1 t)
o FCFF = EBIT(1 t) + Dep WCInv - FCInv
94
FCFE Beginning with EBIT

To get FCFE from EBIT, adjust EBIT for taxes by multiplying
EBIT x (1 t), subtract Int(1 t), add back the non-cash
charges, and then subtract the investments in working capital
and fixed capital, and add the net borrowings
FCFE = EBIT(1 t) Int(1 t) + NCC WCInv FCInv + Net
Borrowings
95
Reading 10c: Free Cash Flow Valuation

FCFF Beginning with EBITDA
To get FCFF from EBITDA, (Earnings before Interest, Taxes,
Depreciation, and Amortization), use the formula for FCFF:
FCFF = EBITDA(1 t) + Depr(t) WCInv FCInv

We add back the NNC (depr) times the tax because we capture
the tax benefit from deducting the depreciation; it represents the
cash flow savings from the deduction
96

FCFE Beginning with EBITDA
To get FCFE from EBITDA, adjust EBITDA for taxes, subtract
interest (1 t), add back Depr (t), subtract working capital and
fixed capital, and add net borrowings
FCFE = EBITDA(1 t) Int (1 t) + NNC (t) WCInv FCInv

+ Net borrowings
97

FCFF Formula Review
FCFF = NI + NNC + [Int (1 t)] WCInv FCInv

FCFF = CFO + [Int (1 t)] FCInv
FCFF = [EBIT(1 t)] + NNC WCInv FCInv
FCFF = EBITDA(1 t ) + (NNC x t) WCInv FCInv
Notice: No net borrowings!
98

FCFE Formula Review
FCFE = NI + NCC WCInv FCInv + Net borrowings
FCFE = CFO FCInv + Net borrowings
borrowings
FCFE = EBITDA(1 t) Int (1 t) + NNC (t) WCInv FCInv +
Net borrowings
FCFE = FCFF [Int(1 t)] + Net borrowings
99

Important Concept FCFF & FCFE
There is only one value for FCFF and only one value for FCFE
The various equations are all different ways to get to the same
value
Use whichever equation is easiest with the data given in the
problem
100

Soft Corp. Balance Sheet
Cash
A/R
Inventory
PP & E (FCInv)
Accumulated dep
Actual
20x6
$24.0
17.0
100.0
100.0
(30.0)
Projected
20x7
$26.0
24.0
150.0
125.0
(35.0)
Total assets
$211.0
$290.0
101

Soft Corp. Balance Sheet
Accounts payable
Actual
20x6
$91.0
Projected
20x7
$101.0
Long-time debt
Common stock
Retained earnings
20.0
80.0
20.0
40.0
90.0
59.0
Total liab, and OE
$211.0
$290.0
102

Soft Corp. Income Statement
Sales
COGS
Gross profit
SG & A
Depreciation
Operating expense
Actual
20x6
$80.0
38.0
$42.0
Projected
20x7
$198.0
90.0
$108.0
13.0
30.0
3.0
5.0
$16.0
$35.0
103

Soft Corp. Income Statement
Interest
expense
Pre-tax
income
Income tax
expense
Net income
Actual
20x6
Projected
20x7
$4.0
$5.0
22.0
68.0
(7.0)
(25.0)
$15.0
$43.0
104

Soft Corp. FCFF and FCFE
FCInv = $125 - $100 = $25
Plant and Equip
Plant and Equip.
Opening NBV
70
Opening cost
NBV of disposals
(0)
Cost of disposals
Depreciation
(5)
Additions
25
Additions
25
Closing cost
125
Closing NBV
90
100
105

Accounts Receivable
Inventory
Accounts
Payable
WC20x7 = ($24 + $150) ($101) = $73

WC20x6= ($17 + $100) ($91) = $26
WCInv = $73 - $26 = $47
Effective tax rate = $25 / $68 37%

Net borrowing = $40 - $20 = $20
106

Soft Corp. FCFF from NI and CFO
FCFF = NI + NNC + [Int (1 t)] WCInv FCInv
- 20.85 = 43 + 5 + 5(1 0.37) 47 25
FCFF = CFO + [Int (1 t)] FCInv
- 20.85 = (43 + 5 47) + 5(1 0.37) 25
Recall, CFO = NI + NCC - WCInv
107

Soft Corp. FCFE from NI and CFO
FCFE = (NI + NCC WCInv) FCInv + Net borrowing
- 4 = (43 + 5 47) 25 + 20
- 4 = (43 + 5 47) 25 + 20
108

FCFE = FCFF [Int(1 t)] + Net borrowing
-$4 = -$20.85 [$5(1 0.37)] + 20
109

FCFE from EBIT and EBITDA
borrowing
- 4 = 73(1 0.37) 5(1 0.37) + 5 47 25
+ 20
FCFE = EBITDA(1 t) Int (1 t) + NNC(t) WCInv FCInv +

Net borrowings
- 4 = 78(1 0.37) 5(1 0.37) + 5(0.37) 47 25 + 20
110

FCFE from EBIT and EBITDA
FCFF = [EBIT(1 t)] + NNC WCInv FCInv
- 20.85 = 73 (1 0.37) + 5 47 25
FCFF = EBITDA(1 t ) + NNC(t) WCInv FCInv

- 20.85 = 78 (1 0.37) + 5(0.37) 47 25
Small differences due to tax effects in interest
111

Problem: FCFF, FCFE
Newday Ltd. Is an Edinburgh manufacturer of beauty supplies
and personal care products. It provides the following financial
statements. Free Cash Flow to the Firm (FCFF) and Free Cash
Flow to Equity (FCFE) for 2011 are closest to what values?
a.
b.
c.
FCFF
72.5
81.5
43.0
FCFE
85.0
85.0
31.5
112

Newday Balance Sheet
Actual
2010
18.0
Projected
2011
66.0
A/R
18.0
20.0
Inventory
PP&E (Net)
14.0
202.0
10.0
228.0
Total assets
252.0
324.0
Cash
113

Newday Income Statement
Projected
2011
Sales
230.0
COGS
Gross profit
Depreciation
80.0
150.0
Operating expense
11.0
14.0
114

Newday Income Statement
Projected
2011
Interest
expense
Pre-tax
income
Income tax
expense
Net income
10.0
115.0
(40.0)
75.0
115

Newday FCFF and FCFE
FCInv = 228 202 + 14 depc = 40
WC2011 = 10 + 20 56 = - 26
WC2010 = 14 + 18 32 = 0
Wcinv = 26 0 = - 26
T = 40 / 115 35%
Net borrowing = 70 60 = 10
116

Newday FCFF from NI and CFO
FCFF = NI + NNC + Int (1 t) WCInv FCInv
- 81.5 = 75 + 14 + 10(1 0.35) (- 26) 40
FCFF = CFO + Int (1 t) FCInv

- 81.5 = (75 + 14 (-26)) + 10(1 0.37) 40
Recall, CFO = NI + NCC WCInv
117

Newday FCFE from NI and CFO
FCFE = (NI + NCC WCInv) FCInv + Net borrowing
85 = (75 + 14 (- 26)) 40 + 10

85 = (75 + 14 (- 26)) 40 + 10
118

Two Approaches to Forecast FCF
Calculate historical FCF: Most common
o Estimate FCF for current period
o Apply growth rate FCF x (1 + g)n
Forecast components of FCF
o Forecast each underlying component of free cash flow: Net
income, FCInv, NCC, and WCInv are tied to sales forecast
o Realistic and flexible but time consuming
119

Recognizing of Value Between FCFE and DDM
The general valuation models are the same but the numerator is
different
The share of common stock is the present value of dividend or
FCFE, where FCFE could be either greater or less than
dividends based on the adjustments to arrive at FCFE
120

Effect of Financing Decisions on FCF
FCFF
FCFE
Dividends
None
None
Share repurchase
None
None
Share issue
None
None
None
ST &LT effects
partially offset*
Change in leverage
Note: Share repurchase/issue is use of FCF; not determinant

* e.g., if leverage increases, FCFE higher in current year (net
borrowing) and lower in future years (interest expense)
121

NI is a Poor Proxy for FCFE
NI is an accrual concept not cash flow
NI recognizes con-cash charges such as depreciation,
amortization, and gains on sale of equipment, alternatively
NI fails to recognize the cash flow impact of investments in
working capital and net fixed assets, and net borrowings
122

EBITDA is a Poor Proxy for FCFF
EBITDA doesnt reflect taxes paid
EBITDA ignores effect of depreciation tax shield [(Depr (tax)]
EBITDA does not account for needed investments in working
capital and net fixed assets for going concern viability
123
Problem: FCFF
Which of the following is most likely to affect Free Cash
Flow to the Firm (FCFF)?
a. Dividends
b. Share repurchases
c. Sale of assets
124
Problem: EBITDA
Which of the following is least likely to be considered a
reason that EBITDA is an ineffective proxy for Free Cash
Flow to the Firm (FCFF)? EBITDA does not account for:
a. working capital investment

b. interest expense
c. cash taxes paid
125
Single-Stage FCFF Model

Point: Analogous to Gordon growth model
o Useful for stable firms in mature industries
Two assumptions:
1. Constant growth rate g forever
2. Growth rate g is less than WACC
Firm value0 = FCFF1
WACC g
= FCFF0 x (1 + g)
WACC g
126
Weighted Average Cost of Capital
Weighted average of rates of return required by capital

suppliers (WACC)
Required returns
WACC = (We x re ) + [wd x rd x (1 t)]
MV weights OR
target weights
127
Single-Stage FCFE Model

Point: Similar to FCFF/GGM model
Often used with international firms, especially in high-inflation
countries
FCFE1
Equity value = r g
FCFE0 x (1 + g)
rg
=
Required return on equity

(CAPM, APT, Build-up)
128
Multi-Stage Models
Four major variations:
1. FCFF or FCFE?
2. Two stages or three?
Base case: 2-stage,

historical growth,
FCFE with the GGM
for terminal value
3. Total FCF or components or FCF?
4. Terminal value via GGM or P/E?
Note: All are very similar
Always: Value = PV of future cash flows discounted at

appropriate required return
129
Selection of Appropriate Model

Single-stage model
o Income stock (slow, constant growth)
o International setting or volatile inflation rates: Use real rates
Two-stage and three-stage models
o Competitive advantage will disappear over time

Match growth pattern or company life cycle approach to the
appropriate model
130
Sensitivity Analysis
Apply sensitivity to each of the following variables:
o The base-year value for the FCFF or FCFE
o Future growth rate
o Risk factors beta, risk-free rate, and ERP
o Relationship between discount rate and the growth rate is

critical
o Most sensitive: Beta and FCF growth rate
o Least sensitive: FCF and Rf
131
1B. Free Cash Flow Valuation
Terminal Value
Terminal value = forecasted value at beginning of normal
growth phase
Apply average trailing multiple (P/E) to forecasted EPS = P/E x
EPSn
Or, use single stage (Gordon Growth) model
Terminal value is added to the last period cash flow and then
discounted along with the prior period dividends or FCFs
132

Problem: FCFF Valuation
Tykes Toys has a required return on equity of 15%, a WACC of 12% and a marginal
tax rate of 40%. FCFF is expected to grow at a constant rate of 4% after three
years. Using the data below, which figure is closest to the value of the firm?
Year 1
Cash flow from operations
Year 3
$400
$500
$600
WCInv
$50
$60
$80
FCInv
$200
$250
$300
$15
$15
$20
Interest expense
a.
b.
c.
Year 2
$4,056
$3,502
$3,900
133

Solution: FCFF Valuation
134

Problem: Terminal Value FCFE
Which is the least appropriate approach for FCFE Valuation
calculating terminal value in a Free Cash Flow to Equity (FCFE)
analysis?
a. Apply average trailing multiple (P/E) to forecasted EPS = P/E x

EPSn
b. Use Gordon growth model = Dividendn / (r g)
c. Add terminal value to the last period cash flow and then
discount along with the prior period FCFEs
135
KEYS TO THE EXAM

Free Cash Flow Valuation
Define FCFF and FCFE
Calculate FCFF and FCFE
Application of models in FCF framework
FCF vs. dividends and ownership perspective

Model selection criteria
136
VALUATION MODELS
Lecturer:
Lecturers name
2012
Price Multiples
Method of Comparables
The method of comparables involves using a price multiple to
evaluate whether an asset is relatively fairly valued, relatively
undervalued, or relatively overvalued in relation to a benchmark
value of the multiple
Most widely used method by analysts
The economic rationale for the method of comparables Law of
One Price
138
Price Multiples
Method of Comparables
Price scaled by a measure of value such as sales, net income, book
value, or CF
Compare relative to a benchmark multiple
Choices for the benchmark value of a multiple include the multiple
of a closely matched individual stock or the average (or median
value) for the stocks peer group of companies or industry
139
Price Multiples
Method of Forecasted Fundamentals
Relates multiples to company fundamentals growth, risk,
payout
Based on discounted cash flow model
Permits the analyst to explicitly examine how valuations differ
across stocks and against a benchmark given different expectations
for growth and risk
140
Price Multiples
Price Multiple Fundamentals
Justified price multiple: What the price multiple should be if the
stock is fairly valued
Also warranted and intrinsic price multiple
o Actual = justified
properly valued
o Actual < justified
undervalued
o Actual > justified
overvalued
141
Price Multiples
What You Need To Know!
For relative valuation measures such as P/E, P/B, P/S, P/CF, and
dividend yield, know the following for each ratio:
o Rationale for using ratio
o Possible drawbacks of ratio
o Calculation of ratio
o Fundamental influences
o Calculate justified ratio
o Evaluate a stock with the ratio
142
Price Multiples
Rationale for P/E Ratio
Rationale:
o Earnings power (EPS) key to investment value
o Focal point for Wall Street
o Differences in P/Es may be related empirically to differences in
long-run stock returns according to research
o Ratio can be used as a proxy for risk and growth
143
Price Multiples
Drawback for Using the P/E Ratio
Drawbacks:
o Negative and very low earnings make P/E useless
o Volatile or transitory earnings make interpretation difficult
o Management discretion on accounting choices can distort
earnings
o Solely using the ratio avoids addressing the fundamentals
(growth, risk, and cash flows)
144
Price Multiples
Market P/E Ratio
Trailing P/E0 : Uses EPS from last year
P0 / E0 =
market price per share

EPS last 12 months
Leading P/E1 (forward or prospective): Uses forecasted earnings

for coming year
P0 / E1=

forecast EPS next 12 months
145
Price Multiples
Example: Trailing and Leading P/E
2001 earnings = $25 million
Forecasted EPS over the next 12 months = $0.60
50 million shares outstanding
Market price = $16

Calculate trailing and leading P/E ratios
146
Price Multiples
Solution: Trailing and Leading P/E
EPS2001 =
Trailing P/E =
Leading P/E =
147
Price Multiples
Problems with Trailing P/E0
When calculating a P/E ratio using trailing earnings, care must be taken
in determining the EPS number. The issues include:
o Transitory, non-recurring components of earnings that are company-
specific
o Cyclicality components of earnings due to business or industry trends
o Differences in accounting methods
o Potential dilution of EPS
148
Price Multiples
Underlying Earnings
Goal: Analysts want to remove nonrecurring items from earnings
for forecasting purposes Non-recurring items to remove
include:
o Gains/losses on asset sales
o Asset write-downs impairment
o Loss provisions
o Changes in accounting estimates
Result : Persistent, continuing, and core earnings
149
Price Multiples
Underlying Earnings
Example:
o 2008 EPS = $8
o Gain on asset sale = $1.40
o Gain from change in accounting estimate = $0.75
Underlying earnings
o
= $8.00 - $1.40 - $0.75 = $5.85
150
Price Multiples
Normalized Earnings
Adjust EPS to remove cyclical component of earnings and capture
mid-cycle or an average of earnings under normal market conditions
Two normalization methods

o Method of historical average EPS
o Method of average ROE
151
Price Multiples
Example: Normalized Earnings

Year
2005
2006
2007
2008
EPS
$4.00
$3.80
$5.25
$4.50
BVPS
$25.00
$26.00
$26.00
$28.00
ROE
15%
15%
21%
16%
152
Price Multiples
Solution: Normalized Earnings

Average EPS = $4.00 + $3.80 + $5.25 + $4.50
4
0.15 + 0.15 + 0.21 + 0.16

Average ROE =
4
= $4.39
= 0.1675
Average ROE x BVPS2008 = 0.1675 x $28.00 = $4.69
153
Price Multiples
Solution: Normalized Earnings
If the current stock price was $60, then the normalized P/E ratios
approaches are:
Average EPS = $4.39
P/E = $60 / $4.39 = 13.7x
Average ROE method EPS = $4.69

P/E = $60 / $4.69 = 12.8x
Preferred method since it more accurately reflects the effect of growth
and company size on EPS
154
Price Multiples
E/P: Earnings Yield

Problem: Negative earnings make P/E ratios meaningless
Potential solution: Substitute E/P, simply the inverse of the P/E
o Price is never negative
o High E/P suggests cheap security

o Low E/P suggests expensive security
155
Price Multiples
Example: Earnings Yield

Current
Price
Trailing EPS
Trailing
P/E
E/P Ratio
ABC
$26.00
$0.49
53.06
1.9%
GHI
$19.20
$(0.11)
NM
- 0.6%
PQR
$8.59
$(0.40)
NM
- 4.7%
TUV
$8.07
$(3.15)
NM
- 39.0%
156
Price Multiples
Justified Price Multiple

Recall :
o Justified multiple = multiple if the stock is fairly valued
Forecasted fundamentals:
o Justified multiple = the ratio of value from any DCF model to

earnings, book value, sales, or cash flow
Typical CFA L2 case: Use the Gordon growth model (GGM) to
derive justified multiples and identify determinants
157
Price Multiples
Justified Leading P/E1

Justified leading P/E1 : Start with GGM
P0 =
D1
rg
Payout
justified leading
Note: All derivations are just (1) substitution and (2) algebra. The
relationships are exact
158
Price Multiples
Justified Trailing P/E1

Justified trailing P/Eo : Start with GGM
P0 = Do (1 + g)
rg
Payout x (1 + g)
justified leading
= (justified leading P/E) (1 + g)
159
Price Multiples
Justified P/E
Fundamental factors affecting justified P/E:
P/E positively related to growth rate and payout, all else equal
o Assumes no interaction between g, payout, and ROE
o Recall: g = ROE x (1 Div/EPS)
P/E inversely related to required return, (real rate, inflation,

and equity risk premium) all else equal
160
Price Multiples
Example: Justified P/E Based on Fundamentals

Example:
Payout ratio = 40%
Required rate of return = 12%
Expected dividend growth rate = 4%

Calculate the trailing P/Eo and leading P/E1 multiple based on
these forecasted fundamentals
161
Price Multiples
Solution: Justified P/E Based on Fundamentals

Trailing P/E =
Leading P/E =
162
Price Multiples
Predicted P/E from Regression

The P/E and company characteristics are measured cross
sectionally
The P/Es are regressed against the stock and company
characteristics
The estimated equation exhibits the relationship between the P/E
and the stocks characteristics
o Positive coefficient with growth and payout

o Negative coefficient with beta
163
Price Multiples
Example: Predicted P/E from Regression

Predicted P/E regression:
Dividend payout ratio = 0.40
Beta = 0.60
Expected earnings growth rate = 3%

A regression on related public utility firms produces the following
equation:
o Predicted P/E = 5 + (6 x dividend payout) + (10 x growth) (0.5 x beta)
Calculate the predicted P/E

164
Price Multiples
Solution: Predicted P/E from Regression

Predicted P/E =
Useful for large data sets
Infrequently used due to these limitations

o Changing relationships
o Multicollinearity
o Unknown predictive power
165
Price Multiples
Valuation Using Comparables

Select and calculate the comparative price multiple for the security
Select the benchmark asset and calculate the mean of median P/E
Compare the stocks P/E with the benchmarks P/E
Are observed differences between asset and benchmark P/E

explained by underlying determinants of P/E? If not, asset may be
mispriced. Watch the fundamentals!
166
Price Multiples
Example: Method of Comparables

Are Alaska and Buffalo relatively over or undervalued?
Stock
5-Year
Current P/E Consensus
Growth
Beta
Alaska Inc.
20.2
15.4%
1.20
Buffalo Inc.
16.3
19.6%
1.20
Industry average
22.7
19.4%
1.20
167
Price Multiples
Solution: Method of Comparables
Buffalo: Undervalue
o Why?
Lower P/E than the industry
Approximately same growth rate and risk
Alaska: Cant determine
o Why?
Lower P/E than industry
But, low P/E may result from lower growth forecast
168
Price Multiples
PEG Ratio
PEG ratio is a stocks P/E divided by the expected long-term
earnings growth rate g
P/E
g
Calculates a stocks P/E per unit of expected growth
PEG =
Lower PEG more attractive valuation,

higher PEG less attractive valuation
169
Price Multiples
Example: PEG Ratio

SGS Inc., leading P/E = 15
Five-year consensus long-term earnings growth rate forecast
= 21%
Median industry PEG = 0.90

Calculate PEG and explain whether the stock appears to be
correctly valued, overvalued, or undervalue
170
Price Multiples
Solution: PEG Ratio

PEG = 15/21% = 0.71
Note do not make growth a decimal
Comparable Industry PEG = 0.90
SGS PEG 0.71 < Industry PEG 0.90
Conclusion: SGS Inc., is undervalued

o SGS Inc., has a lower multiple per unit of expected growth
171
Price Multiples
Problems with PEG Ratios

PEG ratio does not account for:
Differences in firm risk attributes
Differences in the duration of growth
Non linear relationship between growth and P/E ratio
172
Price Multiples
Terminal Value Estimation

Terminal value: Value projected at end of estimation horizon
Terminal value = (trailing P/E) x (earnings forecast)
Two methods:
1. Fundamentals: Requires estimates of g, r, and payout

2. Comparables: Uses market data to calculate benchmark
173
Price Multiples
Price to Book Ratio P/B0

Book value per share (BVPS) attempts to represent the
investment that common shareholders have made in the
company
BVPS is calculated as common equity divided by number of
shares outstanding
There is only a current P0/B0 not a leading P/B
174
Price Multiples
P/B0 Ratio
Rationale:
Usually positive (even when EPS < 0)
Less volatile, more stable than EPS
Good for firms with mostly liquid assets (e.g., financial firms)
Useful for distressed firms, liquidation
Differences in P/B ratios explain differences in long-run average
returns
175
Price Multiples
P/B0 Ratio
Drawbacks:
Does note reflect value of intangible assets, off-B/S assets (e.g., human
capital)
Misleading when comparing firms with significant differences in asset
size
Different accounting conventions obscure comparability (particularly
international)
Inflation and technological change can cause big difference between BV

and MV
176
Price Multiples
Example: Market P/B0 Ratio

market value of
equity
book value of equity
market price per
=
share
book value per share
P/B ratio =
Market price = $80

Book value = $200 million
Shares O/S = 4 million
Compute P/B ratio
177
Price Multiples
Solution: Market Price to Book Value

BV per share = $200 million
4 million
P/B ratio = $80

$50
= $50
= 1.6
178
Price Multiples
Justified P0/B0 ratio
By using the Gordon growth model and using the expression g = b

ROE for the sustainable growth rate, the expression for the justified
P/B ratio based on the most recent book value (B0 ) is
179
Price Multiples
Justified P/B
Fundamental factor affecting P/B:
o (ROE r)
Larger spread = value creation = higher market value
Compare to residual income model

Intuition: Firms that earn ROE = r will have a P/B of 1
180
Price Multiples
Fundamental Factors - Influencing P0/B0 Ratio

Positive relationship
o P/B increases as ROE increases
o P/B increases as g increases
Inverse Relationship
o P/B increases as r decreases (falling risk, interest rates, inflation,
and beta)
181
Price Multiples
Justified P0/B0 Ratio Based on Fundamentals

Example:
o Return on equity = 22%
o Expected growth rate = 6%
justified P/B0 ratio =
182
Price Multiples
Valuation Using Comparable P0/B0

Justified selection of Stock A or B
3-Year
Mean
P/B
6.85
8.62
Stock
Industry
Current
P/B
ROE
Forecast
Beta
4.32
18.9%
1.22
3.31
19.6%
1.26
5.75
19.8
183
Price Multiples
Valuation Using Comparable P0/B0

B is more attractive investment
o Why?
B has lower P/B than A
Bs P/B < industry P/B, Bs ROE = industry ROE

PB undervalued
184
Price Multiples
Rationale for Using P0/S0

P/S useful for distressed firms
Sales revenue is always positive
Sales are generally more stable and less prone to distortion than
EPS, over time

P/S useful for mature, cyclical, and zero-income stocks
Differences in P/S ratios may be related to difference in long-run
average returns
185
Price Multiples
Drawbacks Against Using P0/S0

High sales growth does not translate to operating profitability
P/S ratio does not capture different cost structures between firms
Revenue recognition methods can distort reported sales and
forecasts
186
Price Multiples
Market P/S0 Ratio
P/S =
market value of equity

total sales
= market price per share

sales per share
187
Price Multiples
Justified P0/S0 Based on Fundamental Factors

P0
=
S0
(E0 / S0) x ( 1 b) x ( 1 + g)
rg
Profit margin = E0 / S0
Payout = 1 b
Required return = r
Sustainable growth rate = g
188
Price Multiples
Justified P0/S0 Ratio Based on Fundamentals

Example:
Payout ratio (Div/EPS) = 40%
Required return on equity = 15%
Expected growth in earnings = 8%
Current net profit margin (E0 / S0) = 12%
P0/S0 =
P0/S0 =
189
Price Multiples
Relationship of Fundamentals to the P0/S0 Ratio

P0/S0 increases as:
Current profit
margin (E0/S0)
improves
Sustainable
growth (g)
increases
Risk falls
P0/S0 decreases as:

The profit margin
decreases
Risk increases
Growth
decreases
190
Price Multiples
Valuation Using Comparable P0/S0

Same method as P/E and P/B
Low P/S undervalued
Use trailing sales to calculate
In choosing comparables, control for:

o Profit margin
o Expected growth
o Risk
o Quality of accounting data
191
Price Multiples
Rationales for Using P/CF0

More difficult to manipulate CF than EPS
Cash flow is more stable than earnings
Addresses quality of earnings problem
Differences in P/CFs may explain differences in long-run average
returns
192
Price Multiples
Drawbacks Against Using P/CF0

Earnings plus non-cash charges approach ignores some cash flows
such as net fixed investments, working capital investment, and net
borrowings
FCFE is preferable to CFO, but FCFE more volatile and more
difficult to compute
FCFE can be negative with large CapEx
193
Price Multiples
Market P/CF Ratio
P/CF =
market value of equity

total cash flow
= market price per share

Cash flow per share
194
Price Multiples
What is cash flow?

1. Traditional cash flow:
CF = net income + non-cash charges
2. CFO ( from statement of cash flows)
3. Adjusted CFO:
Adj. CFO = CFO + [interest x (1 t)]
4. EBITDA: (Also used for EV/EBITDA ratio)
5. FCFE: Theoretically superior (from this study session)
195
Price Multiples
Cash Flow Definitions
FCFE cash flow concept with the closest relationship to

theory, although can be more volatile due to Cap Ex
EBITDA is a pre-tax, pre-interest, pre-investment in working

capital and pre-investment in fixed assets
o Appropriate for firm value, not equity
196
Price Multiples
Justified P/CF
Two step Process

o Step 1: Calculate stock value using suitable DCF model
V0 =
FCFE0 (1 +
g)
r-g
o Step 2: Divide result by cash flow:

Justified P/CF = V0/CF
197
Price Multiples
Fundamental Factors Affecting Justified P/CF

Justified P/CF will increase, all else equal, if:
o Cash flow increases
o Growth rate increases
o Required return decreases

o Same relationship as all other ratios
198
Price Multiples
Valuation Using Comparable P/CF
Same method as P/E, P/B, and P/S
Low P/CF undervalued
Control for:
o Return and risk

o Cash flow
o Growth rate
199
Price Multiples
P/EBITDA or EV/EBITDA?
EBITDA is a earnings flow to both debt and equity holders
A multiple using total company value: Enterprise Value (EV) in the

numerator is logically more appropriate than equity market price
(P)
Because the numerator is enterprise value, EV/EBITDA is a

valuation indicator for the overall company rather than common
stock
200
Price Multiples
EV / EBITDA Ratio
Enterprise Value (EV) or Firm Value
= MV of common stock + MV of debt + MV preferred
cash and investments
Divided by
EBITDA = earnings before interest, taxes, depreciation, and
amortization
o Ratio provides an indication of company/firm value, not equity
value
201
Price Multiples
Arguments For/Against EV/EBITDA

Arguments for:
Comparing firms with different financial leverage since EBITDA is
pre-interest
Controls for dep/amort differences
EBITDA usually positive when EPS is negative
Arguments against:
Ignores changes in WC investments

FCFF (which controls for capex) is more closely tied to value
202
Price Multiples
Valuation Using EV/EBITDA

Firm EV/EBITDA < benchmark
Undervalued
Firm EV/EBITDA > benchmark

Overvalued
203
Price Multiples
Arguments For Using D0/P0

Dividend yield is a component of total return
Dividends are a less risky component of total return than capital
appreciation
204
Price Multiples
Arguments Against D0/P0

Dividend yield is just one component of total return
Dividends paid now displace earnings in all future periods (a concept
known as the dividend displacement of earnings). Investors trade
off future earnings growth to receive higher current dividends.
205
Price Multiples
Market Dividend Yield D/P
trailing D/P =
4 x most recent quarterly

DIV
leading D/P = next 4 quarters forecasted DIVs

For practical purposes, dividend
yield, D/P is preferred over P/D
(zero dividends are a problem)
206
Price Multiples
Justified Dividend Yield D0/P0

The justified dividend yield in a Gordon model is:
D0
rg
=
P0
1+g
207
Price Multiples
Example: Justified Dividend Yield D0/P0

Example:
Required rate of return on equity = 10%
Long term earnings growth = 5%
D0
=
P0
rg
1+g
o D0/P0 = (0.10 0.05) / (1.05)

o D0/P0 = 0.048 or 4.8%
208
Price Multiples
Fundamental Factors Affecting D0/P0

Dividend yield increases as:
Required return increases (price falls)
High growth rate decreases the firms payout and therefore the firm is
less able to pay dividends which results in a lower D/P ratio

High D/P strategy = value strategy
209
Price Multiples
Valuation Using Comparable D/P

Consensus
Growth
Beta
D/P
SW Utilities
9%
0.71
8%
NE Utilities
6%
0.74
5%
SW Utilities preferred
Lower risk; higher total expected return
210
Price Multiples
Problem: P/CF
The least accurate description of the advantages and disadvantages
of using the price to cash flow ratio (P/CF) rather than the price to
earnings ratio (P/E) is that the P/CF ratio has the:
a.
advantage of addressing the earnings quality issue
b. advantage that cash flow is generally harder to manipulate than

earnings
c. disadvantage that cash flow is generally less stable than earnings
211
Price Multiples
Problem: Price/Sales
The price/sales ratio is most likely to decrease as:
a.
profit margin increases
b. inflation increases
c. risk decreases
212
Price Multiples
Problem: PEG
Which of the following is least likely to be considered a disadvantage
of using the P/E to growth (PEG) ratio?
a.
The PEG ratio does not account for differences in the duration of
growth between firms
b. The relationship between P/E and growth is non-linear

c. The PEG ratio does not account for differences in risk attributes
between firms
213
Price Multiples
Problem: Dividend Yield

Dividend yield is least likely to increase as:
a. required return increases
b. growth rate increases
c. price decreases
214
Price Multiples
Cross Border Valuation Differences

Comparing companies across borders frequently involves accounting
method differences, cultural differences, economic differences, and
resulting differences in risk and growth opportunities
For example, P/E ratios for individual companies in the same industry
across borders have been found to vary widely
215
Price Multiples
Momentum Indicators
Momentum indicators based on price, such as the relative strength
indicator, have also been referred to as technical indicators
Unexpected earnings (also call earnings surprise) is the difference
between reported earnings and expected earnings
UEt = EPSt - E(EPSt)
216
Price Multiples
Momentum Indicators
Another momentum indicator based on the relative change in
earnings per share is called standardized unexpected earnings
SUEt =
EPSt - E(EPSt)
[EPSt - E(EPSt)]
217
Price Multiples
Measuring Central Tendency in Multiples

Arithmetic mean
o Most affected by outliers
Harmonic mean
o Less affected by large, more by small, outliers
Weighted harmonic mean

o Effect of outliers depends on market value weight
Median
o Least affected by outliers
218
Price Multiples
(Simple) Harmonic Mean

Outliers:
o Reduces impact of large outliers

o May worsen impact of small outliers
Small outliers bounded by zero, so less problematic
Weighting:
o Less weight on higher ratios
o More weight on lower ratios
Lower value than arithmetic mean (unless all observations are the
same value)
Used when marked weight information unavailable
219
Price Multiples
Weighted Harmonic Mean

Similar to simple harmonic mean except in weighting:
o Uses market value weights

o Major advantage: Corresponds to portfolio value (e.g., total
price/total earnings)
220
Price Multiples
Stock Screens
Applies set of criteria to narrow possible investments to those
meeting criteria
May be used with:
o Fundamental and/or valuation criteria
Multiples
Momentum indicators
o Individual securities, industries, economic sectors
221
Price Multiples
Benefits/Limitations to Screening
Benefit:
o Efficient means of narrowing investment universe
Limitations:
o Little control over calculation of inputs in most commercial screening
software
o Lack of qualitative factors
222
KEYS TO THE EXAM
Price Multiples
Method of comparables vs. forecasted fundamentals
Valuation multiples formulas: P/E, P/B, P/S, P/CF
Advantages/disadvantages of different multiples
223
KEYS TO THE EXAM
Price Multiples
Selection of valuation multiple (when to use P/E, etc.)
PEG ratio
P/E to estimate terminal value in the DDM two-stage
framework
224

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Lecturer:

A. Discounted Dividend Valuation

A. Discounted Dividend Valuation

Very important concept!

A. Discounted Dividend Valuation

Key point: Valuation metric (e.g., divs or FCF) must be

measurable and related to earnings power

A. Discounted Dividend Valuation

you buy a stock

A. Discounted Dividend Valuation

o Dividends may not reflect the control perspective desired by the

A. Discounted Dividend Valuation

understandable and consistent relationship to profitability

A. Discounted Dividend Valuation

Much more on this topic in Study Session 12

A. Discounted Dividend Valuation

A. Discounted Dividend Valuation

A. Discounted Dividend Valuation

Problem: requires estimation of infinite stream of CFs

A. Discounted Dividend Valuation

A. Discounted Dividend Valuation

o Expected year-end stock price = $64

A. Discounted Dividend Valuation

A. Discounted Dividend Valuation

oValue = PV two years of cash flows and the future sales

Notice that in the final year, two cash flows occur

A. Discounted Dividend Valuation

oExpect Year 1 dividend = $1.25

oExpected Year 2 dividend = $1.50

A. Discounted Dividend Valuation

A. Discounted Dividend Valuation

Note: If you can do 1 and 2 periods, you can do n periods!

A. Discounted Dividend Valuation

A. Discounted Dividend Valuation

r = required return on equity

A. Discounted Dividend Valuation

Situations in which model is useful:

A. Discounted Dividend Valuation

Calculate the intrinsic value

A. Discounted Dividend Valuation

The numerator was not increased by 5%

A. Discounted Dividend Valuation

=> g = 0.05 = 5.0%

A. Discounted Dividend Valuation

A. Discounted Dividend Valuation

PVGO = $80 - $20 = $60

A. Discounted Dividend Valuation

Point: Morph PVGO model into a leading Po /E1 model

Po /E1 = 1/r + PVGO/ E1

A. Discounted Dividend Valuation

Point: The GGM can also be used to calculate a justified price

As shown in SS#12, rearrange GGM yields

A. Discounted Dividend Valuation

Point: Perpetual cash flows can be valued

Formula: Po = Annual CF / Capitalization rate

A. Discounted Dividend Valuation

Supplement to more complex models

A. Discounted Dividend Valuation

Multi-Stage DDM Models

o Problem: Unrealistic for most firms

A. Discounted Dividend Valuation

Rapid EPS growth, negative FCF

ROE > r, no or low dividend payout

2. Transitional phase use 2-stage/H model