Business

Valuation

Nov 26, 2012

Learning Objectives

Understand the importance of business

valuation.
Understand the importance of stock and
bond valuation.
Learn to compute the value and yield to
maturity of bonds.
Learn to compute the value and expected
yield on preferred stock and common stock.
Learn to compute the value of a complete
business.
2

Importance of
Business Valuation

If the basic goal of the firm is to maximize

the value of the firm, then it is important
to be able to measure that value
When a firm contemplates raising money,
it needs to know the value of its securities
so it knows how much (shares/bonds) to
issue.
If you want to invest in a company, its
important to know if the company is over
valued or under valued

General Valuation
Model

To develop a general model for

valuing a business, we consider
three factors that affect future
earnings:
Size of cash flows (Axiom 3)
Timing of cash flows (Axiom 2)
Risk of receiving cash flows
(Axiom 1)
4

Total Value of a
Business Model
The present value of a firm is equal to:
Present value of current liabilities
+ present value of long term debt
+ present value of preferred stock
+ present value of stockholders
equity
= Total present value of the Business

(Note: the present value of the current

liabilities is basically the same as their
book value)

Bond Valuation Model

Bond Valuation is an application of

time value model introduced in
chapter 8.
The value of the bond is the
present value of the cash flows
the investor expects to receive.
What are the cash flows from a
bond investment?
6

Bond Valuation Model

3 Types of Cash Flows

Amount paid to buy the bond (PV)
Coupon interest payments made to the
bondholders (PMT)
Repayment of Par value at end of Bonds life
(FV).
Other Factors in Bond valuation:
Bonds time to maturity (N)
Discount rate (I/Y)
7

Bond Valuation Model

Calculator:
n = time until maturity
I/Y = k = discount rate/cost of
capital
PV = value of the bond (Vb)
PMT = coupon interest paid ($ Int)
FV = par value at maturity

IBM Bond Wall Street Journal Information:

Bonds

AMR624
ATT 8.35s25
IBM 633/8 05
IBM 6 /8 13
Kroger 9s19

Cur
Yld

Vol

cv
6
8.3 110
6.6 228
6.6 228
8.8

74

Close

Net
Chg

91 -1
102 +
965/58 -1/81
96 /8 - /8
1017/8 -

Link to Bondtrac Financial Information

IBM Bond Wall Street Journal Information:

Bonds

Cur
Yld

Vol

AMR624
cv
6
ATT 8.35s25
8.3 110
IBM 363/8 05
6.6 228
IBM 6 /8 13
6.6
228
Kroger 9s19

8.8

74

Close

Net
Chg

91 -1
102 +
965/58 -1/81
96 /8 - /8
1017/8 -

Suppose
SupposeIBM
IBMmakes
makesannual
annualcoupon
couponpayments.
payments. The
Theperson
person
who
whobuys
buysthe
thebond
bondat
atthe
thebeginning
beginningof
of2009
2009for
for$966.25
$966.25will
will
receive
receive55annual
annualcoupon
couponpayments
paymentsof
of$63.75
$63.75each
eachand
andaa$1,000
$1,000
principal
principalpayment
paymentin
in55years
years(at
(atthe
theend
endof
of2013).
2013). Assume
Assumett00is
is
the
thebeginning
beginningof
of2009.
2009.
10

IBM Bond Timeline:

2009
0

2010
1

63.75

2011
2

63.75

2012
3

63.75

2013
4

63.75

63.75
1000.00

Compute
Computethe
theValue
Valuefor
for the
theIBM
IBM Bond
Bond given
giventhat
thatyou
you
require
requirean
an8%
8%return
return on
on your
yourinvestment.
investment.

11

IBM Bond Timeline:

2009
0

2010
1

2011
2

63.75

63.75

$63.75
$63.75Annuity
Annuityfor
for55years
years

2012
3

2013
4

63.75

63.75

63.75
1000.00

$1000
$1000Lump
LumpSum
Sum in
in 55years
years
935.12

I/YR

PV

PMT

FV

? 63.75 1,000

Bond is selling for

$966.25. Would
you buy it?
12

Yield to Maturity (IRR)

If an investor purchases a 6.375% annual coupon

bond today for $966.25 and holds it until maturity
(5 years), what is the expected annual rate of
return ?
2009
0

-966.25
??
+ ??
966.25

2010

2011

63.75

63.75

2012
3

63.75

2013
4

63.75

63.75
1000.00

VB = 63.75(PVIFA5, x%) + 1000(PVIF5,x%)

Mathematically, solve by trial and error.

13

Yield to Maturity
2009
0

-966.25

2010

2011

63.75

2012

63.75

63.75

Calculator Solution:

2013

63.75

63.75
1000.00

7.203%
N

I/YR

PV

PMT

FV

? -966.25 63.75 1,000

14

Yield to Maturity
2009
0

2010
1

-966.25

63.75

2011
2

63.75

2012
3

63.75

2013
4

63.75

63.75
1000.00

If YTM (7.203%) > Coupon Rate

(6.375%), bond Sells at a DISCOUNT
If YTM < Coupon Rate bond Sells at a
PREMIUM
15

Most Bonds Pay Interest Semi-Annually:

e.g. semiannual coupon bond with 5 years
to maturity, 9% annual coupon rate. K = 10%
Instead of 5 annual payments of $90, the bondholder
receives 10 semiannual payments of $45.
2009
0

2010
1

45

45

2011
2

45

45

2012
3

45

45

2013
4

45

45

45

45.00
1000.00
16

Calculator Solution:
2009
0

2010
1

45

2011
2

45

45

2012
3

45

45

45

2013
4

45

45

45

45.00
1000.00

961.38

10

I/YR

PV

PMT

FV

45 1,000
17

Interest Rate Risk

Bond Prices fluctuate over Time

As interest rates in the economy change,
required rates on bonds will also change
resulting in changing market prices.
Interest
Rates

VB
18

Interest Rate Risk

Bond Prices fluctuate over Time
As interest rates in the economy change,
required rates on bonds will also change
resulting in changing market prices.
Interest
Rates
Interest
Rates

VB

VB

19

Valuing Preferred
Stock
52 Weeks
Yld
Vol
Hi

Lo Stock

Sym Div

% PE

100s

s 42 29 QuakerOats OAT 1.14 3.3 24

s 36 25 RJR Nabisco RN .08p ... 12

5067
6263

Hi

Net
Close Chg

Lo

35 34 34 -
29 285/8 287/8 -

237/8 20 RJR Nab pfB

2.31 9.7

...

966

24

235/8 23 ...

.60

...

2248

5 RJR Nab pfC

P0=23.75

D1=2.31

9.4

D2=2.31

D3=2.31

63/8

-1/8

D=2.31

P0 = Value of Preferred Stock

= PV of ALL dividends discounted at
investors Required Rate of Return

20

Valuing Preferred
Stock
52 Weeks
Yld
Vol
Hi

Lo Stock

Sym Div

% PE

100s

s 42 29 QuakerOats OAT 1.14 3.3 24

s 36 25 RJR Nabisco RN .08p ... 12

5067
6263

Hi

Net
Close Chg

Lo

35 34 34 -
29 285/8 287/8 -

237/8 20 RJR Nab pfB

2.31 9.7

...

966

24

235/8 23 ...

.60

...

2248

5 RJR Nab pfC

P0=23.75

D1=2.31

P0 =

9.4

2.31
(1+ kp)

2.31
(1+ kp )2 +

P0 =

Dp
kp

2.31
=
.10

D3=2.31

D=2.31

2.31
(1+ kp )3+

= $23.10

-1/8

D2=2.31

63/8

Buy?
21

Yield (K) on Preferred

Stock

The rate of return (K) an investor

would earn if they pay the current
market price (MP) and receive the
promised dividends (Div)
If MP = Div / K, then solving for K,
we get
K = Div / MP
If Div is $2.31 and MP is $23.75,
then
K = YTM = $2.31/$23.75 = 9.73%

Valuing Individual
Shares of Common
Stock
P = PV of ALL expected dividends discounted at
0

investors Required Rate of Return

0

P0

D1

P0 =

D1
(1+ ks )

D2

D3

D2
D3
+
+
2
3
(1+ ks )
(1+ ks )

Not
Notlike
likePreferred
PreferredStock
Stock since
since DD00==DD11 == DD22 ==DD33 == DDNN,,
therefore
thereforethe
thecash
cash flows
flowsare
areno
no longer
longer an
an annuity.
annuity.
23

Valuing Individual
Shares of Common
P = PV of ALL expected dividends discounted at
Stock
0

investors Required Rate of Return

P0

D1

P0 =

D2

D1
(1+ ks )

D3

D2
D3
+
+
2
3
(1+ ks )
(1+ ks )

Investors
Investorsdo
donot
notknow
know the
thevalues
valuesof
of
DD11,,DD22,,....
....,, DDNN..The
Thefuture
futuredividends
dividendsmust
must
be
beestimated.
estimated.
Link to Quote.com
24

Constant Growth
Dividend Model
Assume that dividends grow at a constant
rate (g).
0

D0

P0 =

D1=D0 (1+g)

D2=D0 (1+g)2

D3=D0 (1+g)3

D0 (1+ g)3
D0 (1+ g)
D0 (1+ g)2
+
+ (1+ k )3 +
2
(1+ ks )
(1+ ks )
s

D =D0 (1+g)

Reduces to:

P0 =

D0(1+g)
ks g

D1
ks g

Requires
Requires
kkss>>gg

25

Constant Growth
Dividend Model
What is the value of a share of common stock if the
most recently paid dividend (D0) was $1.14 per share and
dividends are expected to grow at a rate of 7%?
Assume that you require a rate of return of 11%
on this investment.

P0 =
P0 =

D0(1+g)
ks g

1.14(1+.07)
.11 .07

D1
ks g

= $30.50
26

Yield, or Total Return on

Common Stock
What is the yield on stock when D0 = .08, g=.20,
and current price (P0) = $28.875

ks = D0(1+g) + g
P0

Link to Financial Web

Link to Yahoo Finance
27

Yield, or Total Return on

Common Stock
What is the yield on stock when D0 = .08, g=.20,
and current price (P0) = 28.875
ks = D0(1+g) + g
P0
ks = .08(1+.2) + .20
28.875
= .0033 + 0.20
= 20.33%

28

Total Market Value of a

Business
Market value of a business:
Present value of current liabilities
+ present value of long term debt
+ present value of preferred stock
+ present value of stockholders equity
= Total value of Business Assets

(Note: the present value of the current

liabilities is basically the same as their
book value)

The P/E Valuation

Model

You can use the Price/Earnings ratio to

value a share of stock if you can determine
the P/E ratio of the Industry
Stock Price = Industry P/E ratio x EPS
EPS is earnings per share of the firm
If projected EPS is $2 and industry P/E is 15,
The Stock price = $2 x 15 = $30
Stock price x shares outstanding = firm
value
If 10M shares, then x $30 = $300,000,000

Other Valuation
Methods

Angel investor investments (uses what

investors are willing to pay for stock
during development stage)
Present value of discounted future cash
flows from operations (depends on
predictability of future cash flows)
Rule of thumb 10 times future earnings
(assumes 10% desired rate of return)

Market Capitalization

Market Cap = Shares Outstanding

x market price per share
Current Market price = $25 per
share
Shares Outstanding =
100,000,000
Then market cap = $2.5 billion