Chapter 18 Equity Valuation

Common Stock - Terms &

Concepts
Equity = ownership. Ownership in a company
= stock
Share of stock = smallest incremental unit of
ownership
Voting rights
Classified stock/dual class shares
Proxy
Claims on residual assets and CFs of firm

Dividend Discount Model (DDM)

The value of a share of common stock is derived from its
claim on a companys future dividend stream. Heres the
logic:
1.) The value of any investment is the sum of the present
values of its expected cash flow stream.
2.) A dividend is a cash flow.

CF1
1

(1 r )

CF2
(1 r )

CF3
(1 r )

....
t 1

CFt
(1 r )

D1 D 2 D3 ....
Dt

V 0 (1 k )1 (1 k )2 (1 k )3
t
t 1 (1 k )
4

DDM - Constant Growth in

Dividends

D1 D 2 D3 ....
Dt

V 0 (1 k )1 (1 k )2 (1 k )3
t
(
1

k
)
t 1

If dividends grow at some constant rate, g, then:

D1
1

(1 k )

D1 (1 g )
(1 k )

D1 (1 g ) 2
(1 k )

....

Which reduces to:

D1
V0
kg
5

DDM - Constant Growth in

Dividends
Steady State stock just paid a dividend per share of $3.81.
The dividend is expected to grow at 5% forever (in perpetuity).
The required rate of return for Steady State stock is 12%.
What is the current value per share of Steady State stock?
One year from now, what is the expected price per share of
Steady State?
If you purchase one share of Steady State now and sell it
one year from now, what would be your expected HPR?
Dividend yield? Capital gains yield?

D1

D1 ( P1 P0 )
HPR
x100%
g x100%
P0
P0
6

DDM - Constant Growth in

Dividends
Valuation Scenarios for Steady State Stock.
D0 = 3.81
Long-term Growth Rate

10%
12%
14%

3%
$56.06
$43.60
$35.66

5%
6%
$80.01 $100.96
$57.15 $67.31
$44.45 $50.48
7

A Brief Review of CAPM

Only non-diversifiable (systematic) risk matters to
investors
Non-diversifiable risk is measured by an assets
beta coefficient,
An assets beta is a relative measure of systematic
risk relative to a broad based portfolio.
Investors demand compensation for time value of
money and risk, but only non-diversifiable risk.

NWE Stock Valuation: Constant Growth

in Dividends
Example: Consider Northwestern Corporation (NWE),
a public utility company.
The company paid a dividend of $1.84 per share
last year which you expect to grow at 3% in
perpetuity.
NWE has an equity beta of 0.70. The risk-free rate
is 3% and the expected return on the market
portfolio is 9%.
What is your estimated intrinsic value of one share of
NWE stock?
9

Multistage DDM/Varying Growth in

Dividends
Consider a company with the following expected per
share dividend stream:
Time
(year)

Dividend

$3.00

$4.00

$4.50

$4.95

$5.20

Y/Y
growth

33%

13%

10%

5% and
on

In year 5 dividends are expected to stabilize and grow at 5%

annually. If k = 12%, what is the value of one share of stock?

D1 D 2 D3 ....
Dt

V 0 (1 k )1 (1 k )2 (1 k )3
t
(
1

k
)
t 1
10

Multistage DDM/Varying Growth in

Dividends
Time
(year)
Dividend
Y/Y
growth

V0

$3.00

$4.00

$4.50

$4.95

$5.20

33%

13%

10%

5% and
on

D1 D 2 D3 D 4 P 4
1
2
3
4
4
(1 k ) (1 k ) (1 k ) (1 k ) (1 k )

P4
11

D5
(k g )

Multistage DDM/Varying Growth in

Dividends
Time

Dividend
Dividend
PVD1
PVD1

$2.68
$2.68

PVD2

$3.19

PVD3
PVD3

$3.20
$3.20

PVD4
PVD4

$3.15
$3.15

$3.00
$3.00

$4.00
$4.00

$4.50
$4.50

$4.95
$4.95

$5.20
$5.20

P4
P4
PVD5
PVD5
(PV P4)
(PV P4)

+$47.21
+$47.21

Stock
Value

$59.43
12

Value and Investment Opportunities:

Growth Prospects, Inc.
k = 12.5%, EPS1 = $5, DPS1 = $5, ROE = 15%
Invested equity = $100 million.
Shares outstanding = 3 million
Value per share under current dividend policy?
Note: g = b x ROE, and b = (1-(DPS/EPS)) = retention ratio
DPS1 EPS1 (1 b)
V0

kg
k bROE

What if the company only pays out 40% of its earnings

and retains and reinvests 60%? Value per share?
13

Value and Investment Opportunities:

Cash Cow, Inc.
k = 12.5%, EPS = $5, DPS = $5, ROE = 12.5%
Invested equity = $100 million
Shares outstanding = 3 million
Value per share under current dividend policy?
Recall: g = b x ROE, and b = (1-(DPS/EPS)) = retention ratio
DPS 1 EPS1 (1 b)
V0

kg
k bROE

What if the company retains and reinvests

60% of its earnings? Value per share?
14

Summary: Growth Prospects vs.

Cash Cow

Under what circumstances does growth enhance value?

15

Growth Prospects, Inc., Revisited

k = 12.5%, EPS = $5, DPS = $5, ROE = 15%
Value with no retention of profits (b=0), $40
Value with 60% retention of profits (b=0.60) $57.14
Price = No-growth value per share + PVGO

E1
P0
PVGO
k
$57.14 = $40 + $17.14
What about Cash Cow, Inc? PVGO?
16

Present Value of Growth

Opportunities (PVGO)

Assumes a risk-free rate of 3% and a market risk

premium of 7%
17

PVGO (2)
What is the value of the
equity at t=0 without vs.
with Project Z? NPV of Z?

18

Free Cash Flow to Equity (FCFE)

FCFE = net income + depreciation - CA + CL
capital expenditures + new debt issuances debt
principal repayments
FCFE = net income + depreciation - working
capital - capital expenditures + net new borrowing
FCFE = CFO - capex + net new borrowing
Extractable cash. Cash flow amount available or
free for distribution to shareholders the implied
dividend!
Actual dividends often differ from FCFE though.
19

Free Cash Flow to Equity (FCFE)

For valuation use TVM formulas, just use FCFE for cash
flow (or equity value) items and k for discount rate.

op

FCFE1
1

(1 k )

FCFE 2
(1 k )

FCFE3
(1 k )

....
t 1

FCFE1
t

(1 k )

Total value of equity = Eop + value of non-operating assets

In theory, valuation using DDM and discounted FCFE
models will produce the same value. Why?
If implemented with internally consistent assumptions,
FCFE, FCFF and DDM models produce the same value
of equity!
20

Free Cash Flow to Equity (FCFE) Valuation

Phoenix, Inc. has the following projected free cash
flow stream. (Amounts in millions.)
Year
FCFE

1
$65.89

2
$58.13

3
$79.53

4
5
$97.92 $110.76

After year 5, FCFE is expected to grow annually at 4%

indefinitely.
Phoenix has interest-bearing debt with a market value
of $1,150 million and a target D/V for EV of 0.48.
It also has $160 million of excess cash on hand and
owns undeveloped land it will never use with an
estimated after-tax market value of $25 million.
The company has a WACC of 7.5%, a 11.1% cost of
equity and 30 million common shares outstanding.
21

Free Cash Flow to Equity (FCFE)

Valuation, Phoenix, Inc., Continued

22

Share Repurchases: The Dividend

Alternative
Consider Midnight Oil, Inc.
Year 1 total dividends (FCFE) expected to be $50
million and grow by 4% in perpetuity
The cost of equity (required rate of return) is 12%
There are 20 million shares outstanding
What is the per-share equity value at t=0? Expected
DPS1? Expected per share equity value at t=1?
Assume expectations are met. Holding period return?
Repeat steps above, but value the stock at t=1 just
before dividends disbursed.
Instead of paying $50 million dividends at t=1, the $50
million is used to repurchase shares at t=1. HPR?
Composition of HPR?
23

Share Repurchases: Continued

($ amounts in
millions except
per-share
amounts.)

24

Share Repurchases: The Dividend

Alternative
Viewing only dividends and ignoring share
repurchases (if any) will understate the amount of
cash that is actually being returned to shareholders.
Traditional Payout ratios (Dividends/Net income) will
be misleading.
Modified payout ratio = (cash dividends + share
repurchases)/FCFE: a more comprehensive
measure of distributions/potential distributions.
Lets look at a few companies net income, dividends,
payout ratios, share repurchases, FCFE and
modified payout ratios
25

26

27

Free Cash Flow (FCF or FCFF)

FCFF = EBIT x (1-tax rate) + depreciation - net
working capital capital expenditures
FCFF = CFO + net interest expense x (1-tax rate)
capital expenditures
Can be thought of as cash flow amount available or
free for distribution to all capital providers.
FCFE if the company was all-equity financed.
For valuation use TVM formulas, just use FCFF for
cash flow (or value) items and WACC for discount rate.
28

Free Cash Flow (FCFF) Valuation

Voperating assets

FCFFt
FCFF2
EV

...
1
2
t
( 1 WACC) ( 1 WACC)
t 1 ( 1 WACC)

FCFF1

This method produces the value of the operating

assets the enterprise value (EV).
Must also add the value of any non-operating assets!
Value of firm = EV + value of non-operating assets =
value of debt + value of preferred equity + value of
common equity
For total common equity value, subtract market value
of interest-bearing debt and any preferred stock.
Divide total equity value by number of common shares
29

Free Cash Flow (FCFF) Valuation

Phoenix, Inc. has the following projected cash flow
streams. (Amounts in millions.)
Year
FCFE
FCFF

1
$65.89
$40.00

2
$58.13
$20.00

3
$79.53
$55.00

4
5
$97.92 $110.76
$85.00 $105.00

After year 5, FCFE and FCFF is expected to grow

annually at 4% indefinitely.
Phoenix has interest-bearing debt with a market value
of $1,150 million and a target D/V for EV of 0.48.
It also has $160 million of excess cash on hand and
owns undeveloped land it will never use with an
estimated after-tax market value of $25 million.
The company has a WACC of 7.5%, a 11.1% cost of
equity and 30 million common shares outstanding.
30

Free Cash Flow (FCFF) Valuation

31

FCFE and FCFF Valuation:

Deriving Cash Flows
-See handout or posted Excel File entitled
Snack Foods

32

The Price-Earnings (P/E) Ratio

Recall Growth Prospects, Inc: EPS1=$5, ROE=15%,
b=0.6, k=12.5%
P=$57.14, EPS1=$5, P/E =11.4
Recall Cash Cow, Inc: EPS1=$5, ROE=12.5%, b=0,
k=12.5%
P=$40, EPS1=$5, P/E=8

P0 1 PVGO

E1 k
E1

P0 1
PVGO
1

E1 k
E1 k

33

FedEx average
annual EPS
growth = 10.2%,
Con Ed = 1.6%

Average P/E, FedEx =

17.4, Con Ed = 15.7

34

Long-run Stable Growth P/E

EPS1 (1 b)
P0
k bROE

P0
(1 b)

EPS1 k bROE

A
Retention ratio 0.20
ROE
15%
Growth
3.0%
Cost of equity 10%
P/E1
11.4

B
0.20
15%
3.0%
12%

C
0.40
15%
6.0%
12%

D
0.40
12%
4.8%
12%

E
0.60
12%
7.2%
12%

8.9

10.0

8.3

8.3

35

P/E for High, Non-Constant Growth

Companies?
Same principles apply to high growth companies as for stable
growth companies:
Price = present value of all expected dividends
Compare current price to this (or next) years forecast earnings

36

P/E Ratios for Different Industries:

9/12/2012

37

Valuation by P/E Multiple

The rationale: Similar companies should have
similar P/E ratios, or, equivalently should sell for the
same multiple of its earnings.
Similar in what ways? Similar in ways weve already
encountered:
Same discount rate (risk or beta)
Same future (ST & LT) investment opportunities or
growth opportunities
Etc., etc.
38

Industry P/E
Waste Management Industry

Company

Price

Republic
$40.11
Services
Waste
$49.93
Management
Waste
$47.62
Connections
Casella Waste
$6.64
Systems

EPS1
EPS2
P/E1
Estimate
Estimate

P/E2

$2.05

19.57

$2.21

18.15

$2.54

19.66

$2.74

18.22

$1.96

24.30

$2.16

22.05

($0.13)

NM

$0.01

664.00

39

Enterprise Value Multiples for

Perpetuities

40

Enterprise Value Multiples for

Perpetuities

F
Tax rate
40%
Retention Rate 0.30
ROIC
12%
Growth
3.6%
WACC
10%
EV/EBIT
6.6

G
40%
0.30
15%
4.5%
10%
7.6

H
40%
0.40
15%
6.0%
10%
9.0

I
40%
0.40
15%
6.0%
9%
12.0

J
35%
0.40
15%
6.0%
9%
13.0

41

Example: Using the EV/EBIT Multiple

Implicit assumption: Similar companies should trade

at similar valuation multiples.
42

Valuation Multiples for Multi-Stage

Growth Companies
Tax rate
WACC
Invested Capital

40%
10.0%
$100

$130

$169

$220

2015(E) 2016(E) 2017(E)

$286

2018(E)

$366

2019(E)

$461

2020(E)

$544

2021(E)

$603

2022(E)

$627

$653

2023(E) 2024(E)

ROIC

30%

30%

30%

30%

28%

26%

24%

22%

20%

20%

Retention

1.00

1.00

1.00

1.00

1.00

1.00

0.75

0.50

0.20

0.20

EBIT

$50.0

$65.0

$84.5

$109.9

$133.3

$158.4

$184.3

$199.3

$201.1

$209.2

EBIT x (1-T)

$30.0

$39.0

$50.7

$65.9

$80.0

$95.1

$110.6

$119.6

$120.7

$125.5

Reinvestment
FCF

$30.0
$0.0

$39.0
$0.0

$50.7
$0.0

$65.9
$0.0

$80.0
$0.0

$95.1
$0.0

$82.9
$27.6

$59.8
$59.8

$24.1
$96.5

$25.1
$100.4

43

Why Use EV Multiples?/Problem(s) with P/E

Assume level
perpetuity.
Capex =
depreciation.
No change in
NWC.
ru = 10%.

re = 13.23%.

44

Why Use EV Multiples?/Problem(s) with P/E

45

Other Common EV Multiples

46

Example: Using the EV/EBITDA Multiple

47

Example: Using the EV/EBITDA Multiple

48

49

50

51

52

Example: Combining Multiples and DCF

53