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–Information set:
• Weak form of EMH : Past history of prices
of the particular security.
• Semistrong form of EMH: All publicly
available information.
• Strong form of EMH: All public and private
information.
Efficient Market Hypothesis
t = n CF
Value = t
t
t = 1 (1 + r)
where,
n = Life of the asset
CFt = Cashflow in period t
r = Discount rate reflecting the riskiness of the
estimated cashflows
Advantages of DCF Valuation
• Since DCF valuation, done right, is based upon an asset’s
fundamentals, it should be less exposed to market moods and
perceptions.
• If good investors buy businesses, rather than stocks (the
Warren Buffett adage), discounted cash flow valuation is the
right way to think about what you are getting when you buy an
asset.
• DCF valuation forces you to think about the underlying
characteristics of the firm, and understand its business. If
nothing else, it brings you face to face with the assumptions
you are making when you pay a given price for an asset.
Disadvantages of DCF valuation
• Since it is an attempt to estimate intrinsic value, it requires far
more inputs and information than other valuation approaches
• These inputs and information are not only noisy (and difficult
to estimate), but can be manipulated by the savvy analyst to
provide the conclusion he or she wants.
• For example:
– An entrepreneur can get a high valuation by overestimating
cashflows and/or underestimating discount rates.
– A venture capitalist can buy equity from an entrepreneur
at a lower price by underestimating cashflows.
– An entrepreneur and venture capitalist can get a higher
price for their IPO by overestimating cashflows and/or
underestimating discount rates.
Disadvantages of DCF valuation
• In an intrinsic valuation model, there is no guarantee that
anything will emerge as under- or over-valued. Thus, it is
possible in a DCF valuation model, to find every stock in a
market to be over-valued. This can be a problem for
– equity research analysts, whose job it is to follow
sectors and make recommendations on the most
under- and over-valued stocks in that sector
– equity portfolio managers, who have to be fully (or
close to fully) invested in equities
When DCF Valuation works best
• This approach is easiest to use for assets (firms) whose
– cashflows are currently positive and
– can be estimated with some reliability for future periods,
and
– where a proxy for risk that can be used to obtain discount
rates is available.
• It works best for investors who either
– have a long time horizon, allowing the market time to
correct its valuation mistakes and for price to revert to
“true” value or
– are capable of providing the catalyst needed to move price
to value, as would be the case if you were an activist
investor or a potential acquirer of the whole firm
Relative Valuation
• What is it?: The value of any asset can be estimated by looking at how
the market prices “similar” or ‘comparable” assets.
• Philosophical Basis: The intrinsic value of an asset is impossible (or
close to impossible) to estimate. The value of an asset is whatever the
market is willing to pay for it (based upon its characteristics)
• Information Needed: To do a relative valuation, you need
– an identical asset, or a group of comparable or similar assets
– a standardized measure of value (in equity, this is obtained by dividing
the price by a common variable, such as earnings or book value)
– and if the assets are not perfectly comparable, variables to control for
the differences
• Market Inefficiency: Pricing errors made across similar or comparable
assets are easier to spot, easier to exploit and are much more quickly
corrected.
Advantages of Relative Valuation
• Relative valuation is much more likely to reflect market
perceptions and moods than discounted cash flow valuation.
This can be an advantage when it is important that the price
reflect these perceptions as is the case when
– the objective is to sell a security at that price today (as in the case of
an IPO)
• With relative valuation, there will always be a significant
proportion of securities that are under- valued and over-
valued.
• Since portfolio managers are judged based upon how they
perform on a relative basis (to the market and other money
managers), relative valuation is more tailored to their needs
• Relative valuation generally requires less information than
discounted cash flow valuation (especially when multiples are
used as screens)
Disadvantages of Relative Valuation
• A portfolio that is composed of stocks which are undervalued
on a relative basis may still be overvalued, even if the
analysts’ judgments are right. It is just less overvalued than
other securities in the market.
• Relative valuation is built on the assumption that markets are
correct in the aggregate, but make mistakes on individual
securities. To the degree that markets can be over or under
valued in the aggregate, relative valuation will fail
• Relative valuation may require less information in the way in
which most analysts and portfolio managers use it. However,
this is because implicit assumptions are made about other
variables (that would have been required in a discounted cash
flow valuation). To the extent that these implicit assumptions
are wrong the relative valuation will also be wrong.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
• Value of Firm =
20
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
21
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
•
• Hence, picking a certain number for the Value/FCFF
ratio implies certain assumptions about k and g.
• Similarly, for
• Price/Earnings,
• Price/Sales,
• Price/EBITDA, etc.
22
When relative valuation works best..
• This approach is easiest to use when
– there are a large number of assets comparable to the one being valued
– these assets are priced in a market
– there exists some common variable that can be used to standardize
the price
• This approach tends to work best for investors
– who have relatively short time horizons
– are judged based upon a relative benchmark (the market, other
portfolio managers following the same investment style etc.)
– can take actions that can take advantage of the relative mispricing; for
instance, a portfolio manager specializing in technology stocks can buy
the under valued and sell the over valued assets
Financial Data about Companies
• Go to http://libraries.colorado.edu/
• Type “hoovers”
• “Go to this resource”
2017 Financial
Industry Market
Facebook Microsoft Google
Median Median1
Current Ratio 5.12 2.60 5.92 4.33 1.44
Quick Ratio 4.96 2.41 5.70 24.18 4.83
Leverage Ratio 1.48 1.83 1.25 1.31 5.46
Total
0.16 0.18 0.07 0.09 0.98
Debt/Equity
Interest
11.51 59.60 167.87 3.12 6.13
Coverage
2017 Valuation
Industry Market
Facebook Microsoft Google
Median Median1
Price/Sales Ratio 10.87 3.57 5.36 5.18 1.19
Price/Earnings
121.95 15.48 20.83 27.10 17.12
Ratio
Price/Book Ratio 3.06 3.91 3.57 3.46 1.90
Price/Cash Flow
26.74 8.33 14.62 16.29 7.78
Ratio
Price/Cash Flow Ratio for different k (in bold) and g (in italics)
k --> 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
g
0.5% 10.53 9.52 8.70 8.00 7.41 6.90 6.45 6.06 5.71 5.41 5.13
1.0% 11.11 10.00 9.09 8.33 7.69 7.14 6.67 6.25 5.88 5.56 5.26
1.5% 11.76 10.53 9.52 8.70 8.00 7.41 6.90 6.45 6.06 5.71 5.41
2.0% 12.50 11.11 10.00 9.09 8.33 7.69 7.14 6.67 6.25 5.88 5.56
2.5% 13.33 11.76 10.53 9.52 8.70 8.00 7.41 6.90 6.45 6.06 5.71
3.0% 14.29 12.50 11.11 10.00 9.09 8.33 7.69 7.14 6.67 6.25 5.88
3.5% 15.38 13.33 11.76 10.53 9.52 8.70 8.00 7.41 6.90 6.45 6.06
4.0% 16.67 14.29 12.50 11.11 10.00 9.09 8.33 7.69 7.14 6.67 6.25
4.5% 18.18 15.38 13.33 11.76 10.53 9.52 8.70 8.00 7.41 6.90 6.45
5.0% 20.00 16.67 14.29 12.50 11.11 10.00 9.09 8.33 7.69 7.14 6.67
5.5% 22.22 18.18 15.38 13.33 11.76 10.53 9.52 8.70 8.00 7.41 6.90
6.0% 25.00 20.00 16.67 14.29 12.50 11.11 10.00 9.09 8.33 7.69 7.14
6.5% 28.57 22.22 18.18 15.38 13.33 11.76 10.53 9.52 8.70 8.00 7.41
7.0% 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 9.09 8.33 7.69
7.5% 40.00 28.57 22.22 18.18 15.38 13.33 11.76 10.53 9.52 8.70 8.00
8.0% 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 9.09 8.33
8.5% 66.67 40.00 28.57 22.22 18.18 15.38 13.33 11.76 10.53 9.52 8.70
9.0% 100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 9.09
Contingent Claim (Option) Valuation
• Options have several features
– They derive their value from an underlying asset,
which has value
– The payoff on a call (put) option occurs only if the
value of the underlying asset is greater (lesser)
than an exercise price that is specified at the time
the option is created. If this contingency does not
occur, the option is worthless.
– They have a fixed life
• Any security or project that shares these features can be
valued as an option.
Direct Examples of Options
• Listed options, which are options on traded assets,
that are issued by, listed on and traded on an option
exchange.
• Warrants, which are call options on traded stocks,
that are issued by the company. The proceeds from
the warrant issue go to the company, and the
warrants are often traded on the market.
Indirect Examples of Options
• Equity in a deeply troubled firm - a firm with negative earnings
and high leverage - can be viewed as an option to liquidate
that is held by the stockholders of the firm. Viewed as such, it
is a call option on the assets of the firm.
• The reserves owned by natural resource firms can be viewed
as call options on the underlying resource, since the firm can
decide whether and how much of the resource to extract from
the reserve,
• The patent owned by a firm or an exclusive license issued to
a firm can be viewed as an option on the underlying product
(project). The firm owns this option for the duration of the
patent.
Advantages of Using Option Pricing
Models
• Option pricing models allow us to value assets that we
otherwise would not be able to value. For instance, equity in
deeply troubled firms and the stock of a small, bio-technology
firm (with no revenues and profits) are difficult to value using
discounted cash flow approaches or with multiples. They can
be valued using option pricing.
• Option pricing models provide us fresh insights into the
drivers of value. In cases where an asset is deriving its value
from its option characteristics, for instance, more risk or
variability can increase value rather than decrease it.
Disadvantages of Option Pricing Models
• When real options (which includes the natural
resource options and the product patents) are
valued, many of the inputs for the option pricing
model are difficult to obtain. For instance, projects do
not trade and thus getting a current value for a
project or a variance may be a daunting task.
• The option pricing models derive their value from an
underlying asset. Thus, to do option pricing, you first
need to value the assets. It is therefore an approach
that is an addendum to another valuation approach.
Discounted Cash Flow Valuation
Discounted Cashflow Valuation: Basis for
Approach
t = n CF
Value = t
t
– where, t =1 (1 + r)
t=n CF to Equity t
Value of Equity = (1+ k e )t
t=1
where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity
• The dividend discount model is a specialized case of equity
valuation, and the value of a stock is the present value of
expected future dividends.
II. Firm Valuation
• The value of the firm is obtained by discounting expected
cashflows to the firm, i.e., the residual cashflows after meeting
all operating expenses and taxes, but prior to debt payments,
at the weighted average cost of capital, which is the cost of
the different components of financing used by the firm,
weighted by their market value proportions.
t= n
CF to Firm t
Value of Firm =
t =1 (1+ WACC)
t
where,
CF to Firmt = Expected Cashflow to Firm in period t
WACC = Weighted Average Cost of Capital
Cash Flows and Discount Rates
• Assume that you are analyzing a company with the following
cashflows for the next five years.
Year CF to Equity Int Exp (1-t) CF to Firm
1 $ 50 $ 40 $ 90
2 $ 60 $ 40 $ 100
3 $ 68 $ 40 $ 108
4 $ 76.2 $ 40 $ 116.2
5 $ 83.49 $ 40 $ 123.49
Terminal Value $ 1603.008 $ 2363.008
• Assume also that the cost of equity is 13.625% and the firm
can borrow long term at 10%. (The tax rate for the firm is
50%.)
• The current market value of equity is $1,073 and the value of
debt outstanding is $800.
Equity versus Firm Valuation
Method 1: Discount CF to Equity at Cost of Equity to get value of
equity
• Cost of Equity = 13.625%
• PV of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 +
76.2/1.136254 + (83.49+1603)/1.136255 = $1073
Method 2: Discount CF to Firm at Cost of Capital to get value of
firm
Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%
WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94%
DCF Valuation
Estimating Inputs: Discount Rates
• Critical ingredient in discounted cashflow valuation. Errors in
estimating the discount rate or mismatching cashflows and
discount rates can lead to serious errors in valuation.
• At an intuitive level, the discount rate used should be
consistent with both the riskiness and the type of cashflow
being discounted.
– Equity versus Firm: If the cash flows being discounted are
cash flows to equity, the appropriate discount rate is a cost
of equity. If the cash flows are cash flows to the firm, the
appropriate discount rate is the cost of capital.
– Currency: The currency in which the cash flows are
estimated should also be the currency in which the
discount rate is estimated.
– Nominal versus Real: If the cash flows being discounted
are nominal cash flows (i.e., reflect expected inflation), the
Estimating Inputs:
Discount Rates or Cost of Capital (WACC)
P = D / (r-g)
r-g = D/P
r = D/P + g
I. Cost of Equity
• The dividend growth model (which specifies the cost of equity
to be the sum of the dividend yield and the expected growth in
earnings) is based upon the premise that the current price is
equal to the value. It cannot be used in valuation, if the
objective is to find out if an asset is correctly valued.
• A risk and return model, on the other hand, tries to answer
two questions:
– How do you measure risk?
– How do you translate this risk measure into a risk
premium?
• Industry Average Returns
– Assumes future returns of the company will be similar to
the past returns of firms in that industry.
– Needs no estimate of risk, or risk and return model.
Measuring Cost of Capital
• It will depend upon:
– (a) the components of financing: Debt, Equity
– (b) the cost of each component
• The cost of capital is the cost of each component weighted by
its relative market value.
WACC = ke (E/(D+E)) + kd (D/(D+E))
The Cost of Debt
• The cost of debt is the market interest rate that the firm has to
pay on its borrowing. It will depend upon three components-
(a) The general level of interest rates
(b) The default premium
(c) The firm's tax rate
What the cost of debt is and is not..
• The cost of debt is
– the rate at which the company can borrow at today
– corrected for the tax benefit it gets for interest
payments.
Cost of debt = kd = Interest Rate on Debt (1 - Tax
rate)
• The cost of debt is not
– the interest rate at which the company obtained
the debt it has on its books.
Estimating the Cost of Debt
• If the firm has bonds outstanding, and the bonds are traded,
the yield to maturity on a long-term, straight (no special
features) bond can be used as the interest rate.
• If the firm is rated, use the rating and a typical default spread
on bonds with that rating to estimate the cost of debt.
• If the firm is not rated,
– and it has recently borrowed long term from a
bank, use the interest rate on the borrowing or
– estimate a synthetic rating for the company, and
use the synthetic rating to arrive at a default
spread and a cost of debt
• The cost of debt has to be estimated in the same currency as
the cost of equity and the cash flows in the valuation.
Calculate the weights of each component
• Use target/average debt weights rather than project-specific
weights.
• Use market value weights for debt and equity.
– The cost of capital is a measure of how much it
would cost you to go out and raise the financing to
acquire the business you are valuing today. Since
you have to pay market prices for debt and equity,
the cost of capital is better estimated using market
value weights.
– Book values are often misleading and outdated.
Estimating Market Value Weights
• Market Value of Equity should include the following
– Market Value of Shares outstanding
– Market Value of Warrants outstanding
– Market Value of Conversion Option in Convertible Bonds
• Market Value of Debt is more difficult to estimate because few
firms have only publicly traded debt. There are two solutions:
– Assume book value of debt is equal to market value
– Estimate the market value of debt from the book value
II. Estimating Cash Flows
DCF Valuation
Steps in Cash Flow Estimation
• Estimate the current earnings of the firm
– Cash flows to equity: look at earnings after interest
expenses - i.e. net income
– Cash flows to the firm: look at operating earnings after
taxes
• Consider how much the firm invested to create future growth
– If the investment is not expensed, it will be categorized as
capital expenditures. To the extent that depreciation
provides a cash flow, it will cover some of these
expenditures.
– Increasing working capital needs are also investments for
future growth
Earnings Checks
• When estimating cash flows, we invariably start with accounting earnings.
To the extent that we start with accounting earnings in a base year, it is
worth considering the following questions:
– Are basic accounting standards being adhered to in the calculation of
the earnings?
– Are the base year earnings skewed by extraordinary items - profits or
losses? (Look at earnings prior to extraordinary items)
– Are the base year earnings affected by any accounting rule changes
made during the period? (Changes in inventory or depreciation
methods can have a material effect on earnings)
– Are the base year earnings abnormally low or high? (If so, it may be
necessary to normalize the earnings.)
– How much of the accounting expenses are operating expenses and
how much are really expenses to create future growth?
Estimating Cashflows
Free cashflow to Firm (FCFF): Cashflow to
common shareholders,
preferred shareholders, and
debtholders.
DCF Valuation
Ways of Estimating Growth in Earnings
• Look at the past
– The historical growth in earnings per share is
usually a good starting point for growth estimation
• Look at what others are estimating
– Analysts estimate growth in earnings per share for
many firms. It is useful to know what their
estimates are.
• Look at fundamentals
– Ultimately, all growth in earnings can be traced to
two fundamentals - how much the firm is investing
in new projects, and what returns these projects
are making for the firm.
I. Historical Growth in EPS
• Historical growth rates can be estimated in a number of
different ways
– Arithmetic versus Geometric Averages
– Simple versus Regression Models
• Historical growth rates can be sensitive to
– the period used in the estimation
• In using historical growth rates, the following factors have to
be considered
– how to deal with negative earnings
– the effect of changing size
Arithmetic versus Geometric Growth Rates
Year EPS Growth Rate
2000 1.50
2001 1.20 -20.00%
2002 1.52 26.67%
2003 1.63 7.24%
2004 2.04 25.15%
2005 2.53 24.02%
2006 2.23 -11.86%
Arithmetic Average = 8.54%
Geometric Average = (2.23/1.50) (1/6) – 1 = 6.83%
• The arithmetic average will be higher than the geometric
average rate
• The difference will increase with the standard deviation in
earnings
The Effects of Altering Estimation Periods
Year EPS Growth Rate
2001 1.20
2002 1.52 26.67%
2003 1.63 7.24%
2004 2.04 25.15%
2005 2.53 24.02%
2006 2.23 -11.86%
Taking out 2000 from our sample, changes the growth rates
materially:
Arithmetic Average from 2001 to 2006 = 14.24%
Geometric Average = (2.23/1.20)(1/5) = 13.19%
Dealing with Negative Earnings
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t High Growth Stable High Growth Transition Stable