Equity Valuation
-- 2017
Instructor: Jie
Brief Introduction
Topic weight:Study Session 1-2 Ethics & Professional Standards 10%-15%
Study Session 3 Quantitative Analysis 5%-10%
Study Session 4 Economics 5%-10%
Study Session 5-6 Financial Reporting and Analysis 15%-20%
Study Session 7-8 Corporate Finance 5%-15%
Study Session 9-11 Equity Valuation 15%-25%
Study Session 12-13 Fixed Income 10%-20%
Study Session 14 Derivative Investment 5%-15% Study Session 15 Alternative Investment 5%-10% Study Session 16-17 Portfolio Management 5%-10% Weights: 100%
Brief Introduction Content:
ØStudy Session 9: Equity Valuation:Valuation Concepts
• Reading 27: Equity Valuation:Applications and Process
• Reading 28: Return Concepts
ØStudy Session 10: Equity Valuation::Industry and Company Analysis and Discounted Dividend Valuation
• Reading 29: Industry And Company Analysis
• Reading 30:Discounted Dividend Valuation ØStudy Session 10: Equity Investments:Valuation Models
• Reading 31: Free Cash Flow Valuation
• Reading 32: Market-Based Valuation:Orice and Enterprise Value Multiples
• Reading 33: Residual Income Valuation
• Reading 34:Private Company Valuation
Brief Introduction
Exam-importance ranking:
• Reading 28: Return Concepts
• Reading 30:Discounted Dividend Valuation • Reading 31: Free Cash Flow Valuation
• Reading 32: Market-Based Valuation:Orice and Enterprise Value Multiples
Brief Introduction
考纲对比:
Ø与2016年相比，2017年考纲删除两个章节(the five competitive forces that shape strategy; your strategy needs a strategy)。其他 考点不变。
Brief Introduction
学习建议:Ø 本课程系统性地搭建了权益估值的框架，学员应能运用合适的估值概
念和技术对权益证券进行分析和评估，同时要掌握如何评估权益证券 的风险和预期回报
Ø 学习本课程需要一定的财务基础，建议同学开始学习本课程前先完成
财务报表分析学习
Ø 一定要及时做练习，推荐原版教材章节后练习题和历年模考题
Equity Valuation:Valuation Concepts(1)
Tasks:
ØDefine valuation and intrinsic value and explain sources of perceived mispricing
ØExplain the going concern assumption and contrast a going concern value to a liquidation value
ØDescribe definitions of value and justify which definition of value is most relevant to public company valuation
ØDefine applications of equity valuation
Definition of Valuation
Valuation
Sources of Perceived Mispricing
Intrinsic Value (V)
ØThe value of an asset given a complete understanding of the asset's investment characteristics.
Perceived Mispricing
ØThe difference between the estimated intrinsic value ( ) and the market price (P) of an asset
- P =(V - P) + ( -V) V - P = true mispricing - V = estimation error
E
V VE
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V
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V
Going-Concern VS. Liquidation
Going-Concern Value
ØThe value under a going-concern assumption that the company will continue its business activties into the foreseeable future
Liquidation Value
ØThe value if the company is dissolved and its assets sold individually
ØOrderly Liquidation Value: Assumes adequate time to realize liquidation value
Going-concern value > Liquidation value
Other Defintions of Value
Fair Market Value
ØThe price at which a willing, informed, and able seller would trade an asset to a willing, informed, and able buyer. Investment Value
ØThe value to a specific buyer taking account of potential synergies and based on the investor's requirements and expectations
Intrinsic value is most relevant to public company valuation
Applications of Equity Valuation 1. Stock selection—our focus
2. Inferring (extracting) market expectations
3. Evaluating corporate event (M&A, divestitures, spin-offs, etc) 4. Fairness opinions for mergers
5. Evaluating business strategies and models 6. Communication with investors and analysts 7. Valuing private business
Ø Importance: ☆
Ø Content:
• Sources of perceived mispricing • definitions of value
• application of equity valuation
Ø Exam tips:
• 理解察觉到的错误定价的来源
• 了解不同价值定义
• 理解权益估值的运用
Summary
Equity Valuation:Valuation Concepts(2)
Tasks:
ØDescribe questions that should be addressed in conducting an industry and competitive analysis
Øcontrast abusolute and relative valuation models and describe examples of each type of model
ØDescribe sum-of-the-parts valuation and conglomerate discounts
ØExplain broad criteria for choosing an appropriate approach for valuing a given company
Valuation Process
1. Understanding the business 2. Forecasting company performance 3. Selecting the appropriate valuation model 4. Converting forecasts to a valuation 5. Applying the valuation conclusions
Issues in Industry and Competitive Analysis
1. How attractive are the industries in terms of offering prospects for sustained profitability?
ØPorter's Five Forces help characterizing industry structure 1. Intra-Industry Rivalry
Issues in Industry and Competitive Analysis
2. What is the company's relative competitive position within its industry, and what is its competitive strategy? ØThe level and trend of the company's market share indicates its
relative competitive position
ØPorter's three competitive strategies 1. Cost leadership
2. Differentiation 3. Focus
Issues in Industry and Competitive Analysis
3. How well has the company executed its strategy and what are its prospects for future execution?
ØAnalysis of financial reports provides a basis for evaluating a company's performance against its strategic objectives and for developing expectations about irs future performance
ØTwo caveats merit mention:
1. The importance of qualitative factors must be considered (ownership structure, potential consequences of legal disputes, etc)
2. Avoiding simply extrapolating past operating results when forecasting future performance
Issues in Industry and Competitive Analysis
Quality of Earnings Analysis ØSelected quality of earnings indicators
• Recognizing revenue early
• Classification of nonoperating income as part of operations • Recognizing too much or too little reserves in current year • Deferral of expenses by capitalizing expenditures as an
asset
• Use of aggresive estimates and assumptions • Use of off-balance sheet financing
Valuation Models
Absolute Valuation Models
ØModels that specify an asset's intrinsic value • Present value model (Discounted cash flow model)
üDDM, FCF, Residual Income • Asset-based valuation Relative Valuation Models
Valuation of the Total Entity and its Components
Sum-of-the-Parts Value/Breakup Value/Private Market Value ØThe value for a company as a whole obtained by adding up the
values of individual parts of the firm Conglomerate Discount
ØThe market applies a discount to the value of a company operating in multiple and unrelated businesses compared to its sum-of-the-parts value
• Inefficient capital allocation among divisions
• Endogenous factors (poorly performing companies tend to expand by making acquisitions in unrelated businesses) • Research measurement errors
Selection of Appropriate Valuation Approach Ø Consistent with characteristics of company
• Understand the company and how its assets create value
Ø Based on quality and availability of data
• DDM problematic when no dividends • P/E problematic with highly volatile earnings
Ø Consistent with purpose of analysis
• Free cash flow vs. dividends for controlling interest
Ø Importance: ☆
Ø Content:
• valuation process
• issues in industry and competitive analysis • valuation models
• sum-of-the-part and conglomerate discount • selection of valuation approach
Ø Exam tips:
• 了解估值过程，行业与竞争分析中需要考虑的问题，估值
模型，分类加总法和跨业大企业估值折价，以及估值方法 选择要考虑的因素
Summary
Definitions of Return and
Equity Risk Premium (ERP)
Tasks:
ØDistinguish among realized holding period return, expected holding period return, required return, return from convergence of price to intrinsic value, discount rate, and internal rate of return
Return Concepts
Holding Period Return (HPR)
ØThe return earned from investing in an asset over s specified time period
Realized Return
ØHistorical return based on observed prices and cash flow
ØEqual to HPR Expected Return
ØReturn based on forecasts of future prices and cash flows yield
ØThe minimum level of expected return that an investor requires over a specified time period, given the asset's riskiness.
ØIt represents the opportunity cost for investment in the asset
ØIt is therefore the issuer's marginal cost of capital (cost of equity) Expected alpha = Expected return - Required return ØWhen expected alpha is higher than zero, the asset is
undervalued
ØThe rate used in finding the present value of a future cash flow
ØIt reflects the compensation required by investors for delaying consumption and for the risk of the cash flow
ØIt depends on the characteristics of the investment rather than on the characteristics of the investor
Internal Rate of Return (IRR)
ØThe discount rate that equates the present value of the asset's expected future cash flows to the asset's price
ØAn IRR coumputed under the assumption of market efficiency equals the required return on equity
Equity Risk Premium
Equity Risk Premium (ERP)
ØThe incremental return that investors require for holding equities rather than a risk-free asset.
ØThe risk free rate should be consistent with the investor's investment horizon
• T-Bills for short horizons • T-Bonds for longer holding periods
Approaches to Estimating ERP
Historical Estimates
ØThe mean value of the differences between broad-based equity market index returns and government debt returns over the sample period
• Strength—objective and simple • Weaknesses:
üAssumes stationary of mean and variance of returns over time
üUpwardly biased due to survivorship bias
üGeometric mean(lower) vs. arithmetic mean(higher)
üWhich risk-free rate to use (T-bond yield or T-bill yield?)
Approaches to Estimating ERP
Forward-Looking Estimates
ØEstimating the ERP based on current market conditions and expectations concerning economic and financial variables
• Strength—less subject to nonstationarity and data biases • Weaknesses:
ü Requires frequent updates
ü Makes lots of assumptions
Approaches to Estimating ERP
Forward-Looking Estimates - Gordon Growth Model
Ø =dividend yield on broad-based equity index based on year-ahead aggregate forecasted dividends and aggregate market value
Ø = Consensus long-term earnings growth rate
Ø = long-term government bond yield Multiple Growth Stages Model ØEquity index price
=PVFastGrowthStage(r)+PVTransition(r)+PVMatureStage(r)
Approaches to Estimating ERP
Forward-Looking Estimates - Macroeconomic Model ØEstimating the ERP from expected macroeconomic and financial
variables such as inflation, earning growth, P/E growth, etc. • Strength—use of proven models and current information • Weakness—only appropriate for developed counties where
Approaches to Estimating ERP
Example of Macroeconomic Model - Ibbotson and Chen Model
ERP = EDY+[(1+EINFL)(1+EGREPS)(1+EGPE)-1]-E( ) ØEDY=expected dividend yield
ØEINFL=expected inflation (yield spread between T-bond and TIPS)
ØEGREPS=expected growth rate in real earnings per share (approximately track the real GDP growth rate)
ØEGPE=expected growth rate in the P/E ratio (the baseline value is zero)
Ø =expected risk-free return
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Approaches to Estimating ERP
Forward-Looking Estimates - Survey Estimates
ØAsking a sample of experts about their expectations for ERP • Strength—easy to obtain
• Weakness—wide disparity among experts
Ø Importance: ☆☆
Ø Content:
• return concepts • ERP estimation
Ø Exam tips:
• 了解不同回报率概念
• 重点掌握权益风险溢价(ERP)评估方法的优缺点和计算。
Summary
Estimation of Required Return (1)
Tasks:
ØEstimate the required return on an equity investment using the capital asset pricing model, the Fama-French model, the Pastor-Stambaugh model, macro-economic multifactor models
ØExplain beta estimation for public companies, thinly traded public companies and nonpublic companies
Models of Required Return
ØThe Capital Asset Pricing Model
ØThe Multifactor Models (APT)
ØThe Build-up Methods
Models of Required Return
The Capital Asset Pricing Model
ØInvestors evaluate the risk of an asset in terms of the asset's contribution to the systematic risk of their portfolio
ØThe beta measures the asset's systematic risk
ØIt assumes that equity prices are largely determined by local investors
ØThe assumption that all investors worldwide participate equally in setting prices results in the international CAPM in which risk premium is relative to a world market portfolio
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Beta Estimation
Beta for a Public Company
ØResulting from regressing the company's returns on the returns of the market index (raw beta, or unadjusted beta)
ØBeta Drift: the beta value in future tends to be closer to the mean value of 1
ØAdjusted Beta = (2/3)(Unadjusted beta) +(1/3)(1)
Beta Estimation
Beta for Thinly Traded stocks or Nonpublic Companies ØFour-step procedure
1. Identify a publicly traded firm with similar industry characteristics
2. Estimate the beta of the publicly traded firm using regression -> BE
Models of Required Return
Multifactor Models
ØUse multiple factors to explain returns
ØCAPM is a single factor model
ØArbitrage pricing theory (APT) models are based on a multifactor representation of the drivers of return
• β = factor sensitivity/factor beta=the asset's sensitivity to a particular factor (holding all other factors constant)
• Factor risk premium=the expected return of a particular factor in excess of the risk-free rate
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Models of Required Return
Arbitrage Pricing Theory (APT) ØThe Fama-French Model
ØThe Pastor-Stambaugh Model
ØMacroeconomic Multifactor Model(The BIRR Model)
Models of Required Return
The Fama-French Model (FFM)
ØRMRF = the return on a market value-weighted equity index in excess of the one-month T-bill rate
ØSMB (small minus big), a size factor = small-cap return premium = the mean return to shorting large-cap shares and investing the proceeds in small-cap shares
ØHML(high minus low), a value factor = value return premium = the mean return from shorting low book-to-market(high P/B) shares and investing the proceeds in high book-to-market shares
Models of Required Return
The Pastor-Stambaugh Model (PSM)
ØThe PSM model adds to the Fama-French model a liquidity factor
ØLIQ, a liquidity factor = liquidity return premium = the mean return to shorting high-liquidity shares and investing the proceeds in low-liquidity shares
Models of Required Return
Macroeconomic Multifactor Model
ØThe FFM and PSM models are based on multiple fundamental factors that reflect attributes of the stocks or issuers themselves
ØThe macroeconomic factor models are based on multiple macroeconomic factors that affect the expected future cash flows of the stocks or issuers and the discount rate appropriate to determining their present value
Models of Required Return
Macroeconomic Multifactor Model
ØA specific example is the five-factor BIRR model (Burmeister, Roll, Ross)
• Confidence risk: the unanticipated change in the return difference between risky corporate bonds and T-bonds • Time horizon risk: the unanticipated change in the return
difference between T-bonds and T-bill
• Inflation risk: the unexpected change in inflation rate • Business cycle risk: the unexpected change in the level of
real business activity
• Market timing risk: the portion of the total return that remains unexplained by the first four risk factors
Ø Importance: ☆☆☆
Ø Content:
• capital asset pricing model • beta estimation
• multifactor models(Fama-French, Pastor Stambaugh, BIRR models)
Ø Exam tips:
• 重要考点，掌握权益要求回报的各种评估方法的计算及其
特征 Summary
Estimation of Required Return (2)
Tasks:
ØEstimate the required return on an equity investment using the buiild-up method
ØDescribe strengths and weaknesses of methods used to estimate the required return on an quity investment
ØExplain international considerations in required return estimation
Models of Required Return
Build-Up Method
ØEstimating the required return as the sum of the risk-free rate and a set of risk premiums
ØIt is useful when beta estimates are “unobtainable”
ØWidely used for closely held companies
scounts)
Models of Required Return
Build-Up Method for Private Business Valuation
Ø = required return on average-systematic-risk large-cap public stocks
ØThe size premium is inversely related to the company size
ØUnsystematic risk related to a privately-held company is less easily diversified away
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Models of Required Return
Bond Yield Plus Risk Premium
ØAppropriate for companies with publicly traded debt
ØRequired return (cost of equity) = YTM on the company's long term debt + risk premium
ØThe YTM on the company's long term debt include: • a real interest rate and a premium for expected inflation • a default risk premium which captures factors such as
profitability, the sensitivity of profitability to the business cycle, and leverage(operating, financial)
ØThe risk premium compensates for the additional risk of the equity holders compared with the debt holders
Strengths and Weaknesses of Required Return Approaches
ØCAPM—simple, easy to compute, single factor model but simplicity comes with potential loss of explanatory power
Ø Multi-factor models—higher explanatory power but more complex and expensive
International Considerations in Required Return Estimation
Ø Exchange rates—compute the required return in the home currency and adjust it by the forecast for the change in the exchange rate
Ø Country Spread Model—use a developed market benchmark and add an emerging market premium
Equity risk premium for an emerging market = Equity risk premium for a developed market + Country premium
• Country premium= YTM of emerging market – YTM of developed market
Weighted Average Cost of Capital
Ø(1-tax rate) adjusts the pretax cost of debt downward to reflect the tax duductibility of interest payments
ØUse the target capital structure
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WACC d
Discount rate Selection in Relation to Cash Flow
ØFirm value = FCFF, discount at WACC
ØEquity value = FCFE/Dividend, discount at RE
• Use FCFE when capital structure are not volatile • Use FCFF with high debt levels, negative FCFE ØEquity value = firm value – MV of debt
ØNominal (real) discount rate must be used with nominal (real) cash flows
Important: you must align the discount rate with the cash flows !
Ø Importance: ☆☆
Ø Content:
• the build-up method • the international consideration
• WACC
• discount selection
Ø Exam tips:
• 重点掌握权益要求回报的叠加法
• 理解不同权益要求回报评估方法的优缺点，以及国际考虑
• 掌握WACC计算，在给定现金流时能选择匹配贴现率
Industry and Company Analysis (1)
Tasks:
ØCompare top-down, bottom-up, and hybrid approaches for developing inputs to equity valuation models
ØCompare “growth relative to GDP growth” and “market growth and market share” approaches to forecasting revenue
ØEvaluate whether economies of scale are present in an industry by analyzing operating margins and sales levels
ØForecast COGS, SG&A, Financing costs and income taxes
Approach for developing inputs to equity valuation models
Ø Bottom-up analysis:start with analysis of an individual company or its business segments
Ø Top-down analysis: begins with expectations about a macroeconomic variable (e.g. GDP)
Ø Hybrid analysis: incorporate elements of both top-down and bottom-up analysis.
Top-Down Approaches to Modeling Revenue Growth Relative to GDP Growth
ØThe relationship between GDP and company sales could be modeled as “GDP growth plus x%”, or “GDP growth rate times (1+x%) Market Growth and Market Share
ØForecasting growth of industry sales, and how the company's market share is likely to change over time
ØRevenue = market share×market sales
Economies of Scale in an industry
ØSales volume and margins tend to be positively correlated
ØEconomies of Scale are observed when larger companies:
• have larger margin
Forecasting COGS, SG&A, Financing Costs, Income Taxes
Cost of Goods Sold (COGS) ØCOGS has a direct link with sales
Forecasted GOGS = (historical COGS/revenue)*(estimate of future revenue) or
Forecasted COGS = (1 – gross margin)*(estimate of future revenue)
ØBe aware of the impact of the company's hedging strategy on gross margin
ØCompetitors' gross margins can provide a useful cross check
Forecasting COGS, SG&A, Financing Costs, Income Taxes
Selling, General, and Administrative Expenses (SG&A) ØSG&A overall are less closely linked to revenue than COGS
ØSelling and distribution expenses are more variable than others and can be estimated as a percentage of sales
ØOther general and administrative expenses (overhead costs, R&D expenses, etc) are more fixed in nature
Forecasting COGS, SG&A, Financing Costs, Income Taxes
Financing Costs
ØGross interest expense depends on the level of debt and market interest rates
Net debt = gross debt – cash/cash equivalents – short term securities
Net interest expense = gross interest expense – interest income on cash and short term debt securities
Forecasting COGS, SG&A, Financing Costs, Income Taxes
Income Taxes
ØStatutory tax rate: the tax rate applying to what is considered to be a company's domestic tax base
ØEffective tax rate: calculated as the reported tax amount on the income statement divided by pre-tax income
ØCash tax rate: the tax actually paid divided by pre-tax income
Ø Importance: ☆☆
Ø Content:
• Approaches for developing inputs • Modeling revenues
• Economies of scale
• Forecasting COGS, SG&A, financing costs and income taxes
Ø Exam tips:
• 重点掌握预期revenue, COGS, SG&A, financing costs和 income taxes的计算方法
• 能判断行业和公司是否实现规模经济
Summary
Industry and Company Analysis (2)
Tasks:
ØDescribe approaches to balance sheet modeling
ØDescribe the relationship between return on invested capital and competitive advantage
ØExplain how competitive factors affect prices and costs
ØJudge the competitive position of a company based on a Porter’s five forces analysis
ØExplain how to forecast industry and company sales and costs when they are subject to price inflation and deflation
Balance Sheet Modeling
ØMany balance sheet items flow directly from, or very closely linked to income statement.
ØPP&E: determined by depreciation and capital expenditures
ØCapital expenditures include:
• Maintenance capital expenditure necessary to sustain the current business
• Growth capital expenditure needed to expand the business ratio
inventory
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Return on Invested Capital and Compatitive Advantage
ØReturn on invested capital (ROIC) measures the profitability of the capital invested by the company's shareholders and debt holders
ØInvested capital = operating assets - operating liabilities • ROIC is not affected by financial leverage
Competitive position based on Porter’s model ØThreat of substitute
• Pricing power and profitability are limited when numerous substitutes exist and switching costs are low.
ØRivalry among incumbent companies
• Pricing power and profitability are limited when industries are fragmented, have limited growth, high exit barriers, high fixed costs, identical products
ØBargaining power of suppliers
• Profitability is limited when suppliers have greater ability to increase prices, limit the quality and quantity of inputs
Competitive position based on Porter’s model ØBargaining power of customers
• Pricing power and profitability are limited when industries have a concentrated customer base, standardized product, low switching costs for customers
ØThreat of new entrants
• Pricing power and profitability are limited when barriers to entry are low
Industry/Company sales - inflation and deflation
ØCompanies that can pass on inflation through higher prices are likely to have higher and more stable profits and cash flow
• Industry structure is an important factor
• Price-volume trade-off makes accurate revenue projections difficult
ühigher price have a negative impact on volume
üthe decline in volume depend on price elasticity of demand, the reaction of competitors, and availability of substitutes
Industry/Company costs - inflation and deflation ØThe impact of volatility in input costs can be mitigated by:
• long-term price-fixed forward contracts and hedges • access to alternative inputs
• vertically integrated
Ø Importance: ☆☆
Ø Content:
• Balance sheet modeling • return on invested capital • Porter’s model
• Impact of inflation and deflation on sales and costs
Ø Exam tips:
• 掌握资产负债表相关科目的预期方法，计算ROIC，利用波
特模型分析行业竞争环境
• 理解通胀和紧缩对销售额和成本的影响
Summary
Industry and Company Analysis (3)
Tasks:
ØEvaluate the effects of technological developments on demand, selling prices, costs, and margins
ØExplain considerations in the choice of an explicit forecast horizon
ØExplain an analyst’s choices in developing projections beyond the short-term forecast horizon
ØDemonstrate the development of a sales-based pro forma company model
Effects of technological developments on demand, price, costs and margin Ø Technological developments can decrease costs of production,
increase profit margins and industry supply and sales
Ø Result in improved substitutes or wholly new products
• Cannibalization factor: the percentage of the market for the existing product that will be taken by the new substitute
Forecast Horizon
Forecast horizon = expected holding period
Ø The horizon for highly cyclical companies should be long enough to include the middle of a business cycle.
Ø Use normalized earnings: expected mid-cycle earnings in the absence of any unusual or temporary factors
Forecast Horizon
ØThe difficult part is recognizing inflection points: instances when the future will not be like the past, due to changes in such as: • Overall economic environment
• Business cycle stage • Government regulations • technology
Methods for projections beyond short term
ØAssume that a trend growth rate of revenue over the previous cycle will continue.
ØUse the earnings/some measure of cash flow over a forecast period, plus the terminal value
ØThe terminal value is can be estimated using either a relative valuation (price multiple) or discounted cash flow approach (DDM)
Sales-based pro forma model
Steps in developing a sales-based pro forma model: 1. Estimate revenue growth and future expected revenue 2. Estimate COGS
3. Estimate SG&A 4. Estimate financing costs
5. Estimate income tax expenses and cash taxes
6. Estimate cash taxes, taking into account changes in deferred tax items
7. Model the balance sheet based on items from income statement
8. Estimate capital expenditure and net PP&E
9. Construct a pro forma cash flow statement with the completed pro forma income statement and balance sheet
Ø Importance: ☆
Ø Content:
• Effects of technological developments • Forecast horizon
• Sales-based pro forma model
Ø Exam tips:
• 评估技术发展对需求，价格，成本，和利润的影响
• 了解影响预期长度的因素
• 了解长期预期方法
• 了解基于销售额的预期模型
Overview of Discounted Cash Flow Models
Tasks:
ØCompare dividends, free cash flow, and residual income as inputs to discounted cash flow models
ØIdentify investment situations for which each measure is suitable
ØCalculate and interpret the value of a common stock using the dividend discount model for single and multiple holding periods
Discounted Cash Flow Valuation
ØAn asset’s intrinsic value is the present value of its expected
future cash flows
ØMeasures of “cash flow”
• Dividends = cash paid to shareholders, used in DDM • Free cash flow = cash “available” to pay shareholders • Residual income = economic profit
• Key point: Valuation metric (e.g., divs or FCF) must be measurable and related to earnings power
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Dividends
ØAdvantages
• Dividendsless volatile than other cash flow measures, more stable and predictable
• DCF model is less sensitive to short term fluctuations in underlying value
• Theoretically justified – dividends are what you receive when you buy a stock
• DCF models reflectlong term intrinsic value
• Accounts forreinvested earnings to provide a basis for increased future dividends
Dividends
Ø Disadvantages
• Firm maynot pay dividends due to lack of profitability or little cash available for distribution
• Historically many firms arepaying less dividends for tax reasons
Dividends Suitability
ØSituations when appropriate
• Company has history of paying dividends
• Board of directors has a dividend policy that has an understandable andconsistent relationship to profitability • Minority shareholder takes anon-control perspective • Mature firms, profitable but not fast growth
Free Cash Flow (FCF) Definitions
Ø Free cash flow to the firm (FCFF) is cash flow from operations (CFO) minus net capital expenditures, represents firm ownership
Ø Free cash flow to equity (FCFE) is cash flow from operations minus net capital expenditures minus net payments to debt holders (interest and principal), represents returns to equity ownership
Free Cash Flow (FCF)
ØAdvantages
• Used with any firm that has different dividend and financing/leverage policies
• FCF can be viewed as what a firm could pay in dividends • Popular with many analysts
ØDisadvantages
• Negative free cash flow, resulting from large capital expenditure demands
• May requirelong forecast periods for CF to turn positive, introducing greater model uncertainty
Free Cash Flow (FCF)
Ø Situations when appropriate • No dividend payment history
• Dividends not related to earnings or dividends and FCF differ significantly
• FCF consistent with profitability within a reasonable time period
Residual Income (RI) Definition
Ø Residual income is the earnings in excess of the investors’ required return on the beginning-of-period investment (common stockholders' equity)
Ø RI focuses on profitability in relation to all opportunity costs faced by the firm
Ø Intrinsic value equals the book value per share plus the present value of expected future residual earnings, similar to DDM and EVA
Residual Income (RI)
Ø Advantages
• Wide applicability, even if FCF < 0 • Used for dividend and non-div paying firms
• Incorporates opportunity cost of capital for both debt and equity holders
• Brings recognition value closer to thepresent by focusing on current book value plus forecasted residual income
• Restated dividend discount model
Residual Income (RI)
Ø Disadvantages
•Application of the RI model requires a detailed knowledge of accrual accounting
• The quality of accounting disclosure can make the use of RI valuation less robust and more error prone
Ø Situations when appropriate
• Used with firms that haveno dividend history • Used withnegative FCF
• Less horizon dependence
Dividend Discount Models
ØThe Rule: Value is present value of all future dividends discounted at required return
Ø Problem: Requires estimation of infinite stream of CFs
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Single Period DDM
Ø Single-period DDM is the present value of the future dividend and sales price
Ø Notice that there are two cash flows in the final period!
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Ø For n-period model, the value of a stock is the present value of the expected dividends for the n periods plus the present value of the expected price in n periods
Øthe expected price in n periods depends on the expected dividends after the n periods.
Example: Fragrance Ltd. Expects dividends of €1, €1.5, and €2.0 over the next three years. Expected stock price at the end of year 3 is €80. If the cost of equity is 18%, compute the value of Fragrance shares today.
If the current market price of Fragrance Ltd is 45.00 euros, then the security is undervalued
3
31.0 1.5 2.0 80 EUR51.83
1.18 1.18 1.18
To use the DDM, the forecasting problem must be simplified. Two broad approaches exist:
1. Future dividends can be forecast by assuming one of several stylized growth patterns
• constant growth forever (Gordon growth model) • two distinct stages of growth
• three distinct stages of growth
Ø Importance: ☆☆
Ø Content:
• DDM
• FCFE/FCFF models • Residual income models
Ø Exam tips:
• 了解DDM，FCF，和residual income模型的优缺点，能判断
每个模型适合的情景
• 能运用单期和多期DDM对权益证券进行估值
Summary
Gordon Growth Model
Tasks:
ØCalculate the value of a common stock using the Gordon growth model and explain the model’s underlying assumptions
ØCalculate and interpret the implied growth rate of dividends using the Gordon growth model and current stock price
ØCalculate and interpret the present value of growth opportunities and the component of the leading price-to-earnings ratio related to PVGO
ØCalculate and interpret the justified leading and trailing P/E using Gordon growth model
Gordon Growth Model
0 1
0 D (1 g) D
V
(r g) (r g)
where
D1 = Dividend expected in one year g = sustainable growth rate r = required return on equity
Gordon Growth Model Assumptions:
1. Dividends grow at constant rate (g) forever 2. Growth rate less than required return (r > g) Situations in which model is useful:
• Mature (late in life cycle) firms • Broad-based equity index
• Terminal value in more complex models • Estimate g, r and PVGO
Gordon Growth Model
Ø The GGM model should reflect long-term growth
expectations – GDP growth, industry life cycle stages and the impact of the five force model
Ø The model’s intrinsic values V0 are very sensitive to the input variables for r and g
Ø Sensitivity analysis may be required to obtain a range of values rather than a specific point estimate of value
Gordon Growth Model
Ø Example: A firm paid a dividend yesterday of $1.50 and dividends are expected to grow at a long term constant rate of 5%. The required return is 10%. Calculate the intrinsic value
Ø Correct answer
V0 = ($1.50 × 1.05) / (0.10 – 0.05) = $31.50
Gordon Growth Model - Implied Growth Rate
Ø Assume:
• Firm just paid $1.20 dividend per share • Required return is 13%
• Market price is $15.75
Ø Implied dividend growth rate is:
$1.20 1 g $15.75
0.13 g g 0.05 5.0%
Gordon Growth Model - Required Return - r
Ø Point: DDM can be used to find implied r Ø Solving GGM for r:
Ø Example: If dividends today are $1.60 and the current price is $40 with expected growth of 9% the required return is:
1 0
D
r =
+ g
P
% 36 . 13 % 9 40
9%) 1.6(1
Present Value of Growth Opportunities (PVGO)
Ø Increase in shareholder wealth comes when reinvested earnings are directed toward investments which earn greater returns than the opportunity cost of the funds needed to undertake the project (ROE > r or ROIC > WACC)
ØCompanies without positive NPV projects should distribute all earnings in dividends because earnings cannot be reinvested profitably and earnings will be flat in perpetuity, assuming a constant ROE
Present Value of Growth Opportunities (PVGO)
ØStock value is the sum of
• Value of no growth (E1/r)
• Present value of future growth opportunities (PVGO) V0 = E1/r + PVGO
ØComponent of leading P/E related to PVGO
P0/E1 = 1/r + PVGO/E1
• 1/r is the P/E1 ratio for a no growth company • PVGO/E1 is the P/E1 component related to growth
Present Value of Growth Opportunities (PVGO)
Ø Example: ABV Inc. shares sell for $80 on future earnings per share of $4.00. If the required return is 20%, compute the PVGO.
$4.00 $80 0.20 PVGO
PVGO = $80-$20 = $60
Market assigns 75% of the price ($60/$80) to future growth
Gordon Growth Model - Justified P/E
Ø The Gordon model can also be used to calculate a “justified (or fundamental)” price multiple
ØJustified leading P/E1 ,
• assuming constant dividend payout ratio • define b as the retention rate
1 0
1 0 1 1 D P =
r - g D
P E
justified leading = = E r - g
Gordon Growth Model - Justified P/E
ØJustified trailing P/E0
• assuming constant dividend payout ratio • define b as the retention rate
g
• Gordon growth model
• Implied growth rate, required return
• PVGO
• Justified P/E
Ø Exam tips:
• 必须掌握戈登增长模型计算和适用前提，能利用戈登增长
模型计算增长率和要求回报率 • 必须掌握PVGO和justified P/E计算 Summary
Multi-Stage Models (1)
Tasks:
ØCalculate the value of a preferred stock
ØExplain the assumptions and justify the selection of the two-stage DDM, the H-model, the three-two-stage DDM
ØDescribe terminal value and explain alternative approaches to determining the terminal value in a DDM
ØCalculate and interpret the value of common shares using the two-stage DDM, the H-model, and three-stage DDM
ØEstimate a required return based on any DDM
Valuation of Non-Callable, Fixed Rate, Perpetual, Preferred Stock
Ø Use the Gordon Growth Model to value preferred stock
Ø The discount or capitalization rate r is often at a positive spread over the firms junior ranking debt yield
Ø Fixed rate level dividends are ranked senior to equity and extend indefinitely into the future
P0 = Annual fixed Dividend/ Capitalization rate
ØExample:
• Annual Dividend = $12 • r = 10%
Multi-Stage DDM Models
ØGrowth can fall into three distinct stages: • Growth phase
ü Rapid EPS growth, negative FCF
ü ROE > r, no or low dividend payout • Transition phase (transition to maturity)
ü Sales and EPS growth slow, dividend payout increases
ü ROE approaching r, positive FCF • Mature phase
ü Growth at economy-wide rate, positive FCF
ü ROE = r, high competition, saturation
Multi-Stage DDM Models
Ø Terminal value = forecasted value at beginning of the final mature growth phase
Ø Two estimation methods:
1. Apply a price multiple to a projected terminal value of a fundamental such as P/E, P/B
2. Gordon Growth Model
Ø the terminal value is then discounted back and added to the present value of prior stage dividends
Multi-Stage DDM Models Terminal value - Example: Postini Ltd had the following data
• D0 = $1.00, payout ratio of 40%, gS = 9.0% for four years and r = 10%
• Trailing P/E for t = 4 is 15.0 Answer: Forecasted EPS for year 4 is • E4 = $1.00(1.09)4 / 0.40 = $3.52
• Apply trailing multiple (P/E) × forecasted EPSt in year t Ø Terminal value in year 4 = 15 × $3.52 = $52.93
Two-Stage DDM Models
ØFirst version of the two-stage DDM assumes:
• the whole of stage 1 represents a period of fixed and abnormal growth
• growth rate is expected to drop suddenly to a mature growth rate at stage 2
08
-L2
-SS
12-S76
Dividend Growth (g)
15%
3%
Stage 1 Stage 2
4 years
Two-Stage DDM Models
ØFirst version of the two-stage DDM assumes: • = the extraordinary growth rate at the first stage
Two-Stage DDM Models
ØSecond version of the two-stage DDM assumes - H-model
• the growth rate declines linearly from an abnormal rate to the mature growth rate during the course of stage 1 • constant growth at the mature growth rate in stage 2
Dividend Growth (g)
15%
3%
Stage 1 Stage 2 4 years
Two-Stage DDM Models
ØH-model:
• = the extraordinary growth rate at the first stage • = the mature growth rate at the second stage • H = half-life in years of the high-growth period
• the first term on the right-hand side is the present value of the company if it were to grow at forever
• the second term is an approximation of the extra value accruing to the stock due to its supernormal growth for year 1 to 2H.
s
Two-Stage DDM Models
Example: BTeam, Inc., currently pays a dividend of $1.30. The growth rate is 25% and is expected to decline over the next 5 year horizon to a stable rate of 5% thereafter. The required return is 14%.
Calculate the intrinsic value of BTeam stock using the H-Model.
H-Models - Required Return - r
For H-model, the required rate of return can be derived as:
Example: BTeam, Inc., currently pays a dividend of $1.30. The growth rate is 25% and is expected to decline over the next 5 year horizon to a stable rate of 5% thereafter. Calculate the implied expected return for BTeam if the market price is $30.
L
• Valuation of preferred stock • Estimation of terminal value • Two-stage DDM (H-model)
Ø Exam tips:
Multi-Stage Models (2)
Tasks:
ØCalculate and interpret the value of common shares using the two-stage DDM, the H-model, and three-stage DDM
ØExplain the use of spreadsheet modeling to forecast dividends and to value common shares
ØCalculate and interpret the sustainable growth rate of a company and demonstrate the use of DuPont analysis to estimate a company’s sustainable growth rate
Three-Stage DDM Models Two version of 3-stage model
1. Three distinct phases, simply add an additional growth stage to the two stage model
• Growth, transition, and mature 1. High-growth phase + H-model pattern
Three-Stage DDM Models
Example: Netweb Inc.’s current annual growth rate of 25% is expected to last three years and then fall linearly to a sustainable 3% over the following seven years.
The most recent dividend was $0.30 and the required return on equity is 10%.
Calculate the value of Netweb’s shares today.
Three-Stage DDM Models
0 1 2 3
D1 = D2 = D3 =
P3 =
$12.48
$0.375
$0.469
$15.646
$0.586 + $15.06
0 $0.375 $0.469 $15.6462 3
P 1.1 1.1 1.1 $12.48
$0.30 × 1.251 = $0.375 $0.30 × 1.252 = $0.469 $0.30 × 1.253 = $0.586
7
$0.586 0.25 0.03
$0.586 1.03 2 $15.06
0.10 0.03 0.10 0.03
Multi-Stage DDM Models
Ø Strengths
• Ability to model many growth patterns • Solve for V, g, and r
ØWeaknesses
• Require high-quality inputs (GIGO) • Model must be fully understood • Value estimates sensitive to g and r • Model suitability very important
Spreadsheet Modeling
ØCan handle any range of growth assumptions over varying periods
ØThe most flexible method Steps:
• Establish base level cash flows
• Forecast deviations for near future (e.g., supernormal growth for first four years)
SGR: The Sustainable Growth Rate
Ø SGR (g) = sustainable growth rate in earnings and dividends if we assume:
• Growth from internally generated sources • Capital structure remains unchanged • No new equity issued
g = retention rate×ROE
• the lower the earnings retention ratio, the lower the growth rate (dividend displacement of earnings)
SGR: The Sustainable Growth Rate
Example: Green, Inc. pays out 25% of it’s $1.00 of earnings as dividends, BVPS is $10.00 therefore Green earns an ROE of 10%. Compute SGR.
SGR = Retention rate× ROE SGR = (1 – 0.25) × 10% = 7.5%
SGR: The Sustainable Growth Rate
Ø 3-Part DuPont ROE Decomposition:
• Note: Always use beginning of year balance sheet numbers on exam (unless told otherwise)
g = retention ratio*net profit margin*asset turnover*leverage
net incom e sales assets ROE sales assets equity
net profit asset equity ROE
m argin turnover m ultiplier
Ø Importance: ☆☆
Ø Content:
• Three-stage DDM • Spreadsheet modeling • Sustainable growth rate
Ø Exam tips:
• 重点掌握三阶段估值模型
• 理解持续增长率的假设，能利用杜邦系统评估持续增长率
Introduction to FCFF and FCFE
Tasks:
ØCompare the free cash flow to the firm and free cash flow to equity approaches to valuation
ØExplain the ownership perspective implicit in the FCFE approach
Introduction to Free Cash Flows
ØDividends are the cash flows actually paid to stockholders ØFree cash flows are the cash flows 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)
Introduction to Free Cash Flows ØFCFF(FreeCash Flowtothe Firm)
Cash available to shareholders and bondholders after taxes, capital investment, and WC investment, pre-levered cash flow ØFCFE(Free Cash Flowto Equity)
Cash available to equity holders after payments to and inflows from bondholders, post-leverage cash flow
Not equal to dividends actually paid
Introduction to Free Cash Flows ØStrengths
• Used with firms that have no dividends
• Functional model for assessing alternative financing policies
• Rich framework provides additional detailed insights into company
• Other measures such as EBIT, EBITDA, and CFO either double count or omit important cash flows
ØLimitations
• If FCF < 0 due to large capital demands
Ownership Perspective Ø FCFE = control perspective
•Ability to change dividend policy
•Used in control perspective
Ø DDM = minority owner
•No control
•Used in valuing minority position in publicly traded shares
Ø Importance: ☆☆
Ø Content:
• Strengths and limitations of FCF models • Ownership perspectives of FCF
Ø Exam tips:
• 理解自由现金流模型的优缺点
• 理解自由现金流的所有权角度
Summary
Calculation of FCFF and FCFE (1)
Tasks:
ØExplain the appropriate adjustments to net income to calculate FCFF and FCFE
ØCalculate FCFF and FCFE
FCF Formula References
Ø NI = Net income to common shareholders, after preferred dividends but before common dividends
Ø NCC = net non-cash charges Ø Int(1-t) = after tax interest expense
Ø FCInv = net fixed capital investment (capital expenditure less proceeds from sales)
FCFF and FCFE Beginning with Net Income Ø FCFF = NI + NCC + Int(1– t) – WCInv – FCInv
Ø Subtracting after-tax interest and adding back net borrowing from the FCFF equations gives us the FCFE from NI
Ø FCFE = FCFF – Int(1 – t) + Net borrowing ØFCFE = NI + NCC – WCInv – FCInv + Net borrowing
Noncash Adjustment
Noncash Item adjustment to NI
depreciation added back amortization and impairment of intangibles added back
restructuring expenses added back restructuring charges (income from reversal) subtracted
losses added back gains subtracted amortization of long-term bond discounts added back amortization of long-term premiums subtracted
Investment in Working Capital
ØNet investment in working capital for the purpose of calculating FCF excludes
• changes in cash/cash equivalents
• notes payable
• current portion of L.T. debt
ØThe exclusions are considered financing activities not operating items and therefore not included in WCInv
Investment in Working Capital
ØThere is an inverse relationship between changes in assets and changes in cash flow
ØAn increase in an asset account is a use (negative/subtraction) of cash
Investment in Working Capital
ØThere is a direct relationship between changes in liabilities and changes in cash flow
ØAn increase in a liability account is a source (addition/plus) of cash
ØA decrease in a liability is a use (negative/subtraction) of cash
Investment in Working Capital
Increase in WCInv
Decrease ↓FCF Decrease inIncrease ↑ FCFWCInv 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
Investment in Working Capital
Account 2009 2008 Change Source/Use
Inventory 50 40 10 Use/Subtract
WCInv = –10 Accounting
receivable 25 30 (5) Source/AddWCInv = +5 Accounting
payable 30 10 20 Source/AddWCInv = +20 Accrued
Expenses 5 20 (15) Use/SubtractWCInv = –15
Net FCInv Adjustments
ØInvestments in fixed capital (FCInv) represent a cash out flow necessary to support the company's current and future operations
ØViewed as a capital expenditure (Cap Ex) that reduces both FCFE and FCFF
ØExpenditures can include acquisition of intangible items such as trademarks
Net FCInv Adjustments ØAsset Purchases
• 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 wereno disposals during the period, to identify the capital expenditures for the period
• If given net PP&E, use the equation:
Ending net PP&E = Beginning net PP&E – Depreciation + Assets purchased – Book value of assets sold
Net FCInv Adjustments
ØIf 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)
ØGain/Loss on asset sale = Proceeds from sale – book value of asset
ØSubtract gains on sales from NI ØAdd losses on sales to NI
ØDeduct the proceeds from sale in arriving at the net FCInv
Net Borrowing Adjustments
ØNet Borrowings only affect FCFE, they do not affect FCFF ØLong Term Debt
• 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
Net Borrowing Adjustments ØNotes Payable
• Incr. in notes payable, add to FCFE
• Decr. in notes payable, subtract from FCFE ØCurrent Portion of LT Debt
• Incr. in short-term debt, add to FCFE
Ø Importance: ☆☆☆
Ø Content:
• FCFF and FCFE beginning with net income • Adjustments to net income
Ø Exam tips:
• 必须掌握通过net income计算FCFF和FCFE
• 理解计算FCFF和FCFE的各项财务调整
Summary
Calculation of FCFF and FCFE (2)
Tasks:
ØExplain the appropriate adjustments to EBIT, EBITDA, CFO to calculate FCFF and FCFE
FCFF and FCFE Beginning with CFO
Ø Recall, CFO = NI + NCC – WCInv
Ø CFO is after-interest under US GAAP
Ø FCFF = CFO + Int(1 – t) – FCInv
Ø Subtracting after-tax interest and adding back net borrowing from the FCFF equations gives us the FCFE from CFO
Ø FCFE = CFO – Inv(FC) + Net borrowing
FCFF and FCFE Beginning with Net Incomehj
IFRS US GAAP
interest received operating or
investing operating interest paid operating or
financing operating dividends received operating or
investing operating dividend paid operating or
FCFF Beginning with EBIT
Ø To show the relation between EBIT and FCFF, assume that the non-cash charge (NCC) is depreciation (Dep):
Ø FCFF = NI + Dep + Int(1 – t) – WCInv – FCInv
Ø Net income (NI) can be expressed as:
Ø NI = (EBIT – Int)(1 – t), rearranging
Ø NI = EBIT(1 – t) – Int(1 – t)
Ø FCFF = EBIT (1-t) + Dep – WCInv – FCInv
ØFCFE = EBIT(1 – t) – Int (1 – t) + Dep –WCInv – FCInv + Net borrowings
FCFF Beginning with EBITDA
ØTo get FCFF from EBITDA (Earningsbefore Interest, Taxes, Depreciation, and Amortization):
ØNI = (EBITDA - Dep - Int)(1-t)
ØFCFF = EBITDA (1 – t) + Dep(t) – WCInv – FCInv
ØWe add back the NCC (dep) times the tax because we capture the tax benefit from deducting the depreciation, it represents the cash flow savings from the deduction
ØFCFE = EBITDA (1 – t) – Int (1 – t) + Dep(t) – WCInv – FCInv + Net borrowings
FCFF Formula Review
ØFCFF = NI + NCC + [Int(1 – t)] – WCInv – FCInv ØFCFF = CFO + [Int(1 – t)] – FCInv
ØFCFF = [EBIT(1 – t)] + NCC – WCInv – FCInv ØFCFF = EBITDA(1 – t) + (NCC × t) – WCInv – FCInv
ØNotice: no net borrowings!
FCFE Formula Review
ØFCFE = NI + NCC – WCInv – FCInv + Net borrowings ØFCFE = CFO – FCInv + Net borrowings
ØFCFE = EBIT(1 – t) – Int(1 – t) + NCC – WCInv – FCInv + Net borrowings
ØFCFE = EBITDA(1 – t) – Int(1 – t)+ NCC(t) – WCInv – FCInv + Net borrowings
Example
Actual
1996 Projected 1997
Cash $24.0 $26.0
A/R 17.0 24.0
Inventory 100.0 150.0
PP&E (FCInv) 100.0 125.0
Accumulated Dep (30.0) (35.0)
Total Assets $211.0 $290.0
Example
Actual
1996 Projected1997
Accounts payable $91.0 $101.0
Long-term debt 20.0 40.0
Common stock 80.0 90.0
Retained earnings 20.0 59.0
Total liab. and OE $211.0 $290.0
Example
Actual
1996 Projected 1997
Sales $80.0 $198.0
COGS 38.0 90.0
Gross profit $42.0 $108.0
SG&A 13.0 30.0
Depreciation 3.0 5.0
Operating expenses $16.0 $35.0
Example
Actual
1996 Projected 1997 Interest
expense Pre-tax income Income tax expense Net income
$4.0
22.0
(7.0)
$15.0
$5.0
68.0
(25.0)
Example - Solutions ØFCInv = $125 – $100 = $25
ØWC1997 = ($24 + $150) – ($101) = $73 ØWC1996 = ($17 + $100) – ($91) = $26 ØWCInv = $73 – $26 = $47
Øt = $25 / $68 ≈ 37%
ØNet borrowing = $40 – $20 = $20
Example - Solutions
ØFCFF = NI + NCC + Int(1 – t) – WCInv – FCInv
• –20.85 = 43 + 5 + 5(1 – 0.37) – 47 – 25 ØFCFF = CFO + Int(1 – t) – FCInv
• –20.85 = (43 + 5 – 47) + 5(1 – .37) – 25
• Recall, CFO = NI + NCC – WCInv ØFCFF = [EBIT(1 – t)] + NCC – WCInv – FCInv
• –20.85 = 73 (1 – 0.37) + 5 – 47 – 25 ØFCFF = EBITDA(1 – t) + NCC(t) – WCInv – FCInv
• –20.85 = 78 (1 – 0.37) + 5(0.37) – 47 – 25
Example - Solutions
ØFCFE = (NI + NCC – WCInv) – FCInv + Net borrowing • – 4 = (43 + 5 – 47) – 25 + 20
ØFCFE = CFO – FCInv + Net borrowings • – 4 = (43 + 5 – 47) – 25 + 20
ØFCFE = FCFF – [Int(1 – t)] + net borrowing • -4 = –20.85 – [5(1 – 0.37)] + 20
ØFCFE = EBIT(1 – t) – Int (1 – t) + NCC – WCInv – FCInv + Net borrowing • –4 = 73 (1 – 0.37) – 5 (1 – 0.37) + 5 – 47 – 25 + 20
ØFCFE = EBITDA(1 – t)+ NCC(t) – WCInv – FCInv + Net borrowings • –4 = 78 (1 – 0.37) – 5 (1 - 0.37) + 5(0.37) – 47 – 25 + 20
Ø Importance: ☆☆
Ø Content:
• FCFF and FCFE beginning with EBIT, EBITDA, CFO
Ø Exam tips:
Forecasting FCFF and FCFE
Effects of Financial Decisions on FCFF and FCFE
Tasks:
ØDescribe approaches for forecasting FCFF and FCFE
ØCompare the FCFE model and dividend discount models
ØExplain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE
FCFF and FCFE on a uses-of-Free-Cash-Flow Basis ØUses of FCFF = increases in cash balances + net payment to
providers of debt capital + payments to providers of equity capital
• net payment to providers of debt capital are calculated as: üplus: int*(1-t)
üplus: repayment of principal in excess of new borrowing
• payment to providers of equity capital are calculated as: üplus: cash dividends
üplus: share repurchases in excess of share issuance
FCFF and FCFE on a uses-of-Free-Cash-Flow Basis ØUses of FCFE = increases in cash balances + payments to
providers of equity capital
• payment to providers of equity capital are calculated as: üplus: cash dividends
üplus: share repurchases in excess of share issuance
Two Approaches to Forecast FCF Ø Calculate historical FCF:
• Estimate FCF for current period
• Apply a constant growth rate to current FCF: FCF × (1+g)n
• Usually,
Ø Forecast components of FCF:
• Forecast each underlying component of free cash flow: net income, FCInv, NCC and WCInv are tied to sales forecast
• Realistic and flexible but time consuming FCFE FCFF
g
Sales-Based Forecasting Method for FCFF and FCFE Ø A simple sales-based forecasting method for FCFF and FCFE
assumes:
• (FCInv -Dep) and WCInv both bear a constant relationship to increases in sales
ØSpecially for FCFE forecasting, we assume:
• the capital structure represented by debt ratio (DR) is constant
• DR indicates the percentage of the investment in fixed capital in excess of depreciation and in working capital that will be financed by debt
Ø Assumptions: keeping the following ratios unchanged
Ønet borrowing = DR(FCInv -Dep) +DR(WCInv)
ØFCFE = NI -(FCInv - Dep) - WCInv + DR(FCInv -Dep) +DR(WCInv)
ØFCFE = NI - (1-DR)(FCInv - Dep) - (1-DR)(WCInv) = NI - (1-DR)(FCInv + WCInv - Dep)
Sales-Based Forecasting Method for FCFF and FCFE
Sales Dep FCInv
Sales WCInv
D E
D DR
ØThe general valuation models are the same but the numerator is different
ØFCFE could be either greater or less than dividends, but the same economic forces that lead to low(high) dividends lead to low(high) FCFE
ØFCFE takes a control perspective that assumes recognition of value should be immediate. While DDM takes a minority perspective that assumes value may not be realized until the dividend policy reflects the firm's long-run profitability
Recognition of Value Between FCFE and DDM Effect of Financing Decisions on FCF
Statement of Cash Flows FCFE/FCFF Net income (NI) Net income (NI) + Non-cash charges (NCC) +Non-cash charges (NCC
– WCInv – WCInv
Cash flow operations (CFO) Cash flow operations (CFO) + Int(1 – tax rate)
– FCInv – FCInv
Effect of Financing Decisions on FCF
Statement of Cash Flows FCFE/FCFF Free cash flow to firm (FCFF) + Net Borrowing + Net Borrowing
– Int(1 – tax rate) Free cash flow to equity (FCFE)
– Dividends – Dividends
+/– Stock issues/repurch +/– Stock issues/purch Net change in cash Net change in cash
Effect of Financing Decisions on FCF
FCFF FCFE
Dividends None None
Share repurchase None None
Share issue None None
Change in leverage None partially offset*ST & LT effects
Note: Share repurchase/issueis use of FCF; not determinant
* if leverage increases, FCFE higher in current year (net borrowing) and lower in future years (interest expense)
Ø Importance: ☆☆☆
Ø Content:
• Uses of FCFF and FCFE
• Sales-based forecasting methods of FCFF and FCFE • Comparison of FCFE model and DDM
• Effects of financial decisions on FCFF and FCFE
Ø Exam tips:
• 重点掌握预测FCFF和FCFE的方法
• 重点掌握融资决策对FCFF和FCFE的影响
• 理解FCFF和FCFE的用途
• 比较FCFE和DDM模型
Summary
FCFF and FCFE Valuations
Tasks:
ØEvaluate the use of net income and EBITDA as proxies for cash flow in valuation
ØExplain the single-stage, two-stage, and three-stage FCFF and FCFE models and select and justify the appropriate model given a company’s characteristics
ØEstimate a company’s value using the appropriate FCF models
NI is a Poor Proxy for FCFE
ØNI is an accrual concept not cash flow
ØNI recognizes non-cash charges such as depreciation, amortization and gains on sale of equipment, alternatively… ØNI fails to recognize the cash flow impact of investments in
working capital and net fixed assets, and net borrowings
EBITDA is a Poor Proxy for FCFE ØEBITDA doesn’t reflect taxes paid
ØEBITDA ignores effect of depreciation tax shield [Depr (tax)] ØEBITDA does not account for needed investments in working
capital and net fixed assets for going concern viability ØEBITDA is a pre-levered figure so it is pre-interest and before
net borrowings
FCFF vs. FCFE Valuation
ØFirm value = FCFF discounted at WACC
ØEquity value = FCFE discounted at required return on equity
• Use FCFE when capital structure is stable
• Use FCFF when high or changing debt levels, negative FCFE
ØEquity value = firm value – MV of debt
Single-Stage FCF Model
ØPoint:Analogous to Gordon growth model
•Useful for stable firms in mature industries Ø Two assumptions:
1. Constant growth rate g forever
2. Growth rate g is less than WACC and r
FCFF 1 g -WACC
FCFF value
Firm
FCFE 1 g -r
Selection of Appropriate Model
Ø Four major variations:
1) FCFF or FCFE? 2) Two stages or three?
3) Total FCF or components of FCF? 4) Terminal value via GGM or Multiples?
Ø Always: Value = PV of future cash flows discounted at appropriate required return
Base case: 2-stage, historical growth, FCFE
with the GGM for terminal value
Selection of Appropriate Model
ØSingle-stage model
• Income stock (slow, constant growth)
• International setting or volatile inflation rates: use real rates
ØTwo-stage and three-stage models
• Competitive advantage will disappear over time Match growth pattern or company lifecycle approach to the
appropriate model
FCF Valuation - Example
Ø Calculate the value of the firm given the data forecast in the table. The required return on equity is 15%, the WACC is 12%, and the marginal tax rate is 40%. FCFF is expected to grow at a constant rate of 4% after 3 years.
Year 1 Year 2 Year 3 Cash flow from operations $400 $500 $600
WCInv $50 $60 $80
FCInv $200 $250 $300
Interest expense $15 $15 $20
FCF Valuation - Solution
Year 1 Year 2 Year 3 Cash flow from operations
+ Int(1 – tax rate)
$209 $259 $312 $4,056 $3,502.141.12 1.12 1.12
