02 valuation models i cvl

Company Valuation (JEM 132) Charles University, Prague

© Jiri Novak, IES UK 1

Lecture 2

Valuation Models I

Jiri Novak

IES, UK

Recap

Importance of Valuation

company valuation is useful whenever a company or its part is purchased or sold

reasonable valuation of assets is crucial for

‐ 2 ‐

healthy financial markets and the entire economy

Limitations of Valuation

task of company valuation is to uncover the uncertain future, which is challenging and always questionable

aim is to structure the analysis well and root it properly in existing historical evidence

l A h1.3 Valuation Approaches

Valuation Approaches

Cost Based

what was the cost to develop the asset?(firm can be seen as portfolio of assets)

Revenue Based

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Revenue Based what is the present value of revenues the asset is expected to generate?

Comparable Based what is the price of comparable assets in liquid markets?


Simple

“rough & dirty” ways to obtain approximate idea about company value for quick orientation

indicators of firm value may be obtained:

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y

– cross‐section

– time‐series


Valuation Multiples (VM) M/B and P/E of comparable companies to be multiplied by Eq = B or NI = E respectively

Dividend Growth Model (DG)

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( )

extrapolate past dividend payouts allowing for constant growth, discount them at cost of equity




Complex

sophisticated valuation models are based on forecasted (pro forma) financial statements, from which discounted items are taken

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valuation model is characterized by forecasted item that is eventually discounted:

– dividends

– free cash flow

– residual income = economic value added


Discounted Dividend Model (DDM) dividends (Dv) – return to owners on their investment in company equity

Discounted Cash Flow Model (DCF)

‐ 8 ‐

free cash flow (FCF) – value generated through operating activities for owners and creditors

Residual Income Model (RIM) economic value added (EVA) – residual value to owners after subtracting all capital charges, added to book value of equity

l l l2.1 Valuation Multiples

Valuation Multiples

Use

quick orientation about the approximate range within which the value is likely to lie

verifying plausibility of value estimate produced

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by more sophisticated forecast

Method

obtain M/B, P/E, and EV/EBITAmultiple of comparable companies (i.e. closest competitors)

multiply the benchmark multiple with the corresponding accounting item (Eq, NI or EBITA) of the of the company of interest

Valuation Multiples

Market‐to‐Book

ratio of stock market value of equity (market cap) divided by (accounting) book value of equity

Price‐to‐Earnings

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g

ratio of share price to earnings per share

EV‐to‐EBITA ratio of:

– enterprise value (market value of equity & debt) to

– operating income (earnings before interest, taxes & amortization)

Valuation Multiples

Logic basic idea is that there is some fixed relationship between company value and the underlying accounting fundamentals (Eq, NI or EBITA)

B fi

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Benefits multiples are often used because they are simple to comprehend and communicate

Shortcomings relative valuation gives sound results only when:

– firms are comparable (unique advantages)

– market values comparables without bias (fads)



d d h d l2.2 Dividend Growth Model

As1 = + € 30 RE1 = € 30

operating

Financial Cycle

$$$$$$$$$$$$$

$$$$$$$$$$$$$assets

equity E € 100

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p gexpenses

€ 267

$$$$$$$$$$$$$

debt

Li0 = € 60

assets

As0 = € 160

revenues

Sl1 = € 320

earningsNI1 = € 30

Eq0 = € 100

interest exp.IE = € 3

EBIT1

taxesTx = € 20 What is the ultimate

way of paying return to company owners?

Dividend Growth

Method

past dividend payouts are implicitly extrapolated into the future and discounted to present value using fixed cost of equity

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makes strong assumptions about dividend payout dynamics and risk dynamics

Use for mature companies (in steady state) that pay stable dividends regularly

plug‐in method in sophisticated models to determine continuing value “after horizon”

Dividend Growth

Gordon Formula

Considerations

0 d

Vr g

~ perpetuity with growth

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o i e a io

V… company value

d… initial dividend payout that should be sustainable in the long‐run (with some growth)

r… discount factor that should reflect the riskiness of the company’s equity

g… dividend growth rate that is sustainable in a very long run

Dividend Growth

Conceptual Shortcomings

dividends capture just the distribution of wealth to the owners failing to uncover the “black box” of value creation

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irrelevance theorem by Miller and Modigliani suggests that in a perfect world dividends do not affect company value (why?)

Dividend Growth

Technical Limitations

d … companies pay less and less dividends and rather repurchase their stocks (due to taxes); current dividend payouts may underestimate th i di id d ti it

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their dividend generating capacity

g… only one growth rate can be used for entire future; growth may have predictable pattern

g << r… else the model “explodes”

r … model “black boxes” financial statements; certain dividend payouts may imply changes in fLev, hence in r



Dividend Growth

60,0%

70,0%

80,0%

Dividend Payout Ratio

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0,0%

10,0%

20,0%

30,0%

40,0%

50,0%

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Pay

ou

t ra

tio

Dividend Growth

5,0%

6,0%

Dividend Yield

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0,0%

1,0%

2,0%

3,0%

4,0%

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Div

iden

d y

ield

d d d d l2.3 Discounted Dividend Model

Comprehensive Valuation

Use (DDM, DCF) very versatile, sophisticated method applicable for any company

provided that one keeps basic accounting relationships it provides a lot of flexibility

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relationships it provides a lot of flexibility

Method first, analyze the company’s historical performance, compute financial ratios

second, forecast future financial statements based on historical financial performance

third, discount forecasted dividends (DDM) or free cash flows (DCF) to present value

Comprehensive Valuation

t+1 t+2 t+3 T

financial ratios forecasted ratios

t‐3 t‐2 t‐1

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t+1 t+2 t+3 T

context

t‐3 t‐2 t‐1

accounting figures

$

forecasted accounting

discounting

operating

Discounted Dividends

working capitalWC0 = € 64

g(NS) = ?

FLV = 0.6

equity EQ € 100

WCT = 5

XAT = 3.33

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operating expenses after taxes

€ 284

debt

ND0 = € 60operating revenues

NS1 = € 320

earningsNI1 = € 30

PM =

11.25%

IR1 = 10%

EQ0 = € 100

interest exp.IEat = € 6

NOI1 = € 36

Dv1 = EQ0 + NI1 – EQ1

fixed assetsFA0 = € 96

ATO decomposed:

XAT – fixed asset turnoverWCT – working capital turnover




Financing Assumptions

dividends obtained from pro forma statements by assuming some after tax cost of debt and explicitly model credit side of BS by either:

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– dividend policy assumption – assumes certain part of FCF are paid out as dividends with residual implications for financial leverage, or

– financial leverage assumption – assumes company maintains certain financial leverage leaving dividend policy residual


Value Creation vs. Distribution

DDM based on value distribution, which should be value irrelevant (assuming no frictions)

DCF based on value creation, i.e. individual value

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drivers that may yield abnormal profitability

that is why some prefer DCF over DDM (despite of their theoretical equivalence)


Operating vs. Financing

DDM mixes effect of operating & financing, hence makes forecasting more difficult (why?)

profitability comparison is harder across

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companies with different capital structure

DDM recommended use to value banks where capital structure is part of operations


‐ 28 ‐

E1.8 Extra

Dividend Irrelevance

Dividend Irrelevance Theorem

Miller, Modigliani showed that in a perfect world dividend payout is irrelevant to firm value

dividends would be residual – they would

‐ 30 ‐

depend on existing investment opportunities so so would be be very volatile

Paradox discounted dividend modelV = [divt / (1+ ke)

t ]

how it is possible that dividend payout is irrelevant to company value?




Dividend Irrelevance Paradox

if shares are fairly priced NPV of $1 invested in any company is equal to $1

investors are indifferent between:

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– receiving $1 dividend & investing it elsewhere

– retaining $1 in the firm & increasing future div

P = DPS

time

share price

dividends paid out


Dividend Irrelevance Paradox

$1 in current dividend == sacrificing future dividends of NPV=$1 == decrease in P of $1

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sum of dividends the company pays throughout its existence remains unchanged – dividend policy determines only when they occur

02 valuation models i cvl

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