Valuation

Part 1

Objectives

• Firm and equity fair valuation methodso Present value DCF methods o Approximate valuation methods

• Drivers of equity value• The price / earnings rati

2

3

Value of Simple Corp

Net Operating

Assets

Invested Capital

Capital Net Operating

Assets

Invested Capital

Capital

Book Value of Fair Value of

Constant FCF Growth

• In the case where FCF is assumed to grow at a constant rate, gFCF, a simple formula is found from series convergence

4

or

Constant FCF Growth

• As the spread between the rate cost and cash flow growth rate narrows, convergence slows considerably

• As cash flow growth rate approaches the rate cost, the series does not converge

0

10

20

30

40

50

60

70

80

90

100

0 50 100 150 200 250 300

s: number of terms in summation

Dis

coun

t Fac

tor

g=7%

g=8%

g=9%

g=10%g=11%

k=10%

5

Variable Growth Value

6

0 1 H H+1 N

gFCF

Step 2

Step 3

Step 1

Homework 19• Find the value of LeanTech by discounting its expected free

cash flow• Use 10% for the cost of capital• Expected free cash flow as follows

o Year 6: $100,000o Years 7 to 10: FCF grows by 80.0% per yearo Years: 11 to 20: FCF grows by 15.0% per yearo Years: 21 to 30: FCF grows by 7.5% per yearo Years: 31 to 50: FCF grows by 2.0% per year

• Checko My year 50 free cash flow is about $14.360M

• What is the value of LeanTech (end of year 5 or beginning of year 6) ?

• Plot the FCFs, the discount factors, and the value (partial sums) at the end of each year beginning at year 6 ?

7

Variable Growth Value

1 2 3 4 5 6 7 8 9 10 11 12 13 14

FCF

Years H

8

Equity Value Management

• Explore the relationships between o Earnings growtho Dividend payoutso Cost of equity o Fair value of equity

• Based on the Dividend Growth Model with constant dividend growth assumption

9

Dividend Discount Model

• Method is most applicable to firms that have a high dividend payout ratio

• Assume that last dividend is a total repurchase of the stock

i = 0 1 2 3 4 5 N

DIV1

10

DIVN

Equity Value Per Share

11