Notes PDF
Notes PDF
Notes PDF
Valuation
WS 2009
Dr. Alex Stomper
Introduction
What does this course offer?
Scientific tools and techniques for
valuing financial assets
We focus on
• Valuation of publicly traded firms
• Value of equity
• Value of total company (debt+equity)
• Valuation of investment projects
Valuation 5
Valuation and market efficiency
(2)
Strong-form market efficiency is theorectically
impossible: Grossman and Stiglitz (1980).
However, the market is usually smarter than
you think.
Therefore, compare your valuation results with
the market price whenever possible
• Do you know something that the market does not
know?
• Or do you make a mistake?
Valuation 6
Approaches to valuation
Discounted cashflow valuation, relates the
value of an asset to the present value of
expected future cash flows on that asset.
Relative valuation, estimates the value of an
asset by looking at the pricing of 'comparable'
assets relative to a common variable like
earnings, cash flows, book value or sales.
Real options approach to valuation,
quantifies the value of managerial flexibility
using option pricing models.
Valuation 7
1. Discount cash flow
valuation
Generic DCF valuation formula
The value of an asset is determined by the present
value of expected future cash flows generated by the
asset.
N
E (CFt )
V =∑
t =1 (1 + r )
t
Valuation 9
Key components in DCF
valuation
Relevant cash flows
• All cash flows from and to investors (inflows and
outflows)
• Difference between cash flow and profit/loss
Appropriate discount rate
• Account for the time value of cash flows (earlier cash
flows are more valuable)
• Account for the uncertainty (risk) of cash flows
Matching principle: different valuation models
use different combinations of cash flows and
discount rates.
Valuation 10
DCF valuation models
Free cash flow valuation model
Capital cash flow valuation model
Adjusted present value model
Divident discount model
Economic-profit-based valuation model
Valuation 11
Key steps in FCF valuation
Estimating current free cash flows
Estimating growth rate
Estimating cost of capital
Estimating residual value (company value at
the end of the explicit forecast period)
n
E ( FCFt ) RV
V0 = ∑ +
t =1 (1 + WACC ) t
(1 + WACC ) n
Valuation 12
I. From earnings to free cash
flows
EBIT (earnings before interest and taxes)
Valuation 13
Firm value vs equity value
Value of firm:
N
E ( FCFt )
V =∑
t =1 (1 + WACC ) t
Value of equity
N
E ( FCFEt )
E=∑
t =1 (1 + k e ) t
Valuation 14
Taxes in FCF valuation
FCF are calculated as if firms are all-equity
financed
Marginal corporate tax rate is applied to EBIT,
without taking into account that interest
payments are tax deductiable
Debt tax shields are recognized through the
discount rate
Alternatively, one can include the debt tax
shields in cash flows, then the discount rate
should be the pretax discount rate (Capital
cash flow valuation model, see later).
Valuation 15
Investment expenditures
Gross investment
= capital expenditures + change in working capital
Working capital = current assets (inventory, cash and
account receivable) - current liabilities (account payable,
short-term debt)
Capital expenditures minus depreciation is called net
capital expenditures
Gross investment minus depreciation is called net
investment
If depreciation is the only noncash expense/income then
FCF = NOPLAT - net investment
Valuation 16
Estimating current FCF:
example
EBIT 1500
Tax rate 40%
NOPLAT 900
Depreciation 300
Gross cash flow 1200
Capital expenditure 500
Change in working capital 100
FCF 600
Interest expense 120
repayment of principal 150
FCF to shareholder 378
Valuation 17
II. Estimating growth rate
Look at historical growth rate
Look at forecasts by analysts
Look at fundamental drivers of growth rate
• Reinvestment rate:
IR = Net investment / NOPLAT
• Return on invested capital (ROIC)
ROIC = NOPLAT / Invested capital
⇒IR*ROIC = Net investment / Invested capital
= capital growth rate
Valuation 18
Invested capital
Invested capital = total assets – excess cash –
marketable securities – noninterest bearing
short term liabilities
Excess cash and marketable securities are
excluded because it is easier to value them
seperately
noninterest bearing short term liabilities are
excluded because they are financed by
suppliers and their costs may have already
been reflected in NOPLAT
Valuation 19
ROIC: example
Valuation 20
Determinants of ROIC
EBIT Re venues
ROIC = (1 − t ) × ×
Re venues Invested Capital
Valuation 21
Fundamental growth rate
The case of constant ROIC
gNOPLAT = IRt * ROIC
Return on new invested capital (RONIC)
≠ ROIC
gNOPLAT = IRt * RONIC
The case of changing ROIC
gNOPLAT = IRt * ROICt+1+(ROICt+1 -ROICt)/ROICt
Valuation 22
Forecasting FCFs: example
Valuation 23
Forecasting FCFs: example
Forecast FCFs in the next three years,
assuming alternatively that
(1) IR and ROIC are the same as in 2006
(2) IR and ROIC are the same as in 2006,
RONIC equals to 0.3
(3) IR and ROIC equal to the average levels in
2004-2006
Valuation 24
Forecasting FCFs: solution
Valuation 25
III. Estimating cost of capital
Valuation 26
WACC
D P E
WACC = k d (1 − t ) + k p + k e
V V V
where
kd = pre-tax cost of debt
kp = cost of preferred stock
ke = cost of equity
t = corporate tax rate
D/V = target debt ratio using market values
P/V = target preferred stock ratio using market values
E/V = target equity ratio using market values
V = market value of the firm (D+P+S)
Valuation 27
Weights in WACC
The target weights instead of the current weights should
be used.
Weights should be calculated using market values.
The market value may not exist, especially for the debt.
Possible estimation procedure:
• Identify all payment obligations to debt holders
• Estimate the credit risk of debt-type financing instruments
• Find market-traded instruments that have similar credit risk
and time to maturity
• Use the market returns to discount the outstanding
payments to debt holders
Valuation 28
Cost of debt/preferred stocks
Cost of debt = expected return on debt *(1-t)
• Expected return on debt ≠ coupon rate
• Expected return on debt ≠ promised yield
Investment-grade debt (debt rated at BBB or better): use
yield to maturity of the company‘s long-term, option-free
bonds
If the bond rarely trades, use the average yield to maturity
on a portfolio of long term bonds with the same credit
rating
Below-investment-grade debt: use CAPM to estimate the
expected return
Adjust for interest tax shields
Preferred stocks: preferred dividend devided by the
market price of preferred stocks
Valuation 29
Cost of equity: CAPM
ke = rf + β [ E ( rm ) − rf ]
where
rf = risk-free rate
ß = the sensitivity of the stock return to market return
E(rm) = expect return of the market portfolio
E(rm)-rf = market risk premium
Valuation 30
CAPM: implementation (1)
Risk-free rate: use long-term goverment bond
Market risk premium: historical data
• Use the longest period possible: short-term estimates
are very noisy (annual standard deviation of stock
returns 20%).
• Use geometric average instead of arithmetic average
• Adjust for survivorship bias.
• Nomally used numbers: 4.5-5.5%
Valuation 31
CAPM: implementation (2)
Beta: estimated from the market model
rit = α + βrmt + ε it
• Normally five-year monthly data are used
• Adjustment for low trading frequency (Dimson(1979))
Market portfolio
• In theory, all assets must be included
• In practice, well-diversified stock indexes are used as a
proxy: S&P 500, MSCI world index, MSCI Europe index,
etc
Valuation 32
Beyond CAPM: APT model
n
ri = α + ∑ β ik Fk + ε
k =1
n
E ( ri ) = rf + ∑ β ik λk
k =1
where Fk = the k-th systematic factor that drives security return,
λk = risk premium of the k-th factor
Valuation 33
Beyond CAPM: Fama-French model
E ( ri ) = rf + β1[ E ( rm ) − rf ] + β 2 [ E ( rS ) − E ( rB )] + β 3[ E ( rH ) − E ( rL )]
Valuation 34
Capital structure and cost of
capital
Modigliani and Miller theorem: In a perfect market without tax,
capital structure has no impact on either the firm value or the cost
of capital.
An easy way to understand this fundamental result in corporate
finance: In a perfect market without tax, capital structure has no
impact on the expected cash flows to the firm.
In the MM world, when the more expensive equity is substituted by
the less expensive debt, the cost of equity increases according,
leaving the weighted cost of capital unchanged.
In a world with tax, debt increases the cash flows to the firm by
reducing taxes. This is not reflected in FCFs, therefore it must be
reflect in WACC.
In the real world (with both tax and market imperfections), an
optimal capital structure is determined by the trade-off between the
tax advantage of debt and the cost of high leverage.
Valuation 35
MM world
ke
WACC
kd
D/E
Valuation 36
MM world with corporate tax
ke
WACC
kd(1-t)
D/E
Valuation 37
Real world with tax and other frictions
ke
WACC
kd(1-t)
D/E
(D/E)*
Valuation 38
Leverage and equity beta
Industry beta is often used to improve the
estimation of company beta.
However, firms in the same industry may have
different leverage ratio
Procedure for inferring beta from comparable
firms
• Estimate beta for each comparable firm
• Back out the unlevered beta
• Calculate the relevered beta using the target leverage
ratio
Valuation 39
Two alternative leverage policies
The relation between levered- and unlevered-beta
depends on the assumed leverage policy.
MM assumption(Modigliani and Miller 1963): constant
debt value
ME assumption (Miles-Ezzell 1980): constant debt ratio
Note that ME assumption is different from MM
assumption even if expected growth rate is zero.
Failing to recognize this difference has led to confusion
even among experts (Fernandez 2004, Cooper and
Nyborg 2006)
Valuation 40
Unlevered beta: constant debt level
(1)
If the debt value is constant, then interest tax shields
should be discounted by cost of debt, therefore
VL = E + D = VU + VTS = VU + tD
E D V tD
⇒ βC = β E + βD = βU U + β D
VL VL VL VL
E (1 − t ) D
⇒ βU = β E + βD
VU VU
E (1 − t ) D
= βE + βD
E + (1 − t ) D E + (1 − t ) D
1 (1 − t ) D / E
= βE + βD
1 + (1 − t ) D / E 1 + (1 − t ) D / E
D
⇒ β E = βU + ( βU − β D ) (1 − t )
E
Valuation 41
Unlevered beta: constant debt level
(2)
If βD = 0 , then we have
• Hamada (1972) formula
1
βU = β E
1 + (1 − t ) D / E
• Relevered beta
D
β E = βU [1 + (1 − t ) ]
E
Valuation 42
Unlevered (levered) cost of
equity
Unlevered cost of equity can be derived
either using unlevered beta or directly
from the following formula
1 (1 − t ) D / E
ku = k e + kd
1 + (1 − t ) D / E 1 + (1 − t ) D / E
D
⇒ ke = ku + ( ku − kd ) (1 − t )
E
tD
=> WACCL = ku (1 − )
E+D
Valuation 43
Unlevered beta: example
A privately-held company has a leverage ratio
(D/E) of 60%.
A comparable publicly-traded company with a
leverage ratio of 40% has an equity beta of 1.2.
The comparable firm is assumed to maintain
the current debt level (in value) in the future.
The corporate tax rate is 35%.
What is the beta of equity for the private
company?
Valuation 44
Unlevered beta: solution
Valuation 45
Unlevered beta: constant debt ratio
(1)
Valuation 46
Unlevered beta: constant debt ratio
(2)
Relevered beta
D
βe = βu + (βu − βd )
E
Valuation 47
Constant leverage ratio:
example
Valuation 48
IV. Estimating residual value
Method 1
NOPLATT +1 (1 − g / RONIC )
RVT =
WACC − g
Method 2
FCFT +1
RVT =
WACC − g
Since FCFT +1 = NOPLATT +1 * (1 − IRT +1 ) = NOPLAT * (1 − g / RONIC )
these two methods are equivalent.
Since the reinvestment rate in the residual period may be different
from that in the explicit forecast period, FCFT+1 may not equal
FCFT*(1+g)
Method 1 automatically takes this into account.
Valuation 49
Residual value: example
FCFT = 100, NOPLATT = 200
From year T+1 on, g = 5%, RONIC=
12%
WACC = 10%
Valuation 50
Residual value: other methods
If RONIC = WACC, then method 1 reduces to the
convergence formula
RV = NOPLATT +1 / WACC
Valuation 51
Other DCF valuation model
Capital cash flow valuation model
Adjusted present value model
Economic-profit-based valuation model
Discount dividend model
Valuation 52
Capital cash flow valuation
model
CCF = FCF + interest tax shield
Firm value is derived by discounting the CCF using
unlevered cost of equity
Given that interest tax shield are discounted using
unlevered cost of equity, it follows that unlevered
cost of equity equals pretax WACC.
Advantage: no need to adjust discount rate for
changes in financial structure.
Valuation 53
CCF valuation model: example
Example: Current FCF of a firm is 200,
interest expense is 50, tax rate is 40%.
The firm has a pretax WACC of 10% and
an expected growth rate of 5%. Value
this firm using CCF valuation model.
Valuation 54
Adjusted present value model
Valuation by components approach:
VL = VU + VTS
where VU is the expected FCF discounted using unlevered
cost of equity, VTS is the present value of interest tax shields
Possible discount rates for interest tax shields:
• Pretax cost of debt: varying or risky debt
• Unlevered cost of equity: costant debt ratio (in this case, APV
model is equivalent to CCF valuation model)
Advantage:
• No need to adjust discount rate for changes in capital structure
• Can easily be combined with a variety of valuation models
Valuation 55
APV model: example
year1 year2 year3 year4
2000 2000
(at (at
debt 0 0 8%) 8%)
Valuation 56
Economic-profit-based valuation
model
Economic profit (or Economic Value Added)
= Invested capital * (ROIC-WACC)
= NOPLAT – invested capital * WACC
Valuation 57
Discount dividend model
General model
∞
E ( DPS t )
P0 = ∑
t =1 (1 + k e ) t
Valuation 58
Gordon growth model
Valuation 59
Two-stage growth mdoel
Assumption: high growth rate (g) in the first n
periods and normal growth rate (gn) in the
rest periods
n
E ( DPS t ) Pn
P0 = ∑ +
t =1 (1 + k e ) t (1 + k e ) n
1+ g n
E ( DPS1 )[(1 − ( ) ]
1 + ke E ( DPS n +1 )
= +
ke − g (1 + k e ) n ( k e − g n )
Valuation 60
2. Relative valuation
How does it work?
In relative valuation, you try to figure out the
value of the firms being analyzed by looking at
the market values of similar or comparable
firms.
Steps in relative valuation
• Identify comparable firms
• Calculate the „multiples“
• Compare the multiples and control for factors that
might affect the multiples
Implicit assumption: market is on average right
Valuation 62
Most popular multiples
Earnings multiples
• Price/earnings ratio and variants
• Value/EBITDA
• Value/FCF
Book value multiples
• Price/book value (PBV, or market-to-book equity)
• Value/book value
• Value/replacement cost (Tobin‘s Q)
Revenues multiples
• Price/sales
• Value/sales
Valuation 63
Price / Earnings ratio
PE = market price per share / Earnings per
share
Price can be
• Current price (most of the time)
• Average price for the year
Earnings per share (EPS) can be
• EPS in most recent financial year
• EPS in trailing 12 months (trailing PE)
• Forecast EPS next year (forward PE)
Valuation 64
Distribution of PE ratio: US
stocks
Valuation 65
PE ratio across countries: July 2000
Developed markets Emerging markets
Valuation 66
Determinants of PE ratio
Valuation 67
PE ratio: regression analysis
Advantage of regression analysis: the informatíon in the entire
cross-section instead of a few comparable firms can be used
Problem: the coefficients may be unstable
Example: regression results for Compustat sample
(Damodaran 2002)
Valuation 68
PEG ratio
PEG = PE / Expected growth rate in earnings
A simple way to control for the influence of growth
rate on PE ratio
But not completely neutralize it since PE is not a
linear function of expected growth rate
Payout ratio (1 + g )
PEG =
g (k e − g )
Valuation 69
Value multiples
V / EBITDA = (E + D) / EBITDA
V / FCF = (E + D) / FCF
FCF = EBIT (1-t) – (CAP EX – D&A) - ∆ working capital
= (EBITDA – D&A)(1-t) - (CAP EX – D&A) - ∆working
capital
= EBITDA(1-t) + t (D&A) – CAP EX - ∆working capital
Advantages
• Less firms with negative EBITDA than firms with
negative earnings
• not influenced by difference in depreciation schemes
• Not influenced by differences in capital structure
Valuation 70
Determinants of V/FCF ratio
Stable growth case
V0 FCF0 (1 + g ) 1+ g
= =
FCF0 FCF0 (WACC − g ) WACC − g
Valuation 71
Value multiples: Example
Consider a firm with the following
characteristics
• Tax rate = 33%
• Capital Expenditure/EBITDA=30%
• Depreciation&Amortization/EBITA=20%
• Cost of capital=10%
• No requirement for working capital
• Stable growth rate=5%
Calculate V/EBITDA & V/FCF
Valuation 72
Value multiples: solution
Valuation 73
Price-to-book ratio
ROE − g
PBV =
ke − g
Valuation 74
PBV and ROE: S&P 500 (Damodaran
2002)
Valuation 75
Value-to-book ratio
Definition
Value market value of equity + market value of debt
=
Book value book value of equity + book value of debt
Valuation 76
Value-to-book ratio: example
Example: Consider a stable growth firm
with the following characteristics:
ROIC=12%, WACC=10%, g=5%.
Estimate its Value-to-book ratio.
Valuation 77
Tobin‘s Q ratio
Definition
Market value of assets in place
Tobin' s Q =
Re placement cos t of assets in place
Valuation 78
Revenue multiples
Price-to-sales ratio
= market value of equity / total revenues
• Internally inconsistent, since the market value of
equity is divided by the total revenues of the firm.
=> High leverage leads to low price-to-sales ratio
Value-to-sales ratio
= market value of firm/ total revenues
Advantages
• Available even for young or troubled firms
• Not heavily influenced by acounting rules
• Relatively stable
Valuation 79
Determinants of revenue
multiples
For a stable growth firm
Valuation 80
Choosing between multiples
There are many potentially useful multiples
Which ones to use in valuation?
• Use a simply average of valuations obtained using
different multiples
• Use a weighted average of valuations obtained using
different multiples
• Rely entirely on one of the multiples
• Most relevent one
• Most accurately estimated one
Valuation 81
Choosing the comparison firms
Three possible choices
• A few very similar firms
• All firms in the same sector
• All firms in the market
Regression analysis is necessary if you
choose the second or third approach
It is recommended to check whether the firm is
over or under valued at both the sector and
market level.
Valuation 82
3. Real options approach
to valuation
Managerial flexibility (strategic
options)
Valuation 84
Strategic options: examples
Option to postpone a project
Option to abondon a project
Option to temporarily shut down a
project
Option to expand a project
Option to downsize a project
Option to change input or output factors
.....
Valuation 85
Certainty equivalent method
Option pricing is based on the Certainty Equivalent Method
as opposed to the Risk-Adjusted Discount Rate Method.
Instead of discounting the expected cash flowes using a
risk-adjusted discount rate, the certainty equivalent
method discounts the certainty equivalent of future
uncertain cash flows at the risk-free rate.
∞
CEQ (CFt )
V =∑
t =1 (1 + r f ) t
Valuation 86
Obtaining certainty equivalents
period
1 2
output
1000 1000
price
S1 S2
revenue
1000S1 1000S2
Costs
300 300
NCF 1000S-300 1000S2-300
Valuation 88
Example: two-period gold mine
(2)
Suppose that risk free rate is 10%, the
current forwards prices are 320 for a
one-year contract and 350 for a two-year
contract. What is the value of this mine?
Valuation 89
Option pricing methods
Binomial model
Black-Scholes formula
Monte Carlo simulation
Valuation 90
I. Binomial model
Su Cu= max(Su-X,0)
p p
S0 C0
1-p 1-p
Sd Cd= max(Sd-X,0)
Valuation 91
Binomial model (2)
The risk-neutral probability q is given by
S 0 (1 + rf ) = qS u + (1 − q ) S d
S 0 (1 + rf ) − S d
⇒q=
Su − Sd
Valuation 92
II. Black-Scholes formula
For European call and put, Black and Scholes (1973) derive the
following formula
− rf T
C = SN ( d 1 ) − Xe N (d 2 )
− rf T
P = Xe N ( − d 2 ) − SN ( − d 1 )
S 1
ln + ( rf + σ 2 )T
d1 = X 2
σ T
d 2 = d1 − σ T
S = underlying price, K = Exercise price, _ = annualized volatility of the
underlying, T = time to maturity, rf = continuously-compounded risk-free rate,
N(.) = cumulative standard normal distribution
Valuation 93
III: Monte Carlo Simulation
Monte Carlo simulation can be used to value
more complex options.
• Step 1: simulate the distribution of underlying value
under the risk neutral probablity by generating a
large number of underlying price paths following
1 ~
~ r f − σ 2 +σZ
S it = S i ,t −1 R = S i ,t −1e 2
~
where Z is a normally distributed random variable.
Valuation 94
Monte Carlo Simulation (2)
• Step 2: calculate the net cash flow in each period on
each sample path
NCFit = max( S it − X t ,0)
where Xt is the production cost in period t.
• Step 3: calculate the option value for each sample
path i T
Vi = ∑ e
−r t
f
NCFit
i =1
Valuation 95
Example: option to shut down
Value a gold mine with the following
characteristics
• Produces gold in two periods
• Temporary shut-down possible
• Current gold price 300
• Annual gold price volatilty 20%
• Annually compounded risk free rate 10%
• Annual production 1000
• Annual Production cost 300
Valuation 96
Solution: Binomial model
u = eσ t
= 1.2214, d = e −σ t
= 0.8187
Suu
Su
S Sud,Sdu
Sd
Sdd
Valuation 97
Solution: Binomial model (2)
1 + rf − d
q=
u−d
qVuu + (1 − q )Vud
Vu = max( S u − 300,0) +
1 + rf
qVud + (1 − q )Vdd
Vd = max( S d − 300,0) +
1 + rf
qVu + (1 − q )Vd
V0 =
1 + rf
Valuation 98
Solution: Black-Scholes
Valuation 99
Solution: Monte Carlo simulation
~
S it = S i ,t −1 R
1 ~
~ r f − σ 2 +σZ
R=e 2
~ ~
Z = NORMSINV (U )
~
U = RAND()
Valuation 100
Monte Carlo simulation: a sample
path
Valuation 101
Option to delay: example
Panel A: Invest now
10 15 15 per year for ever
good
-100
10 2.5 2.5 per year for ever
bad
good
0
0 0 0 per year for ever
bad
Valuation 102
Option to delay (2)
Risk free rate = 5% per year.
$1 invested in the market portfolio will be
worth either $1.3 (when the state is good)
or $0.8 (when the state is bad) in one
year.
Should we invest now or should we wait
until next year?
What is the value of the option to wait?
Valuation 103
Option to delay: solution
Valuation 104
Option to expand: example
A project can generate the following CFs:
200
good
-140 150
bad
100
The firm has the option to double its capacity by investing another 140
in year 1 if the economy looks good.
Valuation 105
Option to expand (2)
Risk free rate 5%.
Risk neutral probabilities: q=0.6 in both
periods.
What is the value of the project without
considering the option value?
What is the value of the project after
considering the option value?
What is the value of the option to expand?
Valuation 106
Option to expand: solution
Valuation 107