CORPORATE

FINANCE
EQUITY VALUATION
CFA STUDY NOTES (DISCOUNTED DIVIDEND VALUATION PDF PAGE 62)
•Stock valuation

Stock valuation is the process of valuing companies and comparing

the valuation to the current market price to see whether a stock is
over- or undervalued.

•Stock valuation can be classified into two categories: absolute

valuation and relative valuation.
 ABSOLUTE VALUATION

• Absolute, or intrinsic, stock valuation relies on the company’s

fundamental information.

• The method involves the analysis of various financial information that

can be found in, or derived from, a company’s financial statements.

• Many techniques of absolute stock valuation primarily investigate the

company’s cash flows, dividends, and growth rates.

• Notable absolute common stock valuation techniques include

the dividend discount model (DDM) and the discounted cash flow
model (DCF).
 RELATIVE VALUATION

• Relative stock valuation compares the potential investment to

similar companies.
• The relative stock valuation method calculates multiples of
similar companies and compares that valuation to the current
value of the target company.
• COMMON MULTIPLES USED ARE P/E , P/BV
• The best example of relative stock valuation is comparable
company analysis, sometimes called trading comps.
Dividend discount model (DDM)
The dividend discount model is one of the most basic techniques of absolute
stock valuation.
The DDM is based on the assumption that the company’s dividends represent
the company’s cash flows to its shareholders.
The model states that the intrinsic value of the company’s stock price
equals the present value of the company’s future dividends.
Note that the dividend discount model is applicable only if a company
distributes dividends regularly and the distribution is predictable.

Discounted cash flow model (DCF)

Under the DCF approach, the intrinsic value of a stock is calculated by
discounting the company’s free cash flows to its present value.
The main advantage of the DCF model is that it does not require any
assumptions regarding the distribution of dividends. Thus, it is suitable for
companies with unknown or unpredictable dividend distributions. However,
the DCF model is more sophisticated from a technical perspective.
Comparable companies analysis

Comparable companies analysis is an example of relative stock valuation.

Instead of determining the intrinsic value of a stock using the

company’s fundamentals, the comparable approach aims to derive a stock’s
theoretical price using the price multiples of similar companies.

The most commonly used multiples include the price-to-earnings (P/E),

and enterprise value-to-EBITDA (EV/EBITDA) multiples.

The comparable companies analysis method is one of the simplest from a

technical perspective.

However, the most challenging part is the determination of truly comparable

companies.
ADVANTAGES AND DISADVANTAGES OF USING DIVIDEND AS A
MEASURE OF CASHFLOWS

The shareholder's investment today is worth the present value of the future cash flows he
expects to receive, and ultimately he will be repaid for his investment in the form of
dividends.

An additional advantage of dividends as a measure of cash flow is that dividends are less
volatile than other measures (earnings or free cash flow), and therefore the value estimates
derived from dividend discount models are less volatile and reflect the long term earning
potential of the company.
DISADVANTAGES
The primary disadvantage of dividends as a cash flow measure is that it is difficult to
implement for firms that don't currently pay dividends.

It is possible to estimate expected future dividends by forecasting the point in the future
when the firm is expected to begin paying dividends. The problem with this approach in
practice is the uncertainty associated with forecasting the fundamental variables that
influence stock price (earnings, dividend payout rate, growth rate, and required return) so
far into the future.

A second disadvantage of measuring cash flow with dividends is that it takes the
perspective of an investor who owns a minority stake in the firm and cannot control the
dividend policy.

If the dividend policy dictated by the controlling interests bears a meaningful relationship
to the firm's underlying profitability, then dividends are appropriate.
However, if the dividend policy is not related to the firm's ability to create value, then
dividends are not an appropriate measure of expected future cash flow to shareholders.
Dividends are appropriate as a measure of cash flow in the following
cases:

• The company has a history of dividend payments.

• The dividend policy is clear and
• Related to the earnings of the firm.
Free Cash FLow.
Free cash flow to the firm (FCFF) is defined as the cash flow generated by the
firm's operations that is in excess of the capital investment required to sustain
the firm's current productive capacity.

Free cash flow to equity (FCFE) is the cash available to stockholders after
funding capital requirements and expenses associated with debt financing.
• ADVANTAGES AND DISADVANTAGES OF FREE CASH FLOW METHOD

• One advantage of free cash flow models is that they can be applied to many
firms, regardless of dividend policies or capital structures.

• However, there are cases in which the application of a free cash flow model
may be very difficult.

• Firms that have significant capital requirements may have negative free cash
flow for many years into the future. This can be caused by a technological
revolution in an industry that requires greater investment to remain
competitive or by rapid expansion into untapped markets.

• This negative free cash flow complicates the cash flow forecast and makes
the estimates less reliable.
Free cash flow models are most appropriate:

• For firms that do not have a dividend payment history or have a

dividend payment history that is not clearly and appropriately
related to earnings.

• For firms with free cash flow that corresponds with their
profitability
For most companies, the Gordon growth model assumption of constant
dividend growth that continues into perpetuity is unrealistic.

For example, many companies experience growth rates in excess of the

required rate of return for short periods of time as a result of a competitive
advantage they have developed.

We need more realistic multistage growth models to estimate value for

companies with several stages of future growth. The appropriate model is the
one that most closely matches the firm's expected pattern of growth.
• We're still just forecasting dividends into the future and discounting
them back to today to find intrinsic value.

• • Over the long term, growth rates tend to revert to a long-run rate
approximately equal to the long-term growth rate in real gross
domestic product (GDP) plus the long-term inflation rate.

• Historically, that number has been between 2% and 5%. Anything

higher than 5% as a long-run perpetual growth rate is difficult to
justifY.
Two stage model is designed to value
the equity in a firm with two stages of growth,
an initial period of higher growth and a
subsequent period of stable growth.
Two-Stage DDM: The most basic
multistage model is a two-stage DDM
in which we assume the company
grows at a high rate for a relatively
short period of time (the first stage)
and then reverts to a long-run
perpetual growth rate (the second
stage
An example in which the two-stage
model would apply is a situation in
which a company has a patent that will
expire. For example, suppose a firm is
expected to grow at 15% until patents
expire in four years, then immediately
revert to a long-run growth rate of 3%
in perpetuity. This stock should be
modeled by a two-stage model, with
divide
H-Model: The problem with the basic
two-stage DDM is that it is usually
unrealistic to assume that a stock will
experience high growth for a short period,
then immediately fall back to a long-run
level. The H-model utilizes a more realistic
assumption: the growth rate starts our high
and then declines linearly over the high-
growth stage until it reaches the long-run
average growth rate. For example, consider
a firm that generates high profit margins,
faces little competition from within its
industry, and is currently growing at 15%.
We might forecast that the firm's growth
rate will decline by 3% per year as
competitors enter the marker until it
reaches 3% at the end of the fourth year,
when the industry matures and growth
rates stabilize (see Figure 2).
While the basic GGM assumes constant growth, most firms go through a
pattern of growth that includes several phases:

• An initial growth phase, where the firm has rapidly increasing earnings,
little or no dividends, and heavy reinvestment.
• A transition phase, in which earnings and dividends are still increasing but
at a slower rate as competitive forces reduce profit opportunities and the
need for reinvestment.
• A mature phase, in which earnings grow at a stable but slower rate, and
payout ratios are stability
Short term growth Long term growth
THE VALUE OF A FIRM
THAT DOESN'T
CURRENTLY PAY A
DIVIDEND
The value of a firm
that doesn't currently
pay a dividend is a
simple version of the
two stage DDM,
where the firm pays
no dividends in the
first stage. Therefore,
the value of the firm
is just the present
value of the
dividends in long
term phase
VALUATION USING THE H-MODEL
The earnings growth of most firms does not abruptly change from a high rate to a low
rate as in the two-stage model but tends to decline over time as competitive forces come
into play. The H-model approximates the value of a firm assuming that an initially high rate
of growth decline