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Valuation: Imperial College Business School
Valuation: Imperial College Business School
Jamie Coen
Autumn 2022
Relative Valuation
• Asset’s value estimated based on what investors are paying for
similar assets.
• Value or price multiples relative to similar firms.
In theory
1 Discounting dividends.
2 Discounting cash flows to equity.
3 Discounting cash flows to the firm.
4 The components of a DCF model.
5 Which cash flows to discount?
E (CF1 ) E (CF2 )
Value of firm = + + ...
1+r (1 + r )2
E (CF1 ) E (CF2 )
Value of firm = + + ...
1+r (1 + r )2
E (CF1 ) E (CF2 )
Value of firm = + + ...
1+r (1 + r )2
E (CF1 ) E (CF2 )
Value of firm = + + ...
1+r (1 + r )2
Steady state
• The value of growth comes from the capacity to generate
excess returns.
• The length of your growth period comes from the strength &
sustainability of your competitive advantages.
• After your growth period you settle down to a stable growth
rate.
E (CF1 ) E (CF2 )
Value of firm = + + ...
1+r (1 + r )2
Shareholders can expect to get two types of cash flow from holding
a stock:
1 Dividends.
2 Price at the end of the holding period.
D D(1 + g)
Value = + + ...
1+r (1 + r )2
D
=
r −g
where
• D is the expected dividend per share next year.
• g is the expected growth rate of dividends.
• r is discount rate (cost of equity).
E (Dn+1 )
Pn =
rn − gn
gn is dividend growth in the stable phase and rn is the cost of
equity.
FCFE models are exactly like DDMs, except now we forecast FCFE
instead of dividends:
n
X E (FCFEt ) Terminal valuen
Value = +
t=1
(1 + r )t (1 + r )n
where
E (FCFEn+1 )
Terminal valuen =
rn − gn
gn is the expected growth rate in perpetuity and rn is the cost of
equity.
2 approaches:
1 Add up cash flows to all claim holders in the firm.
→ Add cash flows to equity to cash flows to debt (interest
and net debt payments).
2 Estimate cash flows to the firm prior to debt payments but
after reinvestment needs have been met.
Both should yield equivalent results.
We can define:
n
X E (FCFFt ) Terminal valuen
Value = +
t=1
(1 + r )t (1 + r )n
where
E (FCFFn+1 )
Terminal valuen =
rn − gn
gn is the expected growth rate in perpetuity and rn is the WACC.
For the DDM, growth in earnings per share can be written as:
net income
return on equity =
BV of equity
Such excess returns cannot last forever: they should draw in new
competitors who compete them away.
High-growth firms tend to have higher betas than low growth firms.
→ We should adjust the cost of equity downwards as firms
enter stable growth.
These are different ways of getting at the same thing: can be the
same in theory, but rarely in practice.
DDMs and FCFE models will give the same answer if:
1 Dividends equal FCFE.
2 FCFE exceeds dividends, but the excess is invested in
zero-NPV investments.
For this example, values of equity, firm and WACC are all mutually
consistent.
Never mix and match the cash flows and the discount rates.
1 Discount cash flows to firm at cost of equity?
2 Discount cash flows to equity at WACC?
Results were consistent when the values for debt and equity used
in the WACC were the same as those we obtained in the valuation.
If firms’ liabilities are not fairly priced to begin with, we will get
different answers.
This, along with other practical factors, means that equity and
firm valuation often yield different results in practice.
Which to use?
Use DDM
• When you cannot estimate the free cash flows to the firm or
to equity, all you can discount are dividends.
• Free cash flows are difficult to estimate for financial firms.
• Unlike manufacturing firms, financial firms invest primarily in
things like brand name and human capital.
→ Often appear as operating expenses rather than expenses,
meaning these firms report very low CapEx and depreciation.
• Without knowing a firm’s reinvestment, we can’t know its cash
flows.
• When firms’ payouts are close to their FCFE, and are likely to
be going forward.
FCFE vs FCFF
• Use firm valuation when firm leverage is likely to change.
1 Hard to estimate FCFE when financial leverage is changing.
2 Still have to change the WACC in firm valuation as leverage
changes, but this is typically easier.
Steps:
1 Decide on length of high growth phase.
2 Project cash flows during high growth phase.
3 Compute WACC.
4 Compute terminal value.
5 Compute value of equity and equity per share.
Steps:
1 Decide on length of high growth phase.
2 Project cash flows during high growth phase.
3 Compute WACC.
4 Compute terminal value.
5 Compute value of equity and equity per share.
Steps:
1 Decide on length of high growth phase.
2 Project cash flows during high growth phase.
3 Compute WACC.
4 Compute terminal value.
5 Compute value of equity and equity per share.
EBIT(1 − τ )
Return on capital2013 =
BV of equity + BV of debt - cash
10032 × (1 − 0.3102)
=
41958 + 16328 − 3387
= 12.61%
Steps:
1 Decide on length of high growth phase.
2 Project cash flows during high growth phase.
3 Compute WACC.
4 Compute terminal value.
5 Compute value of equity and equity per share.
We begin with the cost of capital for the firm as it currently stands.
For Disney:
1 Assume its beta moves smoothly to 1 in years 6 to 10.
2 Assume its debt ratio moves smoothly to 20% (closer to its
optimum) in years 6 to 10.
Steps:
1 Decide on length of high growth phase.
2 Project cash flows during high growth phase.
3 Compute WACC.
4 Compute terminal value.
5 Compute value of equity and equity per share.
This implies:
growth rate
Reinvestment rate =
return on capital
2.5%
= = 25%
10%
Assume the reinvestment rate will drop smoothly from 53.93% to
25% in years 6 to 10.
Jamie Coen Valuation 55 / 151
Growth in cash flows
E (FCFFn+1 )
Terminal valuen =
rn − gn
All we need is the FCFF, which we get from the assumption that
EBIT grows 2.5% from year 10, and the following formula
Steps:
1 Decide on length of high growth phase.
2 Project cash flows during high growth phase.
3 Compute WACC.
4 Compute terminal value.
5 Compute value of equity and equity per share.
This was about 10% below the market price of $67.71 at the time
of valuation.
→ Based on our valuation, the stock was over-valued and investors
should have sold.
1 Value enhancement.
2 Valuing private firms.
3 The implied equity risk premium.
Through the early stages of the life cycle of a firm, it passes from:
1 Private owners who are fully invested.
2 Angel investors with multiple investments who are somewhat,
but not fully, diversified.
3 Public offerings, where investors are fully diversified.
Value varies according to who owns – and will own – the firm.
→ Creates a rationale for acquisitions.
Three techniques:
1 Surveys.
2 Historical data.
3 Implied equity risk premium.
∞
X E (dividends in period t)
Value =
t=1
(1 + required return on equity)t
The implied equity risk premium notes that we can estimate
dividend expectations for stock indices, and can observe their
initial value.
→ Can back out the implied required return.
→ Gives us an estimate of E (Rm ) in the CAPM, which we can use
to get an estimate of the risk premium E (Rm ) − Rf .
Suppose the S&P 500 is in stable growth, its current level is 900,
the expected dividend yield is 2%, and the growth rate is 7%.
D
Value =
r −g
900 × 0.02
900 =
r − 0.07
→ r = 9%
∞
X E (dividends in period t)
Value =
t=1
(1 + required return on equity)t
Note: if we can do this for the equity risk premium, why not do
this for a firm’s cost of equity directly?
→ Why go through the effort of estimating the CAPM?
∞
X E (dividends in period t)
Value =
t=1
(1 + required return on equity)t
Note: if we can do this for the equity risk premium, why not do
this for a firm’s cost of equity directly?
→ Why go through the effort of estimating the CAPM?
1 Relies on the market valuing each stock correctly.
2 If you see the stock price drop, how can you tell if it is due to
the discount rate or unobserved changes in expected future
dividends?
1 Intrinsic valuation.
2 Relative valuation.
3 Contingent claims valuation.
Revenues.
Earnings.
1 To equity investors.
• Earnings per share.
• Net income.
2 To firm.
• Operating income (EBIT).
Book value.
1 Equity.
2 Firm.
3 Invested capital.
Simple?
→ We need to understand multiples: what they are, what they
look like and what drives them.
The rest of this lecture: attempt to get closer to No. 3, either by:
• Refining the set of comparable firms.
• Refining the choice of multiples.
• Statistical methods of controlling for differences → regression.
MV of equity
Price-to-sales ratio =
Revenues
Enterprise value
Enterprise value-to-sales ratio =
Revenues
Multiples can and do change through time, for individual firms and
sectors and for the market as a whole.
Multiples can and do change through time, for individual firms and
sectors and for the market as a whole.
P0 DPS1 1
PE ≡ =
EPS0 r − g EPS0
Recognise that:
payout ratio × (1 + g)
PE =
r −g
(1+g)n
payout ratio × (1 + g) 1 − (1+r )n
PE =
r −g
payout ration × (1 + g)n (1 + gn )
+
(r − gn )(1 + r )n
where:
• g is the high growth rate and gn is the stable growth rate.
• payout ratio is the payout ratio in the high growth phase and
payout ration is the payout ratio in the stable growth phase.
payout ratio × (1 + g)
PE =
r −g
payout ratio × (1 + g)
PE =
r −g
P0 DPS1 1
PBV ≡ =
BV0 r − g BV0
ROE × payout ratio × (1 + g)
=
r −g
where:
net income
ROE =
BV of equity
earnings per share
=
BV of equity per share
But:
1 Even this isn’t valid if Disney’s risk is different to the other
firms.
2 Does the PEG really control for growth?
payout ratio × (1 + g)
PEG =
g(r − g)
Two results:
1 High-risk companies will trade at lower PEG ratios than
low-risk companies with the same growth rate.
2 Companies with very low or high growth rates will tend to
have higher PEG ratios than firms with average growth rates.
→ PEG (and PE) ratios are nonlinear functions of growth.
→ PEG ratio does not fully control for growth.
For a set of firms, regress the relevant multiple on proxies for its
fundamental determinants.
payout ratio × (1 + g)
PE =
r −g
But we ran a linear regression.
2 alternatives:
1 Include nonlinear terms.
2 Manipulate the formula to get a regression equation.
Relative valuation:
• Simpler to compute.
• Does not involve fewer assumptions.
→ Fewer assumptions to compute, but not to believe its
results.
→ Less explicit about its assumptions.
• Requires thought/analysis after computation.
→ Value of a multiple doesn’t imply under-/over-valuation,
even if you believe multiple is correctly computed.
1 Intrinsic valuation.
2 Relative valuation.
3 Contingent claims valuation.
A financial option is a contract that gives its owner the right (but
not the obligation) to purchase or sell an asset at a fixed price at
some future date.
1 Derive their value from the values of other, underlying assets.
2 Cash flows contingent on specific events.
Two types:
1 Call option: right to buy the underlying asset at a fixed price.
2 Put option: right to sell the underlying asset at a fixed price.
If the price on the expiration date exceeds this (say $30), you can
make money by exercising the call and then selling the stock on
the open market for $30.
→ Get a gain of $10.
If the price on the expiration date < than the stock price, the
holder will not exercise the call.
C = max (S − K , 0)
The holder of a put option will exercise the option if the stock
price S is below the strike price K.
P = max (K − S, 0)
Two European call options with a strike price are written on two
different stocks, whose price tomorrow will be as follows
1 Low-volatility stock with price of $50 for certain.
2 High-volatility stock worth either $60 or $40, with equal
probability.
Real options give you the right to make a business decision after
new information is learned.
Equity has value even if current firm value is well below debt
value.
→ Might pay-off in the future!
If firm value is far above value of debt, we’re far way from the
‘kink’ in the value of equity.
→ Incentives better aligned.
→ Risk is bad.
Intrinsic valuation.
1 DCF models in theory.
2 Determinants of intrinsic value.
3 Choice between DDM/FCFE/FCFF.
4 The practicalities of intrinsic valuation.
5 Topics:
• Enhancing value.
• Private firms.
• Implied equity risk premium.
Relative valuation.
1 How to define and work with multiples.
2 Multiples cannot be studied in isolation.
→ Need to understand fundamental drivers.
3 Regression as a means of controlling for fundamentals.
4 Relative vs intrinsic valuation.
• Information.
• Explicit and intrinsic assumptions.
• Role of intrinsic valuation in informing relative valuation.