FIN3218 CORPORATE FINANCE

TOPIC 2: VALUATION
 LEARNING OUTCOMES

 Understand Dividend Valuation

 Understand Free Cash Flow Valuation
 BASIC VALUATION METHODS

Valuation

Free Cash
Assets Earnings Dividend
Flow
 DIVIDEND VALUATION

 Value of a common share:

P 1 + D1
P0 =
Where:
(1+r)
P0 = Present value of the expected stock price at the end of period 1
D1 = Current Share Price at the end of period 1
D1 = Dividends received
r = discount rate
 VALUATION FUNDAMENTALS:
COMMON STOCK

 But how is P1 determined?

 This is the PV of expected stock price P2, plus dividend at time 2
 P2 is the PV of P3 plus dividend at time 3, etc...
 Repeating this logic over and over, you find that today’s price equals PV of
the entire dividend stream the stock will pay in the future
 TYPE OF DIVIDEND VALUATION

Constant
Zero Growth Variable
Growth
Model Growth
Model
 ZERO GROWTH MODEL

 To value common stock, one must make assumptions about the growth of future
dividends
 Zero growth model assumes a constant, non-growing dividend stream:
D1 = D2 = ... = D
 Plugging constant value D into the common stock valuation formula reduces to simple
equation for a perpetuity:
D
P0 =
r
 CONSTANT GROWTH MODEL

 Assumptions:
 Dividend (D1) expected in one year
 Dividends grow at constant rate (g) forever
 Growth rate less than required return (r > g)
 Situations in which model is useful:
 Mature (late in life cycle) firms
 Broad-based equity index
 Terminal value in more complex models
 International valuation
 Can be used to calculate P/E ratio
 CONSTANT GROWTH MODEL

 Assumes dividends will grow at a constant rate (g) that is less than the required return
(r)
 If dividends grow at a constant rate forever, one can value stock as a growing
perpetuity, denoting next year’s dividend as D1:

D1
P0=
r-g
 CONSTANT GROWTH MODEL

 Constant growth model should reflect long-term growth expectations – GDP growth,
industry life cycle stages and the impact of the five force model
 The model’s intrinsic values V0 are very sensitive to the input variables for r and g
 Sensitivity analysis may be required to obtain a range of values rather than a specific
point estimate of value
VARIABLE GROWTH
 EXAMPLE OF VARIABLE GROWTH MODEL

 Estimate the current value of Morris Industries' common stock, P0 = P2003

 Assume
 The most recent annual dividend payment of Morris Industries was $4 per share
 The firm's financial manager expects that these dividends will increase at an 8%
annual rate over the next 3 years
 At the end of the 3 years the firm's mature product line is expected to result in a
slowing of the dividend growth rate to 5% per year forever
 The firm's required return, r , is 12%
 EXAMPLE OF VARIABLE GROWTH MODEL

 Compute the value of dividends in 2004, 2005, and 2006 as (1+g1)=1.08 times the previous year’s dividend

Div2004= Div2003 x (1+g1) = $4 x 1.08 = $4.32

Div2005= Div2004 x (1+g1) = $4.32 x 1.08 = $4.67
Div2006= Div2005 x (1+g1) = $4.67 x 1.08 = $5.04

 Find the PV of these three dividend payments:

PV of Div2004= Div2004  (1+r) = $ 4.32  (1.12) = $3.86

PV of Div2005= Div2005  (1+r)2 = $ 4.67  (1.12)2 = $3.72
PV of Div2006= Div2006  (1+r)3 = $ 5.04  (1.12)3 = $3.59
Sum of discounted dividends = $3.86 + $3.72 + $3.59 = $11.17
 EXAMPLE OF VARIABLE GROWTH MODEL

 Find the value of the stock at the end of the initial growth period using the constant
growth model
 Calculate next period dividend by multiplying D2006 by 1+g2, the lower constant growth
rate:
D2007 = D2006 x (1+ g2) = $ 5.04 x (1.05) = $5.292

 Then use D2007=$5.292, g =0.05, r =0.12 in constant growth model:

D 2007 $5.292 $5.292
P2006 = = = = $75.60
r - g 2 0.12 - 0.05 0.07
 EXAMPLE OF VARIABLE GROWTH MODEL

 Find the present value of this stock price by discounting P for 2006 by (1+r)3:
P 2006 $75.60 $75.60
PV = = = = $53.81
(1  r ) (1.12)
3 3
1.405

 Add the PV of the initial dividend stream (Step #2) to the PV of stock price at
the end of the initial growth period (P2006):

P2003 = $11.17 + $53.81 = $64.98

TIME LINE FOR VARIABLE GROWTH VALUATION
 DIVIDENDS BASED VALUATION

ADVANTAGES
 Dividends less volatile than other cash
flow measures, more stable and predictable
 Theoretically justified – dividends are what
you receive when you buy a stock
 Accounts for reinvested earnings to
provide a basis for increased future
dividends
DISADVANTAGES
 Firm may not pay dividends due to lack
of profitability or little cash available
for distribution
 Historically many firms are paying less
dividends for tax reasons
 FREE CASH FLOW APPROACH

 Begin by asking, what is the total Operating Cash Flow (OCF) generated by
a firm?
 Next subtract from the firm’s operating cash flow the amount needed to fund
new investments in both fixed assets and current assets.
 The difference is total Free Cash Flow (FCF)
 Represents the cash amount a firm could distribute to investors after meeting all its
other obligations
 FREE CASH FLOW (FCF) MODEL
 The FCF valuation model defines the value of a company’s operations as the present
value of its expected free cash flow when discounted at the weighted average cost of
capital (WACC)
 Managerial choices that change operating profitability, asset utilization or growth also
change FCF hence the value of operations
 FCF valuation model can be applied to all companies, whether or not they pay dividend
and whether they are publicly traded or privately held. It also can be applied to divisions
within companies
 SOURCE OF VALUE

 The total value of a company is called its entity value

 FCF is the cash flow available for distribution to all of a company’s
investors
 Weighted Average Cost Of Capital (WACC) is the overall return required
by all of a company’s investors
 HOW TO CALCULATE FCF

 Net Operating Profit after Taxes (NOPAT) = EBIT (1- Tax Rate)
 Net Operating working capital (NOWC) = Operating current asset – operating current
liabilities
 Total net operating capital = Net operating working capital (NOWC) + Operating long
term assets
 FCF = NOPAT – Net investment in operating capital
 VALUATION USING FCF

 Because FCF is generated by the company’s operations, the present value of expected
fcf when discounted by WACC is equal to company’s value of operation
 VOP = FCF1 / (1 + WACC)1 + FCF2 / (1 + WACC)2 …. + FCFn / (1 + WACC)n

 The value of operations is the present value of all the expected cash flow discounted at
the cost of capital
 TOTAL INTRINSIC VALUE

 When using the FCF valuation model, a company’s total intrinsic value is the value of
the operations plus the value of short term investments
 Total intrinsic value = value of operations + short term investments
 INTRINSIC VALUE OF EQUITY

 For intrinsic value of equity, its remaining value after subtracting the claims of
debtholders and preferred stockholders
 Intrinsic value of equity = Total Intrinsic Value – All Debt – Preferred stock
 Intrinsic Stock Price = (Intrinsic Value Of Equity) / (Number Of Shares)