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Equity Valuation


1. Valuation Frameworks the 'technology side' 2. Analyzing historical performance ... Suppose Hokia and Notorola betas are 1.4 against a broad market index. ... – PowerPoint PPT presentation

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Title: Equity Valuation

Equity Valuation
  • Contents - overview
  • 0. About valuation introduction McKinsey
    Valuation Best Practice
  • 1. Valuation Frameworks the technology side
  • 2. Analyzing historical performance
  • 3. Projecting future performance
  • 4. Continuining Value
  • 5. WACC
  • 6. Relative Valuation
  • 7. Examination
  • 50 written exam
  • 50 valuation case

Goal of the module
  • 1. Understand link between stock market valuation
    and fundamentals
  • 2. Acquire and develop practical valuation skills
    - best practice
  • 3. Understanding sources of corporate value
  • 4. SkillsKnowledge to pass CIIA EV in final exam

CIIA EV Syllabus
  • Equity Markets and Structures
  • BKM Ch 2-3, SAB Ch. 2-3 mostly
  • Covered in Module 1 Mats Hansson market
  • 2. Understanding the Industry Life Cycle
  • BKM Ch 16 (17 new) 5 pages only
  • 3. Analysing the Industry Sector and its
    Constituent Companies
  • Mostly very basic macro definitions (Jan Antell
    Module covers), BKM ch 16 (17 new) 19 pages only
  • 3.1. The Industry Sector
  • 3.2. Characteristics of the Industry
  • 3.3. Macro Factor
  • 3.4. Forecasting For Companies in the Sector
  • 3.5. Balance Sheet Factors
  • 3.6. Corporate Strategy
  • 3.7. Valuations

CIIA EV Syllabus cont.
  • 4. Understanding the Company
  • BKM Ch 16 (17 new) 17 pages
  • 4.1. Historical performance
  • 4.2. Segmental Information
  • 4.3. Inventory, debtors and crediitors
  • 4.4. Depreciation and amortization
  • 4.5. Completing the forecasts
  • 5. Valuation Models of Common Stock
  • BKM Ch 17 (18 new), BM esp. ch 17 Leverage and
    WACC (Corporate Finance too), SAB ch. 12, 16-18
  • 5.1. DDM
  • 5.2. FCFF
  • 5.3. EVA MVA, CRROI, Abnormal earnings model
  • 5.4. Measures of relative value

CGW Valuation (4th ed.)
  • Much deeper, practioner oriented book
  • Both for Corporate Developers and Equity/Industry
  • Industry standard best seeling guide to Valuation
  • Best valuation book
  • Ch. 3 Fundamental Principles of Value Creation
  • (Ch 4)
  • Ch. 5 Frameworks for Valuation
  • Ch. 6 Thinking About Return on Invested Caital
    and Growth
  • Ch. 7 Analyzing Historical Performance
  • Ch. 8 Forecasting Performance
  • Ch. 9 Estimating Continuing Value
  • Ch. 10 Estimating Cost of Capital
  • Ch. 11. Calculating and Interpreting Results
  • Ch. 12 Using Multiples for Valuation

Written exam 50
  • 1-2 essay questions
  • Copeland-Goedhart-Wessels Valuation Ch, 3, 5-12
  • Lecture notes
  • 1-2 valuation problems
  • Relative valuation
  • DCF
  • FCF
  • Cost of capital

Valuation Case 50
  • Task Assess fundamental value of company X by
    applying CGW Valuation Framework
  • Teams w/ 3-4 persons
  • Deadline

Econ101 Supply and demand
  • Prices / values increase when demand exceeds
  • Prices / values fall when supply exceeds demand
  • OK. But why does this happen?
  • 1. Unique onetime-transaction
  • severe contraints in demand and supply
  • 2. New information has arrived that changes the
    expected benefits of ownership of an asset

Benefits of owning?
  • Critical decision point is current transaction
    price vs expected benefits from ownership!
  • BUY (hold) if benefits from ownership exceed
    potential purchase price good, value-increasing
    investment decision
  • SELL (short) if prevailing price exceeds benefits
    from owning the asset good, value creating
    financing decision
  • ( Short selling stock lending essentially
    take a loan indexed to value of a stock gt
    profit from price drops negative interest on

Value creation
  • Necessary condition for profitable growth
  • 1. Scarce resources are used as efficiently as
  • 2. Beating industry/market peers
  • 3. Maintaining competitive edge
  • 4. Attract more capital
  • 5. Create basis for higher compensation levels
    for (talented) agents gt better pay
  • (Side note Industrialism and Global warming
    problem we havent yet been able to correctly
    price all input resources fresh air, rain
  • True long run value creation must be based on
    true pricing of all inputs.

Benefits of owning?
  • OK. But what are the benefits from owning an
  • Cash flow rights
  • Dividends (including their growth potential)
  • Control rights
  • Set corporate policy / active management
  • Get access to corporate resources
  • 3. Favorable risk premium
  • If you can fund an investment cheaper than
    others, certain cash flow stream will be worth
    more to you than others
  • gt risks are being mispriced in the market

Listed vs private investments
  • Market listed stock consensus expectations
    revealed in market price continuously
  • Very few constraints on demand and supply
  • Almost non-existant information monopolies
  • Need to move very quickly on information
  • gt Efficient market hypothesis Utility of
    analysis low
  • (others have already done it)
  • b) Private investments no visibility
  • Possibly huge constraints on demand and supply
  • Monopolies on ideas / resources
  • Likely very inefficient market
  • Utility of analysis potentially very high

Valuation defined
  • personal process of attempting to increase
    ones understanding of where, why and how
    benefits from ownership happen
  • That process will be time-consuming, hard work.
  • How motivated am I?
  • Benefits vs costs extra value created thanks to
    analysis minus costs of conducting the analysis

Arguments against valuation
  • No one can forecast
  • This time is different
  • Investors are not rational
  • Numbers can always be tweaked to serve a
  • Life cant be reduced to some formula exercise

Arguments for valuation
  • All of economics allocation of scarce
  • Undervalued activities gt expand! (buy)
  • Overvalued activities gt shrink (sell)
  • E.g. decide what to do in
  • 1. Corporate restructurings
  • 2. MA deals
  • 3. LBOs
  • 4. Capital structure optimizing
  • 5. Value Based Management
  • 6. IPO pricing
  • 7. Capital budgeting
  • 8. Corporate development
  • 9. Real estate appraisals
  • 10. Active money management

Alternative behavioral decision models
  • Basis for resource allocation decisions - how can
    you do it?
  • Do not invest in understanding gt 100 (gut)
    feeling based choices
  • Do not invest in understanding, but watch
    closely what others are doing and follow them
    (herding) because they are likely to be onto
  • want and hope markets to be inefficient so there
    is always time for followers also to benefit from
    fashion waves
  • Invest in understanding, build own opinion about
    value, go against the crowd if supported by
  • If possible adopt a passive investment style
    without investment in understanding enjoying
    market returns (no more no less)
  • No do, if youre the CEO / corporate guy
    (corporate job)
  • No do, if you run an active fund (wealth
    management job)
  • No do, if you work with MAs or related deals
    (investment bank job)

Misconceptions about valuation
  • Valuation...
  • Myth 1 is an objective search for true value
  • Fact 1.1 All valuations are biased. The only
    questions are how much and in which direction
  • Fact 1.2 The direction and magnitude of the bias
    depends on salary level and boss (motivation)
  • Myth 2. provides a precise estimate of value
  • Fact 2.1 There are no precise valuations (/-15
    error normal)
  • Fact 2.2 The payoff to valuation is greatest
    when valuation is least precise
  • Myth 3 . is better the more quantitative a
    valuation model is
  • Fact 3.1 Ones understanding of a valuation
    model is inversely proportional to the number of
    inputs required for the model
  • Fact 3.2 Simpler valuation models do much better
    than complex ones

  • Purpose Profit from informed investments!
  • Detect under- (over)valuation
  • Buy undervalued / sell overvalued
  • Eliminate market risk by finding similar
    (perfectly correlated) asset gt take opposite

Valuation goals
  • Example You believe Hokia is underpriced at 25
    (fair value 25.5) and Notorola overpriced at
    13.5 (fair value 13.23). Suppose Hokia and
    Notorola betas are 1.4 against a broad market
    index. What should you do, given that, within two
  • a) fair prices will be established for sure.
  • b) actual prices are affected by market
    conditions which could go up or down by 4.
  • c) mispricing still prevails unchanged.
  • d) It turns out analysis was misguided and actual
    fair values were Hokia 24.55 Notorola 13.77.

  • Answers
  • a)
  • b)
  • c)
  • d)

1. Valuation means...
  • ...always taking a stand on
  • 1. Company future Earnings/Cash Flow potential
  • profitable growth
  • how profitable?
  • for how long?
  • 2. Required investments to sustain growth
  • Working capital needs
  • CapEx/Acquisition needs
  • 3. The riskiness of the companys stock
  • in relation to other investment alternatives

Valuation process (McKinsey)
  • Framework for valuation technique (ch. 5)
  • Strategy, Profitability, Industry development gt
    ROI Growth? (ch. 6)
  • Analyzing historical performance (ch. 7)
  • Forecasting future performance (ch. 8)
  • Continuing value (ch. 9)
  • WACC (ch. 10)
  • Interpreting results (ch. 11)
  • Using Multiples for Valuation (ch. 12)

Typical valuation process (McKinsey)
  • Choice of internally consistent realistic
    valuation model
  • Forecast of model inputs
  • ROICs
  • Invested Capital
  • Investment needs
  • Growth rates
  • Cost of capital (discount rate)
  • Usually based upon historical analysis of company
    numbers benchmarking to industry peers
  • Adjusting historical inputs to strategic position
    of the company in its industry
  • 4. Eye for details
  • Dealing with capital structure and financial
  • Dealing with the long horizon of equity
  • Etc.

1. Valuation - summary
Cash Flow

Cost of Capital
Target D/V
ROIforec. period T
ROI post-forec. period

Default premium
1. Re-cap of valuation technologies (Ch. 5)
  • A. Discounted cash flow methods (as it looks
    today value)
  • 1. Direct equity valuation
  • 1.1. Dividend discount model (DDM)
  • 1.2. Free Cash Flow to Equity model (FCFE)
  • 2. Firm/enterprise valuation
  • 2.1. Free Cash Flow to Firm model (FCFF)
  • 2.1.1. WACC
  • 2.1.2. APV
  • 2.1.3. (Economic Profit and Capital Cash Flow
  • B. Relative valuation
  • Valuation ratios (benchmarked against industry
  • C. Option based approaches ( value of active
  • Binomial, tree models
  • more or less analytical formulas (Black-Scholes)
  • D. Other valuation methods (old school)
  • (Adjusted) Book value - substance value
  • provides lower bound for value only

1.1. Generic valuation model
  • Generic valuation equation Present Value
  • where
  • k risk-adjusted discount rate or required rate
    of return
  • defined consistently with the cash flow being
    discounted!frequently assumed constant through
    time (we neglect term structure effects!)
  • ECF expected cash flow of investment
  • V stands for Value
  • EVT terminal, horizon or continuing
    value which slices up the valuation into a
    forecast period 1-T and a horizon period T1
    to inf.

1.1. Frameworks for DCF-based valuation

1.1. Value of a multibusiness company (all
present values, mill.)

1.1. Discounted cash flow models
where EVTE Expected horizon or continuing
value of equity kE is the required rate of
return on (typically levered) equity
where EVTF Expected horizon or continuing
value of firm WACC weighted average cost of
capital kE (E/V) kD(1-tC)(D/V)
1.1. Valuation and KVDs
  • While correct, generic formulas are not user
    friendly given the large number of difficult
    forecasts required...
  • Therefore, we frequently simplify valuations by
    specifying cash flows in terms of Key Value
    Drivers (KVD)
  • Most important KVDs are
  • 1. Cash flow growth (g)
  • 2. Quality of investment (ROI or equivalent)
  • 3. Quantitity of investment
  • e.g. retention or plowback ratio
  • investments into net working capital and fixed
  • 4. Required rate of return
  • (5. Starting level of key cash flow or invested
    capital item)

1.1. Simplifying valuations
  • Typical simplifications (apart from assuming a
    constant discount rate over time)
  • 1. No cash flow growth (mature industry w/ full
    capacity utilization)
  • no growthgt no investments either gt cash flow
    steady forever
  • However cash replacement investments needed to
    support long-term production capability of
  • 2. Constant cash flow growth (Gordon model)
  • cash flow grows at g percent per period, forever
  • growth must be supported by investment
  • there are limits to productivity enhancements!
  • given the additional assumption that ROI of new
    investment remains constant over time, the
    retention or plowback ratio b, i.e. periodic
    investments as a percentage of cash flow is a
    constant!g bROI (in DDM of FCFE use ROE

1.1. Simplifying valuations
  • Typical simplifications (apart from assuming a
    constant discount rate over time) (cont.)...
  • 3. Industry competition wipes out economic profit
    after T periods, no profitable growth thereafter
  • industry converges towards perfect competition
  • strategic edge evaporates over time
  • sensible and prudent given that for no firm can
    perpetual g gt nominal GDP -- which often happens
    in practice with 2!
  • 4. Industry competition reduces economic profits
    by period T, but some profitable growth
    opportunities persist
  • some companies have excelled over very long
    periods so 3. may in some cases be downward

1.1. QD valuation formulas
  • Handy formulas include (see appendix for more
  • Formulas given for equity valuation so E cash
    earnings, use after-tax EBIT in place of E in
    firm valuations!
  • (Formulas will be given in final exam.)
  • 1. No growth
  • 2. Constant perpetual cash flow growth

Symbols E cash earnings (DDM, FCFE) or
EBIT(1-TaxRate) k required rate of return on
equity or WACC b plowback (retention) rate of
earnings or EBIT(1-TaxRate) ROE return on
equity or after-tax return on investment
ROIROI(1-TaxRate) g growth rate of
earnings or EBIT(1-TaxRate)
Note EDIV as no investments!
or EP formulation
1.1. Re-cap of valuation theory
  • Handy formulas ... cont.
  • 3. Growth T periodsno growth thereafter4.
    Supernormal growth T periods normal constant
    growth thereafter

or EP formulation
or approximately
or EP formulation
or approximately
1.3. Simple valuation example NOG Corp.
  • Example NOG Corp.
  • 100 equity financed no growth company
  • Produces a constant EBIT of 10 MEUR
  • depr. assumed cash replacement investment
  • 10 mill. shares outstanding
  • Corporate Tax rate 26
  • Past stock returns havebeen...
  • Riskfree rate is currently 4
  • The expected market risk premium is 6

1.3. NOG fair price?
  • Example NOG Corp.
  • What is current fair share price of NOG?
  • V PV(FCF,k)?
  • V PV(DIV,k)?
  • gt we need cash flow forecast FCF and discount
    rate k!
  • FCF EBIT minus taxes DIV (as no debt!
    repl.inv.depr.!)FCF 10(1-0.26) 7.4 MEUR
  • k required rate of return on NOG unlevered
  • Simplest model is CAPM, so we need NOG equity
    beta estimate...suppose NOG unlevered beta
    estimate is 0.81

1.3. Estimating NOG cost of equity
  • Example NOG Corp.
  • Using CAPM to define risk adjusted discount rate
    k 4 0.81 6 8.86 p.a.

1.3. And the fair share value is...
  • Example NOG...
  • Then

per share
1.3. If NOG had growth prospects...
  • Example NOG...
  • If the future expected free cash flows were,
    e.g., ...
  • with no growthafter 2016...
  • Then
  • V 123 MEUR
  • and
  • P 12.3 /sh.
  • (Can you spotan unrealisticassumption inthe

1.3. NOG as levered equity?
  • Example NOG...
  • What if NOG was levered instead with 40 MEUR
    perpetual 4 debt?
  • We have at least three valuation model choices
  • 1. Firm level APV
  • 2. Firm level WACC calculation
  • 3. Direct equity valuation
  • Let us go back to no growth scenario, for

1.3. APV valuation
  • Example NOG...
  • Method 1. Firm level APV Add PV(financing
    side effects) to unlevered firm value, deduct
    debt to arrive at equity value!
  • PV(fin. side FX) PV(interest tax shields)
    PV(tCkDD) 0.26 0.04 40 / 0.04 10.4
  • Value Unlevered firm value PV(int.tax sh.)
  • Value 83.521 19.4 93.921
  • ./. Debt 40 MEUR gt Value of total Equity is
    93.921 - 40 53.921 MEUR.

1.3. WACC valuation
  • Example NOG...
  • Method 2. Firm level WACC valuation WACC kE
    (E/V) kD(1-tc)(D/V)
  • Need target D/V, assume D/V0.4259 (40/93.921)
  • Need kE, cost of levered equity assume int.rate
    tax shields are risk free, then...
  • kE kU (kU-kD)(1- tc)D/E
  • kE 0.0886(0.0886-0.04)0.74(0.4259/0.5741)
    0.11528, i.e. 11.528
  • Thus, WACC11.528(0.5741) 40.74(0.4259)
  • Value of enterprise/firm 7.4 / 0.078789
    93.921 MEUR.
  • ./. Debt 40 MEUR gt Value of total Equity is
    thus 93.921 ./. 40 53.921 MEUR.

1.3. FCFE valuation
  • Example NOG...
  • Method 3. Direct equity valuation (FCFEDDM
    here) Define FCFE (EBIT-IntExpenses)(1-TaxRat
  • ltgt FCFE (10 - 400.04)(1-0.26) 6.216 MEUR.
  • Discount with cost of levered equity
  • Value of equity 6.216 / 0.11528 53.921 MEUR.

1.3. NOG summary
  • Three methods, one result.!

1.3. Key points in example
  • 1. Match cost of capital with CF to be
  • Equity cash flow levered cost of equity
  • Debt cash flow gt cost of debt
  • Firm cash flow gt WACC if levered, cost of
    unlevered equity if unlevered firm or APV
  • 2. Valuation in nominal terms!
  • 3. Leverage increases kE!
  • 4. Normally growth through investments complicate
    the analysis
  • required investment to sustain growth?
  • growth horizon?
  • quality of growth?
  • capital structure implications of growth?
  • target D/V ratio? constant / changing?

2. Relative valuation (ch. 12)
  • Suppose EPS and corresponding P/E ratios of two
    no-growth firms A and B in the same industry
  • We interpret same industry here as meaning cash
    flows of the two firms are perfectly correlated
    due to similar business logic and capital
  • What do the two P/E ratios 12 and 8 tell us about
    the valuation of A and B...?

2. Relative valuation (Ch. 12)
  • Consider investment strategy
  • Buy 10000 B shares, short sell 12000 A shares
    cost of strategy -100009.6 1200012 -96000
    144000 48000 (receive money!)
  • Annual Dividends received from B 100001.2
    12000 /share.
  • Annual Dividends owed from shorting
    A-120001-12000 /share.
  • Annual cash flow difference from position is
  • We receive money up front against no future
    liability gt arbitrage opportunity, likely to be
    short-livedas arbitrageurs / speculators / hedge
    funds etc. rush to exploit it.

2. Relative valuation (Ch. 12)
  • gt buying pressure increases PB, and selling
    pressure lowers PA, causing P/E ratios to
    converge! If P/E of A and B would be equal, for
    example 10, implying PA10 and PB 12, then
    there would be no arbitrage opportunity...Buy
    10000 B shares, short sell 12000 A shares cost
    of strategy -1000012 1200010 -12000
    12000 0.
  • Annual Dividends received from B 100001.2
    12000 /share.
  • Annual Dividends owed from short position in A
    -120001 -12000 /share.
  • Annual cash flow difference is zero.
  • (Running it backwards, buy A short B, produces
    similar outcome.)

2. Relative valuation
  • Example is a Modigliani-Miller Law of One
    Price justification for usage of valuation
    ratios, measures of relative value ltgt
  • Similar things, in terms of expected return and
  • should cost as much.
  • Conversely, if market is efficient ( limits to
    arbitrage small) and P/E ratios are persistently
    different, then the two firms are somehow
  • note besides differing growth prospects and
    risk, low correlation between cash flows of firms
    even in same industry may occur because of low
    quality of reported accounting information

2. Relative valuation
  • Even with limits to arbitrage (e.g. expensive
    shorting or low liquidity), and some degree of
    dissimilarity between the two firms, valuation
    differences offer a tempting risk arbitrage
  • Those who have A strive to sell it quickly when
    the price is still high
  • B looks like a cheap buy, especially compared
    to the roughly similar quality A
  • Demand and supply move to narrow relative
    valuation gap

2. Relative valuation
  • If a stock has a low multiple compared to an
    industry comparison group, it could be due to
  • False comparison group (apples vs oranges)
  • Error in multiple computation
  • Temporary items distort multiple
  • Differences in risk (e.g. leverage)
  • Differences in growth outlook
  • Other differences such as liquidity of stock,
    quality of governance,
  • Market pricing error (buying opportunity)

2. Four best practices (CGW)
  • Choose comparables with similar prospects for
    ROIC and Growth
  • Use multiples based on forward-looking estimates
  • Use enterprise value (EV) multiples based on
    EBITA to mitigate problems with capital structure
    and one-time gains and losses
  • Adjust the EV multiple for nonoperating items,
    such as excess cash, operating leases, employee
    stock options, amnd pension expenses (same as w/
    ROIC and FCFF adjusting)

2. What is relative valuation?
  • In relative valuation, the value of an asset is
    compared to the values assessed by the market for
    similar or comparable assets.
  • To do relative valuation then,
  • we need to identify comparable assets and obtain
    market values for these assets
  • convert these market values into standardized
    values, since the absolute prices cannot be
    compared. This process of standardizing creates
    price multiples.
  • compare the standardized value or multiple for
    the asset being analyzed to the standardized
    values for comparable asset, controlling for any
    differences between the firms that might affect
    the multiple, to judge whether the asset is under
    or over valued

2. Standardizing Value
  • Prices can be standardized using a common
    variable such as earnings, cashflows, book value
    or revenues.
  • Earnings Multiples
  • Price/Earnings Ratio (PE) and variants (PEG and
    Relative PE)
  • Value/EBIT
  • Value/EBITDA
  • Value/Cash Flow
  • Book Value Multiples
  • Price/Book Value(of Equity) (PBV)
  • Value/ Book Value of Assets
  • Value/Replacement Cost (Tobins Q)
  • Revenues
  • Price/Sales per Share (PS)
  • Value/Sales
  • Industry Specific Variable (Price/kwh, Price per
    ton of steel ....)

2.1. Price Earnings Ratio Definition
  • PE Market Price per Share / Earnings per Share
  • There are a number of variants on the basic PE
    ratio in use.
  • They are based upon how the price and the
    earnings are defined.
  • Price is usually the current price
  • is sometimes the average price for the year
  • EPS earnings per share in most recent financial
  • earnings per share in trailing 12 months
    (Trailing PE)
  • forecasted earnings per share next year
    (Forward PE)
  • forecasted earnings per share in future year

2.1. PE from fundamentals
  • For perpetual growth model (Gordon) divide thru
    w/ E1 to get theoretical forward PE
  • For 2-stage model T period growth no

2.1. PE with 2-stage model
  • You need double digit g, ROE and T together with
    below 10 k to generate PE ratios above 20!
  • If required rate of return of equity would be
    13 (high beta stock),
  • PEs have a very hard time exceeding 15!

2.2. PEG ratio
  • PE ratio divided by estimated earnings growth
    rate 100
  • PEG1 is neutral valuation
  • In actual fact, risk and payout (1-plowback)
    continue to affect PEG-ratio
  • Division by g does not neutralize the effect of
    growth due to non-linearities

2.3. Relative PE
  • Ratio of firm PE to overall market P/E
  • should use same earnings base in calculation
  • Normalization by market enables better
    comparisons of valuations over time
  • - Not (as) dependent on market interest rate
  • Increases when firm growth rate above market
    growth rate
  • Decreases when firms riskiness w.r.t. market
    increases (high beta stocks)

2.4. Value/Earnings and Value/Cashflow Ratios
  • While price earnings ratios look at the market
    value of equity relative to earnings to equity
  • Value/earnings ratios look at the market value of
    the firm relative to operating earnings. Value to
    cash flow ratios modify the earnings number to
    make it a cash flow number.
  • The form of value to cash flow ratios that has
    the closest parallels in DCF valuation is the
    value to Free Cash Flow to the Firm, which is
    defined as
  • Value/FCFF (Market Value of Equity Market
    Value of Debt)
  • EBIT (1-tc) - (Cap Ex - Deprecn) - Chg in WC

2.5. Enterprise value / FCFF
  • Multiple is increasing in FCF
    (EBIT) growth and decreasing in cost of capital

2.6. Alternatives to FCFF - EBIT and EBITDA
  • Many find FCFF too messy to use in multiples
    (partly because capital expenditures and working
    capital have to be estimated). They use modified
    versions of the multiple with the following
    alternative denominator
  • after-tax operating income or EBIT(1-tC)
  • pre-tax operating income or EBIT
  • net operating income (NOI), a slightly modified
    version of operating income, where any
    non-operating expenses and income is removed from
    the EBIT
  • EBITDA, which is earnings before interest, taxes,
    depreciation and amortization.

2.6. Pros of Value/EBITDA
  • 1. EBIT gt 0 even when earnings negative.
  • 2. Some long-term high growth firms may have
    misleading (too low) current earnings due to
    heavy investment needs
  • 3. Comparing firms with differing leverage is OK.
  • (EBIT level, WACC might differ though)

2.7. Price-Book Value Ratio Definition
  • The price/book value ratio is the ratio of the
    market value of equity to the book value of
    equity, i.e., the measure of shareholders equity
    in the balance sheet.
  • Price/Book Value Market Value of Equity
    Book Value of Equity

2-stage growth no growth
/ BV0
Note E1 BV0ROE
2.7. P/B to ROE
  • Like PEG, ROE could be normalized against
    differing ROE levels by division to give a Value
  • Value Ratio (P/B) / ROE

2.8. Price Sales Ratio Definition
  • The price/sales ratio is the ratio of the market
    value of equity to the sales.
  • Price/ Sales Market Value of Equity
  • Total RevenuesCould also
    normalize it against profit margins
  • Normalized Price/Sales (Price/Sales) / Profit

2.9. Choosing the right multiple
  • EV/EBIT and EV/EBITDA and P/B have the best
  • P/S and P/E worse
  • Always use foreward earnings / EBIT etc.

2.9. Choosing Between the Multiples
  • Many multiples exist...which one to use?
  • In addition, relative valuation can be relative
    to a sector (or comparable firms) or to the
    entire market
  • Since there can be only one final estimate of
    value, there are three choices at this stage
  • Take a simple average of all multiple implied
  • Take a weighted average of all multiple implied
  • Choose best multiple and imply value from it?

2.9. Picking one Multiple
  • Usually best method (and easiest)compared to
    averaging business...
  • The multiple that is used can be chosen in one
    of three ways
  • Cynics Pick the multiple that serves your
  • Use the multiple that actually has been shown to
    be related to actual market values. How do we
    know? Research team needed.
  • Use the multiple that seems to make the most
    sense for that sector, given how value is
    measured and created.

2.9. Guidelines
  • Some common sense guidelines for multiple
  • Sector Multiple Used Rationale
  • Cyclical Manufacturing PE, Relative PE Often with
    normalized earnings
  • High Tech, High Growth PEG Big differences in
    growth across firms
  • High Growth/No Earnings PS, VS Assume future
    margins will be good
  • Heavy Infrastructure VEBITDA Firms in sector have
    losses in early years and reported earnings
    can vary
  • depending on depreciation method
  • REITa P/CF Generally no cap ex investments
  • from equity earnings
  • Financial Services PBV Book value often marked to
  • Retailing PS If leverage is similar across firms
  • VS If leverage is different

3. Valuation framework (Ch. 6-)
  • Copeland-Koller-Murrin Valuation...
  • Best practice
  • Widely accepted, sound principles
  • Steps are
  • 1. Analyze historical performance
  • 2. Estimate cost of capital
  • 3. Forecast performance
  • 4. Estimate continuing value
  • 5. Evaluate scenarios

3. Step 1. Analyzing Historical Performance
  • Assess historical KVDs and FCF
  • - Strive to pick an entire historical economic
  • - beware of cyclically low/high recent cash
  • - normalization often advisable

3. Step 1. Analyzing Historical Performance
  • Integrate Income and Balance sheets to cash flows
    and further to key ratios
  • Reorganize accounting statements for valuation
  • Invested capital
  • NOPLAT (roughly after-tax EBIT)
  • historical ROIC
  • breakdown in tree ROIC Operating margin
    Capital Turnover
  • historical Economic Profit
  • historical FCFF
  • historical growth
  • historical investment rates (into NWC and CapEx)
  • credit health liquidity position
  • other stuff
  • goodwill, operating leases, reserves
  • Benchmark to peers or market
  • caution to differing international accounting

3. Realistic ROI and growth levels
  • Example Stockmann ROI

3. Realistic ROI and growth levels
  • Example Stockmann Sales Growth

4. WACC or APV?
  • WACC-method works best when...
  • 1. Target long-term capital structure can be
    assumed constant
  • 2. Capital structure is simple, few embedded
    liability options
  • APV-method works best when...
  • 1. Target D/V is not constant through time
  • 2. Complicated option-features present
  • e.g. significant executive options (warrants)
  • significant mezzanine financing convertible debt
  • Valuation steps with APV
  • 1. Compute 100 equity financed (i.e. unlevered)
    enterprise value
  • 2. Add PV of financial side fx like subsidized
    financing, debt capacity
  • 3. Add excess marketable securities
  • 4. Subtract senior claim values senior bonds,
    junior bonds, mezzanine, executive warrants...to
    get value of equity

4.1. Estimating cost of capital
  • Cost of capital reflects, among other things at
  • investors willingness to entrust their money
    with the (managers of) the firm for a reasonable
    price given the expected outlook on company cash
  • Cost of capital increasing in factors reducing
    willingness (mistrust)
  • High risk
  • Illquidity (foreign listed? size/turnover?)
  • Bad/unclear corporate governance
  • Wierd ownership structure (only domestic owners,
    single majority owner?)

4.1. Estimating cost of capital - Risk
  • (Given no pricing error) If cash flow growth
    prospects do not explain (e.g.) a high valuation,
    it must be due to (most) investors being really
    eager to hold the stock low cost of capital
  • they perceive it as low risk OR
  • they truly trust the CG OR
  • it is really big liquid (blue chip) OR
  • it is a large global company listed on many
    stock exchanges
  • (wide globally diversified ownership base)

4.1. Estimating cost of capital - Risk
  • The major component traditionally assumed to
    impact cost of capital
  • Debt financing Use of bond ratings to gauge risk
    class and credit spread
  • Equity financing Level of systematic risk of
    industry (unlevered equity beta) financial
    leverage effect

4.1. Estimating WACC
  • 1. Use market value weights for all types of
  • 2. Specify cost of capital items after-tax to
    match after tax free cash flow.
  • 3. Use nominal cost of capital (1real
  • to match nominal cash flow modelling
  • 4. Utilize market prices at date of valuation, if
  • Debt deducted should equal debt in WACC
  • Check for gross discrepancies between assumed
    target D/V ratio in WACC and that implied by
    your valuation!

4.1. Step 2. Estimating the Cost of Capital
  • The WACC can be defined in many ways, two most
    common definitions include (assumes simple DE
    only capital structure!)
  • where tc is the corporate tax rate
  • kU unlevered cost of equity
  • kD cost of debt
  • kE cost of (levered) equity

assumes debt cash flows are equally risky as debt
and therefore discounted with kD! Can always
be used!
assumes debt cash flows are risky and therefore
discounted with kU!
4.1. Step 2. Estimating the Cost of Capital
  • Current practice tends to measure risk in equity
    through the beta, i.e. assume the CAPM holds.
  • Then beta is the risk measure supposed to
    reflect, systematic risk, liquidity, CG,
    ownership structure
  • Beware!
  • ? Even ignoring 2.-4, a better APM than CAPM is
    the Fama-French 3 Factor Model
  • high (low) beta stocks as well as small value
    (large growth) stocks have higher (lower) than
    average systematic risk and hence cost of equity
  • On top of equity risk financial leverage must be
    taken into account...

4.1. FF 3FM

4.1. Step 2. Estimating the Cost of Capital
  • Relationship between levered and unlevered cost
    of equity are as follows (zero growth case,
    approximation to other cases)
  • where tc is the corporate tax rate
  • kU unlevered cost of equity
  • kD cost of debt
  • kE cost of (levered) equity

assumes debt cash flows are equally risky as debt
and therefore discounted with kD!
assumes debt cash flows are risky and therefore
discounted with ku!
4.1. Step 2. Estimating the Cost of Capital
  • Relationship between levered and unlevered equity
    betas are as follows (zero growth case,
    approximation to other cases)
  • where tc is the corporate tax rate
  • bU unlevered equity beta
  • bD debt beta
  • bE levered equity beta

assumes debt cash flows are equally risky as debt
and therefore discounted with kD!
assumes debt cash flows are risky and therefore
discounted with ku!
4.1. Target D/V?
  • 1. Use market value weights for all types of
  • Market D/E ratio (Book D/E ratio)
    (Book/Market ratio) !
  • Only if B/M 1 then market and book gearing
  • Usually assumed constant through time, although
    not mandatory
  • Think in terms of the long-term target capital
  • 1. Smoothing over recent transitory capital
    structure changes
  • 2. Get around circularity problem
  • 3. Benchmark to industry, why deviation?
  • The debt you subtract to get equity should
    normally be the debt used in the capital
    structure WACC

4.2. Cost of debt
  • Straight investment grade debt
  • Find company bond rating
  • Use current yield from rating class as a proxy
    for expected cost of debt
  • Below investment grade
  • Significant default rates bias (promised) yields
    upward compared to expected yields!
  • Need expected default rates and value in default
    to compte expected yields...
  • May need to use BBB-rated debt yields as proxy
  • Own rating model
  • e.g. interest coverage ratio based

4.3. Cost of hybrids or mezzanine
  • e.g. convertible bonds, capital loans etc.
  • Split up value into
  • (1) bond part and (2) warrant part (or
    equivalent option)
  • Estimate costs as cost of debt and equity for the
    parts separately.

4.4. Cost of equity
  • 1. CAPM expected cost ( return)
  • rf risk free rate
  • Market Risk Premium Erm - rf
  • Beta of security / capital type i, bi
  • 2. Implied IRR from valuation model
  • e.g. solve for kE from P DIV1/(kE - g) given P
    and DIV1 and g forecasts!

4.4. Cost of equity
  • 1. CAPM
  • rf should be defined with
  • no default risk
  • no re-investment risk (term structure effects0)
  • no inflation risk
  • in practice, 5 or 10 year government bond yield
    typically used
  • match with duration of firm cash flow
  • not universally accepted, some advocate short
    maturity TBills
  • choose rf consistently with MRP!
  • New in U.S TIPS (Treasury-Inflation-Protected-
    Securities) replacing Tbills as a riskfree rate!
  • Coming in Europe?

4.4. Cost of equity
  • 1. CAPM
  • Expected Market Risk Premium
  • These days around 2-4 for developed markets
  • Think Europe or World as the market
  • Use consistent rf definition with above!
  • Historical average likely too high
  • Good luck
  • Inconsistency with theories
  • Survivorship bias
  • Dimson-Marsh-Staunton European data

4.4. Cost of equity
  • 1. CAPM
  • Beta?
  • unlevered vs levered equity betas
  • preferably, use industry average unlevered equity
  • historical OLS regression
  • need to unlever to first get industry betas!
  • use monthly data/longer estimation period to
    combat illquidity distortions

4.4.Historical market premium varies a lot

Forecasts made 5 (10) years ahead using D/P
4.4. Implied market return
  • 1. Pick a 2-stage model for T year horizon
  • 2. Obtain market index dividend forecasts up to
  • 3. Estimate long-term nominal growth rate of
    market (nominal long-term GDP growth usually).
  • 4. Back out rm that equates PV(dividendsHV) with
    current market index level.

4.5. Alternative approaches
  • 1. Fama-French 3F model already mentioned as
    being the one
  • (at least) academics mostly believe in
  • although we know it doesnt explain well
    momentum, small growth stocks etc.-
    implementation issues estimate three premia and
    three betas instead of 11...
  • 2. Use of past (long-term!) realized average
    stock return (of peers)?
  • Tend to be very noisy and highly dependent on
    sample period

5. Step 3. Forecasting Performance
  • 1. Length and detail of forecasts
  • 2. Analyze industry
  • business logic
  • threats from new entry/new technology?
  • sustainability of margins, ROIC, growth
  • 3. Link between strategy and future KPIs
  • Strategy gt KPI forecasts gt Inc. and BS
    forecasts gt FCFF forecasts
  • 4. Evaluate alternative scenarios
  • 5. Overall consistency
  • growth ltgt ROIC ltgt Investments vs strategic

5.1. Forecasting cash flows
  • We should forecast expected cash flows or
    alternatively do scenario-based valuations
  • Scenario prob. CF
  • Optimistic 40 10
  • Realistic 40 8
  • Pessimistic 20 -4
  • ECF 6.4
  • Frequent error is to provide upward biased
    budget, or hoped for forecasts instead of
  • e.g., do the forecasts acknowledge there is some
    probability for a zero CF?

5.1. Forecasting FCF
  • 1. Forecast KVDs
  • 2. Build pro forma income statements and balance
    sheets from KVDs
  • check reasonability of numbers, benchmarking,
    financing feasible?
  • 3. Derive FCF from step 2.

5.1. Free Cash Flow To Equity - FCFE
  • EBIT
  • ./. Interest Expense
  • EBT
  • ./. taxes
  • Net Income
  • Depreciation
  • CF from operations
  • ./. Working capital increase (operative,
  • ./. Gross capital expenditures
  • ./. Debt amoritizations
  • New debt issues
  • FCFE

5.1. Free Cash Flow To Firm - FCFF
  • EBITA (EBIT before Interest, Taxes and
    Goodwill Amortization)
  • ./. taxes ( may have to be adjusted for
    financial items)
  • Depreciation (all depreciation but goodwill
    type amortization)
  • Gross CF
  • ./. Working capital increase (non-interest
    bearing or operative)
  • ./. Gross capital expenditures (net investment
  • FCFF before goodwill
  • ./. Investments into goodwill (DGoodwill
    goodwill amort.)
  • FCFF after goodwill

6. Step 4. Estimating Continuing Value
  • 1. Pick simplified long-term growth model
  • Industry analysis - the long run
  • 2. Estimating long run continuing value model
  • ROIC, NOPLAT growth rate, investment rate?

6. Step 4. Estimating Continuing Value
  • 1. Forecast at least 7 years (over a whole
    business cycle).
  • 2. ROIC is marginal ROIC, for many companies
  • 3. NOPLAT(T1) should be normalized.
  • 4. FCF - remember to subtract investments
    required to sustain long-term growth
  • 5. Growth rate - normally long term cons.
    (volume, or real) growth of industrys product
  • Long-term nominal GDP growth is about /-6

6. Step 4. Estimating Continuing Value
  • 6. Long term growth should never exceed nominal
    GDP (nominal RF level) growth
  • 7. Constant growth could be assumed zero or
    negative indicating we model a peak at T and then
    diminishing size for company in relation to
  • 8. Frequently riskiness of firm changes as it
    enters a constant growth phase from high growth
    gt lower beta?

7. Step 5. Interpret the results
  • 1. Calculate PV(FCFF) PV(continuing value)
  • 2. Subtract debt, hybrid securities, PV(leases) ,
    minority interest, executive options
  • in-the-money executive options can alternatively
    be treated as fully diluted equity gt increase
    number of shares instead of subtracting value of
    exec. options.
  • 3. Add cash/excess marketable securities
  • 4. Add PV(non-operative) cash flow or assets
  • 5. Weight each scenario with steps 1.-4 with
    scenario probabilities to sum up.

7. Some closing remarks...
  • Develop a habit of drawing time lines graphs
    (10-30 years ahead) of your projected ROIs
    (compare to WACC), gs
  • Normalize and average out lumpy investments/NWC
  • Positive NWC temporary, prudent to assume zero.
  • Look out for starting level CF, HV assumptions
    many valuation errors can be traced back to
  • Stick to gROIb consistency
  • Dont overdo cost of capital estimations (unless
    you are selling them for a good price )
  • No way these will ever be 100 accurate, so dont
    worry about third decimal of your beta
  • Ask is this a stock investors like? If yes, is
    it just the growth outlook, or is it something
    else? If they dont like a stock, why?
  • Check ownership structure, low cost of capital
    firms have dispersed, global ownership, good
    track record of liquidity and good CG
  • Very high valuation must go together with low
    cost of capital if you cant see it, suspect
  • If overvaluation would actually be present who
    would/could move to exploit it? Why dont they?

7. Valuation - summary
Cash Flow

Cost of Capital
Target D/V
ROIforec. period T
ROI post-forec. period

Default premium
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