Finance Chapter 8 Multistage Two Stage Growth Assumption Exhibit Assumption That Company Will Frequently Have

CHAPTER 8

EQUITY VALUATION

8.1 Important Distinctions

8.1.1 Fairly Valued, Overvalued, and Undervalued

▪ Overvalued

8.1.2 Top-Down Approach versus Bottom-Up Approach

▪ Top-down approach (Exhibit 8.1)

1. Does the Three-Step Process Work?

8.2 An Introduction to Discounted Cash Flow and Relative Valuation

▪ Discounted cash flow analysis and relative valuation

8.2.1 The Foundations of Discounted Cash Flow Valuation

8.2.2 The Constant Growth Model (Gordon growth model) (Exhibit 8.2)

▪ Assumptions of the infinite period DDM:

– Cash flow is a growing perpetuity.

– The required rate of return (k) is greater than the infinite growth rate (g).

▪ Key takeaways:

– If the cash flow is larger (because the company has higher earnings or can pay out a

larger percentage of earnings), then the intrinsic value is greater.

▪ Uses:

– A general estimate of value

8.2.3 The No-Growth Model (Exhibit 8.3)

1. 100 Percent Payout

▪ Assumption is that a company can pay out all of its earnings

8.2.4 Multistage (or Two Stage) Growth Assumption (Exhibit 8.4)

8.3 Discounted Cash Flow

8.3.1 Method #1: The Dividend Discount Model (DDM)

1. Constant Growth Examples

2. No-Growth Examples

3. Present Value of the Growth Opportunity (PVGO), Using Both the Constant Growth Model

and the No-Growth Model

▪ The PVGO represents the portion of a stock’s intrinsic value that is attributable to the

company’s growth.

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▪ Calculated in three steps:

− Calculate the intrinsic value of the stock

▪ PVGO as a Risk Factor

▪ PVGO Can Be Negative

4. Two-Stage DDM (Exhibit 8.5)

8.3.2 Method #2: Free Cash Flow to Equity—The Improved DDM (Exhibits 8.6, 8.7, 8.8)

▪ Goal is to determine the free cash flow that is available to the stockholders after payments to

all other capital suppliers and after providing for the continued growth of the firm.

– Forecast:

o Sales growth

– Solve sustainable growth rate equation for the plowback (the retention rate)

▪ Returning to DDM and PVGO

– Calculate PVGO

▪ Framing Your Research

– Valuation method helps to frame research

▪ What if the Stock Is Trading at Intrinsic Value?

8.3.3 Method #3: Discounted Cash Flow (FCFF)

▪ Discounted cash flow (DCF) or the weighted average cost of capital (WACC) approach

1. Steps in Calculating Free Cash Flow to the Firm (Exhibits 8.10, 8.11, 8.12, 8.13)

▪ Forecast the sales

2. Putting Together the FCFF Model (Exhibit 8.14)

3. Why Didn’t the FCFF Model Value Equal the FCFE Model Value? (Exhibit 8.15)

8.4 Relative Valuation

▪ Multiples are typically used in one of the following ways:

– Comparing multiples to comparable companies

▪ Equity multiples

▪ Trailing multiples

▪ Forward multiple

8.4.1 Implementing Relative Valuation

Step 1: Find Comparable Companies

▪ Common approach is to ask how they are different from a business risk perspective

8.4.3 Advantages of Multiples

▪ Easy to use

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8.4.4 Disadvantages of Multiples

▪ Difficult to use correctly – must find truly comparable companies, must make adjustments

8.5 Ratio Analysis

8.5.1 Growth Rate of Sales

8.5.3 Operating Margins

8.5.5 Accounts Receivable Turnover

8.5.7 Net PP&E Turnover

8.5.9 Changes in Reserve Accounts

8.6 The Quality of Financial Statements

8.6.2 Income Statement

▪ High-quality earnings are repeatable earnings.

8.7 Moving onto Chapter 9