Lecture 13: Equity Valuation

What is book value?

• The net worth of the firm’s common equity as reported on the balance sheet

• It is simply Total Assets minus Total Liabilities

Example of book value

• firm has $500 in assets, $300 in liabilities so book value of equity is $200 and if there are 10 million shares outstanding, the book value per share is $20 

What is the limitation of book value?

• book value uses historical costs, does not reflect what assets are worth today

What is liquidation value?

• Net cash that would be realized if the firm sold all of its assets and paid off all its debts or liabilities 

• It is a “what if we shut down today” measure 

• Often lower than book value because assets may sell at a discount in a forced sale 

Example of liquidation value

• The firm’s assets could be sold for $420 million

• Debts total $300 million

• Liquidation value = $420m - $300m = $120 million

What is replacement cost?

• Cost to replace the firm's assets with the new ones of the same productive capacity 

• It answers “What would it cost to build this firm from scratch today?” 

• Is closer to current economic value than historical book value 

Example of replacement cost

• A firm’s plant and equipment were bought years ago for $200 million

• Today, equivalent new equipment would cost $350 million

• Replacement cost of those assets = $350 million

What is tobin’s q?

• Ratio of the firm’s market value to the replacement cost of its assets 

• Tobin’s q = Market value of firm/ replacement cost of assets

• "Is this company worth more as a business than it would cost me to build the same company from scratch?"

• compares what investors think a company is worth with what it would cost to recreate that company

What does tobin’s q: q > 1 mean?

• the market values the firm more than it would cost to replace its assets

• The company is worth MORE than it would cost to replace its assets

• The firm is creating value

What does tobin’s q: q < 1 mean?

• market values the firm less than its replacement cost, may be cheaper to buy the firm than to build one 

• The company is worth LESS than it would cost to replace its assets.

  
  

Example of tobin’s q

• Market value of the firm = $400 million

• Replacement cost of assets = $350 million

• Tobin’s q = 400 / 350 ≈ 1.14. The firm is creating value

What is the formula for expected HPR?

• E(r ) = (E(D1) + [E(P1) - P0] ) / Po

Example of expected HPR: Example: Suppose you purchased a share for $40 in January. You expect to sell it for $42 in December and expect to receive a dividend of $2.42 during that year. What is your expected HPR?

• E(r ) = (E(D1) + [E(P1) - P0] ) / Po

• E(r ) = 2.42 + 42 - 40 / 40 = 11.05%

What is intrinsic value?

• The present value of a firm’s expected future net cash flows, discounted at the required rate of return 

• Estimate of what the stock is truly worth, based on the cash is expected to generate 

Example of intrinsic value

• A firm is expected to pay $2 in dividends next year, growing at 3% per year forever.

• The required return is 8%.

• Intrinsic value = $2 / (0.08 - 0.03) = $40 per share

• used gordon growth model: Po = D1/ r- g

What is the market capitalization rate (k)?

• market’s consensus estimate of the appropriate discount rate for equity cash flows, often denoted by k 

• the minimum return investors want to earn for investing in a company's stock

• k = The percentage return investors want to earn for taking the risk of investing in a stock

  
  

What is true if the intrinsic value > market price?

• the stock looks undervalued

What is true if the intrinsic value < market price?

• the stock looks overvalued

What is true if the intrinsic value = market price?

• stock returned to being on the SML line

What is the formula to find the intrinsic value for one period?

• Vo = (D1 + P1) / 1+k

• k = market capitalization rate and discount 

• Note: All future dividends and prices are expected values; notation removed to avoid clutter.

How do you find the intrinsic value for holding period H?

• Vo = D1/(1+ k) + D2/(1+k)² + D3/(1+k)³

• Note: All future dividends and prices are expected values; notation removed to avoid clutter.

What is the formula for constant-growth DDM?

• Vo = D1/k-g (present value of perpetuity formula) SOOO

• Vo = Do(1+g) / k-g

• form of DDM that assumes dividends will grow at constant rate

• dividends grow at constant rate of growth (g)

• k > g

The constant growth model states that a stocks value will be greater…

• the larger its expected dividend per share

• the lower the market capitalization rate, k

• the higher the expected growth rate of dividends

What is are key takeaways about this formula/relationship?

• Vo = Do(1+g) / k-g

• future dividend payments are the ones that count, not ones that have already been made

• If D1 increases, then Vo increases

• If k increases, Vo decreases

• If g increases, Vo increases

What does the graph regarding DDM: Stock value show?

• Red firm: low investment, high dividend payout rate

  • 0 reinvestment, then line would be horizontal line 

• Blue firm: reinvests a lot 

• Difference: how much money they retain versus how much they payout 

• Firm that pays less in dividends will make larger payments

What is the dividend payout ratio?

• percentage of earnings paid as dividends 

What is the plowback ratio/earning retention ratio?

• proportion of firm’s earnings reinvested in business

• Retained earning last period/ net income last period

What formula allows you to find the Present Value of growth opportunities (PVGO)?

• Po = No-Growth Value per Share + PVGO = (E1/k) + PVGO

• PVGO = Po - E1/k

• Po = market value of stock, price per share OR intrinsic value per share

• PVGO = present value of growth opportunities

• E1 = earnings per share, will stay constant, can be E1 or Eo

• k = market capitalization (PV = CF/r)

What is true about value of the firm? (free cashflow valuation)

• the value of a firm can be obtained by discounting expected cashflows to the firm — whatever remains after meeting all operating expenses and taxes but excluding debt payments

• project future free cash flows of the firm for as many periods as you can AND discount back to the present (the discount rate is the firm’s WACC) 

• WACC: weighted average of cost of debt, equity, and hybrids such as preferred stocks 

• Cannot use the market capitalization rate alone  

What is true about value of equity? (free cashflow valuation)

• Similarly, we can determine the value of equity by discounting expected cashflows to equity — whatever remains after meeting all operating expenses, taxes, and debt payments

• The discount rate in this case is the market capitalization rate (or cost of equity, ke) as opposed to the WACC

What is the formula for free cash flow to firm?

•  EBIT( 1-t) - (Cap. Exp. - Dep) - Change in WC

What is the formula for free cash flow to equity?

• Net Inc - Net Cap Exp (1-Debt ratio) - Ch WC (1-D.r.) 

How can you find FCFE using FCFF?

• free cash flow to equity = FCFF - Interest (1-t) + Change in Net Debt

What is true about expected growth in EPS?

• g = (retained earnings last period/ net income last period) * ROE

• SO = retention ratio * ROE

• Plowback ratio = 1- Dividend Payment Ratio

• Long run growth rate cannot exceed ROE

• There will be no growth without reinvestment 

• The quality of new projects matters as it affects the ROE 

Why does growth matter?

• Can we assume constant, stable growth? We will have to make that assumption to find the terminal value

• If so, the value of the firm (or its equity, depending on which cash flows and discount rate we use) will be given by: Value = Expected Cash Flow Next Period / (r - g)

• Remember, this rate of growth cannot exceed the rate of growth of the economy as a whole (or your discount rate!)

• This may be a reasonable assumption for a mature firm

• One may argue all firms will eventually get there, so this is not entirely unreasonable

What is true about projecting CFs/dividends, finding the rates of growth, and discount rates?

• it’s a lot of work and valuation is affected by judgement we make, slight changes in assumptions produce different results

• Solution: we can try to price firms relative to the industries in which they operate

What main assumptions do we make if we do relative valuation?

• Easier way: valuations by multiples →

  • Other firms in the industry are, on average, correctly priced

  • They are all of similar risk

  • They are at the same stage of their growth cycle

• If these assumptions have been met, we can obtain the value of a firm based on the values of other, similar firms using common ratios, such as 

  • price/earnings (P/E) ratios

  • price/book value (P/BV) ratios

  • price/sales ratios and their variants

  • Much simpler than discounted cash flow valuation, but we must trust current market price

To find the intrinsic value of the firm’s equity what do we look at?

• look at FCFE and cost of equity

To find the intrinsic value of the firm what do we look at?

• look at FCFF and WACC