Intrinsic Valuation Overview

Intrinsic Valuation Notes

Table of Contents

  • Dividend Discount Models

  • Equity vs. Firm Valuation – Conceptual

  • Steps to DCF Valuation

  • Free Cash Flow Calculations (CF to Equity and CF to Firm)

  • Enterprise Value

  • DCF: FCFF Valuation Example

  • Unlevering Beta

  • Q&A on DDM and FCFF

  • DCF: FCFE

  • Q&A on FCFE

The Essence of Intrinsic Value

  • Definition: Valuation based on inherent benefits an asset provides.

  • Cash flow generating assets: Value is the function of:

    • Magnitude of expected cash flows over the asset's lifetime.

    • Uncertainty about receiving those cash flows.

  • Discounted Cash Flow (DCF) Valuation:

    • Estimates intrinsic value as present value of expected cash flows.

    • Adjust cash flows or discount rate for risk adjustments.

Risk Adjusted Value: Basic Propositions

  1. For an asset to have value, expected cash flows must be positive sometime during its life.

  2. Ceteris paribus, assets generating cash flows early are more valuable than those generating later cash flows, unless compensated by growth potential.

Dividend Discount Models (DDM)

Basic Concepts

  • DDM as a simplest equity valuation model:

    • Value of stock = Present value of expected dividends (V₀ = PV(Dt)).

Constant Growth DDM (Gordon Growth Model)

  • V₀ = ( \frac{D_{t}}{k - g} )

    • Where,

    • V₀ = Current value

    • Dₜ = Dividend at time t

    • k = Cost of equity

    • g = Dividend growth rate

Example of Constant Growth DDM

  • A stock just paid a $3/share annual dividend growing at 8% indefinitely, with a market capitalization rate of 14%:

    • Calculate stock value using DDM.

Implications of DDM

  • DDM suggests stock value increases with:

    • Larger expected dividends

    • Lower required rate of return (k)

    • Higher expected growth rate (g)

  • Assumes stable growth implies stable operations and can be extended to multi-stage DCF models.

Discounted Cash Flow (DCF) Valuation

  • Two approaches:

    1. Estimate cash flows, discount at risk-adjusted discount rate.

    2. Use certainty equivalents, discount at the risk-free rate.

Equity vs. Firm Valuation

  • Equity Valuation: Cash flows considered after debt payments.

  • Firm Valuation: Cash flows before debt payments, reflecting both equity and debt financing costs.

  • Formulae and calculations for both methods discussed, including:

    • Cash flow computations

    • Terminal value calculations

Free Cash Flow Calculations

Free Cash Flow to Firm (FCFF)

  • Formula for FCFF:

    • ( FCFF = EBIT (1 - Tax Rate) + Depreciation - CapEx - ΔNWC )

  • Components explained:

    • EBIT = Earnings before Interest and Tax

    • ΔNWC = Change in Non-Cash Working Capital.

Free Cash Flow to Equity (FCFE)

  • Formula for FCFE:

    • ( FCFE = FCFF - Interest(1 - Tax Rate) + Net Borrowing - Preferred Dividends )

  • Significance of including debt obligations and net borrowing.

Estimation Example for FCFF/FCFE

  • Given company metrics, calculate FCFF and FCFE incorporating depreciation, capital expenditures, changes in working capital, and tax impacts.

  • Processes for adjusting estimates and understanding cash flow implications.

Enterprise Valuation: Cash Flows and Discount Rate

  • Net Present Value (NPV) of cash flows:

    • Cash flows should be estimated and discounted properly based on the appropriate discount rate (WACC or cost of equity).

Terminal Value in DCF

  • Forecasting future growth rates and determining terminal values crucial for DCF.

  • Approaches to calculating terminal and planning period values.

Unlevering Beta

  • Importance of unlevering beta to obtain asset (unlevered) beta for firms with different capital structures.

  • Approximating beta for private firms requires adjustments based on peer group analysis.

DCF Analysis: Pros and Cons

Advantages

  • Cash flow-based valuation.

  • Market-independent, less affected by market volatility.

  • Flexibility in financial performance scenarios.

Disadvantages

  • Dependence on projections; forecasting challenges.

  • Sensitivity to assumptions, affecting valuation drastically.

Summary of Intrinsic Valuation

  • DDM is conceptually simple but may underestimate value compared to free cash flow methods (FCFF, FCFE).

  • Consider multi-stage models for realistic growth projections followed by terminal value calculations for stable periods.

Final Thoughts

  • Intrinsic value is highly dependent on subjective factors, including buyer perception and assumptions reflective of market conditions.

  • Consideration of non-diversifiable risks when using beta in valuation.

  • Importance of accurate financial modeling in valuation processes.