Lecture 9: Equity Valuation P2

Investment Analysis: Equity Valuation Overview


Topic: Discounted Cash Flow (DCF) ModelsFocus: This lecture by David Zynda emphasizes Equity Valuation via the Free Cash Flow to Equity (FCFE) method, detailing how cash flow analysis aids in determining a company’s equity value.

FCFE Definition: FCFE denotes the cash available to stockholders post capital payments and growth needs, crucial for assessing a company’s ability to pay dividends.


FCFE Formula:FCFE = Net Income + Depreciation - Capital Expenditures - Change in Working Capital - Principal Debt Repayments + New Debt Issues

Advantages of FCFE:

  • Overcomes limitations of the Dividend Discount Model (DDM) by evaluating cash flows of non-dividend companies.

  • Offers a comprehensive valuation perspective.

Reasons for Retaining Earnings:

  • Risk management by creating financial buffers.

  • Potential for future acquisitions.

  • Stabilization of dividends for positive investor sentiment.

Inputs for FCFE Valuation:

  • Growth Rate: Based on historical data and market demand.

  • Profit Margin Formula: Net Income / Net Sales

  • Return on Equity (ROE) Formula: Net Income / Common Equity

  • Cost of Equity: Estimated using the Capital Asset Pricing Model (CAPM).

Retention & Sustainable Growth Rate:

  • Retention Rate (RR): Earnings retained versus dividends.

  • Sustainable Growth Rate (g) Formula: g = ROE × Retention Rate

  • Assumptions include constant capital structure and efficiency.

Example Calculation:

  • Given values: Growth rate of 6%, ROE of 10%.

  • Retention Rate calculated at 61%, example net income of 20 results in Free Cash Flow to Equity of $8 (assuming a 40% payout ratio).

Valuing Cisco Using Two-Stage Growth Model:

  • Inputs: Sales growth at 4.59% for 5 years; profit margin of 28.5%; ROE of 38.6%.

  • Estimated stock value of $61.68 against market price of $40 suggests a potential buy.

Adjustments for Bank Stocks:

  • Use asset growth instead of sale growth; apply return on assets over profit margin to signify banking operations, while maintaining consistent valuation methods.