2/26/2024

LECTURE 5: PROSPECTIVE ANALYSIS

Module 1: Introduction of Valuation Methods
ps EPS Dr. Tien Ng

PE Pshare PIEXEPS Pshare PDCE x70% Sum-of-the-Part (SOTP)

NB X PVE1 LOK
=
-

PReach=PERE Indlutry xEPS realplate

=
-

PE multiple
Arg industry Industry PIB PEmultiple 130Kx
15%

PE Sector
Stir out
let

E
PB multiple 118Kx 15%

- - NOTK

VALUATION METHODS

Discounted Discounted
Dividend Free Cash Multiples
Model (DDM) Flows (DFCF) Valuation

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DISCOUNTED CASH FLOWS -

VALUATION MODELS

Intrinsic
value

Terminal
CF CF value
CF CF CF CF
Time
Forecasting period Continuation period

Enterprise value = present value of forecasting period + present value of continuation period

DISCOUNTED CASH FLOWS (DCF) APPROACH

 Equity value is the PV of all cash payoffs that its claimholders

receive
 VALUE = PV (cash flows)
• Dividends = cash paid to shareholders
• Free cash flow = cash available to pay shareholders

 Key point: Valuation metric (e.g., dividends or FCF) must be

measurable and related to earnings power

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DISCOUNTED DIVIDEND
MODEL (DDM)

 Constant Growth Model

(Gordon Growth Model)
 Two Stage Growth & the H – Model
 Three Stage Growth Model

DISCOUNTED DIVIDEND MODEL (DDM)

• Discount the future dividends at the required rate of return:

Step 1: Estimate future dividends
Step 2: Discount at required return
Step 3: Value = PV (dividends)

d1 d2 d3 Pn
V0    
1  r  1  r 2
1  r 
3
1  r n
V0  
n
dt


n
dt

Pn t 1 1  r t
t 1 1  r 
t
1  r n

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THE GORDON GROWTH MODEL

• The simplest pattern …

… expected constant growth in dividends indefinitely
(growth perpetuity, PV=A/(r-g)

d1 d 1  g 
V0   0 ,r  g
re  g re  g

… But very sensitive to small changes in r and g

 Eg. MSEX, current dividend of $0.68, expected dividend growth rate of

6%, and required return on equity of 9.25%. Current market price is
$18.39
• What if the estimates of r and g can each vary 25 basis points?

0.681.06
P0   22.18
0.0925  0.06

Exhibit 5-2: Estimated Price given Uncertain Inputs

g = 5.75% g = 6.00% g = 6.25%
r = 9% $22.13 $24.03 $26.27
r = 9.25% $20.55 $22.18 $24.08 undervalued
r = 9.5% $19.18 $20.59 $22.23

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A thi
:

phai ve

THE TWO-STAGE GROWTH MODEL

• Version 1: high growth period followed by a sustainable and usually lower

growth rate thereafter

n
dt Vn
V0   
t 1 1  r t 1  r n
d 1  g S  1  g L 
n
Vn  0
r  gL
gS: growth at extraordinary short-term rate
Two-stage assumes a “drop-off ” gL: normal long-term growth rate (sustainable g)
in growth n: length of high growth period

8
I
⑪i
I
1

3 %
o

1 2 3

• E.g. Mackinac Inc.– current share price is $37; current dividend is $1.37;
dividend growth rate at 8% in the first 3 years, followed by perpetual growth
rate of 3% forever; estimated required return on equity as 10%
• What is Mackinac’s share value
 V = $23.04 (overvalued)
D4

1.371.08 1.371.08 1.371.08

2 3 ⑳
1.371.08 1.03
3

0.1 0.03
V   
1.1 1.12 1.13 1.13
- -
800 3 %

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THE TWO-STAGE GROWTH MODEL

• Version 2: the H model – high growth period, then declines linearly until reach
normal rate

d 0 1  g L  d 0 H g S  g L 
V0  
r  gL r  gL
gS: growth at extraordinary short-term rate
gL: normal long-term growth rate after year 2H
H: half life in years of high growth period (i.e. high
growth period = 2H years)

H-model assumes a gradual

decrease in g as firm matures

• E.g. Vinci SA (DG) – current share price is $57; current dividend is $1.37; initial
dividend growth rate is 24%; declining linearly during a 12-year period to a final
and perpetual growth rate of 6%; estimated required return on equity as 10%
a. What is DG’s share value, using H model?

12
1.371.06 
1.37 0.24  0.06
V  2  73.3
0.1  0.06 0.1  0.06

b. Estimate the value of DG share if its normal growth period began

immediately
1.371.06
V  36.3
0.1  0.06

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THE THREE-STAGE GROWTH MODEL

• Version 1: the three distinct stages of growth (with constant growth in the
middle stage)

• Version 2: the growth in the middle stage declines linearly to mature growth
rate

• E.g. IBM (2007) – current dividend is $1.60; current share price

is $118.36 14%
2 yrs
• Current required return on equity (discount rate) = 12% 12%
3 yrs

• Dividend will grow at 14% for the next 2 years, 12% for forever
the following 3 years, and 10.2% thereafter 10.2%

• What is the value per share of IBM?

PV=A/(r-g)
1.061.14  1.061.14 1.061.14  1.12  1.061.14  1.12
2 2 2 2
V   
1.12 1.12 2 1.123 1.12 4
1.061.14  1.12  1.102 
2 3

1.061.14  1.12
2 3
  0.12  0.102  109.7
5 5
1.12 1.12

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• E.g. EGN P 15 144 21
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1
=

r q
.
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(9 %3 % - 7 5 .

• current dividend is $0.46; current share price is $57.77;

5 yrs
current required return = 9% 12%

• Forecast an initial 5-year period of 12% p.a. dividends 10 yrs

growth, then 7.5% p.a. as a mature company, allowing 10 forever
years for the transition to the mature growth period 7.5%
• Security trading within ±20% band for “fair value range”
a) What is the value per share of IBM
b) Justify whether EGN under/overvalued?
0.46 1.12  0.46 1.12  0.46 1.12  0.46 1.12  0.46 1.12 
2 3 4 5
V     
1.09 1.09 2 1.09 3 1.09 4 1.09 5
5 10
0.46 1.12  0.12  0.075 
0.46 1.12  1.075 
5
 2 overvalued
 0.09  0.075 0.09  0.075  28 .6
1.09 5
nee S

to vicing
7
10 years

DDM - SUMMARY

• In general:
• Growth phase - Use three-stage model
• Transitional phase – Use two-stage / H-model
• Maturity phase – Use GGM
• DDM is appropriate if:
• Company has history of dividend payments
• Dividend related to earnings
• Take minority shareholder perspective
• What if DDM is not appropriate?
 FCF

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Illustration
Exhibit 5-1: COKE and HRL: The Earnings and Dividends Record
compounding COKE g= g=
HRL
g = 4.4% Payout 8.9% 8.4% Payout
Year EPS ($) DPS ($) (%) EPS ($) DPS ($) (%) Q: Justify whether the
2006 2.55 1.00 39.22 2.05 0.56 27.32 DDM is appropriate
2005 2.53 1.00 39.53 1.82 0.52 28.57 for Coca-Cola
2004 2.41 1.00 41.49 1.65 0.45 27.27 Bottling Co
2003 3.40 1.00 29.41 1.33 0.42 31.58 (COKE) and
2002 2.56 1.00 39.06 1.35 0.39 28.89 Hormel Foods
2001 1.07 1.00 93.46 1.30 0.37 28.46 (HRL)
2000 0.71 1.00 140.85 1.20 0.35 29.17
1999 0.37 1.00 270.27 1.11 0.33 29.73
1998 1.75 1.00 57.14 0.93 0.32 34.41
1997 1.79 1.00 55.87 0.72 0.39 54.17
1996 1.73 1.00 57.80 0.52 0.30 57.69
1995 1.67 1.00 59.88 0.79 0.29 36.71
1994 1.52 1.00 65.79 0.77 0.25 32.47
1993 1.60 0.88 55.00 0.66 0.22 33.33
1992 -0.23 0.88 NM 0.62 0.18 29.03
*NM = not meaningful

DISCOUNTED FREE
CASH FLOWS MODEL
(DCF)

 Constant Growth Model

 Two Stage Growth & the H – Model
 Three Stage Growth Model

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DISCOUNTED FREE CASH FLOWS -

VALUATION MODELS

analogous to the DDM, but with FCF

Intrinsic
value

Terminal
FCF FCF value
FCF FCF FCF FCF
Time
Forecasting period Continuation period

Enterprise value = present value of forecasting period + present value of continuation period

DISCOUNTED FREE CASH FLOWS -

VALUATION MODELS

analogous to the DDM, but with FCF

1. Constant growth (TV): FCF1 FCF0 1  g 

V0   ,r  g
re  g re  g

2. Two stage model: Two-stage H-model:

n
FCFt Vn
V0    FCF0 1  g L  FCF0 H  g S  g L 
t 1 1  r t
1  r n V0  
r  gL r  gL
FCF0 1  g S  1  g L 
n
where: Vn 
r  gL

10
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FREE CASH FLOWS (FCF) DEFINES

• FCFF (Free Cash Flow to the Firm):

Cash flow the company generates after having made all the required expenditures
and is able to distribute to firm’s investors (debt- and equity-holders)
V of firms – Debt = Value of
equity n
FCFF = CFO - CAPEX Lesson 1: FCFF = residual CFs left over after all of
V0   the project’s requirements have been satisfied
t 1 1  WACC t
Lesson 2: FCFF = CFs that can be distributed to the
• FCFE (Free Cash Flow to Equity): Company’s financial claimants (i.e. D&E-holders)

Cash flow available to firm’s equity-holders after having made all the required
expenditures and paid debt-holders = (payments/ D retirement – receipts /D issuance)
n Lesson 1: FCFE = residual CFs left over after all of the
FCFE = FCFF + net borrowings
V0   project’s requirements have been satisfied
t 1 1  re 
t
and all debt financing has been satisfied
Lesson 2: FCFF = CFs that can be distributed to the
Company’s shareholders (i.e. E-holders)

FREE CASH FLOWS (FCF) DEFINES

• Use FCFF when

• volatile capital structure, and/or
• high debt levels, negative FCFE
• then, find:
Equity value = firm value – MV of debt

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SUMMARY

• All valuation models derive from the simple dividend discount model.
• Valuation models differ in three key areas: focus, structure, and terminal
value estimation
• The choice of which model(s) to use depends on the nature of the
prediction task and the information upon which forecasts are based.

MULTIPLES VALUATION
MODELS

 Relative Valuation Method (PE & PB)

 Break-up Method (Sum-of-the-Part,
SOTP)

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VALUATION COMPARISON: DCF LIMITATION

• What if firm has:

• Unknown history, unknown implementation timing
• Unfathomable market, unknown competition, unknown cost structure,
..
• Projecting an unknown growth trajectory … DCF is tough
• Other DCF limitations:
• DCF may miss growth options, options to expand, options to redirect
• Analysts may need to adjust projections for GAAP treatments. All
difficult.

VALUATION COMPARISON (cont.)

• Proactive approaches
• Valuation method to determine what a target firm’s value should be
based on future values of cash flows and earnings
• DCF models
• Reactive pricing approaches:
• Models reacting to general rule of thumb and the relative pricing
compared to other securities
• 1. Relative valuation (use of Multiples)
• 2. Break-up analysis (Liquidation), aka SOTP method

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RELATIVE VALUATION

• Method is simple to implement

• Three Steps:
1) Search and select
- Search for comparable firms
- Select financial performance measure (e.g. EPS, EBIT, EBITDA, BV)
2) Adjust and compute
- Estimate price multiples for comparable firms (e.g. avg. PE)
3) Apply and conclude
• E.g. P = PE x EPS
(PE - avg. PE of comparators ; EPS - forecasted earnings)

• E.g. Amazon - an international online retailer

• Step 1: Peers selection and PE calculation
Barnes & Circuit
Best Buy Wal-mart Amazon
Noble City
Stock price ($/share, ‘01) 24.16 40.06 11.53 49.19 8.63
EPS (estimated 2001) 1.61 1.81 0.53 1.62 (0.93)
PE (leading PE) 15 22 22 30 NM PEavg = 22.25

◦ Step 2: Value Amazon (in $m.)

High Multiple Low Multiple EP E P
(30x) (15x)
Operating Income (01 Est.) 83.4 2,502 = 30x83.4 1,251 Firm value
= 22.25 * 83.4
Debt 2,127
= 1,856
Cash & Mkt Securities 1,264
Net debt 863 Equity value
1,639 388 = 1,856 – 863 = 993
Valuation of Equity
P = 993/355.7 =
Equity Value per Share 2.79 4.61 1.09 2.79
(355.7m outstanding)

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SUM-OR-PART VALUATION

• Sum-of-the-Parts valuation (SOTP)

 Break-up analysis: Assets would be more valuable if broken up and sold
to other companies
How SOTP?
• Calculate each segment’s value using appropriate multiples
• Add these independent values to arrive the total value
• Then adjust for net debt and other non-operating assets & liabilities

SUM-OR-PART VALUATION

• Sum-of-the-Parts valuation (SOTP)

 Break-up analysis: Assets would be more valuable if broken up and sold
to other companies
How SOTP?
• segment A  P = multiple * EBITDA
• segment B  P = multiple * NI
• segment C  P = multiple * REV________
Value of firm = total value
Value of equity (P) = (value of firm – net debt)/#outstanding

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• E.g. P&G’s Acquisition for Gillette in 2005

• What is the valuation of the deal if using the DCF vs. SOTP method?
• Transaction summary:
• Structure 0.975 shares of P&G for each share of Gillette (P&G
closing price on Jan 26, 2005 $55.44)
• Consideration 100% stock acquisition
• Implied offer price $54.05, based on P&G closing price on Jan 26, 2005
(20.1% premium to Gillette share price of $45 on that date)
• Enterprise value Approx. $57.2 b, including $2.3 b of Gillette net debt
• Share outstanding Approx. 1 b. Gillette share outstanding
• Assumption: P&G uses earnings multiples (EBITDA) to value Gillette.

P&G’s Acquisition for Gillette

- Multiple Approach

$ per share
75.00 $46.5 - $59.10
per share
70.00

65.00 $1.62
$2.00 ($1.95)
$63.37 ($2.30)
60.00 $7.00 $61.75 $61.42
$59.75 $59.10 $59.10
V = 12 * 0.595 = 7.14
55.00
$7.14 $50.41 $52.8
$52.76 $47.38 $49.11 $48.80
V = 24 *50.00
1.901 = 45.62 $1.30 $46.50 $46.50
$5.90 $1.73 ($1.61)
45.00 $45.62 ($2.30)
$41.48
$41.58
40.00 $5.36
$36.12
35.00 V = 9 *0.595 = 5.36
V = 19 * 1.901 = 36.12
30.00
B&R Duracell Oral Care Pers Care Braun Unallocated Net debt Equity
value

‘04 EBITDA $1,901 $595 $446 $133 $162 $100 $2,300

($m.)
‘04 EBITDA 19x - 24x 9x – 12x 13x – 15x 13x – 15x 8x - 10x 16.1x –
Multiple range 19.5x

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P&G’s Acquisition for Gillette

$ per share
- DCF Approach
75.00
$70.75
70.00 $65.50

65.00
$59.10 $61.85
60.00
$56.00 $56.60 Implied offer
55.00 $50.50 price:
$52.00 $52.80
50.00 $50.25 $54.05
$45.7 $47.10
$46.50
45.00 $45
$43.25
40.00 $40.75

35.00 $35.01 $35.25

30.00
52 Week PV of Wall SOTP DCF Analysis
trading Street Comparable
range Research price (pretax) Stand Standalone + Standalone +
alone Cost savings total synergies
($9.5) ($14.75)

COMBINE WITH DCF: TERMINAL VALUE ESTIMATION

• Terminal value: value projected at end of estimation horizon

• Terminal value = (P/E) × (earnings forecast)

• Two methods:
1) Fundamentals: requires estimates of g, r, and payout
2) Comparables: uses market data to calculate benchmark

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E.g. Dupont (DD) – 2007

Current dividend is $1.48; Current share price is $50; Discount rate = 10.5%.
Forecast dividends to grow at 10% for the next 4 years. At the end of year 4,
company expects dividend to be 40% of EPS, and trailing PE to be 14
1. What is the terminal value (at year 4) of DD?
2. What is value per share of DD?
D4  D0 (1  g ) 4
1.481.1
4
ter min al  PE  EPS 4  14   $75.84
.4 E 4  D4 / 0.4
1.481.1 1.481.1 1.481.1 1.481.1
2 3 4
75.84
V  2
 3
 4
  $56.72
1.105 1.105 1.105 1.105 1.1054

undervalued

S
MY BCTC co'Operating Profit .
=IBIT .

(lay IS , Operating Profits PIE Valuation (multiples)

Step 1
,
:

Sak-COGS ↑
=

Net
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CFC
FCFF Tax
Amortiation (H CF)
+
=

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and cat EPS=
Depreciation (D
...

net
Depreciation =

assets and other lang term shartant

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=

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Fity + debt
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+

cithe" la -7 Costof x
Change in PE
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raWACC (Cost of equity
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Ev Expected
late a se
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nam san
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:

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+

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bi
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=

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- =

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factor Industry average
=

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terminal value
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V
Total Value of
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Enterprise gan
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(lay
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Debt Get thuis
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Debt Care & Equivalent ;
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Vature =

Equity
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shares of Value
(LD)= Entity
-

Expected price No shares of outstanding

18