Valuation

S ANA TAUSEEF
Outline
Stock valuation models: Absolute and Relative
DCF models: Cash flows and discount rates
Dividend Discount Model: Quick review
Free Cash flow Models: FCFF and FCFE
Residual Income: The last choice

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Types of valuation models
1. Absolute Valuation Models (fundamental approach)
• A model that specifies an asset’s intrinsic value.
• Supplies point estimate of value that can be compared with the asset’s market price.

2. Relative Valuation Models

◦ Models that specify an asset’s value relative to another asset’s.
◦ Underlying idea  similar assets should have similar prices.
◦ Examples:
◦ PE, P/B, P/S, etc.
◦ Important to differentiate between undervaluation and relative undervaluation
◦ The comparison stock itself may be overvalued (in terms of its intrinsic value) and might be the
stock we call undervalued.

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Practice Question 1
ATTOCK CEMENT BESTWAY D G KHAN
LUCKY CEMENT PAKISTAN CEMENT CEMENT

EARNINGS PER SHARE 43.07 30.69 20.83 14.68

SALES PER SHARE 301.64 122.86 88.69 76.38
BOOK VALUE PER SHARE 336.95 109.90 89.52 174.24
PRICE PER SHARE 434.67 113.2 114.58 98.15

1. Compute the relative value of DG Khan Cement based on the multiples of given three peers.
2. What dispersion do you observe in DG Khan’s stock value based on each multiple?

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 To value firms/stocks, we need to:

• Estimate future cash flows: size (how much) and

timing (when)
Absolute • Discount future cash flows at an appropriate rate
Valuation:
DCF Models
Three widely used definitions of cash flows are:

• Dividends
• Free Cash Flows
• Residual Income

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Absolute Valuation: DCF Models
Fair Value of the stock is the discount value of its future
expected cash flows

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Simplifying Assumptions in DCF Valuation
Cash flows are infinite and not necessarily constant over the
years in the future.
1. No (zero) growth in dividend
2. Constant growth in dividend
3. Non-constant growth in dividends

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Discount Rates used
in Valuation
If cash flows are those available to all suppliers of capital to
the firm, then WACC should be used for discounting.
If cash flows are those available to common equity-holders
only, then the cost of equity should be used for discounting.
When cash flows are in nominal terms, then the discount
rate should also be in nominal terms.
When cash flows are on an after-tax basis, then the discount
rate should also be on an after-tax basis.

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Dividends Discount Model
Dividends are useful as the definition of returns when
◦ the company is dividend-paying
◦ the BOD has established a dividend policy bears an
understandable and consistent relationship with the company’s
profitability
◦ the investor takes a non-control perspective

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Constant Growth in Dividends
(Valid for companies in mature phase)
Assume that dividends will grow at a constant rate, g, forever, i. e.,

….. and so on

Since future cash flows grow at a constant rate forever, the value of a
constant growth stock is the present value of a growing perpetuity:

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Estimating Constant Growth Rate
Constant growth in dividends can be computed using the
historical trend or based on company’s fundamentals.
Sustainable/constant growth rate=Retention rate × Return
on common equity
Return on common equity is a function of:
◦ Asset Turnover
◦ Net Profit margin
◦ Financial Leverage (Equity Multiplier)

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The PRAT Model
Constant growth rate can be calculated as the product of four ratios:

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Practice Question 2
SuperCo
Year 1 Year 2
Revenue 10,000 10,000
Net Income 1,000 1,200
Assets 5,000 5,000
Equity 2,000 2,000
Dividends 600 900

Compute ROE and growth rate of the company for both years. Use DuPont
analysis and comment on the factors causing the change in return and
growth rate.

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Practice Question 3
Great Pumpkin Farms just paid a dividend of $3.50 on its
stock. The growth rate in the stock’s dividend is expected to
remain constant at 5 percent per year. Investors require a
return of 12 percent on their investment. What is the current
fair price?

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Variable Growth in Dividends
(Applies for most of the companies)
Assume that dividends will grow at different rates in the foreseeable future and then will
grow at a constant rate thereafter.

To value a Differential Growth Stock, we need to:

◦ Divide the life of the stock into variable and constant growth periods.
◦ Estimate future dividends in the variable growth period and first dividend which falls
under constant growth period.
◦ Estimate the future stock price when the stock becomes a Constant Growth Stock (case
2).
◦ Compute the total present value of the estimated future dividends in variable growth
period and future stock price at the appropriate discount rate.

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Practice Question 4
Rizzi Co. is a new fast-growing venture. Dividends are expected to grow at 25 percent for
each of the next two years, with the growth rate falling to a constant 7 percent thereafter. If
the investors require a return of 13 percent on their investment, and the company just paid a
dividend of $4, what is the current fair price?

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Free cash flow Models
FCFs are useful as the definition of return when:
◦ the company is non dividend paying
◦ the company is dividend paying but dividends exceed or fall
short of free cash flows to equity
◦ the company’s free cash flows align with the company’s
profitability
◦ the investor takes a control perspective

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Variants of Free Cash Flows

FCFF  cash flow FCFE  cash flow

to all suppliers of to common
capital shareholders

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Understanding the Free Cash Flows
Free cash flow means the cash which is left after the necessary operating
expenses and capital expenditures.
It is different from operating cash flow (computed on the cash flow
statement) because some of the OCF is not free and must be used for
reinvestments.
It is different from the net cash flow (net of operating, investing and financing
CF computed on CF statement) because net cash flow is the cash left after all
operating, investing and financing transactions.

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What is FCFF???
• The cash flow available to the company’s suppliers of capital
after all operating expenses have been paid and necessary
investments (working capital and fixed capital) have been made.
• The cash which is available for distribution to all securities
holders of the company.
• It is that part of cash flow generated by company’s operations
that can be withdrawn by bondholders and stockholders without
economically impairing the company.
• FCFF can be computed using EBIT, NI or OCF.

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Computing FCFF: Using EBIT
EBIT × (1-tax rate)
Plus: Net noncash charges (Dep & Amort)
Less: Investment in net operational working capital
Less: Investment in fixed capital

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Computing FCFF: Using Net
Income
Net income
Plus: Interest expense x (1 – Tax rate)
Plus: Net noncash charges (Dep & Amort)
Less: Investment in working capital
Less: Investment in fixed capital

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Computing FCFF: using OCF
Operating Cash Flow
*Plus: Interest expense x (1 – Tax rate)
Less: Investment in fixed capital

* The adjustment is not needed for companies using IFRS and recording the interest expense
under financing activities.

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What is FCFE???
• The cash flow available to the company’s common equity holders
after all operating expenses have been paid, necessary investments
(working and fixed capital) have been made and the payments to
capital suppliers other than common equity holders have been made.

• After netting FCFF for all cash transactions of firm with its debt
holders and preferred equity holders, we are left with FCFE.

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Computing FCFE using FCFF
Free Cash Flow to Firm
Less: Interest expense x (1 – Tax rate)
Less: Preferred Dividends
Add: Net borrowings (additional borrowings minus repayments)

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Computing Fair Price Using FCFF
◦ PV* of FCFF = Value of firm’s operating assets
◦ Value of operating assets + cash/marketable
securities = Firm Value
◦ Firm Value – Market Value of debt and market value of
preferred equity = Value of common equity
◦ Value of common equity divided by number of
common shares = Fair value of common share

* Discounting at WACC

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Computing Fair Price Using FCFE
◦ PV* of FCFE = Value of firm’s common equity

◦ Value of common equity divided by number of common shares =

Fair value of common share

* Discounting at KCE

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Practice Question 5
Pier Inc. has an EBIT of $950,125 in 2015. The interest expense is $215,250, depreciation expense is
$290,155, investment in fixed capital is $775,280 and investment in working capital is $321,255.
The company has net borrowing equal to $540,290. Given a 40% tax rate, what is the free cash flow
available to firm and its common equity holders?

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Constant Growth in Free Cash
Flows
Using FCFF:

Using FCFE:

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Practice Question 6
Proust Company has FCFF of $1.7 million and FCFE of $1.3 million for the year
just ended. Proust’s WACC is 11% and its required return for equity is 13%.
FCFF is expected to grow forever at 7% and FCFE is expected to grow forever
at 7.5%. Proust has $2 million in cash, 500,000 shares outstanding and a debt
outstanding of $25 million.
A. What is the value of Proust’s common share using the FCFF valuation
approach?
B. What is the value of Proust’s common share using the FCFE valuation
approach?

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Variable Growth in Free Cash
Flows
Assume that FCFs will grow at different rates in the foreseeable future
and then will grow at a constant rate thereafter.

Since FCF is based on different components, a better approach is to

estimate each of them (sales forecast, profit margins, working capital
and fixed capital investment, debt ratio).

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Practice Question 7
Proust Company has FCFF of $1.7 billion for the year just ended.
Proust’s WACC is 11% and its required return for equity is 13%. FCFF is
expected to grow at 7% for next two years, at 6% for year 3 and 5% for
year 4, after which it will grow at 4% for each year thereafter. Proust
has $2 billion in cash, 50,000,000 shares outstanding and a debt
outstanding of $20 billion.
What is the value of Proust’s common share using the FCFF valuation
approach?

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FCFF or FCFE???
There are cases in which FCFF preferred over FCFE:
◦ A levered company with changing capital structure
◦ A levered company with negative FCFE

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Residual Income
Model
Residual Income is useful as the
definition of return when:
◦ the company is not paying dividends
◦ the company’s expected free cash flows
are negative within the analyst’s
comfortable forecast horizon

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What is Residual Income???
It is the earnings for a period in excess of investors’ required return on
beginning-of-period investment.
It measures the value added for common equity holders in excess of
opportunity costs.
Due to the degree of distortion and the quality of accounting
disclosure, the application of residual income model is error-prone.

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Axis Manufacturing Company (AMC) has total assets of €2,000,000 financed 50% with debt and
50% with equity capital. The cost of debt capital is 7% pre-tax (4.9% after tax) and the cost of
equity capital is 9%. If EBIT is €200,000, net income for AMC can be determined as follows:
EBIT €200,000
Less: Interest Expense 70,000
Pre-Tax Income €130,000
Income Tax Expense 39,000
Net Income € 91,000
Equity Charge/cost of equity:
Equity Capital (Beg of the year) х Cost of Equity Capital in %
Cost of Equity = €1,000,000 х 9% = € 90,000
Net Income € 91,000
Equity Charge 90,000
Residual Income €1,000

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Fair Price Using Residual Income
Model
In the Residual Income Model (RIM) of valuation, the intrinsic value
of the firm has two components:

Fair value = Current book value per share + PV* of expected

future residual incomes

* Discounting at KCE

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Practice Question 8
A company will earn $1.00 per share forever, and the company also
pays out all of this as dividends, $1.00 per share. The equity capital
invested (book value) is $6.00 per share. Because the earnings and
dividends will offset each other, the future book value of the stock will
always stay at $6.00. The required rate of return on equity (or the
percent cost of equity) is 10%.
a. Calculate the value of this stock using the dividend discount model.
b. What will be the residual income each year? Calculate the value of
the stock using a residual income valuation model.

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References
Equity, CFA-II Program Curriculum.

Financial Management: Theory and Practice. Eugene F. Brigham & Michael C. Ehrhardt, 12 th
edition.

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