CompanyValuation(JEM 132) CharlesUniversity,Prague

JiriNovak,IESUK 1
Lecture3
ValuationModelsII
JiriNovak
IES,UK
Recap
SimpleApproaches
valuationmultiples(VM) assumecrosssectional
homogeneitybetweenvalueandfundamentals
dividendgrowth(DG) assumetimeseries
consistency in dividend payout
2
consistencyindividendpayout
ComplexApproaches
discounteddividend(DDM) forecasteddividends
discountedatcostofequity
discountedcashflow(DCF) forecastedfreecash
flowdiscountedatweightedavg.costofcapital
residualincome(RIM) bookvalueofequity(BE)
+residualincome(EVA)disctd.atcostofequity
Recap
DiscountedDividendModel
first,analyzethecompanyshistorical
performance,computefinancialratios
second,forecastfuturefinancialstatementsbased
on historical financial performance
3
onhistoricalfinancialperformance
third,discountforecasteddividends(DDM)or
freecashflows(DCF)topresentvalue
Limitations
DDMmixeseffectofoperating &financing,
hencemakesforecastingmoredifficult
DDMbasedonvalue distribution,whileDCF
basedonvaluecreation
d h l d l 3.1DiscountedCashFlowModel
DiscountedCashFlow
EquityValuationModels(Direct)
discountcashflowgeneratedonlyforowners
(Dv)atcostofequityrequiredbyowners(k
e
)
Dv =dividends+stockrepurchases stockissue
5
EnterpriseValuationModels(Indirect)
discountcashflowgeneratedtoallcapital
providers(FCF)atcostofcapitalreflecting
weightedrequiredreturnofinvestors(WACC)
subtractclaimsofnonequityinvestors(e.g.ND,
stockoptions,preferredstock,minorityinterest)
DiscountedCashFlow
6
CompanyValuation(JEM 132) CharlesUniversity,Prague
JiriNovak,IESUK 2
DiscountedCashFlow
DiscountedCashFlowModel
insteadofdiscountingdividendscompany
eventuallypaysout(valuedistribution)DCF
focusesonmostimportantpartoftheprocess,
i e value generation
7
i.e.valuegeneration
FreeCashFlow
cashflowleftforinvestors(owners&creditors)
afteralloperatingandinvestmentneedshave
beensatisfied
DiscountedCashFlow
8
financing investing operating
DiscountedCashFlow
GenerationPerspective
FCF =CFO+CFI
cashinflowgeneratedfromoperationsusedfor:
(1)financingoperations(outflowCFO)
9
( ) g p ( )
(2)financinginvestmentsCapEx(CFI)
FCFisnetcashflowgeneratedbyoperations
DistributionPerspective
FCF = CFF+ cash
thiscashisfreetobedistributedtoexternal
investors(owners&creditors)anditconstitutes
returntoexternalcapital(equity&debt)
DiscountedCashFlow
FreeCashFlow(fromOperations)
cashflowleftforinvestors(owners&creditors)
afteralloperatingandinvestmentneedshave
beensatisfied
10
FCF =EBIT (1 TR)+depreciation capital
expenditures increaseinworkingcapital
cashflowisatangiblemeasureindependentof
accountingstandards
DiscountedCashFlow
DiscountRate
sincedividendsarefinancialstreamstoequity
(i.e.theyarepaidtoowners),discountfactor
mustrepresentriskrelevantforowners
11
consistencybetweendiscounteditemand
correspondingdiscountfactorrequires:
freecashflow(FCF) cashgeneratedforowners
&creditorsdiscountedbyWACC representing
averageriskofallcapitalproviders
dividends(Dv) cashgeneratedonlyfor
ownersdiscountedbycostofequity(k
e
),i.e.
ownersrequiredrateofreturn
d l I d l 3.2ResidualIncomeModel
CompanyValuation(JEM 132) CharlesUniversity,Prague
JiriNovak,IESUK 3
ResidualIncome
ValueDetermination
fairvalueofequityequalstothebookvalueof
equityplusthepresentvalueofthestreamof
expectedresidualincome
I k E

13
V fairvalueofequity(i.e.company)
Eq ...bookvalueofequity
NI netincome
k
e
costofequity
( )

= +
+

1
0 0
1 1
t e t
t
t
e
NI k Eq
V Eq
k
ResidualIncome
BookValueofEquity
bookvalueapproximatesthevalueofacompany
Eq=As Li=netassets
ifthecompanyisliquidated,allassetsaresold
14
andcashreceivedisusedtosettletheliabilities;
whateverisleftbelongstotheowners
ConservativeAccounting
recognitionofuncertaingains(| Eq)isdelayed,but
uncertainlosses(+ Eq)recognizedimmediately
bookvalueofequity(Eq)shouldbethelower
boundofcompanyvalue(toprotectcreditors)
ResidualIncome
EconomicValueAdded
EVA
t
=NI
t
k
e
Eq
t1
k
e
costorequity,capitalchargerepresenting
the required rate of return on equity

15
therequiredrateofreturnonequity
NI subtractsthecostofdebt(interestexpense),
butnotthecostofequity;EVA correctsthis
EVA canbeseenasameasuresuperiortoROE
becauseitgivesrightincentivesonpositiveNPV
projectswithROI <ROE
EVA =residualincome=economicprofit
ResidualIncome
Logic
bookvalueofequity(Eq)reflectsaccounting
measurementofcompanyvaluethatshouldbe
thelowerboundtotheintrinsicfairvalue
16
modelstartswithEqandmakesadjustmentsfor
expectedabnormalprofitabilitythatisnot
capturedinaccountingbecauseofconservatism
ResidualIncome
AbnormalProfitability
differencebetweenoperatingprofitability
andcostoffinancing
BalanceSheet
17
assets
(As)
liabilities
(Li)
equity
(Eq)
operatingprofitability
RNOA=ROIC
costoffinancing
WACC

ResidualIncome
Focus
appropriatefocusonkeysourceofvalue,i.e.
companysabilitytogeneratehigherprofit
(ROIC)thanrequiredbyinvestors(WACC)
18
implicitlyreflectscompanycompetitiveposition
anditsabilitytobenefitfromitscompetitive
advantagetogeneratevalue
CompanyValuation(JEM 132) CharlesUniversity,Prague
JiriNovak,IESUK 4
O f d l 3.3OverviewofModels
ValuationModels
ComparableMultiples(CM)
allfirmsareequal
ignoresanycompanyspecificsuperiorstrategy
andunusualprofitability(H&M)
20
susceptibletoindustryhypes(ITbubble)
DiscountedDividends(DDM)
afirmisablackboxofwhichdividends
occasionallyfallout
massiveextrapolationbuiltonthinbasis
dividendsarebecominglesscommonandthus
alesssignificantindicatorofacompanysvalue
ValuationModels
DiscountedCashFlow(DCF)
forecastingfromacrystalsphere
unpackingtheblackboxandlettingthekey
valuedriversdeterminewhatvalueiscreated
21
ResidualIncome(RIM)
benchmarkingbasedon relativestrength
residualincomeisdeterminedbythedifference
betweenROIC andWACC,whichessentially
captureshowgoodthecompanyisexpectedto
performvisvisitscompetitors
Overview
Comparison
focus modelsdifferinwhethertheylookat
companyinisolationorwhethertheyseeit
inbroadercontextofentireindustry
22
sophistication otherdifferenceisinwhether
modelsassumesrelationshipasgivenorwhether
theyallowforcomplexadjustments
simple complex
firm DG DCF,DDM
industry VM RIM
Overview
Equivalence
DDM,DCFandRIMaretheoreticallyequivalent,
i.e.theyproduceidenticalvalueprovidedthat
theyarebasedonconsistentassumptions
23
modelsdifferonlyinperspective,i.e.inwhatis
explicitlyforecastedandwhatfollows(e.g.)
perspective,however,mattersbecausesome
itemsareeasiertopredictthanothers
Reference
Lundholm,OKeefe,Feltham(2001)ReconcilingValue
EstimatesfromtheDiscountedCashFlowModelandthe
ResidualIncomeModel,ContemporaryAccountingResearch
ChallengesofValuation
24