Equity Valuation

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Valuation models
Discounted cash flow models:
Dividend discount Free cash flow to the firm Residual income

Multiples-based valuation:
Price-earnings Value-EBITDA Value-EBIT Value-Sales Price-Book value

Equity valuation
In conjunction with the valuation of Coles Group, contained in “Excel03 Equity valuation”

Real options valuation
Equity markets price shares above the present value of expected future cash flows, due to the presence of embedded options not captured by DCF analysis Real options valuation is introduced in FINM3401 Corporate Finance.

1

Dividend discount model (1)
E=

Dividend discount model (2)
Terminal valuen

∑ (1 + k ) = ∑ (1 + k )
Dt Dt
t =1 t e t =1 e



n

t

+

(1 + ke )t

Equity value under the assumption of constant growth (which necessarily incorporates an assumption of a constant REINVESTMENT RATE and a constant expected return on reinvested earnings): n

Equity value per share is the present value of expected future dividends. Typical process is to estimate expected dividends for an explicit forecast period of, say, 3 – 10 years before making some assumption about dividends thereafter. The present value of these dividends thereafter is referred to as the terminal value (the value which you would expect to sell the shares for at the end of the explicit forecast period). The most common assumption is that dividends continue at a constant growth rate thereafter. But you do not necessarily have to assume constant growth.

E=

∑ (1 + k ) + (k − g )(1 + k ) g = (1 − DPR ) × E ( ROE ) Dt
t =1 t e e e e

Dt (1 + g e )

n

Equity value under the assumption that a constant DOLLAR amount of earnings are reinvested in new projects (or “the simple growth model”):

E=

∑ (1 + k )
Dt
t =1 e

n

t

+

En +1 (1 − DPR ) × En +1 ⎛ E ( ROE ) ⎞ ⎜ + − 1⎟ ⎜ k ⎟ ke ke e ⎝ ⎠

(1 + ke )n

Free cash flow to the firm model (1)
V=

Free cash flow to the firm model (2)
Firm value assuming constant growth in the terminal state (In the event that the firm makes investments which earn their cost of capital, the growth rate computed below will be the same as the growth in earnings and dividends. However, the reinvestment rate will be higher for the firm, offset by the fact that E(ROC) will be less than E(ROE).)


t =1



where : FCFF = EBIT (1 - τ ) + Depn − Capex + Working capital changes WACC = re E D + rd (1 − τ ) V V

FCFFt = (1 + WACC ) t


t =1

n

FCFFn Terminal value of firm + t (1 + WACC ) (1 + WACC )n

V=

Firm value is the present value of expected free cash flow to the firm (FCFF), discounted at the weighted average cost of capital (WACC). Equity value is firm value less the market value of debt. In some instances, you see “net debt” (debt minus cash) used instead of debt, which is a perplexing assumption because it implicitly assumes the business can simultaneously distribute all available cash to debtholders but still maintain cash for working capital. Also common is the statement that this valuation model gives higher valuations than the dividend discount model, because it values all cash flows and not just dividends . This statement is fundamentally incorrect. Under consistent assumptions about growth and capital structure, DDM and FCFF provide exactly the same valuation.

∑ (1 + WACC ) + (WACC − g )(1 + WACC )
FCFFt FCFFn +1
t =1 t

n

n

g = Reinvestment rate × Expected return on capital = RR × E ( ROC ) RR = Capex for new investments Cash available after capex on maintaining assets Total capex - sustaining capex = EBIT (1 − t ) + Depn − Sustainingcapex

Residual income model
E = BVE0 +

Multiples-based valuation: Equity


t =1



Residual incomet

(1 + ke )

t

= BVE0 +


t =1



EPSt − re × BVEt −1

(1 + ke )

Price-earnings:
Compute share price relative to expected earnings per share for a set of comparable firms. Apply the median or mean price-earnings ratio for the...
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