Dcf Valuation

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Discounted Cash Flow Valuation

Stable (Constant) Growth Model:
Illustration 1: Consolidated Edison is the electric utility that supplies power to homes and businesses in New York City. It is a monopoly whose price and profits are regulated by the state of New York. The firm is in stable growth based on its size and the area that it serves. Its rates are also regulated (regulators don’t allow extraordinary profits). Average annual FCF in year 2000 was =$551 million

ROE= 11.63%
Beta =0.9
RF= 5.4%
MRP= 4%
DPR =70%
Shares= 235 million
R = RF + Beta (MRP) =5.4% +0.9(4%) = 9%
Expected growth rate = (1-DPR) (ROE)= (1-70%)(11.73%
The value of the firm is:[pic]
Price = 10369/235 =$44.12
In May 14, 2001 Con Ed was trading for $36.59.
Two-Stage Dividend Discount Model:
The model is based on two-stage growth: an extraordinary growth period and a stable growth period: [pic]
where DT = dividend the shareholder expects to receive at the end of year T. D0 = the most recent dividend which has already been paid (ex-dividend). P0 = actual market price of the stock today

g = expected growth rate = RR x ROE
R= rate of return on common stock
ILLUSTRATION 2: Valuing a Firm with the Two-Stage Dividend Discount Model: Procter & Gamble (P&G) manufactures and markets consumer products all over the world. Some of its best-known brand names include Pampers diapers, Tide detergent, Crest toothpaste, and Vicks cough/cold medicines. RATIONALE FOR USING THE MODEL

• Why two-stage? While P&G is a firm with strong brand names and an impressive track record on growth, it faces two problems. The first is the saturation of the domestic U.S. market, which represents about half of P&G's revenues. The second is the increased competition from generics across all of its product lines. We will assume that the firm will continue to grow but restrict the growth period to five years. • Why dividends? P&G has a reputation for paying high dividends, and it has not accumulated large amounts of cash over the previous decade. BACKGROUND INFORMATION

Earnings per share in 2000 = $3.00
Dividends per share in 2000 = $1.37
Payout ratio in 2000 =1.37/3.00 = 45.67%
Return on equity in 2000 = 29.37%
We will first estimate the cost of equity for P&G, based on a bottom-up beta of 0.85 (estimated using the unlevered beta for consumer product firms and P&G's debt-to-equity ratio), a risk-free rate of 5.4%, and a risk premium of 4%:

Cost of equity = 5.4% + 0.85(4%) = 8.8%

To estimate the expected growth in earnings per share over the five-year high growth period, we use the retention ratio in the most recent financial year (2000) but lower the expected return on equity to 25%: Expected growth rate = Retention ratio x Return on equity

= (1 -1.37/3.00)(0.25) =13.58%
In stable growth, we will estimate that the beta for the stock will rise to 1, leading to a cost of capital of 9.45:

Cost of equity = 5.4% + 1(4%) = 9.4%

The expected growth rate is assumed to be equal to the growth of the economy (5%) and the return on equity will drop to 155, which is lower than the current industry average (17.4%) but higher than the cost of equity estimated above. The retention ratio in stable growth can then be written as: Retention ratio in stable growth= g/ROE= 5%/15% =33.33%

Payout ratio =1-33.33%=66.67%

The value of dividend in year 5 ($3.78) is estimated as follows:

Terminal price= [pic]

Expected earnings per share in period 5 = 3.00 (1+0.1358)5 =5.67

Expected dividends per share in period 5 =5.67 x 0.6667=3.78

The Value of Growth

Investors pay a price premium when they acquire companies with high growth potential. The value of growth can be estimated as follows: VGrowth = VSuper Growth – VStable growth – VNo growth

VGrowth =Value of growth
VSuper Growth =Value of the firm with extraordinary growth in first T years VStable growth =Value of the firm as a table growth firm...
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