bm410-16 equity valuation 2 - intrinsic value 19oct05

7/30/2019 BM410-16 Equity Valuation 2 - Intrinsic Value 19Oct05

1/35

BM410: Investments

Equity Valuation 2:Calculating Intrinsic Value


2/35

Objectives

B. Understand how to calculate intrinsic

value, using the four key methods

C. Understand how to present intrinsic

value in your company report


3/35

A. Review the Importance of

Intrinsic Value

What is intrinsic value?

The present value of a firms cash flows discounted

by the firms required rate of return

In an efficient market, what should the relationship be

between a firms intrinsic value and market value?

In a truly efficient market, the intrinsic value should

equal its market value

What happens if it doesnt?There are opportunities for profit


4/35

Intrinsic Value(continued)

How do you determine Intrinsic Value?

It is a value assigned by the analyst

It is based on specific theories and assumptions

Analysts use specific models for estimation Lots of models exist, but remember, they are

proxies for realitynot reality


5/35

Intrinsic Value(continued)

What happens if the intrinsic value is greater

than the market price (and your intrinsic value

is correct)?

Intrinsic Value > Market Price Buy

Intrinsic Value < Market Price

Sell or Short Sell

Intrinsic Value = Market Price

Hold or Fairly Priced or valued


6/35

Questions

Do you understand the importance of intrinsic

value?


7/35

B. Understand how to calculate

Intrinsic Value

For the purposes of your company report, we

will cover the following topics:1. Discount Rate

2. Discount Dividend Models3. Internal Rate of Return (IRR)

4. Present Value of Free Cash Flows to Equity

5. Present Value of Operating Free Cash Flows

6. Relative Valuation Models


8/35

1. Discount Rate

What is the discount rate?

It is the rate of return required by investors to

compensate them for the risk of the firm

What is the theory behind the discount rate? The CAPM Model

This is one method broadly used by

practitioners to determine a companys required

rate of return. This is the rate that is used todetermine the companys cost of equity.

What is the formula?

K = rf+ beta (risk premium)


9/35

Discount Rate (continued)

What are the discount rates components?

The nominal risk-free interest rate

The risk premium (rM- rf)

If the market is efficient, over time, the returnearned by investors should compensate them for

the risk of the investment.

How is it used?

It is used to discount all future cash flows todetermine the present value of future dividends.

We use it to determine what the appropriate

discount rate is for our company


10/35


Where do you get the risk free rate?

Generally, the risk-free rate is considered the rate

on a 3 month or 1 year US Treasury bill that you

expect to receive over the life of the investmentWhere do you get the beta?

The easiest method is to get it from Bloomberg.

You type your company ticker [equity] and BETA.

Then make sure the index is appropriate for yourcompany.


11/35


What about the time frame?

You get to pick. If you think the next 3 years is

more consistent with the past, choose a longer time

period. If it is more consistent with the most recentperiod, choose a shorter time period. The minimum

period is 60 observations.

What is the adjusted beta?

Beta is volatile depending on the time period.Companies such as Bloomberg calculate an

adjusted beta, which is 2/3 the calculated beta and

1/3 the market beta of 1. It tends to lower the beta

and hence reduce the discount rate, more consistent

with actual results


12/35

2. Dividend Discount Models (DDMs)

What are DDMs?

Models which take into account discounting

expected future cash flows to gain a reference for

the value of a companyHow do they work?

DDMs determine the firms value by taking the

present value of all future cash flows (dividends and

the eventual sale of equity)


13/35

Dividend Discount Models (continued)

How do you determine the final sale price of the stock?

Remember the PE is the price divided by EPS.

Therefore, the future value of the stock is the

estimated PE in the future times the estimated EPS

You calculate the 2006 EPS. Multiply the 2006

EPS estimate by your estimated 2006 PE ratio to

get the price of the stock

So instead of guessing the future price, you guess the

future PE? Any hints?

A good starting point is calculating your harmonic

mean PE for your last 5 years (positive PEs only).

The formula is:

(5/[(1/PE1)+(1/PE2)+(1/PE3)+(1/PE4)+ (1/PE5)])


14/35


What next? Find the present value of the future cash flows

(dividends) for the next three years and the forecastsale price by discounting them by the discount ratecalculated above.

This will give you an intrinsic value at yourestimated discount rate.

Divide the present value by the current market price

and you will get the percentage of overvaluation or(under-valuation)

From this valuation point, you determinewhether the stock is attractive (buy) or not (holdor sell)


15/35


What are we assuming?

We are assuming that the stocks dividend growthrate will be at a constant rate over time. Althoughthis may be unrealistic for fast-growing or cyclical

firms, DDMs may be appropriate for some mature,slower-growing firms. Two and three-growth stagemodels can be used to modify this model asalternative assumptions

What factors will impact the dividend growthrate?

The dividend growth rate will be influenced by theage of the industry life cycle, structural changes,and economic trends


16/35

Problems with DDMs (continued)

What are our assumptions for DDMs? 1. Dividends grow at a constant rate

This is rarely the case

2. The constant growth rate will continue for aninfinite period

This is also rarely the case

3. The required rate of return (k) is greater than theinfinite growth rate (g). If g > k, the model becomemeaningless because the denominator becomesnegative

If you have this problem, you will need toreduce g downward. Document this clearly in

your reports.


17/35

3. Internal Rate of Return

What is the internal rate of return?

It is the discount rate that equates the present value

of cash outflows for an investment with the present

value of its cash inflows.

Theoretically, you compare your firms cost of

capital to the IRR

Accept (reject) any investment proposal with

an IRR greater (less) than your cost ofcapital

What are my cash flows?

Your dividends and your eventual sale of the shares


18/35

4. Free Cash Flow to the Firm (FCFF)

What is the difference between cash flow and

free cash flow?

Free cash flow recognizes that some investing and

financing activities are critical to the ongoingsuccess of the firm over an above net income and

depreciation. Free cash flow takes these additional

costs into account

What is Free Cash Flows to the Firm (OFCF)? Cash flow available to the companys suppliers of

capital after all direct operating costs (CGS, SG&A,

etc.) and necessary investments in working capital

and fixed capital.


19/35

Free Cash Flow to the Firm (continued)

How do we calculate FCFF?

FCFF is equal to:

EBIT (1-tax rate) + depreciation (non cash charges)

capital expenditureschange in net working

capital + terminal value

This is the cash flow generated by a companys

operations and available to all who have provided

capital to the firmboth equity and debt.


20/35


What is the appropriate discount rate? Because we are dealing with the cash flow available

for all capital suppliers, we use the WACC, whichcombines the companys cost of equity and debt.

Where do we find the cost of equity?

The cost of equity was determined with thecalculation of the discount rate k.

Where do you find the cost of debt?

The cost of debt is the interest rate at which thecompany borrows money from the financialmarkets. As a proxy, you can use the imbedded costof debt you calculated for your latest year(generally adding a 1-2.0% premium)


21/35


How do you calculate the weight for debt?

Weight of Debt: LTD/Enterprise Value

What is enterprise value?

The enterprise value is the total market value of anenterprise plus the value of its debt. It is a step

beyond market capitalization. It starts with market

capitalization, and then adds in preferred equity,

minority interest, and the market value of the firmsdebt, then subtracts out the value of cash and cash

equivalents. It is a better statistic than market value


22/35


How about the weight for equity?

Weight of Equity: (1- Weight of Debt)

What is the formula for the WACC?

WACC = (Wd* Kd) (1-T) + (We * Ke)


23/35


Once you have your operating free cash flows,then what?

1. You assume a constant growth rate g for yourfinal cash flow, and discount that cash flow at

WACC-g 2. Sum your discounted cash flows and discount

them at your WACC to get your present value ofthe firms operating Free Cash Flow

3. Subtract out your long-term debt to get the valueof your equity

4. Divide your firm value of equity by the numberof shares outstanding at your last forecast year

5. Compare your intrinsic value (per share) to yourcurrent market price (per share)


24/35

5. Free Cash Flows to Equity (FCFE)

What is free cash flow to equity?

It is the cash flow available to the companys

common equity holders after all payments to debt

holders, and after allowing for all operating

expenditures to maintain the firms asset base


25/35

Free Cash Flows to Equity(continued)

What is our goal?

To determine a value for the firm based on the freecash flow available to equity shareholders afterpayments to all other capital suppliers and after

providing for continued growth of the firmHow is it calculated?

Net Income + depreciationcapital expendituresneeded to achieve revenue forecastchange in net

working capitalprincipal debt repayments + newdebt + terminal value

Remember that net working capital is currentassets less cash minus current liabilities lessnotes payable and current portion of long-term

debt.


26/35

Free Cash Flows to Equity(continued)

Once you have your free cash flows, then

what?

1. You discount your cash flows at your discount

rate k 2. You assume a constant growth rate g for your

final cash flow, and discount that cash flow at k-g

3. Sum your discounted cash flows to get your

present value of the firms equity 4. Divide the firm value by the number of shares

outstanding at your last forecast year

5. Compare your intrinsic value (per share) to your

current market price (per share)


27/35

Problems with PV Methods

Any potential difficulties with these PV

calculations?

These cash-flow techniques are very dependent on

two significant inputs: 1. The growth rate of cash flows g and

2. The estimate of the discount rate k.

A small change in either input will have a

significant impact on the estimated value In addition, it is possible to derive intrinsic values

which aresubstantially above or below current

prices depending on how you adjust your estimated

inputs to the prevailing environment. Be careful!


28/35

6. Relative Valuation Methods

What are relative valuation methods?

Methods which provide information about how themarket is currently valuing stocks at several levels,the market, industry, and comparative stocks in the

industry. These are often called comps orcomparables

What is relative fair value?

It is the value of the company relative to other

similar stocks, or stocks in the same market orindustry

Which relative valuation methods are used most often?

Generally, the most used in the industry is PriceEarnings. However, Price to Sales, Price to Book,

Dividend Yield, and Price to Cash Flow are also


29/35

Relative Valuation Methods (continued)

How do you use relative valuation methods?

You compare your companys valuation ratio to the

market, industry, its history, or other companies

If you notice a change in relative valuation, i.e. it ischeaper (expensive) than it has been historically, it

may signal it may be a buy (sell) assuming no other

major changes in the company and industry

In the Apple case, we used price earnings relative to

the market. Can we use price earnings relative to the

industry?

Yes, although it is harder to find good forecast data

on the industry, as most industry indices do not

have forecasts.


30/35


How do I determine my buy and sell range?

This is one of the most difficult challenges of beingan analyst. Here is where the art comes in!

Look to company history.

If the company has traditionally traded in atight range, the likelihood is that it willcontinue

If your company is volatile, it will be more

difficult and you will need to make the bestdecision you can

Use wisdom and judgment

Determine whether you think its a buy, sellor hold, then set your relative valueconsistent with that view


31/35


How do you calculate relative valuation, say,

for example, relative PE?

1. Calculate your PE for your company

historically, and for your forecast period 2. Calculate your PE for the market/industry

historically, and for the forecast period

3. Calculate the relative PE (i.e. the company PE /

market PE) for all periods


32/35


4. Determine what you consider to be a fair relative

PE range, i.e. at what relative PE would you buy the

stock, and at what relative PE would you sell the

stock

5. Calculate your buy and sell ranges using the

formula: relative PE range * market PE * firm EPS

= Price


33/35

Problems with Relative

Valuation Methods

When is it most appropriate to use RVM?

When you have a good set of comparables, i.e.

industries/companies in terms of size and risk

When the aggregate market is not at a valuation

extreme, i.e. it is neither over or undervalued

When are they inappropriate?

When you have poor comparables or the current

market level is at extremes.

If you compare the value of a company to the

very overvalued market, you might believe it is

cheap. However, you may be wrong as company

may be fully valued and the benchmark, the

market, is overvalued.


34/35

Summary

Intrinsic Value Calculations

The next step is to summarize your intrinsic

calculations thus far.

Take and average of the values calculated from the

Dividend Discount Model, Free Cash Flows FromEquity and Operating Cash Flow and compare

(divide into) with the current market price.

This will let you know if the companys stock is

over- or undervalued on a percentage basis

If you have any models in which the intrinsic values

are negative, try to understand the problem (it is

generally because your g > k--see me), but

generally disregard that model


35/35

Review of Objectives

A. Do you understand the importance of

intrinsic value?

B. Do you understand how to calculate intrinsic

value, using the four key methods discussed?C. Do you know how to present intrinsic value

in your company report?

bm410-16 equity valuation 2 - intrinsic value 19oct05

Documents