Week 2 - Valuation

Question 1

Myths About Valuation

Answer 1

1. Valuation is objective
2. Valuation is timeless
3. Provides precise estimate of value
4. The more quantitative a model, the better the valuation
5. Value is what matters, the process of valuation does not

Question 2

Assumptions Infinite Growth Dividend Discount Model

Answer 2

1. Dividends grow at a constant rate
2. The constant growth rate will continue for an infinite period
3. The required rate of return r > g

Question 3

Dividend Discount Model

Answer 3

PV(D0) = D1/(1+r) + D2/(1+r)^2 + … + Dn/(1+r)^n + (Dn/(r-g))/(1+r)^n

Question 4

Perpetuity in Dividend Discount Model

Answer 4

A perpetuity is an infinite growth, C/(r-g)

So if you are asked to calculate the present value of all future dividends, D/(r-g)

Question 5

NPV Rule in Dividend Discount Model

Answer 5

Invest if NPV > 0

NPV = result from dividend discount model * percentage of equity

Question 6

How to Estimate g?

Answer 6

g = Plowback Ratio*ROE

Plowback Ratio = 1 - Payout

Question 7

How to Estimate r?

Answer 7

CAPM: r = r(f) + β[E(r(m)) - r(f)]

Question 8

How to Estimate β for Non-Traded Assets?

Answer 8

• From regression with volatility of income, dividend yield, debt-equity ratio, g and assets
• Average of unlevered betas (β(u)) of comparable companies:
  β(L) = β(U)[1 + (1-τ)(Debt/Equity)] - β(D)(Debt/Equity)

Question 9

Advantages of Dividend Discount Model

Answer 9

• Easy concept, dividends are what shareholders get

- Dividends are fairly stable in the short-run which makes them easy to forecast in the short-run

Question 10

Disadvantages of the Dividend Discount Model

Answer 10

• Relevance: dividend payout is not related to value in the short-run, dividend forecasts ignore capital gains
• It requires a long forecast horizon
• Some firms don’t pay dividends (most entrepreneurial firms)

Question 11

When to Use Dividend Discount Model

Answer 11

When payout is tied to value generate e.g. when there is a fixed payout ratio (dividends/earnings)

Question 12

Free Cash Flow Model Idea

Answer 12

Derive the value of the firm by discounting the total cash flows available for distribution to capital providers (debt and equity holders)

Question 13

Free Cash Flow Formula

Answer 13

FCF = EBIT*(1 - τ) + Depreciation - Change Net Working Capital - CAPEX

Note: EBIT*(1 - τ) = Net Income

Question 14

Free Cash Flow Model Formula

Answer 14

V = Σ FCF/(1+WACC)^i + TV/(1+WACC)^n

TV = FCFn*(1+g)/(WACC-g)

WACC = r(E)[E/(D+E)] + r(D)[D/(D+E)] -> just weighted returns of equity and debt

Question 15

Advantages of the FCF Model

Answer 15

• Easy application of familiar PV techniques
• Formally correct
• More realistic that dividends-based model

Question 16

Disadvantages of FCF Model

Answer 16

• FCF does not measure value added in short-run
• FCF fails to recognize value generated that does not involve cash
• Requires forecast

Question 17

Relative Valuation Idea

Answer 17

The value of the asset is compared to the value assessed by the market for similar or comparable assets

Question 18

What are multiples driven by?

Answer 18

Fundamentals

E.g. PE ratio is driven by fundamentals such as growth, risk, and payout (similar to cash flow models)

Question 19

Return on Investment (ROI) Formula

Answer 19

ROI = (current value - cost)/cost

ROI = (current AUM - AUM0)/AUM0