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Principles of Finance
with Excel, 2nd edition
Instructor materials
Chapter 16
Valuing stocks
Four approaches to stock
valuation
Valuation method 1: Efficient markets
V
approach
√ Valuation
method 2: Discounting
future free cash flows (FCF)
UValuation method 3: Discounting
future equity payouts
VValuation method 4: Valuation with
multiples ->S APIE EBI , EBT, EBITDA mult"pl"es
-
,
Valuation method 1:
Efficient markets approach
Efficient markets says: The market
knows best
Means: Current stock price is the
right price!
A stocks value is the sum of the
values of its components
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MESSAGE: There’s a lot of evidence showing that you can’t outguess
markets!
MEANING: Before you do complicated stock valuations—consider the
possibility that the market price is correct:
Market price represents sum total of thinking about the stock
The price may subsequently go up or down, but there’s no easy
way to tell …
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Other Efficient Markets Methods
The principle of additivity:the value of
a basket of goods or financial assets
should equal the sum of the values of
components.
Additivity Example
ABC Holding Corp., a publicly traded company
owns shares in two publicly traded companies:
60% of XYZ Widgets
50% of QRM Smidgets
ABC has 30,000 shares outstanding
Besides owning these subsidiaries, ABC does
little else
Market value of XYZ Widgets’ shares:
$1,000,000
Market value of QRM Smidgets’ shares:
$875,000
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Additivity Example
Is telling you: If the market values of
XYZ and QRM are correct, then the
market value of ABC should be
_________.
Is not telling you: The formula tells a
relation among the three share prices.
It tells whether the share prices are
relatively correct, but it does not tell
whether the share prices are absolutely
correct.
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Valuation method 2:
Stock price based on PV(FCF)
Reminder: Free cash flow (FCF) is the cash
produced by the business activities of the
firm (Chapter 6/7)
FCF =
Profit after taxes
+ Depreciation
- Increase in Current Assets
+ Increase in Current Liabilities
- Capital expenditures
+ After-tax interest
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The DCF valuation steps:
Value the enterprise value by
taking the PV of future FCFs
Add back initial cash and
α
Enterpr!se Value =
D!scounted
Us!ng WACS Far's]A
marketable securities ] +
Subtract out debt 3
= Equity valuation } A
Equ!tyValue cash mark -debt
=
= + . Sec .
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DCF example: Arnold Corp.
Current FCF = $2 million
Growth rate of FCF = 8% annually
WACC = 15%
1,000,000 shares
$10 million debt
$ 1 million cash
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DCF Example: Xanthum Corp.
Xanthum Corp. has just finished its 2010
financial year.
FCF for 2010= $1,000,000
For the next five years the growth rate of
FCF’s will be 35%. After 5 years the
growth rate will decrease to 10% per year.
Number of Shares outstanding=3,000,000
WACC=20%
Current amount of cash=$500,000
Value of debt=$3,000,000
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DCF Example: Station Building
Sarah offered a share in partnership
that is being set up by a local real
estate agent.
The partnership will buy an existing
building, called the Station Building,
for $20,000,000. The agent is selling
25 shares.
Is this a fair price?
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DCF Example: Station Building
Allincome from the Station building
partnership will flow through to the
shareholders, who will pay taxes on the
income at their personal tax rates.
Sarah’s tax rate is 40%.
Station building will be depreciated over
40 years.
The building is fully rented out and brings
up annual rents of $7,000,000, which will
stay constant for the next 10 years.
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DCF Example: Station Building
Maintenance, property taxes, and
other expenses for Station Building
cost about $1,000,000 per year.
The agent plans to sell the building
after 10 years at $20,000,000.
WACC=18%
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* tg
=
eps
Valuation method 3:
pr!ce to earn!ng
Share price = PV of future anticipated
equity cash flows discounted at cost of
Br!ehowmuchetors
equity rE
are
w!ll!ng to pay per unt .
of prof!t
This method is more direct
Equity cash flow=Dividends + stock
repurchases equ!ty market-to-book rat!o
rE = cost of equity = MV of equ!ty - h!gher rat!o means
Compute by using Gordon dividend model
(Chapter 6)
BV
of equ!ty
a greater valuat!on
of
Compute by using SML (Chapter 13) equ"ty ,
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enterpr!se value to book rat!o = Enterp-Val.
rat!o means!t BV
h!gher
than other
of assets
valued more h!ghly
enterpr!se value t EBITDA rat!o = Ent V .
.
EBITDA
Why finance professionals shun
direct equity valuation
Equity payouts are even less market enterpr!se value to-sales rat!o
-
predictable than FCFs
Ent value/sales
The WACC is probably more stable
=
than the cost of equity
Compares the total value of the f!rm
to !ts total sales .
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Valuation method 4:
Using multiples
Most common:
Price-earnings ratio * Earnings
Assumption: Similar firms should have similar
P/E ratios.
Problem: It includes firm leverage
Use enterprise value ratios
MV/BV*BV
EBITDA ratio * EBITDA
MV/EBITDA*EBITDA
Kroger (KR) and Safeway (SWY) are in
the supermarket business
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