Last Revised: 08/08/2022

OID129434443.

2023 Level 2 - Equity Valuation

Readings Page

Equity Valuation: Applications and Processes 2

Discounted Dividend Valuation 10

Free Cash Flow Valuation 32

Market-Based Valuation: Price and Enterprise Value Multiples 51

Residual Income Valuation 78

Private Company Valuation 92

Review 107

This document should be used in conjunction with the corresponding readings in the 2023 Level 2 CFA® Program curriculum.
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Equity Valuation: Applications and Processes

a. define valuation and intrinsic value and explain sources of perceived

mispricing

b. explain the going concern assumption and contrast a going concern value to
a liquidation value

c. describe definitions of value and justify which definition of value is most

relevant to public company valuation

d. describe applications of equity valuation

e. describe questions that should be addressed in conducting an industry and

competitive analysis

f. contrast absolute and relative valuation models and describe examples of

each type of model

g. describe sum-of-the-parts valuation and conglomerate discounts

h. explain broad criteria for choosing an appropriate approach for valuing a

given company

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Valuation & Intrinsic Value

Page 1
· The goal of valuation is to identify mispriced securities/assets LOS a
- define
Var1 - explain
Var2 future similar
asset
investment assets
value
Varn returns estimate compare

estimate

liquidation

⇒ Price vs. Value ⇒ Intrinsic Value (unobservable)

- value of an asset given a
market
hypothetically complete understanding
price
of the asset’s investment characteristics
(observable)

Page 2
· undertaking valuation efforts assumes LOS a
➀ mispricing exists (P ≠ V) - define
- at odds with market efficiency - explain

⇒ Grossman-Stiglitz paradox – if markets were

informationally efficient, no rational person would
incur costs of valuation
- how would prices reflect value?
Thus/ - investors will not rationally incur the costs of
analysis unless expectations of reward to effort
exists (abnormal return, excess risk-adjusted return)
(𝜶)

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Page 3
· undertaking valuation efforts assumes LOS a
➁ P&V will converge - define

𝐕𝐞 − 𝐏 = (𝐕 − 𝐏) + (𝐕𝐞 − 𝐕) V- intrinsic value - explain

(unobservable)
true error
estimated market
value price mispricing · forecast ⇒ key element
(𝜶) · model · differ
from consensus
· correct
⇒ convergence should be expected within some Investment Horizon
- requires a catalyst ⇒ what will cause convergence
(i.e. next 2-3 earnings reports)

Going Concern/ Liquidation

Page 4
⇒ going concern value
LOS b
· a company will continue business activities - explain
- some assets only have value if the - contrast
‘going-concern’ assumption is valid
⇒ liquidation value ➞ immediate companies in
vs financial
➞ orderly liquidation value distress
· Focus of valuation readings ➞ intrinsic value estimated
under a going concern assumption

Value
· Intrinsic Value Page 5
LOS c
- typically, the relevant concept of value for valuing
- describe
public equities - justify
· Fair market value
- value at which an asset/liability would change hands between
a willing buyer/seller when they are not under any compulsion
to buy/sell
- both are informed to all material aspects
· Investment value
- an asset may be worth more to a particular buyer (e.g. synergies)

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Applications
Page 6
· Selecting stocks ⇒ I.V. vs. MV. LOS d
(over, under, fairly) - describe
· Inferring (extracting) market expectations
· assume Price reflects consensus
expectations of investors about future performance
- reasonable?
Price = Var1 + Var2 + Var3 + X – solve for fundamental variable X

known
· evaluating corporate events
· M&A, divestiture, spin-off

Page 7
· rendering fairness options
LOS d
- parties to a merger may be required - describe
to get 3rd party opinion on the fairness of the terms
· evaluating business strategies & business models
· communication with analysts/shareholders
· appraise private businesses
- transactional (sale)
- taxation (estate)
- IPO
· evaluating/setting share-based compensation

Industry/Competitive Analysis
Page 8
⇒ Valuation Process
LOS e
· understanding the business - describe
· forecasting company performance
· selecting the appropriate valuation model
· converting forecasts to a valuation
· applying the valuation conclusions

Understanding the business/

- industry/competitive analysis
- identify the economic drivers of a business
- threats/opportunities

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Page 9
Understanding the business/ LOS e
A/ industry attractiveness in terms of prospects - describe
for sustained profitability
⇒ Porter’s 5-forces model · intra-industry rivalry
· threat of new entrants
· buyer power
· supplier power
· availability of substitutes
B/ company’s relative competitive position within
the industry & its competitive strategy
- level of and trend in market share

Page 10
Understanding the business/ LOS e
B/ company’s relative competitive position within - describe
the industry & its competitive strategy

· cost leadership
· business model · differentiation
- how it turns its · focus-niche
strategy into revenues

C/ how well has the company executed on its

strategy and what are its prospects for future execution
Financial
reports
T-10 T-2 T-1 T0 +
qualitative factors

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Absolute vs. Relative

Page 11
- selecting the appropriate valuation model/ LOS f
A/ Absolute valuation models - contrast
- specifies an asset’s intrinsic value - describe
(present value, discounted cash flow)

shareholder level ⇒ Dividends

Cash flows
company level ⇒ FCF, Residual Income

(CFO-Capex-𝚫WC) economic
profit
# type
𝑪𝑭𝒊
, forecasts
(𝟏 + 𝒓)𝒊
𝒊$𝟏

often subjective

Page 12
- selecting the appropriate valuation model/ LOS f
A/ Absolute valuation models - contrast
asset-based valuations ➞ MV of assets/resources it controls - describe
(REIT)

B/ Relative valuation models (method of comparables)

- estimate of value relative to another
- law of one price: similar assets should
sell for similar prices
- price multiples or enterprise multiples
(derives relative over/under valuation)

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Sum-of-the-Parts
Page 13
a.k.a. break-up or private market value LOS g
- the estimated value of the company by the - describe
sum of the estimated values of the various
businesses considered as independent going concerns
- corp. with segments indifferent industries
that have different valuation characteristics
· few synergies · useful for valuing
between segments spin-offs
(although not zero) (+ pure-play premium)
- requires a detailed breakdown of each segments
contribution to earnings & cash flow

Conglomerate Discount
Page 14
⇒ market typically applies a discount LOS g
to the stock of a company operating in multiple, - describe
unrelated businesses
Explanations/ · inefficiency in capital allocation
➞ capital allocation across segments may
not maximize shareholder value
· path to conglomerate status
➞ poorly performing companies tend to expand
by diversifying the earnings base (acquisitions
in unrelated businesses)
· does not exist
➞ measurement error

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Valuation Approach
Page 15
➞ broad criteria/ LOS h
business · consistent with the characteristics of the - explain
understanding company being valued
· appropriate given the availability and
quality of data
· consistent with the purpose of valuation,
including the analyst’s perspective
➞ use of multiple models/valuation approaches
➞ Converting forecasts to a valuation/
· sensitivity analysis – how changes in an
input affect the outcome

Page 16
➞ Converting forecasts to a valuation/ LOS h
· situational adjustments - explain
- incorporate valuation impact of
specific issues
1) control premium
2) lack of marketability discount
3) illiquidity discount

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Discounted Dividend Valuation

a. compare dividends, free cash flow, and residual income as inputs to discounted cash flow
models and identify investment situations for which each measure is suitable

b. calculate and interpret the value of a common stock using the dividend discount model
(DDM) for single and multiple holding periods

c. calculate the value of a common stock using the Gordon growth model and explain the
model’s underlying assumptions

d. calculate the value of non-callable fixed-rate perpetual preferred stock

e. calculate and interpret the implied growth rate of dividends using the Gordon growth model
and current stock price

f. calculate and interpret the present value of growth opportunities (PVGO) and the component
of the leading price-to-earnings ratio (P/E) related to PVGO

g. calculate and interpret the justified leading and trailing P/Es using the Gordon growth model

h. describe strengths and limitations of the Gordon growth model and justify its selection to
value a company’s common shares

i. explain the growth phase, transition phase, and maturity phase of a business

j. explain the assumptions and justify the selection of the two-stage DDM, the H-model, the
three-stage DDM, or spreadsheet modeling to value a company’s common shares

k. describe terminal value and explain alternative approaches to determining the terminal value
in a DDM

l. calculate and interpret the value of common shares using the two-stage DDM, the H-model,
and three-stage DDM

m. explain the use of spreadsheet modeling to forecast dividends and to value common shares

n. estimate a required return based on any DDM, including the Gordon growth model and the
H-model

o. calculate and interpret the sustainable growth rate of a company and demonstrate the use of
DuPont analysis to estimate a company’s sustainable growth rate

p. evaluate whether a stock is overvalued, fairly valued, or undervalued by the market based on
a DDM estimate of value

LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings

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Cash Flow Types

Page 1
- 4 steps in applying DCF analysis LOS a
1) select a definition of cash flow - compare
- identify
2) forecast those cash flows

3) choose a discount rate methodology

4) estimate the discount rate

A/ Dividends

B/ Free Cash Flow

C/Residual Income

Page 2
A) Dividends ⇒ as cash flows LOS a
- less volatile than earnings - compare
- less sensitive to short-term fluctuations - identify

in underlying value than other DCF models

- reflects long-term intrinsic value
- companies usually reluctant to reduce dividends

⇒1978 1999 long-term decline in the number

66.5% 20.8% of companies paying dividends

- combination of both reduction propensity + more small cap stocks

- fraction of companies engaged in share

repurchase has increased over the spread

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Page 3
A) Dividends LOS a
- DDM can be applied to non-div. - compare
paying companies, but rarely is - identify

⇒ DDM suitable when/

i) company is dividend paying

ii) established dividend policy that bears an

understandable and consistent relationship to
the company’s profitability

iii) the investor takes a non-control perspective

Page 4
A) Dividends LOS a
- compare
- identify

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Page 5
B) Free Cash Flow LOS a
- FCFF ⇒ pre-debt - compare
- FCFE ⇒ post-debt - identify

⇒ suitable when/
i) company is non-div. paying

ii) company is div. paying but divs. significantly

exceed or fall short of FCFE

iii) company’s FCF aligns with the company’s

profitability within the forecast horizon

iv) the investor takes a control perspective

Page 6
C) Residual Income LOS a
- compare
- earnings > required rate of return - identify
⇒ suitable when/
i) company is not paying dividends

ii) expected FCFs are negative within the

forecast horizon

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DDM
Page 7
• Single Period/ LOS b
𝐃𝟏 𝐏𝟏 𝐃𝟏 + 𝐏𝟏 - calculate
𝐕𝟎 = + = - interpret
(𝟏 + 𝐫)𝟏 (𝟏 + 𝐫) (𝟏 + 𝐫)
e.g./ D1 = $0.58, P1 = $27 r = 9%

𝟎.𝟓𝟖 + 𝟐𝟕
𝐕𝟎 = 𝟏.𝟎𝟗
= $𝟐𝟓. 𝟑𝟎

• Multiple Periods/
𝐧
𝐃𝐭 𝐏𝐧
𝐕𝟎 = , +
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭$𝟏

e.g./ D1 D2 D3 D4 D5 P5 = $40 r = 10%

2.00 2.10 2.20 3.50 3.75
𝟐 𝟐.𝟏𝟎 𝟐.𝟐𝟎 𝟑.𝟓𝟎 𝟑.𝟕𝟓 𝟒𝟎
𝐕𝟎 = (𝟏.𝟏)𝟏 + (𝟏.𝟏)𝟐 + (𝟏.𝟏)𝟑 + (𝟏.𝟏)𝟒 + (𝟏.𝟏)𝟓 + (𝟏.𝟏)𝟓 = $𝟑𝟒. 𝟕𝟔

Page 8
- general form LOS b
#
𝐃𝐭 - calculate
𝐕𝟎 = , - interpret
(𝟏 + 𝐫)𝐭
𝐭$𝟏

- 2 approaches to using DDM

A/ use a growth pattern

- GGM – constant growth forever
- 2-stage, H-stage or 3-stage DDM

B/ explicit forecast period + terminal value

depends on visibility - apply a growth

of earnings pattern from A/above
or/ multiples-based

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Gordon Growth Model

Page 9
- assumes dividends grow indefinitely at LOS c
a constant rate - calculate
- explain
𝐃𝟎 (𝟏 + 𝐠) 𝐃𝟏 r > g actually
𝐕𝟎 = =
𝐫 − 𝐠 𝐫−𝐠 r >> g Proof/

e.g./ D0 = $5 g = 5% r = 8% 𝐃𝟏 𝐃𝟏 (𝟏 + 𝐠)
𝐕𝟎 = + ×
(𝟏 + 𝐫) (𝟏 + 𝐫) (𝟏 + 𝐫)
𝟓(𝟏+. 𝟎𝟓) 𝟓. 𝟐𝟓
𝐕𝟎 = = = $𝟏𝟕𝟓 𝐃𝟏 (𝟏 + 𝐠)𝟐
. 𝟎𝟖 − . 𝟎𝟓 . 𝟎𝟑
+ × . . ..
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐
- geometric series
∴ we can use infinite sum formula,
𝐃𝟏 𝟏 𝐃𝟏 𝐃𝟏 𝐃𝟏
× = = =
(𝟏 + 𝐫) 𝟏+𝐠 (𝟏 + 𝐠)(𝟏 + 𝐫) (𝟏 + 𝐫) − (𝟏 + 𝐠) 𝐫 − 𝐠
(𝟏 − , (𝟏 + 𝐫) −
𝟏+𝐫 (𝟏 + 𝐫)

Page 10
⇒ both r and g should reflect long-term LOS c
expectations - calculate
- explain
⇒ most appropriate for companies with earnings
expected to grow at a rate comparable to or
lower than the economy’s nominal growth rate

GDP
- if g > GDP growth ⇒ use multi-stage DDM

e.g./ Qtly Div = 31¢ 𝐃𝟏 𝟒(. 𝟑𝟏)(𝟏. 𝟎𝟒) 𝟏. 𝟐𝟖𝟗𝟔

𝐕𝟎 = = =
g = 4% V0 = ? 𝐫 − 𝐠 𝟎. 𝟎𝟕𝟑 − . 𝟎𝟒 . 𝟎𝟑𝟑
rf = 3% = $𝟑𝟗. 𝟎𝟖
β = 0.95
ERP = 4.5%
𝐫 = . 𝟎𝟑 + . 𝟗𝟓(. 𝟎𝟒𝟓) = . 𝟎𝟕𝟑

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D0 = $0.74 g = 3.5% (vs 2.7% by Zacks) LOS c
βraw = 0.70 based on 60 monthly returns - calculate
βadj = 0.80 R2 < 20% - explain

pre-tax rd = 5.6% re = 7% P0 = $20.50 RP = 2.5%

➀ Find V0 ➂ Calculate r using CAPM & BYRP

𝐃𝟏 𝟎. 𝟕𝟒(𝟏. 𝟎𝟑𝟓) - β regresses to the mean
= = 𝟐𝟏. 𝟖𝟖
𝐫 − 𝐠 . 𝟎𝟕 − . 𝟎𝟑𝟓 - rf = 3% ERP = 4.5%

r = .03 + .80(0.045) = 6.6%

➁ under/over/fair?
𝟐𝟏.𝟖𝟖 5 𝟐𝟎.𝟓𝟎 r = 0.056 + .025 . 𝟕𝟒(𝟏. 𝟎𝟑𝟓)
= 𝟔. 𝟕𝟕%
𝟐𝟎.𝟓𝟎 = 8.1% . 𝟎𝟔𝟔 − . 𝟎𝟑𝟓
under V0 = 16.65 = 𝟐𝟒. 𝟕𝟏

Page 12
• sensitive to values of r & g LOS c
- calculate
- explain

⇒ when r – g is greatest, V0 is smallest

· GGM can also be used to value:

- an index (broad market)
- fixed-rate perpetual pref. 𝐕𝟎 = 𝐃A𝐫

g = 0 ∴ D0 = D1 = D2 … = 𝐃#

- a company with a declining g

e.g./ D1 = 4.25 r = 9% 𝟒. 𝟐𝟓 𝟒. 𝟐𝟓
𝐕𝟎 = = = 𝟑𝟐. 𝟔𝟗
g = -4% . 𝟎𝟗 − (−. 𝟎𝟒) . 𝟏𝟑

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Page 13
- since div. grows at g, V0 grows at g LOS c
𝐃 𝐃𝟏 (𝟏+𝐠) 𝐃 - calculate
𝐕𝟎 = (𝐫 5𝟏𝐠) ; 𝐕𝟎 (𝟏 + 𝐠) = ⇒ 𝐕𝟏 = 𝐫 5𝟐𝐠
𝐫5𝐠 - explain

∴ g is the rate or capital appreciation expected

a.k.a. the cap. gains yield (eff. mkts)

⇒ Div yield constant through time

𝐃𝟏 𝐃 𝐃
D0 → grows at g ∴ A𝐏 = 𝟐A𝐏 = 𝐧A𝐏
𝟎 𝟏 𝐧5𝟏
V0 = P0 → grows at g
𝐃𝟏
∴ Total Return = g + A𝐏 (cap. gain + div. yields)
𝟎

⇒ given a constant DPR, earnings also grow at g

Implied Growth Rate

Page 14
𝐃𝟎 (𝟏 + 𝐠) LOS d
⇒ 𝐕𝟎 = 𝐏𝟎 = ⇒ solve for g
𝐫 − 𝐠 - calculate
- interpret
e.g./ β = 1.1 rf = 5.6% ERP = 6% D0 = 2.00 g = 5% P0 = $40

𝐃𝟎 (𝟏 + 𝐠) 𝟐. 𝟎𝟎(𝟏. 𝟎𝟓) 𝟐. 𝟏𝟎
1) 𝐕𝟎 = = = = 𝟐𝟗. 𝟏𝟕
𝐫 − 𝐠 . 𝟏𝟐𝟐 − . 𝟎𝟓 . 𝟎𝟕𝟐
r = 0.056 + 1.1(.06) = .122

2) What g justifies P0 = $40

𝟐(𝟏 + 𝐠)
𝟒𝟎 =
. 𝟏𝟐𝟐 − 𝐠
𝟒. 𝟖𝟖 − 𝟒𝟎𝐠 = 𝟐 + 𝟐𝐠
𝟐. 𝟖𝟖 = 𝟒𝟐𝐠 6.86%
𝐠 = 𝟐. 𝟖𝟖A𝟒𝟐 = . 𝟎𝟔𝟖𝟔

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PVGO
Page 15
Assume a company has a 100% DPR. LOS e
- let g = 0 (a no-growth company) - calculate
- interpret
𝐃 𝐃𝟏A
then 𝐕𝟎 = 𝐫 5𝟏𝐠 = 𝐫

Let r = 10% and D1 = $4, then 𝐕𝟎 = 𝟒A. 𝟏 = $𝟒𝟎

- now assume a company can earn 15% on its

reinvested earnings
- reduce the DPR to 50% or $2, g = 15% × 50% = 7.5%

𝐕𝟎 = 𝟐A. 𝟎𝟐𝟓 = $𝟖𝟎 ROE × RR

if ROE = 10%, 𝐕𝟎 = 𝟐A. 𝟎𝟓 = $𝟒𝟎 since ROE > r,

if RR = 90%, 𝐕𝟎 = . 𝟒𝟎A. 𝟎𝟏 = $𝟒𝟎 g has pos. NPV

20 15 5 Page 16
𝐄𝟏A LOS e
𝐏= 𝐫 + 𝐏𝐕𝐆𝐎 - calculate
value of growth ⇒ depends on - interpret
value of a
company without opportunities and
earnings flexibility in pursing them
reinvestment

e.g./ ABC EPS = 0.79 P0 = 18.39, find PVGO if r = 9.25%

letting g = 0, D1 = EPS (100% DPR)

𝟏𝟖. 𝟑𝟗 = . 𝟕𝟗A. 𝟎𝟗𝟐𝟓 + 𝐏𝐕𝐆𝐎

Risks/
𝟏𝟖. 𝟑𝟗 = 𝟖. 𝟓𝟒 + 𝐏𝐕𝐆𝐎 1) E1 is too low/high
𝐏𝐕𝐆𝐎 = $𝟗. 𝟖𝟓 2) r is too low/high

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Page 17
𝐄
𝐕𝟎 = 𝟏A𝐫 + 𝐏𝐕𝐆𝐎 ⇒ divided by E1 LOS e
- calculate
𝐕𝟎A 𝟏 𝐏𝐕𝐆𝐎
𝐄𝟏 = 𝐫 + 𝐄 𝟏 ⇒ since we assume V0 = P0 - interpret

𝐏𝟎A 𝟏 𝐏𝐕𝐆𝐎
𝐄𝟏 = 𝐏/𝐄 = 𝐫
+ 𝐄𝟏
component of
value of P/E that relates to
P/E for a no-growth growth opportunities
company
𝟏 𝟏
e.g./ P0 = 18.39 = = 𝟏𝟎. 𝟖 no growth
𝐫 . 𝟎𝟗𝟐𝟓
E1 = $0.79 +
𝐏A = 𝟏𝟖. 𝟑𝟗A 𝐏𝐕𝐆𝐎 𝟗. 𝟖𝟓 growth
𝐄 . 𝟕𝟗 = 𝟐𝟑. 𝟑 = = 𝟏𝟐. 𝟓
𝐄𝟏 . 𝟕𝟗 23.3 = P/E

Justified P/Es
Page 18
𝐃𝟎 (𝟏+𝐠) 𝐕𝟎
𝐕𝟎 = 𝐫5𝐠
, then 𝐄𝐏𝐒
= Justified P/E LOS f
- calculate
- interpret
trailing forward
12 months (ttm) 12-months
E0 E1

- again, assuming that V0 = P0

𝐃𝟏
A𝐄 = 𝐃𝐏𝐑 = 𝟏 − 𝐑𝐑
𝟏
𝐃𝟏A
𝐏𝟎A 𝐄𝟏 𝟏 − 𝐑𝐑
𝐄𝟏 𝐫 − 𝐠 = 𝐫 − 𝐠
= ⇒ leading/forward

or/ 𝐃𝟎 (𝟏 + 𝐠)
𝐏𝟎 𝐄𝟎 (𝟏 − 𝐑𝐑)(𝟏 + 𝐠) ⇒ trailing
A𝐄 = =
𝟎 𝐫 − 𝐠 𝐫 − 𝐠

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Page 19
e.g./ P0 = $23.84 rf = 2.8% r = .028 + .8(.04) LOS f
EPSttm = 1.81 ERP = 4.0% = .06 - calculate
D0 = $0.58 β = 0.80 DPR = . 𝟓𝟖A𝟏. 𝟖𝟏 = . 𝟑𝟐𝟎𝟒 - interpret

g = 3.5% RR = .6796

Justified P/E
Forward Trailing
𝟏 − 𝐑𝐑 . 𝟑𝟐𝟎𝟒 (𝟏 − 𝐑𝐑)(𝟏 + 𝐠) . 𝟑𝟐𝟎𝟒(𝟏. 𝟎𝟑𝟓)
= = = 𝟏𝟐. 𝟖𝟏𝟒 = =
𝐫 − 𝐠 . 𝟎𝟔 − . 𝟎𝟑𝟓 𝐫 − 𝐠 . 𝟎𝟐𝟓
𝟎. 𝟓𝟖(𝟏. 𝟎𝟑𝟓) = 𝟏𝟑. 𝟐𝟔𝟒
𝐕𝟎 = = 𝟐𝟒. 𝟎𝟏
. 𝟎𝟐𝟓

𝟐𝟒.𝟎𝟏
= 𝟏𝟐. 𝟖𝟏𝟔 actual 𝟐𝟒. 𝟎𝟏A
𝟏.𝟖𝟏(𝟏.𝟎𝟑𝟓) 𝟏. 𝟖𝟏 = 𝟏𝟑. 𝟐𝟔𝟔
𝟐𝟑. 𝟖𝟒A
𝟏. 𝟖𝟏 = 𝟏𝟑. 𝟏𝟕

Preferred Stock
Page 20
- non-callable, fixed-rate perpetual LOS g
- calculate
level dividend implies

a) D0 = D1 = D2 = … = D∞

b) g = 0

∴ 𝐕𝟎 = 𝐃A𝐫

e.g./ KSV-P 4% par $25 pref., r = 5.5%

𝟐𝟓 ×. 𝟎𝟒 𝟏
𝐕𝟎 = = = $𝟏𝟖. 𝟏𝟖
. 𝟎𝟓𝟓 . 𝟎𝟓𝟓

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Summary
Page 21
+/ · simplest of the DDM models LOS h
· most commonly used - describe
· easy to understand
· has reverse logic
· scope ⇒ indicies, preferreds

-/ · sensitive to levels of r and g

· r >> g
· stock must be dividend paying and dividends must
have a consistent relationship with earnings

Justifications/ · dividends are more stable/predictable

· more reflective of long-term intrinsic value since
they are actual distributions

Multi-Stage DDM
Page 22
· assumption of stable div. growth rate LOS i
not realistic for most companies - explain
- justify
⇒ 2-stage (growth - maturity)

g - assumptions/
- abnormal g is Stage 1 (gS)
gS
- constant g at maturity (gL)
gL - transition from growth to maturity abrupt
- single r at both stages
t
- justification/
- represents reality better (temporary comp.
advantage ⇒ patents, first mover)
- company that pays $0 now but a div. is
anticipated

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Page 23
⇒ H-model (growth - maturity) LOS i
g
- explain
· results in an
gS - justify
approximation of V0
gL
- if gS is a long period or if
(gS – gL) is large, discounting each
t
dividend would be better

⇒ 3-stage (growth – transition – maturity)

g or/ g

gS gS
gt
gL gL

t t
- for all 3 models, no assumptions are made as to the
length of each phase (flexible)

Page 24
⇒ Spreadsheet Modelling LOS i
- explain
- allows for more complex dividend
- justify
patterns

- built-in functions simplify complex/tedious

calculations

- easily shared

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Stages of Growth
Page 25
1) Growth phase LOS j
- rapidly expanding markets - explain
- high profit margins
- abnormally high growth rate in EPS
- often FCFE < 0
- DPR = 0

2) Transition phase
- earnings growth slows towards rate of GDP
- competition puts pressure on prices and
margins
- CAPEX requirements decline
- FCFE & DPR > 0

Page 26
3) Maturity phase/ LOS j
- equilibrium ⇒ investment opps earn - explain
cost of capital

∴ ROE ∼ re

- earnings growth, DPR & ROE stabilize at

sustainable long-term levels

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Terminal Value
Page 27
2-stage LOS k
𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐭 𝐕𝐧 - describe
𝐕𝟎 = , + - explain
(𝟏 + 𝐫) 𝐭 (𝟏 + 𝐫)𝐧
𝐭$𝟏 Vn – terminal
3-stage value
𝐦
𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐚
𝐧5𝐦
𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐦 (𝟏 + 𝐠 𝐭 )𝐛 𝐕𝐧 (continuing
𝐕𝟎 = , + , + value)
(𝟏 + 𝐫) 𝐚 (𝟏 + 𝐫) 𝐦+𝐛 (𝟏 + 𝐫)𝐧
𝐚$𝟏 𝐛$𝟏

𝐧
➀ 𝐕 = 𝐃𝟎 (𝟏 + 𝐠 𝐒 ) (𝟏 + 𝐠 𝐋 ) 𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐦 (𝟏 + 𝐠 𝐭 )𝐧5𝐦 (𝟏 + 𝐠 𝐋 )
𝐧 𝐕𝐧 =
𝐫 − 𝐠𝐋 𝐫 − 𝐠𝐋

GGM
➁ Vn = EPSn × multiple · typically the largest component
BV/sh × multiple of V0

Examples
Page 28
- 2-stage LOS l
𝐃 (𝟏 + 𝐠 𝐒 )𝐭 (𝟏 + 𝐠 𝐋 ) - calculate
𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐭 I 𝟎 J
(𝐫 − 𝐠 𝐋 )
𝐕𝟎 = , + - interpret
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭$𝟏

e.g./ P0 = 23.37 D0 = 0.40

re = 7.1% gS = 9% (10 yrs) gL = 5%

. 𝟒𝟎(𝟏. 𝟎𝟗)𝟏𝟎 (𝟏. 𝟎𝟓)

𝐕𝐧 =
. 𝟎𝟕𝟏 − . 𝟎𝟓
= 𝟒𝟕. 𝟑𝟒𝟕𝟑

𝐕𝟏𝟎
𝐕𝟎 = + 𝟒. 𝟒𝟏𝟏𝟖
(𝟏 + 𝐫)𝟏𝟎
𝟒𝟕. 𝟑𝟒𝟕𝟑
= + 𝟒. 𝟒𝟏𝟏𝟖
(𝟏. 𝟎𝟕𝟏)𝟏𝟎
= 𝟐𝟖. 𝟐𝟓𝟕
4.4118

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Page 29
e.g. 2/ P0 = 52.72 D0 = 1.70 gS = 4% (4 yrs) LOS l
re = 9% DPR4 = .35 - calculate
PEttm = 13 - interpret

V0?
𝟒
𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐭 𝟏. 𝟕𝟎(𝟏. 𝟎𝟒) 𝟏. 𝟕𝟎(𝟏. 𝟎𝟒)𝟐 𝟏. 𝟕𝟎(𝟏. 𝟎𝟒)𝟑 𝟏. 𝟕𝟎(𝟏. 𝟎𝟒)𝟒
, = + + +
(𝟏 + 𝐫)𝐭 (𝟏. 𝟎𝟗) (𝟏. 𝟎𝟗)𝟐 (𝟏. 𝟎𝟗)𝟑 (𝟏. 𝟎𝟗)𝟒
𝐭$𝟏

= 𝟔. 𝟎𝟓𝟓𝟏
𝐕𝐧 𝟏. 𝟕𝟎(𝟏. 𝟎𝟒)𝟒
= 𝟏𝟑 𝐕𝐧 = 𝟏𝟑 × 𝐄𝐧 = 𝟏𝟑 × = 𝟏𝟑 × 𝟓. 𝟔𝟖𝟐𝟐
𝐄𝐧 . 𝟑𝟓
= 𝟕𝟑. 𝟖𝟔𝟖𝟐
𝟕𝟑. 𝟖𝟔𝟖𝟐 𝟓𝟖. 𝟑𝟖𝟓𝟐 − 𝟓𝟐. 𝟕𝟐
𝐕𝟎 = + 𝟔. 𝟎𝟓𝟓𝟏 = $𝟓𝟖. 𝟑𝟖𝟓𝟐
(𝟏. 𝟎𝟗)𝟒 𝟓𝟐. 𝟕𝟐
= 𝟏𝟎. 𝟕𝟒𝟔%

Page 30
H-model/ LOS l
𝐃𝟎 (𝟏 + 𝐠 𝐋 ) 𝐃𝟎 ∙ 𝐇(𝐠 𝐒 − 𝐠 𝐋 ) - calculate
𝐕𝟎 = +
𝐫 − 𝐠𝐋 𝐫 − 𝐠𝐋 - interpret

H = half-life in years of the high growth

period

e.g./ P0 = $23.37 D0 = 0.40 gS = 9% (10 yrs) 2-stage

re = 7.1% gL = 5% V0 = 28.257

. 𝟒𝟎(𝟏. 𝟎𝟓) . 𝟒𝟎(𝟓)(. 𝟎𝟗 − . 𝟎𝟓)

𝐕𝟎 = +
. 𝟎𝟕𝟏 − . 𝟎𝟓 . 𝟎𝟕𝟏 − . 𝟎𝟓
= 𝟐𝟎 + 𝟑. 𝟖𝟎𝟗𝟓
= 𝟐𝟑. 𝟖𝟎𝟗𝟓

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Page 31
H-model/ LOS l
e.g. 2/ P0 = $41.70 D0 = 1.77 - calculate
gS = 7% (10 yrs) - interpret
gL = 4%
re = 9.5%

𝐃𝟎 (𝟏 + 𝐠 𝐋 ) 𝐃𝟎 ∙ 𝐇(𝐠 𝐒 − 𝐠 𝐋 )
𝐕𝟎 = +
𝐫 − 𝐠𝐋 𝐫 − 𝐠𝐋
𝟑𝟖. 𝟑𝟎 − 𝟒𝟏. 𝟕𝟎
𝟏. 𝟕𝟕(𝟏. 𝟎𝟒) 𝟏. 𝟕𝟕(𝟓)(. 𝟎𝟑) 𝟒𝟏. 𝟕𝟎
= +
. 𝟎𝟗𝟓 − . 𝟎𝟒 . 𝟎𝟓𝟓
= −𝟖. 𝟏𝟓𝟑%
= 𝟑𝟑. 𝟒𝟕 + 𝟒. 𝟖𝟑
= 𝟑𝟖. 𝟑𝟎

Page 32
3-stage LOS l
e.g. 1/ P0 = 194.98 D0 = 3.30 re = 9% - calculate
gS = 14% (2 yrs) - interpret

gt = 12% (5 yrs)
gL = 6.75%

𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝟐 (𝟏 + 𝐠 𝐭 )𝟓 (𝟏 + 𝐠 𝐋 ) 𝟑. 𝟑𝟎(𝟏. 𝟏𝟒) 𝟑. 𝟑𝟎(𝟏. 𝟏𝟒)𝟐

𝐕𝟕 = 𝐏𝐕𝐝𝐢𝐯 = +
𝐫 − 𝐠𝐋 𝟏. 𝟎𝟗 (𝟏. 𝟎𝟗)𝟐
𝟑. 𝟑𝟎(𝟏. 𝟏𝟒)𝟐 (𝟏. 𝟏𝟐)𝟓 (𝟏. 𝟎𝟔𝟕𝟓) 𝟑. 𝟑𝟎(𝟏. 𝟏𝟒)𝟐 (𝟏. 𝟏𝟐) 𝟑. 𝟑𝟎(𝟏. 𝟏𝟒)𝟐 (𝟏. 𝟏𝟐)𝟓
= + + . . . +
. 𝟎𝟗 − . 𝟎𝟔𝟕𝟓 (𝟏. 𝟎𝟗)𝟑 (𝟏. 𝟎𝟗)𝟕
= 𝟑𝟓𝟖. 𝟓𝟗𝟎𝟖 = 𝟐𝟔. 𝟔𝟓𝟔𝟏

𝟑𝟓𝟖. 𝟓𝟗𝟎𝟖 𝟐𝟐𝟐. 𝟖𝟏𝟕𝟏 − 𝟏𝟗𝟒. 𝟗𝟖

𝐕𝟎 = + 𝟐𝟔. 𝟔𝟓𝟔𝟏 = 𝟐𝟐𝟐. 𝟖𝟏𝟕𝟏 = 𝟏𝟒. 𝟐𝟕𝟕%
(𝟏. 𝟎𝟗)𝟕 𝟏𝟗𝟒. 𝟗𝟖

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Page 33
3-stage w/H-model LOS l
- calculate
e.g. 2/ V0 =?
- interpret
· P0 = 56.18 · D0 = 0.56 𝐃𝟓 (𝟏 + 𝐠 𝐋 ) 𝐃𝟓 ∙ 𝐇(𝐠 𝐒 − 𝐠 𝐋 )
𝐕𝟓 = +
· gS = 11% (5 yrs) 𝐫 − 𝐠𝐋 𝐫 − 𝐠𝐋
· [gS → gL = 10 yrs]
𝐫 = . 𝟎𝟑 + 𝟏. 𝟐(𝟎. 𝟎𝟒𝟐) = . 𝟎𝟖
· gL = 6.5% · ERP = 4.2%
· βadj = 1.2 - 2 yrs of weekly 𝟎. 𝟓𝟔(𝟏. 𝟏𝟏)𝟓 (𝟏. 𝟎𝟔𝟓) 𝟎. 𝟓𝟔(𝟏. 𝟏𝟏)𝟓 ∙ 𝟓(. 𝟏𝟏 − . 𝟎𝟔𝟓)
𝐕𝟓 = +
obs. . 𝟎𝟖 − . 𝟎𝟔𝟓 . 𝟎𝟖 − . 𝟎𝟔𝟓
· rf = 3% (20 yr T-Bond) = 𝟔𝟔. 𝟗𝟗𝟕𝟗 + 𝟏𝟒. 𝟏𝟓𝟒𝟓
· FairVal = +/- 20% · V0 = 𝟖𝟏. 𝟏𝟓𝟐𝟒

𝟖𝟏. 𝟏𝟓𝟐𝟒 . 𝟓𝟔(𝟏. 𝟏𝟏) . 𝟓𝟔(𝟏. 𝟏𝟏)𝟓

𝐕𝟎 = 𝟑. 𝟎𝟒𝟐𝟏 + = 𝟓𝟖. 𝟐𝟕𝟑𝟏 𝐏𝐕𝐝𝐢𝐯 = + ...+
(𝟏. 𝟎𝟖)𝟓 (𝟏. 𝟎𝟖) (𝟏. 𝟎𝟖)𝟓
= 𝟑. 𝟎𝟒𝟐𝟏

Page 34
Single Stage
LOS l
GGM - calculate
multiples-based - interpret

2-stage
GGM
explicit forecast
multiples-based
period
or/
H-model

GGM
3-stage explicit forecast
multiples-based
explicit forecast period
period
H-model

(1) (2) (3)

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Required Return
Page 35
𝐃𝟏=
GGM/ 𝐕𝟎 = 𝐏𝟎 = 𝐫 − 𝐠 LOS m
𝐃𝟏 - estimate
𝐫= =𝐏 + 𝐠 𝐏𝟎 (𝐫 − 𝐠) = 𝐃𝟏
𝟎
𝐃
𝐫 − 𝐠 = 𝟏=𝐏
𝟎
𝐃𝟏
𝐫 = =𝐏 + 𝐠
𝟎
H-model/
𝐃
𝐫 = ( 𝟎=𝐏 , [(𝟏 + 𝐠 𝐋 ) + 𝐇(𝐠 𝐒 − 𝐠 𝐋 )] + 𝐠 𝐋
𝟎

𝐃𝟎 (𝟏 + 𝐠 𝐋 ) 𝐃𝟎 𝐇(𝐠 𝐒 − 𝐠 𝐋 ) 𝐃
𝐕𝟎 = 𝐏𝟎 = + 𝐫 − 𝐠 𝐋 = ( 𝟎=𝐏 , [(𝟏 + 𝐠 𝐋 ) + 𝐇(𝐠 𝐒 − 𝐠 𝐋 )]
𝟎
𝐫 − 𝐠𝐋 𝐫 − 𝐠𝐋
𝐃
𝐫 = ( 𝟎=𝐏 , [(𝟏 + 𝐠 𝐋 ) + 𝐇(𝐠 𝐒 − 𝐠 𝐋 )] + 𝐠 𝐋
𝐏𝟎 (𝐫 − 𝐠 𝐋 ) = 𝐃𝟎 (𝟏 + 𝐠 𝐋 ) + 𝐃𝟎 𝐇(𝐠 𝐒 − 𝐠 𝐋 ) 𝟎

𝐃𝟎 (𝟏 + 𝐠 𝐋 ) 𝐃𝟎 𝐇(𝐠 𝐒 − 𝐠 𝐋 )
𝐫 − 𝐠𝐋 = +
𝐏𝟎 𝐏𝟎

Page 36
2-stage 𝐃𝐧+𝟏 LOS m
𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐭 𝐕𝐧 𝐫 − 𝐠𝐋 - estimate
, +
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭$𝟏

3-stage 𝐃𝐧+𝟏
𝐦 𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐚 𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐚 (𝟏
+ 𝐠𝐭 )𝐛 𝐕𝐧 𝐫 − 𝐠𝐋
, + , +
(𝟏 + 𝐫)𝐚 (𝟏 + 𝐫)𝐛5𝐦 (𝟏 + 𝐫)𝐧
𝐚$𝟏 𝐛$𝐦+𝟏

⇒ given P0, solve for r (IRR) ⇒ efficient market

required return
(implied r)
𝐃𝐧+𝟏A
𝐕𝐧 = 𝐫 − 𝐠 initial est.
D1 D2 . . . . + Dn 𝐃
𝐫 = 𝟏A𝐏 + 𝐠 𝐋
𝟎
P0

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Spreadsheet Modelling
Page 37
⇒ any dividend pattern LOS n
- explain
Q: how to estimate g for the terminal value

𝐧
𝐃𝐢 𝐕𝐧 𝐃𝐧+𝟏
, +
(𝟏 + 𝐫) (𝟏 + 𝐫)𝐧
𝐢 𝐫 − 𝐠
𝐢$𝟏

1) g = ROE × RR in mature stage

set ROE = r (equilibrium condition)

set to the median industry ROE
DuPont decomposition based on forecasts for
the components of ROE

2) relate g to macro or industry growth projections

gL
Page 38
⇒ gL – sustainable growth rate for a LOS o
given level of ROE - calculate
(assumes a constant capital structure) - interpret

g = ROE × RR higher ROE Not

higher g
higher RR !
quite
b = (1 – DPR) dividend
- lower RR ⇒ lower g
displacement
or earnings
e.g./ ROE = 25%
g = .25 × .60 = 15%
RR = 60%

T0 T1
Sh. Eq. $1M Sh. Eq. $1.150M
NI 250k NI = Sh. Eq × ROE 287,500
Div 100k (15% increase)
(DPR = 40%) Div (40% DPR) 115,000
(15% increase)

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Page 39
⇒ g = ROE × RR LOS o
- calculate
- interpret
𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞
=
𝐒𝐡. 𝐄𝐪𝐮𝐢𝐭𝐲
× 𝐑𝐑 (or Avg. TA)
(ROA × leverage)
𝐍𝐈 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬
= × × 𝐑𝐑
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 𝐒𝐡. 𝐄𝐪𝐮𝐢𝐭𝐲 Pr. margin
𝐍𝐈 𝐒𝐚𝐥𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 ×
= × × × 𝐑𝐑 turnover
𝐒𝐚𝐥𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 𝐒𝐡. 𝐄𝐪𝐮𝐢𝐭𝐲
×
leverage

𝐍𝐈 − 𝐃𝐢𝐯. 𝐍𝐈 𝐒𝐚𝐥𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬

𝐠= × × ×
𝐍𝐈 𝐒𝐚𝐥𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 𝐒𝐡. 𝐄𝐪𝐮𝐢𝐭𝐲

PRAT model

Page 40
e.g./ ABC ROA = 10% LOS o
RR = 30% - calculate
leverage = 1.25 (a.k.a. equity multiplier) - interpret

XYZ ROA = 10%

RR = 𝟐A𝟑
leverage = 2.0 g = RR × ROA × leverage

ABC/ g = .3 × .1 × 1.25 = 3.75%

higher RR
XYZ/ g = 𝟐A𝟑 × .1 × 2 = 13.33%
higher leverage

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Page 41
g = RR × Profit × turnover × leverage LOS o
Margin - calculate
- interpret

= RR × ROA × financial
leverage

• match estimates of each factor with the

forecast horizon

- typically, 𝐬𝐚𝐥𝐞𝐬A𝐚𝐬𝐬𝐞𝐭𝐬 & 𝐚𝐬𝐬𝐞𝐭𝐬A𝐞𝐪𝐮𝐢𝐭𝐲 are forecast to be fixed

⇒ implies sales, assets & debt will grow at g

→ RR usually fixed as well, ∴ div grows at g as well

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Free Cash Flow Valuation

a. compare the free cash flow to the firm (FCFF) and free cash flow to equity
(FCFE) approaches to valuation

b. explain the ownership perspective implicit in the FCFE approach

c. explain the appropriate adjustments to net income, earnings before interest and
taxes (EBIT), earnings before interest, taxes, depreciation, and amortization
(EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE

d. calculate FCFF and FCFE

e. describe approaches for forecasting FCFF and FCFE

f. compare the FCFE model and dividend discount models

g. explain how dividends, share repurchases, share issues, and changes in leverage
may affect future FCFF and FCFE

h. evaluate the use of net income and EBITDA as proxies for cash flow in valuation

i. explain the single-stage (stable-growth), two-stage, and three-stage FCFF and

FCFE models and justify the selection of the appropriate model given a company’s
characteristics

j. estimate a company’s value using the appropriate free cash flow model(s)

k. explain the use of sensitivity analysis in FCFF and FCFE valuations

l. describe approaches for calculating the terminal value in a multistage valuation

model

m. evaluate whether a stock is overvalued, fairly valued, or undervalued based on a

free cash flow valuation model

LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings

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FCFF vs. FCFE

Page 1
• FCFF/E - not readily available LOS a
- must be computed - compare
- forecasting more complicated

Recap/ ⇒ use FCF when:

Company pays no dividend
Company pays a dividend, but it shows
no relationship with earnings or capacity
to pay
FCF has alignment with profitability
over the forecast period

Page 2
FCFF = CFO + Int(1-t) – CAPEX LOS a
- compare
CF available to suppliers of capital

FCFE = FCFF – Int(1-t) + Net Borrowings

CF available to holders of common equity

# #
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐅𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐄𝐭
=, =,
𝐅𝐢𝐫𝐦 (𝟏 + 𝐖𝐀𝐂𝐂)𝐭 𝐄𝐪𝐮𝐢𝐭𝐲 (𝟏 + 𝐫)𝐭
𝐭$𝟏 𝐭$𝟏

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟
= − 𝐌𝐕𝐝 Should give the save value
𝐄𝐪𝐮𝐢𝐭𝐲 𝐅𝐢𝐫𝐦

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟
𝐄𝐪𝐮𝐢𝐭𝐲 g
𝐕𝟎 = #𝐨𝐟
𝐬𝐡𝐚𝐫𝐞𝐬

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# # Page 3
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐅𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐄𝐭 LOS a
=, =,
𝐅𝐢𝐫𝐦 (𝟏 + 𝐖𝐀𝐂𝐂)𝐭 𝐄𝐪𝐮𝐢𝐭𝐲 (𝟏 + 𝐫)𝐭 - compare
𝐭$𝟏 𝐭$𝟏

𝐌𝐕𝐝 𝐌𝐕𝐞 r = rf + 𝛃(ERP)

𝐫𝐝 (𝟏 − 𝐭) + 𝐫
𝐌𝐕𝐝 + 𝐌𝐕𝐞 𝐌𝐕𝐝 + 𝐌𝐕𝐞 r = BY + RP

• FCFF preferred if/ • FCFE preferred if/

• Levered company with • Company capital
FCFE < 0 structure is stable and
• Levered company with FCFE > 0
changing capital
structure
(WACC less sensitive to
change than r is)

FCFE
Page 4
FCFF = CFO + Int(1-t) FCFE = FCFF – Int(1-t) LOS b
- CAPEX + Net Borrowings - explain

Cash flow available to: Cash flow available to:

Common stockholders Common stockholders

Debtholders

Preferred stockholder

34
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NI
EBIT
EBITDA
Required Adjustments CFO

Page 5
⇒ To Net Income/ LOS c
FCFF = NI + NCC + Int(1-t) – FCInv – WCInv - explain
(+ Pref. Div)
NI – after dep./am., int. exp., taxes, pref. div
NCC – net non-cash charges
Int(1-t) – after-tax interest exp. Long-term tangible & intangible
FCInv – net investments in fixed capital Acquisitions (cash)
WCInv – net investments in working capital

Excludes cash/equiv. and any CL accts.

that are debt
FCFE = FCFF – Int(1-t) + Net Borrowings
= NI + NCC – FCInv – WCInv + Net Borrowings

Net Borrowings = Debt issued – Debt repaid

Page 6
LOS c
- explain

FCFF 2010 2011 2012

NI 97.52 107.28 118.00

+NCC 45.00 49.50 54.45
+Int(1-t) 10.98 12.08 13.28
-FCInv 0 (50) (55)
-WCInv (56) (11.60) (12.76)

97.50 107.26 117.97

(100) (10) (11)
(6) (6.6) (7.26)
50 5 5.5

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Page 7
LOS c
- explain

FCFF 2010 2011 2012

97.50 107.26 117.97

FCFE 97.50 107.26 117.97
-Int(1-t) (10.98) (12.08) (13.28)
+NetB. 22.40 24.64 27.10
108.92 119.82 131.79

Page 8
⇒ To CFO/ LOS c
FCFF = CFO + Int(1-t) – FCInv (+ Pref. Div) - explain

Includes NCC
WCInv
Exp. GAAP IFRS
Interest CFO
Rec. CFO CFF
CFO CFO CFI adjustments
Pd.
Dividends CFF CFF CFO required
Rec.
CFO CFO CFI

No adjustments

FCFE = FCFF – Int(1-t) + Net Borrowings

= CFO + Int(1-t) – FCInv – Int(1-t) + Net Borrowings
= CFO – FCInv + New Borrowings

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Page 9
LOS c
- explain

FCFF 2010 2011 2012

CFO 86.52 145.18 159.69
+Int(1-t) 10.98 12.08 13.28
-FCInv 0 (50) (55)
97.50 107.26 117.97

FCFE

FCFF 97.50 107.26 117.97

-Int(1-t) (10.98) (12.08) (13.28)
Net. Borr. 22.40 24.64 27.10
108.92 119.82 131.79

Tax rate = 30%

Page 10
⇒ a note on NCC LOS c
- starting with CFO - explain
- NCC reflected in CFO
- starting with NI
- add back NCC – but which ones?
- some NCCs can be buried in other line items

- Forecasting FCFF may require forecasting each component

of NI, Int(1-t), FCInv, WCInv, NCC

e.g./ NCCs: What components?

• restructuring charges - typically want to exclude
• losses/gains unpredictable NCCs from
• am. of bond pr./disc. forecasts

• Dep/Amort.
• Def. Taxes (special attention) – usually ignored unless persistent

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Page 11
⇒ a note on NCC LOS c
e.g./ NCCs: Con’t. - explain
• Employee share-based compensation
IFRS/GAAP – exp. on I.S. (NCC)
- determine impact on CFO
⇒ If they are not expected to persist,
do not forecast them

Page 12
⇒ to EBIT/ LOS c
FCFF = NI + NCC + Int(1-t) – FCInv – WCInv - explain

NI = (EBIT – Int)(1-t)
= EBIT(1-t) – Int(1-t)

FCFF = EBIT(1-t)[-Int(1-t) + Int(1-t)] + NCC – FCInv – WCInv

= EBIT(1-t) + NCC – FCInv – WCInv

We assume the only NCC is Dep.

Why? – many non-cash charges are made after computing
EBIT (or EBITDA)
FCFE = FCFF – Int(1-t) + Net Borrowing
= EBIT(1-t) + NCC – Int(1-t) – FCInv – WCInv + New Borrowing

Page 13
⇒ to EBITDA/ LOS c
FCFF = NI + NCC + Int(1-t) – FCInv – WCInv - explain

NI = (EBITDA – Dep – Int)(1-t)

= EBITDA(1-t) – Dep(1-t) – Int(1-t)
FCFF = EBITDA(1-t)[- Dep + Dep(t) + NCC][- Int(1-t) + Int(1-t)]
– FCInv – WCInv
= EBITDA(1-t) + Dept(t) – FCInv - WCInv

FCFE = FCFF – Int(1-t) + Net Borrowings

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Page 14
FCFF NI LOS d
NI 240 - calculate
NCC 300
Int(1-t) 60
- FCInv (400)
- WCInv (45)
155

FCFE FCFF
FCFF 155 FCFE NI
- Int(1-t) (60) NI 240
+ Net B. 75 NCC 300
170 - FC (400)
- WC (45)
+ Net B. 75
170

Page 15
LOS d
FCFF CFO - calculate
CFO 495
Int(1-t) 60
- FCInv (400)
155

FCFE CFO
CFO 495
- FCInv (400)
+ Net B. 75
170

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Page 16
LOS d
FCFF EBIT
- calculate
EBIT(1-t) 300
+ NCC 300
- FCInv (400)
- WCInv (45)
155

FCFE EBIT
EBIT(1-t) 300
FCFF EBITDA
NCC 300
EBITDA(1-t) 480
- FCInv (400)
+ Dep(t) 120
- WCInv (45)
- FCInv (400)
- Int(1-t) (60)
- WCInv (45)
+ Net B. 75
155
170

Forecasting FCFF/E
Page 17
1) apply a constant growth rate to a current level of FCF LOS e
- if FCF has grown at some constant rate - describe
And/
- historical relationships between CF & fundamental factors are
expected to continue
e.g./
2012 2013 2014 2015
FCFF $155M 178.25 204.99 235.74
g = 15%

𝐅𝐂𝐅𝐅𝟎 (𝟏 + 𝐠) One-stage
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐅𝐢𝐫𝐦 =
𝐖𝐀𝐂𝐂 − 𝐠 model

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Page 18
LOS e
b) forecast each of the components/
- describe
EBIT – forecast directly or as some relationship
Effective
t with sales
tax rate
NCC
(FCInv - NCC) * NCC assumed
FCInv
to be Dep/Am.
𝐖𝐂𝐈𝐧𝐯
WCInv – basic assumption
∆𝐒𝐚𝐥𝐞𝐬 only
– constant relationship
- Constant relationship
to increase in size of
e.g./ 0.20 implies 20¢ of
company
incremental WCInv for
every $1 of sales
𝐖𝐂𝐈𝐧𝐯 (𝐅𝐂𝐈𝐧𝐯 − 𝐍𝐂𝐂)
∴ 𝐟𝐨𝐫𝐞𝐜𝐚𝐬𝐭 = × 𝐈𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 $ 𝐬𝐚𝐥𝐞𝐬 ∆𝐒𝐚𝐥𝐞𝐬
∆𝐒𝐚𝐥𝐞𝐬
e.g./ Sales increase of $10M e.g./ .15 implies 15¢ of
WCInv = .2 × $10 = $2M incremental (FCInv – NCC)
for every $1 increase in Sales

Page 19
• if (FCInv – NCC) = 0, implies FCInv at a level necessary LOS e
to maintain existing capacity - describe

𝐅𝐕𝐈𝐧𝐯 − 𝐍𝐂𝐂
∴ = 𝟎 Does not imply FCInv = 0
𝚫 𝐒𝐚𝐥𝐞𝐬
• (FCInv – NCC) > 0 ⇒ level of FCInv required to support growth

• (FCInv – NCC) < 0 ⇒ unsustainable

•

FCInv = $ to maintain capacity + $ to support growth

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Page 20
FCFE = FCFF (- Int(1-t) + Net Borrowing) LOS e
- describe
(FCInv – NCC) + WCInv

FCFE = NI + NCC – FCInv – WCInv Financed according to a target DR

+ Net Borrowing e.g./ DR = 40%
= NI – (FCInv – NCC) – WCInv $10M + $5M = $15M
+ DR (FCInv – NCC) + DR (WCInv) .4(10) + .4(5) = $6M in
new borrowing

= NI – (1-DR)(FCInv – NCC) – (1-DR)(WCInv)

Proportion financed with CF (i.e. equity)

Page 21
LOS e
- describe

𝐖𝐂𝐈𝐧𝐯 𝟒𝟓 2013
= Sales 3,300
∆𝐒𝐚𝐥𝐞𝐬 𝟑𝟎𝟎
EBIT 550
=15%
EBIT(1-t) 330 → Up $300M over
2011
- IncFC (100)
- WCInv (45)
FCFF13 $185

t=40%

2014
Sales 3,630
EBIT 605
EBIT(1-t) 363 𝐄𝐁𝐈𝐓 = 𝟓𝟎𝟎*𝟑, 𝟎𝟎𝟎 = 𝟏𝟔. 𝟔𝟕%
IncFC (110) (𝐅𝐂𝐈𝐧𝐯 − 𝐃𝐞𝐩) 𝟒𝟎𝟎 − 𝟑𝟎𝟎 𝟏𝟎𝟎
= =
WCInv (49.50) 𝚫 𝐒𝐚𝐥𝐞𝐬 𝟑𝟎𝟎 𝟑𝟎𝟎
$203.50 = 𝟑𝟑 𝟏*𝟑 %

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Page 22
LOS e
- describe

Page 23
FCFE/ - assumptions: LOS e
Sales 3,300 - Up 10% - describe
+ NI 264 - 8% of sales
- IncFC (100) - 𝟑𝟑 𝟏A𝟑 % of 𝚫Sales
- WCInv (45) - 15% of 𝚫Sales
+ Net Borr. 72.50 - DR = 50% (100 + 45).50
$191.50

Note/ if the company has significant NCC other than Dep., this
approach will result in inaccurate forecasts of FCFF/E (best to
forecast each component separately i.e. – no relationship)

43
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FCFE vs. Dividends

Page 24
𝐃𝟎 (𝟏 + 𝐠) 𝐅𝐂𝐅𝐄𝟎 (𝟏 + 𝐠)
𝐕𝟎 = 𝐕𝟎 = LOS f
𝐫−𝐠 𝐫−𝐠 - compare
- g need not be, and often is not, the same in both models

- dividends ⇒ the cash flow FCFE ⇒ the cash flow

actually going to available to be
shareholders (when paid) distributed to shareholders
- discretionary without impairing the
- may imperfectly signal a company’s value
company’s long-term profitability

- if D0 = FCFE0 & both gs are equal, both models will yield the same V0

Page 25
FCFF = NI + NCC + Int(1-t) – FCInv – WCInv LOS g
FCFE = NI + NCC – FCInv – WCInv + Net Borrowings - compare

Sources of cash
- cash flows available to providers of capital
- dividends, share repurchases ⇒ uses of those cash flows

∴ Transactions between a company and its shareholders (divs., buybacks,

issuance) do not affect FCF

- changes in leverage – increase the interest: - expense

– tax shield

- increases FCFE in year debt is issued, will decrease FCFE in subsequent

years by Int(1-t)

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Cash Flow Proxies

Page 26
FCFF = NI + NCC + Int(1-t) – FCInv – WCInv LOS h
= EBITDA(1-t) = Dep(t) – FCInv – WCInv - evaluate

Vs.
EBITDA - as a proxy for CF available to
capital providers
𝐄𝐁𝐈𝐓𝐃𝐀 - before tax measure
(𝟏 + 𝐖𝐀𝐂𝐂)
after-tax measure

FCFE = NI + NCC – FCInv – WCInv + Net Borrowings

Vs.
NI – as a proxy for CF available to
common stockholders

Preferred Shares
Page 27
FCFF ⇒ + Pref. Div.
FCFE ⇒ if starting from FCFF ⇒ – Pref. Div.
if starting from NI ⇒ no adjustment
but/ + Net Pref. Issuance
(+ sh. issuance – sh. buyback)

e.g./ MV r
Bonds 400 8% NI = 110 Int. exp. = 32 NCC = 40
Pref. 100 8 WCInv = 20 FCInv = 70 Net. Borr. = 25
Comm. 500 12 t=30% gFCFF = 4% gFCFE = 5.4%
1000
WACC FCFF = 110 + 40 + 32(.7) – 70 – 20 + 8
= (.4)(.08)(.7) + .1(.08)+ .5(.12) = 90.4
= 9.04% 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝟗𝟎. 𝟒(𝟏. 𝟎𝟒)
= = 𝟏𝟖𝟔𝟓. 𝟒𝟎
𝐭𝐡𝐞 𝐅𝐢𝐫𝐦 . 𝟎𝟗𝟎𝟒 − . 𝟎𝟒
− 𝟓𝟎𝟎
𝟏𝟑𝟔𝟓. 𝟒𝟎

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Page 28
e.g./ MV r
Bonds 400 8% NI = 110 Int. exp. = 32 NCC = 40
Pref. 100 8 WCInv = 20 FCInv = 70 Net. Borr. = 25
Comm. 500 12 t=30% gFCFF = 4% gFCFE = 5.4%
1000
𝐅𝐂𝐅𝐄 = 𝟏𝟏𝟎 + 𝟒𝟎 − 𝟕𝟎 − 𝟐𝟎 + 𝟐𝟓
= 𝟖𝟓
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝟖𝟓(𝟏. 𝟎𝟓𝟒)
= = 𝟏𝟑𝟓𝟕. 𝟒𝟐
𝐄𝐪𝐮𝐢𝐭𝐲 . 𝟏𝟐 − . 𝟎𝟓𝟒
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟
= − 𝐌𝐕𝐝 − 𝐌𝐕𝐏𝐫
𝐄𝐪𝐮𝐢𝐭𝐲 𝐅𝐢𝐫𝐦
= 𝟏𝟖𝟔𝟓. 𝟒𝟎 − 𝟒𝟎𝟎 − 𝟏𝟎𝟎 = 𝟏𝟑𝟔𝟓. 𝟒𝟎

FCFF/E Models
Page 29
- single-stage (stable growth) LOS i
- explain
• GGM 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐅𝟎 (𝟏 + 𝐠) = − 𝐌𝐕𝐝
= 𝐄𝐪𝐮𝐢𝐭𝐲 𝐅𝐢𝐫𝐦
𝐅𝐢𝐫𝐦 𝐖𝐀𝐂𝐂 − 𝐠
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐄𝟎 (𝟏 + 𝐠) 𝐄𝐪𝐮𝐢𝐭𝐲
= 𝐕𝟎 =
𝐄𝐪𝐮𝐢𝐭𝐲 𝐫−𝐠 # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬

• Multiples-based
𝐧
- Two-stage growth model 𝐅𝐂𝐅𝐅𝟎 (𝟏 + 𝐠) 𝐅𝐂𝐅𝐅𝐧.𝟏 𝟏
! + + - + -
(𝟏 + 𝐖𝐀𝐂𝐂)𝐢 𝐖𝐀𝐂𝐂 − 𝐠 (𝟏 + 𝐖𝐀𝐂𝐂)𝐧
Explicit forecast GGM 𝐢/𝟏

period Multiples-based

𝐧
𝐅𝐂𝐅𝐅𝐢 𝐅𝐂𝐅𝐅𝐧.𝟏 𝟏
H-model ! ++ -+ -
(𝟏 + 𝐖𝐀𝐂𝐂)𝐢 𝐖𝐀𝐂𝐂 − 𝐠 (𝟏 + 𝐖𝐀𝐂𝐂)𝐧
𝐢/𝟏

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Page 30
- 3-stage growth model LOS i

Explicit forecast Explicit forecast GGM - explain

period period Multiples-based

H-model
Stage 1 Stage 2 Stage 3
one-stage • constant g
two-stage • constant g • constant g
• declining g
three-stage • constant g • constant g • constant g
• growing g • declining g

Page 31
e.g. 1/ 2-stage w/ constant g in each stage
LOS j
Sales0/sh =25 β =1.2 rf =7% ERP =4.5% - estimate
gsales =20% (-3yrs), 6% after
NI Margin =10%
(FCInv – Dep) =50% $𝚫Sales WCInv =20% $𝚫Sales
DR =40%
V0=?
𝟑
𝐅𝐂𝐅𝐄𝐢 𝐅𝐂𝐅𝐄𝐧+𝟏 𝟏
𝐕𝟎 = , 𝐢
+ ⋅
(𝟏 + 𝐫) 𝐫 − 𝐠 (𝟏 + 𝐫)𝟑
𝐢$𝟏

r = .07 + 1.2(.045) = 12.4%

30 36 43.20 45.792
FCFE 1 2 3 4
NI 3 3.6 4.32 4.5792
- (FCInv-Dep) (2.50) (3.0) (3.60) (1.296)
- WCInv (1.00) (1.20) (1.44) (0.518)
+ Net Borr. 1.40 1.68 2.016 0.726
0.90 1.08 1.296 3.491

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Page 32
e.g. 1/ 2-stage w/ constant g in each stage LOS j
Sales0/sh =25 β =1.2 rf =7% ERP =4.5% - estimate

gsales =20% (-3yrs), 6% after

NI Margin =10%
(FCInv – Dep) =50% $𝚫Sales WCInv =20% $𝚫Sales
DR =40%
𝟎. 𝟗𝟎 𝟏. 𝟎𝟖 𝟏. 𝟐𝟗𝟔 𝟑. 𝟒𝟗𝟏 𝟏
𝐕𝟎 = + + +I J⋅
𝟏. 𝟏𝟐𝟒 (𝟏. 𝟏𝟐𝟒) 𝟐 (𝟏. 𝟏𝟐𝟒) 𝟑 . 𝟏𝟐𝟒 − . 𝟎𝟔 (𝟏. 𝟏𝟐𝟒)𝟑
𝟓𝟒. 𝟓𝟓
= . 𝟖𝟎𝟏 + . 𝟖𝟓𝟓 + . 𝟗𝟏𝟑 +
(𝟏. 𝟏𝟐𝟒)𝟑
= 𝟒𝟎. 𝟗𝟖

Page 33
e.g. 2/ 2-stage w/ declining g in stage 1 LOS j
and constant g in stage 2 - estimate

• EPS2012 = 2.40
2013 2014 2015 2016 2017
gEPS 30% 18% 12% 9% 7%
(FCInv-Dep) $3 2.50 2.00 1.50 1.00

• WCInv =50% of (FCInv-Dep)

• DR = 30% rf =6% ERP =4.0% βadj =1.10
𝟒
𝐅𝐂𝐅𝐄/𝐬𝐡𝐢 𝐅𝐂𝐅𝐄/𝐬𝐡𝟓 𝟏
V2013 =? 𝐕𝟏𝟑 = , 𝐢
+ ⋅
2013 (𝟏 + 𝐫) 𝐫−𝐠 (𝟏 + 𝐫)𝟒
𝐢$𝟏
P/Ettm 2017
𝐫 = . 𝟎𝟔 + 𝟏. 𝟏𝟎(. 𝟎𝟒) = 𝟏𝟎. 𝟒%
As of Jan 1/13 𝐅𝐂𝐅𝐄A = 𝐍𝐈A − (𝐅𝐂𝐈𝐧𝐯 − 𝐃𝐞𝐩. ) − 𝐖𝐂𝐈𝐧𝐯 + 𝐍𝐞𝐭 𝐁𝐨𝐫𝐫.
𝐬𝐡 𝐬𝐡

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Page 34
e.g. 2/ 2-stage w/ declining g in stage 1 LOS j
and constant g in stage 2 - estimate
EPS2012 = 2.40 gEPS 30% 18% 12% 9% 7%
1 2 3 4 5
NI/sh 3.12 3.682 4.123 4.494 4.809
- (FCInv-Dep) (3) (2.50) (2) (1.50) (1)
- WCInv (1.5) (1.25) (1) (.75) (.50)
+ Net Borr. 1.35 1.125 .90 .675 .45
-.03 1.057 2.023 2.919 3.759 𝟏
2013 𝟐 𝟑 𝟒 ⋅
𝐕𝟎 = (𝟏. 𝟏𝟎𝟒) + (𝟏. 𝟏𝟎𝟒) + (𝟏. 𝟏𝟎𝟒) + (𝟏. 𝟏𝟎𝟒) +. 𝟏𝟎𝟒− . 𝟎𝟕 (𝟏. 𝟏𝟎𝟒)𝟒
𝐏= 𝟕𝟖. 𝟕𝟑
=
𝐄𝐭𝐭𝐦 𝟐. 𝟒𝟎 𝐕𝟎 = −. 𝟎𝟐𝟕 + . 𝟖𝟔𝟕 + 𝟏. 𝟓𝟎𝟒 + 𝟏. 𝟗𝟔𝟓 + 𝟏𝟏𝟎. 𝟓𝟔@
(𝟏. 𝟏𝟎𝟒)𝟒
= 𝟑𝟐. 𝟖𝟎 𝐕𝟎 = 𝟕𝟖. 𝟕𝟑 2017
𝐏= 𝟏𝟏𝟎. 𝟓𝟔
𝐄𝐭𝐭𝐦 = 𝟒. 𝟒𝟗𝟒 = 𝟐𝟒. 𝟔

Page 35
e.g. 3/ 2-stage - declining sales growth plus LOS j
declining Net. Pr. Margin - estimate

• Sales0 = $600M
1 2 3 4 5 6
gsales 20% 16% 12% 10% 8% 7%
Net. Pr. Margin 14% 13% 12% 11% 10.5% 10%

• (FCInv – Dep) =60% $𝚫Sales WCInv =25% $𝚫Sales DR =40%

β =1.10 rf =6.0% ERP =4.5% 70M shares
𝟓
MVe =? 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐄𝐢 𝐅𝐂𝐅𝐄𝟔 𝟏
=, + ⋅
V0 =? 𝐄𝐪𝐮𝐢𝐭𝐲 (𝟏 + 𝐫)𝐢 𝐫 − 𝐠 (𝟏 + 𝐫)𝟓
𝐢$𝟏

YR1 r = rf + β(ERP)
NI 100.80
MVe = $1,401.9M V0 = 20.02
- (FCInv – Dep) (72)
- WCInv (30)
+ N.B. 40.8
39.6

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Sensitivity Analysis
Page 36
LOS k
- explain

r = .052 + 1.2(.055) = 11.8% highlights which

g = 6% variables are most
critical to final
valuation
⇒ Recall ⇒ GGM very sensitive to values of r & g

⇒ Allows you to develop a range for fair value

Terminal Value
Page 37
1) GGM: LOS l
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐅𝐧+𝟏 𝐅𝐂𝐅𝐅𝐧 (𝟏 + 𝐠) - describe
= =
𝐅𝐢𝐫𝐦𝐧 𝐖𝐀𝐂𝐂 − 𝐠 𝐋 𝐖𝐀𝐂𝐂 − 𝐠 𝐋

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐄𝐧+𝟏 𝐅𝐂𝐅𝐄𝐧 (𝟏 + 𝐠)

= =
𝐄𝐪𝐮𝐢𝐭𝐲𝐧 𝐫 − 𝐠𝐋 𝐫−𝐠

2) Multiples-based
e.g./ Vn = EPSn × multiple

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Market-Based Valuation: Price and Enterprise Value Multiples

a. contrast the method of comparables and the method based on forecasted fundamentals as
approaches to using price multiples in valuation and explain economic rationales for each
approach

b. calculate and interpret a justified price multiple

c. describe rationales for and possible drawbacks to using alternative price multiples and dividend
yield in valuation

d. calculate and interpret alternative price multiples and dividend yield

e. calculate and interpret underlying earnings, explain methods of normalizing earnings per share
(EPS), and calculate normalized EPS

f. explain and justify the use of earnings yield (E/P)

g. describe fundamental factors that influence alternative price multiples and dividend yield

h. calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and
price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals

i. calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and
explain limitations to the cross-sectional regression methodology

j. evaluate a stock by the method of comparables and explain the importance of fundamentals in
using the method of comparables

k. calculate and interpret the P/E-to-growth (PEG) ratio and explain its use in relative valuation

l. calculate and explain the use of price multiples in determining terminal value in a multistage
discounted cash flow (DCF) model

m. explain alternative definitions of cash flow used in price and enterprise value (EV) multiples and
describe limitations of each definition

n. calculate and interpret EV multiples and evaluate the use of EV/EBITDA

o. explain sources of differences in cross-border valuation comparisons

p. describe momentum indicators and their use in valuation

q. explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and the
median to describe the central tendency of a group of multiples

r. evaluate whether a stock is overvalued, fairly valued, or undervalued based on comparisons of

multiples

LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings

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Comparables vs. Forecasted Fundamentals

Page 1
- Comparables/ LOS a
- based on a multiple of similar assets - distinguish
(comparables, comps, guideline assets/companies) - explain
over - closely matched stock
- relative valuation fairly vs.
- avg. value of a
under stock’s peer group
- Law of One Price
- 2 identical assets should sell at the same price

relatively
e.g./ A EPS = $1.50 ➀ 𝐏𝐀 = 𝟏. 𝟓𝟎 × 𝟐𝟐 = $𝟑𝟑 overvalued
PA = $37.50
or/ by (37.50-33)
B P/E = 22
➁ P/EA = 𝟑𝟕. 𝟓𝟎A𝟏. 𝟓𝟎 = 𝟐𝟓 relatively
overvalued
by (25-22) × 1.50

Page 2
⇒ Forecasted Fundamentals/ LOS a
- distinguish
V0 or Value of · arrived at by
- explain
the firm some DCF model

𝐏A firm level (EBITDA)

𝐱 𝐏A
per 𝐗
share fundamental forecasted value
(EPS)

e.g./
𝐕𝟎 = 𝟏𝟎. 𝟐𝟎
forward P/E = 𝟏𝟎. 𝟐𝟎A𝟏. 𝟐𝟎 = 𝟖. 𝟓
𝐄𝟏 = 𝟏. 𝟐𝟎

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Justified Multiple
Page 3
- the estimated fair value of that multiple LOS b
𝐃𝟏 𝐃𝟏 - calculate
Recall/ 𝐕𝟎 = 𝐫5𝐠
and letting 𝐕𝟎 = 𝐏𝟎, 𝐏𝟎 =
𝐫−𝐠 - interpret
𝐃𝟏
=𝐄
- divide both sides by E1 𝐏𝟎
=𝐄 = 𝟏 forward
𝟏 𝐫−𝐠
e.g./ P/B = 2.2 (peer group) 𝐃𝟎
Comp. C. BV = $23 =𝐄 (𝟏 + 𝐠)
𝐏𝟎
PO = 52 =𝐄𝟎 = 𝟎
trailing
V0 = $46 𝐫 −𝐠
· justified P/B based on V0 = 𝟒𝟔A𝟐𝟑 = 𝟐. 𝟎 $12
· justified P/B based on peer-group = 𝟐𝟑 × 𝟐. 𝟐 = 𝟓𝟎. 𝟔𝟎
$11 × 1.5 = 16.50

P/E
Page 4
⇒ Rationale/
· earnings power is a chief driver of investment value
· widely recognized and used

⇒ Drawbacks/
· EPS can be zero, negative or very small vs. P0
⇒ P/E will make no economic sense
· what to keep (recurring components) vs. what
to take out can be difficult to forecast and adjust for
· EPS is a highly managed number

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Page 5
⇒ Alternative Definitions/
· Time Period:
- trailing P/E ⇒ most recent 4 quarters (current)
· if forecasts are not possible
· logical elimination
⇒ must consider – potential dilution of EPS ➀
- transitory effects on EPS
· company specific ➁
· cyclicality ➂
- differences in actg. methods ➃
- forward P/E ⇒ next year’s expected earnings (leading, prospective)
- valuation is forward looking so it makes sense to use
a forward P/E

Page 6
⇒ Trailing P/E/
➀ Potential Dilution
- Basic and Diluted EPS given
- for comparison purposes, used of diluted EPS
compensates for differences in convertible sec.
➁ Transitory company–specific components
- items not expected to recur are usually removed
- gets at underlying earnings
(persistent, continuing, core)
- companies usually report adjusted earnings
(non-IFRS, non-GAAP, pro-forma)

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Page 7
⇒ Trailing P/E/
➁ Transitory company–specific components
e.g./
P0 = 50.11 2012 2013
34¢ restructuring charge
Q2–Q4 Q1
Diluted EPS 3.71 0.81
26¢ amort. of intangible
Core EPS 4.60 1.41
assets arising from
𝐏A 𝟓𝟎. 𝟏𝟏A acquisition
𝐄𝐭𝐭𝐦 = 𝟒. 𝟓𝟐 = 𝟏𝟏. 𝟏 × 𝐫𝐞𝐩𝐨𝐫𝐭𝐞𝐝 𝐄𝐏𝐒
𝐏/𝐄𝐭𝐭𝐦 = 𝟓𝟎. 𝟏𝟏A𝟔. 𝟎𝟏 = 𝟖. 𝟑 × 𝐜𝐨𝐫𝐞 𝐄𝐏𝐒

➂ Transitory business–cycle components

Molodousky effect
but repeatable may signal
depressed at bottom of cycle – high P/E - undervalued
𝐄𝐏𝐒𝐭𝐭𝐦
high at top of cycle - low P/E - overvalued

counter-cyclical

Page 8
⇒ Trailing P/E/
LOS e
➂ Transitory business–cycle components - calculate
- normalized EPS – level of EPS expected under - interpret
mid-cycle conditions

historical avg. EPS

(avg. ROE from most recent
over most recent full cycle
full cycle) × BVPS
(does not account for size)
(if BVPS makes sense)
e.g./ Measure 2006 2007 2008 2009 2010 2011 2012
P0 = $18.21 EPS (ADR) $0.74 $0.63 $0.61 $0.54 $1.07 $0.88 $1.08
BVPS (ADR) $3.00 $2.93 $2.85 $2.99 $3.80 $4.03 $4.82
ROE 24.7% 22.4% 21.8% 18.0% 28.1% 21.3% 22.9%

∑𝟐𝟎𝟏𝟐
𝟐𝟎𝟎𝟔 𝐄𝐏𝐒 𝐏A = 𝟏𝟖. 𝟐𝟏A
normalized EPS (his. avg. EPS) = = 𝟎. 𝟕𝟗 𝐄 . 𝟕𝟗 = 𝟐𝟑. 𝟏
𝐧
∑𝟐𝟎𝟏𝟐
𝟐𝟎𝟎𝟔 𝐑𝐎𝐄
normalized EPS (avg. ROE) = × 𝐁𝐕𝐏𝐒𝟏𝟐 = 𝟐𝟐. 𝟔% × 𝟒. 𝟖𝟐 = $𝟏. 𝟎𝟗
𝐧
𝐏A = 𝟏𝟖. 𝟐𝟏A
𝐄 𝟏. 𝟎𝟗 = 𝟏𝟔. 𝟕

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Page 9
⇒ Trailing P/E/
- a note on adjustments/
· analyst adj. EPS do not have to equal company adj. EPS
· adjustments require detailed work
- non-recurring charges may appear in
continuing operations of I.S.
➃ Differences in actg. methods
- usually done early in the analysis
i.e. LIFO to FIFO
Dep. methods, assumptions, etc…
Low, Zero, Negative EPS/
𝐏𝟎A - small EPS = very large P/E
𝐄𝐏𝐒 - cannot divide by zero
- neg. P/E makes no sense

Page 10
⇒ Trailing P/E/ LOS f
Low, Zero, Negative EPS/ - explain
𝐄𝐏𝐒A ⇒ problem solved (inverse price ratio) - justify
𝐏𝟎
earnings · can be done for all ratios of
yield 𝐏 Div. y.
the form 𝟎A𝐗 ⇒ 𝐗A𝐏 ⇒ yield
𝟎 CF y. etc…
e.g./

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Page 11
⇒ Forward P/E
- next year’s expected earnings
- next 4 quarters X
EPS = Q3 + Q4 + Q1 +Q2 QR Q3 Q4 Q1 Q2

- next 12 months X
𝐱A ∙ 𝐄(𝐄𝐏𝐒 ) + 𝟏𝟐5𝐱 ∙ 𝐄(𝐄𝐏𝐒 ) Q4 – YR-end
𝟏𝟐 𝟏 𝟏𝟐 𝟐
𝟏𝟖𝟒.𝟏𝟓
𝟑5 (𝟏𝟔.𝟏𝟗). 𝟗5 (𝟏𝟖.𝟑𝟓)
𝟏𝟐 𝟏𝟐 𝐱A (𝟏𝟐 − 𝐱)A
𝟏𝟐 𝟏𝟐
= 𝟏𝟎. 𝟑𝟒
- next fiscal year
X
Q4 – YR-end Q4 – YR-end
e.g./ 𝐈𝐁𝐌 𝐏𝟎 = 𝟏𝟖𝟒. 𝟏𝟓
· early Sep/13
· fiscal YR. = Cal. YR. Fiscal YR. 1 Fiscal YR. 2
· consensus 𝐏𝐄𝟏𝟑 = 𝟏𝟖𝟒. 𝟏𝟓A𝟏𝟔. 𝟏𝟗 = 𝟏𝟏. 𝟒 × 𝐘𝐑 𝟏
EPS (2013) = 16.19
· consensus EPS (2014) = 18.35 𝐏𝐄𝟏𝟒 = 𝟏𝟖𝟒. 𝟏𝟓A𝟏𝟖. 𝟑𝟓 = 𝟏𝟎. 𝟎 × 𝐘𝐑 𝟐

Page 12
⇒ Forward P/E
e.g./ 03/31 06/30 09/30 12/31 YR
2013 0.01 0.00 E (0.01) E (0.05) (.05)
2014 E 0.07 E 0.08 E 0.03 E (0.03) 0.15

Aug. 9/13 ⇒ 𝐏𝟎 = 𝟏𝟐. 𝟐𝟎

1) next 4 Quarters/
𝟏𝟐. 𝟐𝟎A
(.01) + (.05) + .07 + .08 = .09 . 𝟎𝟗 = 𝟏𝟑𝟓. 𝟔

2) NTM P/E 𝟓A (. 𝟎𝟓) + 𝟕A P/E = 𝟏𝟐. 𝟐𝟎A. 𝟎𝟔𝟕 = 𝟏𝟖𝟐. 𝟏𝟎

𝟏𝟐 𝟏𝟐 ∙ 𝟎. 𝟏𝟓 = . 𝟎𝟔𝟕

3) Fiscal YR. 1 P/E = 𝟏𝟐. 𝟐𝟎A(. 𝟎𝟓) = 𝐍𝐌 (−𝟐𝟒𝟒)

4) Fiscal YR. 2 P/E = 𝟏𝟐. 𝟐𝟎A. 𝟏𝟓 = 𝟖𝟏. 𝟑

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Page 13
Actual vs. Justified
𝐏𝟎A 𝐕𝟎A P0
observed
𝐄𝐏𝐒 𝐄𝐏𝐒 EPS
ttm ntm ttm ntm

justified V0
justified estimated
forward E (EPS)
trailing

- lower WACC, r higher justified

- higher g P/E
e.g./
P0 = 63.40
2013 Sept. V0 = 67.22 2014 justified P/E
x
Apr. 1 March 31 =
𝟔𝟕.𝟐𝟐
= 𝟏𝟏. 𝟐
𝟔

Fiscal YR. EPS = 6.00

Predicted P/E
Page 13b
Predicted LOS i
P/E = 𝛂 + 𝛃𝟏 𝐗 𝟏 + 𝛃𝟐 𝐗 𝟐 + 𝛃𝟑 𝐗 𝟑 - calculate
- interpret
- explain

dependant DPR 𝜷 g
variables
explanatory variables

e.g./ P/E = 12.12 + 2.25DPR - .2𝛃 + 14.43g

ABC 𝛃 = .9 DPR = 0.45 g = 0.08

P/E = 12.12 + 2.25 (.045) - .2 (.9) + 14.43 (.08) = 14.1

Limitations/
· useful only for TTM (predictive power questionable)
· relationships between P/Es and fundamentals not stable over time
· multicollinearity

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P/E
Page 14
⇒ Comparables/
avg. or median value of the P/E for the
some subjective
company’s industry, sector, or peer group (or
adjustments Benchmark value
an index) vs. avg. past values of the P/E for
perhaps of P/E
the stock relative to the:
· industry
× target EPS vs. target P/E multiple
· sector
V0 vs. P0 target P/E vs. benchmark P/E
· peer group
· index
are differences explained by
differences in fundamentals

growth risk
- asset turnover - liquidity
- profitability - coverage
- leverage

Page 15
⇒ Comparables/ LOS k
valuation - calculate
e.g./
metric - interpret

undervalued?

target company

which benchmark?

PEG ratio
- assumes a linear relationship
𝐏/𝐄 < 1 undervalued between P/E & g
⇒
𝐠 = 1 fairly valued - ignores risk
> 1 overvalued - does not account for differences
in duration of g

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Page 16
⇒ Comparables/ LOS k
- calculate
- interpret

ranked
by
g

under?

· Industry/Sector multiples/
- the larger the comparison group, the more likely
that mispricing of individual assets cancel out
Index e.g./ A B C SnP
P0 23 50 80 1569.19
P/E 12.5 25.5 12.5 17.9
5-yr. avg. P/E 80% 120% 105% 100% (% of SnP)
Adj. SnP 14.32 21.48 18.795

Page 17
⇒ Comparables/ 𝐧
𝐌𝐕𝐢
· index P/E – often , ∙ 𝐏/𝐄𝐢
𝐓𝐌𝐕
reported as 𝐢$𝟏
- largest stocks heavily influence calculated P/E
- use of median P/E for the index instead
⇒ is the index overvalued?
- comparison with historical avg. P/E ⇒ time frame important
⇒ lower r/higher g ⇒ higher current P/E
Fed. Model/ - valuation of the equity market itself
E/P = YTM 10yr. T-Bond – fairly valued
< YTM - overvalued

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Page 18
⇒ Comparables/
𝟏
Fed. Model/ - fair value of SnP500 =
(𝐘𝐓𝐌 𝟏𝟎𝐲𝐫. 𝐓 − 𝐁𝐨𝐧𝐝)
· ignores ERP
June/ 2016 10-yr. YTM = 1.4597
· inadequately
𝟏
𝐉𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐏A𝐄 = = 𝟔𝟖. 𝟓𝟎 reflects effects
𝐒𝐧𝐏 . 𝟎𝟏𝟒𝟓𝟗𝟕
of inflation
V0 = 68.50 × 118.39 (est. 2016 earnings)
= 8109.71 (US 2001) ⇒ low rates fail
Yardeni Model/
CEY = CBY – b × LTEG + Residual CEY - current E/P
growth consensus 5-yr. CBY – current
weight earnings growth bond yield
rate (A-rated corporate)
𝟏 - lower corp. bond yield higher
𝐣𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐏A𝐄 =
𝐂𝐁𝐘 − 𝐛 × 𝐋𝐓𝐄𝐆 - higher LTEG justified P/E

Page 19
⇒ Comparables/
- own historical P/E

overvalued
hist.
avg. 5-yr. avg. trailing P/E
undervalued 𝐦𝐨𝐬𝐭
P/E · justified 𝐕𝟎 = (𝐚𝐯𝐠. 𝐏A𝐄) × t u
𝐫𝐞𝐜𝐞𝐧𝐭 𝐄𝐏𝐒

e.g./ 2008 2009 2010 2011 2012 Mean Median

35.8 19.8 10.0 23.1 15.8 20.9 19.8

may be - changes in business mix? Leverage?

considered an - changes in the inflationary
outlier environment over time?

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Page 20
⇒ Comparables/
- inflation rates and pass-through ability
𝐄 (𝟏 + 𝐈)
- assume 𝐏𝟎 = 𝟎 - no growth, can only come 𝐄𝟎 (𝟏 + 𝐠)
𝐫−𝐈 𝐏𝟎 =
from inflation 𝐫−𝐠
- let 𝛌 represent pass-through proportion
𝐄𝟎 (𝟏 + 𝛌𝐈) 𝐄𝟏A
𝐏𝟎 = 𝐫
𝐫 − 𝛌𝐈
- now let 𝝆 = real required rate of return
𝐄𝟎 (𝟏 + 𝛌𝐈) and 𝐏𝟎A 𝟏
𝐏𝟎 = 𝐄𝟏 =
𝛒 + (𝟏 − 𝛌) 𝐈 𝛒 + (𝟏 − 𝛌) 𝐈

Page 21
⇒ Comparables/
𝐏𝟎A 𝟏 e.g./ Company M P
=
𝐄𝟏 𝛒 + (𝟏 − 𝛌) 𝐈 𝛒 3% 3%
1. 𝛌 75% 75%
justified forward P/E I 6% 2%
2. I 6% 6%
𝛌 90% 70%
𝟏 𝟏
1. 𝐏A𝐄 = = = 𝟐𝟐. 𝟐
𝐦 . 𝟎𝟑 + (𝟏 − . 𝟕𝟓). 𝟎𝟔 . 𝟎𝟑 + . 𝟎𝟏𝟓
𝐏A = 𝟏 𝟏
𝐄𝐩 . 𝟎𝟑 + (𝟏 − . 𝟕𝟓). 𝟎𝟐 = . 𝟎𝟑 + . 𝟎𝟎𝟓 = 𝟐𝟖. 𝟔 – lower inflation
𝟏 𝟏
2. 𝐏A = = = 𝟐𝟕. 𝟖 – higher-pass through
𝐄𝐦 . 𝟎𝟑 + (𝟏 − . 𝟗). 𝟎𝟔 . 𝟎𝟑 + . 𝟎𝟎𝟔

𝐏A = 𝟏 𝟏
𝐄𝐩 . 𝟎𝟑 + (𝟏 − . 𝟕). 𝟎𝟔 = = 𝟐𝟎. 𝟖
. 𝟎𝟑 + 𝟎. 𝟎𝟏𝟖

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Page 22
⇒ Terminal P/Es/ LOS l
- key condition of TV ⇒ must reflect sustainable LTEG - calculate
𝐕𝐧 - explain
A𝐄 = 𝐏𝐄𝐭𝐭𝐦
GGM 𝐧 terminal price multiples
𝐕𝐧
A𝐄 = 𝐏𝐄𝐧𝐭𝐦 based on fundamentals
𝐧+𝟏

𝐕𝐧 = 𝐛𝐞𝐧𝐜𝐡𝐦𝐚𝐫𝐤 𝐏/𝐄𝐭𝐭𝐦 × 𝐄𝐧 terminal price multiples

𝐕𝐧 = 𝐛𝐞𝐧𝐜𝐡𝐦𝐚𝐫𝐤 𝐏/𝐄𝐧𝐭𝐦 × 𝐄𝐧+𝟏 based on comparables

e.g./ r = 10% ➀ Vn =? V3 = 14.3 × 3 = 42.90

vs. 16.92
avg. DPR = 0.45
➁ Vn =? using GGM 𝐕 = 𝐃𝟑 (𝟏 + 𝐠)
Industry ROE = 13% 𝟑
𝐫−𝐠
E3 = 3.00 𝐠 = 𝐑𝐎𝐄 × 𝐑𝐑 𝟏. 𝟑𝟓 (𝟏. 𝟎𝟕𝟏𝟓)
Industry avg. P/E = 14.3 = . 𝟏𝟑 × . 𝟓𝟓 = = $𝟓𝟎. 𝟕𝟔
. 𝟏𝟎 − . 𝟎𝟕𝟏𝟓
= 𝟎. 𝟎𝟕𝟏𝟓

P/B
Page 23
- book value represents, on a per share basis, the investment common
shareholders have made in the company
Pr. Sh.
𝐁𝐕A = 𝐒𝐡. 𝐄𝐪𝐮𝐢𝐭𝐲 − 𝐓𝐕 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐜𝐥𝐚𝐢𝐦𝐬 𝐬𝐞𝐧𝐢𝐨𝐫 𝐭𝐨 𝐜𝐨𝐦𝐦𝐨𝐧
𝐬𝐡 # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠 Div. in
arrears to
Pref. Sh.
Rationales/
(cumulative)
· cumulative B.S. amount, ∴ BV > 0 even when EPS ≤ 0
· BV/sh. more stable than EPS
· appropriate for valuing companies composed chiefly of liquid assets
(finance, investment, insurance, banks)

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Page 24
Rationales/
· useful for companies not expected to continue as going concerns

Drawbacks/
· does not account for critical non-balance sheet factors
(human capital, reputation)
· difficult to compare companies with asset-related business models
(capital vs. labor intensive)
· accounting effects compromise usefulness of BV as a measure of
shareholder investment
- internally generated intangibles
not included
- internally generated brands
as assets
- internally developed patents

Page 25
Drawbacks/
· BV reflects reported value of A&L
financial A/L ➞ some reported at FMV – perhaps model derived???
non-financial A/L ➞ some historical cost-accum. dep.
· Share repurchases/issuances

e.g./ Colgate-Palmolive (CG)

2008 Sep/13

𝐏A 𝐏A + 5.5%
𝐄𝐭𝐭𝐦 = 𝟐𝟑. 𝟓𝟓 𝐄𝐭𝐭𝐦 = 𝟐𝟒. 𝟖𝟒
P/B = 15.94 P/B = 36.01 +125.9%
[Link]. = $2.48B [Link]. = $1.53B
when a company repurchases
shares at a price > BV, overall BV/sh. drops

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Page 26
· Determining BV

𝐁𝐕A = 𝐒𝐡. 𝐄𝐪. − 𝐬𝐞𝐧𝐢𝐨𝐫 𝐞𝐪𝐮𝐢𝐭𝐲 𝐜𝐥𝐚𝐢𝐦𝐬

𝐬𝐡 # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬
- adjustments/ - make BVPS more accurately reflect the
value of sh. investment
- make P/B more useful for making comparisons
e.g./ · tangible BVPS
[Link]. – reported intangible assets

if separate, perhaps non-separable, then omit

keep in i.e. Goodwill

· LIFO to FIFO
· significant off-balance-sheet assets/liab. included

Page 27
· Valuation/
a) forecasted fundamentals
𝐃𝟏 𝐄𝟏 × (𝟏 − 𝐑𝐑) since
(GGM) 𝐕𝟎 = 𝐏𝟎 = =
𝐫−𝐠 𝐫−𝐠 𝐄𝟏
ROE = A𝐁
𝟎
𝐁𝟎 × 𝐑𝐎𝐄 × (𝟏 − 𝐑𝐑) ∴ 𝐄𝟏 = 𝐁𝟎 × 𝐑𝐎𝐄
𝐏𝟎 =
𝐫−𝐠

divided by 𝐏𝟎 𝐑𝐎𝐄 × (𝟏 − 𝐑𝐑) since g = RR × ROE

A𝐁 =
𝐫−𝐠 𝐠
B0 𝟎
RR = A𝐑𝐎𝐄
𝐠
𝐏𝟎 𝐑𝐎𝐄 × t𝟏 − A𝐑𝐎𝐄u
A𝐁 =
𝟎 𝐫−𝐠
𝐏𝟎 𝐑𝐎𝐄 − 𝐠
A𝐁 =
𝟎 𝐫−𝐠

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Page 28
· Valuation/
a) forecasted fundamentals

𝐑𝐎𝐄 − 𝐠 e.g./ ROE = 12%, r = 10%, g = 7%

𝐏𝟎
A𝐁 = .𝟏𝟐 5 .𝟎𝟕
𝟎 𝐫−𝐠 justified P/B = .𝟏𝟎 5 .𝟎𝟕
= 𝟏. 𝟔𝟕

- just. P/B increasing function of ROE

⇒ 2 stocks with the same P/B, one with the higher ROE may be undervalued
𝐏𝟎 𝐏𝐕 𝐨𝐟 𝐄 (𝐑𝐈)
A𝐁 = 𝟏 + 𝐏𝟎
𝟎 𝐁𝟎 if E(RI) = 0, A𝐁 = 𝟏
𝟎

b) Comparables
- BV – trailing metric
- must consider differences in ROE, r, g

P/S
Page 29
· Rationales/
· sales less subject to distortion/manipulation
· sales > 0 even when EPS ≤ 0
· sales more stable than EPS
· appropriate for mature, cyclical & zero-income firms

· Drawbacks/
· a business must ultimately generate earnings and cash
· share price reflects the effect of debt, sales do
not, thus P/S is a logical mismatching
· does not reflect differences in cost structures
· revenue recognition can distort P/S

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Page 30
· Sales × Net Profit Margin = NI
⇒ P/E × Net Profit Margin = P/S relationships
𝐏/𝐒 S × % = NI
and = Net Profit Margin
S = 𝐍𝐈A%
𝐏/𝐄

e.g./ Sales = $100/sh. P/E = 𝟏𝟓𝟎A𝟐𝟎 = 𝟕. 𝟓 𝟏A = %A

NI = 20 𝐒 𝐍𝐈
P/E × 𝐍𝐏𝐌 = P/S 𝐏A = 𝐏A × %
margin = 20% 𝐒 𝐍𝐈
7.5 × . 𝟐 = 𝟏. 𝟓
P0 = $150
P/S = 𝟏𝟓𝟎A𝟏𝟎𝟎 = 𝟏. 𝟓

Page 31
· Determining Sales/
𝐏A = 𝐏𝐫𝐢𝐜𝐞 typically most recent
𝐒 𝐀𝐧𝐧𝐮𝐚𝐥 𝐧𝐞𝐭 𝐬𝐚𝐥𝐞𝐬/𝐬𝐡.
fiscal year

e.g./ Sales0 = $10,814.8M # Shares = 786.6 P0 = 6.72

𝐏A = 𝟔. 𝟕𝟐 𝟔. 𝟕𝟐
𝐒 = = 𝟎. 𝟒𝟗𝟎
t𝟏𝟎, 𝟖𝟏𝟒. 𝟖A𝟕𝟖𝟔𝟔u 𝟏𝟑. 𝟕𝟏

· Revenue recognition issues/

- barter
- bill & hold

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Page 32
· Valuation/
a) forecasted fundamentals
𝐃𝟎 (𝟏 + 𝐠)
𝐕𝟎 = 𝐏𝟎 = D0 = E0 (1 – RR)
𝐫−𝐠
𝐄 (𝟏 − 𝐑𝐑)(𝟏 + 𝐠)
so... 𝐏𝟎 = 𝟎 · divide by S0
𝐫−𝐠
𝐄𝟎
A𝐒 (𝟏 − 𝐑𝐑)(𝟏 + 𝐠) 𝐄𝟎
𝐏𝟎 𝟎 A𝐒 = Net Profit Margin
A𝐒 = 𝟎
𝟎 𝐫−𝐠
𝐏𝟎
thus, A𝐒 is an increasing function of Net Profit Margin
𝟎
and earnings growth rate
𝐍𝐈 𝐒𝐚𝐥𝐞𝐬 𝐓𝐀
𝐠 = 𝐑𝐑 × 𝐑𝐎𝐄 = 𝐑𝐑 × × ×
𝐒𝐚𝐥𝐞𝐬 𝐓𝐀 𝐒𝐡. 𝐄𝐪.

Page 33
· Valuation/
a) forecasted fundamentals
𝐍𝐈
e.g./ = 9.0% DPR = 35% g = 7% r = 9%
𝐒𝐚𝐥𝐞𝐬
𝐄
t 𝟎A𝐒 u (𝟏 − 𝐑𝐑)(𝟏 + 𝐠) . 𝟎𝟗(. 𝟑𝟓)(𝟏. 𝟎𝟕)
1) 𝐣𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐏A𝐒 = 𝟎
= = 𝟏. 𝟕
𝐫−𝐠 . 𝟎𝟗 − . 𝟎𝟕
𝐒𝟏
2) A𝐒𝐡. = 108.9, find V0? P = 1.7 × 108.9 = $185.13
𝟐𝟎𝟏𝟑
𝟏𝟖𝟓. 𝟏𝟑 − 𝟏𝟗𝟔. 𝟐
3) P0 = 196.2 = −𝟓. 𝟗𝟖%
𝟏𝟖𝟓. 𝟏𝟑
under/over/fair?
+/- 5% - over
+/- 10% - fairly

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Page 34
· Valuation/
b) Comparables
- most common – trailing sales
- can use forecasted sales
e.g./

NIM
g

1) GETI ⇒ over/under/fair? – using P/S only!

2) SN or BCR? more closely comparable to GETI?

P/CF
Page 35
· Rationales/
· CF less subject to manipulation
· more stable than earnings
· sidesteps issues related to actg. choices

· Drawbacks/
· some definitions of cash-flow inadequate
· FCFE most appropriate but also most volatile
of CF definitions
· CF still open to some manipulation
· IFRS-CFO may not be readily comparable to
GAAP-CFO

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Page 36
· Determining Cash Flow/ LOS m
not - simple approximations typically used - explain
technically - describe
𝐄𝐏𝐒 + 𝐃𝐞𝐩./𝐀𝐦./𝐃𝐞𝐩𝐥.A
accurate e.g. 1/ 𝐬𝐡. = 𝐂𝐅

last 4 quarters

e.g./ EPS = 0.28 – from continuing operations 𝐏𝟎A 𝟐𝟒. 𝟎𝟔A

𝐂𝐅 = 𝟏. 𝟖𝟏 = 𝟏𝟑. 𝟑
Dep./Am. = 1.53/sh. · P0 = 24.06

e.g. 2/ CFO/sh. normalizing

adjustments as necessary non-recurring
more IFRS to GAAP
technically
accurate e.g. 3/ FCFE/sh. – may be difficult to compare
most similar companies with differing
ate
accur timing of CAPEX
e.g. 4/ EBITDA/sh.

Page 36b
· Valuation/
a) forecasted fundamentals
⇒ find V0 using most suitable DCF model
(GGM, two-stage, H-model, 3-stage)
- divide V0 by any definition of cash flow

𝐕𝟎A CF · 𝐏/𝐂𝐅 positively related

justified 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 CFO
𝐏/𝐂𝐅 to g and negatively
FCFE related to r
EBITDA
r - g
e.g./ FCFEttm = 7.96 𝐅𝐂𝐅𝐄𝟎 (𝟏 + 𝐠)
CFttm = 12.00 𝐕𝟎 =
𝐫−𝐠
g = 3
just. 𝐏A𝐂𝐅 = 𝟗𝟏. 𝟏𝟎A𝟏𝟐 = 𝟕. 𝟔 = .𝟏𝟐 5 .𝟎𝟑 = 𝟗𝟏. 𝟏𝟎
𝟕.𝟗𝟔(𝟏.𝟎𝟑)
r = 12
𝐏
just. 𝐏A𝐂𝐅 = 𝟎A𝐅𝐂𝐅𝐄 = 𝟕.𝟗𝟔 = 𝟏𝟏. 𝟒
𝟗𝟏.𝟏𝟎

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Page 36c
· Valuation/
b) Comparables

e.g./

based on P/CF only, Company A actually has

we would expect Company B the higher g and both
to have the higher growth have the same r (𝜷)
rate (or lower risk)
∴ Company A appears to be
(efficient pricing)
relatively undervalued/

P/D0 & D0/P

Page 37
· Rationale/
· div. yield is a component of total return
· div. less risky than cap. app.

· Drawbacks/
· div. yield is only one component of total return
· many stocks do not pay a dividend

· Calculation of Div. Yield/

Dividends

trailing Leading div. yield

last Q × 4 (dividend next 4 Q’s

rate) (forecasted)

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Page 38
· Valuation/
a) forecasted fundamentals
𝐃𝟎 (𝟏+𝐠)
𝐕𝟎 = 𝐏𝟎 = 𝐫5𝐠 rather than
𝐏
use 𝟎A𝐃 , we
𝐏𝟎 (𝐫 − 𝐠) = 𝐃𝟎 (𝟏 + 𝐠) 𝟎
𝐃𝟎
use A𝐏
(𝐫 − 𝐠) = 𝐃𝟎A𝐏 (𝟏 + 𝐠) 𝟎
𝟎

𝐃𝟎 (𝐫5𝐠)
A𝐏 𝟏+𝐠
𝟎

b) Comparables
- relative yields considering r & g
- must also consider safety of dividend
- high DPRs may be risky

Page 39
· Valuation/
b) Comparables

➂
➀
Highest
3.7 + 6.45 g Low r DPR < 100
= 10.15% ➁

𝐃
➀ POM ⇒ DPR = NMF ⇒ negative EPS t 𝟎A𝐄𝐏𝐒u TR = 5.6 + 3.82 = 9.42%
➁ PPL ⇒ negative earnings growth 4.8 – 2.4 = 2.4%
➂ DUK ⇒ DPR > 100% - not sustainable with low grow 4.4 + 3.66 = 8.06

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EV Multiples
Page 40
➀ EV/EBITDA – most widely used LOS n
- a measure of pre-tax, pre-interest - calculate
operating cash flow - interpret
- evaluate
(pre financial leverage &
pre operating leverage measure)
𝐄𝐕 = 𝐌𝐕𝐞 + 𝐌𝐕𝐝 + 𝐌𝐕𝐏𝐫 − 𝐂𝐚𝐬𝐡/𝐄𝐪𝐮𝐢𝐯. − 𝐌𝐤𝐭. 𝐒𝐞𝐜.
Rationales/
· more appropriate for comparing companies with
different financial leverage
· EBITDA controls for differences in capital intensiveness
· EBITDA usually positive even when EPS < 0

Page 41
➀ EV/EBITDA LOS n
- calculate
⇒ Drawbacks/
- interpret
· EBITDA will overestimate CFO if - evaluate
WCInv. > 0

· Determining EV/
𝐄𝐕 = (𝐏𝟎 × # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬) + 𝐌𝐕𝐝 + 𝐌𝐕𝐏𝐫. − (𝐂𝐚𝐬𝐡/𝐄𝐪𝐮𝐢𝐯. + 𝐌𝐤𝐭. 𝐒𝐞𝐜. )

if MV not available, use BV

· Determining EBITDA/

EBITDA = NI + Int. exp. (net of Int. Inc.) + IT + D/A

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Page 42
➀ EV/ EBITDA CP/LTP 230 LOS n
e.g./ Cash/Equiv. $4,060M LTD 1,783 - calculate
P0 = 63.06 shares out. = 238M - interpret
- evaluate

(𝟔𝟑. 𝟎𝟔 + 𝟐𝟑𝟖𝐌) + (𝟏, 𝟕𝟖𝟑 + 𝟐𝟑𝟎) + ∅ − 𝟒, 𝟎𝟔𝟎 𝟏𝟐, 𝟗𝟔𝟏

EV/ EBITDA = =
𝟏, 𝟗𝟗𝟎 + 𝟒𝟏 + 𝟐𝟔𝟒 + 𝟏, 𝟐𝟕𝟎 𝟑, 𝟓𝟔𝟓
= 𝟑. 𝟔

Page 43
➀ EV/EBITDA LOS n
⇒ Valuation/ - calculate
a) forecasted fundamentals - interpret
- evaluate
justified 𝐄𝐕A𝐄𝐁𝐈𝐓𝐃𝐀 - positively related to (g in FCFF)
𝐎𝐩.𝐏𝐫. 𝐚𝐟𝐭𝐞𝐫 𝐭𝐚𝐱
& (ROIC) - 𝐓𝐨𝐭𝐚𝐥 𝐈𝐧𝐯 .𝐂𝐚𝐩.
- negatively related to WACC

𝐓𝐈𝐂 = 𝐌𝐕𝐞 + 𝐌𝐕𝐝 + 𝐌𝐕𝐏𝐫.

b) Comparables
A B C D

difference

A = under/over/fair?

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Page 44
2) Other EV Multiples/ LOS n
EV/ · FCFF - calculate
· EBITDAR – rent exp. - interpret
all add back - evaluate
· EBITA – amort. is the major NCC
interest
· EBIT
D/A is not a major item
3) EV/Sales
vs. P/S – not all sales belong to a company’s equity investor

D/E
𝐏A not comparable to 𝐏A
Company A. 80:20 𝐒𝐀 𝐒𝐁
Company B. 20:80 Since P0 is after-tax, after interest

Cross-Border Valuation
Page 45
⇒ Sources of Difference/ LOS o
· accounting methods – GAAP vs. IFRS - explain
- even with convergence, the
need for reconciliation will not
disappear
· tax regimes – affect rd vs. re
- level of financial leverage
· economic differences
- stage of business cycle
- labour laws/union strength
- forex effects
· cultural differences
- attitude to risk, debt, employees

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Momentum Valuation Indicators

Page 46
1) Earnings surprise LOS p
- unexpected earnings consensus - describe

𝐔𝐄𝐭 = 𝐄𝐏𝐒𝐭 − 𝐄(𝐄𝐏𝐒𝐭 ) estimate

must consider range in estimates

i.e. 87¢ 62¢
vs
93¢ $1.21

surprises
here more
meaningful
𝐄𝐏𝐒𝐭 − 𝐄 (𝐄𝐏𝐒𝐭 ) s.d. of the analyst’s
𝐒𝐜𝐚𝐥𝐞𝐝 𝐔𝐄𝐭 =
𝛔 [𝐄 (𝐄𝐏𝐒)] earnings forecasts

Page 47
2) Standardized unexpected earnings/ LOS p
- describe
𝐄𝐏𝐒𝐭 − 𝐄(𝐄𝐏𝐒𝐭 ) s.d. of past earnings
𝐒𝐔𝐄𝐭 =
𝛔 [𝐄𝐏𝐒𝐭 − 𝐄(𝐄𝐏𝐒𝐭 )] surprises
3) Relative strength indicators/
- compares a stock’s performance during a particular period with
its own past performance or some group of stocks
e.g./ 𝐒𝐧𝐏𝟓𝟎𝟎𝟎 2,085 26.50
= .012709 - div. by .012709
𝐏𝟎 26.50 2,085
= 1

𝐒𝐧𝐏𝟓𝟎𝟎𝐧 2,163 29.72 . 𝟎𝟏𝟑𝟕𝟒

= .013740 = 𝟏. 𝟎𝟖𝟏𝟏
𝐏𝐧 29.72 2,163 . 𝟎𝟏𝟐𝟕𝟎𝟗

rel. st. 8.11%

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Averaging Multiples
∑𝐧𝐢$𝟏 𝐗 𝐢 Page 48
- arithmetic mean LOS q
𝐧
- explain
𝐧 - the reciprocal of the
- harmonic mean
∑𝐧𝐢$𝟏 t𝟏A𝐗 u arithmetic mean of the
𝐢
reciprocals

gives less weight to higher P/Es

and more weight to lower P/Es
· harmonic mean < arithmetic mean

- weighted harmonic 𝟏 - 𝐰𝐢 are portfolio

mean ∑𝐧𝐢$𝟏 t𝐰𝐢A𝐗 u weights, ∑ = 𝟏
𝐢
· most accurate

Page 49
Market Cap. LOS q
𝟕𝟏𝟓 + 𝟓𝟖𝟓 - explain
Security $ % E0 P/E 𝐏/𝐄 =
𝟕𝟏. 𝟓𝟎 + 𝟐𝟗. 𝟓𝟎
A 715 55 71.50 10
B 585 45 29.50 20 𝟏𝟑𝟎𝟎
= = 𝟏𝟐. 𝟗𝟎
𝟏𝟏𝟎. 𝟕𝟓

AM HM WHM
𝟏𝟎 + 𝟐𝟎 𝟐 𝟏
= 𝟏𝟓
𝟐 𝟏 𝟏 . 𝟓𝟓 . 𝟒𝟓
𝟏𝟎 + 𝟐𝟎 𝟏𝟎 + 𝟐𝟎
𝟐 𝟏
= =
𝟑A 𝟏. 𝟓𝟓A
𝟐𝟎 𝟐𝟎
= 𝟏𝟑. 𝟑𝟑 = 𝟏𝟐. 𝟗𝟎

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Residual Income Valuation

a. calculate and interpret residual income, economic value added, and market
value added

b. describe the uses of residual income models

c. calculate the intrinsic value of a common stock using the residual income
model and compare value recognition in residual income and other present
value models

d. explain fundamental determinants of residual income

e. explain the relation between residual income valuation and the justified
price-to-book ratio based on forecasted fundamentals

f. calculate and interpret the intrinsic value of a common stock using single-
stage (constant-growth) and multistage residual income models

g. calculate the implied growth rate in residual income, given the market price-
to-book ratio and an estimate of the required rate of return on equity

h. explain continuing residual income and justify an estimate of continuing

residual income at the forecast horizon, given company and industry
prospects

i. compare residual income models to dividend discount and free cash flow
models

j. explain strengths and weaknesses of residual income models and justify the
selection of a residual income model to value a company’s common stock

k. describe accounting issues in applying residual income models

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RI – EVA – MVA
Page 1
⇒ Residual Income/ a.k.a. economic profit LOS a
abnormal profit - calculate
- interpret
RI = NI – estimated cost of equity capital (marginal)

e.g./ D = $1M → 7% EBIT 200,000

E = 1M → 12% - Int. 70,000
TA = 2M EBT 130,000
Tax = 30% - Tax 39,000
NI 91,000

RI = 91,000 – ($1M × 0.12) = -29,000

or/ Capital Charge:

12% of $1M 120,000 NOP 200,000 NOPAT - [Link]

7% (1 – 30%)$1M 49,000 - Tx 60,000 = 140,000 – 169,000
169,000 NOPAT 140,000 = -29,000

Page 2
⇒ Residual Income/ LOS a
- calculate
RI = NOPAT – (% Cap. Cost × Tot. Cap)
- interpret
previous e.g./ WACC = .50(.07)(.7) + .12(.5)

= 2.45% + 6% = 8.45%
current cost marginal cost
of debt of equity

• if RI > 0 company is creating value

RI < 0 company is destroying value

e.g./ P0 = BVPS = $10 EPS = 0.91 𝐃𝟏 𝟎. 𝟗𝟏

𝐕𝟎 = = = $𝟕. 𝟓𝟖𝟑/𝐬𝐡
100,000 shares DPR = 100% 𝐫 . 𝟏𝟐
g = 0 to keep P0 = $10, r = 9.1%

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Page 3
⇒ Residual Income/ LOS a
- calculate
- so when: RI < 0, shares will sell at
- interpret
a discount to BV
RI > 0, premium to BV

⇒ Economic Value Added - EVAⓇ (Stern Stewart & Company)

EVA = NOPAT – (C% × TC)

+ adjustments
- over 150 adjustments defined

common/ · operating leases treated as financing leases

· LIFO reserves added back to cap.
· Deferred taxes eliminated, only cash taxes
treated as expense

Page 4
⇒ Economic Value Added - EVAⓇ LOS a
+ adjustments - calculate
· R&D capitalized net of estimated - interpret

amortization
e.g./
YR1 YR2 YR3 YR4
R&D Exp. 12k 10k 8k 15k (NOP + 15k)
5yr. Amort. 2.4 2.4 2.4 2.4
2.0 2.0 2.0
1.6 1.6
3.0
Carrying 9.6 15.2 17.2 23.2 (TC + 23.2k)
amount
equity
- requires new
WACC calculation

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Page 5
⇒ Market Value Added – MVA LOS a
- calculate
MVA = MVcompany - BVTC - total capital
- interpret
MVe + MVd + MVPr

· sometimes just MVA = MVe – BVe

· a company that generates positive economic

profit should have MV > BV

- 2 points here/ MVA measures the effectiveness of/

➀ numerator – the ability of mgmt. to generate
excess returns
➁ denominator – the ability of mgmt. to manage
perceived risk

Uses of RI Models
Page 6
• assess performance of an investment LOS b
center (internal corporate performance) - describe

• estimate intrinsic value of a stock – key focus

• measuring goodwill impairment

• determining executive compensation

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RI Models
# # Page 7
𝐑𝐈𝐭 𝐄𝐏𝐒𝐭 − 𝐫𝐁𝐕𝐏𝐒𝐭5𝟏 LOS c
𝐕𝟎 = 𝐁𝐕𝐏𝐒𝟎 + , = 𝐁𝐕𝐏𝐒𝟎 + ,
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭 - calculate
𝐭$𝟏 𝐭$𝟏
- compare

⇒ BVPSt-1 - expected BVPS at any time t–1

e.g./ r = 2.8 + 1.5(4.2) = 9.1% 1. forecast BVPS

P0 = 27.70 2013 Bt-1 = 8.77
BVPS0 = 8.77 Bt = 8.77 + 1.40 - .52 = 9.65
Consensus Earnings Bt-1 + E1 – D1
2013 1.40 2014 Bt-1 = 9.65
2014 1.60 Bt = 9.65 + 1.60 - .60 = 10.65
Consensus Dividends ➁ calculate equity charge
2013 0.52 2013 .091 × 8.77 = 0.80
2014 0.60 2014 .091 × 9.65 = .88
2013 RI/sh = 1.40 - .80 = .60
2014 RI/sh = 1.60 - .88 = .72

Page 8
e.g. 2/ using the model LOS c
EPS ⇒ 2.00, 2.50 & 4.00 (next 3 yrs) - calculate
- compare
Div ⇒ 1.00, 1.25 & 12.25 (liquidating dividend)
BVPS0 = $6.00 r = 10%
➁/ V0 = ?
1) BVPS + RI (YR1-YR3)/ 𝟑
𝐄𝐏𝐒𝐭 − 𝐫𝐁𝐕𝐏𝐒𝐭5𝟏
1 2 3 𝐕𝟎 = 𝐁𝟎 + ,
(𝟏 + 𝐫)𝐭
Bt-1 6.00 7.00 8.25 𝐭$𝟏
𝟏. 𝟒𝟎 𝟏. 𝟖𝟎 𝟑. 𝟏𝟕𝟓
+ EPS 2.00 2.50 4.00 = 𝟔 + + +
𝟏. 𝟏 (𝟏. 𝟏) 𝟐 (𝟏. 𝟏)𝟑
- Div (1.00) (1.25) (12.25)
= 𝟔 + 𝟏. 𝟐𝟕𝟐𝟕 + 𝟏. 𝟒𝟖𝟕𝟔 + 𝟐. 𝟑𝟖𝟓𝟒
Bt 7.00 8.25 0
𝐕𝟎 = 𝟏𝟏. 𝟏𝟓

EPS 2.00 2.50 4.00 ➂ DDM/

- rBt-1 .60 .70 .825 𝟏. 𝟎𝟎 𝟏. 𝟐𝟓 𝟏𝟐. 𝟐𝟓
𝐕𝟎 = + +
1.40 1.80 3.175 𝟏. 𝟏 (𝟏. 𝟏) 𝟐 (𝟏. 𝟏)𝟑
= 𝟏𝟏. 𝟏𝟓

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Page 9
Note: LOS c
RI model V0 = 6 + 1.2727 + 1.4876 + 2.3854 - calculate
DDM model V0 = .9091 + 1.0331 + 9.2036 - compare

· recognition of value typically occurs

earlier in RI models

· clean surplus relation · earnings reflect all

Bt = Bt-1 + EPSt – Dt changes in the BVe other
than ownership
Dt = EPSt – (Bt – Bt-1) transactions

Page 10
Dt = EPSt – (Bt – Bt-1) LOS c
- calculate
DDM/ - compare
# #
𝐃𝐭 𝐄𝐭 − (𝐁𝐭 − 𝐁𝐭5𝟏 )
𝐕𝟎 = , = ,
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭
𝐭$𝟏 𝐭$𝟏
𝐄𝟏 + 𝐁𝟎 − 𝐁𝟏 𝐄𝟐 + 𝐁𝟏 − 𝐁𝟐 𝐄𝟑 + 𝐁𝟐 − 𝐁𝟑
= + + + …
𝟏+𝐫 (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟑
𝐄𝟏 − 𝐫𝐁𝟎 𝐄𝟐 − 𝐫𝐁𝟏 𝐄𝟑 − 𝐫𝐁𝟐
= 𝐁𝟎 + + + +⋯
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟑
#
𝐄𝐭 − 𝐫𝐁𝐭5𝟏
= 𝐁𝟎 + ,
(𝟏 + 𝐫)𝐭
𝐭$𝟏
#
(𝐑𝐎𝐄𝐭 − 𝐫) 𝐁𝐭5𝟏
= 𝐁𝟎 + ,
(𝟏 + 𝐫)𝐭
𝐭$𝟏

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Page 10a
𝐄𝟏 + 𝐁𝟎 − 𝐁𝟏 𝐄𝟐 + 𝐁𝟏 − 𝐁𝟐 𝐄𝟑 + 𝐁𝟐 − 𝐁𝟑
➀ 𝐕𝟎 = + + … LOS c
𝟏+𝐫 (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟑 - calculate
use a zero-sum identity - compare

𝐁𝟏 − (𝟏 + 𝐫)𝐁𝟎 𝐁𝟐 − (𝟏 + 𝐫)𝐁𝟏 𝐁𝟑 − (𝟏 + 𝐫)𝐁𝟐

➁ 𝟎 = 𝐁𝟎 + + + …
𝟏+𝐫 (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟑
𝐁𝟏 (𝟏 + 𝐫)𝐁𝟎 𝐁𝟐 (𝟏 + 𝐫)𝐁𝟏 𝐁𝟑 (𝟏 + 𝐫)𝐁𝟐
𝐁𝟎 + − + − + − …
𝟏+𝐫 (𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟑 (𝟏 + 𝐫)𝟑
𝐁𝟏 𝐁𝟐 𝐁𝟏 𝐁𝟑 𝐁𝟐
𝐁𝟎 + − 𝐁𝟎 + 𝟐
− + 𝟑
− …
𝟏+𝐫 (𝟏 + 𝐫) (𝟏 + 𝐫) (𝟏 + 𝐫) (𝟏 + 𝐫)𝟐

𝐁𝐭
𝐥𝐢𝐦𝐭$# =𝟎
(𝟏 + 𝐫)𝐭

Add ➀ + ➁
#
𝐄𝟏 + 𝐁𝟎 − 𝐁𝟏 + 𝐁𝟏 − 𝐁𝟎 − 𝐫𝐁𝟎 𝐄𝐭 − 𝐫𝐁𝐭5𝟏
𝐕𝟎 + 𝟎 = 𝐁𝟎 + +. . . ⇒ 𝐕𝟎 = 𝐁𝟎 + ,
𝟏+𝐫 (𝟏 + 𝐫)𝐭
𝐭$𝟏

Page 11
e.g./ EPS ⇒ 2.00, 2.50, 4.00 LOS c
Div ⇒ 1.00, 1.25, 12.25 - calculate
B0 = 6.00 r = 10% - compare

find
𝐧
(𝐑𝐎𝐄𝐭 − 𝐫) 𝐁𝐭5𝟏
𝐕𝟎 = 𝐁𝟎 + ,
(𝟏 + 𝐫)𝐭
𝐭$𝟏
𝟏. 𝟒𝟎 𝟏. 𝟖𝟎 𝟑. 𝟏𝟕𝟓
𝐕𝟎 = 𝟔 + + +
1 2 3 𝟏. 𝟏 (𝟏. 𝟏)𝟐 (𝟏. 𝟏)𝟑
EPS 2.00 2.50 4.00
÷ 𝐁𝐭5𝟏 6.00 7.00 8.25 = 𝟏𝟏. 𝟏𝟓
ROE .333 .3571 .4848
- r .10 .10 .10
(ROEt – r) .2333 .2571 .3848
× 𝐁𝐭5𝟏 6.00 7.00 8.250
1.40 1.80 3.175

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Fundamental Determinants
# Page 12
(𝐑𝐎𝐄𝐭 − 𝐫) 𝐁𝐭5𝟏 LOS d, e
𝐕𝟎 = 𝐏𝟎 = 𝐁𝟎 + ,
(𝟏 + 𝐫)𝐭 - assume constant - explain
𝐭$𝟏
earnings and dividend

⇒
(𝐑𝐎𝐄𝟏 − 𝐫)𝐁𝟎 growth (i.e. g)
𝐏𝟎 = 𝐁𝟎 +
𝐫 − 𝐠

div. by B0 𝐏𝟎 𝐑𝐎𝐄 − 𝐫 · increasing function of

A𝐁 = 𝟏 +
𝟎 𝐫 − 𝐠 ROE

𝐍𝐈 𝐒𝐚𝐥𝐞𝐬 𝐓𝐀
𝐑𝐎𝐄 = × ×
𝐒𝐚𝐥𝐞𝐬 𝐓𝐀 𝐒𝐡. 𝐄𝐪.

RI Models
Page 13
⇒ Single Stage RI (constant g) LOS f
𝐑𝐎𝐄 − 𝐫 - calculate
𝐕𝟎 = 𝐁𝟎 + ∙ 𝐁𝟎 - interpret
𝐫 − 𝐠
e.g./ B0 = 26.24 expected LT-ROE = 11% re = 9.5%
P0 = 34.68 LTEG = 5.5%
Note:
. 𝟏𝟏 − . 𝟎𝟗𝟓 𝐏𝟎
𝐕𝟎 = 𝟐𝟔. 𝟐𝟒 + ∙ 𝟐𝟔. 𝟐𝟒 =𝐁 = 𝟑𝟔. 𝟎𝟖=𝟐𝟔. 𝟐𝟒
𝟎
. 𝟎𝟗𝟓 − . 𝟎𝟓𝟓
= 𝟏. 𝟑𝟕𝟓 > 𝟏
= 𝟐𝟔. 𝟐𝟒 + 𝟗. 𝟖𝟒 = 𝟑𝟔. 𝟎𝟖 - since ROE > r
(LOS g)
.𝟏𝟏 5 .𝟎𝟗𝟓
using P0 = 34.68 𝟑𝟒. 𝟔𝟖 = 𝟐𝟔. 𝟐𝟒 + .𝟎𝟗𝟓 5 𝐠
∙ 𝟐𝟔. 𝟐𝟒

𝐏 . 𝟎𝟏𝟓
t 𝟎A𝐁 u → 𝟏. 𝟑𝟐𝟏𝟔𝟒 = 𝟏 +
𝟎 . 𝟎𝟗𝟓 − 𝐠
. 𝟑𝟐𝟏𝟔𝟒 = . 𝟎𝟏𝟓A. 𝟎𝟗𝟓 − 𝐠 ⇒ 𝐠 = 𝟒. 𝟖𝟑𝟔𝟒%

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Page 14
⇒ Single Stage RI (constant g) LOS f
- Drawback ⇒ assumes (ROE – r) > 0 persists - calculate
- interpret
· more likely LT – ROE ∼ r and RI = 0

⇒ Multi-Stage RI/
B0 + explicit forecast + terminal value based on
period continuing residual
ROE
income
stage 1
typically, not a large
r
continuing RI component of V0
(unlike other DCF models)
t
explicit forecast
period

Page 15
⇒ Multi-Stage RI/ LOS f, h
- assumptions about continuing RI: - calculate
→ one of/ ➀ RI continues indefinitely - interpret
- explain
𝐓
(𝐄𝐭 − 𝐫𝐁𝐭(𝟏 ) at some positive level
A - justify
(𝟏 + 𝐫)𝐭 𝐏𝐓 − 𝐁𝐓
𝐭*𝟏 +
(𝟏 + 𝐫)𝐓
𝐕𝟎 = 𝐁𝟎 +
➁ RI = 0 from terminal year onwards
𝐓(𝟏
(𝐄𝐭 − 𝐫𝐁𝐭(𝟏 ) ➂ RI declines to 0 as ROE reverts
A to r lower case omega
(𝟏 + 𝐫)𝐭
𝐭*𝟏
𝐄𝐓 − 𝐫𝐁𝐓5𝟏 𝛚 – persistence
+
(𝟏 + 𝐫 − 𝛚)(𝟏 + 𝐫) 𝐓5𝟏
factor
➃ RI reflects ROE reverting to some
mean level

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Page 16
⇒ Multi-Stage RI/ (RI = 0) LOS f, h
- calculate
e.g./ P0 = 95.60 ·re = 12% ·D0 = 2.9995 ·B0 = 28.8517
- interpret
E 7.162 (2013) 8.356 (2014) - explain
Forecasts - justify
D 2.9995 3.2995

ROE = 25% (2015-2019) 2020-2032 – 20% 2033 ➝ RI = 0

RR = 60%
Bt-1 Et Dt Bt r RI PV(RI)
2012 28.8517 28.8517
2013 28.8517 + 7.162 - 2.9995 33.0142 3.4622 3.6998/(1.12) 3.3033
2014 33.0142 + 8.356 - 3.2995 38.0707 3.9617 4.3943/(1.12)2 3.5031
2015 38.0707 + 9.5177 - 3.8071 43.7813 4.5685 4.9492/(1.12)3 3.5227
2016 43.7813 + 10.9453 - 4.3781 50.3485 5.2538 5.6916 3.6171
50.3485
2032 298.3296 59.6654 23.8664 334.1291 35.7996 23.8664 2.4741
86.41

Page 17
⇒ Multi-Stage RI/ (RI > 0) LOS f, h
- calculate
e.g./ P0 = 95.60 ·re = 12% ·D0 = 2.9995 ·B0 = 28.8517 - interpret
E 7.162 (2013) 8.356 (2014) - explain
Forecasts - justify
D 2.9995 3.2995

ROE = 25% (2015-2019) 2020-2032 – 20% 2033 ➝ RI = 0

RR = 60%

⇒ assume continuing residual income in 2033 is 2032

RI = 23.8664
𝟐𝟎
𝐄𝐭 − 𝐫𝐁𝐭(𝟏 𝐏𝐓 − 𝐁𝐓 𝟐𝟑. 𝟖𝟔𝟔𝟒
𝐕𝟎 = 𝐁𝟎 + A + . 𝟏𝟐
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐓
𝐭*𝟏
(𝟏. 𝟏𝟐)𝟐𝟎
86.41 𝐄𝟏5
𝟏𝟗𝟖. 𝟖𝟖𝟔𝟕 𝐕𝟐𝟎 𝐫
+ 20.6179
(𝟏. 𝟏𝟐)𝟐𝟎
V0 = 107.03 2013 2032
(1.12)20

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Page 18
⇒ Multi-Stage RI/ (RI decays to r) LOS f, h
- calculate
e.g./ P0 = 95.60 ·re = 12% ·D0 = 2.9995 ·B0 = 28.8517
- interpret
E 7.162 (2013) 8.356 (2014) - explain
Forecasts - justify
D 2.9995 3.2995

ROE = 25% (2015-2019) 2020-2032 – 20% 2033 ➝ RI = 0

RR = 60%

⇒ assume RI will decay at a rate of 40% beginning in 2033

𝟐𝟎
𝐄𝐭 − 𝐫𝐁𝐭(𝟏 𝐄𝐓 − 𝐫𝐁𝐓(𝟏 𝐑𝐈𝟐𝟏 = 𝐑𝐈𝟐𝟎 (𝟏 + 𝐠)
𝐕𝟎 = 𝐁𝟎 + A +
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫 − 𝛚)(𝟏 + 𝐫)𝐓(𝟏 𝐠 = 𝐑𝐑 × 𝐑𝐎𝐄
T-1 𝐭*𝟏
= . 𝟔𝟎 ×. 𝟐𝟎
𝐄𝟐𝟏 − 𝐫𝐁𝟐𝟎 = . 𝟏𝟐
𝟖𝟔. 𝟒𝟏
(𝟏. 𝟏𝟐−. 𝟔)(𝟏. 𝟏𝟐)𝟐𝟎
𝐑𝐈𝟐𝟏 = 𝟐𝟑. 𝟖𝟔𝟔𝟒(𝟏. 𝟏𝟐)
+
𝟓. 𝟑𝟑 𝟐𝟔. 𝟕𝟑𝟎𝟒
$
𝟗𝟏. 𝟕𝟒 . 𝟓𝟐(𝟏. 𝟏𝟐)𝟐𝟎
2013 2032 2033
T T+1

Valuation Models
Page 19
· DDM/FCF · RI LOS i
𝐓 𝐓
𝐂𝐅𝐭 𝐑𝐈𝐭 - compare
𝐕𝟎 = , + 𝐓𝐕 𝐕𝟎 = 𝐁𝟎 + ,
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭
𝐭$𝟏 𝐭$𝟏

large large

· recognition of value is different, but V0 should

be the same

e.g./ E0 = 1.00/sh forever 1) DDM 𝐕𝟎 = 𝐃A𝐫 = 𝟏. 𝟎𝟎A. 𝟏 = 𝟏𝟎

D0 = E0
B0 = 6.00/sh 2) RI 𝑽𝟎 = 𝑩𝟎 + 𝑹𝑰A𝒓
𝟏 5 .𝟏(𝟔)
r = 10% =𝟔+ .𝟏
= 𝟔 + . 𝟒A. 𝟏
= 𝟏𝟎

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Strengths/Weaknesses
Page 20
+/ · TVs do not make up a large portion LOS j
of total-PV - explain
· RI models use readily available actg. data - justify
· can be applied to non-div. companies or to
FCF < 0 companies
· can be used when CFs are unpredictable

-/ · actg. data is subject to manipulation

· actg. data may require significant adjustments
· clean surplus relation must hold
· assumes cost of debt is appropriately reflected
in interest expense

Page 21
· appropriate when/ LOS j
· company does not pay divs. or divs. - explain
are not predictable - justify
· expected FCFs are negative within the
forecast horizon
· great uncertainty exists in forecasting TVs
using DDM/FCF models

· least appropriate when/

· significant departures from clean surplus
accounting exist
· significant determinants of RI (BVPS, ROE)
are not predictable

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Accounting Issues
Page 22
1) Violations of the clean surplus relation/ LOS k
- when charges bypass the I.S. and are - describe
made directly to shareholder’s equity

e.g./ ‘available-for-sale’ - GAAP ⇒ changes in market value

not recorded as gains/losses
· on B.S. at MV on I.S.

⇒ CI = NI + OCI · common items of OCI/

· unrealized changes in FMV of some fin. assets
· forex translation adjustments
· certain pension adjustments
· portions of gains/losses on certain hedges
etc …

Page 23
1) Violations of the clean surplus relation/ LOS k
- result/ - BVe stated properly (includes accum. OCI) - describe
- NI not stated accurately ∴ ROE not accurate

→ items that bypass I.S. are excluded from

historical ROE data

- implication: if future OCI is expected to be significant

Bt-1 relative to net income and if the
+ E1 year-to-year amounts of OCI are not
- D1 expected to net to zero, attempt to
- OCI1
incorporate these items (i.e. adjust NI)
= Bt
RI = (Et – OCIt) - lacking a basis for explicit assumptions about
– rBt-1 future OCI, forecast ‘clean surplus relation’

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Page 24
2) Balance Sheet adjustments for FV/ LOS k
· off-balance sheet A/L – footnotes - describe
e.g./ Operating leases
· reported A/L should be adjusted to FV
when possible
e.g./ LIFO to FIFO

3) Intangible Assets/
· acquired, separable intangibles should be
included

4) Nonrecurring Items/
· removed from operating earnings when
forecasting residual income

Page 25
5) Other Aggressive Actg. Practices/ LOS k
- overstate assets (and BV) - describe

- overstate revenues (and ROE)

6) International Considerations/
- if:
1) reliable earnings forecasts are available
2) clean surplus relation generally holds
3) high quality actg. data exist

- then no problems.

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Private Company Valuation

a. compare public and private company valuation

b. describe uses of private business valuation and explain applications of

greatest concern to financial analysts

c. explain the income, market, and asset-based approaches to private company

valuation and factors relevant to the selection of each approach

d. explain cash flow estimation issues related to private companies and

adjustments required to estimate normalized earnings

e. calculate the value of a private company using free cash flow, capitalized
cash flow, and/or excess earnings methods

f. explain factors that require adjustment when estimating the discount rate for
private companies

g. compare models used to estimate the required rate of return to private

company equity (for example, the CAPM, the expanded CAPM, and the
build-up approach)

h. calculate the value of a private company based on market approach methods

and describe advantages and disadvantages of each method

i. describe the asset-based approach to private company valuation

j. explain and evaluate the effects on private company valuations of discounts

and premiums based on control and marketability

LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings

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Public vs. Private

Page 1
Company specific factors/ LOS a
maturity - compare
stage in lifecycle
earlier
growth decline
= riskier emerging

size private public

smaller = riskier (smaller)

may reduce growth prospects

overlap of shareholders and management

- top mgmt. typically has controlling interest
- lack of external pressure may allow for a
longer-term perspective (typically a motivation
for taking a comp. private)

Page 2
Company specific factors/ LOS a
- compare
quality/depth of mgmt.
- may be lacking ⇒ increases risk, reduces
growth prospects

quality of financial and other information

- regular disclosures not required (for pr. comp.)
- greater uncertainty (i.e. risk)

tax concerns
- private companies far more likely to focus
on minimization of taxes paid by reductions
to reportable taxable income

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Page 3
stock-specific factors/ LOS a
- compare
liquidity

concentration of control
- above-market transactions

marketability
- agreements restricting sale

- stock-specific factors usually a negative for private

company valuation

- company-specific factors can be pos. or neg.

Uses & Issues of Valuation

Page 4
1) Transaction-related/ LOS b
- describe
a) private financing - value is typically
- explain
arrived at by negotiation (VCs)

b) IPOs - use of comparables (Inv. Banking)

c) acquisition - strategic investment

d) bankruptcy - determine if company is viable

through restructuring or just liquidate

e) share-based payment

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Page 5
2) Compliance related/ LOS b
financial reporting - describe
- goodwill impairment ⇒ components of - explain

public companies are valued using pr. comp. valuation

techniques
IFRS - cash generating unit
GAAP - reportable unit
tax reporting

3) Litigation related/

damages
lost profits
shareholder disputes
divorce

Standards of Value
Page 6
⇒ specifies how value is understood LOS c
1) Fair Market Value - explain
- hypothetical value: includes DLOC - control - demonstrate
DLOM - marketability
- sale does not take place
∴ since no expenses are associated with
a hypothetical sale, FMV = gross amount
- focus is on price, not proceeds

- hypothetical willing and able buyer and seller

ofte
n - arm’s length
most in a
ied - open & unrestricted market
appl or ting
re p - neither is under compulsion
tax t ext.
c on
- both have reasonable knowledge of the
relevant facts

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Page 7
2) Fair Value (financial reporting) LOS c
- explain
- market price cannot be determined
- demonstrate
- model derived price without DLOC, DLOM
- focus is on exit value ➞ net proceeds
- litigation definition ⇒ similar (but may differ by
jurisdiction)

3) Market Value
- requires normal & typical market conditions
- presumes the transfer of an asset at a price
currently available in the most advantageous
market
- gross amount (net amt. = settlement value)

Page 8
4) Investment Value LOS c
- the value to a particular investor - explain
- specific buyer vs. general market - demonstrate

5) Intrinsic Value
- fundamental value
- private estimate of value or worth (of the whole)

MV - what you can get

FMV - what you could get
IV - what you should get
FV - what you should walk away with

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Valuation Approaches
Page 9
1) Income approach (growth, mid-size) LOS d
FCF issues/ - explain
- DCF Cap. CF - earnings normalization
RI - cash flow estimates
- required rate of return
- absolute valuation
2) Market approach (mature, larger, more stable)
- guideline public company method issues/
- guideline transactions method - finding comparables
- prior transactions method
- relative valuation

3) Asset-based approach (smaller, emerging)

- absolute valuation issues/
- identifying non-operating and
discretionary A & L

Earnings/CF Issues
Page 10
1) Earnings normalization/ LOS e
- private company earnings typically reflect - explain
inefficiencies or redundancies
- earnings should be adjusted to a basis that
is relevant for forecasting (given that the firm
is acquired)

- earnings may reflect discretionary or non-arm’s-length

transactions
- earnings may reflect tax minimization motivations
smaller the size ⇒ greater the impact

e.g./ - above/below market compensation

- family member employment
- personal expenses

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Page 11
1) Earnings normalization/ LOS e
- real estate ⇒ removed as an asset, rental - explain
charge added (valuation for the business
excluding owned real-estate)
- now classified as non-operating asset
- if leased by a related party, may have to be
adjusted to market rates

e.g./ CEO pay = $1.5M, market rate = $500K reduce exp. $1M
↑ EBITDA
personal assets = $400k exp.
- reduce Dep. Exp. by $100k
100k 300k
- reduce Op. Exp. by $300k
Dep. exp.
- exclude Int. exp.
debt level ⇒ not optimal (Op. Inc. after tax)

Page 12
2) Cash Flow estimation/ LOS e
- the whole or the part - FCFE without - explain

adjustments
(fair value)
FCFF
with adjustments (investment
value)
- if substantial capital structure changes lie
ahead, FCFF

- wider range of uncertainty in estimates

- multiple scenarios each with an r
V0 = prob.-weighted average

- mgmt. bias in forecasts

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Income Approach
Page 13
⇒ need a discount rate LOS g
1) Size premium - explain
2) Use of CAPM - may not be suitable
3) Expanded - CAPM = (CAPM r) + size pr. + risk pr.
4) Build-up approach = rf + ERP + size pr. + risk pr.
+ industry risk pr.
5) Relative debt availability and cost of debt
- level of debt usually lower
- cost of debt usually higher
6) acquisition ⇒ use target comp. cost of capital, not
the acquirer’s
(does not transfer value from the buyer to
the seller)

Page 14
e.g./ 𝐫𝐟 = 4.8% size pr. = 3% LOS h
ERP = 5.0% company-specific risk = 1% - compare
𝜷 = 1.1 industry-risk pr. = 0% 𝐭 = 40%
𝐫𝐝 = 7.5% D:E Industry 20:80
company 10:90 – optimal
actual : 2:98

1. CAPM r = 4.8% + 1.1(5.0) = 10.3%

2. Expanded CAPM = r = 10.3 + 3% + 1% = 14.3%

3. Build-up method r = 4.8 + 5.0 + 3.0% + 1% + 0% = 13.8%

4. Capital structure weights A) 20:80 B) 10:90 C) 2:98

5. WACC (2:98) r = 14% .02(.075)(.6) + .98(.14) = 13.81%

6. WACC (10:90) r = 14% .1(.075)(.6) + .9(.14) = 13.05%

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Page 15
1) FCF method/ LOS f
explicit forecast + T.V. - cap. CF - calculate
period method
(3 - 5 yrs.)

2) Capitalized CF method/
- growing perpetuity (single-stage FCF model)
- smaller pr. companies w/ expectations of
stable future operations
or/ - calculating implied g from a market-based
valuation
𝐅𝐂𝐅𝐅𝟏 or/ 𝐅𝐂𝐅𝐄
𝐕𝐟 = 𝐕𝐞 = 𝐕𝐟 − 𝐌𝐕𝐝 𝐕𝐞 =
𝐖𝐀𝐂𝐂 − 𝐠 𝐟 𝐫−𝐠

denominator = cap rate

Page 16
3) Excess Earnings Method/ (EEM) LOS f
- calculate
a) estimate values of working capital
& fixed assets e.g./ $200k & $800k

b) normalize earnings $120k

c) develop discount rates for WC & FA

rWC < rFA rWC = 5% rFA = 11%

d) Earnings - rWC(WC) - rFA(FA)

$120k - .05(200k) - .11(800k)
= 120K - 10k - 88k = $22K

e) estimate disc. rate and cap. rate required

for the valuation of intangible assets ri = 12%

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Page 17
3) Excess Earnings Method/ (EEM) LOS f
f) Value intangible assets - if g = 3% - calculate

𝐑𝐈(𝟏 + 𝐠)
𝟐𝟐, 𝟎𝟎𝟎(𝟏. 𝟎𝟑)
𝐫𝐢 − 𝐠 𝐕𝐢 = = 𝟐𝟓𝟏, 𝟕𝟕𝟖
. 𝟏𝟐 − . 𝟎𝟑
g) EEM = WC + FA + Intg.

= 200k + 800k + 251,778 = $1,251,778

* usually only used on smaller companies, but still

rarely
* rWC, rFA, ri not realistic

Market-Based Methods
Page 18
- direct comparisons with public and acquired LOS i
companies - calculate
- preferred by tax courts
- describe
- actg. standards related to FV give highest
priority to market-based evidence
⇒ Challenges/ finding comparable companies
adjusting for r and g valuation
time drift date
observation
(esp. for GTM/PTM)
key multiple/ 𝐌𝐕𝐈𝐂 dates
⟶ 𝐌𝐕𝐞 + 𝐌𝐕𝐝 (face
𝐄𝐁𝐈𝐓𝐃𝐀
value)
𝐌𝐕𝐈𝐂
𝐕𝐞 = 𝐜𝐨𝐦𝐩. × 𝐄𝐁𝐈𝐓𝐃𝐀 − 𝐌𝐕𝐝
𝐄𝐁𝐈𝐓𝐃𝐀

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Page 19
- GPCM - guideline public company method LOS i
- identify public company comparables - calculate
- calculate avg. multiple - describe

- adjust for r & g

trading in public companies
- adjust for control
typically reflects small blocks
+/ potential large pool
-/ subjective adjustments
of comparables
⇒ Control premium/discount adjustment/ larger
type of transaction strategic - synergies premium
financial - no synergies

industry factors - recent M&A activity may

distort comp. multiples

form of consideration - stock deals may be less

relevant

Page 20
- GPCM - guideline public company method LOS i
- calculate
e.g./ avg. 𝐌𝐕𝐈𝐂 - describe
= 𝟕. 𝟎 COMP × EBITDA - MVd
𝐄𝐁𝐈𝐓𝐃𝐀
r & g adjustments - 15%

control pr. +20% - several yrs. ago, all stock

transaction
no strategic buyers

normalized EBITDA = $16.9M

MVd = $2M

(7.0 × .85)16.9M - 2M
= 100.555M - 2M = $98.55M

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Page 21
- GTM - guideline transactions method LOS i
⇒ uses multiples derived from acquisitions - calculate
of public and private companies - describe

reported to more difficult * most relevant

reg. auth. (e.g. SEC) to get valuation - if you
can get comparables
will already reflect control premium

⇒ previous transactions may also reflect/

1) synergies (strategic not comparable to financial)
2) contingent consideration - potential future PMTs
to seller if certain targets/milestones
achieved
3) non-cash consideration
4) changes between transaction date & valuation date

Page 22
- PTM - prior transactions method/ LOS i
- calculate
- actual transactions in the stock - describe
of the subject company

- should be timely & arm’s length

financing rounds usually structured

around key milestones

considerable value may have been

added between rounds

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Asset-Based Approach
Page 23
⇒ Vf = FV(assets) - FV(liabilities) LOS j
- describe
- also called cost approach
- considered weakest method for valuing a going
concern
- lack of market data to value intangible
assets
- special use assets also difficult

- resource & financial companies may be more suited

to the approach (help set lower bound)
(as with holding companies, REITs)

Discounts/Premiums
Page 24
Control - synergies LOS k
control - determined from - explain
Control - no synergies premiums transactions - evaluate
(MVICbefore event - MVICpost event)
Baseline
DLOC: discount for lack of
control
Small pr. comp. control
discounts
equity interests - usually require a
‘disproportionate returns’ test
𝟏
𝐃𝐋𝐎𝐂 = 𝟏 − I J CP - control premium
𝟏 + 𝐂𝐏

𝟏
e.g. CP = 20% 𝟏− = 𝟏𝟔. 𝟕%
(𝟏. 𝟐)

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Page 25
- when DLOC is used/ LOS k
- explain
valuation based on/ - evaluate
GTM - control assumed CCM/FCF - if control CFs used
- discount rate reflects
optimal cap. structure

- DLOM - discount for lack of marketability/

- amt./% deducted from value of an ownership
interest to reflect the absence of a market
- usually applied to non-controlling equity interests
in private companies
e.g./ DLOC = 10% DLOM = 20%
- DLOC & DLOM are multiplicative

Page 26
e.g./ CEO - 90% LOS k
ownership
you - 10% - explain
- evaluate
DLOC = 0% 𝐕𝐟 = $96M
- if company sold
DLOM = 5%

- if not sold DLOC = 𝐕𝐟 (reported earnings)

𝐕𝐟 = $80M DLOM = 25%

1. IF sold, you get/ ($96M × 10%).95 = $9.12M - FMV

normalized earnings
optimal cap. structure

2. IF not sold, you get/ ($80M × 10%).75 = $6.0M - FV

reported earnings
actual cap. structure

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Valuation Standards
Page 27
Intent ⇒ protect users of valuations LOS L
⇒ Standards cover the development and reporting - describe

of the valuation

Uniform Standards of International Valuation

Professional Appraisal Standards (9th ed.)
Practice (IVS)
(USPAP)
- Jan. 1/2012 added
- no legal requirement
Businesses, Business Interests,
to comply (for business
Intangible Assets
valuation
purposes)

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REVIEW

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Equity Valuation: Applications & Processes

Review - 1
Price vs. Intrinsic Value
observable unobservable Grossman-
- undertaking valuation assumes mispricing exists Stiglitz
paradox
𝐕𝐞 − 𝐏 = (𝐕 − 𝐏) + (𝐕𝐞 − 𝐕)
estimated price true error
forecasts
value mispricing model
(𝜶)
convergence ➞ over some holding period horizon
requires a catalyst
Values/
➀ going concern value - company will continue operations

➁ liquidation value immediate financial

orderly liquidation distress

Review - 2
Values/ ➂ Intrinsic value – focus of valuation here
➃ Fair market value - asset/liability would trade hands
- willing buyer/seller, no compulsion
- both informed
➄ Investment value – value to a particular buyer

Uses/ 1) Selecting stocks

2) Inferring market expectations Price = Var1 + Var2 + Var3 + X

solve for X
3) evaluating corporate events (M&A, spin-off)
4) rendering fairness options
etc…

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Review - 3
- Valuation Process/
· understand the business - Porter’s 5-forces
· forecast company performance
· select the appropriate valuation model
· arrive at valuation
· conclusions
Valuation models/ 𝒏
𝑪𝑭𝒊
1) Absolute valuation models ➞ 𝑰𝑽 = ,
(𝟏 + 𝒓)𝒊
𝒊$𝟏

➞ asset–based valuations
- MV of assets/resources
2) Relative valuation models
- price multiples or enterprise multiples

Review - 4
⇒ sum of the parts - few synergies between segments
- useful for valuing spin-offs

⇒ Conglomerate Discount – companies operating in multiple

unrelated businesses

- Valuation Approach – consistent w/ the characteristics of the company

- appropriate given available data
- consistent w/ the purpose of valuation

Valuation/ - sensitivity analysis

- situational adjustments

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Discounted Dividend Valuation

Review - 1
dividends
to the firm
- definitions of cash flow free cash flow
to equity
residual income

DDM/suitable
- company pays a div.
- div. policy bears an understandable relationship
with profitability
- non-control perspective

FCFF/FCFE/suitable
- company has no div.
- company has a div., but no relationship with FCF
- company’s FCF aligns with profitability
- control perspective

Review - 2
Residual Income/suitable
- company has no div.
- expected FCFs negative
𝐃𝟏 + 𝐏𝟏
DDM/ Single Period 𝐕𝟎 =
(𝟏 + 𝐫)

𝐧 #
Multiple Periods 𝐃𝐢 𝐏𝐧 𝐃𝐢
𝐕𝟎 = , + ,
(𝟏 + 𝐫) (𝟏 + 𝐫)𝐧
𝐢
(𝟏 + 𝐫)𝐢
𝐢$𝟏 𝐢$𝟏

- 2 approaches to using DDM

1) GGM 2-stage, H-model, 3-stage

2) explicit forecast period + terminal value

from 1) above or multiple based

GGM/
𝐃𝟎 (𝟏 + 𝐠) 𝐃𝟏
𝐕𝟎 = =
𝐫−𝐠 𝐫−𝐠

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Review - 3
GGM/ r = rf + β · ERP sust: g = ROE · RR g → the rate
of capital
𝐃𝟏
Total return = g + A𝐏 appreciation
𝟎
cap. gain div. yield (constant (cap. gains yield)
yield through time)

𝐃𝟎 (𝟏 + 𝐠)
implied g/ 𝐕𝟎 = 𝐏𝟎 = - solve for g
𝐫−𝐠
𝐃
𝐕𝟎 = - perpetuity (g = 0)
𝐫

Present Value of Growth Opportunities/PVGO

𝐄 𝐏𝟎A 𝟏 𝐏𝐕𝐆𝐎
𝐏𝟎 = 𝟏A𝐫 + 𝐏𝐕𝐆𝐎 𝐄𝟏 = 𝐫 + 𝐄 𝟏 P/E component
value of company value of P/E related
without reinvestment for no growth to growth
DPR = 100% (DPS = EPS) company

Review - 4
𝐃𝟎 (𝟏 + 𝐠)
𝐕𝟎 = (divide by EPS) E1 – exp. E0 – hist.
𝐫−𝐠
𝐃𝟎 𝐕𝟎
A𝐄 (𝟏 + 𝐠) (𝟏 − 𝐑𝐑)(𝟏 + 𝐠) A𝐄𝐏𝐒
𝐕𝟎 𝟎 𝟎
A𝐄 = =
𝟎 𝐫−𝐠 𝐫−𝐠 trailing justified P/E

𝟏 − 𝐑𝐑 𝐕𝟎
𝐕𝟎A A𝐄𝐏𝐒
𝐄𝟏 = 𝟏
𝐫−𝐠 forward
g
gS
⇒ Multi-Stage DDM/ 2-stage
gL
g t

H-model 3-stage gS
gL gt
gL
t

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Review - 5
2-stage/
𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐭 𝐕𝐧 (𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐭 )(𝟏 + 𝐠 𝐋 )
𝐕𝟎 = , + 𝐕𝐧 =
(𝟏 + 𝐫) 𝐭 (𝟏 + 𝐫)𝐧 𝐫 − 𝐠𝐋
𝐭$𝟏

3-stage/
𝐦 𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐚 𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐦 (𝟏 + 𝐠 𝐭 )𝐛 𝐕𝐧
𝐕𝟎 = , + , +
(𝟏 + 𝐫) 𝐚 (𝟏 + 𝐫) 𝐛 (𝟏 + 𝐫)𝐧
𝐚$𝟏 𝐛$𝐦+𝟏

𝐃𝟎 (𝟏 + 𝐠 𝐒 )𝐚 (𝟏 + 𝐠 𝐭 )𝐛 (𝟏 + 𝐠 𝐋 )
𝐕𝐧 =
H-model/ 𝐫 − 𝐠𝐋

𝐃𝟎 (𝟏 + 𝐠 𝐋 ) 𝐃𝟎 𝐇(𝐠 𝐒 − 𝐠 𝐋 ) or/
𝐕𝟎 ≈ + Vn = EPSn × multiple
𝐫 − 𝐠𝐋 𝐫 − 𝐠𝐋
𝐃𝟎 (𝟏 + 𝐠 𝐋 ) + 𝐃𝟎 ∙ 𝐇(𝐠 𝐒 − 𝐠 𝐋 )
H – half life in years
𝐫 − 𝐠𝐋

Review - 6
Single Stage GGM
multiples-based

2-stage explicit forecast period – Single Stage

H-model

3-stage explicit forecast period – 2-Stage

Required Return/ (price implied) – efficient market required return

𝐃 𝐃𝟎 (𝟏 + 𝐠) 𝐃𝟏
GGM/ 𝐫 = 𝟏A𝐏 + 𝐠 𝐏𝟎 = =
𝟎 𝐫−𝐠 𝐫−𝐠
𝐃
H-model/ 𝐫 = ( 𝟎=𝐏 , [(𝟏 + 𝐠 𝐋 ) + 𝐇(𝐠 𝐒 − 𝐠 𝐋 )] + 𝐠 𝐋
𝟎
𝐫 − 𝐠𝐋
2-stage/3-stage - IRR - iterative approach

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Review - 7
gL /
g = ROE × RR

𝐍𝐈
𝐠= × 𝐑𝐑
𝐒𝐡. 𝐄𝐪.
𝐍𝐈 𝐀𝐯𝐠. 𝐀𝐬. (ROA × leverage)
𝐠= × × 𝐑𝐑
𝐀𝐯𝐠. 𝐀𝐬. 𝐒𝐡. 𝐄𝐪.
𝐍𝐈 𝐒𝐚𝐥𝐞𝐬 𝐀𝐯𝐠. 𝐀𝐬. pr. margin × turnover
𝐠= × × × 𝐑𝐑
𝐒𝐚𝐥𝐞𝐬 𝐀𝐯𝐠. 𝐀𝐬. 𝐒𝐡. 𝐄𝐪. × leverage

𝐍𝐈 − 𝐃𝐢𝐯. 𝐍𝐈 𝐒𝐚𝐥𝐞𝐬 𝐀𝐯𝐠. 𝐀𝐬.

𝐠= × × ×
𝐍𝐈 𝐒𝐚𝐥𝐞𝐬 𝐀𝐯𝐠. 𝐀𝐬. 𝐒𝐡. 𝐄𝐪.

PRAT model

g = RR × ROA × leverage

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Free Cash Flow Valuation

Review - 1
• company pays no dividend, or div. shows no relationship
with earnings or capacity to pay
• control perspective

Net Income/ FCFF = NI + NCC + Int(1-t) - FCInv - WCInv

FCFE = FCFF (-Int(1-t) + Net Borrowing) - always
𝐧
𝐅𝐂𝐅𝐅(𝟏 + 𝐠)𝐢 𝐅𝐂𝐅𝐅(𝟏 + 𝐠)𝐧+𝟏
𝐅𝐂𝐅𝐅 = , +‘ ’ ∕ (𝟏 + 𝐖𝐀𝐂𝐂)𝐧 NOTE:
(𝟏 + 𝐖𝐀𝐂𝐂)𝐢 𝐖𝐀𝐂𝐂 − 𝐠 ➀ FCInv = net
𝐢$𝟏
investment
𝐧
𝐢
𝐅𝐂𝐅𝐄(𝟏 + 𝐠) 𝐅𝐂𝐅𝐄(𝟏 + 𝐠) 𝐧+𝟏 (additions less
𝐅𝐂𝐅𝐄 = , +‘ ’ ∕ (𝟏 + 𝐫)𝐧 sales)
(𝟏 + 𝐫) 𝐢 𝐫−𝐠
𝐢$𝟏 ➁ WCInv - excludes
& FCFE = FCFF - MVd - MVPr. cash/equiv. and any
CL accts that are debt.

Review - 2
CFO/ FCFF = CFO + Int(1-t) - FCInv
(NI + NCC - WCInv) = CFO
FCFE = FCFF - Int(1-t) + Net Borrowing

EBIT/ FCFF = EBIT(1-t) + NCC - FCInv - WCInv

NI = (EBIT - Int)(1-t)
FCFE = FCFF - Int(1-t) + Net Borrowing

EBITDA/ FCFF = EBITDA (1-t) + Dep(t) - FCInv - WCInv NI = (EBITDA - NCC - Int)
FCFE = FCFF - Int(1-t) + Net Borrowing (1-t)

FCFF/ FCFE/
levered company with FCFE < 0 stable capital structure
levered company with FCFE > 0
changing capital structure

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Review - 3
Remember/ FCFF discounted by WACC - more stable than r
FCFE discounted by r
CFO → if IFRS & GAAP follow the same allocations,
no adjustments required

GAAP IFRS
Pd CFO CFO CFF
Interest
Rec CFO CFO CFI
adjustments
Pd CFF CFF CFO
Dividends
Rec CFO CFO CFI

no adjust
• NCC - could be more than just Dep/Amort.
- if we start at EBIT, we assume the
only NCC is Dep. (since many NCC come after
EBIT)

Review - 4
Forecasting FCFF/E
1) apply a constant g to a current level of FCF
𝐅𝐂𝐅𝐅(𝟏 + 𝐠)
𝐕𝐟𝐢𝐫𝐦 = one-stage model
𝐖𝐀𝐂𝐂 − 𝐠

2) forecast each of the components

EBIT - some relationship w/sales
t
NCC
FCInv (FCInv - NCC) - constant relationship
𝐖𝐂𝐈𝐧𝐯
WCInv with size of company
∆𝐒𝐚𝐥𝐞𝐬 (𝐅𝐂𝐈𝐧𝐯 − 𝐍𝐂𝐂)
Net Borrowing ∆𝐒𝐚𝐥𝐞𝐬
[(FCInv - NCC) + WCInv] DR (FCInv - NCC) < 0 - unsustainable
$ maintenance CAPEX
Debt Ratio $ growth CAPEX

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Review - 5
vs. Dividends/
𝐃𝟎 (𝟏 + 𝐠) 𝐅𝐂𝐅𝐄𝟎 (𝟏 + 𝐠)
𝐕𝟎 = 𝐕𝟎 =
𝐫−𝐠 𝐫−𝐠 - g need not
- CF going to - CF available to be the same
shareholders shareholders
- non-control perspective - control perspective

- Dividends/Share Buybacks - do not affect FCFF/E

- Changes in Leverage - does not affect FCFF
- increases FCFE in year new debt raised,
lowers FCFE in subsequent years

- EBITDA FCFF = EBITDA (1-t) + Dep(t) - FCInv - WCInv

(as proxies vs EBITDA
for cash flow) FCFF = NI + NCC + Int(1-t) - FCInv - WCInv
- NI vs NI

Review - 6
- Models/ single stage

• GGM 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐅𝟎 (𝟏 + 𝐠)

= Value of - MVd - MVPr
𝐟𝐢𝐫𝐦 𝐖𝐀𝐂𝐂 − 𝐠
equity
𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐅𝐂𝐅𝐄𝟎 (𝟏 + 𝐠)
= 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲
𝐞𝐪𝐮𝐢𝐭𝐲 𝐫−𝐠 𝐕𝟎 =
# 𝐬𝐡𝐚𝐫𝐞𝐬
• multiples based
GGM
• two-stage explicit forecast period
multiples based
H model
𝐧
𝐅𝐂𝐅𝐅(𝟏 + 𝐠)𝐢 𝐅𝐂𝐅𝐅(𝟏 + 𝐠)𝐧+𝟏 𝟏
, + ×
(𝟏 + 𝐖𝐀𝐂𝐂) 𝐢 𝐖𝐀𝐂𝐂 − 𝐠 (𝟏 + 𝐖𝐀𝐂𝐂)𝐧
𝐢$𝟏

explicit forecast GGM

• 3-stage explicit forecast
period multiples based
period
H model

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Market-Based Valuation: Price & Enterprise Value Multiples

Review - 1
Comparables - multiple of similar assets (relative valuation)
𝐏𝟎A
𝐱 ➞ some fundamental value
vs./
𝐃𝟎 (𝟏+𝐠)
Forecasted Fundaments – 𝐕𝟎 = (𝐫5𝐠)
or 𝐕𝐄 = 𝐅𝐂𝐅𝐄 (𝟏 + 𝐠)(𝐫 − 𝐠)

𝐕𝟎A 𝐄𝐕A
𝐱 𝐱

justified multiples
➀ P/E – widely recognized
and used 𝐃𝟏 𝐃𝟎
#𝐄 #𝐄 (𝟏 + 𝐠)
⇒ EPS can be zero or 𝐏𝟎 𝟏 𝐏
or #𝐄 =
𝟎 𝟎
#𝐄 =
𝟏 𝐫−𝐠 𝟎 𝐫−𝐠
negative
forward trailing
⇒ highly managed number
⇒ non-recurring adjustments required
𝐏𝟎A trailing (most recent 4 Q) – when forecasts are not possible
𝐄𝐏𝐒
forward – valuation is forward looking

Review - 2
➀ P/E A) trailing – must consider:
- potential dilution (use diluted EPS)
- transitory effects (adjusted EPS) – non-recurring events
- normalized EPS (mid-cycle) – business cycle
(historical avg. EPS or avg. ROE × BV/sh.)
- differences in actg. methods
Low, Zero or Negative EPS ➞ use earnings yield 𝐄𝐏𝐒A𝐏
𝟎
B) forward – next 4 quarters
𝟏𝟐C𝒙
- next 12 months ➞ 𝐱%𝟏𝟐 ∙ 𝐄𝐏𝐒𝟎 + 𝐄𝐏𝐒𝟏
𝟏𝟐
- next fiscal YR. ➞ 𝐄𝐏𝐒𝟏
𝐃𝟎
A𝐄 (𝟏 + 𝐠)
P/E drivers: 𝐏A = 𝟎 lower r ⇒ 𝐫𝐟 + 𝛃 ∙ 𝐄𝐑𝐏
𝐄𝟎 (𝐫 − 𝐠) higher g ⇒ ROE × RR

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industry use of Review - 3

➀ P/E Benchmark P/E – avg. P/E for
market median P/E
adjustments peer group avoids outliers
vs target
(× target EPS) P/E
must consider past values
𝐏/𝐄 < 1 under
𝐏𝐄𝐆 𝐫𝐚𝐭𝐢𝐨 = relative to the avg.
𝐠 = 1 fairly
> 1 over
= fairly valued
Fed Model/ E/P on Index vs. YTM 10-yr. bond < overvalued
𝟏
- fair value of SnP = 𝐘𝐓𝐌 𝟏𝟎 − 𝐲𝐫. (ignores ERP, inflation)

Yardeni Model/ 𝐂𝐄𝐘 = 𝐂𝐁𝐘 − 𝐛 × 𝐋𝐓𝐄𝐆 + 𝐑𝐞𝐬𝐢𝐝𝐮𝐚𝐥

corporate consensus 5-yr. growth rate

growth weight
𝟏 lower CBY higher
𝐣𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐏/𝐄 =
𝐂𝐁𝐘 − 𝐛 × 𝐋𝐓𝐄𝐆 higher LTEG justified P/E

𝟏 Review - 4
➀ P/E inflation pass through 𝐏𝟎A𝐄 = 𝛌 - pass through
𝟏 𝛒 + (𝟏 − 𝛌) 𝐈
proportion
- higher justified P/E
different countries,
- lower inflation
different strategies
- higher pass-through

𝐕𝟎A
⇒ Terminal P/E 𝐄𝐧 - trailing 𝐕𝐧 = 𝐛𝐞𝐧𝐜𝐡𝐦𝐚𝐫𝐤 𝐏/𝐄𝐭𝐭𝐦 × 𝐄𝐧
𝐕𝟎
A𝐄 - forward 𝐕𝐧 = 𝐛𝐞𝐧𝐜𝐡𝐦𝐚𝐫𝐤 𝐏/𝐄𝐧𝐭𝐦 × 𝐄𝐧+𝟏
𝐧+𝟏

𝐒𝐡. 𝐄𝐪𝐮𝐢𝐭𝐲 − 𝐄𝐪𝐮𝐢𝐭𝐲 𝐜𝐥𝐚𝐢𝐦𝐬 𝐬𝐞𝐧𝐢𝐨𝐫 𝐭𝐨 𝐜𝐨𝐦𝐦𝐨𝐧

➁ P/B 𝐁𝐕/𝐬𝐡. =
# 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠
- BV/sh. > 0 even when EPS < 0
- more stable than EPS windups/liquidations
- appropriate for valuing financials, insurance
EPS not suitable

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Review - 5
➁ P/B 𝐏𝟎 𝐑𝐎𝐄 − 𝐠 𝐁𝟎 × 𝐑𝐎𝐄 = 𝐄𝐏𝐒𝟏
A𝐁 =
𝟎 𝐫−𝐠 𝐄𝐏𝐒𝟏 (𝟏 − 𝐑𝐑) = 𝐃𝟏
𝐏𝟎 - higher ROE, g
- justified A𝐁
𝟎 - lower r

𝐏𝟎
- 2 stocks with same A𝐁 , higher ROE undervalued
𝟎
➂ P/S ➞ less subject to manipulation -/ P0 reflects effect
- S > 0 even when EPS < 0 of debt, Sales do not
- S more stable than EPS - revenue recognition
- mature, cyclical, zero-profit firms can distort P/S
𝐏/𝐒
P/S = P/E × net profit margin so, = NPM
𝐏/𝐄
𝐄𝟎
A𝐒 (𝟏 − 𝐑𝐑)(𝟏 + 𝐠) - higher NPM, g ➞ RR × ROE
𝐏 𝟎
𝐉𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝟎A𝐒 =
𝟎 𝐫−𝐠 - lower r

Review - 6
➃ P/CF - CF less subject to manipulation
- more stable than earnings
-/ some definitions of CF inadequate
FCFE most appropriate, but most volatile

𝐃𝐞𝐩./𝐀𝐦𝐨𝐫𝐭./𝐃𝐞𝐩𝐥.
CF/sh. = 𝐄𝐏𝐒 + – not technically accurate
𝐬𝐡.
CFO/sh.
𝐕
FCFE/sh. – most accurate - 𝐉𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐏/𝐂𝐅 = 𝟎A𝐜𝐚𝐬𝐡𝐟𝐥𝐨𝐰
EBITDA/sh.
𝐏𝟎 𝐃𝟎 𝐫5𝐠
➄ A𝐃 A𝐏 = 𝟏+𝐠
𝟎 𝟎

div. yield

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Review - 7
EV Multiples/ 𝐄𝐕 = 𝐌𝐕𝐞 + 𝐌𝐕𝐝 + 𝐌𝐕𝐏𝐫. − 𝐂𝐚𝐬𝐡/𝐄𝐪𝐮𝐢𝐯. − 𝐌𝐤𝐭. 𝐒𝐞𝐜.
𝐄𝐕A
𝐄𝐁𝐈𝐓𝐃𝐀 – most widely used
financial
- comparing companies with different leverage
operating
- EBITDA usually > 0 when EPS < 0

𝐣𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐄𝐕A𝐄𝐁𝐈𝐓𝐃𝐀 - positively related to g & ROIC

- negatively related to WACC
𝐓𝐈𝐂A
𝐄𝐁𝐈𝐓𝐃𝐀 - Total Invested Capital (𝐌𝐕𝐞 + 𝐌𝐕𝐝 + 𝐌𝐕𝐏𝐫. )

Others/ EV/ · FCFE

· EBITDAR
· EBITA
· EBIT

Review - 8
⇒ Cross Border Valuation/ actg. methods
· sources of differences tax regimes
economic differences
cultural differences
⇒ Momentum Valuation Indicators/
consensus
1) Earnings surprise 𝐔𝐄𝐭 = 𝐄𝐏𝐒𝐭 − 𝐄 (𝐄𝐏𝐒𝐭 ) estimate

𝐄𝐏𝐒𝐭 − 𝐄 (𝐄𝐏𝐒𝐭 )
𝐒𝐜𝐚𝐥𝐞𝐝 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐬𝐮𝐫𝐩𝐫𝐢𝐬𝐞 =
𝛔 (𝐄 (𝐄𝐏𝐒)) - s.d. of analyst’s
forecasts
2) Relative strength indicators
- comparison of a stock’s performance
during a period of time with
➀ its own past performance
➁ some group of stocks

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Review - 9
⇒ Averaging Multiples/

- arithmetic mean ∑𝐗 𝐢
𝐧
𝐧
- harmonic mean
∑ t𝟏A𝐗 u - gives less weight to higher P/E
𝐢
& more weight to lower P/E
harmonic mean < arithmetic mean

- weighted harmonic mean

𝐧 - 𝐰𝐢 are portfolio
𝐰 weights
∑ t 𝐢A𝐗 u
𝐢 ”𝐰𝐢 t𝟏A𝐗 u•
· most accurate 𝐢

∑𝐰𝐢 = 𝟏

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Residual Income Valuation

Review - 1
⇒ Residual Income (economic profit)
Net Incomet – reBt-1
or/ NOPATt – (WACC × TC)

if RI > 0 - company is creating value (shares will sell at

a premuim to BV)
RI < 0 - company is destroying value (shares will sell
at a discount to BV)

⇒ Economic Value Added

EVA = NOPAT – (WACC × TC) +/- adjustments

⇒ Market Value Added

MVA = MVcompany - BVTC - total capital if RI > 0,

MVe + MVd + MVPr MVe > BV

Review - 2
⇒ RI models/
#
𝐑𝐈𝐭
𝐕𝟎 = 𝐁𝐭5𝟏 + , E – EPS
(𝟏 + 𝐫)𝐭
𝐢$𝟏
B – BVPS
# t – end of YR
𝐄𝐭 − 𝐫𝐁𝐭5𝟏 ⇒ (earnings
, t-1 – beg of YR.
(𝟏 + 𝐫)𝐭 - equity charge)
𝐢$𝟏

Bt-1 + Et – Dt = Bt - clean surplus

relation ⇒ earnings reflect all
Et - rBt-1 = RIt changes in BV other than
ownership transactions
Dt = Et – (Bt – Bt-1)

⇒ DDM
# # #
𝐃𝐭 𝐄𝐭 − (𝐁𝐭 − 𝐁𝐭5𝟏 ) 𝐄𝐭 − 𝐫𝐁𝐭5𝟏
𝐕𝟎 = , = , = ,
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭
𝐭$𝟏 𝐭$𝟏 𝐭$𝟏
#
(𝐑𝐎𝐄 − 𝐫) 𝐁𝐭5𝟏
= 𝐁𝟎 + ,
(𝟏 + 𝐫)𝐭
𝐭$𝟏

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#
Review - 3
(𝐑𝐎𝐄 − 𝐫) 𝐁𝐭5𝟏
𝐕𝟎 = 𝐏𝟎 = 𝐁𝟎 + ,
(𝟏 + 𝐫)𝐭
𝐭$𝟏
B0 = Bt-1
(𝐑𝐎𝐄𝐭 5 𝐫) 𝐁𝟎
- constant E&D growth 𝐕𝟎 = 𝐏𝟎 = 𝐁𝟎 + 𝐫5𝐠

𝐏𝟎 𝐑𝐎𝐄 5 𝐫
divide by B0 A𝐁 = 𝟏 + 𝐫 5 𝐠 (justified P/B)
𝟎

· assumes (ROE-r) > 0

(𝐑𝐎𝐄 5 𝐫) 𝐁𝟎
⇒ Single Stage RI/ 𝐕𝟎 = 𝐁𝟎 + persists
𝐫5𝐠
· LR → ROE → r
⇒ Multi-Stage RI/ RI → 0
V0 = B0 + explicit forecast + TV based on
ROE
period continuing RI
stage 1
r continuing RI
t

Review - 4
⇒ Multi-Stage RI/ 𝐄
premium overlook t𝐢𝐞. 𝟏A𝐫u
𝐓
𝐄𝐭 − 𝐫𝐁𝐭(𝟏 𝐏𝐓 − 𝐁𝐓 RI continues
A
(𝟏 + 𝐫)𝐭
+ indefinitely at some
𝐭*𝟏 (𝟏 + 𝐫)𝐓
positive level
𝐕𝟎 = 𝐁𝟎 +
+ 0 ROE = r

𝐓(𝟏
𝐄𝐭 − 𝐫𝐁𝐭(𝟏 𝐄𝐓 − 𝐫𝐁𝐓5𝟏 𝛚 – persistence
A +
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫 − 𝛚)(𝟏 + 𝐫)𝐓5𝟏 factor
𝐭*𝟏

- RI declines to 0 as ROE
+/ · can be used when FCF < 0 reverts to r
& no dividends -/ · clean surplus relation must hold
· can be used when CFs are · relies on actg. data
unpredictable

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Review - 5
⇒ Violations of clean surplus/ · when charges bypass
the I.S. and are made directly to equity

BV stated properly
CI = NI + OCI
NI overstated ∴ ROE not accurate

- if future OCI is expected to be significant and are not

expected to net to zero ⇒ adjust NI
when
Bt-1 + Et – Dt – OCIt = Bt (OCI < 0)

RI = (Et – OCIt) - rBt-1

Other Adjustments/ · Balance Sheet adjustments for FV

(op leases, LIFO to FIFO)
· Nonrecurring Items – removed from OP Inc.

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Private Company Valuation

Review - 1
- Valuation issues: Public vs. Private/
stage in lifecycle (earlier)
size (smaller)
m p a n y
co overlap of shareholders & mgmt.
e c i f ic
sp quality/depth of mgmt.
c to r s
fa quality of financial/other information (disclosure
tax concerns (motivation to not required)
report lower income)

liquidity
stock
c concentration of control (DLOC)
specifi
s
factor marketability (DLOM)

Review - 2
Uses/Issues of Valuation: private financing (VC, PE)
IPO strategic
- transaction related acquisition financial
bankruptcy - restructure? liquidate?
share-based compensation

- compliance related financial reporting

tax reporting
damages
- litigation related lost profits
divorce
Definitions of Value/
- Fair Market Value - includes DLOC & DLOM
- hypothetical value

- Fair Value - market price cannot be determined

- model derived (no DLOC, DLOM)

- Market Value - price currently available in most

advantageous mkt.

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Review - 3
Definitions of Value/
- Investment Value - value to a particular buyer
- Intrinsic Value - value of the whole (DCF)

Valuation Approaches/
growth, mid-size comp.
1) Income approach
DCF
(absolute valuation)
2) Market approach - mature, larger comp.
(relative valuation) 1. guideline public company method
2. guideline transaction method
3. prior transaction method
3) Asset-based approach - smaller, emerging
(absolute valuation)

Earnings Normalization/ - given that the firm is being acquired

- remove non-market/discretionary transactions
(e.g. CEO comp., extra expenses)

Review - 4
Earnings Normalization/
- real estate removed, rental charge added back

Cash Flow Estimation/ - whole - FCFF w/ adjustments (inv. value)

- part - FCFE w/o adjustments (FV)
- substantial cap. structure changes ahead ⇒ FCFF

Discount Rate/ - size premium

- expanded CAPM (+ size + risk pr.)
- build-up approach (rf + ERP + size + risk + industry)
- relative debt availability - as it affects cost of
- acquisition - use target wacc, not acquirer’s debt
optimal, not actual
⇒ Income Approach/ a) FCF method
b) Capitalized CF - single stage FCF model
𝐅𝐂𝐅𝐅 𝐅𝐂𝐅𝐄
𝐕𝐟 = 𝐕𝐞 =
𝐰𝐚𝐜𝐜 − 𝐠 𝐫−𝐠

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Review - 5
⇒ Income Approach/ (smaller companies, rarely used)
c) Excess Earnings Method (EEM)
- r on WC acts. NI (normalized)
- r on Fixed Assets - r(WC)
- r(FCInv)
excess earnings
(𝐄𝐄)(𝟏 + 𝐠) ⇒ value of
(Note: rWC, rFA, rint - not
𝐫𝐢𝐧𝐭 − 𝐠 intangibles
realistic)
⇒ Market Based Approach/ - direct comparisons with public &
acquired companies
𝐌𝐕𝐈𝐂
⟶ 𝐌𝐕𝐞 + 𝐌𝐕𝐝 𝐌𝐕𝐈𝐂
𝐄𝐁𝐈𝐓𝐃𝐀 –𝐕𝐞 = 𝐜𝐨𝐦𝐩. × 𝐄𝐁𝐈𝐓𝐃𝐀 − 𝐌𝐕𝐝 —
𝐄𝐁𝐈𝐓𝐃𝐀
1) GPCM - Public Company Method
- identify comparable, find multiple, adjust r & g
adjust for control

Review - 6
⇒ Market Based Approach/
1) GPCM - control premium/discount adjustment
- transaction strategic - larger premium
financial
- form of consideration - stock vs. cash

less relevant
- industry factors - recent M&A

2) GTM - guidelines transactions method

- multiples from acquisitions (already reflects
- most relevant if available control premiums)
synergies
- may also reflect
contingent consideration
non-cash consideration
3) PTM - prior transactions method - actual transactions
in the stock of the subject company

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Review - 7
⇒ Asset-Based Approach / Vf = FVa - FVL
- considered weakest approach
⇒ Discounts/Premiums/
Control - synergies
control premium
Control - no synergies

Baseline 𝟏
control 𝐭𝐨 𝐠𝐞𝐭 𝐃𝐋𝐎𝐂 = –𝟏 − —
(𝟏 + 𝐂𝐏)
minority interest discount

- DLOM ➞ lack of marketability 1 - [(1 - DLOC)(1 - DLOM)]

(usually applied to non-controlling
equity interests)
⇒ Valuation Standards/ protect users of valuations

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