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Valuation: Intrinsic Valuation

 The essence of intrinsic value
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 In intrinsic valuation, you value an asset based upon its

fundamentals (or intrinsic characteristics).
 For cash flow generating assets, the intrinsic value will
be a function of the magnitude of the expected cash
flows on the asset over its lifetime and the uncertainty
about receiving those cash flows.
 Discounted cash flow (DCF) valuation is a tool for estimating
intrinsic value, where the expected value of an asset is written
as the present value of the expected cash flows on the asset,
with either the cash flows or the discount rate adjusted to
reflect the risk.

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 The two faces of discounted cash flow valuation
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 The value of a risky asset can be estimated by discounting the

expected cash flows on the asset over its life at a risk-adjusted
discount rate:

where the asset has an n-year life, E(CFt) is the expected cash flow in period t
and r is a discount rate that reflects the risk of the cash flows.
 Alternatively, we can replace the expected cash flows with the
guaranteed cash flows we would have accepted as an alternative
(certainty equivalents) and discount these at the risk-free rate:

where CE(CFt) is the certainty equivalent of E(CFt) and rf is the riskfree rate.

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 Risk Adjusted Value: Two Basic Propositions
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 The value of an asset is the risk-adjusted present value of the

cash flows:

1. The “IT” proposition: If IT does not affect the expected cash flows
or the riskiness of the cash flows, IT cannot affect value.
2. The “DON’T BE A WUSS” proposition: Valuation requires that you
make estimates of expected cash flows in the future, not that you
be right about those cashflows. So, uncertainty is not an excuse for
not making estimates.
3. The “DUH” proposition: For an asset to have value, the expected
cash flows have to be positive some time over the life of the asset.
4. The “DON’T FREAK OUT” proposition: Assets that generate cash
flows early in their life will be worth more than assets that
generate cash flows later; the latter may however have greater
growth and higher cash flows to compensate.

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 DCF Choices: Equity Valuation versus Firm
Valuation
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Firm Valuation: Value the entire business

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives

Equity valuation: Value just the

equity claim in the business

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 1. Equity Valuation
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Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth Discount rate reflects only the
Growth Assets Equity cost of raising equity financing

Present value is value of just the equity claims on the firm

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 2. Firm or Business Valuation
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Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets, Discount rate reflects the cost
prior to any debt payments of raising both debt and equity
but after firm has financing, in proportion to their
reinvested to create growth
assets use
Growth Assets Equity

Present value is value of the entire firm, and reflects the value of
all claims on the firm.

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 Firm Value and Equity Value
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 To get from firm value to equity value, which of the

following would you need to do?
a. Subtract out the value of long-term debt
b. Subtract out the value of all debt
c. Subtract the value of any debt that was included in the cost of
capital calculation
d. Subtract out the value of all liabilities in the firm
 Doing so, will give you a value for the equity which is
a. greater than the value you would have got in an equity
valuation
b. lesser than the value you would have got in an equity
valuation
c. equal to the value you would have got in an equity valuation

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 Cash Flows and Discount Rates
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 Assume that you are analyzing a company with the following

cashflows for the next five years.
Year CF to Equity Interest Expense (1-t) CF to Firm
1 $ 50 $ 40 $ 90
2 $ 60 $ 40 $ 100
3 $ 68 $ 40 $ 108
4 $ 76.2 $ 40 $ 116.2
5 $ 83.49 $ 40 $ 123.49
Terminal Value $ 1603.0 $ 2363.008
 Assume also that the cost of equity is 13.625% and the firm can
borrow long term at 10%. (The tax rate for the firm is 50%.)
 The current market value of equity is $1,073 and the value of debt
outstanding is $800.

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 Equity versus Firm Valuation
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 Method 1: Discount CF to Equity at Cost of Equity to get value

of equity
 Cost of Equity = 13.625%
 Value of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 +
76.2/1.136254 + (83.49+1603)/1.136255 = $1073
 Method 2: Discount CF to Firm at Cost of Capital to get value
of firm
 Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%
Cost of Capital = 13.625% (1073/1873) + 5% (800/1873) = 9.94%
 PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 +
(123.49+2363)/1.09945 = $1873
 Value of Equity = Value of Firm - Market Value of Debt
= $ 1873 - $ 800 = $1073

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11 DCF: First Steps
 Generic DCF Valuation Model
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 Same ingredients, different approaches…
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Input Dividend Discount FCFE (Potential FCFF (firm)

Model dividend) discount valuation model
model
Cash flow Dividend Potential dividends FCFF = Cash flows
= FCFE = Cash flows before debt
after taxes, payments but after
reinvestment needs reinvestment needs
and debt cash and taxes.
flows
Expected growth In equity income In equity income In operating
and dividends and FCFE income and FCFF
Discount rate Cost of equity Cost of equity Cost of capital
Steady state When dividends When FCFE grow at When FCFF grow at
grow at constant constant rate constant rate
rate forever forever forever

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 Start easy: The Dividend Discount Model
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 Moving on up: The “potential dividends” or FCFE
model
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16 Discount Rates
The D in the DCF..
 Estimating Inputs: Discount Rates
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 While discount rates obviously matter in DCF valuation, they

don’t matter as much as most analysts think they do.
 At an intuitive level, the discount rate used should be
consistent with both the riskiness and the type of cashflow
being discounted.
 Equity versus Firm: If the cash flows being discounted are cash flows to
equity, the appropriate discount rate is a cost of equity. If the cash
flows are cash flows to the firm, the appropriate discount rate is the
cost of capital.
 Currency: The currency in which the cash flows are estimated should
also be the currency in which the discount rate is estimated.
 Nominal versus Real: If the cash flows being discounted are nominal
cash flows (i.e., reflect expected inflation), the discount rate should be
nominal

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 Risk in the DCF Model
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 The Cost of Equity: Competing “ Market Risk” Models
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Model Expected Return Inputs Needed

CAPM E(R) = Rf +  (Rm- Rf) Riskfree Rate
Beta relative to market portfolio
Market Risk Premium
APM E(R) = Rf + j (Rj- Rf) Riskfree Rate; # of Factors;
Betas relative to each factor
Factor risk premiums
Multi E(R) = Rf + j (Rj- Rf) Riskfree Rate; Macro factors
factor Betas relative to macro factors
Macro economic risk premiums
Proxy E(R) = a +  j Yj Proxies
Regression coefficients

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 Classic Risk & Return: Cost of Equity
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 In the CAPM, the cost of equity:

Cost of Equity = Riskfree Rate + Equity Beta * (Equity Risk
Premium)
 In APM or Multi-factor models, you still need a risk
free rate, as well as betas and risk premiums to go
with each factor.
 To use any risk and return model, you need
 A risk free rate as a base
 A single equity risk premium (in the CAPM) or factor risk
premiums, in the the multi-factor models
 A beta (in the CAPM) or betas (in multi-factor models)

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21 Discount Rates I
The Risk-free Rate
 The Risk Free Rate: Laying the Foundations
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 On a risk-free investment, the actual return is equal to the expected

return. Therefore, there is no variance around the expected return.
 For an investment to be risk-free, then, it has to have
 No default risk
 No reinvestment risk
 It follows then that if asked to estimate a risk free rate:
1. Time horizon matters: Thus, the risk-free rates in valuation will depend
upon when the cash flow is expected to occur and will vary across time.
2. Currencies matter: A risk free rate is currency-specific and can be very
different for different currencies.
3. Not all government securities are risk-free: Some governments face
default risk and the rates on bonds issued by them will not be risk-free.

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23 Discount Rates: II
The Equity Risk Premium
24 Discount Rates: III
Relative Risk Measures
 The CAPM Beta: The Most Used (and
Misused) Risk Measure
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 The standard procedure for estimating betas is to regress

stock returns (Rj) against market returns (Rm) -
Rj = a + b Rm
where a is the intercept and b is the slope of the regression.
 The slope of the regression corresponds to the beta of
the stock, and measures the riskiness of the stock.

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 The Cost of Equity: A Recap
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27
Estimating Cash Flows
Cash is king…
 Free Cash Flow: FCFE and FCFF
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 Steps in Cash Flow Estimation
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 Estimate the current earnings of the firm

 If looking at cash flows to equity, look at earnings after interest
expenses - i.e. net income
 If looking at cash flows to the firm, look at operating earnings after
taxes
 Consider how much the firm invested to create future growth
 If the investment is not expensed, it will be categorized as capital
expenditures. To the extent that depreciation provides a cash flow, it
will cover some of these expenditures.
 Increasing working capital needs are also investments for future
growth
 If looking at cash flows to equity, consider the cash flows from
net debt issues (debt issued - debt repaid)

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 Measuring Free Cash Flow to Equity:
Alternative Pathways
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31 Cash Flows III
From the firm to equity
 FCFE from the statement of cash flows
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 The statement of cash flows can be used to back into a

FCFE, if you are willing to navigate your way through it
and not trust it fully.
 FCFE
= Cashflow from Operations
- Capital Expenditures (from the cash flow from investments)
- Cash Acquisitions (from the cash flow from investments)
- (Debt Repaid – Debt Issued) (from financing cash flows)
= FCFE
 Alternatively, you can also do the following:
 FCFE – Dividends + Stock Buybacks – Stock Issuances + Change
in Cash Balance

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33
Estimating Growth
Growth can be good, bad or neutral…
 The Value of Growth
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 When valuing a company, it is easy to get caught up in

the details of estimating growth and start viewing
growth as a “good”, i.e., that higher growth translates
into higher value.
 Growth, though, is a double-edged sword.
 The good side of growth is that it pushes up revenues and
operating income, perhaps at different rates (depending on how
margins evolve over time).
 The bad side of growth is that you have to set aside money to
reinvest to create that growth.
 The net effect of growth is whether the good outweighs the bad.

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 Ways of Estimating Growth in Earnings
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 Look at the past

 The historical growth in earnings per share is usually a
good starting point for growth estimation
 Look at what others are estimating
 Analysts estimate growth in earnings per share for many
firms. It is useful to know what their estimates are.
 Look at fundamentals
 With stable margins, operating income growth can be tied
to how much a firm reinvests, and the returns it earns.
 With changing margins, you have to start with revenue
growth, forecast margins and estimate reinvestment.

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36 Growth I
Historical Growth
 Historical Growth
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 Historical growth rates can be estimated in a number

of different ways
 Arithmetic versus Geometric Averages
 Simple versus Regression Models

 Historical growth rates can be sensitive to

 The period used in the estimation (starting and ending
points)
 The metric that the growth is estimated in..

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 A Test
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 You are trying to estimate the growth rate in

earnings per share at Time Warner from 1996 to
1997. In 1996, the earnings per share was a deficit of
$0.05. In 1997, the expected earnings per share is $
0.25. What is the growth rate?
a. -600%
b. +600%
c. +120%
d. Cannot be estimated

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 Dealing with Negative Earnings
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 When the earnings in the starting period are negative,

the growth rate cannot be estimated. (0.30/-0.05 = -
600%)
 There are three solutions:
 Use the higher of the two numbers as the denominator (0.30/0.25 =
120%)
 Use the absolute value of earnings in the starting period as the
denominator (0.30/0.05=600%)
 Use a linear regression model and divide the coefficient by the average
earnings.
 When earnings are negative, the growth rate is
meaningless. Thus, while the growth rate can be
estimated, it does not tell you much about the future.

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40 Growth II
Analyst Estimates
 Analyst Forecasts of Growth
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 While the job of an analyst is to find under and over

valued stocks in the sectors that they follow, a significant
proportion of an analyst’s time (outside of selling) is
spent forecasting earnings per share.
 Most of this time, in turn, is spent forecasting earnings per share
in the next earnings report
 While many analysts forecast expected growth in earnings per
share over the next 5 years, the analysis and information
(generally) that goes into this estimate is far more limited.
 Analyst forecasts of earnings per share and expected
growth are widely disseminated by services such as
Zacks and IBES, at least for U.S companies.

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42
Closure in Valuation
 Getting Closure in Valuation
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 A publicly traded firm potentially has an infinite life. The

value is therefore the present value of cash flows forever.
t=¥ CF
Value = å t
t
t=1 (1+r)

 Since we cannot estimate cash flows forever, we estimate

cash flows for a “growth period” and then estimate a
terminal value, to capture the value at the end of the period:
t=N CF
Value = å t + Terminal Value
t (1+r) N
t=1 (1+r)

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 Ways of Estimating Terminal Value
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Approach Inputs and Value Types of business

Liquidation Liquidation value of assets held Businesses built around
Value by the firm in the terminal year. a key person or a time-
limited competitive
advantage (license or
patent)
Going Concern TV in year n = CFn+1/ (r – g), where Going concerns with
(Perpetuity) g = growth rate forever long lives (>40 years)
Going Concern TV in year n = PV of CF in years Going concerns with
(Finite) n+1 to n+ k, where k is finite shorter lives

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 1. With perpetual growth, obey the growth cap
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 When a firm’s cash flows grow at a “constant” rate forever, the

present value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
 The stable growth rate cannot exceed the growth rate of the
economy but it can be lower.
• If the economy is composed of high growth and stable growth firms, the
growth rate of the latter will be lower than the growth rate of the
economy.
• The stable growth rate can be negative, for companies in declining
businesses.

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46 The Dark Side of Valuation
Anyone can value a company that is stable,
makes money and has an established
business model!
 The fundamental determinants of value…
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 The Dark Side of Valuation…
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 Valuing stable, money making companies with

consistent and clear accounting statements, a long and
stable history and lots of comparable firms is easy to do.
 The true test of your valuation skills is when you have to
value “difficult” companies. In particular, the challenges
are greatest when valuing:
 Young companies, early in the life cycle, in young businesses
 Companies that don’t fit the accounting mold
 Companies that face substantial truncation risk (default or
nationalization risk)

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 Difficult to value companies…
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 Across the life cycle:

 Young, growth firms: Limited history, small revenues in conjunction with big operating losses
and a propensity for failure make these companies tough to value.
 Mature companies in transition: When mature companies change or are forced to change,
history may have to be abandoned and parameters have to be reestimated.
 Declining and Distressed firms: A long but irrelevant history, declining markets, high debt loads
and the likelihood of distress make them troublesome.
 Across markets
 Emerging market companies are often difficult to value because of the way they are
structured, their exposure to country risk and poor corporate governance.
 Across sectors
 Financial service firms: Opacity of financial statements and difficulties in estimating basic
inputs leave us trusting managers to tell us what’s going on.
 Commodity and cyclical firms: Dependence of the underlying commodity prices or overall
economic growth make these valuations susceptible to macro factors.
 Firms with intangible assets: Accounting principles are left to the wayside on these firms.

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 I. The challenge with young companies…
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 Upping the ante.. Young companies in young
businesses…
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 When valuing a business, we generally draw on three sources of information

 The firm’s current financial statement
◼ How much did the firm sell?
◼ How much did it earn?
 The firm’s financial history, usually summarized in its financial statements.
◼ How fast have the firm’s revenues and earnings grown over time?
◼ What can we learn about cost structure and profitability from these trends?
◼ Susceptibility to macro-economic factors (recessions and cyclical firms)
 The industry and comparable firm data
◼ What happens to firms as they mature? (Margins.. Revenue growth… Reinvestment
needs… Risk)
 It is when valuing these companies that you find yourself tempted by the dark
side, where
 “Paradigm shifts” happen…
 New metrics are invented …
 The story dominates and the numbers lag…

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 52

VALUE, PRICE AND

INFORMATION:
CLOSING THE DEAL
Value versus Price
 Are you valuing or pricing?
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Tools for pricing

Tools for intrinsic analysis Tools for "the gap" - Multiples and comparables
- Discounted Cashflow Valuation (DCF) - Behavioral finance - Charting and technical indicators
- Intrinsic multiples - Price catalysts - Pseudo DCF
- Book value based approaches
- Excess Return Models

Value of cashflows, INTRINSIC THE GAP

adjusted for time PRICE
VALUE Value Is there one? Price
and risk Will it close?

Drivers of intrinsic value

- Cashflows from existing assets Drivers of "the gap" Drivers of price
- Information - Market moods & momentum
- Growth in cash flows
- Quality of Growth - Liquidity - Surface stories about fundamentals
- Corporate governance

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Value versus Price

View of the gap Investment Strategies

The Efficient The gaps between price and value, if Index funds
Marketer they do occur, are random.
The “value” You view pricers as dilettantes who Buy and hold stocks
extremist will move on to fad and fad. where value < price
Eventually, the price will converge on
value.
The pricing Value is only in the heads of the (1) Look for mispriced
extremist “eggheads”. Even if it exists (and it is securities.
questionable), price may never (2) Get ahead of shifts in
converge on value. demand/momentum.

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WHAT’S NEXT?
 Submitting the assignment
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 You are required to value the equity of your firm,

using DCF method.
 In the report, you need to write about:
 How did you do the valuation (step by step)?
 What is your opinion on the equity value? Over/under value?
 When you done this, together with the firm financial
analysis report (Assignment 1), submit it to E-
learning, by the deadline:
 5pm – Tuesday, 7th Jan 2024
 What to submit:
 1 report (including Assignment 1 and Assignment 2).
 The excel model for valuation.
 The group evaluation form.

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 Recommended outline
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 Part A: Financial Analysis and Forecasting

◼ …
◼ …
◼ (Follow the order that you have done in the 1st Assignment)
 Part B: Equity Valuation
◼ Cost of Equity
◼ Beta
◼ Risk-free rate
◼ Market return
◼ Free cashflows to Equity
◼ Terminal Value
◼ Value of equity
◼ Conclusions

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