Valuation Methods

You can estimate market values of companies using

DCF, Economic Value Added or Residual Income
Em via DCF = [FCFi/(1+Rwacc)i] Dm
Em via EVA = IK0 + [EBITix(1-T)-IKixRwacc] - Dm
____________________(1+Rwacc)I
Em via Residual Income = EB0+[(NIi-EBixRe)/(1+Re)i

Dividend Discount Model also works!!!

Although less often used, the Dividend
Discount Model can help you find Em
Em = Divi/(1+Re)I
It is a deceivingly simple method, but may
not work well in real sector companies as
these may not pay regular dividends
Is there a way to check DDM ~ DCF et al?

Valuing Coke using DDM

Question to ask when valuing Coke with the DDM
method is What is the maximum dividend Coke
can afford to pay while still allowing it to grow at
its trend growth of 1.5% without new equity?
To answer the above question, we know this:
SGR = RxROE/(1-RxROE), where R=[NI-Divs]/NI
Set SGR=2%, and take ROEKO=25%. If we know
that last 12 mos of NI = $8.37B, then Div=$7.7B

Note: SGR stands for sustainable growth rate (the maximum growth level a company can self-fund without additional equity issues). This SGR can be found by either of the
following two equations: SGR = RxROE/(1-RxROE) or SGR = ROICxFLx(1-d)/(1-ROICxFLx(1-d)), where ROIC=EBITx(1-T)/IK, FL = (Eb+Db)/Eb and d=1-(NI-Divs)/(EBIT(1-T))

Valuing Coke using DDM

If we assume Dividends grow at 1.5% and that Re,
based on current data, is 6% (from Rf+Be x (Rm-Rf) =
2.4%+0.6x6%), then:
Em = $7.7Bx(1+1.5%)/(6%-1.5%)+Excess Cash
Em = $187.65B (Ps=$42)
As of Aug 7th, 14, Cokes MarketCap = $173B (Ps=$39)
Note that Cokes 12mo trailing DIVs are $5.27B but
we used $7.7B (from SGR formula). Why?
Because $7.7B is the highest Coke can pay and still be able to grow
at its trend of 1.5% without requiring additional equity
If we had used $5.27B, we wouldve undervalued Coke using DDM

Valuing Coke using DDM

How did we find the expected growth? We assumed it would be the growth priced in the stock price

EBIT
Dep
CAPex
-Inc WK

$
$
$
$

FCF
Rdx(1-T)
Re
Rwacc
EC
Em
gimp

Ps

7,000,200
1,997,000
(2,511,000)
(352,000)

6,134,200
1.56% $ 18.64
6.00% $ 173.00
5.57%
$
9,307,000
$ 173,000,000
1.61%

39.41

ROE
R
g*

25%
7.994%
2.04%

NI
DIV
R

$
$

EC
Em

$ 9,307,000
$ 187,655,228

Ps

Note: See Appendix for an expanded view of this exercise

8.37
7.70
7.994%

42.75

DDM needs some tweaks, so why use it?

Is best to use DCF or EVA before relying on DDM,
specially for Real Sector companies that dont pay
dividends
Whether companies pay or not pay dividends, we must find
a level of dividends based on growth trends and SGR. This is
due to the fact that even what companies pay might not be
suited for use in DDM valuations (as was the case with Coke)

However, DDM is most helpful to value commercial

and investment banks. For these type of companies
(Financial Institutions), DDM works like a charm

More on why DDM is good for FIs

DDM is well suited to value banks because:
Banks operate under very tight regulations
Banks have stable dividend policies. That allows us to look
back and, just as easy, project dividends forward
Unlike real sector companies (which buy raw inputs to
manufacture products which then are sold for money), banks
raw inputs are money. Banks then use that capital to create
money-like products and sell these, again, for money.
Concepts of working capital needs are thus very different.
Banks also invest more on IT technology than on CAPex and
those IT investments are expensed as they occur. As such, Net
Income (from which Divs come) includes good info about it.
Banks pool all funds (a dollar from deposits might end up
exactly where another dollar in Long Term Debt ended up) to
invest in various projects (whether it be lending to people or
investing in companies). As a result, as Banks even use its
Deposits (a short term liability), is not as easy to estimate a
reasonable Em% and Dm% to weigh Rd and Re in WACC

Using DDM to value Banks

See Damodaran article on valuing Banks using DDM

http://tinyurl.com/d9gghzo

What is the alternative to DDM in FIs?

An alternative to DDM is to value Banks via their
fundamentals
Valuing the bank via its fundamentals requires
another set of tools that is different to those used
for real sector companies
Well expand more on banks fundamental
valuation towards the end of the course because
DDM is only a rough approximation. For ex, what
would we say are the right dividends when
projected growth >> SGR? Or, what would we do
if Net Income is biased by accounting gimmicks?

But lets return to Divs for Real Sector companies

We can still ask Why should companies return capital to their
shareholders? Why not keep Excess Capital for extreme situations?
Well lets start by saying that such Excess Capital belongs to
shareholders if they so like (Managers have to convince shareholders
that they have good use for the Excess Cash, or else dividend it out)
Excess Cash in a company belongs to those who invested in the company
assets that generated it, not to agents managing these assets. By contrast,
your parents earned excess cash by way of labor and own the rights to it.
They are simultaneously shareholders and managers of their assets.

That said (that Shareholders, not managers, own the rights to the
Excess Cash), there is also a value-conservation rationale to divesting
Excess Cash when good corporate opportunities are hard to come by

If IKi (invested capital on ith year) is larger than needed (as when
Excess Cash is there), the right side term of IKi x Rwacc (a.k.a. capital
charge) will make the value in between brackets smaller!!!

But lets return to Divs for Real Sector companies

Moreover, paying dividends to shareholders
provides some added benefit to stock owners:
Shareholders pay lower capital gain tax on dividends
Shareholders can then reinvest cash where they want

So when do companies accumulate Excess Cash?

Cash increases when projected growth (gp) <<< SGR
Growing below SGR is not so bad (i.e. Cokes SGR=11% but
youd be happy with a 0%-2% growth due to saturation)
When gp <<< SGR, company consumes less than its
invested capital
When gp >>> SGR, it consumes more than its invested
capital (so the company either can issue new equity, can
improve its SGR by levering itself and/or improving its
ROIC or it can grow below SGR to avoid funds shortage)

But, I hear that Cash is King

We wrap up by questioning the wisdom of the Cash is King
idiom in corporate settings
Is not that Cash does not serve us well at times of need, but
rather that if it can not be invested above the companys
opportunity cost (Rwacc), too much of it destroys value
In spite of the above, there may be times when you, as a
manager, convince shareholders to hold some or most of the
Excess Cash for valid purposes (i.e. buy a competitor using cash,
guarantee solvency during potential bank system crisis )
Lastly, think of it this way: Would you prefer holding cash at the
expense of growth, even when economically profitable growth
can be attained by putting that Excess Cash to work?

Returning to valuing Banks

(2) Now, to have a more

precise valuation (closer to the
real sector company technique
DCF but for banks), we need a
new valuation paradigm for FIs

Fundamental
Valuation

Valuation
shortcuts

(3) An interesting thing on valuation

shortcuts: What works for real sector
companies does NOT work for FIs

(1) Damiodarans article

proposes DDM as way to value
banks but that is somewhere
between a valuation shortcut
and a fundamental valuation

To understand the FIs Fundamental

Valuation model, we need to delve
deeper into the topology of banks

The FIs Fundamental Valuation model

- Separates FIs into fee and Fin Instrs side
- Values fee side discounting FCFEs by Re
- Values Financial Instruments side using:
PVLiquidationValue + PVFranchise Value -PVOPEX-PVTaxpenalty
This technique is sometimes referred to as the Balance Sheet approach

Lets focus on the traditional side, the least understood

The FIs Fundamental Valuation model

Liabs+Equity

DIVi = NIi-(TEi-TEi-1) because: NIi+Tei-1 DIVi =TEi

Value of Taxable Bond

Single Component

Value of Taxable Bond

Two Components

TB

ETFB

TB

ETFB

PV taxable bond = PV tax-free bond + (Addnl Cap Gains on taxable bond) x T

ETFB

TB