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FCF (Free Cash Flows) - The cash that is actually available to distribute to investors after the
company has made all investments in working capital and fixed assets necessary to sustain ongoing
business operations. You would see this as dividends in a cash flow statement.
DCF (Discounted Cash Flows) - A way of measuring the intrinsic value of a company, (or asset or
project proposal), It's purpose is to figure out the company value now based upon projections of all the
cash it could potentially make available to investors in the future. The purpose of "discounting" is to take
into consideration the time value of money.
Hi Class,
I hope you find this attachment helpful. I break down each of the formulas and valuation
definitions on your worksheet that we will be completing this Tuesday. Remember, this
worksheet is "conceptual" in nature, so the questions are looking to see your understanding of the
formulas. No calculations are being done for the worksheet. At the bottom of the attachment,
I've included some links for some basic videos on investopedia.com to exemplify understanding.
Risk Free Rate: (Intermediate rate of return on Treasury Bonds historical yield on
treasury bills) / Rate of return on Treasury Bills
Market Risk Premium: The premium required by investors for accepting risk
above and beyond the risk free rate.
Abnormal Earnings Model: (See question 2 on your Forecasting Worksheet);
Also known as the Residual Earnings Model. To understand this model, lets first
understand the difference between the Book Value of the firm and the Market
Value of the firm. The book value of the firm is an accounting value. Broadly
stated, it is calculated from the firms balance sheet as follows: Assets Liabilities =
Equity, (Book Value). What this is saying is the Equity section of the balance sheet
is effectively the book value of the firm.
The market value of the firm is the valuation of the firms stock price by the market.
Effectively the stock price.
If the book value of the firm is lower than the market value of the firm, then the firm
is valued higher than its stated value, which is good for investors. If the book value
of the firm is greater than the market value, then the market is valuing the firm for
less than its stated value, which is not good for investors. In other words, the
market doesnt believe or have faith that the firm can generate the cash flow and
profits required by investors.
Conceptually, every stock is worth the book value per share if an investor expects to
receive a normal rate of return. A rate of return that is unexpected will cause a
deviation in the firms stock price.
This deviation is typically attributed to
management whether they are over or under delivering profitability results based
upon their operation of the business. The Abnormal Earnings model attempts to
arrive at a real value of the stock based upon these deviations from the normal
return.
Now lets look at the model 3(b) formula on your worksheet. This is also known as
the clean surplus relation. This formula is calculating the Book Value for the firm
at the end of the period. Book Value at the end of the year, B t, is equal to the book
value of the firm at t-1, (which is the BV at the beginning of the period), plus the
earnings in year t less the dividends paid to stock holders.
Moving to model 3(a), we can evaluate the Abnormal Earnings, (AE). AE t = Xt-rEBt-1
Abnormal Earnings at time t, (end of the period), is equal to the earnings in year t,
(earnings at the end of the period) less the expected return on the Book Value at
time t-1 (meaning book value at the beginning of the period).
The result of this formula tells us the amount of earnings we can attribute to
management performance over or under the normal expected return.
Now looking to model 3, we see that the market value of the firm at F, (the forecast
period), is equal to the book value of the the firm at time F plus the sum of AE t
divided by (1+rE)t, (Abnormal Earnings at time t divided by 1 + the expected return
to the power of time t.)
http://www.investopedia.com/video/play/understanding-enterprise-value/
http://www.investopedia.com/video/play/compound-annual-growth-rate/
http://www.investopedia.com/video/play/return-on-equity/