Approaches to Valuation

Approaches to Valuation
ValuationModels

AssetBased
Valuation

DiscountedCashflow
Models

RelativeValuation

Liquidation
Value

Equity
Stable

Current

ContingentClaim
Models

Sector

Twostage
Threestage
ornstage

EquityValuation
Models

Normalized

Earnings Book Revenues

Value

Sector
specific

Young
firms

Dividends
Costofcapital
approach

APV
approach

ExcessReturn
Models

Optionto
liquidate
Equityin
troubled
firm

Undeveloped
land

FirmValuation
Models
Patent

FreeCashflow
toFirm

Optionto
expand

Firm
Market

Replacement
Cost

Optionto
delay

Undeveloped
Reserves

Valuation
Equity shareholders

All stakeholders

Equity valuation

Firm valuation

Equity Valuation Models

Dividend discount model

Free cash flow to

equity model

Equity Discounted Models

Dividend Discount Model

Free Cash flow to Equity

(Actual Dividend Paid)

(Potential Dividend)

Single Stage

Two Stage

Three stage Single Stage

Two Stage Three stage

Dogs of Dow

Dogs of Dow

Dogs of Dow
Buying the stocks with the highest dividend yield in the index
every year
CRISIL and GlaxoSmithKline have doubled their dividend
rate in three years while maintaining a payout of 70 % plus

Limitations of Dogs of Dow

But buying stocks based only on their current dividend yield, without
looking into their business prospects, can be fraught with risk
Buying stocks purely for their current dividend yield can backfire if the
company happens to be in a cyclical business
In April Varun Shipping. With a regular dividend payout of Rs 5 per share
on a market price of Rs 50, Dividend yield = 10 %
Between 2007-08 and 2009-10, the companys dividend rate plummeted
from 50 to 8 per cent, as profits dropped by 90 per cent
GE Shipping, Excel Crop Care, Prime Securities falling victim to lower
dividend yield owing to the cyclical swings in their core business
Buying stocks based on just their current dividend yield can be fraught with
risk. Focus on dividend potential instead

 India Card Clothing

It was one of the highest dividend yielding stocks in the
market five years ago, paying out annual dividends of 125
per cent, translating into a yield of nearly 8 per cent in
2007.
But the fluctuating fortunes of the textile industry have led
to high volatility in profits of this company too.
Its annual dividend payouts have declined from 125 per
cent to 30 per cent over five years
India is today one of the lowest dividend yielding markets
in the world. (The Nifty companies dividend yield is 1.6
per cent).
Average dividend payout ratios hover at 26 per cent for
NSE-listed companies.

Single Stage Dividend Discount Model

When should I use this model?
This model is applicable when the dividend paid is 75
% or above the Free cash flows to equity and the
company is in a stable growth category.
How do I find the value of the company under this
model?
The value of the company is calculated by using
Gordon Model of dividend policy.
What does Gordon Model say about the value of a
company?
Under Gordon Model, the value of share depends on the
expected dividend and growth in dividend forever.

Gordon Model of Dividend Policy

Cost of Equity

Ke = D/P + g

Value of Share

Value of stock = D/Ke - g

What are the inputs required for this model?

Value of stock = D/Ke - g

3 Basic Inputs Required for Gordon Model

Expected dividend
Cost of equity
Growth rate

Dividend for the

next year
CAPM
Growth in dividend
forever

THE FCFE Discount Models

Selection of DCF Model

Firm

All investors
Equity + Debt holders

Equity Shareholders

Equity Valuation
Models

Dividend
Discount Models

Single Stage

Firm Valuation
Models

FCFE Models

Two Stage

FCFF Models

Three stage or
Multi stage

Firm

Leverage is
constant

Yes

Equity valuation
model

yes

D/P ratio is
more than
75 %

Dividend Discount
Model

NO

Firm Valuation
model

NO

Equity valuation
model

Single Stage, Two stage, Three stage or Multi Stage

THE FCFE Discount Models

The Constant Growth FCFE Model / single stage

growth model
The Two -Stage FCFE Model
The Three stage FCFE Model

The constant growth FCFE Model

The constant-growth FCFE Model
The constant growth FCFE model is designed to value firms
that are growing at a stable-growth rate and are hence in
steady state.

What is stable growth rate?

The growth rate of the firm has to be reasonably relative to the
nominal growth rate in the economy in which the firm
operates.
The stable growth rate cannot exceed the growth rate of the
economy in which the firm operates by more than one or two
percent.

The constant growth FCFE Model

The model is appropriate when
the firm has to be in steady state
capital expenditure is not significantly greater than
depreciation / capital expenditure is offset by depreciation
the beta of the stock is close to one or below one
The firm FCFE which are significantly different from
dividends or dividends are not relevant
The leverage is stable

The constant growth FCFE Model

Value of Equity
Po = FCFE1
Ke g
Po = Value of stock today
FCFE1 = Expected FCFE over the next year
Ke = cost of equity of the firm
g =growth rate

Calculation of FCFE
Earnings per share

xxxxxxx

- ( Capital spending - depreciation) x (1 - Debt ratio)

xxxxxxx

- ( change in non cash working capital) x ( 1 - Debt ratio)

xxxxxxx

-----------------------Free Cash Flow to Equity

xxxxxx

------------------------

How do you measure change in working

capital?

The Constant Growth FCFE Model

Calculate the value of stock by using the following data
Earnings per share = Rs 154.53
Capital Expenditure per share = Rs 421
Depreciation per share = Rs 285
Change in working capital = None
Debt financing ratio = 50 %
Expected growth rate = 10 %
The beta for the stock is 0.90, long-term bond rate is 9.50 % and
risk premium is 6.50 %

The Constant Growth FCFE Model

In 2003 Indian Oil Corporation had earnings per share of Rs 40.65 and
paid out dividends of Rs 13 per share. The capital spending per share was
Rs 109 and the depreciation per share was Rs 91.12 in 2003. The working
capital increased by Rs 4.48 per share from 2002 to 2003. IOC was
expected to maintain a growth rate of 6 % in the long term.
The firm had a debt equity ratio of only 11.7 % and was expected to
maintain it for the foreseeable future. The stock had a beta of 0.89, relative
to BSE sensex. The 10-year RBI bond rate was 6.42 % and the risk
premium used is 3.50 %.
Calculate the value of stock.

The Constant Growth FCFE Model

LG electronics, a household product manufacturer, reported earnings per share of $3.20 in
2003, and paid dividends per share of $1.70 in that year. The firm reported depreciation of
$315 million in 2003, and capital expenditures of $475 million. (There were 160 million shares
outstanding, trading at $51 per share.) This ratio of capital expenditures to depreciation is
expected to be maintained in the long term. The working capital needs are negligible. LG
electronics had debt outstanding of $1.6 billion, and intends to maintain its current financing
mix (of debt and equity) to finance future investment needs. The firm is in steady state and
earnings are expected to grow 7% a year. The stock had a beta of 1.05. (The Treasury bond
rate is 6.25%.) and risk premium used is 5.5 %
1. Estimate the value per share, using the Dividend Discount Model.
2. Estimate the value per share, using the FCFE Model.
3. How would you explain the difference between the two models, and which one would you
use as your benchmark for comparison to the market price?

FCFE Two stage model

FCFE Two Stage Model

Ecolab Inc. sells chemicals and systems for cleaning, sanitizing, and maintenance. It
reported earnings per share of $2.35 in 2012, and expected earnings growth of 15.5%
a year from 2013 to 2017, and 6% a year after that. The capital expenditure per share
was $2.25, and depreciation was $1.125 per share in 2012. Both are expected to grow
at the same rate as earnings from 2013 to 2017. Working capital is expected to remain
at 5% of revenues, and revenues which were $1,000 million in 2012 are expected to
increase 6% a year from 2013 to 2017, and 4% a year after that. The firm currently has
a debt ratio (D/(D+E)) of 5%, but plans to finance future investment needs (including
working capital investments) using a debt ratio of 20%. The stock is expected to have a
beta of 1.00 for the period of the analysis, and the treasury bond rate is 6.50%. (There
are 63 million shares outstanding.) The market risk premium is 5.5 %
A. Assuming that capital expenditures and depreciation offset each other after 2017,
estimate the value per share.

ECOLAB SOLUTION
Growth rate = 15.5 %

G.R = 6 %

2012

2013

2014

2015

2016

2017

2018

Year
EPS
Capx
Dep
Change in WC
FCFE
Terminal price (Pn)
Net cash flows

2012
Revenue
WC
Change in WC
Change in WC per share

2013
2014
2015
2016
2017
Calculation of change in working capital

2018

2012

2013

2014

2015

2016

2017

2018

Calculation of change in working capital

Revenue
WC

1000.00
50.00

1060.00
53.00

1123.60
56.18

1191.02
59.55

1262.48 1338.23
63.12

66.91

1391.75
69.5.00

Change in WC

3.00

3.18

3.37

3.57

3.79

2.67

Change in WC per share

0.05

0.05

0.05

0.06

0.06

0.042

2012
0
2.35
2.25
1.125

Year
EPS
Capx
Dep
Change in WC
FCFE
Terminal price (Pn)
Net cash flows

ECOLAB SOLUTION
Growth rate = 15.5 %
2013
2014
2015
2016
1
2
3
4
2.71
3.13
3.62
4.18
2.60
3.00
3.47
4.00
1.30
1.50
1.73
2.00
0.05
0.05
0.05
0.06
1.63
1.89
2.19
2.53
1.63

Year

1.89

2.19

2.53

Calculation of present value

cash flows PV @ 12 % T.cash flows
1
1.63
0.893
1.46
2
1.89
0.797
1.51
3
2.19
0.712
1.56
4
2.53
0.635
1.61
5
87.67
0.567
49.71
Value per
share
55.84

G.R = 6 %
2017
2018
5
6
4.83
5.12
4.62
2.31
0.06
0.05
2.93
5.08
84.74
87.67

FCFE Single Stage

Solution

Two Stage FCFE Model

The Two -Stage FCFE Model

When to use this model?

The two stage model is designed to value a
firm that is expected to grow much faster than
a stable firm in the initial period and at a
stable rate after that

High growth rate

Stable growth rate

The Two -Stage FCFE Model

The model
The value of any stock is the present value
(PV) of the FCFE of each year for the
extraordinary growth period plus the PV of the
terminal price
PV of FCFE

High growth rate

PV of terminal price
Stable growth rate

The Two Stage FCFE Model

Value = PV of FCFE + PV of terminal price
High growth
period

Stable Growth period

= FCFEt / (1+r)t + Pn / (1+r)n

t=1

FCFEt = Free Cash flow to equity in year t

Pn = Price at the end of extraordinary-growth period
r = required rate of return to equity investors in the
firm
Pn = FCFEn+1/ r-g

Particulars

Years
C.Y

2013

2014

2015

2016

2017

Earnings per share

Less (Capital ex - Dep) (1-debt ratio)
Change in working capital (1-debt ratio)
Terminal value
FCFE

xxxxxx

2018

How to calculate the value of Equity

Using Two Stage Model.
FCF format excell.xls

Ecolab

Three stage FCFE Model

What are the three stages of growth ?

High growth period

Transition period
Stable growth period

STAGES OF GROWTH

High stable growth

Declining growth

Infinite stable growth

Low pay out

Low payout ratio

Increasing pay out

The Three Stage Model

t=n
t = n2
FCFEt / (1+r)t + FCFEt / (1+r)t + Pn2 / (1+r)t
t=1
t = n +1

Pn2 = FCFEn2+1/ r-gn

Firm Valuation Model

VALUING A FIRM
Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF

Value of Operating Assets

+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity

Firm is in stable growth:

Grows at constant rate
forever

Terminal Value= FCFF n+1 /(r-g n )

FCFF1
FCFF2
FCFF3
FCFF4
FCFF5
FCFFn
.........
Forever
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Equity

Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows

Expected Growth
Reinvestment Rate
* Return on Capital

Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)

Beta
- Measures market risk

Type of
Business

Operating
Leverage

Weights
Based on Market Value

Risk Premium
- Premium for average
risk investment

Financial
Leverage

Base Equity
Premium

Country Risk
Premium