MGM Case

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MGM Case

• With your groups case write-up include a cd that
  has your pro forma financial statements. The
  excel file should include all of the assumptions
  used in putting together your forecast.

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Marriott Case

• Write-up portion of the case due on Tuesday
  December 4th for all groups.
• Order of presentations to be determined
• Group evaluation form is on the website is due
  by Thursday December 6th.

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Valuation Theory and Implementation

• The value of a firm can be shown as

The value of a firm is its future expected cash
flows discounted by the companys equity cost of
capital.
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Valuation Theory and Implementation

• The valuation formula creates a number of
  difficult problems
• How can we estimate the future cash flows that
  will be received by an investor
• What are the cash flows?
• How long do we have to forecast?
• What is the relevant discount rate?

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Valuation

• The simplest method of valuing a firms equity is
  to discount its future dividends. For a firm
  that pays dividends the formula can be shown as
• Rewriting

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Approaches to Valuation

• In a NO growth world this formula reduces to

• So if a company pays a 1.00 dividend and it is
  expected to last into perpetuity and the company
  has a cost of equity capital of 12, the company
  should have a value of
• V 1.00 / .12 8.33 per share

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Approaches to Valuation

• In a growth world this formula is

• So if a company pays a 1.00 dividend and it is
  expected to grow at a rate of 5 per year and the
  company has a cost of equity capital of 12, the
  firms equity should have a value of
• V 1.05 / (.12-.05) 15.00 per share

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Dividend example

• Nordstrom
• Current stock price 38.55
• Current Dividend 0.56
• Expected growth rate 12

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Dividend example

• Nordstrom
• Cost of equity capital CAPM
• Risk free rate 5
• Nordstrom Beta 1.46
• Expected market return for similar sized
  companies 11
• re 5 1. 46 (11 - 5)
• re 13.8

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Dividend example

• Nordstrom
• V 0.56 (1.12)
• .138-.12
• V 34.84 versus actual price of 38.55

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Problems with the easy method

• Many companies dont pay dividends
• What if the growth rate exceeds the cost of
  equity capital?
• What growth rate should be used?
• How long do we need to forecast out cash flows?
• What is the role of accounting role in the
  valuation formula?

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Accounting numbers and valuation

• What is the link between accounting and security
  prices
• Current period earnings provides information
  about future period earnings, which
• Provide information to develop expectations about
  future dividends, which
• Provides information about the expected future
  cash flows paid to equity holders which determine
  security prices.

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Alternative Valuation Methods

• Accounting-Based Valuation
• Abnormal earnings (Residual Income)
• PV of Free Cash Flows - leveraged or unleveraged
• Non-present value based valuation methods
• Price-Earnings Comparables
• Price-Book Value Comparables

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Abnormal Earnings

• Abnormal Earnings
• accounting profit charge for opportunity cost
• In accounting terms
• Abnormal Earnings NI (re BV Equity),
• where re the cost of equity capital
• When a firm earns more than its opportunity cost
  it adds to shareholder value.

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Abnormal Earnings

• Abnormal Earnings NI (re BV Equity)
• Accounting Income NI ROE BV Equity
• Substituting
• Abn. Earnings ROEBV Equity reBV Equity
• So for the firm to grow (have positive abnormal
  earnings) ROE re

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Abnormal Earnings

• We can express a firms value as
• A firms equity value is the sum of its current
  book value and the discounted values of all
  future abnormal earnings.
• A firms value can be improved by
• increasing ROE
• lowering cost of equity capital

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Free Cash Flow Valuation

• Free Cash Flows (FCF) are the cash flows that
  belong to equity holders after reinvesting
  money back into the firm to maintain the current
  level of productivity
• Free Cash Flow CFO Capital Expenditures
  (CAPX)
• This is called Leveraged Free Cash Flow, this is
  the amount available to make dividend payments.
  LFCF will be used to value the equity of a
  company.

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Present Value of Free Cash Flow

• Many times we may also want to calculate Free
  Cash Flows attributable to both equity and debt
  holders. This calculation is called Unleveraged
  Free Cash Flow
• FCF CFO Interest Exp. - CAPX
• These cash flows are available to make both
  dividend and interest payments. UFCF will be
  used to value the assets of a company ( i.e.
  liabilities stockholders equity).

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Present Value of Free Cash Flow

• To summarize the difference between Unleveraged
  and Leveraged Free Cash flows
• Leveraged Free Cash flows is used to value the
  Equity of a Firm. LFCF represent amounts
  available to common shareholders for dividends or
  reinvestment.
• Unleveraged Free Cash flows is used to value the
  assets of a Firm. UFCF are the cash flows
  generated by the firm before considering
  companies debt/equity mix.

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Present Value of Free Cash Flow

• The estimate of a firms equity value using
  Leveraged Free Cash Flows is based on the
  following expression
• where r the firms cost of equity capital

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Present Value of Free Cash Flow

• This model is equivalent to dividend discount
  model in that
• It is an estimate of the value of a firms equity
• Because the LFCF is cash flows to common
  stockholders the discount rate is the cost of
  equity capital

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Present Value of Free Cash Flow

• To estimate the value of a firms assets we use
  Unleveraged Free Cash Flows
• here D0 the market value of debtWACC the
  weighted average cost of capital

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Unleveraged Free Cash Flow

• UFCF is an estimate of the value of the whole
  firm, not just the owners equity
• Because the free cash flows available to all
  contributors of capital is being discounted, the
  discount rate is the weighted average cost of
  capital (WACC) not the cost of equity

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Free Cash Flow

• Using these concepts we can then determine the
  market value of liabilities
• Unleveraged Free Cash Flows (Assets)
• -Leveraged Free Cash Flows (Equity)
• Value of liabilities

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Valuation using discounting

• For both dividends, residual income and free cash
  flow the value of the firm is being determined by
  examining future forecasted amounts
• How do we do these calculations?

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Forecasting and valuation

• Imagine that you have forecasted the following
  information about a firms future results

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Basing Valuation On Comparables

• The previous valuation methods are sensitive to
  forecasts and assumptions about the future.
• An alternative is to base the valuation on a
  comparison to comparable firms or industry
  averages.
• This method uses the forecasts and assumptions
  implicit in their current market prices of the
  companies or industry average

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Basing Valuation On Comparables

• The two ratios that are most commonly used to
  value a firm using comparables are
• Price-Earnings ratio
• Price-Book Value Ratio
• Using these ratios provides a very simple way to
  estimate the value of a firm
• However using comparables assumes that the firm
  has the same expected residual earnings growth
  (g), and cost of capital (r) as the comparable
  firm(s)

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Basing Valuation On Comparables

• Example Nordstrom
• Compute Nordstroms P/E ratio and P/BV ratio
  given that
• Price is 46.86
• Trailing twelve months (TTM) earnings is 2.23
• Book Value for most recent quarter is 7.15
• Compute Nordstroms estimated value
• Assuming that industry P/E is 21.67
• Assuming that industry P/BV is 4.82

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Basing Valuation On Comparables

• Example Nordstrom
• Compute Nordstroms intrinsic stock price given
  industry comparables
• Ind. P/E of 21.67 Nordstroms EPS of 2.23
  48.32
• Ind. BV of 4.82 Nordstroms BV 7.15 34.46
• Nordstroms current stock price 46.86

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Basing Valuation On Comparables

• Valuing firms on this basis is very simple, but
• Implicitly makes many assumptions about the
  future growth, cost of capital and return on
  equity of that firm
• Using industry ratios that may include companies
  that are not that comparable
• This is done on faith, without analyzing the
  specifics of that firm
• On the other hand, these ratios may be useful as
  a screen to identify firms that are worth
  analyzing more carefully

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Sensitivity Analysis

• Obviously, the forecasts and the estimates of
  risk and growth are subject to error
• To evaluate the potential effect of this error,
  you can conduct a sensitivity analysis in which
  alternative value estimates are made for small
  changes in in the estimates of risk and growth.

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Sensitivity Analysis

• An Example
• Assume that a company has Total Dividends of
  4,580 and 1000 shares outstanding
• Assume that the cost of capital is 12 percent and
  the growth rate is 7 percent so that the dividend
  discount model yields V0 4.58 (1 .07) /
  (.12 - .07) 98.01
• How would this value change for alternative
  estimates of growth and cost of capital?

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Sensitivity Analysis
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Sensitivity Analysis

• An Example
• If the current share price were 80, we would
  conclude that
• Given our best estimates for cost of capital
  (12) and growth (7) this firm is undervalued
  by about 22 percent

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Evaluate Current Price

• Compare current price to highs and lows in prior
  one or two years
• If stock price has been rising you would be
  buying based on your expectation of additional
  growth that is not reflected in the current
  price
• If stock price has been falling you would be
  buying based on your expectation that the firm
  has additional value that is not reflected in
  the current price

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Evaluate Current Price

• Compare price-earnings ratio to the
  price-earnings ratio for
• A comparable firm
• The firms industry average
• A wider market average such as the SP 500
• If the firms P/E ratio is below the ratio you
  are comparing it with this provides some comfort
  that the firm is not overvalued.