Common Stock Valuation: The Inputs

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• Common Stock Valuation The Inputs

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Valuation Inputs

• Now that we have an understanding of the models
  used, we are going to focus on developing
  estimates for the inputs the models require.

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DCF Model Cash Flow

• In the cash flow valuation models, there are
  three cash flows we can use to determine value
  dividends, free cash flow to the firm (FCFF) and
  free cash flow to equity (FCFE).
• Using dividends as the cash flow is restrictive
  because we would not be able to value
  non-dividend paying or low dividend paying firms.
• The cash flow that we will use is the Free Cash
  Flow to the Firm. This represents the cash flow
  available to ALL the investors of the firm,
  including equity holders and debt holders.
• Valuing the firm using FCFF and FCFE are
  equivalent.

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DCF Model Calculating Current FCFF

• Free cash flow to the firm (FCFF) can be
  calculated in the following way
• Where
• EBIT Earnings Before Interest and taxes
  (Income statement)
• t marginal tax rate (assumed to be 35)
• NCC non-cash charges (such as depreciation)
  (statement of cash flows)
• FCInv Investment in fixed capital (statement
  of cash flows)
• WCInv Investment in working capital (balance
  sheet)

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DCF Model Calculating Current FCFF

• In general, working capital is defined as current
  assets minus current liabilities.
• However, for valuation purposes, working capital
  should exclude cash and cash equivalents and
  short term debt, which can be notes payable or
  the current portion of long-term debt.
• Our focus is on calculating a value for operating
  working capital.
• Investment in working capital in year t then is
• WCInv WC(t) WC(t-1)

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DCF Model Discount Rate

• The discount rate used in any valuation model
  should reflect the return required by the
  investors that are to receive the cash flows.
• In the DCF model, with FCFF, since the cash flow
  is to all investors of the firm, we have to
  determine the required return for the debt
  holders and equity holders.
• The weighted average of these required returns is
  referred to as the weighted average cost of
  capital (WACC)

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DCF Model Discount Rate

• The WACC (k) is calculated as
• Where ke required rate of return for equity
  holders (cost of equity)
• kd required rate of return for debt
  holders (cost of debt)
• MVe market value of equity
• MVd market value of debt
• t marginal tax rate

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DCF Model Discount Rate Cost of Equity

• The cost of equity for a stock can be estimated
  using the capital asset pricing model (CAPM ).
• We will discuss the CAPM in a later chapter.
• However, we can estimate the discount rate for a
  stock using this formula
• Cost of equity (ke) risk-free rate risk
  premium
• T-bond yield (stock beta x stock
  market risk premium)

T-bond yield return on 30-yr U.S. T-bonds
Stock Beta risk relative to an average stock
Stock Market Risk Premium risk premium for an average stock (Long-term geometric average)
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DCF Model Discount Rate Cost of Debt

• Just like with equity, the cost of debt or the
  required rate of return for debt holders can be
  stated as
• Cost of debt (kd) risk-free rate risk premium
• The risk premium here represents the extra return
  that investors require to compensate them for the
  possibility that the firm may default on their
  debt obligation.
• The cost of debt (kd) can be estimated in one of
  two ways
• Look for prices and yields of bonds outstanding
• Estimate the cost of debt from the firms credit
  rating

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DCF Model Discount Rate Cost of Debt

• If the firm has bonds outstanding, and the bonds
  are traded, the yield to maturity (YTM) on a
  long-term, straight (no special features) bond
  can be used as the before tax cost of debt.
• The YTM incorporates the risk-free rate and
  firm-specific default risk.
• Sources
• Look at the Corporate Bond excerpt in the WSJ or
  other publications
• Yahoo may also have this information
• kd YTM (1-t)

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DCF Model Discount Rate Cost of Debt

• Rating agencies, such as Standard and Poors and
  Moodys provide ratings for companys debt. This
  rating is an indication of the riskiness of the
  debt.
• Standard and Poors ratings can be found at
• www.standardandpoors.com
• If the firm is rated, use the credit rating and a
  typical default spread on bonds with that rating
  to estimate the cost of debt.
• Default spreads represent the risk premium.
• Default spreads can be found at
  www.bondsonline.com (premium service) OR inferred
  from bond spreads of other bonds with the same
  rating
• kd (30-yr. T-bond yield default spread)
  (1-t)

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DCF Model Discount Rate Market Value of Equity

• The market value of equity (MVe) is the market
  capitalization of the firm
• Market Cap Shares outstanding current stock
  price

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DCF Model Discount Rate Market Value of Debt

• The market value of debt (MVd) consists of two
  components
• The value of long-term debt
• The value of operating leases (off-balance sheet)
• The market value of long-term debt can be
  approximated using the book value of long-term
  debt which can be found on the firms balance
  sheet.

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DCF Model Discount Rate Market Value of Debt

• Operating leases represent payments for things
  such as leasing a building, etc.
• These leases do not show up on the balance sheet.
• The debt value of leases is the present value
  of the lease payments, at a rate that reflects
  their risk.
• In general, this rate will be close to or equal
  to the rate at which the company can borrow,
  i.e., pre-tax cost of debt.

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RIM

• One of the very attractive properties of the RIM
  is that apart from the discount rate and the
  growth rate, all the other inputs can be taken
  directly from the firms financial statements.
• Book value of equity Total shareholders equity
  Preferred Stock
• ROE Net Income / Book value of equity

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RIM Discount Rate

• The cash flows used in the RIM is the earnings
  per share. This represents a cash flow to the
  equity holders only.
• Therefore, the discount rate should reflect a
  required rate of return to the equity holders.
• This rate is the cost of equity (ke).

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Readings

• Reserve Material