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Equity Valuation I:



Understand the relationship between intrinsic

value and market value
B. Understand the various types of valuation
models, including balance sheet, dividend
discount , free cash flow, relative value and PE
C. Understand other key metrics used in valuing

A. The Relationship between

Intrinsic Value and Market Value

What is intrinsic value?

The present value of a firms cash flows discounted
by the firms required rate of return
What is the firms market value (or price)?
The total value of a firms outstanding shares times
its market price
In an efficient market, what should this relationship
In a truly efficient market, the intrinsic value should
equal its market value
What happens if it doesnt?

Intrinsic Value (continued)

How do you identify mis-priced securities?

Determine the intrinsic or fair value of the security.
This can be done by many methods:
Models, i.e. CAPM, APT (E(rs) = rf + s [E(rM) - rf ])
Fundamental analysis
Balance sheet methods
Dividend Discount Models (DDMs)
Then you compare the fair value to the current price

Intrinsic Value (continued)

Do all analysts look at companies the same way?

No. If you have 30 analysts, you will generally
have more than 60 sets of intrinsic values.
How much is intrinsic value used in the real world?
It is used a lot in terms of equity valuation and
financial analysis. These have a more solid
foundation and are not as affected by key
It is not used as much with DDMs and PV models,
as slight changes in assumptions can have large
changes in a companys intrinsic value. Also these
models assume a longer time frame generally.

Intrinsic Value (continued)

If DD and PV models are not used as much in

the real world, why do we include them in our
The concepts are critical to understanding
investments and finance
They can add value with specific industries and
They can be used to support your
recommendations from other models if
assumptions are stated clearly

Intrinsic Value (continued)

How do you determine Intrinsic Value?

It is a value assigned by the analyst
It is based on specific theories and assumptions
Analysts use specific models for estimation
Lots of models exist
Remember, these models are proxies for
reality they are not reality

Intrinsic Value (continued)

What happens if the calculated intrinsic value is greater

than the market price?
Intrinsic Value > Market Price
Intrinsic Value < Market Price
Sell or Short Sell
Intrinsic Value = Market Price
Hold or Fairly Priced or valued
In this class, we use a 10% estimation factor. If the
IV > (<) MP by greater (less) than 10%, then buy
These models are not as accurate as most students
would like. Valuation is much more an art than a


Do you understand the relationship between

intrinsic value and market value or price?

B. Understand Various Types of Equity

Valuation Models

Fundamental Stock Analysis: Models of Equity

Basic Types of Models
1. Balance Sheet Models
2. Dividend Discount Models
3. Discount Models, i.e. Free Cash Flow
4. Working Capital Models
5. Relative Valuation Models
6. Price/Earning Ratios


Balance Sheet Models

Balance sheet models assume that the intrinsic

value of the firm is the value of its assets.
What is the value of the firms assets?
Is it the value on the books?
Is it the value we could really get for the assets
(liquidation value)?
Is it the value we could get to replace the
What are the main types of models?
Book Value, Liquidation Value, Replacement
Cost, and Tobins Q

Balance Sheet Models (continued)

Book Value (per share)

The Book Value is Equity / shares outstanding
Example: Ford
243,283 million
Owners Equity
Shares Outstanding
What is the Book Value per share?
$23,547/1,169 = Book value of $20.14 per share
Logic: the value of the assets should be equal to their
value on the books.
Caution: Be careful as book value does not tell
you depreciation methods or the true value of the
assets (they may actually be worthless)

Balance Sheet Models (continued)

Liquidation Value (per share)

Liquidation value is the value realized by breaking up
the firm, selling off assets and repaying debt
Company A has a market value of $250 mn with $50
mn in debt, cash of $150 mn and other assets likely
worth $200 mn if sold today.
What is the liquidation value?
Liquidation value is the cash on hand and what they
could liquidate the other assets for
Logic: if price falls below liquidation value, the firm
becomes a takeover target as investors buy the company
and sell it in pieces
Caution: Can they realize the value of the assets?

Balance Sheet Models (continued)

Replacement Cost (per share)

Replace cost is the money necessary to replace the
tangible and intangible assets of a company
Company B is a trucking company valued at $25
mn. Since Company C takes 60% of the
companys business and is planning to expand, you
know that its CEO could replicate the trucking
company for $20 million and build her own
trucking division.
What is the replacement cost? $20 million
Logic: If the value gets too high above the
replacement cost, competitors would replicate the firm
and competition would drive down value of all firms.
Concerns: Are all parts of the firm replicable?

Balance Sheet Models (continued)

Tobins Q
Tobins Q is the ratio of a firms price to its estimated
replacement cost
In the long run, the market price to replacement
cost will tend toward 1 as investors correctly
value the replacement cost of the assets
Logic: Investors will be willing to purchase the
company as long as the companys market price is
below the replacement cost. As soon as its price is
greater than the replacement cost, competition will
come in, dropping the price to close to its
replacement cost.
Concerns: Differences may remain over time

Challenges of Balance Sheet Models


What are the major challenges of Balance

Sheet Models?
- It may be difficult to determine the real value of the
assets, i.e. depreciated cost versus real value
- It is uncertain how long it will take for replacement
cost to move toward unity. The time factor is a real
- It may be difficult to determine the value of
intangible assets, which may be significant in some

2. Dividend Discount Models

These are models which take into account

discounting expected future cash flows to gain
a reference for the value of a company
These are the oldest and simplest present value
approach to valuing a stock
Primary Dividend Discount Models
General Model
Constant Growth Model


Dividend Discount Models (continued)

General Dividend Discount Model

Vo= Sum [(Dt+ Pt) /(1+k)t ]

V0 = Value of Stock

Dt = Dividend at time t

Pt = Expected Price at time t

k = Required return on the stock

The value of a company is the discounted value of
dividends and the eventual sale of the company stock

Dividend Discount Models (continued)

Constant (or Gordon) Growth Rate Model
Vo = Do * (1+g)
(k - g)
This is for stocks that are growing at a constant
growth rate (this rate is assumed in perpetuity)
g = constant perpetual growth rate
b = plowback or retention ratio (rr)
Note: take out the g and the formula becomes the
no growth model
E1 = $5.00
b = 40%
k = 15%
(1-b) = 60% D1 = $3.00
g = 8%
V0 = 3.00 / (.15 - .08) = $42.86

Dividend Discount Models (continued)

Estimating Dividend Growth Rates

g = ROE x b
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
Internal Growth Rate (ROE x (1-payout))
This is the rate that the company can continue to
grow without any additional external financing
Note: if the firm distributes all its earnings as
dividends, there is nothing to allow the firm to
continue to grow

Dividend Discount Models (continued)

More Changes to the DDM

What about growth opportunities?
Do those impact the value of the company?
Does the DDM only look at dividends?
What about earnings on specific projects?
Can we fix the DDM to look at the value of new
There are a number of different DDM models that
can handle each of these situations

Challenges of Dividend Discount Models


Major challenges to DDMs include:

- A slight change in the discount rate can have a huge
change in the result
- It is difficult to determine the terminal value of the
- A small change in the termination value (i.e., the PE
multiple) can have a large change in the result
- Not all firms have dividends

3. Discounting Models

Discounting models assume the intrinsic value

of the company is the present value of the
firms expected future cash flows. It is useful
The company does not pay dividends
Dividends paid differs from what the firm could pay
Free cash flows align with profitability within a
specific forecast period
The investor takes a control perspective

Discounting Models (continued)

Free Cash Flow to the Firm (FCFF)

FCFF is the cash flow available to the suppliers of
capital after all operating expenses (including taxes)
are paid and working and fixed capital investments
are made (i.e. less capital expenditures)
FCFF = cash prior to the payment of interest to the
debt holders
FCFF = EBIT - taxes + depreciation (non-cash
costs) capital spending increase in net
working capital change in other assets +
terminal value
Discount this at the firms WACC
- Firm Value = Operating free cash flow
WACC growth OFCF

Discounting Models (continued)

Free Cash Flows to Equity (FCFE)

FCFE is the cash flow available after all operating
expenses, interest, and principle repayments have
been made and necessary investments in working
capital and fixed capital have been made
FCFE = Adjusts operating cash flows for debt
FCFE = EBIT interest - taxes + depreciation
(non-cash costs) capital expenditures increase
in net working capital principal debt
repayments + new debt issues + terminal value.
Discount at k = required return on equity
Firm Value = Free CF to Equity/(k growth FCFE)

Discounting Models (continued)

Calculation Methodology for Discounting:

Determine the appropriate discount rate

Set up each of the individual cash flows
Discount each of the individual cash flows
Discount the final cash flow assuming a constant
growth rate = cash flow / (k g)
The question remains whether the final cash
flow representative of all future cash flows
Sum all the discounted cash flows
Make adjustments as required

Challenges of Discounting Models


Major challenges of Discounting Models

- A slight change in the discount rate can have a huge
change in the result
- A small change in the terminal growth rate can have
a large change in the result
- You must be very careful of your choice of discount
rates and capitalization rates

4. Working Capital Models

These models, based on historical experience,

state that most companies are worth some
multiple of EBITDA (Earnings before Interest,
Taxes, Depreciation and Amortization).
Calculate their EBITDA for the past year, multiply
EBITDA by multiples of 6 and 9, and divide by
diluted shares outstanding
Calculate working capital, subtract out long-term
debt, and divide by diluted shares outstanding
Add EBITDA per share and working capital per
share to get a value for the firm

Working Capital Models

Easy to calculate
Works for many different types of companies

Not all companies are worth a 7.5x EBITDA

5. Relative Value Models

Relative value models assume that companies

have a fair-value trading range versus the
market and versus their respective indices
Companies that trade within their fair-value ranges
are correctly valued by the market
When companies are outside their fair value ranges,
this gives information that the company should be
looked at, either to buy or sell
The fair trading PE range times EPS times the
market PE gives the price per share.

Relative Value Models

Easy to calculate
Identifies when stock appreciation is due to general
market movement versus the benchmark
Works for many different types of companies
Can be compared to the market and industry

Not all companies trade versus the market index in
the same way
May not be useful if the market is at extreme
valuation levels

6. Price Earnings Ratios

P/E Ratios are a function of two factors

Required Rates of Return (k)
Expected growth in Dividends

Valuation of new companies
Relative valuation versus market and industry
Note: this is used extensively in the industry.
Research has found that low PE stocks have
given a higher return to Investors than high PE
stocks over the last 70 years

Price Earnings Ratios (continued)


Earnings Key Terms

Price Earnings = Price per share/Average Common

diluted Earnings Per Share
Forward or Prospective PE = Current Price /
Forward EPS
Historic PE = Year-end Price/Year-end EPS
Normalized PE = Current Price/normalized
earnings (earnings adjusted to take into account the
cycles in the economy)
Earnings Yield (E/P) = 1 / Price Earnings

Challenges of Price Earnings Models


Used extensively in the industry

Generally low PE firms outperform high PE firms

Earnings are accounting earnings, which can be

manipulated through depreciation, inventory, etc.
Earnings can fluctuate widely around a trend
You cannot know if the PE is high or low unless you
compare it to a trend, to long-run growth prospects,
to an industry, or to the market

1.Price/Earnings (PE=P/EPS)

PE Ratio
The most common measures of a firms stock price
relative to its earnings--what you are paying for $1
of earnings.
How is it analyzed?
Versus its historical average
If lower that than its history, it may indicate it is
moving into more attractive territory, i.e.,
growth is increasing
Versus the market.
Gives a historical view. If it is trading at a lower
relative PE, it may be becoming more attractive.
Versus the industry
If the relative PE versus the Industry is
declining, it may indicate the stock is becoming

2. Price/Book (PB=P/BVS)

P/BV or PB or Market to Book

Gives the relationship between the stock price and the
book value of the firm (i.e. owners equity).
How it is analyzed?
If the PB ratio is high when compared to peer firms,
the stock may be overvalued, all else being equal.
If the PB is negative, the firm is in serious trouble.
Remember that owners equity is based on
accounting depreciation and may not have
relevance to the actual value of the assets of the
Generally, the higher the P/BV (or the lower its
inverse, Book to Price) the more expensive the

3. Price/Sales (PS=P/SPS)

Price to Sales
Sales multiples are indicator of growth in sales and
hence a future indicator of growth in profits.
How it is analyzed?
Can be positive or negative
Note that growth in sales translates into growth
in profits only if the other drivers of profits are
sustained, i.e. profit margins, turnover, etc.
New companies
New companies like PS ratios when they dont
have any earnings. But if earnings fail to
materialize, then PS ratios are irrelevant.
Generally, the lower the PS ratio, the more attractive
the company, all else being equal

4. Dividend Yield (DY=DPS/P)

Dividend Yield
Certain companies are known for their high dividend
Historically we have seen an overall decline in the
markets dividend yield as firms decided that they
could use dividend payouts more effectively in their
own firms
How is it analyzed?
DY assesses the amount of dividend an investor will
receive for his dollar if invested at the current share
A high dividend yield can be perceived as both
positive and negative. Positively, as you have a return
of capital; negatively, as the company has no better
use for the funds

5. Price/Operating Cash Flow (POCF=P/OCFS)

Price to Operating Cash Flow

P/OCF is an important measure of a firms health
It gives an assessment of the firms power to
generate operating cash flow on a price per share
How is it analyzed?
Firms that are generating a high amount of cash are
perceived to be more attractive than firms which are
not generating cash
Generally, the lower the P/OCF the more
attractive the firm


Price to Earnings before Interest and Taxes

In evaluating firms which are potential takeover targets
or which are not making earnings, analysts often use
Price/EBIT, which they would use instead of Price
Earnings (as there are no earnings).
This gives the relevant ratio assuming the firm had no
other expenses, i.e. debts, taxes, etc.
This was used in valuing the high-flying tech firms
How is it analyzed?
Generally the lower the ratio, the more attractive the
Be careful as this ratio says nothing about overall
profits, but only operating earnings.


Price to Earnings Before Interest and Taxes and

Depreciation and Amortization
Used to put a price on firms which have no
earnings but are generating cash and which may be
attractive as acquisition candidates
P/EBITDA is similar to the Price/EBIT, except that
it includes depreciation and amortization, which are
non-cash charges
How is it analyzed?
Takeover firms are concerned with the amount of
cash firms are generating assuming no other
charges and taxes. Generally the lower the ratio,
the more attractive the company

8. PE to IGR (PE/Internal Growth Rate or g)

PE to Internal Growth Rate (which is a proxy for a

firms sustainable growth rate)
Used to relate a companys PE to its sustainable
growth rate
How is it analyzed?
A low PE stock with a high internal growth rate will
have a low ratio, while a high PE stock with a low
IGR will have a high ratio.
Generally the lower the ratio, the more attractive

9. PE to Earnings Growth (PE/EPS Growth)

Price Earnings to Earnings Growth

Another takeoff on the PE to growth ratio
Sometimes used this as a screening device, only
looking at companies whose PE divided by
Earnings growth rates are 1 or less
How is it analyzed?
Generally, companies are more attractive when this
ratio is lower, as they have not only higher
earnings, but those earnings are expected to growth
in the near future.
Can be very volatile due to the volatility of earnings
per share growth
Due to volatility, some investors prefer the PE to
IGR above


If value from this model is lower than expected,

it may be because the firms dividend payout ratio

may be low for a stable firms

the beta is high for a stable firm

Try using the FCFE Model

Use a beta closer to one

If value is too high, it is because

the expected growth rate is too high for a stable firm

Use a growth rate closer to economy growth

Discounted cash flow:FCFE

In FCFE model
Value of Stock = FCFE1
(Ke - g)

Where FCFE1 is free cash flow to equity after one year

Discounted cash flow:FCFE

Revenues - Operating Expenses
= Earnings before interest, taxes and depreciation (EBITDA) - Depreciation
& Amortization
= Earnings before interest and taxes (EBIT) - Interest Expenses
= Earnings before taxes Taxes
= Net Income + Depreciation & Amortization
= Cash flows from Operations - Preferred Dividends- Capital Expenditures
- Working Capital Needs - Principal Repayments of debt + Proceeds from
New Debt Issues
= Free Cash flow to Equity

Growth rate
Growth i.e. g= b*ROE
Where b= retention ratio
ROE=return on equity
or g=b* [ROA+D/E{ROA-i(1-t)}]
Where ROA is return on assets.
D/E is debt equity ratio.
Real growth rate=(1+Nominal growth rate)(1+inflation rate)-1

What growth model should be used?

stable growth model, if

the firm is growing at a rate which is below or close to the
growth rate of the economy

two-stage growth model, if

the firm is growing at a moderate rate fore some period
and then cool down to stable rate.

three-stage growth model, if

the firm is growing at a very high rate

Discounted Cash flow: Firm

The value of the firm is obtained by

discounting expected cash flows to the firm,
i.e., the residual cash flows after meeting all
operating expenses, reinvestment needs and
taxes, but prior to any payments to either debt
or equity holders.
Value of Firm = CF to Firm t

Free cash flow to firm

EBIT ( 1 - tax rate) + Depreciation
- Capital Spending - Change in Working
= Cash flow to the firm

Relative Valuation approach

In Relative Valuation approach, firms

performance is compared by the market or with
comparable standards from the market.
So for valuation under this method,
first identify comparable assets and obtain market
values for these assets.
convert these market values into standardized
values.(standardization can be done using common
variables such as earnings, cash flows, book value
or revenues.
compare the standardized value or multiple for the
asset being analyzed to the standardized values for
comparable asset.

Relative Valuation approach

Different Ratios for relative valuation approach.

Price/Earnings Ratio (PE)/ (PEG)

Price/Book Value(of Equity) (PBV)
Price/Sales per Share (PS)

Relative valuation: brand name

In general, the value of a brand name can be

written as:
Value of brand name ={(V/S)b-(V/S)g }* Sales
(V/S)b = Value of Firm/Sales ratio of the firm
with the benefit of the brand name
(V/S)g = Value of Firm/Sales ratio of the firm
without the brand name.

Valuation in acquisition analysis

Synergy are of two types

Economies of scale, backward/forward integration,
better pricing power
tax benefits, high debt capacity, better cash

Which model to be chosen

In the asset based valuation method

Liquidation cost method
Replacement cost method

Generally assets which are separable and

marketable are being valued as per this method like
real estate companies.

Which model to be chosen

Based on the cash flow generation capacity

If company is generating the cash flow or going to
generate in near future then DCF method can be
If cash could not be generated at all like paintings
then relative valuation method can be followed

Which model to be chosen

Assets based (liquidity) valuation approach

value the assets considering the current situation
DCF method value the business considering firm
as going concern till infinity (generally)
Option pricing or relative valuation method
follow a limited time consideration approach.

Which model to be chosen

If cash flow can be predicted
If leverage is stable
If leverage unstable

If cash flow cant be predicted

Dividend growth model

Which model to be chosen

In relative valuation

High growth firm

P/E to growth
High growth/negative earning
Price to sales
Retails business
Real estate
Price to cash flow
Financial Services
Price to book value

The journey begins

Wishing You all the best for the Mid Term