Valuation

Approaches to Valuation

• Discounted cashflow valuation: Relates the value of an

asset to the present value of expected future cashflows on
that asset.

• Relative valuation: Estimates the value of an asset by

looking at the pricing of 'comparable' assets relative to a
common variable like earnings, cashflows, book value or
sales.
 Discounted Cash Flow Valuation

• What is it: In discounted cash flow valuation, the value of

an asset is the present value of the expected cash flows on
the asset.
• Philosophical Basis: Every asset has an intrinsic value
that can be estimated, based upon its characteristics in
terms of cash flows, growth and risk.
• Information Needed: To use discounted cash flow
valuation, you need
– to estimate the life of the asset
– to estimate the cash flows during the life of the asset
– to estimate the discount rate to apply to these cash
flows to get present value
Discounted Cashflow Valuation: Basis for
Approach

t = n CF
Value =  t
t
t = 1 (1 + r)
where,
n = Life of the asset
CFt = Cashflow in period t
r = Discount rate reflecting the riskiness of the
estimated cashflows
 Advantages of DCF Valuation

• Since DCF valuation, done right, is based upon an asset’s

fundamentals, it should be less exposed to market moods and
perceptions.

• If good investors buy businesses, rather than stocks,

discounted cash flow valuation is the right way to think about
what you are getting when you buy an asset.

• DCF valuation forces you to think about the underlying

characteristics of the firm, and understand its business. If
nothing else, it brings you face to face with the assumptions
you are making when you pay a given price for an asset.
 Disadvantages of DCF valuation
• Since it is an attempt to estimate intrinsic value, it requires far
more inputs and information than other valuation approaches
• These inputs and information are not only noisy (and difficult
to estimate), but can be manipulated to provide the
conclusion one wants.
• For example:
– An entrepreneur can get a high valuation by overestimating
cashflows and/or underestimating discount rates.
– A venture capitalist can buy equity from an entrepreneur
at a lower price by underestimating cashflows.
– An entrepreneur and venture capitalist can get a higher
price for their IPO by overestimating cashflows and/or
underestimating discount rates.
 When DCF Valuation works best
• This approach is easiest to use for assets (firms) whose
– cashflows are currently positive and
– can be estimated with some reliability for future periods,
and
– where a proxy for risk that can be used to obtain discount
rates is available.

• It works best for investors who either

– have a long time horizon, allowing the market time to
correct its valuation mistakes and for price to revert to
“true” value or
 Valuation Comparison: DCF Limitations
• What if firm has:
• Unknown history, Unknown implementation timing
• Unfathomable market, Unknown competition, Untested
product, Unknown cost structure, Unknown market
acceptance
• Projecting an unknown growth trajectory …. DCF is tough!
 Relative Valuation
• What is it?: The value of any asset can be estimated by looking at how
the market prices “similar” or ‘comparable” assets.

• Philosophical Basis: The intrinsic value of an asset is impossible (or

close to impossible) to estimate. The value of an asset is whatever the
market is willing to pay for it (based upon its characteristics)

• Information Needed: To do a relative valuation, you need

– an identical asset, or a group of comparable or similar assets
– a standardized measure of value (in equity, this is obtained by dividing
the price by a common variable, such as earnings or book value)
 Advantages of Relative Valuation

• Relative valuation is much more likely to reflect market

perceptions and moods than discounted cash flow valuation.
This can be an advantage when it is important that the price
reflect these perceptions as is the case when
– the objective is to sell a security at that price today (as in the case of
an IPO)

• Relative valuation generally requires less information than

discounted cash flow valuation
 Disadvantages of Relative Valuation

• Relative valuation is built on the assumption that markets are

correct in the aggregate, but make mistakes on individual
securities. To the degree that markets can be over or under
valued in the aggregate, relative valuation will fail

• Relative valuation may require less information in the way in

which most analysts and portfolio managers use it. However,
this is because implicit assumptions are made about other
variables (that would have been required in a discounted cash
flow valuation). To the extent that these implicit assumptions
are wrong the relative valuation will also be wrong.
 P/E MULTIPLE:
• You wish to value Target (retailer):
– Find benchmark firms
– Assume market correctly sets competitors’ stock
prices.
– Assume all firms have the same risk (systematic &
industry).
– Assume cashflow growth is similar for all the firms.
– Assume accounting techniques to calculate earnings
(or book equity or sales or EBITDA) are similar for all
the firms.
– Implication: the P/E model is the same for competitors and Target Corp.
– A Multiples Valuation Approach:
• Take average P/E of competitors
• Multiply by Target’s EPS to obtain the predicted price of Target.
 Balance Sheet multiple
• What if today’s (and near-term) earnings are not relevant?
– Firm is generating losses now and near future.
• Difficult to predict future cash flows.
– What other financial information can we use?
• The Balance Sheet!
– What is break-up value of company if it liquidated?
• Compare market value of equity (M=P) to the book value of
equity: M/B ratio
 When relative valuation works best..
• This approach is easiest to use when
– there are a large number of assets comparable to the one being valued
– these assets are priced in a market
– there exists some common variable that can be used to standardize
the price

• This approach tends to work best for investors

– who have relatively short time horizons
 Financial Data about Companies

2011 Financial

Industry Market
Facebook Microsoft Google
Median Median1
Current Ratio 5.12 2.60 5.92 4.33 1.44
Quick Ratio 4.96 2.41 5.70 24.18 4.83
Leverage Ratio 1.48 1.83 1.25 1.31 5.46
Total
0.16 0.18 0.07 0.09 0.98
Debt/Equity
Interest
11.51 59.60 167.87 3.12 6.13
Coverage
2011 Valuation

Industry Market
Facebook Microsoft Google
Median Median1
Price/Sales Ratio 10.87 3.57 5.36 5.18 1.19
Price/Earnings
121.95 15.48 20.83 27.10 17.12
Ratio
Price/Book Ratio 3.06 3.91 3.57 3.46 1.90
Price/Cash Flow
26.74 8.33 14.62 16.29 7.78
Ratio
 Equity Valuation Analysis: What Do Analysts
Use?

• P-E 97%
• Price-to-Book 25%
• DCF 13%
Discounted Cash Flow Valuation
Discounted Cashflow Valuation: Basis for
Approach

t = n CF
Value =  t
t
– where, t =1 (1 + r)

– n = Life of the asset

– CFt = Cashflow in period t
– r = Discount rate reflecting the riskiness of the
estimated cashflows
 Equity Valuation versus Enterprise
Valuation

• Value just the equity stake in the business

• Value the entire business, which includes, besides equity, the

other claimholders in the firm
 I.Equity Valuation
• The value of equity is obtained by discounting expected
cashflows to equity, i.e., the residual cashflows after meeting
all expenses, tax obligations and interest and principal
payments, at the cost of equity, i.e., the rate of return required
by equity investors in the firm.
t=n CF to Equity t
Value of Equity =  (1+ k e )t
t=1

where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity
• The dividend discount model is a specialized case of equity
valuation, and the value of a stock is the present value of
expected future dividends.
 II. Enterprise Valuation
• The value of the firm is obtained by discounting expected
cashflows to the firm, i.e., the residual cashflows after meeting
all operating expenses and taxes, but prior to debt payments,
at the weighted average cost of capital, which is the cost of
the different components of financing used by the firm,
weighted by their market value proportions.

t= n
CF to Firm t
Value of Firm = 
t =1 (1+ WACC)
t

where,
CF to Firmt = Expected Cashflow to Firm in period t
WACC = Weighted Average Cost of Capital
 Cash Flows and Discount Rates
• Assume that you are analyzing a company with the following
cashflows for the next five years.
Year CF to Equity Int Exp (1-t) CF to Firm
1 $ 50 $ 40 $ 90
2 $ 60 $ 40 $ 100
3 $ 68 $ 40 $ 108
4 $ 76.2 $ 40 $ 116.2
5 $ 83.49 $ 40 $ 123.49
Terminal Value $ 1603.008 $ 2363.008
• Assume also that the cost of equity is 13.625% and the firm
can borrow long term at 10%. (The tax rate for the firm is
50%.)
• The current market value of equity is $1,073 and the value of
debt outstanding is $800.
 Equity versus Firm Valuation
Method 1: Discount CF to Equity at Cost of Equity to get value of
equity
• Cost of Equity = 13.625%
• PV of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 +
76.2/1.136254 + (83.49+1603)/1.136255 = $1073
Method 2: Discount CF to Firm at Cost of Capital to get value of
firm
Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%
WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94%

PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 +

116.2/1.09944 + (123.49+2363)/1.09945 = $1873
• PV of Equity = PV of Firm - Market Value of Debt
= $ 1873 - $ 800 = $1073
 First Principle of Valuation

• Never mix and match cash flows and discount rates.

• The key error to avoid is mismatching cashflows and discount

rates, since discounting cashflows to equity at the weighted
average cost of capital will lead to an upwardly biased
estimate of the value of equity, while discounting cashflows to
the firm at the cost of equity will yield a downward biased
estimate of the value of the firm.
 Discounted Cash Flow Valuation: The Steps
• Estimate the discount rate or rates to use in the valuation
– Discount rate can be either a cost of equity (if doing equity valuation)
or a cost of capital (if valuing the firm)
– Discount rate can be in nominal terms or real terms, depending upon
whether the cash flows are nominal or real
• Estimate the current earnings and cash flows on the asset,
to either equity investors (CF to Equity) or to all claimholders
(CF to Firm)
• Estimate the future earnings and cash flows on the asset
being valued, generally by estimating an expected growth rate
in earnings.
• Estimate when the firm will reach “stable growth” and what
characteristics (risk & cash flow) it will have when it does.
• Choose the right DCF model for this asset and value it.
Discounted Cash Flow Valuation:
The Inputs
 The Key Inputs in DCF Valuation
• Discount Rate
– Cost of Equity, in valuing equity
– Cost of Capital, in valuing the firm
• Cash Flows
– Cash Flows to Equity
– Cash Flows to Firm
• Growth (to get future cash flows)
– Growth in Equity Earnings
– Growth in Firm Earnings (Operating Income)
I. Estimating Discount Rates

DCF Valuation
 Estimating Inputs: Discount Rates
• Critical ingredient in discounted cashflow valuation. Errors in
estimating the discount rate or mismatching cashflows and
discount rates can lead to serious errors in valuation.
• At an intuitive level, the discount rate used should be
consistent with both the riskiness and the type of cashflow
being discounted.
– Equity versus Firm: If the cash flows being discounted are
cash flows to equity, the appropriate discount rate is a cost
of equity. If the cash flows are cash flows to the firm, the
appropriate discount rate is the cost of capital.
– Currency: The currency in which the cash flows are
estimated should also be the currency in which the
discount rate is estimated.
– Nominal versus Real: If the cash flows being discounted
are nominal cash flows (i.e., reflect expected inflation), the
 Estimating Inputs:
Discount Rates or Cost of Capital (WACC)

• It will depend upon:

– (a) the components of financing: Debt, Equity
– (b) the cost of each component
• The cost of capital is the cost of each component weighted by
its relative market value.
WACC = ke (E/(D+E)) + kd (D/(D+E))

where ke is cost of equity

kd is cost of debt,
E is market value of equity, D is typically book value of
debt.
 Calculate the weights of each component
• Use target/average debt weights rather than project-specific
weights.
• Use market value weights for debt and equity.
– The cost of capital is a measure of how much it
would cost you to go out and raise the financing to
acquire the business you are valuing today. Since
you have to pay market prices for debt and equity,
the cost of capital is better estimated using market
value weights.
– Book values are often misleading and outdated.
 Estimating Market Value Weights
• Market Value of Equity should include the following
– Market Value of Shares outstanding
– Market Value of Warrants outstanding
– Market Value of Conversion Option in Convertible Bonds
• Market Value of Debt is more difficult to estimate because few
firms have only publicly traded debt. There are two solutions:
– Assume book value of debt is equal to market value
– Estimate the market value of debt from the book value
II. Estimating Cash Flows

DCF Valuation
 Steps in Cash Flow Estimation
• Estimate the current earnings of the firm
– Cash flows to equity: look at earnings after interest
expenses - i.e. net income
– Cash flows to the firm: look at operating earnings after
taxes
• Consider how much the firm invested to create future growth
– If the investment is not expensed, it will be categorized as
capital expenditures. To the extent that depreciation
provides a cash flow, it will cover some of these
expenditures.
– Increasing working capital needs are also investments for
future growth
 Estimating Cashflows to Equity
1. Revenues - Operating expenses
= Earnings before interest, taxes, depreciation, and amort. (EBITDA)
2. EBITDA - Depreciation and Amortization
= Earnings before interest and taxes (EBIT)
3. EBIT - Interest Expenses
= Earnings before taxes
4. Earnings before taxes – Taxes = Net Income
5. Net Income + Depreciation and Amortization
= Cashflow from Operations
6. Cashflow from operations - Working Capital change - Capital
spending - Principal Repayments + Proceeds from New Debt
Issues = Free Cashflow to Equity.
 Estimating Cashflows to Firm
Free cashflow to Firm (FCFF): Cashflow to
common shareholders,
preferred shareholders, and
debtholders.

FCFF = EBIT(1-t) + Depreciation – Changes in Working Capital

- CAPEX
= EBIT(1-t) – Changes in Working Capital – (CAPEX –
Depreciation)
OR
= Free Cashflow to Equity
+ Interest expense (1 - tax rate) + Principal
repayments - New debt issues.
III. Estimating Growth

DCF Valuation
 Ways of Estimating Growth in Earnings
• Look at the past
– The historical growth in earnings per share is
usually a good starting point for growth estimation
• Look at what others are estimating
– Analysts estimate growth in earnings per share for
many firms. It is useful to know what their
estimates are.
• Look at fundamentals
– Ultimately, all growth in earnings can be traced to
two fundamentals - how much the firm is investing
in new projects, and what returns these projects
are making for the firm.
 Historical Growth in EPS
• In using historical growth rates, the following factor has to be
considered
– how to deal with negative earnings
 Dealing with Negative Earnings

• When the earnings in the starting period are negative, the

growth rate cannot be estimated. (0.30/-0.05 = -600%)

• When earnings are negative, the growth rate is meaningless.

Thus, while the growth rate can be estimated, it does not tell
you much about the future.
 IV. Growth Patterns

Discounted Cashflow Valuation

 Stable Growth and Terminal Value
• When a firm’s cash flows grow at a “constant” rate forever, the
present value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
• This “constant” growth rate is called a stable growth rate and
cannot be higher than the growth rate of the economy in
which the firm operates.
• While companies can maintain high growth rates for extended
periods, they will all approach “stable growth” at some point in
time.
• When they do approach stable growth, the valuation formula
above can be used to estimate the “terminal value” of all cash
flows beyond.
V. Beyond Inputs: Choosing and
Using the Right Model
Discounted Cashflow Valuation
 Summarizing the Inputs
• In summary, at this stage in the process, we should have an
estimate of
– the current cash flows on the investment, either to equity
investors (dividends or free cash flows to equity) or to the
firm (cash flow to the firm)
– the current cost of equity and/or capital on the investment
– the expected growth rate in earnings, based upon historical
growth, analysts forecasts and/or fundamentals.

• The next step in the process is deciding

– which cash flow to discount, which should indicate
– which discount rate needs to be estimated and
– what pattern we will assume growth to follow.
 Which cash flow should I discount?
• Use Equity Valuation
(a) for firms which have stable leverage, whether high or not,
and
(b) if equity (stock) is being valued
• Use Firm Valuation
(a) for firms which have leverage which is too high or too low,
and expect to change the leverage over time, because
debt payments and issues do not have to be factored in
the cash flows and the discount rate (cost of capital) does
not change dramatically over time.
(b) for firms for which you have partial information on
leverage (eg: interest expenses are missing..)
(c) in all other cases, where you are more interested in
valuing the firm than the equity.
 Given cash flows to equity, should I
discount dividends or FCFE?
• Use the Dividend Discount Model
– (a) For firms which pay dividends (and repurchase stock)
which are close to the Free Cash Flow to Equity (over an
extended period)
– (b)For firms where FCFE are difficult to estimate (Example:
Banks and Financial Service companies)
• Use the FCFE Model
– (a) For firms which pay dividends which are significantly
higher or lower than the Free Cash Flow to Equity. (What
is significant? ... As a rule of thumb, if dividends are less
than 80% of FCFE or dividends are greater than 110% of
FCFE over a 5-year period, use the FCFE model)
– (b) For firms where dividends are not available (Example:
Private Companies, IPOs)
 What discount rate should I use?
• Cost of Equity versus Cost of Capital
– If discounting cash flows to equity -> Cost of Equity
– If discounting cash flows to the firm-> Cost of Capital
• What currency should the discount rate (risk free rate) be in?
– Match the currency in which you estimate the risk free rate
to the currency of your cash flows
• Should I use real or nominal cash flows?
– If discounting real cash flows-> real cost of capital
– If nominal cash flows -> nominal cost of capital
– If inflation is low (<10%), stick with nominal cash flows
since taxes are based upon nominal income
– If inflation is high (>10%) switch to real cash flows
 The Building Blocks of Valuation
Choose a
Cash Flow Dividends Cashflows to Equity Cashflows to Firm
Expected Dividends to Stockholders
Net Income after tax EBIT (1- tax rate)
- (Capital Exp. - Deprec’n) - (Capital Exp. - Deprec’n)
- Change in Work. Capital – Debt - Change in Work. Capital
payment + Debt Issues = Free Cash flow to Firm (FCFF)
= Free Cash flow to Equity (FCFE)

& A Discount Rate Cost of Equity Cost of Capital

 Basis: The riskier the investment, the greater is the cost of equity. WACC = ke ( E/ (D+E))
 Models: + kd ( D/(D+E))
CAPM: Riskfree Rate + Beta (Risk Premium) kd = Current Borrowing Rate (1-t)
E,D: Mkt Val of Equity and Debt
& a growth pattern S table Growth Two-S tage Growth Three-S tage Growth
g g g

| |
t High Growth Stable High Growth Transition Stable
 Summary: What is a Venture Theoretically Worth?

• Present value (PV): value today of all future

cash flows discounted to the present at the
investor’s required rate of return
• “Investors pay for the future; entrepreneurs pay
for the past.”
• “If you’re not using estimates, you’re not doing
a valuation.”

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 Basic Mechanics Of DCF Valuation

• Discounted cash flow (DCF):

valuation approach involving discounting future cash flows for risk
and delay
• Explicit forecast period:
two- to ten-year period in which the venture’s financial statements
are explicitly forecast
• Terminal (or horizon) value:
value of the venture at the end of the explicit forecast period
• Stepping stone year:
first year after the explicit forecast period

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Divide and Conquer: Terminal

VCFT
Terminal Value 
r - g
where : VCFT  next period' s cash flow
r  constant disount rate
g  growth rate

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