2024 University of Edinburgh Business School ICF Lecture 8 Valuing Businesses PDF

BUST08030 Introduction to Corporate Finance Lecture 8 Valuing Businesses Dr Huacheng Zhang University of Edinburgh Business School ▪ In this lecture… Value vs Price Valuation methods Using DCF method to value a business 2024...

BUST08030 Introduction to Corporate Finance Lecture 8 Valuing Businesses Dr Huacheng Zhang University of Edinburgh Business School ▪ In this lecture… Value vs Price Valuation methods Using DCF method to value a business 2024 BUST08030 ICF 2 Why Business Valuation? Evaluating Business Strategies What is the effect on firm value of a new strategy? Communicating with Analysts and Shareholders How is firm value being affected? Appraising Private Businesses What is the value of a private firm? Compensation What is the value of equity compensation? Evaluating Corporate Events What is the effect of a firm value from a merger? 2024 BUST08030 ICF 3 Price vs. Value ▪ Price-agreed dollar value in the market, or market value ▪ Value-participant’s subjectively estimated dollar value: intrinsic value ▪ Going-concern value: firm will continue its operations Fair Market Value firm will continue to sell its goods and services - well-informed, willing buyer and seller firm will use its assets for value maximization firm will access its optimal source of financing Fair Value ▪ Liquidation value: firm will be dissolved （“Gone Concern”) - Financial reporting firm’s assets will be sold separately Investment Value ▪ Going-concern value > Liquidation value - Value to specific buyer Value added from asset synergy Value added by managerial skills 2024 BUST08030 ICF 4 Price vs. Value cont. ▪ For example, if the market price of an asset is $10 and the analyst estimates intrinsic value at $10, a logical conclusion is that the security is fairly valued. ▪ If the security is selling for $20, the security would be considered overvalued. If the security is selling for $5, the security would be considered undervalued. ▪ By estimating value, we can assume that the market price may not be the best estimate of intrinsic value. Undervalued fairly valued overvalued If the estimated If the estimated If the estimated value exceeds the value equals the value is less than market price market price the market price 2024 BUST08030 ICF 5  The “value” and “price” can be very different Price earning ratio did a good job in predicting stock return. (Siegel 2016 Financial analyst journal) However, you might need to wait for years until the adjustment eventually happen. Markets can remain irrational for longer than you can remain solvent" (by John Maynard Keynes, 1930s). 2024 BUST08030 ICF 6 Value vs Price-Robinhood ▪ “This is a company that some analysts essentially wrote off a year ago, that has been shuttering hundreds of stores, that has struggled for years” ▪ “GameStop is currently worth more than almost 90% of U.S. companies in the Russell 3000.” ▪ “But GameStop’s shares are no longer rooted in business reality after Reddit fans propelled them to stratospheric highs” ▪ “At around $326, the share price is more than 10 times higher than it would be based on the company’s fundamentals. Analysts typically look at cash flow, growth and debt to figure out target prices.” ▪ “ ‘I think it’s fair to say that the market is completely disconnected from GameStop fundamentals here,’ said Matthew Kanterman, an analyst at Bloomberg Intelligence.” https://www.nasdaq.com/market-activity/stocks/gme https://www.bloomberg.com/news/articles/2021-01-27/what-s-the-23-billion-gamestop-really-worth-maybe-2-billion 2024 BUST08030 ICF 7 Principles in Valuing Businesses (recap) 1. Understanding the Business Industry and competitive ▪ Invest in projects that yield a return analysis Financial statement analysis greater than the minimum acceptable hurdle rate. 2. Forecasting Company Performance ▪ The hurdle rate should be higher for Forecast sales, earnings, dividends, and financial position riskier projects and reflect the financing mix (equity/debt). 3. Selecting the Appropriate Valuation Model ▪ Returns on projects should be Base selection on company characteristics measured based on cash flows generated and their timing. 4. Using Forecasts in a Valuation ▪ If there are not enough investments Use judgment in valuation application that earn the hurdle rate, return the cash to stockholders. 5. Applying the Valuation Conclusions Investment Valuation opinions Strategic decisions recommendations 2024 BUST08030 ICF 8 Valuation Models Absolute Valuation Models Relative Valuation Models Present value models Price ratios Dividend discount models Price-to-earnings ratio Free cash flow to equity Price-to-book-value ratio Free cash flow to firm Price-to-cash-flow ratio Residual income Enterprise value multiples Asset-based models 2024 BUST08030 ICF 9  Cashflow Discounting Models 2024 BUST08030 ICF 10 Discounted Cash Flow Valuation (DCF) ▪ Recall the concept of time value of money: ▪ Time value of money concerns equivalence relationships between cash flows occurring on different dates. In other words: Money has different values at different points of time. 𝒕=𝒏 𝑪𝑭𝒕 𝑽𝟎 = ෍ 𝟏+𝒓 𝒕 𝒕=𝟏 ▪ where V0 = value of the asset at time t = 0 n = life of the asset (number of cash flows in the life of the asset) CFt = cash flow in period t r = discount rate reflecting the riskiness of the estimated cash flows 2024 BUST08030 ICF 11 Present Value of Future Cash Flows - Example ▪ An asset is expected to generate cash flows of 100 in one year, 150 in two years, and 200 in three years. ▪ The discount rate is set at 10%. What is the value of the asset today? 𝟏𝟎𝟎 𝟏𝟓𝟎 𝟐𝟎𝟎 𝑽𝟎 = 𝟏 + 𝟐 + 𝟑 = 𝟗𝟎. 𝟗𝟎𝟗 + 𝟏𝟐𝟑. 𝟗𝟔𝟕 + 𝟏𝟓𝟎. 𝟐𝟔𝟑 = 𝟑𝟔𝟓. 𝟏𝟑𝟗 𝟏. 𝟏𝟎 𝟏. 𝟏𝟎 𝟏. 𝟏𝟎 ▪ Similarly, we can value the asset at a future date, for instance at t = 1? 𝟏𝟓𝟎 𝟐𝟎𝟎 𝑽𝟏 = 𝟏 + 𝟐 = 𝟏𝟑𝟔. 𝟑𝟔𝟒 + 𝟏𝟔𝟓. 𝟐𝟖𝟗 = 𝟑𝟎𝟏. 𝟔𝟓𝟑 𝟏. 𝟏𝟎 𝟏. 𝟏𝟎 2024 BUST08030 ICF 12 Dividend Discount Model ▪ 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. 𝑫𝟏 𝑫𝒏 𝑷𝒏 𝑽𝟎 = 𝟏 + ⋯+ 𝒏+ 𝒏 𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝒏 𝑫𝒏 𝑷𝒏 𝑽𝟎 = ෍ 𝒏+ 𝒏 𝟏+𝒓 𝟏+𝒓 𝒕=𝟏 ▪ where V0 = value of the share at time t = 0 Pn = expected price per share at t = n D1 = expected dividend per share for Year 1, assumed to be paid at the end of the year at t = 1 r = discount rate reflecting the riskiness of the estimated cash flows n = life of the asset (number of cash flows in the life of the asset) 2024 BUST08030 ICF 13 Dividend Discount Model – Example ▪ For the next five years, the annual dividends of a stock are expected to be 2.00, 2.10, 2.20, 3.50 and 3.75. The stock price is expected to be 40.00 in five years. What is the value of the stock assuming a 10% required return on equity? 𝟐. 𝟎𝟎 𝟐. 𝟏𝟎 𝟐. 𝟐𝟎 𝟑. 𝟓𝟎 𝟑. 𝟕𝟓 𝟒𝟎. 𝟎𝟎 𝑽𝟎 = 𝟏 + 𝟐 + 𝟑 + 𝟒 + 𝟓 + 𝟓 𝟏 + 𝟎. 𝟏𝟎 𝟏 + 𝟎. 𝟏𝟎 𝟏 + 𝟎. 𝟏𝟎 𝟏 + 𝟎. 𝟏𝟎 𝟏 + 𝟎. 𝟏𝟎 𝟏 + 𝟎. 𝟏𝟎 𝑽𝟎 = 𝟑𝟒. 𝟕𝟔 2024 BUST08030 ICF 14 Gordon Growth Model ▪ The simplest pattern that can be assumed in forecasting future dividends is growth at a constant rate. This can be expressed as 𝑫𝒕 = 𝑫𝒕−𝟏 (𝟏 + 𝒈) where g = expected constant growth rate in dividends Dt = expected dividend payable at time t ▪ Hence, for any time t, Dt, equals the dividend at time t = 0, compounded at g for t periods 𝒕 𝑫𝒕 = 𝑫 𝟎 𝟏 + 𝒈 ▪ If we now substitute this to the Dividend Discount Model, we can derive the Gordon Growth Model 1 𝑫𝟎 𝟏 + 𝒈 𝑫𝟏 𝑽𝟎 = 𝒐𝒓 𝑽𝟎 = 𝒓−𝒈 𝒓−𝒈 2024 BUST08030 ICF 15 Gordon Growth Model – Example ▪ Sonoco Products Company: Most recent quarterly dividend 0.31 (annual dividend 4 x 0.31 = 1.24 per year) Dividend growth rate is forecasted at 4% Rate of return (CAPM) is 7.3% ▪ What is the value of the stock using the Gordon Growth Model? 𝐷0 (1 + 𝑔) 1.24 × 1.04 1.2896 𝑉0 = = = = 39.08 𝑟−𝑔 0.073 − 0.04 0.033 2024 BUST08030 ICF 16 Estimating Growth Rate Industry Macroeconomic g = b x ROE Average Average ROE = DuPont formula Profits/Sales × Sales/Assets × Assets/Equity 2024 BUST08030 ICF 17 Sustainable Growth Rate ▪ We define the sustainable growth rate as the rate of dividend (and earnings) growth that can be sustained for a given level of return on equity, assuming that the capital is constant through time and that no additional stock is issued. 𝒈 = 𝒃 × 𝑹𝑶𝑬 ▪ where ▪g = dividend growth rate ▪b = earnings retention rate (1 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜) ▪ ROE = return on equity 2024 BUST08030 ICF 18 Business life cycle and dividend growth sustainability Rapidly increasing Transition ROE = r earnings Earnings and dividends Heavy reinvestment Earnings growth slows growth matures Small/no dividends Capital reinvestment Gordon growth model slows useful FCFE/ dividends increasing Growth Maturity 2024 BUST08030 ICF 19 Two-stage Dividend Discount Model ▪ The two-stage model assumes that the first n dividends grow at an extraordinary short-term rate gS. ▪ After time n the dividend growth rate changes to a normal long-term growth rate gL. ▪ To find V0 at time t = 0 we need to find the present value of the first n dividends and the present value of the projected value at time n: 𝒏 𝑫𝟎 𝟏 + 𝒈𝑺 𝒕 𝑫𝟎 𝟏 + 𝒈𝑺 𝒏 (𝟏 + 𝒈𝑳 ) 𝟏 𝑽𝟎 = ෍ + ∗ 𝟏+𝒓 𝒕 (𝒓 − 𝒈𝑳 ) 𝟏+𝒓 𝒏 𝒕=𝟏 2024 BUST08030 ICF 20 Two-stage Dividend Discount Model – Example ▪ Current dividend = 2.00 Growth rate for next three years = 15% ▪ Long-term growth = 4% Required rate of return = 10% _________________________________________________________________________________________ ▪ Step 1: Calculate the first three dividends 𝑫𝟏 : 𝟐. 𝟎𝟎 × 𝟏 + 𝟎. 𝟏𝟓 = 𝟐. 𝟑𝟎, 𝑫𝟐 : 𝟐. 𝟑𝟎 × 𝟏 + 𝟎. 𝟏𝟓 = 𝟐. 𝟔𝟒𝟓, 𝑫𝟑 : 𝟐. 𝟔𝟒𝟓 × 𝟏 + 𝟎. 𝟏𝟓 = 𝟑. 𝟎𝟒𝟏𝟖 ▪ Step 2: Calculate the Year 4 dividend 𝑫𝟒 : 𝟑. 𝟎𝟒𝟏𝟖 × 𝟏 + 𝟎. 𝟎𝟒 = 𝟑. 𝟏𝟔𝟑𝟒 ▪ Step 3: Calculate the value of the constant growth dividends 𝟑. 𝟏𝟔𝟑𝟒 𝑽𝟑 = = 𝟓𝟐. 𝟕𝟐𝟑𝟕 (𝟎. 𝟏𝟎 − 𝟎. 𝟎𝟒) ▪ Step 4: Valuation 𝟐. 𝟑𝟎 𝟐. 𝟔𝟒𝟓 𝟑. 𝟎𝟒𝟏𝟖 𝟓𝟐. 𝟕𝟐𝟑𝟕 𝑽𝟎 = + + + = 𝟒𝟔. 𝟏𝟕 (𝟏 + 𝟎. 𝟏𝟎) 𝟏. 𝟏𝟎𝟐 𝟏. 𝟏𝟎𝟑 𝟏. 𝟏𝟎𝟑 2024 BUST08030 ICF 21  Valuing Businesses Applying DCF models 2024 BUST08030 ICF 22 Equity Valuation ▪ I. The value of equity is the value of the firm minus the value of its debt: 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑭𝒊𝒓𝒎 𝒗𝒂𝒍𝒖𝒆 − 𝑫𝒆𝒃𝒕 𝒗𝒂𝒍𝒖𝒆 ▪ II. The value of equity can also be obtained by discounting expected cash flow to equity, i.e., the residual cash flow 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 𝑭𝑪𝑭𝑬𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 = ෍ 𝟏 + 𝒓𝒆 𝒕 𝒕=𝟏 ▪ where ▪ FCFEt = expected cash flow to equity in period t ▪ re = cost of equity 2024 BUST08030 ICF 23 Firm Valuation ▪ The value of the firm is obtained by discounting expected cash flow to the firm, i.e., the residual cash flow 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 𝑭𝑪𝑭𝑭𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑭𝒊𝒓𝒎 = ෍ 𝒕 𝟏 + 𝑾𝑨𝑪𝑪 𝒕=𝟏 ▪ where ▪ FCFFt = expected cash flow to firm in period t ▪ WACC = weighted average cost of capital 2024 BUST08030 ICF 24 Constant Growth DCF Models ▪ The assumption that free cash flows grow at a constant rate leads to a single-stage (stable-growth) FCFF (or FCFE model). If FCFF grows at a constant rate g the FCFF for the current period is: 𝑭𝑪𝑭𝑭𝒕 = 𝑭𝑪𝑭𝑭𝒕−𝟏 𝟏 + 𝒈 ▪ Hence, firm value can then be calculated as: 𝑭𝑪𝑭𝑭𝟏 𝑭𝑪𝑭𝑭𝟎 (𝟏 + 𝒈) 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑭𝒊𝒓𝒎 = = 𝑾𝑨𝑪𝑪 − 𝒈 𝑾𝑨𝑪𝑪 − 𝒈 ▪ Likewise, for equity value we can assume: 𝑭𝑪𝑭𝑬𝒕 = 𝑭𝑪𝑭𝑬𝒕−𝟏 𝟏 + 𝒈 𝑭𝑪𝑭𝑬𝟏 𝑭𝑪𝑭𝑬𝟎 (𝟏 + 𝒈) 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 = = 𝒓𝒆 − 𝒈 𝒓𝒆 − 𝒈 2024 BUST08030 ICF 25 Single-Stage DCF Model Current FCFF 6,000,000 Target debt/capital 0.25 Market value/debt 30,000,000 Shares outstanding 2,900,000 Required return on equity 12% Cost of debt 7% Long-term growth 5% Tax rate 30% 𝑾𝑨𝑪𝑪 = 𝟎. 𝟐𝟓 × 𝟎. 𝟎𝟕 × 𝟏 − 𝟎. 𝟑𝟎 + 𝟎. 𝟕𝟓 × 𝟎. 𝟏𝟐 = 𝟎. 𝟏𝟎𝟐𝟑 ~ 𝟏𝟎. 𝟐𝟑% 𝟔, 𝟎𝟎𝟎, 𝟎𝟎𝟎 × (𝟏 + 𝟎. 𝟎𝟓) 𝑭𝒊𝒓𝒎 𝑽𝒂𝒍𝒖𝒆 = = 𝟏𝟐𝟎. 𝟓 𝑴 𝟎. 𝟏𝟎𝟐𝟑 − 𝟎. 𝟎𝟓 𝑬𝒒𝒖𝒊𝒕𝒚 𝑽𝒂𝒍𝒖𝒆 = 𝟏𝟐𝟎. 𝟓 𝒎𝒏 − 𝟑𝟎 𝒎𝒏 = 𝟗𝟎. 𝟓 𝑴 𝟗𝟎. 𝟓 𝑴 𝑬𝒒𝒖𝒊𝒕𝒚 𝒗𝒂𝒍𝒖𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 = = 𝟑𝟏. 𝟐𝟏 𝟐. 𝟗 𝑴 2024 BUST08030 ICF 26 Two-stage DCF Models The expression for the two-stage FCFF model is: 𝒏 𝑭𝑪𝑭𝑭𝒕 𝑭𝑪𝑭𝑭𝒏+𝟏 𝟏 𝑭𝒊𝒓𝒎 𝒗𝒂𝒍𝒖𝒆 = ෍ 𝒕 + × 𝒏 𝟏 + 𝑾𝑨𝑪𝑪 𝑾𝑨𝑪𝑪 − 𝒈 𝟏 + 𝑾𝑨𝑪𝑪 𝒕=𝟏 The expression for the two-stage FCFE model is: 𝒏 𝑭𝑪𝑭𝑬𝒕 𝑭𝑪𝑭𝑬𝒏+𝟏 𝟏 𝑬𝒒𝒖𝒊𝒕𝒚 𝒗𝒂𝒍𝒖𝒆 = ෍ 𝒕 + × 𝒏 𝟏+𝒓 𝒓−𝒈 𝟏+𝒓 𝒕=𝟏 2024 BUST08030 ICF 27 Forecasting FCFF and FCFE ▪ Two approaches to forecast FCFF and FCFE: ▪ 1) Use historical free cash flow and apply a growth rate under the assumptions that growth will be constant and firm fundamentals are unchanged. ▪ 2) Forecast the underlying components of free cash flow. Sales growth to future capital expenditures Depreciation expenses Changes in working capital 2024 BUST08030 ICF 28 Uses of Free Cash Flows ▪ A firm has the following alternative uses of positive FCFF: 1. Retain the cash and increase the firm's balances of cash and marketable securities. 2. Use the cash for payments to providers of debt capital (i.e. interest payments or principal repayments in excess of new borrowings). 3. Use the cash for payments to providers of equity capital (i.e. dividend payments and/or share repurchases in excess of new share issuances). ▪ Similarly, the firm has the following general alternatives to cover negative cash flows: 1. Draw down cash balances 2. Borrow additional cash 3. Issue equity 2024 BUST08030 ICF 29 Which Cashflow? Choice of DCF Models Dividend History of dividend payments Dividends related to earnings Discount Models Non-controlling perspective Free Cash Flow Small or zero dividends Positive cash flow related to earnings Models Controlling perspective Residual Income Small or zero dividends Negative free cash flows Models High-quality accounting disclosures 2024 BUST08030 ICF 30 Criticism FT.com, 13/10/16: Bernstein questions foundation of finance. Again. 2024 BUST08030 ICF 31 Corner: Criticism cont. ▪ ‘Musings on Markets’ by Aswath Damodaran http://aswathdamodaran.blogspot.co.uk/2011/ 04/alternatives-to-capm-part-1-relative.html FT.com, 13/10/16: Bernstein questions foundation of finance. Again. 2024 BUST08030 ICF 32 Main readings ▪ BMEA Ch. 4 ▪ BD Ch. 9 2024 BUST08030 ICF 33