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# Equity Valuation

Self-Paced Tutorial
Online tutorials for mini classes at: http://tradingroom.bentley.edu

and how to search for those variables using Bloomberg. as well as Relative Value analysis. Our valuation is thus based on estimated future data.Equity Valuation Tutorial Hughey Center for Financial Services © 2003 Introduction: This tutorial is to be used in conjunction with the FI 640A Final Project or any other equity valuation. and that we download historical data to estimate these figures. Multex. not historical data alone! The instructions provided for the retrieval of input variables suggest the repeated opening of Multex and other software. In it we will introduce the Gordon growth.a the Dividend Growth Model) relies on the principle that the value of a stock is equal to the present value of its future cash flows. Po = ∑ n DPS t =1 (1 + k e ) t t + (1 + k e ) Pn n . Reuters. Gordon Growth Model: The Gordon Growth model (a. and First Call. where Pn = DPS n +1 (ke − g n ) Gordon Growth Model Variables: DPSt = expected total dividends per share in year t . Free Cash Flow to Equity. and Free Cash Flow to the Firm models. What must be remembered throughout this tutorial is that future revenues and future costs are what we seek to analyze. These cash flows take the form of dividends. If you seek to retrieve more than one variable over the course of your analysis it is not necessary to repeatedly open and close these software. You must simply leave the application running and change the required ticker information. A cautionary note: the data this tutorial will lead you to analyze is. You will apply growth rates to these historical data to estimate future revenues and costs. Use this model if your stock meets the following criteria: • • • It pays out 90% or more of its Net Income in dividends Its leverage is expected to remain stable into the future Its growth rates are expected to remain stable. historical data. with the exception of earnings estimates. the variables associated with their employment. We will discuss when to use these models.k.

Ke = cost of equity The cost of equity can be found using the Capital Asset Pricing Model. 4. Click .1. Open First Call 4. or you can grow the dividends at what you believe to be realizable growth rates. Numbers in the Earnings Estimates section with the letter A next to them (i. The CAPM equation is as follows: K e = r f + β ( rm − r f ) rf = the risk free rate (typically a US treasury yield that matches your investment horizon) β = Beta (a measurement of a stocks return relative to the market) rm = 5. 3.36A for the 1st quarter of 2003 for Home Depot) are actual recorded earnings.e. enter the company’s ticker symbol (i. You can use these estimates to predict Dividends Per Share (Earnings Per Share * Payout Ratio = Dividends Per Share).2 2.e. HD for Home Depot). Numbers without an A next to them represent the consensus estimates of the analysts following the stock. and towards the top of the page you will see EPS forecasts and actual EPS broken down by quarters. Click and click ok .5%) rf = the risk free rate . 0.5% = the return on the market (the historically accepted risk premium is 5.

β = Beta . 2.1. Open Reuters Kobra Select the quote box and type: “0#USBMK=X” 3. 0. Select the treasury bill/note/bond whose maturity most appropriately represents your holding period. For example. and use its yield as the risk free rate.8545% if your holding period is 1 month.0981% if your holding period is 5 years. or 3.

the greater the number of years you should use in your beta calculation. So we enter the following command: MSFT <equity> BETA And it brings us to the following page: 1. let’s say we’re interested in Microsoft. 3. The market index set as the default in the S&P500. the Beta you would pull is 0. If you were to repeat this process with Home Depot. Five is generally a safe minimum.Beta is a measure of risk. You should change this if you feel another index better represents the risk associated with your market. 2. We will begin by entering the ticker of a company in which we are interested into Bloomberg. For example. The greater the number of years in your forecast. For all intensive purposes we will use the raw beta as it presents us with a larger and more conservative cost of equity. In the range box we type the dates that give us an appropriate timeline by which to measure beta. or if you believe the S&P500 is not large enough a market. Pn = price (terminal value) at the end of year n .53.

Open First Call 4. and these rates are best approximated by the growth rate of the industry. The Payout Ratio is also listed in the Selected Financial Ratios section in First Call. it can be used to grow variables like EPS. 3. It can be found by multiplying the company’s Return On Equity by its Retention Rate (the % of earnings the company does not pay out in dividends). and assorted balance sheet items in the first stage. Finding ROE: 1. 2. A company experiencing rapid growth is expected to have those growth rates approach levels that are more sustainable.2 2. gn = steady state growth rate forever after year n 1. DPS. Your retention rate will equal one minus the payout ratio. Under company reports select Company Comparison. . Click on MultexNet . Pn is a value that must be calculated for the final year of your valuation (the price of the stock at the time you intend to sell it.) Ke represents the cost of equity in the final year. Retention rate = 1 – Dividend Payout Ratio. Enter the username and password located under the keyboard. Click and click ok 3. and click on the fundamentals tab. enter the company’s ticker symbol (i. Terminal growth rates are what mature companies reach. g = extraordinary growth rates for the first n years = retention rate * ROE 1. and DPSn+1 represents the dividend you expect to pay in the year following the terminal year of your valuation. Click on On Equity %.e. . Extraordinary growth can be defined as growth that cannot be sustained indefinitely. HD for Home Depot). . scroll down to selected financial ratios.Pn = DPS n +1 (ke − g n ) 1. In a two-stage model. and you will find Return Finding the Retention Rate: 1. gn represents the company’s terminal growth rate.

Under the Growth Rates section you will find EPS quarterly. Under the Growth Rates section you will find EPS quarterly. To be conservative we will take the lower of the three. Industry.4.N) Growth Rate Terminal Growth Rate (Market Growth Rate) payout ratio Cost of Equity Capital Beta Risk Free Rate Market Risk Premium 15. The terminal growth rate is the growth rate that you expect your company’s to eventually reach. This can be represented as the EPS 5-year growth rate of the industry.e.50% . and 5-year growth rates for the Company.78% 14% 10. sector. 3. click 5. Sector. Dividend Discount Model Home Depot (HD.3% 1. Terminal Growth Rate 1. Enter your company’s ticker into the ticker search (i. Click on MultexNet . Sector. Select the one you believe is most feasible. Under company reports select Company Comparison. Industry. enter HD for Home Depot) and click .e. and the S&P 500. or market. annual. 2. annual.2825% 5. Enter the username and password located under the keyboard. and click on the fundamentals tab. 4. Enter your company’s ticker into the ticker search (i.28 3. HD for Home Depot) and .39% 8. and 5-year growth rates for the Company. and the S&P 500.

1 .29 \$ 0.Year Dividends Terminal Value PV of Dividend Cashflows Stock Value per share Closing stock price 10/21/03 \$ 0 2003 0. To say a firm is leveraged is to say that they are borrowing money and must pay it back. the DDM is not the appropriate model to use. Free Cash Flow to Equity Model: The Free Cash Flow to Equity model is to be used to value firms that possess debt as well as firms that do not payout out more than 90% of their earnings as dividends.76 6 2009 0.74 35. and these cash flows are created after debt payments are taken out. Given the notes listed above.25 \$ 0.48 20. valuations of the stocks given by these models will be different. It is important to note that this model bases its valuation on cash flows to equity.52 \$ \$ 21.34 \$ 0. resulting in a large negative terminal value. the value from the FCFE provides a better estimate of value.23 \$ 2 2005 0.22 \$ \$ 1 2004 0.26 \$ 5 2008 0.60 conclusion: Stock is overvalued Notes The payout ratio is too small to use the Dividend Discount Model The terminal growth rate is larger than the Cost of Equity.25 \$ 4 2007 0. When firms have FCFE different from the dividends they pay out. Damodaran says: “In valuing firms for takeovers or in valuing firms in which there is a reasonable chance of changing corporate control.” FCFE for an unlevered1 firm Cash Flows from Operations -Capital Expenditures -∆Working Capital =Free Cash Flow to Equity FCFE for a levered firm Cash Flows from Operations -Preferred Dividends -Capital Expenditures -∆ Working Capital -Principal repayments +Proceeds from new debt issues =Free Cash Flow to Equity After the FCFE are calculated they must be discounted to the present by dividing each year’s FCFE by (1+WACC)^t.45 \$ 33. Many firms will reinvest their earnings back into the company and these reinvested earnings will not show up as dividends. The essential difference between the Gordon Growth Model and the Dividend Discount Model is the definition of cash flows. Using the Gordon Growth model would thus value the equity incorrectly.24 \$ 3 2006 0.39 \$ \$ 0. Leverage is another word for debt.

Cost Cap. In the “Cash from Operating Activities” you will find “Capital Expenditures.” i.t = the number of years from today WACC = Weighted Average Cost of Capital 1. 2. Under financial reports select Cash Flow Statement. Example: HD <equity> WACC 2. Avg. Enter your company’s ticker into the ticker search (i. 3. Enter the username and password located under the keyboard. HD for Home Depot) and click . Scroll down and you will find in bold letters “Cash from Operating Activities. . 4. Enter the username and password located under the keyboard. and click on the fundamentals tab. HD for Home Depot) and click . The Weighted Average Cost of Capital is next to the title “Wgt. 3. Click on MultexNet . Under financial reports select Balance Sheet. enter the username and password located under the keyboard. Click on MultexNet . and click on the fundamentals tab.” Free Cash Flow to Equity Variables: Cash Flows From Operations 1. and click on the fundamentals tab. 4. Next to financial reports select Cash Flow Statement. Enter your company’s ticker into the ticker search (i.e. On a Bloomberg terminal enter the ticker of your company followed by <equity> followed by “WACC. 2.e. 2.” Working Capital = Current Assets minus Current Liabilities 1.” Capital expenditures 1. Click on MultexNet .

Enter the username and password located under the 1. enter HD for Home Depot) and click . This information may present itself in Multex under the Cash Flows from Investing Activities. Enter your company’s ticker into the ticker search (i.com/servlets/edgarscan 4.” (Proceeds from Long Term Debt) 2003 FPRD LT Debt Proceeds 1. Click on MultexNet keyboard.pwcglobal. It would most likely be stated in the company’s statement of retained earnings. Type in the company’s name. HD <equity> CH3 b.00 1999 0. and it is most likely to appear in the footnotes. of LT Debt. This can prove to be a time consuming hunt. 3.00 Because we see large fluctuations between the years we are led to take an average of the past five years and grow that amount by the growth rate as opposed to only growing the one million we find in 2003. select the hyperlink to its most recent 10-K filing. If it does not pull up on either of these sources. EDGARscan (see above explanation) may be used to find this data.00 2000 522.3. To access this information via EDGARscan go to the following website: http://edgarscan. 2. Scroll down and you will see Current Assets and Current Liabilities in bold letters.e. with additional related information listed in the footnotes. Enter your company’s ticker into the ticker search (i.00 2001 32. In the “Cash from Financing Activities” you will find “Proc. 4. Principal Repayments 1. . 3. Click on “2) Liabilities and Equity. It can also be retrieved from Bloomberg using the following steps: a.” 2. Preferred Dividends 1. This information is presented in the 10-K. and click on the fundamentals tab.e. it must be gotten from the company’s 10-K. Under financial reports select Cash Flow Statement. so be patient. HD for Home Depot) and . and begin your perusal. click 4.00 2002 532. Proceeds from new debt issues .

825.874.05 3.29) 289. It can be used when a company has significant amounts of debt.292.823.00 less Change in Working Capital \$ (22.679.92 \$ 5 2008 \$ 9.394.51 (29. .51 \$ \$ \$ \$ \$ \$ \$ 3 2006 7.172.47 4.13 \$ \$ 5.25 (39.59 \$ (45.29 \$ \$ \$ \$ \$ \$ \$ 2 2005 6.39) 250.91 \$ 2.749.412.22 3.508.60 \$ \$ \$ \$ \$ \$ \$ 1 2004 5.40 conclusion: Stock is undervalued Notes The terminal growth rate is barely less than the WACC.064.690.06 2. which results in an astronomically high terminal value Principal Payments were not listed for the company in the footnotes of its 2003 10-K Free Cash Flow to the Firm Model: This model bases its valuation on all cash flows to the firm.78% 9.01) \$ \$ 444.367.543.337.41 \$ \$ \$ \$ \$ \$ \$ 4 2007 8.021.052.514.378.Free Cash Flow to Equity Home Depot (HD.80) 334.61 \$ \$ 6.48 3.802.N) in millions Growth Rate Terminal Growth Rate (Market Growth Rate) WACC Year 15.97 \$ 2.94) \$ \$ 513.00) less principal repayments \$ plus proceeds from new debt issues \$ 217.00 less preferred dividends \$ less Capital Exenditures \$2.01 (33.34 Stock Value per share \$ 197.87 2.522.01) 385.65 \$ 2.224.29 \$ 5.624.56 4.541.39% 8.645.14 \$ 456.81 \$ 4.660.05 Closing stock price 10/21/03 \$ 35.36 \$ 714.42 4.24 3.40 Free Cash Flows to Equity Terminal Value PV of FCFE Common Shares Outstanding \$2.40 \$2. and when it does not pay the majority of its earnings out in dividends.54% 0 2003 Cash Flows from Operations \$4.414.44 \$ (51.18 (25.490.21 6 2009 \$11.

this measure should be used to approximate the value of a firm in its entirety. Click on MultexNet . . Depreciation 1. Under financial reports select Income Statement. HD for Home Depot) and click . Enter the username and password located under the keyboard. including stockholders. and click on the fundamentals tab. Enter your company’s ticker into the ticker search (i. Click on MultexNet . 4. and click on the fundamentals tab. and preferred stockholders.Damodaran says: “It is the sum of the cash flows to all claim holders in the firm.” As such. 2.e. 3. HD for Home Depot) and click . Under financial reports select Income Statement.e. It is calculated as follows: Net Income +Depreciation -Capital Expenditures -∆Working Capital +Interest expense (1-tax rate) =Free Cash Flows to the Firm After the FCFF are calculated they must be discounted to the present by dividing each year’s FCFF by (1+WACC)^t. 4. Use the expense titled “Depreciation” for the purpose of your analysis. bondholders. Free Cash Flow to the Firm Variables: Net Income 1. 2. 3. Enter your company’s ticker into the ticker search (i. Use “Net Income After Taxes” for the purpose of your analysis. Enter the username and password located under the keyboard. not just the firm’s equity value.