1.

2 Valuation

Valuation is the estimation of an asset‟s value based on variables perceived to be related to

future investment returns, on comparisons with similar assets, or, when relevant, on estimates of

immediate liquidation proceeds (Pinto, et al, 2010).

The valuation approach highly depends on whether the company is at liquidation state or has a

going- concern. The liquidation approach values the company‟s equity by measuring the net

proceeds that the company can obtain if it liquidates all its assets and settles all its liabilities

(Petersen and Plenborg,

2012). As such, this approach should only be used if liquidation is expected at the end of the

forecast period, which is not the case of BMW, CON and/or VOW. Therefore this approach will

not be further discussed or utilized for valuing in this thesis.

For companies with going concern, there exist two main valuation techniques that may be

applied to estimate the valuate equity of companies with going-concern. They are;

A. The relative valuation model is a going concern valuation models that estimate an asset‟s

value relative to that of another asset (Pinto et al. 2010). The idea behind this model is, similar

assets should sell at similar prices and it is implemented using pricing multiples. (Which are

ratios of stock price to a fundamental such as earnings per share) or enterprise value multiples

(ratios of the total value of common stock and debt net of cash and short-term investments to a

fundamental such as operating earnings). Since my focus is on some selected present value

models, the relative valuation model will also not be further discussed in this thesis.

B. The absolute valuation model is a model that specifies an asset‟s intrinsic value. Such models

are used to produce an estimate of value that can be compared with the asset‟s market (Pinto, et

al, 2010). The most important type of absolute equity valuation models are present value models.
In finance theory, present value models are considered the fundamental approach to equity

valuation. The logic of such models is that the value of an asset to an investor must be related to

the returns that investor expects to receive from holding that asset. Generally, those returns can

be referred to as the asset‟s cash flows, and present value models are also referred to as

discounted cash flow models.

1.2.1 Discounted Cash Flow (DCF)

The value of an asset must be related to the benefits or returns we expect to receive from

holding it (Pinto, et al, 2010). It views the intrinsic value of common stock as the present value

of its expected future cash flows. Discounted cash flow valuation is one of our main ways of

approaching valuations, and according to Damodaran, (2012) DCF is the foundation on which all

other approaches are built on. In order to do relative valuation correctly we need to understand

the fundamentals of discounted cash flows valuation. Moreover discounted cash flow models are

based on the concept that the value of a share of stock is equal to the Present Value (PV) of the

cash flow that the stockholders expects to receive from it (Elton et al. 2011).

Discounted cash flow valuation is a method of valuing a project, company, or an asset using the

concepts of the time value of money. All future cash flows are estimated and discounted to give

their PVs – the sum of all future cash flows, both incoming and outgoing, is the net present value

(NPV), which is taken as the value or price of the cash flows in question. This section will

present a result of the firm‟s PV as well as the value of the stock.

Basis for discounted cash flow valuation has its foundation in the net present value (NPV), where

the value of any asset is present value of expected future cash flows that the asset generates.

Formula 1: Discounted Cash Flow

Where;

DFC = Discounted Cash flow,

CF= Cash flow,

n = Life of the asset and

r = Discount rate reflecting the riskiness of the estimated cash flows

Cash Flow varies from asset to asset; the discount rate is a function of the riskiness of the

estimated cash flows, the riskier assets the higher rates and vice versa for safer projects.

(Damodaran, 2002)

According to Neale & McElroy (2004), the main problems with the Discounted Cash Flow

approach centers on the key variables in the model. Can future investment levels be accurately

projected? How can we measure the discount rate? Over what time should we assess value?

Should we accept the current earning figure? These are relevant questions in understanding

valuation.

There are numbers of different discounted cash flow models one can use, however in this paper i

will focus on Equity Valuation using Dividend Discount Model (DDM) and Free Cash Flow

models (FCF), since we are only interested in valuing the stock price.

1.2.1.1 Dividend Discount Model (DDM)

There are numbers of different discounted cash flow models one can use, however in this thesis;

I will focus on equity valuation using Dividend Discount Model (DDM) and Free Cash Flow to

Equity (FCFE), since we are only interested in valuing the stock price. DDM is a method for
valuing the price of a stock for a company which pays out dividends, assuming that the price of a

stock is equivalent to the sum of all of its future dividend payments discounted to the present

value. Within this model you can use a set of different approaches such as;

• Price of stock with zero growth dividends

• Gordon Growth Model (Price of stock with constant growth dividends)

• Price of stock at time n with constant growth dividends (Terminal Value)

• Multistage Dividend Discount Models

1.2.1.1.1 Price of stock with zero growth dividends

Since the zero growth model assumes that the dividend always stay the same, the stock price

would in that case be equal to the annual dividends divided by the Rate of Return (ROR). The

stockholders can therefore expect that future earnings will be flat and there will not be any

further increase in the dividends payout, e.g. preferred stockholders In order to calculate the

value of the stock for we use the formula:

Formula 2: Price of stock with zero growth dividends

Where;

Vo = The value of equity,

DPS = Dividend per Share and

r = discounting/capitalization rate

1.2.1.1.2 Gordon Growth Model (Price of stock with constant growth dividends)

The Gordon growth model, developed by Gordon and Shapiro (1956) and Gordon (1962),

assumes that dividends grow indefinitely at a constant rate. Using the Dividend Discount Model
to value the price of the stock, we sum all the company’s future dividends, which in this case are

assuming to grow at a constant rate. This model works best when valuating stocks for established

companies, meaning that they should have increased the dividend steadily over the years.

Although the annual increase is not always the same Gordon Growth Model can be used to

approximate an intrinsic value of the stock. This is the least sophisticated of the DDM, but there

are still some important aspects that are needed to be considered, as mentioned before the growth

has to be stable which could be difficult to determine for some companies. Important is also to

realize the importance of growth in all DDM‟s, since small variations in growth will make a

large impact on the value.

Formula 3: Gordon Growth Model (Price of stock with constant growth dividends)

Where;

V0 = The value of equity,

D0 = Current dividend,

D1 = Next year’s dividend

r = The required rate of return for equity investors g = Constant dividend growth rate.

Further it is important to recognize that growth cannot exceed the market capitalization rate. If

dividends were expected to grow forever at a rate faster than k, the value of the stock would be

infinite (Bodie et al. 2014). It might be nonsensical but in reality this occurs often for firms in the

real market especially those that are in a period of high growth, usually this growth settles down

after a period of time to a more normalized growth. If r is equal to or less than g , equation

above as a compact formula for value assuming constant growth is not valid; If r equals g,
dividends grows at the same rate at which they are discounted, leading to an infinite stock value.

This is also true is g exceeds r where dividends grows faster than they are discounted. If r is less

than g, dividends grow faster than they are discounted. There are two ways to handle such a

situation so the DDM would be effective;

• First, the growth could be considered as a long term average or a normal growth rate.

This is a far from a satisfactory way to handle the problem, since the rapid growth often occurs

the early stage of the life cycle and the value computed when using an average growth will

highly underestimate the near future dividends.

• Alternatively, the growth could be segmented into different stages of the company’s

financial cycle, and each of these stages could be valued separately, this is being explained more

detail later (Pike et al 2012).

Generally, the Gordon Growth Model form of the DDM is most appropriate for companies with

earnings expected to grow at a rate comparable to or lower than the economy’s nominal growth

rate, measured by the growth in Gross Domestic Product (GDP). GDP is a money measure of the

goods and services produced within a country’s borders. GDP growth (nominal) can be estimated

as the sum of the estimated real growth rate in GDP plus the expected long – run inflation rate.

i. The Implied Dividend Growth Rate

Different growth rate assumptions might explain the differences between estimated values of a

stock and its actual market value since the dividend growth rate affects the estimated value of a

stock when using the Gordon growth model. Calculation of the implied dividend growth rate

provides an alternative perspective on the valuation of the stock; it shows if stock is fairly

valued, overvalued, or undervalued. It can be used to judge whether the implied dividend growth
rate is reasonable, high, or low. The Gordon growth model can be used to infer the market’s

implied growth rate for a stock.

ii. The Present Value of Growth Opportunities (PVGO)

Equity stock valuation can be analyzed as either the value of a firm without earnings reinvested

or the PVGO. PVGO sums the expected value today of opportunities to profitably reinvest future

earnings (Pinto et al. 2010). Growth of earnings may increase, not changed, or reduce

shareholder wealth depending on whether the growth results from earning returns is in excess of,

equal to, or less than the opportunity cost of funds. Companies should settle for reinvestment of

earning if they have a positive NPV, i.e., returns on earnings reinvested should be higher than the

required return of equity (re). If the returns to an investment decision is less than or equal to the

required return of equity (NPV≤ 1), it would be better for such a company to distribute earnings

rather than reinvest them. Companies can only exploit profitable growth opportunities if the rate

of return (r) exceeds the required return of equity (re).

A company with a negative NPV is referred to as a no-growth company. Such a company as I

earlier mentioned should distribute earnings in dividends since it can’t reinvest profitably and

earnings will be flat in perpetuity, assuming a constant return on equity. This flatness occurs

because earnings equals ROE x Equity and equity is constant because retained earnings are not

added to it. The no- growth value per share is outlined as E 1/r , which is the present the value of a

perpetuity in the amount of E1 where the discount/capitalization rate, (r), is the required rate of

return on the company’s equity. E1/r can also be interpreted as the per share value of assets in

place because of the assumption that the company is making no new investments since it’s not
profitable. For any company, the actual value per share is the sum of the no – growth value per

share and the present value of growth opportunities (PVGO):

Formula 4: Present Value of Growth Opportunities

Where; variables are same like previous

iii. Estimating a Required Return Using the Gordon Growth Model

Under the assumption of efficient prices, the Gordon growth model has been used to estimate a

stock‟s required rate of return, or equivalently, the market-price-implied expected return.

The Gordon growth model solved for r is;

Formula 5: Required rate of return using the Gordon Growth Model

Where; variables are same like previous

1.2.1.1.3 Price of stock at time n with constant growth dividends (Terminal Value).

According to Damodaran, (2012) many companies grow very rapidly in its first few years and

then subsequently settling down to a constant growth rate. In this case we have to con-sider both

the initial hyper growth stage and then the subsequent constant growth stage in order to value the

price of the stock of a company. The constant growth stage is similar to the Gordon growth

model where we value the price of a constant growth stock.

Formula 6: Terminal Value

Where;

Vn = Price (terminal value) at end of year n,

Dn = Expected dividends per share in year n,

re = Cost of Equity (st: Stable growth period) and

g = expected growth rate forever after year n

A characteristic of the constant growth model is that the components of total return (dividend

yield and capital gains yield) will also stay constant through time, given that price tracks value

exactly. The dividend yield, which is D1 / P0 at t0, will stay unchanged because both the dividend

and the price are expected to grow at the same rate, leaving the dividend yield unchanged

through time.

1.2.1.1.4 Multistage Dividend Discount Models

For many publicly traded companies, practitioners assume growth falls into three stages (Sharpe

et al. 1999).

• Growth phase. Companies at their growth phase typically enjoy rapid expanding

markets, high profit margins, and abnormally high growth rates in per share earnings

(supernormal growth). Companies in this phase often have negative Free Cash Flow to Equity

because they heavily invest on operations to expand. The dividend payout ratios of growth-

phase companies are often low or even zero but promising high prospective equity returns. As

the companies markets mature or as unusual growth opportunities attract competitors, earnings

growth rates eventually decline.

• Transition phase. At this phase, earnings growth slows as competition puts pressure on

prices and profit margins or as sales growth slows because of market saturation. In this phase,

earnings growth rates may be above average but declining toward the growth rate for the overall

industry. They experience capital requirements declines, often resulting in positive Free Cash

Flow and increasing dividend payout ratios or the initiation of dividends for companies that did

not pay dividends in the past.

• Mature phase. Here, companies attain equilibrium in which investment opportunities on

average just earn as much as their opportunity cost of capital. Return on equity approaches the

required return on equity, and earnings growth, the dividend payout ratio, and the return on

equity stabilize at levels that can be sustained long term. At this phase, the dividend and earnings

growth rate is called the mature growth rate. This phase, in fact, reflects the stage in which a

company can properly be valued using the Gordon Growth Model.

A company may attempt and succeed in restarting the growth phase by changing its strategic

focuses and business mix. Technological advances may alter a company’s growth prospects for

better or worse with surprising rapidity. Nevertheless, this growth phase picture of a company is

a useful approximation. The growth phase concept provides the intuition for multistage

discounted cash flow (DCF) models of all types, including multistage Dividend Discount

Models.

Two-stage Dividend Discount Model

As mentioned above companies tend to initially grow very rapidly in its first few years and then

subsequently settling down to a constant growth rate, however to value the stock price of a

company with non-constant growth increases the difficulty, one way is to assume that the

company instead have a two stage growth.

Formula 7: Two-stage Dividend Discount Model

Where;

V0 = Value of share at t0,

D0 = Current Dividends,

gs = short – term dividend growth rate,

gL = long – term dividend growth rate,

r = required rate of return

t = length of high growth period.

Two-stage DDM is better suited than Gordon growth model for companies that has not yet

reached a state of steady growth, but it far from a perfect way to value stock price. First there are

now two different growths to be considered, we have the high growth stage which could

be difficult to determine since the growth can vary heavily from year to year. Then the constant

growth rate has to be determined for the perpetuity. Second, you have to determine for how

many years the high-growth phase will continue before the firm will enter into a steady state.

Third the two-stage DDM implies that the growth would abruptly end and that the company

would then immediately enter a constant growth state; more realistic would be that this transition

would happen over a longer period of time.

The H - Model

The basic two-stage model assumes a constant, extraordinary rate for the supernormal growth

period that is followed by a constant, normal growth rate thereafter. The difference in growth
rates may be substantial. Fuller & Hsia (1984) developed a variant of the two – stage model in

which growth begins at a high rate and declines linearly throughout the supernormal growth

period until it reaches a normal rate at the end. The value of the dividend streaming the H-model

is;

Formula 8: The H – Model

Where;

Vo = Value per share at t0 ,

D0 = Current Dividends,

gs = short – term dividend growth rate,

gL = normal long – term dividend growth rate after year H2,

r = required rate of return,

t = length of high growth period.

t
And H = denoting half-life of the high growth period in years
2

The H-model is an approximation model estimating the valuation that would result from

discounting all future dividends individually. In many circumstances, the approximation is

somewhat accurate. For a long extraordinary growth period (a high H) or for a large difference in

growth rates (the difference between gS and gL), however, the analyst might abandon the

approximation model for the more exact model.

 Three-stage Dividends Discount Model

There are two popular versions of this stage, distinguished by the modeling of the second stage.

With the first version it is assumed the company has three distinct stages of growth and the
second stage growth rate is typically constant. For example, stage 1 could assume 10% growth

for four years, stage 2 could have 5% growth for four years, and stage 3 could have 3% growth

thereafter while with the second version, the growth rate in the middle stage is assumed to

decline linearly to the mature growth rate; essentially, the second and third stages are treated as

an H - model. In the first stage, dividends grow at a high, constant abnormal rate for the whole

period. At the second stage, dividends decline linearly as they do in the H–model and in stage 3;

dividends grow at a sustainable, constant growth rate. The following steps apply in the use of this

version:

1. Gather the required inputs:

 The current dividend.

 The lengths of the first, second, and third stages.

 The expected growth rates for the first and third stages.

 An estimate of the required return on equity.

2. Compute the expected dividends in the first stage and find the sum of their present values.

3. Apply the H-model expression to the second and third stages to obtain an estimate of their

value as of the start of the second stage and find the present value of this H-value as of today (t0).

4. Sum the values obtained in the second and third steps.

Three-stage DDM is superior to the two-stage DDM in the way that there is a transaction phase

where you can account for the time it takes to go from an initial high growth phase to a normal

growth. With the extra input there is also some negative aspects, as mentioned before it’s

difficult to determine for how long the initial high grow phase will continue this is still a problem

in the three-stage model but know there is also the aspect of determining how long the decline
from high to low-growth will take but also how the decline will occur. The decline can occur in a

number of ways with the easiest to use arguably being a straight line decline. The difficulties in

determine the length of the high growth phase and the transaction period together with

determining in what whey de decline will happen affects the accuracy of the prediction.

A problem with all dividend-based valuations are that they apply the assumption that there is an

informative relationship between current dividends and future dividends, this might hold true in

most cases, but in theory it might not. The biggest fundamental problem with the dividend-based

valuation however might be that they do not address the determinants of dividend growth.

Dividend-based models have no explanation between current dividends and future dividends

(Baker et al. 2001).

Estimating the required return using any DDM

Given current price and all inputs to a DDM except for the required return, an Internal Rate of

Return (IRR) can be calculated. Such an IRR has been used as a required return estimate

(although reusing it in a DDM is not appropriate because it risks circularity). This IRR can also

be interpreted as the expected return on the issue implied by the market price essentially, an

efficient market expected return. Keep in mind that if price does not equal intrinsic value, the

expected return will need to be adjusted to reflect the additional component of return that accrues

when the mispricing is corrected, as discussed earlier.

In some cases, finding the IRR is very easy. In the Gordon growth model, r= D 1 / P 0 + g. The

required return estimate is the dividend yield plus the expected dividend growth rate.

For the H - model, the expected rate of return can be derived as;

Formula 9: Estimating a Required Return Using Any DDM

Where; variables are same like previous

For multistage models, finding a single equation for the rate of return can be more complicated.

The process generally used is similar to that of finding the IRR for a series of varying cash flows.

Using a computer or trial and error, the analyst must find the rate of return such that the present

value of future expected dividends equals the current stock price. In performing trial and error

with the two-stage model to estimate the expected rate of return, having a good initial guess is

important. The expected rate of return formula from the Gordon growth model can be used to

make this guess. The long-term growth rate can be used to find a first approximation. If the first

NPV (NPVa ) is greater than the current market price of stock ( ), you discount at a higher rate

so as to obtain lower NPV ( NPV b). If P0 is between the NPV a and b, use the following formula

to obtain the IRR;

Formula 10: Internal Rate of Return

Where;

IRR = Internal Rate of Return,

ra = Lower Discount Rate,

rb = Higher Discount Rate,

NPVa = Net Present Value at Lower Discount Rate

NPVb = Net Present Value at Higher Discount Rate

The financial determinants of growth rates

The following section comprises of components that determine the growth rate of a firm. They

include:
I. Sustainable Growth Rate

Sustainable growth rate is the rate of dividend (and earnings) growth that can be sustained for a

given level of return on equity, assuming that the capital structure is constant through

time and that additional common stock is not issued (Pinto, et al, 2010). This concept can help

in estimating the stable growth rate in a Gordon growth model valuation, or the mature growth

rate in a multistage DDM in which the Gordon growth formula is used to find the terminal value

of the stock. The formula is;

Formula 11: Sustainable Growth Rate

g = b X ROE

Where;

g = the sustainable growth rate,

b = the retention ratio (1 ⁄p ), where p is the dividend payout ratio

ROE = Return on Equity

II. Dividend growth rate, retention rate, and ROE Analysis

Formula 12: Return on Equity

Return on Equity can be broken down into different financial ratios for clarity and for the

purpose of analysis. These analyses include the Du Pont and Extended du punt analysis. The du

punt analysis breaks down ROE in two different financial ratios; Return on Assets (ROA) and

Financial Leverage (Equity Multiplier).

Formula 13: Return on Equity

Therefore, a company can increase its ROE either by increasing ROA or by the use of leverage

assuming the company can borrow at a rate lower than it earns from its assets.

With the extended du punt analysis, the ROA ratio is further broken down into Profit Margin and

Total Asset Turnover ratios as seen below;

Formula 14 : Return on Equity

The first part shows the profit margin, an increase in profit margin as earlier mentioned would

lead to an increase in equity return with every other thing being equal. The second part is an

efficiency ratio; measuring the company‟s rate of asset turnover. A turnover of 0.5 explains the

company earns half a Euro for every one Euro invested. Finally, the third part of the extended du

punt is the Equity Multiplier measuring the extent of leverage.

The formula below shows that the dividend growth rate is equal to the retention rate multiplied

by ROE:

Formula 15: substantial growth rate via DuPont

This expansion of the sustainable growth (g) expression has been called the PRAT model

(Higgins 2007). Growth is a function of profit margin (P), retention rate (R), asset turnover (A),

and financial leverage (T). The profit margin and asset turnover determine ROA while the other

two factors; the retention rate and financial leverage, reflect the company’s financial policies.

Thus, the growth rate of dividends can be viewed as determined by the company’s ROA and

financial policies. Analysts may use this equation to forecast a company’s dividend growth rate

in the mature growth phase.

 This sustainable growth rate expression and this expansion of it based on the extended DuPont

decomposition of ROE hold exactly only if beginning-of-period shareholders‟ equity is

used to compose ROE.

1.2.2 FCFF and FCFE valuation approaches

Whereas dividends are the cash flows actually paid to stockholders, free cash flows are the cash

flows available for distribution to shareholders. Unlike dividends, FCFF and FCFE are not

readily available data. Analysts need to compute these quantities from available financial

information, which requires a clear understanding of free cash flows and the ability to interpret

and use the information correctly. Forecasting future free cash flows is also a rich and

demanding exercise. The analyst’s understanding of a company’s financial statements, its

operations, its financing, and its industry can pay real “dividends” as he addresses that task.

Many analysts consider free cash flow models to be more useful than DDMs in practice. Free

cash flows provide an economically sound basis for valuation. Analysts like to use free cash flow

as the return (either FCFF or FCFE) whenever one or more of the following conditions is

present:

• The company does not pay dividends.

• The company pays dividends but the dividends paid differ significantly from the company’s

capacity to pay dividends.

• Free cash flows align with profitability within a reasonable forecast period with which the

analyst is comfortable.
• The investor takes a control perspective. With control comes discretion over the uses of free cash

flow. If an investor can take control of the company (or expects another investor to do so),

dividends may be changed substantially; for example, they may be set at a level approximating

the company’s capacity to pay dividends. Such an investor can also apply free cash flows to uses

such as servicing the debt incurred in an acquisition.

Common equity can be valued directly by using FCFE or indirectly by first using an FCFF

model to estimate the value of the firm and then subtracting the value of non -common stock

capital (usually debt) from FCFF to arrive at an estimate of the value of equity.

Free cash flow to the firm is the cash flow available to the company’s suppliers of capital after

all operating expenses (including taxes) have been paid and necessary investments in working

capital (e.g., inventory) and fixed capital (e.g., equipment) have been made. FCFF is the cash

flow from operations minus capital expenditures. A company’s suppliers of capital

include common stockholders, bondholders, and sometimes, preferred stockholders. The

equations analysts use to calculate FCFF depend on the accounting information available.

Valuing stock using this category of cash flow is known as the indirect method.

To valuate a company from the FCFF, you discounting FCFF with the weighted average cost of

capital (WACC), because is the after tax cash flow goes to all suppliers of capital to the firm

(both debt and equity).

Free cash flow to equity is the cash flow available to the company’s holders of common equity

after all operating expenses, interest, and principal (debt) payments have been paid and necessary

investments in working and fixed capital have been made. FCFE is the cash flow from operations

minus capital expenditures minus payments to (and plus receipts from) debt holders.
The value of equity can also be estimated directly by discounting FCFE at the required rate of

return for equity, reason why it is called the direct method.

Both approaches for valuing equity should theoretically yield the same estimates if all inputs

show identical assumptions. Depending on the characteristics of the company being valued, an

analyst may prefer to use one approach rather than the other. For instance, if the company‟s

capital structure is relatively stable, using FCFE to value equity is more direct and simpler than

using FCFF. The FCFF model is often chosen, however, in two other cases

A. A levered company with negative FCFE. In this case, working with FCFF to value the

company’s equity might be easiest. The analyst would discount FCFF by the WACC and

then subtract the market value of debt to obtain an estimate of the intrinsic value of

equity.

B. A levered company with a changing capital structure. First, if free cash flow growth rates

are forecasted using historical data, FCFF growth might reflect fundamentals more

clearly than the FCFE growth, which will certainly reflects unstable amounts of net

borrowing. Secondly, in a forward-looking context, the required return on equity is

expected to be more sensitive to changes in financial leverage than changes in the

WACC, making the use of a constant discount rate difficult to justify.

Free Cash Flow model valuations include:

1.2.2.1 Present Value of Free cash flow

Here, the general expressions for both valuation models (FCFF and FCFE) are similar to

the expression for the general dividend discount model.

The FCFF valuation approach estimates the value of the firm as the present value of future FCFF

discounted at the WACC. The formula is expressed as follows;

Formula 16: Present Value of FCF

Where;

FCFF = Free Cash Flow from Firm

WACC = Weighted Average Cost of Capital

The FCFF is the cash flow available to both debt and equity holders, discounting at the WACC

FCFF gives the total value of all of the firm‟s capital. The value of equity is the value of the firm

minus the market value of its debt (Equity value = Firm value - Market value of debt), since

FCFE is the cash flow going precisely to common stockholders. Dividing the total value of

equity by the number of outstanding shares gives the per share value

Equity value can also be found by discounting the FCFE by the required return rate of equity (r).

The formula is;

Formula 17: Equity value

Where;

FCFE = Free Cash Flow from Equity

r = equity required rate of return

r is the appropriate risk-adjusted rate for discounting FCFE.

1.2.2.2 Single-Stage (Constant - Growth) FCFF and FCFE Models

The assumption that free cash flows grow at a constant rate leads to a single-stage (stable

growth) FCFF or FCFE model similar to the assumption on dividends with the DDM.
Assume that FCFF grows at a constant rate ‘g’, such that FCFF in any period is equal to FCFF in

the previous period multiplied by (1 + g), the formula is as follows;

Formula 18: Single-Stage (Constant - Growth)

FCFFt = FCFFt-1 (1 +g)

If FCFF grows at a constant rate;

Formul 19: Firm Value Single-Stage (Constant - Growth)

Where variables are same as previously defined

Subtracting the market value of debt from the firm value will give the value of equity

For direct calculation of equity value, if g is constant,

FCFFt = FCFFt-1 (1 +g) The formula is as follows;

Formula 20: Equity value Single-Stage (Constant - Growth)

Where variables are same as previously defined

Opposed to the WACC used in valuing the entire firm is r, subject to equity valuation.

Computing FCFF

I. From Net Income

Formula 21: FCFF from Net Income

Where,

NI = Net Income

NCC – Net Non-Cash Charge (e.g. depreciation, provisions)

Int = Interest Expenses

T = Tax rate

FCInv = Fixed Capital Investment

WCInv = Working capital Investment.

II. From the Statement of Cash Flows

Formula 22: FCFF from the Statement of Cash Flows

Where,

CFO = Cash Flow from Operations.

III. From Earnings Before Interest and Tax

Formula 23: FCFF from Earnings Before Interest and Tax

Where,

EBIT = Earnings Before Interest and Tax

Dep = Depreciation

IV. From Earnings before Interest, Tax, Depreciation and Amortization.

Formula 24: FCFF From Earnings before Interest, Tax, Depreciation and Amortization

FCFF = EBITDA (1- T) + DEP (T) – FCinv –WCinv

Where,
EBITDA = Earnings Before Interest, Tax, Depreciation and Amortization and other variables

remain the same.

Computing FCFE

There are several ways to derive company’s FCFE. They include,

I. From FCFF

Formula 25: FCFE form FCFF

II. From Cash flow from operations

Formula 26: from Cash flow from operations

III. From Net Income

Formula 27: NI

1.2.2.3 Weighted Average Cost of Capital

Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which

each category of capital is proportionately weighted.

All sources of capital, including equity and other debt, are included in a WACC calculation. A

firm’s WACC increases as the beta and rate of return on equity increase, as an increase in

WACC denotes a decrease in valuation and an increase in risk. To calculate WACC, multiply the

cost of each capital component by its proportional weight and take the sum of the results. The

method for calculating WACC can be expressed in the following formula:

Formula 28: WACC

Where, D = Value of Debt

E = Value of Equity

rd = cost of debt

T = Tax and

re = Cost of Equity

1.2.2.3.1 Cost of Debt Capital (rd )

The after-tax cost of debt capital is generally derived as follows (Petersen & Plenborg, 2012):

Formula 29: Cost of debt

Where,

Rf = Risk Free,

rs = default spread, T = tax

According to Koller et al. (2010) there are two commonly used approaches to estimate the cost

of debt capital to the firm. If the firm has long-term bonds outstanding that is regularly traded,

the yield to maturity of the outstanding bonds may be calculated and used as an estimate of the

firm’s pre-tax cost of debt capital.

The second approach to estimate the cost of debt capital to the firm, as described by Koller et al.

(2010), is to utilize the firm’s credit rating and associated default spread. The intuition is,

the likelihood of the firm to default is shown by its credit rating and the risk premium demanded

by lenders to cover the default exposure, by the associated default spread. As such, companies
with equal credit ratings should in theory have comparable default spreads. So, a firm’s cost of

debt should equal the risk-free rate (Rf) plus the default spread (rs).

1.2.2.3.2 The Corporate Tax Rate (T)

The cost of debt capital is composed after-tax because a firm’s interest expense is tax deductible.

According to Damodaran (2012) the marginal tax rate should be used rather than the firm’s

effective tax rate when calculating the after-tax cost of debt capital as interest expenses save

taxes at the margin. That is, the savings are deducted from the last euro of income. Furthermore,

Graham (1996) estimates the future marginal tax rate for investment grade companies to equal

the full statutory tax rate.

1.2.2.3.3 Costs of Equity Capital

With an estimate of the equity risk premium, it is possible to estimate the required rate of return

on the equity holdings of a particular issuer. The choices include the following:

• The Capital Asset Prizing Model (CAPM).

• A multifactor model such as the Fama – French or related models.

• A build - up method, such as the bond yield plus risk premium method.

From the above possible models of deriving the required rate of return for equity, the CAPM is

most used and will be further analyzed.

1.2.2.3.3.1 The Capital Asset Pricing Model (CAPM)

The CAPM is an equation for required rate of return that should hold in equilibrium if the

model’s assumptions are met. These assumptions amongst others include;

• That investors are risk averse

• Investors make investment decisions based on the mean return and variance of returns of

their total portfolio.

According to this model, investors evaluate an asset’s risk in terms of its contribution to

the systematic risk of their total portfolio (systematic risk is that type of risk that cannot be

hedged by portfolio diversification). The CAPM is widely accepted for equity valuation because

it provides an economic ground and a relatively objective procedure for required rate estimation.

Formula 30: Capital Asset Pricing Model

Where;

r = Expected (required) return on equity,

Rf = Risk free rate of return,

β = beta coefficient,

REP = Equity risk premium,

1.2.2.3.3.1.1 Risk free (Rf ) rate of return

An asset is considered Rf when is has no risk of default associated with its cash flows and no

reinvestment risk as well. But in reality, there is no true risk-free investment, where the investor

is guaranteed a return without any risk. However, government securities have minimal risk of

default and are considered as closest to risk-free investments, thus their return rates are

considered Rf. This is usually the starting point of all risk and return models in finance.

According to Koller et al. (2010), it would be ideal to discount each separate expected cash flow

with a government bond with the same maturity. For instance, the rate of a three-year

government bond would be used to discount an expected cash flow three years from now.

However, the use of year- specific rates is not very practical, and the rates usually do not deviate
significantly across time according to Damodaran (2008) therefore, it is a usually a good

compromise to use a single risk-free rate on all cash flows. Koller et al. (2010) argues that 30-

year government bonds might match the cash flow stream better than 10-year government bonds;

however, 30-year bonds often suffer from illiquidity that affects the yields. Furthermore, the

government bond used as an estimate for the risk-free rate should be denominated in the same

currency as the company’s cash flows in order to handle issues such as inflation. Therefore, 5-10

year German sovereign bonds are yield is used as an estimate of the risk-free rate for valuation.

According to Bloomberg (04/2016), the 5-10 year German sovereign bonds yield is 0.153%

1.2.2.3.3.1.2 Stock Specific Risk ( β )

The simplest and most used estimate of beta is from an ordinary least squares regression of stock

on market return. The result is often called an unadjusted or “raw” historical beta, which is

further adjusted. The most commonly used adjustment was introduced by Blume (1971):

Formula 31: Adjusted beta