Introduction to valuation

CFV600 CORPORATE FINANCE AND EQUITY VALUATION

FALL SEMESTER 2022, NICLAS ANDRÉN

Value in corporate finance

• What do we mean by firm or equity ”value”?

• What value measures are available, and what do they measure?

Value concepts
• Book value
– Accounting view of equity value
– In essence, the money put into the business
– Sensitive to choice of accounting principles
• Intrinsic value (V in Pinto)
– Value given a hypothetically complete understanding of asset characteristics
– ”True” or ”real” value
• Estimated value (VE in Pinto)
– Investor’s estimation of intrinsic value
• Market value (P in Pinto)
– Equilibrium price of trading in marketplace
– Includes the value that the market already believes the firm will create or destroy
» Sensitive to (accuracy of and changes in) market expectations
– The perennial favorite value concept in corporate finance
» The value concept in virtually all theoretical models
• How (or, rather, when) trustworthy is market value?
Information efficiency and market rationality
Traditional finance theory assumes…
…efficient capital markets
…economically rational (utility-maximizing) investor behavior
…any characteristic that can predict future returns is a priced risk factor

• Do stock prices reflect available information?

– Weak form of information efficiency
– Semi-strong form of information efficiency
– Strong form of information efficiency
• Do stock prices fully reflect investors’ expectations?
– Investor irrationality may lead to systematic mispricings
– If markets aren’t efficient, investors may earn abnormal returns by trading on the inefficiency
• Market efficiency requires economic efficiency
– Transparency/access to information
– Low transactions costs 𝑉𝐸 − 𝑃 = 𝑉 − 𝑃 + 𝑉𝐸 − 𝑉
– Market liquidity
– Large supply of risky securities
Semi-strong information efficiency
• As new information about a firm arrives, the market price of the firm’s stock should
immediately and unbiasedly change to reflect this information

Implications:
• Shareholders can judge the efficacy of management’s decisions and performance
• Managers can better understand how the market determines prices
Value concepts
• Enterprise value (EV)
– Market convention = MV Debt + MV Equity – Cash and ST investments
– Valuation textbooks = estimated value, sometimes incl cash and equivalents,
sometimes excluding them

• Shareholder value (SV)

– Some textbooks use it to denote estimated equity value

• Going-concern value vs liquidation value

• Fair market value

– Pinto: “The price at which an asset (or liability) would change hands between a willing buyer
and a willing seller when the former is not under any compulsion to buy, and the latter is not
under any compulsion to sell.”

• Fair value
– IFRS and US GAAP: “the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between marketplace participants at the measurement date.”
 Levels of value
20% strategic
acquisition premium
20% minority interest
discount; 25% control
premium premium
25% discount for lack
B of marketability for
restricted stock
A $6.00
Additional 20% discount for
private company
stock
Per share
value
$12.00 Synergistic (strategic) value
$10.00 Value of control shares
Control or minority
discount
Publicly traded equivalent or
$8.00 market value of minority
Discount for shares freely traded
restricted stock of
public company
Value of restricted stock
of public company
Additional discount
for private company
stock
Value of nonmarketable minority
$4.40 (illiquid lack of control) shares
Value creation in corporate finance

• What do we mean by value creation?

• How do we measure value creation?

Value creation in corporate finance

• NPV > 0
– ROI > WACC

• Stock prices include the value that the market already believes the firm will create or
destroy
– What about expected future value creation from previously made investments?
– What if investors expect the firm to report NPV > 0?

• Firm value = Value of assets in place + PV(growth options)

 Cornerstones of corporate finance

• For more on this, listen to McKinsey partner Tim Koller’s tutorial on creating value.

Dobbs et al (2010), ”The CEO’s guide to corporate finance”, McKinsey Quarterly.

Rappaport (2006, HBR), ”10 ways to create
shareholder value”

Some of the suggestions

• Focus on maximizing value, not profits
• Focus on maximizing value, irrespective of impact on short-term earnings
• Only carry assets that maximize value (the best owner test)
• Return cash to owners if you lack credible investment opportunities
• Reward management for delivering superior long-term returns
• Provide investors with value-relevant information
• Do not manage earnings
Dobbs and Koller (2005), ”Measuring long-term
performance”

Where to focus the performance assessment

• Company performance = value delivered
• Health = scope to create additional value
• Stock market performance = market expectations
Dobbs and Koller (2005), ”Measuring long-term
performance”
The valuation process
Discounted Cash Flow value
• Forecast expected future cash flows from the core business
+ Value of non-operating assets
• Value of assets whose values are not captured by the forecasted CFs
• Passive assets; assets outside of the firm’s operations; assets correctly valued on the
balance sheet or with reliable market values; assets that are incorrectly valued by
forecasted CFs
= Estimated firm value
• Often referred to as Enterprise value in valuation textbooks (though not in Pinto)

Estimated firm value

– Value of all debt and other nonequity financing claims
= Estimated equity value
• Sometimes referred to as Shareholder value in valuation textbooks (though not in Pinto)
Model structure
• Discounted cash flow valuation:
∞
𝐶𝐹𝑡
𝑉=෍ 𝑡
1+𝑟
𝑡=1

• Dividend discount model

– CF = expected dividends
– Discount rate = cost of equity = rate of return investors expect to earn from investing in the
systematic risk of the firm’s equity
• FCFF model = CF generated by operations after investments in new operating capital
– Expected CF from operations =
» Operating profits after taxes minus...
» Investments in operating fixed capital and…
» Investments in operating working capital
– Discount rate = WACC = rate of return investors expect to earn from investing in company
• FCFE model = CF available for payout to owners
– FCFF minus expected net payouts to creditors
– Discount rate = cost of equity
(An impractical) DCF example
Year CF PV Year CF PV Sum PV r 7,50%
2025 163 2051 352 54 g 3,0%
2026 168 156 2052 362 51
2027 173 150 2053 373 49
2028 178 143 2054 384 47
2029 183 137 2055 396 45
2030 189 132 2056 408 43
2031 195 126 2057 420 41
2032 201 121 2058 432 40
2033 207 116 2059 445 38
2034 213 111 2060 459 36
2035 219 106 2061 473 35
2036 226 102 2062 487 34
2037 232 98 2063 501 32
2038 239 94 2064 516 31
2039 247 90 2065 532 29
2040 254 86 2066 548 28
2041 262 82 2067 564 27
2042 269 79 2068 581 26
2043 278 76 2069 599 25
2044 286 72 2070 617 24
2045 294 69 2071 635 23
2046 303 66 2072 654 22
2047 312 64 2073 674 21
2048 322 61 2074 694 20
2049 331 58 2075 715 19
2050 341 56 2076 736 18 3310
 Model structure
• We typically simplify the model by dividing the future into an explicit forecast period and
a terminal value:

Year
0 1 2 3 4 5 6 7 8

Explicit forecast period Terminal (residual,

continuing) period

7 7 𝐶𝐹8
𝐶𝐹𝑡 𝑉7 𝐶𝐹𝑡 ൘𝑟−𝑔
𝑉=෍ 𝑡
+ 7
=෍ 𝑡
+ 7
1+𝑟 1+𝑟 1+𝑟 1+𝑟
𝑡=1 𝑡=1

• TV = V7 = PV as of end of year 7 of all expected cash flows expected from year 8

onwards
Terminal value in DCF model

𝐶𝐹8
𝑉7 = = 𝑇𝑉
𝑟 − 𝑔𝐶𝐹

Example
• CF8 = 168
• r = 7.5%
• g = 3%

168
𝑉7 = = 3,733
0.075 − 0.03
 DCF example – TV
Year CF PV Sum PV ΣPV/TV Year CF PV Sum PV ΣPV/TV r 7,50%
2025 163 2051 352 54 2504 67,1% g 3,0%
2026 168 156 156 4,2% 2052 362 51 2555 68,5% TV 3733
2027 173 150 306 8,2% 2053 373 49 2605 69,8%
2028 178 143 449 12,0% 2054 384 47 2652 71,1%
2029 183 137 587 15,7% 2055 396 45 2697 72,3%
• TV = PV of all free 2030 189 132 718 19,2% 2056 408 43 2740 73,4%
cash flows the firm is 2031 195 126 844 22,6% 2057 420 41 2782 74,5%
expected to generate 2032 201 121 965 25,9% 2058 432 40 2822 75,6%
2033 207 116 1081 29,0% 2059 445 38 2860 76,6%
from year 2026
2034 213 111 1192 31,9% 2060 459 36 2896 77,6%
onwards 2035 219 106 1298 34,8% 2061 473 35 2931 78,5%
2036 226 102 1400 37,5% 2062 487 34 2965 79,4%
• Technically, you sum
2037 232 98 1498 40,1% 2063 501 32 2997 80,3%
CFs into eternity, but 2038 239 94 1591 42,6% 2064 516 31 3028 81,1%
cash flows beyond 2039 247 90 1681 45,0% 2065 532 29 3057 81,9%
the first 50 years or 2040 254 86 1767 47,3% 2066 548 28 3085 82,7%
so typically have little 2041 262 82 1849 49,6% 2067 564 27 3112 83,4%
impact on value 2042 269 79 1928 51,7% 2068 581 26 3138 84,1%
2043 278 76 2003 53,7% 2069 599 25 3163 84,8%
2044 286 72 2076 55,6% 2070 617 24 3187 85,4%
2045 294 69 2145 57,5% 2071 635 23 3210 86,0%
2046 303 66 2211 59,3% 2072 654 22 3232 86,6%
2047 312 64 2275 61,0% 2073 674 21 3252 87,2%
2048 322 61 2336 62,6% 2074 694 20 3273 87,7%
2049 331 58 2394 64,2% 2075 715 19 3292 88,2%
2050 341 56 2450 65,7% 2076 736 18 3310 88,7%
Simplifying terminal value models
Stable growth model Two-stage growth model
g g

gS
g gL
0 t t

Declining growth model Three-stage declining growth model

g g

gS gS
gL gL
t t
 Simplifying terminal value models
No growth Stable growth

𝐶𝐹𝑛+1 𝐶𝐹𝑛 𝐶𝐹𝑛+1 𝐶𝐹𝑛 1 + 𝑔𝐶𝐹

𝑇𝑉𝑛 = = 𝑇𝑉𝑛 = =
𝑟 − 𝑔𝐶𝐹 𝑟 𝑟 − 𝑔𝐶𝐹 𝑟 − 𝑔𝐶𝐹

Example
• CFn = 163
• r = 7.5%
• g = 3%

𝐶𝐹𝑛+1 163 𝐶𝐹𝑛+1 163 1.03

𝑇𝑉𝑛 = = = 2,173 𝑇𝑉𝑛 = = = 3731
𝑟 − 𝑔𝐶𝐹 0.075 𝑟 − 𝑔𝐶𝐹 0.075 − 0.03
 Simplifying terminal value models
Two-stage growth H (declining growth) model
ℎ
1 + 𝑔𝐻 𝐶𝐹𝑛+ℎ 1 + 𝑔𝐿
𝐶𝐹𝑛 1 + 𝑔𝐻 1−
1 + 𝑟𝐻 𝑟𝐿 − 𝑔𝐿 𝐶𝐹𝑛 𝑔𝑆 − 𝑔𝐿 𝐻 𝐶𝐹𝑛 1 + 𝑔𝐿
𝑇𝑉𝑛 = + 𝑇𝑉𝑛 = +
𝑟𝐻 − 𝑔𝐻 1 + 𝑟𝐻 ℎ 𝑟 − 𝑔𝐿 𝑟 − 𝑔𝐿

Example
• CFn = 163 𝐶𝐹𝑛+ℎ =?
• r = 7.5% ℎ+1 6
𝐶𝐹𝑛+ℎ = 𝐶𝐹𝑛 1 + 𝑔𝐻 = 163 1 + 0.05 = 218
• gH = 5%
• gL = 3%
• h = 5 years

5
1 + 0.05 218 1 + 0.03
163 1 + 0.05 1 −
1 + 0.075 0.075 − 0.03
𝑇𝑉𝑛 = +
0.075 − 0.05 1 + 0.075 5
 Simplifying terminal value models
Three-stage H (declining growth) model

ℎ
1 + 𝑔𝑆 𝐶𝐹𝑛 𝑔𝑆 − 𝑔𝐿 𝐻 𝐶𝐹𝑛 1 + 𝑔𝐿
𝐶𝐹𝑛 1 + 𝑔𝑆 1− +
1+𝑟 𝑟 − 𝑔𝐿 𝑟 − 𝑔𝐿
𝑇𝑉𝑛 = +
𝑟 − 𝑔𝑆 1+𝑟 ℎ