Valuation: Imperial College Business School

Valuation
Jamie Coen
Imperial College Business School
Autumn 2022
Jamie Coen Valuation 1 / 151

Valuation
Maximise the Value of the Firm
The Investment Decision The Financing Decision The Dividend Decision

Which assets should a How should a firm How and when should a firm
firm invest in? finance itself? return cash to shareholders?

Goals of this section
1 How to value a firm and its equity.
2 How valuation is affected by:

1 Investment decision.
2 Financing decision.
3 Dividend decision.

Approaches to Valuation
Intrinsic Valuation
• An asset’s value depends on its fundamentals: cash flows,
growth & risk.
• Use discounted cash flow models to estimate this.
Relative Valuation
• Asset’s value estimated based on what investors are paying for
similar assets.
• Value or price multiples relative to similar firms.
Contingent Claim Valuation

• Where cash flows depend on external event (e.g. (absence of)
default), we can estimate value based on option pricing
models.
Intrinsic Valuation

Roadmap
In theory
1 Discounting dividends.
2 Discounting cash flows to equity.
3 Discounting cash flows to the firm.
4 The components of a DCF model.
5 Which cash flows to discount?
Estimating DCF models in practice.
Special topics in valuation.

Discounted Cash Flow Valuation
E (CF1 ) E (CF2 )
Value of firm = + + ...
1+r (1 + r )2

E (CF1 ) E (CF2 )
1+r (1 + r )2
Cash flows from existing assets

• Base earnings reflect the earnings power of the firm, net of
taxes and any reinvestment needed to sustain the base
earnings.

E (CF1 ) E (CF2 )
1+r (1 + r )2
Growth in cash flows

• Future cash flows will reflect expectations of how quickly
earnings will grow in the future (as a positive) and how much
the company will have to reinvest to generate that growth (as
a negative).
• The net effect will determine the rate of growth.

E (CF1 ) E (CF2 )
1+r (1 + r )2
Steady state
• The value of growth comes from the capacity to generate
excess returns.
• The length of your growth period comes from the strength &
sustainability of your competitive advantages.
• After your growth period you settle down to a stable growth
rate.

E (CF1 ) E (CF2 )
1+r (1 + r )2
Risk in the cash flows

• The risk from investing in the firm is captured in the discount
rate.
1 Beta in the cost of equity.
2 Default spread in the cost of debt.

Cash flows
Using a discounted cash flow model requires two decisions about

cash flows:
1 Which type of cash flows?
1 Dividends?
2 Cash flows to equity?
3 Cash flows to firm?
2 What is their profile through time?

Dividend Discount Model
Shareholders can expect to get two types of cash flow from holding
a stock:
1 Dividends.
2 Price at the end of the holding period.
Because that price is in turn determined by future dividends, a

stock’s value is just the present value of future dividends.
Dividend Discount Model:

∞
X E (dividends in period t)
Value per share =
t=1
(1 + cost of equity)t

Gordon Growth Model
Can’t estimate dividends into the infinite future → need more
practical approach.
Special case: dividends assumed to grow at constant rate.
D D(1 + g)
Value = + + ...
1+r (1 + r )2
D
=
r −g
where
• D is the expected dividend per share next year.
• g is the expected growth rate of dividends.
• r is discount rate (cost of equity).
NB: can see that if firm can ↓ cost of equity, it ↑ value.

A more flexible approach
Assume there is a finite period where dividends can grow at an

extraordinary rate.
At some point, the growth rate of dividends hits a stable rate.

n
X E (Dt ) Pn
Value = +
t=1
(1 + r )t (1 + r )n
where, as in the Gordon Growth Model,
E (Dn+1 )
Pn =
rn − gn
gn is dividend growth in the stable phase and rn is the cost of
equity.

Dividends vs Free Cash flows
When discussing dividend policy, we introduced the concept of free

cash flows to equity (FCFE):
→ cash flow firm can afford to pay out as dividends.
Often firms don’t pay out as much as they could (either by
dividends or buybacks).
So DDMs may not be a good measure of a firm’s ability to
generate cash flows for stockholders.

FCFE Models
FCFE models are exactly like DDMs, except now we forecast FCFE
instead of dividends:
FCFE = Net income−(Capital expenditures − Depreciation)−

Change in working capital+
(New debt issued − Debt repayments)
Note: the cash included in working capital is cash that is not

invested to earn a market rate of return.
→ e.g. in safe or a cash register.
Estimate these terms and proceed as with DDM.

Equity valuation with FCFE
n
X E (FCFEt ) Terminal valuen
Value = +
t=1
(1 + r )t (1 + r )n
where
E (FCFEn+1 )
Terminal valuen =
rn − gn
gn is the expected growth rate in perpetuity and rn is the cost of
equity.

Firm valuation
DDM and FCFE models value the equity in a firm directly.
An alternative is to value the entire business and use this to

arrive at a value for the equity.
This is what we do in firm valuation, where we focus on the

operating assets of the firm and the cash flows they generate.

Free cash flows to the firm
We need to measure cash flows to the firm.
2 approaches:
1 Add up cash flows to all claim holders in the firm.
→ Add cash flows to equity to cash flows to debt (interest
and net debt payments).
2 Estimate cash flows to the firm prior to debt payments but
after reinvestment needs have been met.
Both should yield equivalent results.

Free cash flows to the firm
Free cash flows to the firm (FCFF) can be written as:
FCFF = EBIT(1 - tax rate)

− (capital expenditures - depreciation)
− Change in working capital

An alternative formula for FCFF
Net capital expenditures and the increase in working capital

represent the reinvestment made by the firm to generate future
growth.
We can define:
CapEx - Depreciation + ∆Working capital

Reinvestment rate =
EBIT(1 - tax rate)
FCFF can then be written as:
FCFF = EBIT(1 - tax rate)(1 - reinvestment rate)

Interpreting FCFF
FCFF are often referred to as unlevered cash flows, as they are

unaffected by a firm’s debt payments.
Note: the tax benefits from interest payments show up in the

discount rate (WACC) via the after-tax cost of debt.
→ If we included this tax benefit when computing FCFF, we would
be double counting.

Firm valuation with FCFF
n
X E (FCFFt ) Terminal valuen
Value = +
t=1
(1 + r )t (1 + r )n
where
E (FCFFn+1 )
Terminal valuen =
rn − gn
gn is the expected growth rate in perpetuity and rn is the WACC.

Components of a DCF model
Each of the DCF models involves the following components:

1 Cash flow growth during high growth period.
2 Length of high growth period.
3 Terminal value.
4 Discount rate.


3 Terminal value.
4 Discount rate.

Fundamental growth in cash flows
Growth in cash flows is determined by a firm’s investment policy.
For the DDM, growth in earnings per share can be written as:
growth = retention ratio × return on equity

where:
retention ratio = 1 − payout ratio

dividends
=1−
earnings
That is, it equals the % of net income retained to generate future

growth, and the return on equity in these investments.

For free cash flow models, the principle is the same but the
variables differ.
For firm
growth = reinvestment rate × return on capital

where:
CapEx - Depreciation + ∆Working capital

reinvestment rate =
EBIT(1 − tax rate)
EBIT(1 − tax rate)

return on capital =
BV of equity + BV of debt - cash

For free cash flow models, the principle is the same but the
variables differ.
For equity
growth = equity reinvestment rate × return on equity

where:
CapEx - Deprec. + ∆WC − ∆debt

equity reinvestment rate =
net income
net income
return on equity =
BV of equity


3 Terminal value.
4 Discount rate.

High growth period
High growth in value comes from firms earning high returns:

returns on equity (or capital) that exceed their cost of equity (or
capital).
Such excess returns cannot last forever: they should draw in new
competitors who compete them away.
Length of high growth period determined by:

1 Size of firm: small firms find it easier to maintain excess
returns.
2 Existing excess returns and growth rate.
3 Magnitude and sustainability of competitive advantages.


3 Terminal value.
4 Discount rate.

Terminal value
At the end of the period of high growth, the firm reaches a steady
state where growth is at a fixed rate forever.
Infinite growth places clear restrictions on what can feasibly be

assumed:
1 Can dividends grow at 4% and earnings grow at 2%?
2 Can a firm grow at 4% and the economy grow at 2%?
4 Can a firm grow at -1%?

Terminal value
At the end of the period of high growth, the firm reaches a steady
state where growth is at a fixed rate forever.
Infinite growth places clear restrictions on what can feasibly be

assumed:
1 Can dividends grow at 4% and earnings grow at 2%?
4 Can a firm grow at -1%?
In practical terms: if the valuation is done in nominal (real) terms,

the stable growth rate cannot be larger than the nominal
(real) growth rate of the economy.


3 Terminal value.
4 Discount rate.

Discount rate
The discount rate to use is clear: cost of equity if valuing equity

and WACC if valuing firm.
High-growth firms tend to have higher betas than low growth firms.
→ We should adjust the cost of equity downwards as firms
enter stable growth.

Which cash flows to discount?
For valuing a company’s stock, this gives us three options:

1 Discount dividends.
2 Discount FCFE.
3 Discount FCFF to value the firm and subtract debt.
These are different ways of getting at the same thing: can be the
same in theory, but rarely in practice.

Dividends vs FCFE
DDMs and FCFE models will give the same answer if:
1 Dividends equal FCFE.
2 FCFE exceeds dividends, but the excess is invested in
zero-NPV investments.
Otherwise they will differ.

→ For example, if FCFE exceeds dividends, and the excess is
invested in poor projects, then value from DDM will be lower than
from FCFE.

Equity vs firm valuation
Year CF(equity) Int. exp. (1-tax) CF(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 val. 1603 2363.008
Cost of equity is 13.625% and WACC is 9.94%.

1 Value the equity.
2 Value the firm.
3 What is the implied after-tax cost of debt?

Equity vs firm valuation
For this example, values of equity, firm and WACC are all mutually
consistent.
Provided you are consistent in your assumptions and approach, you

can choose to value the firm or the equity.
Never mix and match the cash flows and the discount rates.
1 Discount cash flows to firm at cost of equity?
2 Discount cash flows to equity at WACC?

Equity vs firm valuation in practice
Results were consistent when the values for debt and equity used
in the WACC were the same as those we obtained in the valuation.
If firms’ liabilities are not fairly priced to begin with, we will get
different answers.
This, along with other practical factors, means that equity and
firm valuation often yield different results in practice.
Which to use?

Use DDM
• When you cannot estimate the free cash flows to the firm or
to equity, all you can discount are dividends.
• Free cash flows are difficult to estimate for financial firms.
• Unlike manufacturing firms, financial firms invest primarily in
things like brand name and human capital.
→ Often appear as operating expenses rather than expenses,
meaning these firms report very low CapEx and depreciation.
• Without knowing a firm’s reinvestment, we can’t know its cash
flows.
• When firms’ payouts are close to their FCFE, and are likely to
be going forward.

FCFE better than dividends

• For firms that pay dividends significantly higher or lower than
FCFE.
• For firms where dividends are not available.
• Private firms.
• IPOs.
FCFE vs FCFF
• Use firm valuation when firm leverage is likely to change.
1 Hard to estimate FCFE when financial leverage is changing.
2 Still have to change the WACC in firm valuation as leverage
changes, but this is typically easier.

Estimating DCF models in practice

Overview
We will estimate the value of Disney’s equity in 2013 by valuing

the cash flows to the firm and working out what this means for the
value of equity.
Steps:
1 Decide on length of high growth phase.
2 Project cash flows during high growth phase.
3 Compute WACC.
4 Compute terminal value.
5 Compute value of equity and equity per share.

Overview

value of equity.
Steps:
3 Compute WACC.

Length of high growth phase
Disney one of the largest firms in an established market

(entertainment & theme parks), but there are new opportunities
for growth.
→ e.g. streaming.
Firm’s returns have exceeded its cost of capital.
Firm has very strong brand name → hard for competitors to

compete on that front.
High-growth period: 10 years.

→ More art than science...

Overview

value of equity.
Steps:
3 Compute WACC.

Cash flows during high growth phase
Initial EBIT of $10,032.
CapEx − Depreciation + ∆WC

Reinvestment rate =
EBIT(1 − τ )
6114 − 2485 + 103
=
10032 × (1 − 0.3102)
= 53.93%

EBIT(1 − τ )
Return on capital2013 =
BV of equity + BV of debt - cash
10032 × (1 − 0.3102)
=
41958 + 16328 − 3387
= 12.61%
Expected growth rate = Reinvestment rate × Return on capital

= 53.93% × 12.61%
= 6.80%

Year g EBIT EBIT(1-τ ) Reinvestment FCFF

2014 6.80% 10714 7391 3985 3405
2015 6.80% 11442 7893 4256 3637
2016 6.80% 12221 8430 4546 3884
2017 6.80% 13052 9003 4855 4148
2018 6.80% 13939 9615 5185 4430
Reinvestment rate held constant at 53.93% and effective tax rate

is 31.02%.

Overview

value of equity.
Steps:
3 Compute WACC.

Cost of equity and WACC
We begin with the cost of capital for the firm as it currently stands.
Cost of equity for Disney is 8.52%.

1 Bottom-up β is 1.0012.
2 Risk-free rate of 2.75%.
3 Equity risk premium of 5.76% (weighted average of region
ERPs to reflect Disney’s geographies).
Pre-tax cost of debt 3.75% and after-tax cost of debt 2.4%.
Ratio of debt to (debt + equity) is 11.5%.
Leads to a WACC of 7.81%.

WACC through time
Stable firms are different from growth firms:

1 Have betas closer to 1.
2 Have debt ratios closer to industry averages, mature company
averages or optimum for the firm.
For Disney:
1 Assume its beta moves smoothly to 1 in years 6 to 10.
2 Assume its debt ratio moves smoothly to 20% (closer to its
optimum) in years 6 to 10.

WACC through time
Year Beta Cost of equity CoDAT Debt ratio WACC

1 1.0012 8.52% 2.40% 11.50% 7.81%
2 1.0012 8.52% 2.40% 11.50% 7.81%
3 1.0012 8.52% 2.40% 11.50% 7.81%
4 1.0012 8.52% 2.40% 11.50% 7.81%
5 1.0012 8.52% 2.40% 11.50% 7.81%
6 1.001 8.51% 2.40% 13.20% 7.71%
7 1.0008 8.51% 2.40% 14.90% 7.60%
8 1.0005 8.51% 2.40% 16.60% 7.50%
9 1.0003 8.51% 2.40% 18.30% 7.39%
10 1 8.51% 2.40% 20.00% 7.29%

Overview

value of equity.
Steps:
3 Compute WACC.

Terminal value
Assume growth rate of EBIT is 2.5% in stable growth.
Assume RoC will drop smoothly from 12.61% in high growth to

10% in year 10.
→ Higher than the WACC, representing expectation Disney will
retain some competitive advantages.
This implies:
growth rate
Reinvestment rate =
return on capital
2.5%
= = 25%
10%
Assume the reinvestment rate will drop smoothly from 53.93% to
25% in years 6 to 10.
Year g EBIT EBIT(1-τ ) Reinvestment FCFF

2014 6.80% 10714 7391 3985 3405
2015 6.80% 11442 7893 4256 3637
2016 6.80% 12221 8430 4546 3884
2017 6.80% 13052 9003 4855 4148
2018 6.80% 13939 9615 5185 4430
2019 5.94% 14767 10187 4904 5283
2020 5.08% 15517 10704 4534 6170
2021 4.22% 16172 11156 4080 7076
2022 3.36% 16715 11531 3550 7981
2023 2.50% 17133 11819 2955 8864

Terminal value
We know the terminal value is given by:
E (FCFFn+1 )
Terminal valuen =
rn − gn
All we need is the FCFF, which we get from the assumption that
EBIT grows 2.5% from year 10, and the following formula
FCFF11 = EBIT11 (1 − τ )(1 − reinvestment rate)

= 11819 × 1.025 × (1 − 0.25)
= $9086mn
The terminal value is then:

9086
Terminal valuen = = $189, 738mn
0.0729 − 0.025
Overview

value of equity.
Steps:
3 Compute WACC.

Cash flows to firm
PV of operating cash flows to the firm is the present value of the

terminal value, plus the present value of the cash flows in the
high-growth phase.
To get the present values when discount rates are changing, we

need to compound the discount rates.

PV of cash flows
Year FCFF WACC Cumulated WACC PV of CF

2014 3405 7.81% 1.0781 3158
2015 3637 7.81% 1.1623 3129
2016 3884 7.81% 1.253 3100
2017 4148 7.81% 1.351 3070
2018 4430 7.81% 1.457 3042
2019 5283 7.71% 1.569 3368
2020 6170 7.60% 1.688 3655
2021 7076 7.50% 1.815 3900
2022 7981 7.39% 1.949 4096
2023 8864 7.29% 2.091 4240
Aggregate 34751

Value of the firm
The PV of the terminal value is the terminal value we have

computed disocunted at the 2023 cumulated WACC: $90733.
To get the value of the firm, we then add

1 cash and marketable assets ($3931mn); and
2 non-operating assets (holdings (book value) in other
companies: $2849mn).
value of firm = 34751 + 90733 + 3931 + 2849

= $132, 264mn

Value of equity
Now we have the PV of the firm, we need to subtract other
liabilities to get the value of equity. These include:
1 Debt of $15,961.
2 Minority interests of $2721mn.
• Disney consolidates its holdings in a few subsidiaries in which
it owns less than 100%.
• The portion of the equity in these subsidiaries that does not
belong to Disney is shown on the balance sheet as a liability.
• Subtract the (book) value.
3 Equity options of $869mn.
• Stock options granted to employees.
• Value using option-pricing model and subtract from equity to
leave value of equity in common stock.
Subtracting these gives the value of equity in common stock as
$112,713mn.

Value per share
We can then divide the value of equity in common stock by the

number of shares outstanding (1800 million) to get a value per
share of $62.62.
This was about 10% below the market price of $67.71 at the time
of valuation.
→ Based on our valuation, the stock was over-valued and investors
should have sold.

Special topics

Special topics
1 Value enhancement.
2 Valuing private firms.
3 The implied equity risk premium.

Value enhancement

Value enhancement

Valuing private firms

Valuing private firms is in many ways the same as valuing any
other firm.
1 Discount expected cash flows at a rate reflecting their risk.
2 Can discount cash flows to equity or to the firm.
There are, however, a number of differences:
1 No market value for debt or equity.
2 Accounting standards can be much more lax, and data scarcer.
3 Hard to disentangle personal from business expenses, and
salaries from dividends.
4 Is it appropriate to assume marginal investor is diversified?
5 Private firms typically don’t have access to bond markets, and
so will have higher cost of debt.

Private business and diversification
Through the early stages of the life cycle of a firm, it passes from:
1 Private owners who are fully invested.
2 Angel investors with multiple investments who are somewhat,
but not fully, diversified.
3 Public offerings, where investors are fully diversified.
What will happen to their cost of capital as they go through this

process?
What will happen to their valuation as they go through this

process?

All else equal:

1 A private firm that is expected to transition to being a publicly
traded company will have higher value than one who won’t.
2 A private firm that is expected to transition to being a
publicly traded company sooner will have higher value.
Value varies according to who owns – and will own – the firm.
→ Creates a rationale for acquisitions.

The implied equity risk premium

Having now studied DCF techniques, we return to estimating the

equity risk premium.
Three techniques:
1 Surveys.
2 Historical data.
3 Implied equity risk premium.

Value of a market portfolio
∞
Value =
t=1
(1 + required return on equity)t
The implied equity risk premium notes that we can estimate
dividend expectations for stock indices, and can observe their
initial value.
→ Can back out the implied required return.
→ Gives us an estimate of E (Rm ) in the CAPM, which we can use
to get an estimate of the risk premium E (Rm ) − Rf .

Value of the S&P 500
Suppose the S&P 500 is in stable growth, its current level is 900,
the expected dividend yield is 2%, and the growth rate is 7%.
D
Value =
r −g
900 × 0.02
900 =
r − 0.07
→ r = 9%
It is straightforward to adjust this to have periods of high growth

and stable growth.

This approach yields an estimate of the equity risk premium that:

1 is market-driven;
2 is forward-looking; and
3 can change at a high frequency.
Thus this approach has a number of advantages.
Which you use depends on the goal of your analysis.

1 Valuation & equity research? Implied risk premium makes
sense.
2 Discount rate for long term investment decisions? Historical
premium makes sense.

Cost of equity from DCF models
∞
Value =
t=1
Note: if we can do this for the equity risk premium, why not do
this for a firm’s cost of equity directly?
→ Why go through the effort of estimating the CAPM?

Cost of equity from DCF models
∞
Value =
t=1
Note: if we can do this for the equity risk premium, why not do
this for a firm’s cost of equity directly?
→ Why go through the effort of estimating the CAPM?
1 Relies on the market valuing each stock correctly.
2 If you see the stock price drop, how can you tell if it is due to
the discount rate or unobserved changes in expected future
dividends?

Intrinsic valuation
Intrinsic valuation has solid theoretical grounding: value of a firm

is the discounted cash flows it generates.
→ Estimate these!
Like many models, when taking it to data we have to make an

uncomfortable number of modelling assumptions.
→ Calls for sensitivity analysis.
Does not appear to use all the relevant data.

→ If you asked a non-economist how to tell if something was
cheaper than it should be, they would likely start talking about
relative valuation.

1 Intrinsic valuation.
2 Relative valuation.
3 Contingent claims valuation.

Relative Valuation

Relative vs Intrinsic Valuation
Discounted cash flow valuation: try to find value of assets given

their cash flow, growth, and risk characteristics.
Relative valuation: try to value assets based on how similar

assets are currently priced in the market.
→ essentially standardised versions of price.

Relative valuation
1 How to use relative valuation.
2 Defining, analysing and applying multiples.

→ Importance of understanding what drives multiples.
3 Intrinsic vs relative valuation.

The essence of relative valuation
In relative valuation, the value of an asset is compared to the

values assessed by the market for similar or comparable assets.
To do relative valuation we need:

1 Comparables. Identify comparable assets and obtain their
market values.
2 Multiples. Convert these market values into standardized
values (multiples), since the absolute prices cannot be
compared.
3 ‘Story’. Compare the asset’s multiple to those of the
comparable assets, controlling for relevant differences, to
judge whether the asset is under- or over-valued.

Examples of relative valuation

Examples of relative valuation

Popularity of Relative Valuation
Most asset valuations are relative.
Most equity valuations are relative valuations.

• Almost 85% of equity research reports.
• More than 50% of all acquisition valuations.
• Rules of thumb based on multiples are not only common but
are often the basis for final valuation judgments.
While there are more DCF valuations in consulting and corporate

finance, they often incorporate features of relative valuation.
→ For example the terminal value in a significant number of DCF
valuations is estimated based on relative valuation.

Multiples
Multiples are just standardised estimates of price.
Numerator: what you are paying for the asset

Multiple =
Denominator: what you are getting in return

Multiples: what you are paying for the asset
• Market value of equity.

• Market value of the firm.
• Market value of operating assets of the firm.
Enterprise value = MV of equity + MV of debt − Cash

Multiples: what you are getting in return
Revenues.
Earnings.
1 To equity investors.
• Earnings per share.
• Net income.
2 To firm.
• Operating income (EBIT).

Multiples: what you are getting in return
Cash flows.
1 To equity.
• Free cash flows to equity.
2 To firm.
• Earnings before interest, taxes, depreciation and amortization
(EBITDA).
• Free cash flows to the firm.
Book value.
1 Equity.
2 Firm.
3 Invested capital.
Invested capital = BV of equity + BV of debt − Cash

Relative valuation & multiples
Relative valuation consists of computing multiples for the firm

you’re valuing and a set of comparable firms, and comparing them.
→ If this comparison suggests what you pay for your firm is less
than what you get in return, the firm is under-valued.
Simple?
→ We need to understand multiples: what they are, what they
look like and what drives them.

Working with Multiples
1 Define the multiple.

2 Describe the multiple.
3 Analyze the multiple.
4 Apply the multiple.



Defining the Price-to-earnings ratio
Market price per share

PE =
Earnings per share
• Compares price of a firm’s equity with earnings it generates.
• Trailing PE: based on earnings in recent periods.
• Forward PE: based on expected earnings.
Basic logic: high PE ratio → over-valued.

Price-to-earnings question
If firm A has a PE ratio that is half that of B, would you be willing

to conclude A is under-valued if you knew:
1 Nothing else about these firms?



2 These firms were in the same market?



3 These firms were identical in every way except their PE ratios?



3 These firms were identical in every way except their PE ratios?
The rest of this lecture: attempt to get closer to No. 3, either by:
• Refining the set of comparable firms.
• Refining the choice of multiples.
• Statistical methods of controlling for differences → regression.

Defining the Price-to-book ratio
Market value of equity per share

PBV =
Book value of equity per share
Compares the value of a firm’s equity to its book value.
Basic logic: high PBV ratio → over-valued.

Define the multiple
Is the multiple consistently defined?

• Both the value (numerator) and the standardizing variable
(denominator) should be to the same claimholders in the firm.
• The value of equity should be divided by equity earnings or
equity book value, and firm value should be divided by firm
earnings or book value.

Consistent Definitions?
MV of equity
Price-to-sales ratio =
Revenues
Enterprise value
Enterprise value-to-sales ratio =
Revenues

Define the multiple
Is the multiple consistently defined?

• Both the value (numerator) and the standardizing variable
(denominator) should be to the same claimholders in the firm.
• The value of equity should be divided by equity earnings or
equity book value, and firm value should be divided by firm
earnings or book value.
Is the multiple uniformly estimated?

• The variables used should be estimated uniformly across
assets in the comparable firm list.
• If earnings-based multiples are used, the accounting rules to
measure earnings should be applied consistently across firms.



Describe the multiple
To undertake a relative valuation we need to understand how our

multiple behaves.
1 What is its distribution?
2 Is it symmetric? What is its mean/median/standard
deviation?
3 How to deal with outliers?
4 How has the multiple changed through time?

Describing the PE ratio: US firms in early 2020

PBV ratios through time
Multiples can and do change through time, for individual firms and
sectors and for the market as a whole.
Average PBV for US firms in 2020 was 3.81.

→ In 2016 it was 2.68.

PBV ratios through time
Multiples can and do change through time, for individual firms and
sectors and for the market as a whole.
Average PBV for US firms in 2020 was 3.81.

→ In 2016 it was 2.68.
If you’re comparing your firm to a benchmark, that benchmark

must change through time.

Describing the multiple
Multiples often follow skewed distributions, and there are often

outliers.
→ Better to compare to medians.
Distributions of multiples can change through time.

→ Simplistic/absolute rules destined to fail.



Analyze the multiple
What are the fundamentals that determine and drive these

multiples?
• Embedded in every multiple are all of the variables that drive
every discounted cash flow valuation - growth, risk and cash
flow patterns.
How do changes in these fundamentals change the multiple?
• It is impossible to properly compare firms on a multiple, if we
do not know how fundamentals and the multiple co-move.

From intrinsic value to multiples
1 Start with a basic intrinsic value model.

→ If equity multiple, start with dividend or FCFE model.
2 Divide by the denominator of the multiple.
3 Manipulate to get an expression for the multiple in terms of

fundamentals.

Analysing the PE ratio
Take Gordon Growth Model and divide both sides by today’s

earnings per share:
P0 DPS1 1
PE ≡ =
EPS0 r − g EPS0
Recognise that:
DPS1 = DPS0 (1 + g) DPS0 = payout ratio × EPS0

Gives:
payout ratio × (1 + g)
PE =
r −g

We can do the same for high-growth firms:
(1+g)n

payout ratio × (1 + g) 1 − (1+r )n
PE =
r −g
payout ration × (1 + g)n (1 + gn )
+
(r − gn )(1 + r )n
where:
• g is the high growth rate and gn is the stable growth rate.
• payout ratio is the payout ratio in the high growth phase and
payout ration is the payout ratio in the stable growth phase.

PE =
r −g
If firm A has a lower PE than firm B, does this mean A is

under-valued relative to B?

PE =
r −g
If firm A has a lower PE than firm B, does this mean A is

under-valued relative to B?
1 Different growth?
2 Different payout policy?
3 Different risk (→ discount rate)?
If firms are identical along these lines, we can (maybe) draw
conclusions about under-/over-valuation, but if they differ we
cannot.

Analysing the PBV ratio
We can do something similar for the price-to-book value ratio.
P0 DPS1 1
PBV ≡ =
BV0 r − g BV0
ROE × payout ratio × (1 + g)
=
r −g
where:
net income
ROE =
BV of equity
earnings per share
=
BV of equity per share

Controlling for fundamentals
If a firm has a multiple that is higher than other firms, we don’t

know if this is:
1 because it is over-valued; or
2 because it has different fundamentals that can explain this.
When assessing multiples, we need to control for differences in

fundamentals:
1 Subjective: are the differences in fundamentals sufficient to
explain differences in multiples?
2 Restrict to ‘truly’ comparable set of firms.
3 Adjust the multiple.
4 Regression approach.



Applying the Multiple
To undertake a relative valuation we need to decide on the set of

comparable firms.
Comparable firms should in principle be as similar as possible to

firm being analysed.
1 Same business line.
2 Similar size (if possible).
Goal is to get firms that are similar on fundamentals, so if (after

controlling for differences vs comparable firms) multiple is higher
than average a firm is over-valued.
Trade-off between sample size and comparability.

Relative valuation for Disney
Let’s value Disney in November 2013, based on the PE ratio.
Collect a peer group of entertainment firms, and compare Disney’s

PE ratio to the median.

Applying the Multiple
Firm Market cap ($000bn) Current PE Forward PE

Disney 126 20.6 18.4
Fox 70 9.9 19.7
Time Warner 57 18.8 15.5
Viacom 35 14.8 14.8
MSG 4 30.2 28.5
Lions Gate 4 18.4 19.4
Live Nation 4 NA NA
Cinemark 3 20.4 16.6
Regal 3 21.3 17.7
DreamWorks 3 NA 43.3
AMC 2 32.9 14.9
WWE 2 51.2 NA
Rentrak 1 NA 152.8
Carmike 1 6.3 24.4
Median 3.8 20.4 18.9

Control for Growth
Disney’s PE ratios pretty comparable to median: looks relatively

fairly valued.
But this conclusion is based on an assumption that Disney’s

expected growth rate is roughly equal to the median.
→ not true in reality.
Growth-adjusted PE ratio (PEG ratio): PE ratio divided by

expected growth rate.

Apply the Multiple
Firm Expected growth (%) PEG ratio

Disney 12.4 1.66
Fox 20.9 0.55
Time Warner 12.6 1.15
Viacom 13.1 1.13
MSG 17.6 1.68
Lions Gate 20.0 0.99
Live Nation 9.00 NA
Cinemark 14.8 1.45
Regal 10.0 1.81
DreamWorks 82.3 NA
AMC 86.6 0.23
WWE 20.0 7.11
Rentrak 115.0 NA
Carmike 6.75 0.96
Median 16.2 1.15

Apply the Multiple
Based on PEG, Disney looks a little overvalued, at least relative to

the median.
But:
1 Even this isn’t valid if Disney’s risk is different to the other
firms.
2 Does the PEG really control for growth?

Controlling for growth
PEG =
g(r − g)

Controlling for growth
Two results:
1 High-risk companies will trade at lower PEG ratios than
low-risk companies with the same growth rate.
2 Companies with very low or high growth rates will tend to
have higher PEG ratios than firms with average growth rates.
→ PEG (and PE) ratios are nonlinear functions of growth.
→ PEG ratio does not fully control for growth.
Lesson: beware simplistic adjustments of multiples just as

much as comparisons of unadjusted multiples.

Controlling for Multiple Variables
How, then, do we control for fundamentals when undertaking a

relative valuation?
Econometrics gives us the tool to do this: regression.
For a set of firms, regress the relevant multiple on proxies for its
fundamental determinants.
If a firm’s multiple is greater than the predicted multiple, the firm

is over-valued.

Regression approach
Given in regression we are explicitly controlling for fundamentals,

we can have a broader group of firms.
→ Variation in fundamentals is fine, provided we control for it.
Approach (PE for Disney):

1 Collect data on sample of US firms’ PE ratios.
2 Collect data on proxies of fundamental determinants:
1 Growth: EPS growth forecasts.
2 Payout ratios.
3 Risk: betas.
3 Regress PE ratios on determinants.
4 Compare Disney’s predicted PE ratio to its actual PE ratio.

Market regression for Disney
PEi = α0 + α1 giEPS + α2 payouti + α3 betai + ϵi

where:
• giEPS the analyst consensus estimate for EPS growth for firm i.
• payouti is firm i’s payout ratio.
• betai is firm i’s beta.

Variable Coefficient t statistic

Constant 7.95 10.63
Growth 57.72 18.13
Payout ratio 11.48 12.69
Beta -3.6 8.04
• Dependent variable is PE ratio.

• R-squared of 35.4%.
• Sample of 7870 US firms in January 2013.

Plug Disney’s fundamentals into the regression:
ˆ = 7.95 + 57.72g EPS + 11.48payout − 3.60beta

PE
Disney’s values are:
1 g EPS = 14.73%.
2 payout = 21.58%.
3 beta = 1.0012.
This yields a predicted PE ratio for Disney of 15.33.
Disney’s actual PE ratio was much higher, suggesting it was

significantly over-valued.

Issues with regression approach
Regression approach has a number of benefits:

• More objective and data-driven than any subjective approach.
• Can control for multiple factors.
It still has issues:

• Are the relationships consistent across different firms?
• What if we’re missing driving factors?
1 Wrong intrinsic model?
2 Poorly measured terms?
• Still imposing linearity.

Nonlinearity
We have a formula for PE:
PE =
r −g
But we ran a linear regression.
2 alternatives:
1 Include nonlinear terms.
2 Manipulate the formula to get a regression equation.

Efficiency in intrinsic and relative valuation
Relative and intrinsic valuation have different assumptions

about market efficiency.
By comparing to a peer group, you are implicitly recognising that

peer group as appropriately valued.
→ Firm X being over-valued relative to peers means it is
over-valued in general.
→ If all peers are under-valued, maybe this is not true.
Intrinsic valuation in principle allows the market to mis-price

individual stocks, sectors, and the whole market.

Information in intrinsic and relative valuation
Intrinsic valuation is focused on the firm being valued.

→ No direct comparison to other firms.
→ Price is compared to intrinsic measure of what it should be
based on fundamentals.
Relative valuation uses much more information on other firms.

→ Price (multiple) is compared to what it should be based on
other firms’ data.

Relative vs Intrinsic Valuation
Relative valuation:
• Simpler to compute.
• Does not involve fewer assumptions.
→ Fewer assumptions to compute, but not to believe its
results.
→ Less explicit about its assumptions.
• Requires thought/analysis after computation.
→ Value of a multiple doesn’t imply under-/over-valuation,
even if you believe multiple is correctly computed.

1 Intrinsic valuation.
2 Relative valuation.
3 Contingent claims valuation.

Contingent Claims Valuation

Equity valuation and options
Equity can be viewed as an option on the firm’s assets.

→ Can shed light on value of a firm.
Goal of this section:

1 Basic understanding of how options work.
2 Understand sense in which equity can be viewed as an option.
3 Understand what this tells us about the value of equity.

Options
A financial option is a contract that gives its owner the right (but
not the obligation) to purchase or sell an asset at a fixed price at
some future date.
1 Derive their value from the values of other, underlying assets.
2 Cash flows contingent on specific events.
Most commonly written on stocks.
Two types:
1 Call option: right to buy the underlying asset at a fixed price.
2 Put option: right to sell the underlying asset at a fixed price.

Options
When the holder of an option enforces the agreement, they are

exercising the option.
The price at which the option is exercised is the strike price or

exercise price.
Two types of options:

1 American options: allow the holder to exercise the option at
any point up to the expiration date.
2 European options: allow the holder to exercise the option
only on the expiration date.

Payoffs of options: call options
Suppose you own an option with strike price of $20.
If the price on the expiration date exceeds this (say $30), you can
make money by exercising the call and then selling the stock on
the open market for $30.
→ Get a gain of $10.
If the price on the expiration date < than the stock price, the
holder will not exercise the call.
Let S be the stock price at expiration, K be the exercise price and

C be the value of the call.
C = max (S − K , 0)

Payoffs of options: call options

Payoffs of options: put options
The holder of a put option will exercise the option if the stock
price S is below the strike price K.
Because the holder receives K when the stock is worth S, the

holder’s gain is equal to K - S.
Thus, the value of a put at expiration is:
P = max (K − S, 0)

Factors affecting option prices
Value of a call option:

1 Higher when strike price is lower.
→ Can get the asset for cheaper.
2 Higher when value of asset is higher.
→ Option to obtain a more valuable asset.
3 An American option cannot be worth less than the European
option.
4 Value of an option tends to increase in the volatility of the
asset.

Option prices and volatility
Two European call options with a strike price are written on two
different stocks, whose price tomorrow will be as follows
1 Low-volatility stock with price of $50 for certain.
2 High-volatility stock worth either $60 or $40, with equal
probability.
If the exercise date of both options is tomorrow, which option will

be worth more today?

Option prices and volatility
Expected value of both stocks is $50.
Options have very different values.

• Option on low-volatility stock worth nothing.
• Option on high-volatility stock worth a positive amount as
with 50% chance it yields a positive payoff.
Options more valuable when underlying asset is more volatile.

Financial & real options
Financial options give you the right to sell or buy a particular

asset.
Real options give you the right to make a business decision after
new information is learned.

Options are everywhere
When thinking of options we tend to think of financial options.
But options are everywhere:

1 It’s hard to renege on a job offer.
→ Declining an offer now gives you the option to take other
ones in the future.
2 If you have a patent and don’t pay a fee to renew it, the
patent is permanently cancelled.
→ Renewing gives you the chance to consider again next year.
3 Don’t know if a movie franchise will be a success.
→ Option to produce a sequel is valuable.
4 And in corporate finance...

Equity and options
We can think of a share of stock as a call option on the assets

of the firm with a strike price equal to the value of debt
outstanding.
To see why, consider a single-period world in which at the end of

the period the firm is liquidated.
• If firm value is less than the debt outstanding, the firm must
declare bankruptcy and the equity holders get nothing.
• If firm value exceeds the debt, the equity holders get whatever
is left over after debt is repaid.
Value of equity = max(Value of firm − debt, 0)

Equity as a call option
Like debtholders effectively hold the company now, but

shareholders have the option to buy it back at the value of debt.
Implications of viewing equity as an option
Equity has value even if current firm value is well below debt
value.
→ Might pay-off in the future!
This follows from our results on options.

→ Call options are valuable even if stock price is currently below
strike price.
Intuitive result, but very different to spirit of DCF valuation.

Implications of viewing equity as an option
Increasing risk of a firm can increase value of equity.

• Call options benefit from the volatility in the underlying asset,
as they enjoy the upside and are protected in the downside.
• Very different perspective to DCF valuation: in that paradigm
more risk is almost always a bad thing.
• Note the connection back to the conflicts between debt and
equity in times of distress.

When is this perspective relevant?
Options-based view of firm equity is most relevant for highly

levered firms and firms in financial distress.
If firm value is far above value of debt, we’re far way from the
‘kink’ in the value of equity.
→ Incentives better aligned.
→ Risk is bad.

Wrapping up on valuation
Intrinsic valuation.
1 DCF models in theory.
2 Determinants of intrinsic value.
3 Choice between DDM/FCFE/FCFF.
4 The practicalities of intrinsic valuation.
5 Topics:
• Enhancing value.
• Private firms.
• Implied equity risk premium.

Relative valuation.
1 How to define and work with multiples.
2 Multiples cannot be studied in isolation.
→ Need to understand fundamental drivers.
3 Regression as a means of controlling for fundamentals.
4 Relative vs intrinsic valuation.
• Information.
• Explicit and intrinsic assumptions.
• Role of intrinsic valuation in informing relative valuation.

Contingent claims valuation.

1 Nature and features of option contracts.
2 (Real) options are more common than you think.
3 Equity can be viewed as an option.
• Equity valuable even when debts exceed assets.
• Risk can enhance value of equity.
4 Concepts, not details!

Valuation: Imperial College Business School

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Valuation

Imperial College Business School

Jamie Coen Valuation 1 / 151

Maximise the Value of the Firm

The Investment Decision The Financing Decision The Dividend Decision

Jamie Coen Valuation 2 / 151

1 How to value a firm and its equity.

2 How valuation is affected by:

Jamie Coen Valuation 3 / 151

Contingent Claim Valuation

Jamie Coen Valuation 5 / 151

Estimating DCF models in practice.

Special topics in valuation.

Jamie Coen Valuation 6 / 151

Jamie Coen Valuation 7 / 151

Cash flows from existing assets

Jamie Coen Valuation 7 / 151

Growth in cash flows

Jamie Coen Valuation 8 / 151

Jamie Coen Valuation 9 / 151

Risk in the cash flows

Jamie Coen Valuation 10 / 151

Using a discounted cash flow model requires two decisions about

Jamie Coen Valuation 11 / 151

Because that price is in turn determined by future dividends, a

Dividend Discount Model:

Jamie Coen Valuation 12 / 151

Special case: dividends assumed to grow at constant rate.

NB: can see that if firm can ↓ cost of equity, it ↑ value.

Assume there is a finite period where dividends can grow at an

At some point, the growth rate of dividends hits a stable rate.

Jamie Coen Valuation 14 / 151

When discussing dividend policy, we introduced the concept of free

Jamie Coen Valuation 15 / 151

FCFE = Net income−(Capital expenditures − Depreciation)−

Note: the cash included in working capital is cash that is not

Estimate these terms and proceed as with DDM.

Jamie Coen Valuation 16 / 151

Jamie Coen Valuation 17 / 151

DDM and FCFE models value the equity in a firm directly.

An alternative is to value the entire business and use this to

This is what we do in firm valuation, where we focus on the

Jamie Coen Valuation 18 / 151

We need to measure cash flows to the firm.

Jamie Coen Valuation 19 / 151

Free cash flows to the firm (FCFF) can be written as:

FCFF = EBIT(1 - tax rate)

Jamie Coen Valuation 20 / 151

Net capital expenditures and the increase in working capital

CapEx - Depreciation + ∆Working capital

FCFF can then be written as:

FCFF = EBIT(1 - tax rate)(1 - reinvestment rate)

Jamie Coen Valuation 21 / 151

FCFF are often referred to as unlevered cash flows, as they are

Note: the tax benefits from interest payments show up in the

Jamie Coen Valuation 22 / 151

Jamie Coen Valuation 23 / 151

Each of the DCF models involves the following components:

Jamie Coen Valuation 24 / 151

Each of the DCF models involves the following components:

Jamie Coen Valuation 25 / 151

growth = retention ratio × return on equity