Chapter 4: Stock Valuation A Second Look

The Discounted Free Cash Flow Model

The Discounted Free Cash Flow Model focuses on the cash flows
to all the firm’s investors, both debt and equity holders.

Enterprise Value = Market Value of Equity + Debt - Cash

Valuing the Enterprise

To estimate a firm’s enterprise value, we compute the present value of the firm’s free cash
flow available to pay all investors.

Free Cash Flow = EBIT x (1-Tax Rate) + Depreciation – Capital Expenditures – Increases Net
Working Capital
Discounted Free Cash Flow Model

V0 = PV(Future Free Cash Flow of Firm)

o Given the enterprise value, we can solve for the value of equity and divide by the
total number of shares outstanding to estimate the share price:
V 0 +Cash0−Debt 0
P 0=
Shares Outstanding

Implementing the Model

o Since we are discounting (actualization) the cash flows to all investors, we use the
weighted average cost of capital (WACC), denoted by rwacc
o Forecast (prévoir) free cash flow up to some horizon, together with a terminal value
of the enterprise:
FCF 1 FCF 2 FCF N VN
V 0= + 2
+ …+ N
+ N
1+r WACC ( 1+ RWACC ) ( 1+ R WACC ) ( 1+ R WACC )

o Estimate the terminal value by assuming a constant long-run (long terme) growth
rate gFCF for free cash flows beyond (au dela de) year N

V N=
FCF N+1
(
=
1+ g FCF
r WACC −g FCF r WACC−g FCF)∗FCF N

o The long-run growth rate gFCF is typically based on the expected long-run growth rate
of revenues
Connection to Capital Budgeting
o Free cash flow is the sum of (la somme de) the free cash flows from the firm’s
current and future investments, so enterprise value is the sum of the present value
of existing projects and the NPV of future (new) ones
 NPV of any investment decision represents its contribution to the firm’s
enterprise value
 To maximize share price, we should accept projects that have a positive NPV
 We must forecast all the inputs (toutes les entrées) to free cash flow
 This process gives us flexibility to incorporate many details
 However, some uncertainty surrounds(entoure) each assumption
 Given this fact, sensitivity analysis is important
 Translates the uncertainty into a range of values for the stock

Valuation Based on Comparable Firms

Another application of the valuation principle is the method of comparables

— Estimate the value of the firm based on the value of other, comparable firms
or investments that we expect will generate very similar cash flows in the
future
Consider the case of a new firm that is identical to an existing publicly traded
firm
— The Valuation Principle implies that two securities with identical cash flows
must have the same price
— If these firms will generate identical cash flows, we can use the market value
of the existing company to determine the value of the new firm
— We can adjust for scale differences using valuation multiples
Valuation Multiples
— A ratio of a firm’s value to some measure of the firm’s scale (taille de
l’entreprise) or cash flow
— Price-Earnings ratio
— Enterprise Value Multiples
— Other multiples
— Multiples of sales
— Price-to-book value of equity
— Industry- specific ratios
Price-Earnings Ratio
— Most common valuation multiple
— Share price divided by earnings per share

We can compute a firm’s P/E ratio using:

o Trailing earnings – earnings over the prior 12
months
o Forward earnings
The resulting ratio is either:
o Trailing P/E
o Forward P/E
 For valuation purposes(objectif), the
forward P/E is generally preferred, as we
are most concerned about future
earnings

P/E ratios are related to other valuation techniques

 In the case of constant dividend growth, we had:

¿1
P 0=
r E−g

 Dividing through by EPS1:

¿1
P0 EPS 1 Dividend Payout Rate
Forward P / E= = =
EPS 1 r E −g r E −g

EPS = Earnings per Share / P = Price per Share

Enterprise Value Multiples
o P/E ratio relates exclusively to equity, ignoring the effect of debt
o Enterprise value multiples use a measure of earnings before interest payments are
made
— EBIT
— EBITDA
— Free cash flow
 Because capital expenditures (dépenses) can vary substantially
(essentiellement) from year to year, most practitioners use enterprise value
to EBITDA multiples
o When expected free cash flow growth is constant, we can write EV to EBITDA as:
FCF 1 FCF 1
V0 r WACC−g FCF EBITDA 1
= =
EBITDA 1 EBITDA A r WACC −g FCF

Other multiples
o Multiples of sales can be useful if it is reasonable to assume margins are similar in
the future
o Price-to-book value of equity can be used for firms with substantial tangible assets
o Some multiples are specific to an industry

Limitations of Multiples
o Firms are not identical
 Usefulness of a valuation multiple will depend on the nature of the differences
between firms and the sensitivity of the multiples to the differences
 Differences in multiples can be related to differences in:
 Expected future growth rate
 Risk (cost of capital)
 Differences in accounting conventions between countries
Comparables provide only information regarding the value of the firm relative to other firms
in the comparison set
 Cannot help determine whether an entire industry is overvalued
 Internet boom is an example

Comparison with Discounted (rabais) Cash Flow Methods

o Valuation multiple does not take into account material differences between firms
 Talented managers
 More efficient manufacturing processes
 Patents on new technology
o Discounted cash flow methods allow us to incorporate specific information about
cost of capital or future growth
 Potential to be more accurate : possibilité d’être plus précis

Stock Valuation Techniques : The Final Word

 o No single technique provides a final answer regarding a stock’s true value
o Practitioners use a combination of these approaches
o Confidence comes from consistent results from a variety of these methods

Information, Competition, and Stock Prices

Information in Stock Prices

o For a publicly traded firm, its market price should already provide very accurate
information regarding the true value of its shares
o A valuation model is best applied to tell us something about the firm’s future cash
flows or cost of capital, based on current stock price
— Only in the relatively rare case in
which we have some superior
information that other investors lack
would it make sense to second-guess
the stock price

Competition and Efficient Markets

o Efficient markets hypothesis:
— Implies that securities will be fairly priced, based on
their future cash flows, given all information that is
available to investors
o Public, Easily Available Information:
— Information available to all investors includes
information in news reports, financial statements,
corporate press releases, or other public data sources
o Private or Difficult-to-Interpret Information

Private or Difficult-to-Interpret Information

 Example: Phenyx Pharmaceuticals had just announced the
development of a new drug for which the company is seeking
approval from the FDA

- If the drug is approved future profits will increase Phenyx’s market value by $15 per
share
- Suppose the announcement comes as a surprise to investors, and average likelihood
of FDA approval is 10%
- The announcement should lead to a 10% × $15.00= $1.50 per share immediate stock
price increase
Over time, investors will make their own assessments of the probable efficacy of the drug
o If they conclude that the drug looks more (less) promising than average, they will
buy (sell) the stock and the price will drift higher (lower) over time
o At the time of the announcement, uninformed investors do not know which way it
will go
Lessons for Investors and Corporate Managers
o Consequences for Investors
o Must have some competitive advantage
- Expertise or access to information known to only a few people
- Lower trading costs than others
- If stocks are fairly priced according to valuation models, then
investors who buy stocks can expect fair compensation for the
risk they take
o Implications for Corporate Managers
o Cash flows paid to investors determine the value of the firm and this result has the
following implications for corporate managers
- Focus on NPV and free cash flows
- Avoid accounting illusions
- Use financial transactions to support investment
The Efficient Markets Hypothesis Versus No Arbitrage
o An arbitrage opportunity is a situation in which two securities (or portfolios) with
identical cash flows have different prices
— Because anyone can earn a sure profit in this situation by buying the low-
priced security and selling the high-priced one, we expect investors to
immediately exploit and eliminate these opportunities
— Thus, in a normal market, arbitrage opportunities will not be found
o The efficient markets hypothesis states that the best estimate of the value of a
share of stock is its market price
o This does not mean that the market price always correctly estimates the value of a
share of stock
o Different investors may perceive risks and returns differently (based on their
information and preferences)
o There is no reason to expect the efficient markets hypothesis to hold perfectly;
rather, it is best viewed as an idealized approximation for highly competitive
markets

Individual Biases and Trading

Excessive Trading and Overconfidence

o Trading is expensive because of commissions and the difference between the bid
and ask
o Given the difficulty of finding over- and under-valued stocks, you might expect
individual investors to trade conservatively
— However, a study of the trading behavior of individual investors at a discount
brokerage found individual investors trade very actively
 Average turnover almost 50% above the overall average (including
institutions) during the time of the study
Overconfidence hypothesis
o Tendency of individual investors to trade too much based on the mistaken belief that
they can pick winners and losers better than investment professionals
o Implication is that investors who trade more will not earn higher returns
— Performance will actually be worse because of trading costs

Hanging On to Losers and the Disposition Effect

o Investors tend to hold on to stocks that have lost value and sell stocks that have
risen in value
o This tendency is called the disposition effect
o Researchers Hersch Shefrin and Meir Statman suggest that this effect arises due to
investors’ increased willingness to take on risk in the face of possible losses
— May also reflect a reluctance to admit a mistake by taking the loss

From a tax perspective, this behavioral tendency is costly

o Capital gains are taxed only when an asset is sold, so delaying the tax payment
reduces its present value
o Capital losses are tax deductible (to a certain extent), so investors should capture tax
losses early
Keeping losers and selling winners might make sense if losing stocks would outperform the
winners going forward
o This belief does not appear to be justified – if anything, losing stocks that investors
continue to hold underperform the winners they sell
o According to one study, losers underperformed winners by 3.4% over the next year

Investor Attention, Mood, and Experience

o Individual investors are not generally full-time traders
— They have limited time and attention
— More likely to buy stocks that have been in the news, advertised more, had
very high trading volume, or recently had extreme (high or low) returns
o Investor mood affects investment behavior
— Annualized market returns at the location of the stock exchange is higher
on sunny days than on cloudy days
o Investors appear to put too much weight on their own experience rather than
considering all the historical evidence
— People who grow up and live during a time of high stock returns are more
likely to invest in stocks