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Chapter Four

Corporate Valuation

 Required readings:
 Ehrhardt, M.C. Brigham, E. F. (2011), Financial Management: Theory

and Practice, 13th Ed., South-Western Cengage Learning. (Chapter

7,9,13,)
 Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan (2013),

Fundamentals of Corporate Finance, 10th ed. McGraw-Hill. (Chapter 8)

 Overview of Corporate Valuation
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 Corporate valuation is the process of determining the

value of a firm.
 Firm Value - the value of all investors who have

claims on it.
 Value of Equity - the value of common stock for a

publicly traded firm.

 The primary objective of any firm’s management is
maximizing intrinsic value.
 Intrinsic value - the “true” value of the firm’s stock,

it cannot be directly observed and must instead be

estimated.
 Cont’d……….
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 It is important for investors to understand how to

estimate intrinsic values.
 When investing in common stocks, the goal is to

purchase undervalued stocks (price is below the

intrinsic value) and avoid overvalued stocks.
 Market equilibrium occurs when stock price of a

firm equals with intrinsic value.

 Analysts and investors are quite interested in finding
reliable models that help to predict intrinsic value.
 Cont’d………
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 The value of a firm is determined by the size, timing,

and risk of its expected future free cash flows (FCF).
 FCF is the cash from operations available for

distribution to investors.
 FCF = Net operating profit after taxes - required

investments in operating capital

 Cont’d………..
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 The basic components of valuation are:

 Estimation of the future free cash flow stream from

owning assets
 The required rate of return for each period based

upon the riskiness of the asset

 The value is then found by discounting each cash
flow by its respective discount rate and then
summing the present value.
 What model should we have to use to discount the
cash flows?
 Cont’d………
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 Two basic models use to estimate intrinsic values:

 Discounted dividend model - focuses on the

regular dividends.
 Corporate valuation model - focuses on sales,

costs, and free cash flows.

 Discounted Dividend Model
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 Common stocks are expected to provide a stream of

future cash flows, and a stock’s value is the present
value of its expected future cash flow stream.
 The expected cash flows consist of two elements:
 Dividends expected in each year and
 The price that investors expect to receive when

they sell their stocks.

 Cont’d……….
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 For all present and future investors, expected cash

flows must be based on expected future dividends.
 Unless a firm is liquidated or sold to another, the

cash flows it provides to its stockholders will

consist only of a stream of dividends.
 Therefore, the value of a stock must be the present
value of the expected dividend stream.
 Cont’d……..
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 The value of the stock today is calculated as the

present value of an infinite stream of dividends:
D1 D2 Dn
VStock     
1 rs  (1 rs )
1 2
(1 rs ) n

 Cost of Equity (rs) affects by

 Market interest rate
 Market risk aversion
 Firm’s debt/equity mix (financial risk)
 Firm’s business risk
 Cont’d………
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Valuing a Constant Growth Stock

 D can be rising, falling, fluctuating randomly, or
t
even zero for several years.
 In practice, the hard part is getting an accurate

forecast of the future dividends.

 In many cases the stream of dividends is expected to

grow at a constant rate.

 The model uses to compute value of the stock is

called constant growth model, or Gordon model, after

Myron J. Gordon, who did much to develop and
popularize it.
 Cont’d………
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D 0 (1  g ) 1 D 0 (1  g ) 2 D 0 (1  g ) 
VS    ... 
1  rs  1
(1  rs ) 2
(1  rs ) 

(1  g ) t
V S  D 0 
t 1 (1  r s ) t

 When dividend grows at a constant rate;

D0 (1  g) D1
VS  
rs  g rs  g
 Cont’d……….
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 A necessary condition for validity of the Equation is

rs should be greater than g.
If g is greater than rs, the constant growth model
cannot be used, and the answer you would get from
using the model would be wrong and misleading.
Illustration
 Alibad Inc. paid a dividend of $1.15 (i.e., D =
0
$1.15). Its stock has a required rate of return, rs, of
13.4%, and investors expect the dividend to grow at a
constant 8% rate in the future.
 Cont’d…….
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 The estimated dividend of year 1 hence would be

D1 = $1.15(1.08) = $1.24; D2 would be $1.34; and
The estimated dividend 5th year;
Dt = D0 (1+ g)t = $1.15(1.08)5 = $1.69
 It could find each expected future dividend, calculate
its present value, and then sum all the present values
to find the intrinsic value of the stock.
 Such a process would be time-consuming

1.15 (1.08)
VS   1 .242 / 0 .054  23 .00
0.134  0 .08
 Cont’d……….
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 However, it is not appropriate to assume that

dividends will grow at a constant rate.
 So, the value of stock of such firms’ is PV of its

expected future dividends determined as


D 0 (1  g ) D 0 (1  g )
1 2
D 0 (1  g )
VS    ... 
1  rs  1
(1  rs ) 2
(1  rs ) 

 When Dt is growing at a constant rate

D1
VS 
rs  g
 Cont’d……….
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For example:
 Yara Company currently paid dividend of 2.00 per

share. The stocks required rate of return is 14%, and

dividend grows as follows:

Year Dividend Growth Rate

1-3 25%
4-6 20%
7-9 15%
10 on 9%
 Cont’d………
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 The value of Yara Company stock is

2 . 00 (1 . 25 ) 2 . 00 (1 . 25 ) 2 2 . 00 (1 . 25 ) 3
VS   2
 3
1 . 14 3 1 . 14 1 . 14
2 . 00 (1 . 25 ) (1 . 20 ) 2 . 00 (1 . 25 ) 3 (1 . 20 ) 2
 4
 5
1 . 14 3 1 . 14
2 . 00 (1 . 25 ) (1 . 20 ) 3 2 . 00 (1 . 25 ) 3 (1 . 20 ) 3 (1 . 15 )
 6
 7
1 . 14 3 1 . 14
2 . 00 (1 . 25 ) (1 . 20 ) 3 (1 . 15 ) 2 2 . 00 (1 . 25 ) 3 (1 . 20 ) 3 (1 . 15 ) 3
 8
 9
13. 14 1 . 14
2 . 00 (1 . 25 ) (1 . 20 ) 3 (1 . 15 ) 3 (1 . 09 )
(. 14  . 09 )

(1 . 14 ) 9
 Cont’d…….
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Discount Present Growth

Year Dividend Factor Value Rate
1 $ 2.50 0.8772 $ 2.193 25%
2 3.13 0.7695 $ 2.408 25%
3 3.91 0.6750 $ 2.639 25%
4 4.69 0.5921 $ 2.777 20%
5 5.63 0.5194 $ 2.924 20%
6 6.76 0.4556 $ 3.080 20%
7 7.77 0.3996 $ 3.105 15%
8 8.94 0.3506 $ 3.134 15%
9 10.28 0.3075 $ 3.161 15%
10 11.21 9%
a b
$ 224.20 0.3075 $ 68.943
$ 94.365
a
Value of dividend stream for year 10 and all future dividends, that is
$11.21/(0.14 - 0.09) = $224.20
b
The discount factor is the ninth-year factor because the valuation of the
remaining stream is made at the end of Year 9 to reflect the dividend in
Year 10 and all future dividends.
 Corporate Valuation Model
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 Dividend model is often unsuitable for managerial

purposes.
 Assume a start-up company;

 Focuses on product development, marketing, and

raising capital.
 Managers of such company, their decision to
initiate dividend payments in the foreseeable
future will be totally off the radar screen.
 So, dividend growth model is not useful for
valuing most start-up companies.
 Cont’d……..
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 Established Firms
 As long as internal opportunities and acquisitions

are attractive, dividends will be postponed.

 As a result, dividend growth model is generally of

limited use for internal management purposes,

even for a dividend paying company.
 The main thought behind corporate valuation model
is that the firm worth is equal to the present value of
all its estimated future free cash flows.
 Cont’d……….
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 The total value of any firm is the value of its

operating and non-operating assets.
 Operating assets take two forms: assets-in-place

and growth options.

 Assets-in-place includes tangible assets and
intangible assets.
 Growth options are opportunities to expand that
arise from the firm’s current operating
knowledge, experience, and other resources.
 Both provides an expected stream of cash flows.
 Cont’d……..
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 Non-operating assets, which come in two forms.

 Marketable securities portfolio.
 Investments in other businesses reported as
“Equity in Net Assets of Affiliated Companies”.
 Most companies operating assets are far more
important than non-operating assets.
 Companies can influence the values of their
operating assets, whereas the values of non-operating
assets are beyond their direct control.
 Cont’d…….
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 Value of the firm is the present value of expected

future free cash flows discounted at the weighted
average cost of capital (WACC).
FCF1 FCF2 FCFt FCFn
Vop        
1  WACC1 (1  WACC 2 ) 2
(1  WACC t ) t
(1  WACC n ) n

n
FCF
V op  
t1 (1  WACC
t
) t
t
 Cont’d………
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 When the FCF is stabilize and begin to grow at a

constant rate;
FCF
V op  1
WACC  g

Example:
 Mayo Inc. has the following forecasted free cash
flows (in millions) for the years 2011 to 2014. A
10.84% cost of capital, and a 5% growth rate
 Cont’d…….
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Actual Projected
Calculate FCF 2010 2011 2012 2013 2014
Net Operating WC 212.00 250.00 275.00 289.00 303.00
Net Plant & Equipment 279.00 310.00 341.00 358.00 376.00
Net Operating Capital 491.00 560.00 616.00 647.00 679.00
Annual Investment in 69.00 56.00 31.00 32.00
operating capital
NOPAT 43.80 51.00 33.00 77.40 81.00
Less Investment in 69.00 56.00 31.00 32.00
operating Capital
FCF -18.00 -23.00 46.40 49.00
 Cont’d………
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49 (1  0 .05 ) 51 .45
Vop (12 / 31 / 2014 )    880 .99
0 .1084  0 .05 0 .0584
 This $880.99 million is called the firm’s terminal or
horizon value, because it is the value at the end of the
forecasted period.
 It is also sometimes called a continuing value, the
amount that Mayo Inc. could expect to receive if it
sold its operating assets on December 31, 2014.
 Cont’d……….
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 The value of operations as of December 31, 2010.

18.00 23.00 46.40 49.00 880 .99
)
Vop(12/31/2010    
(10.1084
) (10.1084
1
) (10.1084
2
) (10.1084
3
) (10.1084
4
)4

) 615
Vop(12/31/2010 .27
 The sum of the PVs is approximately $615 million,
and it represents an estimate of the price Mayo Inc.
could expect to receive if it sold its operating assets
in December 31, 2010.
 Cont’d……..
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 Assume as of December 31, 2010 Mayo Inc. has

 An investment of $63 million of marketable
securities.
 Notes payable and long-term debt is $123 million

and $124 million respectively

 Preferred stock has a claim of $62 million

 Total Value of Mayo Inc. = 63 + 615.27 = 678.27

 Intrinsic value of equity = 678.27 − 123 −124 − 62
= 369.27
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Questions?

Thank You!