FI 623 Chapter 18

EQUITY VALUATION
MODELS
FI 623: Chapter 18
1 © 2019-2021 Alain Chinca All Rights Reserved
WHAT IS EQUITY VALUATION?
• It is the comparison of the current market

price and the intrinsic value of the firm
• The farther apart these 2 values are, the
higher the performance can be
• We will study 3 fundamental methods:
o
Gordon Growth Model (DDM)
o
Valuation Comparison
o
Discounted Free Cash Flows

BALANCE SHEET MODELS
• Book Value: Equity / Outstanding Shares

o
Problem: Book value is an accounting number reflecting
historical or inaccurate values (e.g. Land, Inventory)
• Liquidation or Breakup Value: Proceeds per share for
selling all the company assets
o
Problem: Investors do not acquire (usually) a firm to break it
apart or liquidate it – can be used at the floor for an acquisition
price
• Tobin’s Q ratio: Price/Replacement Cost
o
Although Tobin’s study has shown the power of the Q ratio, it is
extremely complicated and time consuming to compute. The
short cut version [(Market Cap + Total Liabilities + Preferred
Equity + Minority Interest) / Total Assets] has limited impact
GORDON GROWTH MODEL
Expected
Return
• How do we know if it is high enough?
• We compare to the Required Rate of Return
(let’s call it k)
o CAPM: Rf + b(RM – Rf)
o
Market Capitalization Rate: Market-consensus
estimate of appropriate discount rate for firm
o APT: Rf + b(RM – Rf) + b1l1 + b2l2 + ... + bNlN

GORDON GROWTH MODEL
• Intrinsic Value:
• For holding period H
• This is the Gordon Growth model also

known as the Dividend Growth Model:
“Intrinsic value of firm equal to present value
of all expected future dividends”
GORDON GROWTH MODEL –
CONSTANT GROWTH
• Constant Growth DDM

o
Assumes dividends will grow at constant rate g
D0 1  g  D1
V0  
kg kg
• Implications
o
Higher the dividend, higher the valuation
o
Lower the market cap rate, higher the valuation
o
Higher expected growth, higher the valuation – This
explain why growth stock can command high valuation
with little earnings

CONSTANT GROWTH
• If the stock is in equilibrium (i.e. Intrinsic Value =
Market Price meaning k = E(r) ), the HPR will be
• A value stock will mainly gets its return from its

dividends
• A growth stock will mainly gets its return from its
growth rate
CONSTANT GROWTH
• Preferred Stock Example

o
No growth case (fixed dividends)
o
Value a preferred stock paying a fixed dividend
of $2 per share when the market cap rate is 8%:
$2
Vo   $25
0.08  0

CONSTANT GROWTH
• Constant Growth Example

o
A stock just paid an annual dividend of $3/share
o
Dividend is expected to grow at 8% indefinitely
o
Market capitalization rate is 14%
D1 $3.24
V0    $54
k  g .14  .08

ESTIMATING DIVIDEND
GROWTH RATES
• g = growth rate in dividends

• ROE = Return on Equity
• b = plowback or retention rate (1 - dividend
payout rate)
g  ROE x b

STOCK PRICE AND
REINVESTMENT RATE
• Consider a firm with EPS of $5, Dividend

Payout Ratio of 100% and a market cap
rate of 12.5%
• Its price would be 5 / 12.5% = $40
• The stock price would not grow as the firm
does not reinvest in itself and consequently
cannot grow the earnings

STOCK PRICE AND
REINVESTMENT RATE
• A new management team arrives and

starts projects that will earn 15%. Should
they continue the dividend payout ratio of
100%?
• No because the investors would reinvest
the dividends at 12.5% (paying all earnings
to investor would prevent the projects from
happening)

STOCK PRICE AND
REINVESTMENT RATE
• The firm changes it dividend payout ratio to

40%. What happens to the stock price?
• It rises! Why?
• The growth rate is retention ratio x return 
60% x 15% = 9%
• The earnings and the dividends will grow by
9%
• The price will be: 5x40%x(1+9%)/(12.5%-9%) =
$62.29
STOCK PRICE AND
REINVESTMENT RATE
• The price increased by $22.29. Why?

• The price when paying out all earnings as
dividends represents the value per share of
the assets the company already has in place.
• The increase in the stock price reflects the
fact that planned investments provide an
expected rate of return greater than the
required rate i.e. positive NPV

STOCK PRICE AND
REINVESTMENT RATE
• This net present value is called the

present value of growth opportunities
(PVGO).
• Price = No Growth Value + PVGO
• $62.29 = 40 + 22.29

STOCK PRICE AND
REINVESTMENT RATE
• But wait …. Don’t dividend cuts usually result in

share value dropping? That is a contradiction.
• Not necessarily: Dividend cuts are usually taken as
bad news about the future prospects of the firm
(cash flow concerns), and this new information is
responsible for the stock price decline, about the
firm, not the reduced dividend
• If the cut is seen as making sense (e.g. building
reserve to improve capitalization), it will not result in
a drop in price

STOCK PRICE AND
REINVESTMENT RATE - EXAMPLE
• Firm has declared next year dividend to be $2, has a

market cap rate of 10%, a ROE of 8% and a Dividend
Payout Ratio of 50%
• What is the price?
2 / (10% - (8% x 50%)) = $33.33
• Is a firm takeover candidate?
• Yes. Because PVGO = Price – No Growth Value 
33.33 – 4 / 10% = -6.67
• An acquirer could increase value simply by changing
its dividend payout ratio

LIFE CYCLES AND MULTISTAGE
GROWTH MODELS
Firms typically pass through life cycles
Early Years Later Years
• Ample opportunities for profitable • Attractive opportunities for reinvestment

reinvestment in the company may become harder to find.
• Competitors may have not entered the • Competitors enter the market
market.
• Payout ratios are low • Payout ratios are high
• Growth is correspondingly rapid. • Dividend growth slows because the

company has fewer investment
opportunities.

GROWTH MODELS

GROWTH MODELS

GROWTH MODELS
• Growth might be at high rate early in the

life of a firm but will ultimately level off
• Two-stage DDM
o
DDM in which dividend growth assumed to level
off only at future date
• Multistage Growth Models
o
Allow dividends per share to grow at several
different rates as firm matures

TWO STAGES DDM
• This allow to use the Gordon Growth model to

price companies in their growth phase when g > k
• First step is to calculate the present value of each
individual dividend while the growth is supernormal
• Once the growth stabilizes (g < k), you calculate
the present value of a constant growth price

TWO STAGES DDM-EXAMPLE
• A firm’s dividends are expected to grow at

20% for 3 years and after the growth slows
to 5%. The stock just paid a dividend of
$1.00. If the market capitalization rate is
12%, what is the price of this stock?
1.2/1.12 + 1.44/1.122 + 1.73/1.123 + [1.81/(0.12-0.05)]/1.123

MULTISTAGE GROWTH MODEL
• What is the drop in growth rate was more

gradual than in the two stages DDM?
• How do we handle the transition period
from super-growth to constant growth?
• We assume a linear gradual decline
• It is easier and faster than estimating
individual dividends

MULTISTAGE GROWTH MODEL
• Methodology
1. Calculate the average growth rate for the super
growth rate period
2. Identify the long term constant growth rate
(ROE x Retention Ratio) and Market Cap Rate
3. Calculate the declining growth rate
4. Identify the Cash flows
5. Compute the present value which will be the
price

MULTISTAGE GROWTH MODEL-
EXAMPLE
• A firm with a beta of 1.5 (risk free rate is 2%

and market premium is 8%) just paid its first
dividend of $1. We expect the dividend to
grow by 40%, 30% and 20% for Year 1, 2
and 3, Respectively. We believe that growth
will decline for the 10 following years and
the long term ROE will be 14% with a
retention ratio of 50% after that. What is the
price of the stock?
EXAMPLE
• Step 1: Super growth average

[(1+40%)x(1+30%)x(1+20%)](1/3)-1=29.74%
This is the growth for Year 4
• Step 2: Long Term Growth
14% x 50% = 7% (Year 2034)
2% + 1.5 x 8% = 14%
• Step 3: Linearly declines super growth rate
Annual Adjustment: (+29.74% - 7.00%)/10
• Step 4a: Calculate the annual dividends

EXAMPLE
• Step 4b: Calculate the price of the stock in

2034
P2033 = D2034/(k-g) = D2033x(1+g)/(k-g)
P2033=13.68x1.07/(14%-7%)
• Step 5: Compute the PV of each cash flow
at the market cap rate and sum them to get
the price

EXAMPLE
PV of
Investor
Dividend CF at
Year Growth Market
Number Year Rate Dividend Term value Investor CF Cap Rate Inputs
0 2020 1.00 beta 1.5
1 2021 40.00% 1.40 1.40 1.23 mkt_prem 8%
2 2022 30.00% 1.82 1.82 1.40 rf 2%
3 2023 20.00% 2.18 2.18 1.47 k_equity 14%
4 2024 29.74% 2.83 2.83 1.68 plowback 50%
5 2025 27.47% 3.61 3.61 1.88 roe 14%
6 2026 25.19% 4.52 4.52 2.06 term_gwth 7.00%
7 2027 22.92% 5.56 5.56 2.22
8 2028 20.65% 6.71 6.71 2.35
9 2029 18.37% 7.94 7.94 2.44
Super Growth 10 2030 16.10% 9.22 9.22 2.49
11 2031 13.82% 10.49 10.49 2.48
12 2032 11.55% 11.70 11.70 2.43
13 2033 9.27% 12.79 195.45 208.23 37.91
14 2034 7.00% 13.68 13.68
Transitional period Price 62.04
with slowing dividend
growth
Beginning of constant
growth period

DISCOUNTED CASH FLOW WHEN
NO DIVIDENDS ARE PAID
• Basic Investment Banking Valuation
problem:
• A company expects to generate FCF of
6,500 next year that will grow 30%, 25%,
20%, 10% in year 2 to 5 and then 5% going
forward. If the firm has $50,000 of debt and
26,500 shares outstanding, what is the
intrinsic value (i.e. the stock price) if our
required rate of return is 10%?

DISCOUNTED CASH FLOW WHEN
NO DIVIDENDS ARE PAID

RATIOS ANALYSIS OVERVIEW
• Ratios are a group of indicators that allow for better

comparison through time or between companies
• A stand alone ratio is useless and needs a frame of
reference a.k.a. a ratio usefulness come from
comparison
• To understand a ratio you need to understand what
the ratio is trying to measure and why that
information is important
• A ratio should always be compared to the company
history and the sector/industry
© 2019-2021 Alain Chinca All Rights
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Reserved
RATIOS ANALYSIS
• Liquidity Ratios
• Asset Management Ratios
• Debt Management Ratios
• Growth Ratios
• Profitability Ratios

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Reserved
LIQUIDITY RATIOS
• Liquidity ratios answer the question:

o can the company meet its short-term obligations
using the resources it currently has on hand?
• Main Ratios:
o Current Ratio = Current Assets / Current
Liabilities
o
Quick Ratio = (Current Assets – Inventory) /
Current Liabilities
o Cash Ratio = Cash / Current Liabilities

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ASSET MANAGEMENT RATIOS
• Asset Management ratios answer the

question:
o
How efficiently does the firm use its assets?
• Main Ratios:
o
Inventory Turnover = Cost of Goods Sold /
Inventory
o
Days’ Sales in Inventory = Inventory / (Cost of
Goods Sold / 365 days)
Note: IT x DSI = 365
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Reserved
ASSET MANAGEMENT RATIOS
• Main Ratios (continued):

o
Receivables Turnover = Sales / Accounts Receivable
o
Days’ Sales in Receivables = Accounts Receivable/
(Sales / 365 days)
o
Payables Turnover = Cost of Goods Sold / Accounts
Payable
o
Days in Payables = Accounts Payable / (Cost of
Goods Sold / 365 days)
o
Total Asset Turnover = Sales / Total Assets
o
Fixed Asset Turnover = Sales / Net Fixed Assets

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DEBT MANAGEMENT RATIOS
• Debt Management ratios answer the question:

o
Can the company’s earnings meet its debt servicing
requirements and avoid insolvency?
• Main Ratios
o
Total Debt Ratio = Total Liabilities / Total Assets
o
Debt to Equity Ratio = Total Liabilities/ Total Equity
o
Times Interest Earned = EBIT / Interest
o
CFO Coverage: Coverage = Cash Flow for
Operations / Interest

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GROWTH RATIOS
• Growth ratios answer the question:

o
How fast is the company growing?
• The time frame for the growth period is
usually 1, 3 or 5 years
• Main Ratios
o
Sales Growth
o
EBIT Growth
o
Net Income Growth

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PROFITABILITY RATIOS
• Profitability ratios answer the question:

o
Is the firm getting the appropriate return for its
shareholders?
• Main Ratios
o
Gross Profit Margin= (Sales – COGS) / Sales
o
Operating Profit Margin= EBIT / Sales
o
Net Profit Margin = Net Income / Sales
o Return on Assets (ROA) = Net Income / Total
Assets
o
Return on Equity (ROE) = Net Income / Total Equity

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IMPACT OF DEBT ON ROE AND
ROA
• Debt, a financing decision can really impact

profitability ratios and lead to the wrong
conclusion
• ROA is lowered by debt (interest expense lowers
net income, which lower ROA)
• ROE is increased by debt (more debt means less
equity, which higher ROE)
• How do we solve this issue? The DuPont
Analysis

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THE DUPONT ANALYSIS
Constructing the DuPont Equation

Starting Point: ROE = NI / TE
Step 1: Multiply & Divide by Total Assets and

rearrange
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM

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THE DUPONT ANALYSIS
Step 2: Multiply & Divide by Sales and

rearrange
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM
ROE = Profit Margin x Total Asset Turnover x the Equity

Multiplier

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THE DUPONT ANALYSIS
• Profit margin is a measure of the firm’s operating

efficiency
• Total asset turnover is a measure of the firm’s

asset use efficiency
• Equity multiplier is a measure of the firm’s

financial leverage

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PRICE-EARNINGS RATIO
• Price-Earnings ratio or P/E ratio or price

multiple is the most common valuation
measure
• The proper measure is current price
dividend by next year earnings (P0/E1)
a.k.a. as P/E FY1
• However, in practice there are many P/E
published (P/E FY0, P/ELTM, P/ENTM)

PRICE-EARNINGS RATIO-THEORY
• If, then
• The P/E must reflect the growth

opportunity of the firm
• A no-growth firm P/E is simple 1 over the
market cap rate

• Gordon
growth: P0=D1/(k-g)
• If dividends are earnings NOT reinvested
in the firm and b is the retention ratio, then
thus
• P/E will be higher with increased ROE and

retention ratio

• However growth does not always generate

higher P/E is the ROE is below the market
cap rate (12% in the example)

& PRACTICE
• If then the riskier the stock, the lower the

P/E, because of the high k
• However high growth, high risk companies
(think startup) have very high P/E. How do we
explain it?
• The theoretical approach of P/E is based on
matured, dividend paying companies with a
constant growth lower than the firm market
capitalization rate
& PRACTICE
• However, only a minority of firms fall into

that category.
• In addition, we know that a market cap
rate based on beta is less than optimal.
• In practice, P/E is a measure of the market
estimate of a firm's growth prospect. Low
P/E firm are cheap while high P/E firm are
expensive but have high growth prospects

PEG RATIO
• To
reconcile high P/E valuation, the PEG
ratio was developed
• It is the price multiple to the EPS growth
rate
• This is why high P/E firms can be seen at

being cheap

P/E - LARGE CAP

P/E - TECHNOLOGY

PEG - LARGE CAP

PEG - TECHNOLOGY

P/E VS. PEG
• On a P/E basis, the FAANG are more

expensive than the Mature Companies
except for FB
• On a PEG basis, only BAC and CAT are
cheaper than the FAANG
• Who is right?

IS PEG SUPERIOR TO P/E?
• PEG is used by growth managers to justify

certain valuations
• P/E is used by value manager
• The main issue is the quality of the growth
estimate
• We know that analysts have consistently over-
estimated EPS growth
• PEG is not better or worse than P/E. It is just
different
PITFALLS IN P/E ANALYSIS
• Earnings Management
o
Practice of using flexibility in accounting rules to
improve apparent profitability of firm – Pro forma
statements to reflect “operating earnings”
o
Large amount of discretion in managing
earnings
• P/E fluctuates significantly
• P/E are Sector/Industry specific

S&P 500 P/E BY SECTOR
(10/26/21)
(WEIGHTED HARMONIC AVERAGE)

S&P 500 P/E HISTORICALLY

P/E VS. GROWTH - EXAMPLE


• FDX EPS growth has consistently beaten INTC

over the last 5 years
• FDX valuation has not always been higher than
INTC
• What could cause that?
• INTC Growth is consistently between 6 and 10%.
FDX growth varies from went from 17 to 8%
• P/E reflects the higher growth volatility of FDX
compared to INTC

USING STOCK PRICE MULTIPLES
TO ESTIMATE STOCK PRICE
• We use P/E multiple to identify what

possible value the future stock price can
be
• We compare the current firm P/E to its
history (highest and lowest last 5 years)
and the industry
• Based on FY1 EPS, we get a range of
potential outcomes

• Example: Data from FactSet for WFC ($50.63)
• If the NTM EPS is $3.88 =>

o Match Industry: 3.88 x 13.56 = $52.61 (+4%)
o
Best Case: 3.88 x 21.2 = 82.26 (+62%)
o Worst Case: 3.88 x 6.3 = 24.44 (-52%)

• Example 2:
o
Firm price is $25.00
o
Firm projected EPS are $1.67
o Firm P/E is 15
o
Industry P/E is 18
• If EPS change to $2.00 and firm get
market valuation (i.e. reaches industry
P/E), what is projected price target and
return?

• There are 2 sources of price increase:

o
P/E changes from 15 to 18
o
EPS changes from $1.67 $2.00
• Projected price 2.00 x 18 = $36.00 (+44%)
o
EPS gain: 1.67 vs 2.00 => 20% gain
• Rerating: 15 vs 18 = 20% gain
• (1.2 x 1.2) = 1.44 or 44% gain

OTHER COMPARATIVE
VALUATION RATIOS
• Price-book (P/B or B/P) - Indicates how aggressively

market values firm
• Price-[free]cash flow (P/[F]CF) (free cash flow harder to
compute) - Cash flow less affected by accounting
decisions than earnings
• Price-sales (P/S) - For start-ups with no earnings
• Dividend yield (D/P) – For mature, value oriented
companies
• Price-earnings growth (PE/G) – For growth manager
justifying nosebleed valuation
Excepted for (B/P and D/P), low value means cheap

CAPITAL STRUCTURE AND
VALUATION RATIOS
• Company A and B have the same sales but Company

A is 100% equity while Company B is 50% equity and
50% debt
• Company A P/S will be half of Company B P/S yet the
sales are the same
• Solution: Enterprise Value
Enterprise value = Market Value of Equity + Market
(Book) Value of Debt – Cash
• Two most commonly used measured
o
EV/Sales
o
EV/EBITDA (free cash flow proxy)

EV/EBITDA
• Rationales for using EV/EBITDA:

o
More appropriate than PE for comparing
companies with different financial leverage
o
By adding back DA, EBITDA controls for
differences in DA across firms. For this reason,
EV/EBITDA is frequently used for capital
intensive businesses (e.g., cable, steel
companies)
o
EBITDA is frequently positive when EPS is
negative.
EV/SALES
• Rationales for using EV/SALES:

o
This is more robust multiple than the PS
multiple, because it is internally consistent.
o
It divides the total value of the firm by the
revenues generated by the firm.
o
Eliminates the P/S bias that yields lower values
for more highly levered firms.
• In the end, valuation measures should
provide the same conclusions

VALUATION MEASURES - FB

FREE CASH FLOW VALUATION
APPROACHES
• Free cash flow approach solves some of

the limitations of the dividend based
approach
• The Free Cash Flow to the Firm (FCFF) is
the after-tax cash flow generated by the
firm's operations, net of investments in
capital and net working capital.
FCFF = EBIT(1-t) + D&A – Capital Expenditures – Change in NWC

APPROACHES
• Another approach is to focus on the Free

Cash Flow to Equityholders (FCFE)
FCFE = FCFF – Interest Expenses(1-t) + Change in Debt
• FCCE is used when analyzing potential

take over or if the leverage decisions
cannot be impacted by the equityholders

APPROACHES
• Value of the firm based on FCFF is
• Value of the firm based on FCFE is

FCFF EXAMPLE
• Assume FCFF for the next 3 years will be

1M, 1.5M and 2M respectively. After that
they will grow at 8%. The firm WACC is
13%. The firm has 500,000 shares
outstanding and 5M in debt. What is the
price per share of this firm?
Price = (Firm Value – Debt) / Shares Outstanding

FCFF EXAMPLE
Present
Terminal Value at
Year FCFF Value WACC
1 1,000,000 884,956
2 1,500,000 1,174,720
3 2,000,000 43,200,000 31,325,867
4 2,160,000
Firm Value 33,385,543
Debt 5,000,000
Shares 500,000
Price 56.77

FCFE EXAMPLE
• Assume FCFE for the next 3 years will be

0.8M, 1.2M and 1.6M respectively. After
that they will grow at 8%. The firm ke is
18%. The firm has 500,000 shares
outstanding and 5M in debt. What is the
price per share of this firm?
Price = Market Value of Equity / Shares Outstanding

FCFE EXAMPLE
Terminal Present
Year FCFE Value Value at Ke
1 800,000 677,966
2 1,200,000 861,821
3 1,600,000 17,280,000 11,490,951
4 1,728,000
Firm Value 13,030,738
WHY IGNORED? Debt 5,000,000
Shares 500,000
Price 26.06

FCFF & FCFE COMPLEX
EXAMPLE - ASSUMPTIONS
• P/E is 14.50 growing 0.15 per year for the next 4 years
• Cap spending/shares is 1.35 growing 0.05 per year for the next 4
years
• LT debt constant at 247,000
• Outstanding shares constant at 10,000
• EPS is 1.70 growing 0.25 per year for the next 4 years
• Working Capital is 275,000 growing 10,000 per year for the next 4
years
• Depreciations are 9,500 growing 500 per year for the next 4 years
• Constant growth in year 4 is 4.00%
• Cost of debt is 3.50% and Tax Rate is 35.00%
• Risk-free rate is 3.00% and Market risk premium is 8.00%
• Current beta is 1.20
• What is the firm intrinsic value?
FCFF & FCFE COMPLEX
EXAMPLE - METHODOLOGY
• Step 1: Calculate Cost of Equity, After tax cost

of Debt and WACC in 2024
• Step 2: Calculate the FCFF and FCFE
• Step 3: Calculate the PV of the FCFF and
FCFE
• Step 4: Calculate the firm intrinsic value per
share
[(Equity/(Debt + Equity)]x(Rfr + Beta x MP) +
[(Debt/Equity+Debt)]x(Cost Debt x (1 - Tax Rate)
[407,700/654,700]x12.60% + [247,000/ 654,700] x 2.28% =
8.70%
FCFF & FCFE COMPLEX
EXAMPLE - ASSUMPTIONS
Assumptions 2020 2021 2022 2023 2024
P/E 14.50 14.65 14.80 14.95 15.10
Capital spending/share 1.35 1.40 1.45 1.50 1.55
LT debt 247,000 247,000 247,000 247,000 247,000
Shares 10,000 10,000 10,000 10,000 10,000
EPS 1.70 1.95 2.20 2.45 2.70
Working capital 275,000 285,000 295,000 305,000 315,000
Depreciation 9,500 10,000 10,500 11,000 11,500
Current beta 1.20
Constant growth 4.00%
Tax Rate 35.00%
Cost of debt 3.50%
Risk-free rate 3.00%
Market risk premium 8.00%
FCFF & FCFE COMPLEX
EXAMPLE – CAPITAL COSTS
WACC Calculation Capital Structure

Cost of Equity 12.60% Equity 407,700 62.27% Rfr + Beta x MP / 2024 EPS x P/E x Shares
Cost of Debt 2.28% Debt 247,000 37.73% Cost Debt x (1 - Tax Rate)
WACC in 2024 8.70% 654,700 100.00%
[(Equity/(Debt + Equity)]x(Rfr + Beta x MP) +

[(Debt/Equity + Debt)]x(Cost Debt x (1 - Tax Rate)
[407,700/654,700]x12.60% + [247,000/ 654,700] x 2.28%
= 8.70%

FCFF & FCFE COMPLEX
EXAMPLE – FCFF & FCFE
CALCULATIONS
Free Cash Flow Calculations 2020 2021 2022 2023 2024
Profits (after tax) 17,000 19,500 22,000 24,500 27,000 EPS x Shares
Interest (after tax) 5,619 5,619 5,619 5,619 5,619 (1 - tax_rate) x Cost debt x LT debt
Depreciation 9,500 10,000 10,500 11,000 11,500
Change in working cap 10,000 10,000 10,000 10,000
Capital spending 14,000 14,500 15,000 15,500 Cap Spending x Shares
FCFF & FCFE Calculations 2020 2021 2022 2023 2024

FCFF 11,119 13,619 16,119 18,619 Profit + Int + Dep - Chg WC - Capex
Terminal Value FCFF 411,592 Gordon Growth with WACC
FCFE 5,500 8,000 10,500 13,000 Profit + Dep - Chg WC - Capex
Terminal Value FCFE 157,209 Gordon Growth with Cost Equity
FCFF & FCFE COMPLEX
EXAMPLE – PRICE
CALCULATIONS
Present Values 2021 2022 2023 2024 Total

Present Value of FCFF 10,229 11,525 12,549 308,098 342,401
Present Value of FCFE 4,885 6,310 7,355 105,884 124,433
Intrinsic Equity
Price per Share Value Value IV/Share
FCFF 342,401 95,401 9.54
FCFE 124,433 124,433 12.44

PROBLEMS WITH FREE CASH
FLOW APPROACH
• DCF estimates are always somewhat imprecise

because analysts are always forced to make
simplifying assumptions:
o
How long will it take the firm to enter a constant-growth
stage?
o
How should depreciation best be treated?
o
What is the best estimate of ROE?
• Most of the action in these models is in the terminal
value and that this value can be highly sensitive to
even small changes in some input values

FREE CASH FLOW DATA IN
BLOOMBERG
• Function is FA CF (Financial Analysis –

Cash Flows)

DIFFERENCE BETWEEN THE 3?



QUALITATIVE VS. QUANTITATIVE
ANALYSIS
In evaluating a stock, is the st

ory or the number more impor
tant?

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EQUITY VALUATION

• It is the comparison of the current market

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• Book Value: Equity / Outstanding Shares

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• This is the Gordon Growth model also

• Constant Growth DDM

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• A value stock will mainly gets its return from its

• Preferred Stock Example

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• Constant Growth Example

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• g = growth rate in dividends

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• Consider a firm with EPS of $5, Dividend

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• A new management team arrives and

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• The firm changes it dividend payout ratio to

• The price increased by $22.29. Why?

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• This net present value is called the

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• But wait …. Don’t dividend cuts usually result in

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• Firm has declared next year dividend to be $2, has a

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Early Years Later Years

• Ample opportunities for profitable • Attractive opportunities for reinvestment

• Payout ratios are low • Payout ratios are high

• Growth is correspondingly rapid. • Dividend growth slows because the

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• Growth might be at high rate early in the

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• This allow to use the Gordon Growth model to

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• A firm’s dividends are expected to grow at

1.2/1.12 + 1.44/1.122 + 1.73/1.123 + [1.81/(0.12-0.05)]/1.123

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• What is the drop in growth rate was more

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• A firm with a beta of 1.5 (risk free rate is 2%

• Step 1: Super growth average

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• Step 4b: Calculate the price of the stock in

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• Ratios are a group of indicators that allow for better

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• Liquidity ratios answer the question:

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• Asset Management ratios answer the

• Main Ratios (continued):

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• Debt Management ratios answer the question:

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• Growth ratios answer the question:

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