References

• Reilly, Frank K. and Keith C. Brown, Analysis of Investment and

Management Portfolios (9th Edition), Thomson South-Western, 2009.
• Chapter 11

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Overview of the valuation process

• Two General Approaches

• Top-down, three-step approach
• Bottom-up, stock valuation, stock picking approach
• The difference between the two approaches is the
perceived importance of economic and industry
influence on individual firms and stocks
• Both of these approaches can be implemented by
either fundamentalists or technicians

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Three-Step Valuation Approach
• General Economic Influences
• Fiscal policy initiatives, such as tax credits or tax cuts, can
encourage spending
• Monetary policy though controlling money supply growth
or interest rate therefore affects all segments of an
economy and that economy’s relationship with other
economies
• Inflation changes the spending and savings behavior of
consumers and corporations
• Other events such as war, political upheavals in foreign
countries, or international monetary devaluations exert
strong effects on the economies

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Three-Step Valuation Approach
• Industry Influences
• Identify global industries that will prosper or suffer in the
long run or during the expected near-term economic
environment
• Different industries react to economic changes at different
points in the business cycle
• Alternative industries have different responses to the
business cycle
• Demographic factor and international exposure will also
have different impacts on different types of industries

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The Stock Market and the Business Cycle
Stylized graphic of industry
Basic
performance in different stages
of the business cycle Industries
Excel

Consumer
Consumer peak Staples Excel
Durables
Excel

Capital
trough Goods Excel
Financial
Stocks Excel
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Three-Step Valuation Approach
• Company Analysis
• The purpose of company analysis to identify the best
companies in a promising industry
• This involves examining a firm’s past performance, but more
important, its future prospects
• It needs to compare the estimated intrinsic value to the
prevailing market price of the firm’s stock and decide
whether its stock is a good investment
• The final goal is to select the best stock within a desirable
industry and include it in your portfolio based on its
relationship (correlation) with all other assets in your
portfolio

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Economic Analysis and Efficient Markets
• If markets are efficient,
should we bother with
analysis?
• Yes! In fact, in an efficient
market, likely the only way to
outperform market averages
is to forecast the future
better than the consensus.

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 Does the Three-Step Process Work?

• Studies indicate that most changes in an individual

firm’s earnings can be attributed to changes in
aggregate corporate earnings and changes in the
firm’s industry
• Studies have also found a relationship between
aggregate stock prices and various economic series
such as employment, income, or production
• Remember how we linked GDP changes to expected return of the
market portfolio

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 Does the Three-Step Process Work?

• An analysis of the relationship between rates of return for the

aggregate stock market, alternative industries, and individual stocks
showed that most of the changes in rates of return for individual
stock could be explained by changes in the rates of return for the
aggregate stock market and the stock’s industry

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 Theory of Valuation

• The value of an asset is the present value of its expected returns

• To convert this stream of returns to a value for the security, you must
discount this stream at your required rate of return
• This requires estimates of:
• The stream of expected returns, and
• The required rate of return on the investment

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 Theory of Valuation

• Stream of Expected Returns

• Form of returns
• Dividends
• Free Cash Flow to Equity
• Time pattern and growth rate of returns
• When the returns (Cash flows) occur
• At what rate will the return grow

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 Theory of Valuation

• Required Rate of Return

• Reflect the uncertainty of Return (cash flow)
• Determined by economy’s risk-free rate of return, plus
• Expected rate of inflation during the holding period, plus
• Risk premium determined by the uncertainty of returns on
• Business risk; financial risk; liquidity risk; exchange rate risk and country

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 Theory of Valuation

• Investment Decision Process: A Comparison of Estimated Values and

Market Prices
• You have to estimate the intrinsic value of the investment at your required
rate of return and then compare this estimated intrinsic value to the
prevailing market price
• If Estimated Value > Market Price, Buy
• If Estimated Value < Market Price, Don’t Buy

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 Valuation of Common Stock

• Two General Approaches

• Discounted Cash-Flow Techniques
• Present value of some measure of cash flow, including dividends, operating cash flow,
and free cash flow
• Relative Valuation Techniques
• Value estimated based on its price relative to significant variables, such as earnings, cash
flow, book value, or sales

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 Valuation of Common Stock

• Both of these approaches and all of these valuation

techniques have several common factors:
• All of them are significantly affected by investor’s
required rate of return on the stock because this rate
becomes the discount rate or is a major component of the
discount rate;
• All valuation approaches are affected by the estimated
growth rate of the variable used in the valuation
technique

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Why Discounted Cash Flow Approach

• These techniques are obvious choices for valuation

because they are the epitome of how we describe
value—that is, the present value of expected cash
flows
• Dividends: Cost of equity as the discount rate
• Operating cash flow: Weighted Average Cost of Capital
(WACC) - Not considered in this Course
• Free cash flow to equity: Cost of equity as the discount rate
• Dependent on growth rates and discount rate

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When to Use Discounted Cash Flow Valuation

• What is the measure of cash flow?

• Dividends
• These are cash flows that go straight to the investor, and would be discounted at the
required return on the stock
• Difficult to apply to firms that pay low or no dividends because of growth opportunities
• Reduced form useful when evaluating stable, mature firms where the assumption of
relatively constant growth for the long term is appropriate

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When to Use Discounted Cash Flow Valuation

• What is the measure of cash flow?

• Free cash flow to equity
• Measure of cash flows available to equity holders (including those retained by the firm),
after payments to debt holders and allowing for expenditures to maintain the firm’s
asset base, would be discounted at the firm’s cost of equity
• Operating free cash flow
• Measure of cash flows available (after direct costs and before payments to capital
suppliers) to all suppliers of capital to a firm, would be discounted the firm’s weighted
average cost of capital

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When to Use Discounted Cash Flow Valuation

• Potential difficulty DCF techniques

• Estimates of value are highly dependent on two important inputs:
• The growth rates of cash flows
• The estimate of the appropriate discount rate
• Small changes in either one can mean significant
differences
• GIGO (garbage in garbage out)

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Why Relative Valuation Techniques
• Provides information about how the market is
currently valuing stocks
• aggregate market
• alternative industries
• individual stocks within industries
• No guidance as to whether valuations are
appropriate
• best used when have comparable entities
• aggregate market and company’s industry are not at a
valuation extreme

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Which approach to use?

• No need to choose!
• The best approach is to use both approaches to come up with the
best valuation estimate possible.

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Discounted Cash Flow Techniques
• General Formula
t n
CFt
Vj   Vj  
t n
FCFEt
t 1 (1  k )
t
t 1 (1  k )
t

Dt
n
Vj  
t 1 1  k 
t
Where:
Vj = value of stock j
n = life of the asset
CFt = cash flow in period t (could be DIV or FCFE)
k = the discount rate that is equal to the investor’s
required rate of return for asset j,
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Dividend Discount Models

Assumes that the value of the share of common

stock is the present value of future dividends

D1 D2 D3 D
Vj     ... 
1  k  1  k  1  k 
2 3
1  k  
n Dt
Vj  
t 1 1  k 
t

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Dividend Discount Models

• Sale of stock at end of year 2

D1 D2 SPj 2
Vj   
 1  k  1  k   1  k  2
2

D3 D4 D
SPj 2    ... 
1  k   1  k 
• Short holding period 2
1  k  
• For longer holding periods the infinite period DDM model must be used

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DCF - Example
• You expect Blum Foods Ltd. to pay a dividend of $0.30 next year. The
shares will be sold after the dividend for $5.20. Assume ke=15%. The PV
of one share is:

D1 P1
PV  
(1  k e ) (1  k e )
$0.30 $5.20
 
(1  0.15) (1  0.15)
 $4.78

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The Dividend Discount Model (DDM)
• Infinite Period Model (Constant Growth Model)
• Assumes a constant growth rate for estimating all of future
dividends

D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) n
Vj    ... 
(1  k ) (1  k ) 2
(1  k ) n
where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k = required rate of return on stock j
n = the number of periods, which we assume to be infinite

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The Dividend Discount Model (DDM)
• Given the constant growth rate, the earlier formula
can be reduced to:
D1
Vj 
kg
• Assumptions of DDM:
• Dividends grow at a constant rate
• The constant growth rate will continue for an infinite period
• The required rate of return (k) is greater than the infinite
growth rate (g)

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 Valuation with Temporary Supernormal
Growth
• First evaluate the years of supernormal growth and then use
the DDM to compute the remaining years at a sustainable
rate
• Suppose a 14% required rate of return, a current dividend of
$2 with the following dividend growth pattern
Dividend
Year Growth Rate
1-3 25%
4-6 20%
7-9 15%
10 on 9%

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Valuation with Temporary Supernormal Growth
• The Value of the Stock

2.00(1.25) 2.00(1.25) 2 2.00(1.25) 3

Vi   2

1.14 1.14 1.14 3
2.00(1.25) 3 (1.20) 2.00(1.25) 3 (1.20) 2
 4

1.14 1.14 5
2.00(1.25) 3 (1.20) 3 2.00(1.25) 3 (1.20) 3 (1.15)
 6

1.14 1.14 7
2.00(1.25) 3 (1.20) 3 (1.15) 2 2.00(1.25) 3 (1.20) 3 (1.15) 3
 8

1.14 1.14 9
2.00(1.25) 3 (1.20) 3 (1.15) 3 (1.09)
(.14  .09)

(1.14) 9
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 Exhibit 11.3

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PV of dividends

• If you could buy shares in this firm for less than $94.35, what would
you do?
• If the price of the shares is more than $94.35, what would you do?
• People are greedy (which is good)! While markets may not be
perfectly efficient, they are certainly competitive!
Dividend Discount Models
• What if the stock does not pay any dividends (e.g., Ellex in Australia)?
• A firm with a non-dividend paying stock is reinvesting its capital in profitable
projects rather than paying current dividends so that its earnings and
dividend stream will be larger and grow faster on the future
• Same concept but early dividends equals zero
• Difficult to estimate when a firm will initiate a dividend, hence most analyst would not
apply this model

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 Example
• Great Plains Corporation plans to reinvest its profits for the next 6 yrs.
In yr 7, the company will pay its first dividend of $0.20, after which
constant growth is expected at a rate of 5% p.a. If ke = 15% p.a. what is
the ‘value’ of Great Plains?

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 Dividend Discount model
• PV of dividend stream at year 6:

• Discount $2.00 back to present:

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Free Cash Flow to Equity
• More expansive definition of cash flows to equity
• “Free” cash flows to equity are derived after operating cash
flows have been adjusted for debt payments (interest and
principal)
• These cash flows precede dividend payments to the
common stockholder
• The discount rate used is the firm’s cost of equity (k)

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Present Value of Free Cash Flow to Equity

FCFE =
• Net Income/Earnings per share
• + (Depreciation Expense
• -Capital Expenditures)
• -  in Working Capital
• - Principal Debt Repayments
• + New Debt Issues

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 Present Value of Free Cash Flow to Equity

Simplification: assume firm maintains target capital

structure or debt ratio:
FCFE =
• Net Income/Earnings per share
• -(Capital Expenditures-Depreciation)(1-)
• - ( in Working Capital) (1-)

Where (1-) =(1-debt ratio)

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Discounted Cash Flow Techniques
• General Formula

t n
FCFEt
Vj  
t 1 (1  k )
t

Where:
Vj = value of stock j
n = life of the asset
FCFEt = cash flow in period t
k = the discount rate that is equal to the investor’s
required rate of return for asset j,
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Present Value of Free Cash Flow to Equity

FCFE = FCFE1
• Net Income
Value 
k  g FCFE
• + Depreciation Expense
• -Capital Expenditures
• - ∆ in Working Capital
• - Principal Debt Repayments
• + New Debt Issues

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