Session 4

Chapter 10
Advanced Corporate Finance

Prof. GOHAR G. STEPANYAN
Chapter Outline
10.1 The Discounted Free Cash Flow Model
10.2 Valuation Based on Comparable Firms
10.3 Stock Valuation Techniques: The Final Word
10.4 Information, Competition, and Stock Prices
10.5 Individual Biases and Trading
2
Learning Objectives
Value a stock as the present value of the company’s
free cash flows
Value a stock by applying common multiples based
on the values of comparable firms
Understand how information is incorporated into
stock prices through competition in efficient markets
Describe some of the behavioral biases that influence
the way individual investors trade
3
10.1 The Discounted Free Cash
Flow Model
The Discounted Free Cash Flow Model focuses on the cash
flows to all of the firm’s investors, both debt and equity
holders
Enterprise Value  Market Value of Equity  Debt  Cash
4
Flow Model
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
FreeCash Flow  EBIT  (1  Tax Rate)  Depreciation

Capital Expenditures  Increasesin Net Working Capital
5
Flow Model
Discounted Free Cash Flow Model
V0 = PV(Future Free Cash Flow of Firm)
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:
V0  Cash 0  Debt 0
P0 
Shares Outstanding
6
Flow Model
Implementing the Model
Since we are discounting the cash flows to all investors,
we use the weighted average cost of capital (WACC),
denoted by rwacc
Forecast free cash flow up to some horizon, together
with a terminal value of the enterprise:
FCF1 FCF2 FCFN VN

V0    ...  
1  rwacc (1  rwacc ) 2
(1  rwacc ) N
(1  rwacc ) N
7
Flow Model
Estimate the terminal value by assuming a constant
long-run growth rate gFCF for free cash flows beyond
year N
FCFN1  1  g FCF 
VN     FCFN
rwacc  g FCF  rwacc  g FCF 
The long-run growth rate g is typically based on the

FCF
expected long-run growth rate of revenues
8
Example 10.1 Valuing Nike, Inc.,
Stock Using Free Cash Flow
Problem:
 Nike had sales of $25.3billion in 2012. Suppose you expect its sales to
grow at a rate of 10% in 2013, but then slow by 1% per year to the long-
run growth rate that is characteristic of the apparel industry—5%—by
2018. Based on Nike’s past profitability and investment needs, you
expect EBIT to be 10% of sales, increases in net working capital
requirements to be 10% of any increase in sales, and capital
expenditures to equal depreciation expenses. If Nike has $3.3 billion in
cash, $1.2 billion in debt, 893.6 million shares outstanding, a tax rate
of 24%, and a weighted average cost of capital of 10%, what is your
estimate of the value of Nike’s stock in early 2013?
9
Solution:
 We can estimate Nike’s future free cash flow by constructing a pro
forma statement as we did for HomeNet in Chapter 9. The only
difference is that the pro forma statement is for the whole company,
rather than just one project. Furthermore, we need to calculate a
terminal (or continuation) value for Nike at the end of our explicit
projections.
 Because we expect Nike’s free cash flow to grow at a constant rate
after 2018, we can compute a terminal enterprise value. The present
value of the free cash flows during the years 2013–2018 and the
terminal value will be the total enterprise value for Nike. Using that
value, we can subtract the debt, add the cash, and divide by the
number of shares outstanding to compute the price per share.
10
Solution:
 The spreadsheet below presents a simplified pro forma for Nike based
on the information we have:
Year 2012 2013 2014 2015 2016 2017 2018
FCF Forecast ($ million)
Sales 25,300.0 27,830.0 30,334.7 32,761.5 35,054.8 37,158.1 39,016.0

Growth Versus Prior Year 10% 9% 8% 7% 6% 5%
EBIT (10% of sales) 2,783.0 3,033.5 3,276.1 3,505.5 3,715.8 3,901.6
Less: Income Tax (24%) 667.9 728.0 786.3 841.3 891.8 936.4
Plus: Depreciation
Less: Capital Expenditures
Less: Increase in NWC (10% Δ
Sales) 253.0 250.5 242.7 229.3 210.3 185.8
Free Cash Flow 1,862.1 2,055.0 2,247.2 2,434.8 2,613.7 2,779.4

11
Solution:
 Because capital expenditures are expected to equal depreciation, these
two lines in the spreadsheet cancel out. We can set them both to zero
rather than explicitly forecast them.
 Given our assumption of constant 5% growth in free cash flows after
2018 and a weighted average cost of capital of 10%, we can compute a
terminal enterprise value as follows:
12
Solution:
 Nike’s current enterprise value is the present value of its free cash
flows plus the present value of the firm’s terminal value:
 We can now estimate the value of a share of Nike’s stock:
13
Evaluation:
 The total value of all of the claims, both debt and equity, on the firm
must equal the total present value of all cash flows generated by the
firm, in addition to any cash it currently has. The total present value
of all cash flows to be generated by Nike is $42,881.5 million and it has
3,300 million in cash. Subtracting off the value of the debt claims
(1,200 million), leaves us with the total value of the equity claims and
dividing by the number of shares produces the value per share.
14
Flow Model
Connection to Capital Budgeting
Free cash flow is the sum of 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
15
Flow Model
We must forecast all the inputs to free cash flow
This process gives us flexibility to incorporate many
details
However, some uncertainty surrounds each
assumption
Given this fact, sensitivity analysis is important
Translates the uncertainty into a range of values for the
stock
16
Example 10.2 Sensitivity Analysis
for Stock Valuation
Problem:
 In Example 10.1, Nike’s EBIT was assumed to be 10% of sales. If Nike
can reduce its operating expenses and raise its EBIT to 11% of sales,
how would the estimate of the stock’s value change?
Solution:
 In year 1, EBIT will be 1% X $27,830 million = $278.3 million higher.
After taxes, this increase will raise the firm’s free cash flow in year 1 by
(1-0.24) X $278.3 million = $211.5 million, to $2,073.6 million. Doing
the same calculation for each year, we get the following revised FCF
estimates:
Year 2013 2014 2015 2016 2017 2018

FCF 2,073.6 2,285.5 2,496.2 2,701.2 2,896.1 3,075.9
17
Example 10.2 Sensitivity Analysis
for Stock Valuation
Evaluation:
 Nike’s stock price is fairly sensitive to changes in the assumptions
about its profitability. A 1% permanent change in its margins affects
the firm’s stock price by 10%.
18
Figure 10.1 A Comparison of Discounted
Cash Flow Models of Stock Valuation
19
10.2 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
20
Comparable Firms
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
21
Comparable Firms
Valuation Multiples
A ratio of a firm’s value to some measure of the firm’s
scale or cash flow
 Price-Earnings ratio
 Enterprise Value Multiples
 Other multiples
 Multiples of sales
 Price-to-book value of equity
 Industry- specific ratios
22
Comparable Firms
Price-Earnings Ratio
Most common valuation multiple
 Usually included in basic statistics computed for a stock (see
Figure 10.2)
Share price divided by earnings per share
23
Figure 10.2
Stock Price
Quote for
Nike (NKE)
24
Example 10.3 Valuation Using the
Price-Earnings Ratio
Problem:
 Suppose furniture manufacturer Herman Miller, Inc., has earnings per
share of $1.38. If the average P/E of comparable furniture stocks is 21.3,
estimate a value for Herman Miller’s stock using the P/E as a valuation
multiple. What are the assumptions underlying this estimate?
Solution:
 We estimate a share price for Herman Miller by multiplying its EPS by
the P/E of comparable firms:
P0=$1.38 × 21.3 = $29.39.
 This estimate assumes that Herman Miller will have similar future risk,
payout rates, and growth rates to comparable firms in the industry.
25
Price-Earnings Ratio
Evaluation:
 Although valuation multiples are simple to use, they rely on some
very strong assumptions about the similarity of the comparable firms
to the firm you are valuing.
 It is important to consider whether these assumptions are likely to be
reasonable—and thus to hold—in each case.
26
Comparable Firms
We can compute a firm’s P/E ratio using:
Trailing earnings – earnings over the prior 12 months
Forward earnings
The resulting ratio is either:
Trailing P/E
Forward P/E
 For valuation purposes, the forward P/E is generally
preferred, as we are most concerned about future earnings
27
Comparable Firms
P/E ratios are related to other valuation techniques
In the case of constant dividend growth, we had:
Div1
P0 
rE - g
Dividing through by EPS1:
P0 Div1 / EPS1 Dividend Payout Rate

Forward P / E   
EPS1 rE - g rE - g
28
Figure 10.3 Relating the P/E Ratio
to Expected Future Growth
29
Example 10.4 Growth Prospects
and the Price-Earnings Ratio
Problem:
 Amazon.com and Macy’s are both retailers. In 2013, Amazon had a
price of $306.87 and forward earnings per share of $3.18. Macy’s had a
price of $49.75 and forward earnings per share of $4.47. Calculate their
forward P/E ratios and explain the difference.
Solution:
 We can calculate their P/E ratios by dividing each company’s price per
share by its forward earnings per share.
 The difference we find is most likely due to different growth
expectations.
30
Example 10.4 Growth Prospects
and the Price-Earnings Ratio
Solution:
 Forward P/E for Amazon = $306.87/$3.18= 96.5
 Forward P/E for Macy’s = $49.75/$4.47=11.13
 Amazon’s P/E ratio is higher because investors expect its earnings to
grow more than Macy’s.
Evaluation:
 Although both companies are retailers, they have very different
growth prospects, as reflected in their P/E ratios.
 Investors in Amazon.com are willing to pay 96.5 times this year’s
expected earnings because they are also buying the present value of
high future earnings created by expected growth.
31
Comparable Firms
Enterprise Value Multiples
P/E ratio relates exclusively to equity, ignoring the
effect of debt
Enterprise value multiples use a measure of earnings
before interest payments are made
 EBIT
 EBITDA
 Free cash flow

 Because capital expenditures can vary substantially from year
to year, most practitioners use enterprise value to EBITDA
multiples
32
Comparable Firms
When expected free cash flow growth is constant, we
can write EV to EBITDA as:
FCF1
V0 rwacc  g FCF FCF1 / EBITDA1
 
EBITDA1 EBITDA1 rwacc  g FCF
33
Enterprise Value Multiple
Problem:
 Fairview, Inc., is an ocean transport company with EBITDA of $50
million, cash of $20 million, debt of $100 million, and 10 million shares
outstanding. The ocean transport industry as a whole has an average
EV/EBITDA ratio of 8.5. What is one estimate of Fairview’s enterprise
value? What is a corresponding estimate of its stock price?
Solution:
 To estimate Fairview’s enterprise value, we multiply its EBITDA by the
average EV/EBITDA ratio of its industry. From there, we can subtract
Fairview’s debt and add its cash to calculate its equity value. Finally,
we can divide by the number of shares outstanding to arrive at its
stock price.
34
Solution:
 Fairview’s enterprise value estimate is $50 million × 8.5 = $425 million
 Next, subtract the debt from its enterprise value and add in its cash:
$425 million - $100 million + $20 million = $345 million, which is an
estimate of the equity value.
 Its stock price is equal to its equity value divided by the number of
shares outstanding:
$345 million ÷ 10 million = $34.50
35
Evaluation:
 If we assume that Fairview should be valued similarly to the rest of the
industry, then $425 million is a reasonable estimate of its enterprise
value and $34.50 is a reasonable estimate of its stock price.
 However, we are relying on the assumption that Fairview’s expected
free cash flow growth is similar to the industry average.
 If that assumption is wrong, so is our valuation.
36
Comparable Firms
Other multiples
Multiples of sales can be useful if it is reasonable to
assume margins are similar in the future
Price-to-book value of equity can be used for firms with
substantial tangible assets
Some multiples are specific to an industry
 e.g. Cable TV – Enterprise value per subscriber
37
Comparable Firms
Limitations of Multiples
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
38
Comparable Firms
Limitations of Multiples
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
39
Table 10.1 Stock Prices and Multiples
for the Footwear Industry, July 2013
40
Comparable Firms
Comparison with Discounted Cash Flow Methods
Valuation multiple does not take into account material
differences between firms
 Talented managers
 More efficient manufacturing processes
 Patents on new technology
Discounted cash flow methods allow us to incorporate

specific information about cost of capital or future
growth
 Potential to be more accurate
41
10.3 Stock Valuation Techniques:
The Final Word
No single technique provides a final answer regarding
a stock’s true value
Practitioners use a combination of these approaches
Confidence comes from consistent results from a
variety of these methods
42
Figure 10.4 Range of Valuations for Nike
Stock Using Various Valuation Methods
43
10.4 Information, Competition, and
Stock Prices
Information in Stock Prices
For a publicly traded firm, its market price should
already provide very accurate information regarding the
true value of its shares
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
44
Figure 10.5 The Valuation Triad
45
Example 10.6 Using the
Information in Market Prices
Problem:
 Suppose Tecnor Industries will have free cash flows next year of $40
million. Its weighted average cost of capital is 11%, and you expect its
free cash flows to grow at a rate of approximately 4% per year, though
you are somewhat unsure of the precise growth rate. Tecnor has 10
million shares outstanding, no debt, and $20 million in cash. If
Tecnor’s stock is currently trading for $55.33 per share, how would you
update your beliefs about its dividend growth rate?
46
Solution:
 If we apply the growing perpetuity formula for the growing FCF based
on a 4% growth rate, we can estimate a stock price.
 If the market price is higher than our estimate, it implies that the
market expects higher growth in FCF than 4%.
 Conversely, if the market price is lower than our estimate, the market
expects FCF growth to be less than 4%.
47
Solution:
 Applying the growing perpetuity formula, we have
PV(FCF)=40 ÷ (0.11-0.04)= $571.43 million.
 The price per share would be ($571.43 million – 0 + $20 million ) ÷ 10
million shares = $59.14 per share.
 The market price of $55.33, however, implies that most investors
expect FCF to grow at a somewhat slower rate.
Evaluation:
 Given the $55.33 market price for the stock, we should lower our
expectations for the FCF growth rate from 4% unless we have very
strong reasons to trust our own estimate.
48
Example 10.6a Using the
Problem:
 Suppose SWGSB Industries will pay a dividend this year of $6.50 per
share. Its equity cost of capital is 11.5%, and you expect its dividends to
grow at a rate of about 5% per year, though you are somewhat unsure
of the precise growth rate. If SWGSB’s stock is currently trading for
$63.32 per share, how would you update your beliefs about its
dividend growth rate?
49
Solution:
 If we apply the constant dividend growth model based on a 5% growth
rate, we can estimate SWGSB Industries’ stock price. If the market
price is higher than our estimate, it implies that the market expects
higher growth in dividends than 5%. Conversely, if the market price is
lower than our estimate, the market expects dividend growth to be
less than 5%. We can solve for the growth rate (instead of price),
allowing us to estimate the growth rate the market expects.
 Using Div1 of $6.50, equity cost of capital (rE) of 11.5%, and a dividend
growth rate of 5%, we get P0 = $6.50/(0.115 – 0.05) = $100.00 per share.
The market price of $63.32, however, implies that investors expect
dividends to grow at a much slower rate.
50
Solution:
 In fact, if we continue to assume a constant growth rate, we can solve
for the growth rate consistent with the current market price:
Div1 $6.50
g  rE   11 .5%   1.2 %
P0 $63.32
 This 1.2% growth rate is much lower than our expected growth rate of
5%.
Evaluation:
 Given the $63.32 market price for the stock, we should lower our
expectations for the dividend growth rate from 5% unless we have
very strong reasons to trust our estimate.
51
Stock Prices
Competition and Efficient Markets
Efficient markets hypothesis:
 Impliesthat securities will be fairly priced, based on their
future cash flows, given all information that is available to
investors
Public, Easily Available Information:
 Information available to all investors includes information
in news reports, financial statements, corporate press
releases, or other public data sources
Private or Difficult-to-Interpret Information
52
Stock Prices
53
Example 10.7 Stock Price Reactions
to Public Information
Problem:
 Myox Labs announces that it is pulling one of its leading drugs from
the market, owing to the potential side effects associated with the
drug. As a result, its future expected free cash flow will decline by $85
million per year for the next 10 years. Myox has 50 million shares
outstanding, no debt, and an equity cost of capital of 8%. If this news
came as a complete surprise to investors, what should happen to
Myox’s stock price upon the announcement?
54
Solution:
 In this case, we can use the discounted free cash flow method. With
no debt, rwacc = rE = 8%.
 The effect on the Myox’s enterprise value will be the loss of a ten-year
annuity of $85 million.
 We can compute the effect today as the present value of that annuity.
55
Solution:
 Using the annuity formula, the decline in expected free cash flow will
reduce Myox’s enterprise value by
 Thus the share price should fall by $570.36/50 = $11.41 per share.
Evaluation:
 Because this news is public and its effect on the firm’s expected free
cash flow is clear, we would expect the stock price to drop by $11.41 per
share nearly instantaneously.
56
Stock Prices
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
 Ifthe 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
57
Stock Prices
Over time, investors will make their own assessments
of the probable efficacy of the drug
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
At the time of the announcement, uninformed
investors do not know which way it will go
58
Figure 10.6 Possible Stock Price
Paths for Phenyx Pharmaceuticals
59
Stock Prices
Lessons for Investors and Corporate Managers
Consequences for Investors
 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
60
Stock Prices
Lessons for Investors and Corporate Managers
Implications for Corporate Managers
 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
61
Stock Prices
The Efficient Markets Hypothesis Versus No
Arbitrage
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
62
Stock Prices
Arbitrage
The efficient markets hypothesis states that the best
estimate of the value of a share of stock is its market
price
This does not mean that the market price always
correctly estimates the value of a share of stock
63
Stock Prices
Arbitrage
Different investors may perceive risks and returns
differently (based on their information and preferences)
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
64
10.5 Individual Biases and
Trading
Excessive Trading and Overconfidence
Trading is expensive because of commissions and the
difference between the bid and ask
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
65
Trading
Overconfidence hypothesis
Tendency of individual investors to trade too much
based on the mistaken belief that they can pick winners
and losers better than investment professionals
Implication is that investors who trade more will not
earn higher returns
 Performance will actually be worse because of trading
costs
10-66
Figure 10.7 Individual Investor
Returns Versus Portfolio Turnover
67
Trading
Hanging On to Losers and the Disposition Effect
Investors tend to hold on to stocks that have lost value
and sell stocks that have risen in value
This tendency is called the disposition effect
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
68
Trading
From a tax perspective, this behavioral tendency is
costly
Capital gains are taxed only when an asset is sold, so
delaying the tax payment reduces its present value
Capital losses are tax deductible (to a certain extent), so
investors should capture tax losses early
69
Trading
Keeping losers and selling winners might make sense
if losing stocks would outperform the winners going
forward
This belief does not appear to be justified – if anything,
losing stocks that investors continue to hold
underperform the winners they sell
According to one study, losers underperformed winners
by 3.4% over the next year
70
Trading
Investor Attention, Mood, and Experience
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
Investor mood affects investment behavior
 Annualized market returns at the location of the stock
exchange is higher on sunny days than on cloudy days
71
Trading
Investor Attention, Mood, and Experience
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
72
Chapter Quiz
1. What is the relation between capital budgeting and
the discounted free cash flow model?
2. What implicit assumptions do we make when valuing
a firm using multiples based on comparable firms?
3. What are the implications of the efficient markets
hypothesis for investors? For corporate managers?
4. What are several systematic behavioral biases that
individual investors fall prey to?
5. Why would excessive trading lead to lower realized
returns?
73

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Chapter 10

Advanced Corporate Finance

Enterprise Value  Market Value of Equity  Debt  Cash

FreeCash Flow  EBIT  (1  Tax Rate)  Depreciation

V0 = PV(Future Free Cash Flow of Firm)

Given the enterprise value, we can solve for the value of

FCF1 FCF2 FCFN VN

The long-run growth rate g is typically based on the

Sales 25,300.0 27,830.0 30,334.7 32,761.5 35,054.8 37,158.1 39,016.0

EBIT (10% of sales) 2,783.0 3,033.5 3,276.1 3,505.5 3,715.8 3,901.6

Free Cash Flow 1,862.1 2,055.0 2,247.2 2,434.8 2,613.7 2,779.4

 We can now estimate the value of a share of Nike’s stock:

have a positive NPV

Year 2013 2014 2015 2016 2017 2018

 Industry- specific ratios

Dividing through by EPS1:

P0 Div1 / EPS1 Dividend Payout Rate

 Free cash flow

 Differences in accounting conventions between countries

 Patents on new technology

Discounted cash flow methods allow us to incorporate

investors, and average likelihood of FDA approval is 10%

 If stocks are fairly priced according to valuation models, then

 Use financial transactions to support investment

advertised more, had very high trading volume, or recently

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