STOCK VALUATION Valuation Three approaches to valuing a stock 1 2 3 Discounted value of dividends or discounted value of total equity payouts Present value of the company s free cash flows Discounted Free Cash Flow Model adjusting for the value of debt Applying multiples based on the values of comparable firms Each approach has advantages and disadvantages Valuation is very much an art as much as an exact science DIVIDEND DISCOUNT MODEL The Dividend Discount Model Suppose you plan to invest in a stock for one year There are two potential sources of cash flows from owning the stock 1 2 Dividends paid during the year here we assume it is paid at the end of the year Price when selling the shares at the end of the year These cash flows must be discounted to get the present value of the stock The correct discount rate is the stock s equity cost of capital So the value of a share today is then 1 What is P1 The FV of the Div2 P2 Valuing the firm as a perpetual flow of dividends Iterating forward this implies that future dividends per share Special cases using our familiar perpetuity formulae If dividends are expected to be constant If dividends are expected to grow at a constant rate g Example Dividend discount model AT T plans to pay 1 44 per share in dividends in the coming year Its equity cost of capital is 8 Dividends are expected to grow by 4 per year in the future According to the dividend discount model what s the value of AT T s stock Solution Div1 1 44 P0 36 00 rE g 08 04 Limitations of the Dividend Discount Model Uncertain Dividend Forecasts Non Dividend Paying Stocks or firms that also buy back their stock If the firm is only temporarily not paying dividends we can still use the dividend discount model although future dividends are now even more uncertain Many companies repurchase shares as a substitute for paying dividends This requires modifying the dividend discount model Share Repurchases In a share repurchase the firm uses its cash to buy back its own stock An alternative way for firms to return money to shareholders By repurchasing shares the firm decreases its share count which increases its earnings and dividends on a per share basis Share repurchases make the dividend discount model difficult to use because the number of shares are changing Share Repurchases and the Total Payout Model In the dividend discount model we value a single share discounting the dividends the shareholder will receive future dividends per share Total Payout Model Values all of the firm s equity rather than a single share To apply the Total Payout Model Calculate the present value of all payouts that the firm makes to shareholders and divide by the current number of shares future total dividends and repurchases Shares Outstanding DISCOUNTED FREE CASH FLOW MODEL Discounted Free Cash Flow Model Approach Value the total cash flows the business is expected to generate for both equity and debt holders i e the Enterprise Value Enterprise Value Market Value of Equity Debt Cash To get the equity value we subtract the the net debt from enterprise value Strength Forecasting total cash flows can be easier than forecasting dividends or share repurchases e g does not depend on payout policy leverage choices and interest expenses etc Weakness Still relies heavily on projections Garbage In Garbage out Valuing the Enterprise 1 Enterprise value V0 Market Value of Equity Debt Cash PV Future Free Cash Flow of the Firm Where we can calculate estimated Free Cash Flows as Free Cash Flowt EBIT 1 tax rate Depreciation Capital Expenditures Change in NWC Note These free cash flows are after tax and are not adjusted for interest deductibility We will discount using WACC which uses the tax adjusted interest rate which has the effect of accounting for the benefit of tax deductibility of interest payments Valuing the Enterprise 2 We are discounting the cash flows to both equity holders and debt holders so we use the Weighted Average Cost of Capital WACC rwacc We usually explicitly forecast free cash flow up to some horizon N and then assume a terminal value TN of the enterprise Given the enterprise value V0 to get the share price we solve for the value of equity and divide by the total number of shares outstanding Shares outstanding How to calculate the Weighted Average Cost of Capital E E rwacc rE rD 1 C E D E D D rwacc rU C rD E D 1 2 If there s a firm with similar business risk and capital structure Cost of equity capital rE can be estimated using CAPM rE rF E rM rF Cost of debt capital rD can be estimated using CAPM or by adjusting the firm s yield to maturity for the risk of default Then apply traditional WACC formula 1 above If there s no firm with similar capital structure only similar business risk We can estimate rU for firms with similar business risk Then calculate rwacc by adjusting for the tax benefit of debt with the firm s capital structure recall rU is the correct discount rate if the firm is unlevered using formula 2 above Note We generally want to use net debt when calculating D How to get Terminal Value Estimate the terminal value by assuming a constant long run growth rate gFCF for free cash flows beyond year N 1 g FCF FCFN 1 VN rwacc g FCF rwacc g FCF FCFN Note The long run growth rate gFCF usually assumes that cash flows remain flat or increase only moderately e g at the rate of inflation or growth rate of the economy Example Valuing Nike Inc using the Discounted Free Cash Flow method 1 Problem Nike had sales of 19 2 billion in 2009 Suppose you expect its sales to grow at a rate of 10 in 2010 but then slow by 1 per year to the long run growth rate that is characteristic of the apparel industry 5 by 2015 Based on Nike s past profitability an 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 2 3 billion in cash 32 million in debt 486 million shares outstanding a tax rate of 24 and a WACC of 10 what is your estimate of the value of Nike s stock in early 2010 Example Valuing Nike Inc using the Discounted Free Cash Flow method 2 Note Because capital expenditures are expected to equal depreciation lines 7 and 8 in the spreadsheet cancel out We can set them both to zero rather than explicitly forecast them Given a constant 5 growth in free cash flows after 2015 and a WACC of 10 we can compute a terminal enterprise value 1 g FCF 1 05 V2015 FCF 2 109 3 44