STOCK VALUATIONValuation• Three approaches to valuing a stock:1. Discounted value of dividends; or discounted value of total equity payouts2. Present value of the company’s free cash flows (Discounted Free Cash Flow Model), adjusting for the value of debt3. 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 MODELThe 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. Dividends paid during the year (here we assume it is paid at the end of the year)2. 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:10E $1.44 $36.00 .08 .04 DivPrgLimitations 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 modelShare Re purchases• 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‐disc ount 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 repurchasesShares OutstandingDISCOUNTED FREE CASH FLOW MODELDiscounted 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 outValuing 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 NWCNote: 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 horizo n 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 outstandingHow to calculate the Weighted Average Cost of Capital?• If there’s a firm with similar business risk and capital structure:—Cost of equity capital