Firm valuation (1) Class 6 Financial Management, 15.414MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Today Firm valuation • Dividend discount model • Cashflows, profitability, and growth Reading • Brealey and Myers, Chapter 4MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Firm valuation The WSJ reports that FleetBoston has a DY of 4.6% and a P/E ratio of 16, IBM has a DY of 0.8% and a P/E ratio of 27, and Intel has a DY of 0.3% and a P/E ratio of 46. What explains the differences? What do the financial ratios tell us about the prospects of each firm? Your firm has the opportunity to acquire a smaller competitor. You forecast that the target will earn $78 million this year, $90 million next year, and $98 million in the following year. The target reinvests 75% of its earnings and long-term growth is expected to be 6% for the foreseeable future. Is the growth rate adequate given its payout policy? How much would you be willing to pay for the firm? 3MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 S&P price-earnings ratio, 1871 – 1999 35 28 21 14 7 0 1871 1887 1903 1919 1935 1951 1967 1983 1999 4MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Firm valuation Similar to projects DCF analysis Forecast cashflows (inflation, working capital, taxes, …) Discount at the opportunity cost of capital Additional issues Assets or equity value? Is growth sustainable? How does growth affect cashflow? Firms have no end date. Do we have to forecast cashflows forever? 5MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Balance sheet view of the firm Assets Liabilities and EquityCash flows from assets Current Assets Fixed Assets 1. Tangible fixed assets 2. Intangible fixed assets Current Liabilities Long-Term Debt Shareholders’ Equity Cash flows to debt and equity Total value = Total value 6MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Approach 1 Asset value PV of assets = HH H 2 21 FCF ... FCF r1 FCF + + + ++ + + +r) (1 value Term. r) (1 r) (1 Free cashflow Cash generated by the assets after all reinvestment FCF = EBIT (1 – τ) + depreciation – ∆NWC – CAPX Terminal value Firm value at the end of the forecast horizon Equity Equity value = Assets – Debt 7MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Approach 2 Equity value PV of equity = HH H 2 21 Div ... Div r1 Div + + + ++ + + + r) (1 value Term. r) (1 r) (1 Equity is a claim to future dividends Divt = expected dividend Terminal value Equity value at the end of the forecast horizon Assets Asset value = Equity + Debt Most useful if payout policy is stable Not for high growth firms 8MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Approach 3 Equity value PV of equity = stock price (Look in the WSJ!) Why does this approach make sense? If the market is efficient, stock price is the best estimate of value Why shouldn’t we always use it? Private companies (no stock price) Private information Acquisitions create value not yet reflected in stock prices (?) Sometimes the market gets it wrong But, typically not a bad benchmark 9MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Takeover announcements Stock price of target firm 10MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Capital gains vs. dividends What about capital gains? Buy stock today ⇒ future cashflow of Div1 + P1 P0 = E[Div ] + E[P ]1 1 1+ r P1 = E[Div ] + E[P2]2 1+ r E[Div2] E[P2]Substitute P1 into first formula: P0 = E[Div1] + +1+ r r) (1 2 r) (1 2+ + If prices are rational, then repeating for P2, P3, …, gives the dividend discount formula 11MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Approach 2 – Dividends Equity value PV of equity = Div1 + Div2 DivH value Term. + ... + +1+r r) (1 2 r) (1 H r) (1 H+ + + Special cases No growth Mature firms, few new investment opportunities Ex. Kodak, AT&T Sustainable growth Firms with moderate growth that is expected to persist Ex. IBM, Procter and Gamble 12MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Case 1: No growth No net investment Reinvestment covers depreciation Firm pays out all its earnings: Divt = EPSt Equity value, dividends, earnings aren’t expected to grow Div0 = E[Divt] = E[Div2] = … Div0 Div0 Div0 Div0 Price = + + + L1+ r r) (1 2 r) (1 3 r) (1 4+ + + Price = r Div0 = r EPS0 13MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Example It’s 2001 and you’re attempting to value AT&T’s equity. The long-distance market is mature and new competition makes growth difficult. In fact, AT&T has experienced little growth over the last few years, which you believe will continue. Dividends Year 1996 1997 1998 1999 2000 DPS 0.88 0.88 0.88 0.88 0.88 No growth formula: If r = 7%: price = 0.88 / 0.07 = $12.57 (actual price = $17.25) If r = 5%: price = 0.88 / 0.05 = $17.60 14MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 AT&T earnings and dividends -$2.0 -$1.0 $0.0 $1.0 $2.0 $3.0 1985 1987 1989 1991 1993 1995 1997 1999 EPS DPS 15MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Case 2: Sustainable growth Growth opportunities Positive net investment (reinvestment > depreciation) Firm pays out only a portion of its earnings (Divt < EPSt) Equity, dividends, earnings are all expected to grow Exp[Div]: Div0×(1+g), Div0×(1+g)2, … Div0(1+ g) g) (1 Div 2 g) (1 Div 3 + L Price = + 0 ++ 0 + 1+ r r) (1 2 r) (1 3 ++ Price = gr Div1 − = gr g)1(Div0 − +× 16MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Example Firms in the S&P 500 are expected to pay, collectively, around $20 in dividends next year. Dividends have grown 5.57% annually since 1950. If the historical pattern continues, what is the value of index if the discount rate is 8%? Constant growth 20.0 21.11 22.29 20 Value = + + + ... = (1.08) (1.08)2 (1.08)3 08 . 0 − 0557. 0 = 823.05 Current index level = 989.28 17MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Forecasting growth How quickly will the firm grow? Payout ratio = DPS / EPS Plowback ratio = 1 – payout ratio = retained earnings / EPS If growth is financed internally: ∆Equityt-1 to t = retained earnings = EPS × plowback ratio Growth rate = ∆Equityt-1 to t / Equityt-1 EPS × plowback = Equity = ROE × plowback Growth rate = g = ROE × plowback ratio 18MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 6 Forecasting growth Observations Growth is faster if ROE is high Growth is faster if plowback is high Growth ≠ good investments If margins and payout are constant, equity, dividends, and earnings all grow at the same rate EPSt = ROE × equityt-1