discounted cash flow model, dividend discount models, & multiples valuation mu investment club...

DISCOUNTED CASH FLOW MODEL, DIVIDEND DISCOUNT MODELS, & MULTIPLES

Valuation

MU Investment Club Spring 2013

Discounted Cash Flow (DCF) Model


4-Step Process

1)Project Free Cash Flow2)Discount Free Cash Flows3)Calculate Perpetuity Value4)Put it all together


Step 1: Project Free Cash Flows

Free Cash Flow = EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure


Step 2: Discount Free Cash Flows

Discount Rate is usually equal to or near the company’s WACC, but can be adjusted based on other risk factors

Discounted Free Cash Flow = Free Cash Flow /(1+discount rate or WACC)^# years

For example: If the discount rate is 10% and in the 3rd year the predicted free cash flow is $20,000, the discounted cash flow for that year will be:$20,000/(1.1)^3= $15,026.30


Step 3: Calculate Perpetuity Value

Most DCFs only project 5 or 10 years into the future and then use a perpetuity value to account for the rest of the time

Perpetuity values are usually between 1-3% Perpetuity Value = (final free cash flow * (1 +

perpetuity rate) / (discount rate – perpetuity rate)

For example: If the 10th year’s free cash flow was $300, with a discount rate of 8% and a perpetuity rate of 2%, then the perpetuity value would be: ($300*1.02) / (8%-2%) = $5,100


Step 4: Put it all together

1) Add together discounted cash flows2) Discount perpetuity value 3) Add discounted cash flows to discounted

perpetuity value4) Divide that sum by # shares outstanding to

find the per share value of the company


DCF Equations

Free Cash Flow = EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

Discounted Free Cash Flow = Free Cash Flow / (1+discount rate)^# years

Perpetuity Value = (final free cash flow * (1 + perpetuity rate)) / (discount rate – perpetuity rate)

Discounted Perpetuity Value = Perpetuity Value / (1 + discount rate) ^ # year


Dividend Discount Models


Stable Dividend Discount

Two-Stage Model

Use for firms with long term stable growth

Use for firms going through a period of high growth and then expect long term stable growth

Dividend Discount Models


Stable Dividend Discount Model

DPS(1): Total Annual Dividends per Share expected one year forward

K: Discount Rate (or Required Rate of Return)

g: Dividend Growth RateValue of Stock = DPS(1) / (K – g)

For example, if DPS in one year is expected to be $1.20, the discount rate is 9%, and growth is 6%, the value of the stock = $1.20/ (9%-6%) = $40.00


Two-Stage Model

Like a DCF using DPS instead of Free Cash Flow

Stage 1: Project future dividends DPS * (1+high growth rate) Discount Projected Dividends

Stage 2: Find Perpetuity Value DPS(final) / (discount rate – long-term growth rate) Discount Perpetuity Value Add Discounted Projected Dividends and Discounted

Perpetuity Values together to arrive at the Value of the Stock


Two-Stage Model Example

DPS(0)= $1.00; Discount Rate = 12%; High-Growth Rate = 30%; Long-Term Growth Rate = 6%; High-Growth Period = 4 years

Stage 1:DPS(1) = $1.00 * 1.3= $1.30 / (1.12)^1 = $1.16DPS(2) = $1.00 * 1.3= $1.69 / (1.12)^2 = $1.35DPS(3) = $1.00 * 1.3= $2.20 / (1.12)^3 = $1.56DPS(4) = $1.00 * 1.3= $2.86 / (1.12)^4 = $1.82Sum of Projected Discounted Dividends = $5.89


Two-Stage Model Example

DPS(0)= $1.00; Discount Rate = 12%; High-Growth Rate = 30%; Long-Term Growth Rate = 6%; High-Growth Period = 4 years; DPS(4) = $2.86

Stage 2:DPS(4) = $2.86 / (12%-6%) = $47.67 Perpetuity ValueDiscounted = $47.67 / (1.12)^4 =$30.30

Value of Stock =$30.30 + $5.89 = $36.19MU Investment Club Spring 2013

Multiples


Price to Earnings (P/E)

Price of a share of stock to the most recent annual earnings per share Historical P/E: based on an average of historical P/E Competitor P/E: based on a market cap weighted

average of competitor P/E Forward P/E: what some analyst thinks the P/E will be

in the future based on his stock price and earnings estimates

Generally used to predict the future price of the stock based off of projected earnings per share


Price to Book

Price of a share of stock to book value per share of stock

Book value is the difference between the book value of assets and the book value of liabilities, so is heavily dependent on accounting practices

Commonly used when valuing financial institutions


Example of How Multiples Work

To use a multiple, simply multiply the multiple by expected EPS, expected free cash flow per share, expected sales, book value per share, or whatever else the multiple is measuring

For example, if expected EPS is $1.15 and the P/E multiple that is most fitting is 9.57, the expected future value of the stock will be $1.15 * 9.57 = $11.01.


Enterprise Value

Enterprise Value (EV) is the theoretical price a company could be acquired for by buying all the outstanding equity and paying off debts

EV = Equity Value + Net Debt + Noncontrolling (Minority) Interests + Preferred Stock + Capital Leases Equity Value: calculated as current stock price

multiplied by diluted shares outstanding Net Debt: total debt minus cash and cash equivalents


EV/EBITDA

To use an EV/EBITDA multiple, you essentially reverse engineer the way the multiple is calculated. Determine appropriate model based on historical or

competitor averages Multiply EV/EBITDA multiple by the forecasted

EBITDA for desired year Subtract estimated values of capital leases, minority

interests, preferred stock, and net debt to arrive at a new Equity Value

Divide the new Equity Value by diluted shares outstanding to arrive at the price per share


For More Information:

DCF: http://news.morningstar.com/classroom2/course.asp?docId=145102&page=1&CN=COM

Dividend Discount: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/ddm.htm

Multiples: http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch8.pdf

EV/EBITDA: http://macabacus.com/valuation/enterprise-value


http://news.morningstar.com/classroom2/course.asp?docId=145102&page=1&CN=COM



http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/ddm.htm




http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch8.pdf




http://macabacus.com/valuation/enterprise-value

http://macabacus.com/valuation/enterprise-value

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