Course Overview

Primer
1. Time Value of Money 2. Analysis of Financial Statements

Company Valuation
Financing Decisions
Investment Decisions 1. DCF Method:
1. Bond Valuation
1. Capital Budgeting a. Forecast CFs
2. Equity Valuation
2. NPV/IRR/Payback b. Discount rate
3. Capital Structure
2. Relative Valuation

Imperial College Business School Imperial means Intelligent Business 1

Imperial College Business School Imperial means Intelligent Business 2
Valuation Principle

▪ In our analysis, we determined that:

𝑃𝑟𝑖𝑐𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦 = 𝑃𝑉 𝐹𝑢𝑡𝑢𝑟𝑒 𝐶𝑎𝑠ℎ 𝐹𝑜𝑤𝑠

Where the present value (PV) is computed using the (opportunity) cost
of capital.

▪ How can we apply this to equities? Some key issues to resolve:

-What are the cash flow flows from holding equity?

-How does risk affect our analysis?
-How does the investor’s horizon affect our analysis?

Imperial College Business School Imperial means Intelligent Business 3

A 1-year investor

▪ Consider an investor who

- Buys the stock today at its current price 𝑃0
- Hold it for one year, receiving any dividends paid 𝐷𝑖𝑣1
- Sells the stock at the end of the year at price 𝑃1

0 1

−𝑃0 𝐷𝑖𝑣1 + 𝑃1
For simplicity, we assume dividends are paid at year end,
and 𝑃1 is the “ex-dividend price”
▪ Valuation principle implies:
𝐷𝑖𝑣1 + 𝑃1
𝑃0 =
1+𝑟
How is this different from bonds?

Imperial College Business School Imperial means Intelligent Business 4

Risky Cash Flows

▪ Cash flows are uncertain

- Future stock prices are obviously uncertain.
- Dividends are announced shortly in advance, before that there is no
commitment
- Rather then having precise estimates of these cash flows, as an
investor you have “expectations”

Imperial College Business School Imperial means Intelligent Business 5

How dividends are paid

▪ Key dividends dates

- Declaration/Announcement date: The date the board authorizes the dividend.
Once declared, it is a legal liability the firm must pay.
- Record date: Shareholders on record on this date will receive the dividend.
Because it takes 3 days for a share to be registered, the date two days prior is
called the ex-dividend date. Buyers of the shares on or after this date will not
receive the dividend.
- Payable date/ Distribution date: The date the dividend is paid to shareholders.
Example: Microsoft’s special dividend of $3.000 per share

Imperial College Business School Imperial means Intelligent Business 6

Ex-dividend Price Drop
Stock prices drop when the stock goes ex-dividend
https://www.pfizer.com/news/press-release/press-release-detail/pfizer-declares-
fourth-quarter-2022-dividend

Imperial College Business School Imperial means Intelligent Business 7

Equity Cost of Capital

▪ What is the appropriate discount rate, r?

- Is buying a share of Microsoft stock equivalent to investing in an one-year
Treasury, or saving at the bank?

No! The cash flows you receive are likely to be either higher or lower than
what you expect. Why take this risk if you can earn the same return with no
risk?

- Investors will require a return on the stock equal to what they expect to earn
on other investments with similar risks.

- This return is the firm’s equity cost of capital

𝑟𝑒 = 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

Depends on stock’s systematic risk

Imperial College Business School Imperial means Intelligent Business 8
Total Return

𝐷𝑖𝑣1 + 𝑃1
▪ Recall the formula: 𝑃0 =
1 + 𝑟𝐸

▪ We can rearrange the formula as:

Imperial College Business School Imperial means Intelligent Business 9

A 2-year Investor

Imperial College Business School Imperial means Intelligent Business 10

Constant Dividend Growth Model

▪ To apply the Dividend-Discount Model, we need to forecast future dividends.

▪ If dividends per share are expected to grow at a constant long-run rate g:

Then dividends can be valued as a constant growth perpetuity:

𝐷𝑖𝑣1
𝑃0 =
(𝑟𝐸 − 𝑔)

Best applied to mature firms/industries.

Imperial College Business School Imperial means Intelligent Business 11
Dividends vs Share Repurchase

▪ What if a company does not pay dividends?

▪ Another way in which companies distribute cash to the shareholders is

through share repurchase, i.e. the company buys back some of its own
stock in exchange for cash.

▪ If a company does not pay out $X in dividends but uses the $X to

repurchase shares, will the shareholders be better off or worse off?

Imperial College Business School Imperial means Intelligent Business 12

Dividends vs Share Repurchase in Perfect Markets

Firm with $10,000 in the bank, 1,000 shares outstanding

- Current stock price = $10 per share
- Desires to pay our $2,000 to shareholders

▪ Pay $2 dividend per share ▪ Repurchase shares

- $ 8,000 in the bank, 1000 shares - $8,000 in the bank, 800 shares
- New stock price = $8 per share - New stock price = $10 per share
- Price drops when stock goes “ex- - No price drop with share
dividend” repurchase

▪ Shareholder owing 10 shares ▪ Shareholder owning 10 shares

- $80 in shares + $20 in cash = $100 - Sell 2 shares ⇒
$ 80 in shares + $20 in cash = $100

Imperial College Business School Imperial means Intelligent Business 13

Total Payout Model

▪ Dividends and Repurchases are both payouts to the equity holder:

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 & 𝑅𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠)

𝑃0 = =
#𝑠ℎ𝑎𝑟𝑒𝑠 #𝑠ℎ𝑎𝑟𝑒𝑠

Consider a firm that will be in business for just two years.

Assuming 𝑟𝐸 = 25% and initial shares outstanding = 140

Year 0 Year 1 Year 2

Share Repurchases 1,500 0
Dividends 0 2,500
Total Paid to Equity 1,500 2,500

1,500 2,500
Total Value of Equity 1+25% + (1+25%)2 = 2,800
#shares 140 ⇒ Price per share $20
Imperial College Business School Imperial means Intelligent Business 14
Total Payout Model

▪ Suppose the firm pays out a fraction of its earnings:

X Total Payout Ratio (TPR)

Dividends &
Repurchases
Earnings

Retained
X Retention Rate (=1-TPR) Earnings

▪ The growth of the firm’s total payout is governed by the growth rate of earnings.
Let 𝑔𝐸 be the expected growth rate of earnings:
𝑇𝑃𝑅 ∗ 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠1
𝐸𝑞𝑢𝑖𝑡𝑦 =
𝑟𝑒 − 𝑔𝐸

𝑇𝑃𝑅∗𝐸𝑃𝑆1 𝑃 𝑜 𝑇𝑃𝑅
𝑃𝑜 = or 𝐸𝑃𝑆 =𝑟
𝑟𝐸 −𝑔𝐸 1 𝐸 −𝑔𝐸

Imperial College Business School Imperial means Intelligent Business 15

Dividend vs. Shares buyback

Why Cash Dividend?

▪ The cash dividend provides a regular stream of cash for investors. It

allows the shareholder to remain invested in the company and still
receive regular cash flows.

▪ Cash dividend can be a big incentive for investors who rely heavily on
their investments to meet their living expenses, especially retired
investors who may not have another source of income.

▪ Since the size of a dividend payout is smaller, compared to a buyback, it

allows the company to maintain a conservative capitalization structure
every quarter rather than just hold large piles of cash.

Imperial College Business School Imperial means Intelligent Business 16

Dividend vs. Shares buyback

Why Shares buyback?

▪ Buybacks are a more tax-efficient way to return capital to shareholders

because the investor doesn’t incur any additional tax on the buyback sale
process. Tax is only applicable on the actual sale of shares, whereas
dividends attract tax in the range of 15% to 20%.

▪ It prevents a decline in the value of a stock by reducing the supply of the

stock

▪ With the reduction in outstanding shares, the Earnings Per Share (EPS)
of the company improves. This is a good indication of the company’s
profitability and may boost its share price in the long run.

▪ It is used as a strategy by management to show its confidence in the

company and to send a message that the stock is undervalued

Imperial College Business School Imperial means Intelligent Business 17

Discounted Free Cash Flow (DCF)
Market Value Balance Sheet

Assets Liabilities

Excess Cash
Debt
Tangible

Enterprise Intangible
Value
NWC
Equity
Other assets

Enterprise Value is the value of the firm’s underlying business.

Enterprise Value = Equity + Debt – Excess Cash = PV(FCF)

Value of Equity = PV(FCF) + Excess Cash – Debt
Imperial College Business School Imperial means Intelligent Business 18
Net Working Capital

▪ Our definition for purposes of projecting free cash flow for valuation:

Working Current Assets*

- Spontaneous Liabilities**

*includes cash needed to run the business (a suitable %age of sales) but
excludes any Excess Cash, i.e. any {cash + cash equivalents + marketable
securities} held over and above what is needed for operations

**non‐interest‐bearing liabilities that arise on the spot, not from borrowing

money but from the operations of the business e.g. Accounts Payable.

Imperial College Business School Imperial means Intelligent Business 19

Discounted Free Cash Flow (DCF)

▪ Free Cash Flow in year t:

𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 − 𝐶𝑎𝑝𝐸𝑥 − 𝐷𝑒𝑝 − ∆𝑁𝑊𝐶

Net CapEx
▪ Enterprise Value
∞
𝐹𝐶𝐹𝐹𝑡
𝐸𝑉 = 𝑃𝑉 𝐹𝐶𝐹 = ෍
(1 + 𝑟)𝑡
𝑡=1
Where r is the blended cost of capital for debt and equity.

▪ Share price:
𝐸𝑞𝑢𝑖𝑡𝑦 𝐸𝑉+𝐶𝑎𝑠ℎ −𝐷𝑒𝑏𝑡
𝑃0 = =
# 𝑠ℎ𝑎𝑟𝑒𝑠 #𝑠ℎ𝑎𝑟𝑒𝑠

Imperial College Business School Imperial means Intelligent Business 20

Discounted Free Cash Flow (DCF)

▪ DCF in practice:
𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹10 𝑉10
𝑉0 = + + ⋯ + +
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)10 (1 + 𝑟)10

Continuation or Terminal Value.

- Beyond a 5 to 10-year horizon, our forecasts are unlikely to be accurate.

- Strong tendency of firms to mean-revert to industry norms.
𝐹𝐶𝐹11 1 + 𝑔𝐹𝐶𝐹
𝑉10 = = 𝐹𝐶𝐹10 𝑥
(𝑟 − 𝑔𝐹𝐶𝐹 ) 𝑟 − 𝑔𝐹𝐶𝐹

Often, the terminal value (i.e. value beyond the forecast horizon) is
estimated by assuming a constant expected long-run growth rate, 𝑔𝐹𝐶𝐹

Imperial College Business School Imperial means Intelligent Business 21

Valuation based on comparable firms

▪ Method of Comparables:
- Estimate the value of the firm based on the value of comparable firms that
we expect will generate very similar cash flows in the future.

▪ We need to adjust for differences in scale between firms by expressing

their value in terms of valuation multiple, i.e. a ratio of firm’s value to
some measure of a firm’s earnings/ cash flow.

▪ The Price/Earnings ration (P/E):

- Share price dividend by earnings per share: how much investors are
willing to pay per dollar of earnings
- Trailing P/E (uses earnings over the last 12 months)
- Forward P/E (uses expected over the next 12 months)

Imperial College Business School Imperial means Intelligent Business 22

Identifying Comparables

▪ Size (revenue, market capitalizations, assets, employees)

▪ Diversification
▪ Market advantage

▪ Breakdown by line of business

▪ Geographic focus

▪ Future prospects
▪ Similar strategic advantages
▪ Growth rates

Imperial College Business School Imperial means Intelligent Business 23

What are some of the multiples used?

Market-to-Sales multiple 𝐸𝑉
Based on overall firm value 𝑆𝑎𝑙𝑒𝑠

𝐸𝑉 𝐸𝑉
EBIT (or EBITDA) multiple 𝑜𝑟
𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇𝐷𝐴
Based on overall firm value

Price-Earnings ratio 𝑀𝑉(𝐸𝑞𝑢𝑖𝑡𝑦) 𝑃𝑟𝑖𝑐𝑒

=
Based on equity value 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐸𝑃𝑆

Imperial College Business School Imperial means Intelligent Business 24

EV or Equity Multiple?

Revenue Enterprise Value Multiples:

- Operating Expenses Revenue
= EBITDA EBITDA
EBIT
- Depreciation & Amortization
= EBIT (above the line)

- Interest (below the line)

=EBT
Equity Value Multiples
-Taxes
=Net Profit Net Profit (P/E)

Imperial College Business School Imperial means Intelligent Business 25

Above or below the line: why does it matter?

Interest ----- Bond-holders

EBIT EV (all capital)

Net Profit ---- Shareholders

Net Profit Shareholders Equity Value

Imperial College Business School Imperial means Intelligent Business 26

P/E Multiples

▪ P/E multiples vary by firm and

industry

▪ P/E multiples are determined by

investors’ expectations for the:
- Payout ratio;
- Risk; and
- Future earnings growth.

Imperial College Business School Imperial means Intelligent Business 27

Valuation Based on Comparable Firms

▪ Assumption: Firms in similar businesses should have similar multiples.

▪ Procedure:
1. Identify the comparable firms

2. Calculate the P/E ratio for each comparable, and take an average

3. Multiply the estimated P/E ratio by the actual E of the firm you want to value

Imperial College Business School Imperial means Intelligent Business 28

Summary: Stock Valuation Techniques
▪ Dividend-Discount Model
- Stock price equal to PV of all future dividends
- Difficult to accurately estimate future dividends, or future dividend growth.

▪ Total Payout Model

- Value of equity to PV of total dividends and share repurchase
- More reliable to use if the firm undertakes share repurchase, still need to accurately
estimate future dividends and share repurchases.

▪ Comparable Firm
- Value stocks by using valuation multiples based on comparable firms.
- Need to find comparable firms that have the same risk and future growth

▪ Discounted Free Cash Flow Model

- Value of equity is Enterprise Value (i.e. PV of firm’s future FCF) + Cash – Debt
- Uses more detailed information regarding the firm’s underlying business and
profitability, not subject to payout changes, accounting changes etc.
Imperial College Business School Imperial means Intelligent Business 29
Final Word

▪ No single technique provides a final answer regarding a stock’s true value. All
approaches require assumptions or forecasts that are too uncertain to
provide a definitive assessment of the firm’s value.

▪ Most real-world practitioners use a combination of these approaches and

gain confidence if the results are consistent across a variety of methods.

Imperial College Business School Imperial means Intelligent Business 30