Chapter 9: Valuation
Cost of capital fundamental principles
1) Money in the future is always worth less than today's money; 2) Financial instruments, containing economic claims on a corporation's future benefits, are paid for by today's money; 3) Since investors must be compensated to bear risk, the riskier the investment, the greater should be the expected return that the capital provider charges to the corporation.
Going concern
A business that has an indefinite duration, which suggests that the firm is not under the threat of liquidation.
Unique (firm-specific) risk
A risk that is specific to a firm and can be eliminated through diversification. It is sometimes called firm-specific or unsystematic risk. It is distinguished from market risk
"Wall Street" Rule
A shareholders sole remedy when they are unhappy with dividends: to sell their shares that disappoint expectations.
Unique risk
An investment of stock in a specific company is always subject to the unique risk (sometimes called firm-specific or unsystematic risk) associated with that company.
Arbitrage
Arbitrage is the process wherein riskless profit is made by exploiting incorrectly priced securities.
Beta
Beta measures the covariance of the stock price to the market return. In other words, it is the sensitivity of the stock price to the market return. For example, a beta of 1.0 means that if the market return increases by 10%, the stock price increases by 10%. Beta is the measure of the stock's risk relative to the market risk. A diversified portfolio has a beta of 1.0, which means that the portfolio's return mimics the market's movements and earns the average return on the market of Rm.
Book value
Book value refers to the value stated in the financial statements.
Comparable companies
Comparable companies are the group of companies that a company, which is the subject of a valuation, is compared against for the purpose of a multiples-based valuation.
Cost of the preferred stock
Cost of the preferred stock is the dividend yield on the preferred stock. Cost of preferred stock = (Dividend Amount/Market Price of Preferred) Unlike the cost of debt, there is no adjustment for the interest tax shield because dividends are paid from net income or equity, which are after taxes.
Diversification notes
Diversification should not be confused with the elimination of all risk. Diversification only eliminates exposure to firm-specific risk of investing in a particular company. An investment in the market is still risky and diversification cannot eliminate the risk inherent in an investment in a market portfolio.
EBIT ratio
EBIT ratio = (Enterprise value/EBIT)
EBITDA ratio
EBITDA ratio = (Enterprise value/EBITDA)
Firm Value (or Enterprise Value)
Enterprise value (EV), also called firm value, is the market value of all secutiries issued by the company: i.e. debt, preferred stock, and common stock. Firm Value = Market Value of Equity + Market Value of Debt
Market multiples
Financial ratios of comparable companies that are used to imply the value of a peer company. For example, if the price to earning (P/E) ratio of comparable companies is 15x, and the company that is valued generates earnings of 10, the implied equity value of the company is 150.
Multiples
Multiples tell us the quality of a firm's market valuation - whether the company is lowly or highly valued.
P/B ratio
Price to book ratio; the ratio of market capitalization to book value. Price/book ratio = (Market cap/Book value)
Revenue ratio
Revenue ratio = (Enterprise value/revenue)
Law of One Price
The Law of One Price is the principle that securities with the same returns and risks must be priced at the same level irrespective of how they are packaged in securities - it embodies the commonsense notion that there must be one price for the sam thing. The Law of One Price is enforced by a process called arbitrage.
Weighted average cost of capital (WAAC)
The average cost of capital that is based on the weight contribution of each form of capital to the total capitalization of a firm. For example, if a firm is capitalized with 100 debt, 100 preferred stock, and 100 common stock, and the cost of these securities are 8%, 10%, and 15% respectively, then the WACC would be 11%. WACC is the discount rate R that is used to discount the future free cash flow of the firm, which is the value of the firm. See page 187 for equation
Free cash flow
The cash flow that is free to all capital providers of a firm. It is calculated as NOPLAT plus noncash operating expenses minus investments in invested capital. NOPLAT is net operating profit less adjusted taxes. Noncash operating expenses are depreciation and amortization. Investments in invested capital are capital expenditures and investments in working capital. Under the discounted cash flow method of valuation, the sum of the free cash flow discounted by a firm's cost of capital is the theoretical value of a firm. Free cash flow is the after-tax cash flow available to all investors: debt holders and equity holders. Unlike cash flow from operations reported in a company's financial statement, free cash flow is independent of financing and nonoperating items. Free cash flow is defined as: FCF = + NOPLAT + Noncash Operating Expenses - Investments in Invested Capital Noncash operating expenses are depreciation and amortization. NOPLAT is net operating profit less adjusted taxes. It is the after-tax operating income that is available to all capital providers of the firm. Conceptually, free cash flow is cash that is available to all capital providers from core operations fo the firm after payment of all operating expenses, taxes on operations, and continuing investments.
Cost of debt
The expected return on the debt securities of a firm. The cost of debt is the rate of return required by creditors to provide debt financing, which is a cost to the firm. Important nuances: cost of debt must account for the interest tax shield & R is not the stated interest rate on the debt instrument. Cost of debt = R (1 - T) where R is the interest rate and T is the tax rate The cost of debt is the interest rate on debt, net of tax benefit
Cost of equity
The expected return on the equity securities of a firm. It is calculated through the capital asset pricing model (CAPM). Cost of equity = B (Rm - Rf) + Rf where B = Beta, Rm = market return, and Rf = risk-free rate The cost of equity is the shareholder's expected return commensurate with the specific risk associated with the firm, and shareholders are compensated in the process of valuation of the stock, which can be monetized through the capital markets.
Cost of capital
The expected return that a firm must provide to an investor in the firm given other investment opportunities available to the investor. The discount rate applicable for discounting the streams of income a corporation is expected to generate is called the cost of capital. The cost of capital is the discount rate used to value a firm. The cost of capital is the rate of return required by each capital provider in order to provide capital to the business enterprise.
Capital Asset Pricing Model (CAPM)
The formula that provides the cost of equity, which is : B (Rm - Rf) + Rf CAPM is a part of the discount rate used to discount the corporation's future cash flows, which is the process of valuing the corporation's equity (it is the R in the time value of money calculation). CAPM's logic is: 1) An investor always has the opportunity to invest in risk-free instruments and get Rf, and she would bear no risk. 2) An investor also has the opportunity to invest in a diversified market portfolio and get Rm, and she would bear the market risk. 3) If an investor chooses to invest in the market portfolio and forgo the opportunity to invest in a risk-free rate, she must be compensated additionally for bearing the market risk: thus, Rm > Rf. 4) The difference is measured as (Rm - Rf), called the equity risk premium which is the additional compensation that an investor requires to forgo the opportunity to earn a risk-free return and bear the market risk. 5) Thus far, we have focused on the difference between the market rate and the risk-free rate. The investor also has the option to forgo a market return and invest in the stock of an individual company. This risk must be measured so that the investor can be appropriately compensated. Step 5 is where beta comes into the picture. Beta is the measure of covariance between the market return and the return on the company's stock. This means that beta is the sensitivity of a company's stock return to the movement of the market return. A beta of 1.0 means that the stock return is correlated one for one with the market return.
Interest Tax Shield
The government subsidizes the use of debt capital by allowing interest expense to be deductible from taxable income. This tax policy effectuates an interest tax shield: the interest deduction reduces the effective cost of debt by shielding some of the firm's profit from tax liability.
Market value
The market value of an asset, liability of equity as determined by prevailing market prices of assets, liabilities, and equity of the firm. The market value of a firm can be stated as (1) equity value which is market cap, or as (2) firm value which is market cap plus debt. It is sometimes called fair market value (FMV), and it is distinguished from book value.
EBIT and EBITDA ratios
The ratios of firm (enterprise) value to EBIT, and firm (enterprise) value to EBITDA. For example, if enterprise value (EV) is calculate as 100, and EBIT and EBITDA are 20 and 25 respectively, EV/EBIT = 5x and EV/EBITDA = 4x.
Liquidation value
The residual value left over upon a liquidation, when assets are sold and liabilities are paid off in the liquidation of a firm. Liquidation value only applies when a firm is no longer a going concern; thus its assets are sold off and liabilities are paid off therefrom. Liquidation valuation may be an inappropriate measure of value for a going concern because the value of a going concern will be the expectation of future returns, and not the current sale value of assets and liabilities.
Market risk (systematic risk)
The risk associated with an investment in the market, and it cannot be eliminated through diversification. This is distinguished from unique risk.
Security market line
The security market line says that as risk increases, the expected return must also increase in a precise mathematical relationship such that stocks literally "line up" on the security market line.
Intrinsic (theoretical) value
The theoretically correct value of a firm that is independent of the current market value of a firm, which at any given time may be equal to, greater than, or less than the intrinsic value. It is typically calculated using the discounted cash flow method. The theoretical value of a firm is the present value of its future stream of free cash flow, discounted by the riskiness of that cash flow.
Firm (enterprise) value
The total market value of invested securities, and is calculated as the market capitalization plus long-term debt.
Discounted cash flow (DCF) method
The valuation method used to calculate the theoretical value of a firm. It is the sum of a firm's free cash flows in the future discounted by a firm's cost of capital. DCF model is broken into 2 time periods: 1) forecast period constituting the first several years of projections; 2) Perpetuity period constituting the remaining time in perpetuity.
Terminal (continuing) value
The value attributed to a company from a fixed period of time in the future to infinity in a discounted cash flow analysis.
Value of an asset
The value of an asset is the expected future return discounted by time and risk.
Treasury securities (Treasuries)
Treasury debt instrument, including Treasury bills, notes and bonds
P/E ratio
price to earnings ratio; the ratio of current share price to EPS. Another way to calculate this ratio is to divide market capitalization by net income. Price Earnings ratio = (Market cap/earnings) = (Stock price/EPS)