Valuation Concepts & Methods

- Christian Maupetit
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Valuation concepts
Valuating an ongoing company is neither easy
nor exact.
The field of finance, however, has developed
methods for getting close to the value.

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Valuation concepts
The true value of a business is never “knowable”
with certainty.
The lack of certainty is the result of two
problems

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Valuation concepts
First, alternative valuation methods consistently
fail to produce the same outcome
Second, the product of valuation methods is only
good as the data and the estimates we bring to
them, are often incomplete or unreliable.

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Valuation concepts
Methods used to value a company.
 Asset-based valuation
 Multiple approach valuation
 Discounted cash flow method
 Dividend discount model
 Other models

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Asset-based valuations
One way to value a company is to determine the
value of its assets.
Four approaches :
• Equity book value
• Adjusted book value
• Liquidation value
• Replacement value

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Equity book value
Equity book value is the simplest valuation approach
and uses the balance sheet as its primary source of
information.
Equity book value = Total assets - total liabilities
but assets are placed on the balance sheet at their historical costs,
which may not be their value today

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Adjusted book value
Adjusted book value attempts to restate the value of
the balance sheet assets to realistic market levels.
When adjusting asset values, it is important to
determine the real value of any listed intangibles, such
as goodwill and patents.

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Adjusted assets (market value)

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The various assets-based valuation approaches share
some strengths and weaknesses:
+ easy and inexpensive to calculate
- fail to reflect the actual market value of assets

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Earning-based valuations
Another approach to valuing a company is to capitalize
its earnings.
This involves multiplying one or another income
statement earnings by some multiple.
For a publicly traded company, the current share price multiplied by
the number of outstanding shares indicates the market value of the
company’s equity.

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In the multiple approach, we assume the ratio of
value of some firm-specific variable is the same
across firms.
We call this ratio the multiple.
The firm-specific variable is the driver.
Common multiples include PE ratio, market to
book value ratio (MB)

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Earnings multiple
P/E ratio
The price earning ratio (market price/EPS) is a
multiple approach to pricing the equity on a
company.
Here is the formula :
Equity value = Net income (earnings) * P/E
driver multiplier

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EBIT multiple
Selected adjusted multiple
for example :TIC*/EBIT
Equity value = EBITDA * multiple
*TIC = CS+Debts+PS-cash

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Dividend based value
The dividend discount model is based on the
idea that the value of any security is the present
value of the security’s expected future cash
flows discounted at the rate of return demanded
by stockholders
Return (expected or required)

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Dividend Discount Model
The Gordon Growth Model,
Common Equity :
Dividend/(cost of equity-growth)

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3 assumptions:
 Initial dividend
 Cost of equity
 Dividend growth rate

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The initial dividend has to be determined
(annual report, public sources…)
The cost of equity has to be estimated.

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Example
A company is paying a dividend of 3 €/share
The cost of equity is 12%
The growth (indefinitely) 5%/year
What is the firm’s value ?

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Firm’s value:
Dividend / k-g

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Firm’s value:
3 €/12%-5% = 42.86€ * # shares

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The CAPM formula is: Expected Security Return =
Riskless Return + Beta x (Expected Market Risk
Premium)or:
r = Rf + Beta x (RM - Rf)
where:
- r is the expected return rate on a security;
- Rf is the rate of a "risk-free" investment, i.e. cash;
- RM is the return rate of the appropriate asset class.

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Beta is the overall risk in investing in a large market, like
the New York Stock Exchange.
Each company also has a Beta. A company's Beta is
that company's risk compared to the Beta (Risk) of the
overall market.
If the company has a Beta of 3.0, then it is said to be 3
times more risky than the overall market.
Beta measures the volatility of the security, relative to
the asset class.

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The beta, measures stock price volatility relative
to the overall stock market. We use the S&P 500
as a proxy for the market and we automatically
define it's Beta as being 1.00.
A higher beta indicates that a stock is more
volatile while a lower beta indicates more
stability.

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A stock with a Beta of 0.90 would, on average,
be expected to rise or fall only 90% as much as
the market.
So if the market dropped 1.0%, such a stock
might rise or fall .90%
How do we value a firm with no dividend ?

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Cost of capital
The assets of a company are financed by either
Debts Equity
or

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+
Cost of capital
Cost

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Cost of capital
Definition
The cost of capital is the sum of the cost of
equity plus the cost of debt.

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Definition
Cost of Debt is the required rate of return
on investment of the lenders of a
company.
Cost of Debt

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Definition
Cost of common Stock is the required rate
of return on investment of the
shareholders of the company.
Cost of Equity

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Definition
The weighted average of the cost of equity
and the cost of debt are determined by the
relative proportions of equity and debt in a
firm's capital structure.
WACC

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Discounting cash flows means converting future
earning to today’s money.
The future cash flows have to be discounted in
order to express present value in order to
properly determine the value of the company.
Free cash flows

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Free cash flow looks at the cash the company's
operations actually generated in a given year,
and subtracts important "non-operating" cash
outlays; capital spending and dividend
payments.
Free cash flows

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Key indicators
Free cash flows (definition)
Cash not required for operations or for
reinvestment.
Often defined as earnings before interest (often
obtained from the operating income line on the
income statement) less capital expenditures less
the change in working capital.
Free cash flows

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Free cash flows (formula)
Sales (Revenues from operations)
- COGS (Cost of goods sold-labor, material, book depreciation)
- SG&A (Selling, general administrative costs)
EBIT (Earnings before interest and taxes or Operating Earnings)
- Taxes (Cash taxes)
EBIAT (Earnings before interest after taxes)
+ DEP (Book depreciation)
- CAPX (Capital expenditures)
- ChgWC (Change in working capital)
C (Free cash flows)
Free cash flows

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Example 1

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Example 1

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WACC
Weighted cost of Debts 2.59 %
Weighted cost of Equity 6.47%
Weighted Average cost of capital 9.07 %
2,59%
6,47%
9,07%
Weighted Cost
of Debt +
Weighted Cost
of Equity =
Weighted Average
Cost Of Capital
Example 2

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Discounted Free Cash Flows
19 0 0
2 0 0 0
2 10 0
2 2 0 0
2 3 0 0
2 4 0 0
2 50 0
2 6 0 0
2 0 12 2 0 13 2 0 14 2 0 15 2 0 16 2 0 17 2 0 18 2 0 19
FC Fs
2033.45
1938.57
1831.98
1729.90
1634.42
1557.37
1484.56
12 209.45
Cash
flow
Example 3

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Growth rate (activity)
2012 2014 = 3% per year
2014 2017 = 2% per year
2017 2019 = 3% per year
Discount rates
9% for cash flows and 10% for terminal
value
Σ FCFs
64%
TV
36%
Example 4

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