1. THE STABLE GROWTH DDM: GORDON GROWTH MODEL ‘The Model: Value of Stock ~ DPS /¢r-9) where DPS) ~ Expected Dividends one year from now 1 Required rate of return for equity investors Annual Growth rate in dividends forever A BASIC PREMISE ynomy (GNP) by mote than a small amount (1 yal rate for the overall 6 trate cannot exeved the + This infinite Estimate for the US Upper end: Long term inflation raie (526) + Growih rate in real GNP (3%) =8% Lower end: Long term inflation rate (2%) + Growth rate in real GNP (2%) = 5% be the growih rate of th d economy, whch (s about one p Je _ ifthe company is a multinational. the reat growth rate w The inflation rate used should be consistent wil the eurency b saluation.WORKS BEST FOR: ‘¢ firms with siable growin rates ‘© rms which pay out dividends that are high and approximate FCFF © flims with stable leverage. ‘Some obvious candidates for the Gordon Growth Model ‘+ Regulated Companies, such as utilities, because ‘© their growth rates are constrained by gs ‘+ they pay high dividends, largely again es a function of history ‘© they have stable leverage (usually high) e financial service companies, because + their size makes its unlikely tha hey will gnerate xiraorinary growth + Ficecast Hows to equity ae dificult compute ‘they pay large dividends ‘+ they generally donot have much leeway in terms of ehanging leverage ‘+ Real estate investmont ums, because + they have to pay out 95% of their earings as dividends ‘© they are constrained in terms of invesment policy and cannot grow ath aphy and population to be close to the grovth rate in the economy in which they operateApplications: Tu stocks Mustration 1: To a utllity: Con Edison - Electrical Utility (North Kast United States) Rationale for sine the moet The frm is in stable growth; based upon size and the ara ta it serves. Its rates are also cegulated; His unlikely tht the regulators \ill allow profits to grow at extraordinary rates, The beta is 0.75 and has been stable over time. The fim isin stable leverage. The lem pays out dividends that are rom ly equal fo FCFT Average Anmal POT petween 1907 and 19S — SaN0 malTom \verage Annual Dividends between [99] and 1995 ~ $461 million Dividends as % of FCFE = 96.04% tekeround Faforiaiion Earnings per share in 1995 ~ $ 2.95 Dividend Payout Ratio in 1995 ~ 69.1 Dividends per share in 1995 ~ $2.08 Expected Growth Rate in Eamings and Dividends = 5% Con Ed Beta Cost of Equity = 6% + 0.75%5.5% = 10.13%Value of Equity = $2.04 °1.05 / (1013 05) = $ 41.80) Con Ed was train for$ 30 on the day of tis analysis, (Funuary 1996) Wat growth rate would Con {have (0 attain the justify the current stock price? The Following lable estimates Value as a function of the expected gro th rato (assuming a beta oF 0.75 and current dividends pet share of $2.04), Con Ed: Value versus Expected Growth 40.00 70 6.00% 50% 4.00% 3.00% 200% 1.00% 0.00% 1.00% Expected GrowthSolving for the expected growth rate that provides the current price, $30.00 = 2.04 (+g) 4.1013-g) Solving for g, 2 (.1013*30-2.04)/ (30.00+2.04) = 3.12% The growth rate in earnings and dividends would have to be 3.12% a year to justify the stock price of $30.00 Mhusiration 2: To a financial service firm: JP. Morgan A Rationale for using the Gordon Growth Modet © Asa financial service firm in an extremely competitive environment, itis unlikely that J.P. Morgan's eamings are going to grow ‘much faster than the economy over the long tem. Allowing for expansion, the expected growth rate used is + Asatinancial service firm, free cash flows to equity are difficult to estimate. Hence, the dependence on dividends. ‘+ The leverage of financial service firms is high and unlikely to change over time Background Information Current Earnings per share ~ $ 6.30 Current Dividend Payout Ratio ~ 47.62% Dividends per share = $ 3.00 Expected Growth Rate in Earnings and Dividends = 7%Stock Beta = 1.15 Cost of Equity = 6% + 1.15 *5.5% Value of Equity = $3.00 “1,07 /(.1233 07) = $ 00.2 J.P. Morgan vais trading for $ 80) on the day of thisanalysis. January 199%) Notes of Concern ‘* The beta is high fora stable growth firm, It reflects the additional risk that many financial service firms have eneounteredd an exposed themselves to in the last few years, Iibustration 3° Yo the overall market: S&P 500 Index on January 1, 1997 dividend yield (Dividends’ Price) for stoeks in the index at the end of 1995 was 1.92%. + Theave ©The level of the index on January 1, 1997 was 783.79, © Using the 1. Hond rate of 7.00% and an exp rowth rate in the nominal GNP of 6%, the level ofthe index ean be obtained trom the Gordon Growth mode! Dividends per share in year 0 ~ 1,95% of 753.79 ~$ 14.70 Infinite growth rate ~ 6% Reguited return of retum for equity investors ~ 7.00% 1 1 * 5.5% ~ 12.50%. Intrinsic Value of the market ~ 14.70 L.06/(.125 + 06) ~ 239.72Scary! So what are we miss ‘© Maybe dividend yields donot reflect the capacity of firms to buy back stock, With stock buybacks, this measure rises to about 3% of the overall index. ‘© The socks inthe index are expected to see thelr earnings grow Faster than the economy for the next Wo oF three yeas. (Estimates - 10-12%) ‘©The risk preminm may be trending down, reflecting ‘+ the greater willingness of investors to go with the flow = take losses and continue in he market, rater than panic ‘the greater low of cash into pension funds ‘© tor paradigm shiis ‘© With a 3% dividend yield, 12% growth nest year in eamings a vi 3.5% premium, you can arrive al an index level of $62.83. Implied Risk Premium: What would the risk premium have to be to justify the level of the index today? What is wrong with this valuation? DDM Stable J+ Ifyou gota low value trom this model, it may be bos fuse Solution + the fim’s dividend payout ratio may be Jow for a stable flams (© 406) Ty using the FCFE Stable Model + the beta is high fora stable fim Use a bela closer to one J+ Ifyou get too high a value i is because + the expected growth rate is too high for a stable firm, Use a growth rate closer to GNP growthI. TWO-STAGE GROWTH MODEL WITH INFINITE GROWTH RATE AT END The Model: + ‘Tho models asod pon two tages of grout, an extardinary growth phase that lasts n years anda stable growth phase that Isis forever afer that Extraordinary growth rate: 2% eaeh year for n years Stable growth: gp forever # Value of the Stoek ~ PY of Dividends curing extraordinary phase + PV of terminal priee Py = SS DPS Pa yere ny —EPSAY iga)*New payout ratio (ent Cine a where DPS, ~ Expected dividends per share in year t 1 Required rate of return: Cost of equily (may be different for high growth and stable growth phas P= Price at the end of year Growth rate forever after year n# Inthe case whore the extraordinary growth rate (g) and payout ratio are the same for the frst n years, this formula can be simplited as follows: where k, — Cost of Equity dur growth phase k,q ~ Cost of Equity dur a he stable growth phase This simplifies calculations because it does not require the estimation of dividends each Year forthe first Yeats. Calculating the terminal price # The growth rate for the Gordon Growth Rate model (within 2% of growih rate in nominal GNP) apply hee as well # The payout ratio has to be consistent with the estimated grovth tate. IF the fowth rate is expected to drop signif yearn, the payout ratio shoul be higher, This can be estimated in one oF two Ways = from frutarnen Stable Period Payout ratio — 1+ b= I -(g (ROC + D/E (ROC -1C-D) = 1 ‘where the inputs for this equation will be for the stable growth period. © sromother stable firms Stable Period Payout Ratio = Average Payout Ratio for other stable firms (40-70% d pending on industry Works best for ‘© firms where the grovwth rate is not yet stable, but is moderating ‘© firms which pay out dividends that roughly approximate FCFE (or) FCFE cannot be estimated easilyMlusiration 4: Valuing « firm with the Qvo-stage dividend discount nodtel::American Express 4 Rationale for using the Model © Why nwo-stage? While American Express tsa lange finanedal service fim in a competitive market place, normally not a candi for above-siable growth, it has gone throu ‘an extended period of depressed carnings . Iti expected that the recovery in eam will create h yer growth over the next five yeas © Why dividends? Asa tinancial service firm, free cash flows to equity are difficult to estimate © Lovorage is stable Backerowt hvormation ‘© Current Eamings / Dividends 4 Earnings per share in 1995 ~ $3.10 + Divisends per share in 1995 ~ $0.90 ‘© Inputs for the High Growth Period Length of the High Growth Period ~ 5 yearsTota during High Growth Period — 145 Cost of Equity during High Growth Period ~ 6.0% 4 1.45 (5.5%) ~ 13.98%. Return on Assels during high growth period — 14.56% (Ihis was the 1905 return on assets) # Dividend Payout Ratio ~ 29.03% © DebuEquity Ratio ~ 100% slighlly higher than the current deblequity ratio of 92.14%) = Inerest rate on debt ~ 8.50% Tas Rate ~ 36%) Txpected Growth Rate PCROCT DR (ROC = 1a) OU T0NT aay Ta SGT RAPA TO = TORT ‘© Inpuls for the Stable Growth © Expected Growth Rate — 6% * bk rowth phase ~ 1.10): Cost of Equity ~ 6.00% 1 1.1 (5.5%) ©The ROC is expected fo drop to 12.50%; DIF Ratio and inerest rate are assumed to remain unche «luring the stable growth period. Sabre Paya Rao T= CROC TDP ROC 1 Tay T= eT ESI TTS Se NSO LT So OI Estimating the value‘+ The first component of value is the present value of the expected dividends during the high growth period. Bas sd upon the current earings ($3.10), the expected growth rate (16.81%) and the expected dividend payout rai 29,03%), the expected dividends can be computed foreach year in the high growth period, oo rs DPS] Peet Vale wo sae Wat sz ODF sae 305" Soe SOT 3 sat Cumula Present Vali of Dividens (a TS 8" SIT STs TIN SBS Sop OT So a HE Te TO (.1681)') (assy 1308-1681 PY of Dividenils 485 The price at the end ofthe high owth phase (end of year 5), can be estimated using the constant rowth model. Terminal prive~ Expected Dividends per sharey 1 / (t= ga) Expected Earnings por shareg ~ 3.10 “1.168159 1,06 $715 Expected Dividends par shares ~ $7.15 * 0.6933 ~$ 4.95 Tominal price =$ 4,95 (1208-.06) = 81.87The present value of the terminal price ean be then written as TANT PV of Tminal Price ~ = (ri9Ry Tihs CumiaTaTod prOSMT val OF Civ ions an Whe Terminal prive can Mhon Bo CaleutSd as TOTIOWS soonest SE) T3981681 T3987 R SHns 4 54257 ~ $4742 Amevican Express was trading at $40,00 in February 1996, atthe time of this analysisTavesiment Financing Dividend Decisions Decisions Decisions (ROA) (DERatioy (Payout) 19. 0.58% 28.71% y Y Expected Return Cursent Expected Riskitve Rate Eaumiigs Growl Beta*Risk Premiuun 7 2 (I-PayoutyROA* DIE(ROA-)) 14.58% + L147.5% R078 7 4.689% ~ (1-.2579(.19674.0058(.1967-804(1-.6))) t Future Famings Payout Ratio 0.78 grows 14.68 25.71% 1 1 Y DPS, DPS, DPS, DPS, DPS. weve ' 2 3 2 PS Yalu ofSock fe e0.23 0.26 ROBO RNAS ROAD RID Dividends = PV= RIDA Year! Yor? Ye} Years Yous VALUING GENTING BERHAD (MALAYSIA)What is wrong with this valuation? DDM 2 Stage © Iryou extremely Jow value from the 2-stage DDM, the likely culprits are ~ the stable period payout ratio is too low for a stable firm (= 40%) fusing fundamentals, use a higher ROC Irenterin directly, enter a higher payout = the beta in the stable period is too b fora stable firm Use a bets closer to one - the use of the two-stage model when the three-stage model is mere appropriate Use a three-stage model © Iryou get an extremely high value ~ the growth rate in the stable growth period is too high for stable fim Use a growth rate closer to GNP.‘THE VALUE OF GROWTH DPS, Py DPS, DPS) DPS), DPSy aaa org) tego ) e pi LL bxtaorinary Growth Stable Growth Asotin place DPS ~ Expected dividends per share in year t 1 Required rate of retum the end of year n {gn ~ Growth rate Forever after yearn Value of extraordinary growth ~ Value of the fim with extraordinary growth in frst n years = Value of the firm asa stable growth firm! Value of stable jowth ~ Value of the firm as a stable growth firm = Value of firms with no growth As Inpplace ~ Value of fim with no growth: Mbustration 5: An Hlustration of the value of growth: American Express Consider the example of American Express in February 1996, 1 The payout ratio used to calculate the value ofthe fim asa stable in can be either the erent poycut rai, i iis reasonable, or the new payout aio cleat usin the Framer growth feral,Value of the assets in place Current EPS * Payout ratio /r $3.10 * 0.2903 / 1205 = $7.47 * The discount rate from the stable growth phase is used for this calculation Value of stable growth Current EPS * Payout ratio * (1-'gn)/(r-gn)- $7.47 (S3.10* 0.2903 *1.06)(.1205 -.06) - $ 7.47 = $8.30 Value of extraordinary growth = $ 47.42 -(7.47+8.30)=$ 31.65 The Deterntinants of the Value af Growth © Length of the high growth period © Extent of the extraordinary growth © Costs of higher growth , Le., how much risk is added and how much cash is drained as a consequenceIL. THREE-STAGE DIVIDEND DISCOUNT MODEL, The Model EARNINGS GROWTH RATES| OWA] [Dechining growthy Infinite Stable growthy [DIVIDEND PAYOUTS Payout ratio] Tncreasiparey out ratio ow Payout ratio]‘The value of the stock is then the present value of expected dividends dr comth andthe transitional periods, and of the terminal price a the stat ofthe final sable rovith phase p, STEPS. Ue Se _pps, "a ERY an ky High growth phase Iransition Stable growth phase where, EPS, ~ Eamings per share in year DPS1 = Dividends per share in year t Growth e im high growth phase (lasts nl periods) ga ~ Growth rate in stable phase Ta~ Payout ratio in high growth phase Ty = Payout ratio in stab wrth phase k,~ Requited rate of return on equity: Can vary across periods: k, isthe cost ofequity during the high growth and transition period and k,, isthe eost of equity during the stable growth period.Works best for: Lis best suited for firms which are ‘© paying out and plan to continue paying dividends which are roughly equal to FCFE * growing at ‘© an extraordinary rate now and are expected to maintain this rate for an initial period! ‘© alfer which the differential advantage of the fim is expected to deplete leading to g radual declines in the growth rate © twastable growth rate ‘¢ instable leverage Mbtration 6: Vatuing withthe Diree-stage DM mode: The Home Depot 4 Rationale for using ihe Three-Stage Dividend Discount Mode: + Why rhave-stage? ‘The Home Depot isstllin very high growth, Analysts project tha its earings per-share wil grow at 362% for tho nxt five yeas. © Why dividends? ‘The finw has had a waek record of paying out dividends that roughly approximate FCFE ‘©The financial leverage is stable. Background Information© Current Eamings / Dividends + Eamings per share in 1994 ~$ 1 * Dividends per share in 1994 =$ 0.19 © Inputs for the High Growth Period # Length of the High Growth Period ~ 5 years + Expected growth rate ~ 36.00% (Based upon analyst projections) * Beta during High Growth Period = 1.60 + Cost of Equity during High Growth Period Mo + 1.60 (5.5%) ~ 16.30% * Dividend Payout Ratio ~ 12.03% (based on existing payout ratio) Inputs for the transition period * Length of the transition period ~ 5 years + Growth rate in earings will decline from 36% in year 5 to 6% in year 10 in linear increments, + Payout ratio will increase from 12.03% to 60% over the same period in linear inerements. * Beta will drop from 1.60 to 1.00 over the same period in linear increments, © Inputs for the Stable Growth‘© Expected Growth Rate ~ 6" © Bota during stable 3.00% wth phase ~ 1.00 » Cost of Equity ~ 7.50% + 1.0 (5.5% © Payout Ratio ~ 60% Estimal ng the Value + ‘Those inputs are used to estimated expected earnings per share, dividends por share and eo ovwth and of equity for both the high stable periods. The present values are also showa, Foriod TPS] Paya Rao. | DPS] Cost oT Equity] Proven Vale T TTsT THOR SOIT TIO OTF z wT wt aT ws + ss 0 7 TOT TOIT ; SEIT so ¥ ST] aT SIRT ST > TTF SOIT Tear TSB sTF 7 ST as oF | TOT | aD)(Note: Sinee the costs of equity change each year, the present value has to be calculated using the cumulated cost oF equity. ‘Thus, in year Tuthe present value of dividends is - PV of year 7 dividend = $3.11 /9(1.1630)5 (1 564) (1.1498) — 31.10 The TT parce a Who oT jour TO eam Re CaTEU TATOO DINED Up Ue CANIN por Share Wy your TT Uno aGTe Grown Fave oT cost of equity of 13.00% (based upon the bela of 1) and the payout ratio of 60.00% - Taminal pee STITT OTIS TS TO aT STOTT Present Value of dividends in high growth phase: $1.31 Present Value of dividends in transition phase; $7.12 Prosent Value of terminal price at end of transition: $30.57 Value of Home Depot Stock $39.00 Home Depot was trading at $45, in February 19%Sensitivity to Growth Rates VALUE VS. EXPECTED GROWTH 45.00 ‘840.00 $35.00 's30.00 1925.00 20.00 value pat Share: $15.00 ‘810.00 $5.09 $0.09 Expected GreatWhat iy wrong with this model? (3 stage DDM) Je Ifyou are too Low a value from this model the stable period payout ratio is tos Low fora stable firm (= 4 using fundamentals, use a higher ROC entering directly, enter a higher payout ~ the bota in the stable period is too high for a stable firm Use a beta closer to one. J+ Iyou get an extremely high value, =the growth rate in the stable rowth rate closer to GNP growth fowth period is too high for stable firm Usa ~ the period of growth (high + transition) is too hi Use shorter high growth & transition perioWHY ARE DIVIDENDS DIFFERENT FROM FCFE? # The FCFE isa measure of what a firm ean afford to pay out as dividends, Dividends paid are different from the FCFE for a number of reasons — © Desire for Stability Future Investment Needs © Tax Factors Signalling Prevogatives I. THE CONSTANT GROWTH FCFE MOD! The Modet The value of equity, under the constant growth model, is a function of the expected FCFE in the next period, the stable growth rate and the required rate of retum, p, = Cee £0 where, Pg ~ Value of stock todayFCFE| ~ Expected FCFE nest year r= Cost of equity ofthe firm an ~ Growth rate in FCFE for the firm forever This model ix appropriate when ‘© The fiem has to by in steady state. This also implies that (1) Capital expenditure is not significantly greater than depreciation (2) The beta of the stock is close to one or below one, ‘©The fiem has CFE which are significantly different from dividends, or dividends are not relevant © The leverage is stable th Model: Telefonica de Espana PE Stable Gr Rationale or using Model ‘© Given that the market that is serves (Spain) is reaching maturity (40.5 phone lines per 100 people), and the regulations on local er above-normal growth, Ibis expected to grow about 10% a year in itis unlikely that Telefon, Espana will be able to pric Spanish peseta terms, ‘© Telefonica pays out much less in dividencl than it generates in FCEE Dividends in 190954 Pry share FCTE por Share im 1905 —NOSS PL share© The leverage is stable Background Information © Current Information: ‘© Earnings per Share ~ 154.53 Pt ‘© Capital Expenditures per share ~ 421 Pt '* Depreciation per share ~ 285 Pt ‘* Change in Working Capital / Share ~ None ‘© Debi Financing Ratio ~ S0% © Eamings, Capital Expenditures anc! Depreciation are all expected to grow 10%: year ‘The bets forthe stock is 0.90, and the Spanish long boned rate is 9.50%, A premium of 6.50% is used for the Spanish market. Valuation 0% + 0.90 (6.50%) © Cost of Equity =9 © Expected! Growth Rate = 10.00% © Bose Year FFEEarnings per Share 154.83 = (Capital Expenditures - Depreciation) (1 = Debt Ratio) = 68.00) = (Change in Working Capital) (1 = Debt Ratic = 0.00) Perr 86.53 Value per Share — 86.83 ( 1-10) (1S38- 10) — 177) Pr The sack was trading Tor TER PTIn Tanaary Te Ntustvation 8: Valuing a firm with depressed earnings: Daimler Benz A rationale for using the PCFE Stable Modet © Asone of the largest firms in a mature sector, itis unlikely that Daimler Benz will he able to register super normal growth over time. © Like most German finns, the dividends paid bear no resemblance to the cash flows generated The leverage is stable and unlikely to change Rackyround Information © The company had a loss of 38,63 DM per share in 1995, partly because of restructuring charges in aerospace andl partly because of troubles (hopelully temporary) at it automotive division, The book value of equity in 1995 was 20.25 billion DM.‘While the return on equity in 1995 period is negative, the five-year average (1988-1993) return on eqpity is 10.17% + The company reported capital expenditures of 10.35 billion DM in 1995 and depreciation of 9.7 billion DNC ‘©The company has traditionally financed its investment needs with 35% deat and 6$% equity ‘©The working capital requirements are about 2.5% of revenues, The revenues in 1995 is 104 billion DM. © The stock had a beta of 1.10, relative to the Franklunt DAX, The German long bond rate is 6%, The risk premium for the German market is 4.5% © [nthe Jong term, earnings are expected to grow al the same rate as the world economy (6.5%) © There are 51.30 million shares outstanding. Vaatuation = Estimating FOFE Normalized Net Income 20.250 © 0.1017 2059 million DM. = (Cap Ex = Depree’n) (1- Debt Ratio) = (10380-9700) (1-35) = 423 million DM = Change in Working Capital (1 = Debt Ratio) ~ (.025 © 065° 104,000) ° 0.65 = 110 million DM. Free Cash Flows to Equity 1526 million DM © Cost of Equity ~ 6% + 1.10 (4.5%) ~ 10.95% Value of Equity — 1526 million DWI(1008) (1095-068) — 86501 million DN Value per Share ~ 36,521/51,30- 712 DM The stock was tradit for 814 DM in February 1996.What is wrong with this valuation? FCFE Stable Ifyou get a low value from this model, it may be because ~ capital expenditures are too high relative to depreciation - working capital as a perwent of revenues is too high = the beta is high fora stable fim If you get too high a value, iis because = Capital expenditures are lower than depreciation ~ Worki pital ratioas % of revenue is negative - the expected growth rate is too high for a stable firm Solution Use a smaller Cap Ex or use the 2-slage model Nomalize this ratio, using historical averages Use a beta closer to one Set Capital expenditures equal to depreviation Set equal 10 ze70 Use @ growth rate closer to GNP growthI. THE TWO-STAGE FCFE MODEL The Model ‘Phe value of any stock is the present value of the FCFE per year for the extraordinary growth period plus the present value ofthe terminal priv al the end of the period Value PV of FCF + PVof terminal price ERCPE,/(+K)E Py (LK where, FCFE(~ Free Cashflow to Equity in year t Pq ~ Price at the end of the extraondinary growth period k, Cost of equity during h growth phase The terminal price is generally calculated using the infinite growth rate model Pa = FCFEns1 /(k, where, Cost of Equity during stable growth phase sn ~ Growth rate alter the terminal year ForeverCaleutating the terminal price aswell. ©The same caveats that apply to the growth rate for the stable growth rate model, described in the previous section, apply hee ‘+ Inaddition, the assumptions made to derive the free eashfloyy to equity ater the terminal year have to be consistent with this assumption of stability. (Difference between capital expenditures and depreciation will narrow; Beta eloser to one) penditures in Steady State Estimating Net Capital B 1. The Bludgeon Approach: Assume that capital expenditures offset depreciation, resulting ina net cap ex of Zero. Limitations: If net cap ex is zero, where is real growth coming from 2. Industry Averages: Use industry average ratios of cap ex to depreciation to determine the nel cap ex in Sable growth. (See Industry Average Table on last page) Limitations: Incustry averages may themselves shift aver time; Firms may vary within the industry 3. Firm-Specific Approach: Use the firm’s characteristics to estimate what the net cap ex will need to be in steady stale. Based upon the inerease in earnings hefore interest and taxes and retumm on capital in the steady siate period, the net capital expenditures can be Est Themen Copia dam TLC apilal Expenditures tn ermal year — (increase 1a EBM lay mr torn Tand Taxes OFS 150 miilon In the lis year papery Thais, 17a firm with earnings betore inter Tigh growih expects growth oF and has a retum on capital of 12.5%, the net capital expenditures in the terminal year will be as follows (Tax rate~40%) Not Cap Ex ~ 150 (.6) (05.125 $36 million Note that 12 'o oF $36 million yields the earnings growth of the next year.Works best jor ‘© firms where growih will be high and constant in the initial period and drop abrupily to stable growth afler that. ¢ Dividends are very different from FCFE or not relevant / messurable (private firms, IPOs) ‘+ Firms which dont pay dividends but have negative FCFE, Iitustration 9: Two-Stage FCFE Model: Amgen Ine 4 Rationale for using the Model © Why nvo-stage? While A thas had a history of extraordinary growth, i wth is moderating because (a) itis bocoming a much larger company and (b) its products are maturing and may face competition soon. Why FCFE? Amgen does not pay dividends, but has some FCFE, This CFE is likely to inerease as the growih rate moderates, and the firm Background Information + Current Earnings / Capital Expencitures Earnings per share in 1995 =$ 195 © Capital Expenditures in 1995 per share = $ 0.40)‘Depreciation per share in 1995 ~ $0.32 + Revenues per share ~ $ 7.45 Inputs for the High Growth Period ‘© Length of high growth period ~ 5 years © Growth Rate inputs: © Return on Equity = 21.74% (This is unuch lower than the euctent return on equity of about 28%, This ROE is going to be difticult to sustain as the firm gets larger) © Reiention Ratio 100% (The firm pay's no dividenls now, an is unlikely to Jo so in the near future because its stockholders are more interested in price appreciation Expected Growth Rate ~ 1 * 21.74% — 21.74% ‘Phe beta during the high growth phase is expected to be 1.30 Cosi of Equity ~ 6.00" ‘© Capital expenditures, depreciation and revenues are expected to grow atthe same rate as earn ‘© Working capilal is expected to be 20% of revenues, The debt ratio is approximately 9.55%: itis expected to remain uncha#Inpnts forthe Stable Growth ‘© Expected Growth Rate ~ 6% Bota during stal ovwth phase ~ 1.10: Cost of Equity ~ 6.00% + 1.1 (5.5%) ~ 12.05% Capital expenditures and depreciation are assumed to continue growing 6% a year © Working capital is expected to he 20% of revenues ‘© The debt ratio is expected to remain at 9.55 Estimating the value the hi ‘© The first component of value isthe present value of the expected FCFE: durin: h growth period. amines TTcapheDeprecrnon tay | SOD | SmTT | Soy arking Capa OST Tet TN Tree Cashitn Sra Tay PV of FCPE durin TIO a1 + o80~ S10,The price atthe end of thei ovvth phase (end of ye 5), can be estimated using the constant growth model Terminal price ~ Expected ECFEy 44 /(r nb Expected Earnings per share 1.06 =8 5. Expected FCFEs~ EPS, - Net Capital Expenditures - A Working Capital (1 - Debt Ratio) $ 5.52 - $0.20 (1-.0085)- $0.24 (1-.0985) = $ 5.11 Terminal price ~ $ 5.11 (1205 -.06) ~ $ 84.39 The present value of the terminal price ean be then written as = se PV of Terminal Price — == (Bi The cumulated present yalue of dividends and the terminal price can then be ealeulated as follows: PV today PY of FCFE during high growth phase + PW ot Terminal Price Boas SSO BSS TS Amgen was tradi at $60.75 in February 1996, atthe time ofthis analysis,What is wrong with this valuation? TCTE 2 Stage J+ Lyou get a extremely low value from the 2-siage FCFE, the likely culprits are - earnings are depressed ce to some reason (economy...) Use normalized earnings capital expenditures are significantly higher than depreciation in Offset capital expenditures by depreciation (or) stable growth phase Reduce the difference for stable growth period - tho beta in the stable period is too high fora stable firm Use a hota closer to ote. Use a working capital ratio closer to industry Use a three-stage model sarnings are inflated above normal levels Use normalized earnings - capital expenditures offset depreciation during high growth peviod| Capital expenditures should be set higher - capital expenditures are less than depreciation Set capital expenditures equal te depreciation, + the growth rate inthe Slable growth period is too high for stable fim Use a growth cate clover to GNP growthSTAGE FCFE MODEL IIL. THE E-MODEL The Modet The E model calculates the present value of expected five cash Mow to equity overall three stages of growth: p= SFCFEL , SP _FCFE, “tk atk, where, Po = Value of the stock today FOPE, = FCFE in year t rowth phase to k,, during the stable k, ~ Cost of equity: can vary across periods from k, during the high Pq — Terminal price at the end of transitional period = FCFEyps1/(k,, nl ~End of initial high growth period 12+ End of transition periodCaveats in using model 1, Capitat Spend crsus Depreciation ‘Inthe high growth phase, capital spending fs likely to much larger than depreciation. Inthe transitional phase, the difference is likely to narrow and capital spenciing and depreciation shoud be in rough parity in the stable growth phase. ([RENINTSTROWTHRATES, Eg] ¥ Fepersemigy | Pe2. Risk © Overtime, as these firms get larger and more diversified, the average betas of these portfolios move towards one. Works best for: ‘© firms with very high growth rates eurrently ‘© firms whose dividends are significantly higher or lower than the FCFE or dividends are not measurable © firms with stable leverage Mlusiration 10: Valuing America Online with the 3-stage FCFE mostet Rationale for using Three-Stage FCFE Model + Why ihree stage? The expected growth rate in earnings is in excess of 50%, partly because of the growth in the overall market and parily because of the fimn’s position in the business. ive FEE, k + Why FCFE? The firm pays out no dividends, but has n ly as a consequence of large capital expenditures. + The firm uses little debt (about 1026) in meeting finane ;oquirements, and does not plan to change tis inthe near future. Background Information + Current Information Earnings per Share~$ 0.38‘© Capital Spending per Share ~ § 1.21 ‘© Depreciation per Share ~ $0.17 Revenues per share ~ $7.21 © Working Capital asa percent of revenues = 10.00% (This is significantly lower than the cursent WC ratio} # Phase 1: High Growth Period ‘© Length of the high growth period ~ $ years ‘© Expected growth rate in earnings during the period ~ $22% (from analyst projections and market growth) ‘© Capital Spending. depreciation and revenues will grow 20% a year during this period (based upon past grov.th. © Working capital will remain at 10% of revenues ‘© Approximately 10% of external finaneing will come from debt. © The beta for the high growth peried is 1.60 © Phase 2: Transition period ofthe transition period + Growth rate will decline from 52% in year 5 to 6% in year 10 linearly ‘© Capital Spending will grow 6% a year in this period, while depreciation will continue to grow | 1 during this periock working capital will remain 10% of revenues, The debt ratio will remain at 10% during this period© The beta will decline linearly from 1.60 in year $ to 1.20 in year 10, © Phase 3: Stable Growth Phase © Earnings will grow 6% a year in perpetuity Capital expenditures will be 125% of depreciation during the high growth phase # Revenues will also grow 6% a year: Working capital will remain 10% of revennes, The debt ratio will remain at 10% during this period © The beta for the stock will be 1.20 Valuing the Stock The following are the expected cashflows over both periods. [Tigh Growth Poriod Famings $0.58 Taplx-Depreciationy 11-01) WIE ‘A Working Capital *(1-0.1) wOTS 5 TZ | soz TCT D007) 7 yoay event Value TOSS)| Tem 7 7 7 7 Growth Rae MI INCI STITT TSI CO Tmalated Growth TERT PHO TN TITAS AT I] STS Tamings WITT SREY TIE YS SRT Toaphx-Deprectariony 1-07) SEAT SESE SEOR | SEAT] SIOT A Working Capital (10.1) SHIT | SUIT | SU | SUIT | 030 TCTT SITS Sa Tiara TS Ta 136 | os] Tt Castor qty a TET exon Wale STITT TT The five cashflow to equity in year 11, assuming that capital expenditures are offset by depreciation, is $9.15, yielding a tominal price o' $112.94 FCFE in year U1 = EPS11 - Net Cap Ex (1- Debt Ratio) «Rev -Revio)* Working Capital as % of Revenues (58.948 1.06) - $0.35 (1-10) ~ $9.15 7.5% 14.10% Cost of Equity in stable phase 20(5.50" Terminal price ~ $9.15 (1410-06) ~ $112.94 Thue present value of free cashflows to equity and the terminal price is as follows * (1 Debi Ratio)Treen Vale TCT raion pT 3SoT FESeaT Valo ot Term Pe SIT ane oe SITS America Online was traci in March 1995 ye FCFE model Emerging Market Mustration 11: Vatuing Titan Watches (india) with the se fo Ratio sing ThreeStage FCFE Model (vhile 143 watches are ovvth rate in e is 35%, partly because he overall market is hu ee siage? The expected Id in India), and partly because of the company’s .¢ per 1000 people worldwide, only 17 are sold per 1000 are purchased on aver. strong brand name ‘© Why FCFE? The firm pays out dividend, but the dividend has been fixed at Rs 2.50 per share for three years. The free cash flows, to equity are much more volatile and have generally been negative in the last few years. this in the near Future. ig requirements, and does mot plan to chan ‘© The firm uses little debt (about 10%) in meeting financi Background Information © Current Information # Earnings per Share ~ Rs 6.20‘Capital Spending per Share ~ Rs 10.40 Depreciation per Share ~ Rs-440 + Revenues per share = Rs 90.00 + Working Capital asa percent of revenues = 15.00% Growth Period ength of the bi growth period = 5 years ‘© Expected growth rate in earnings during the period ~ 35% (from analyst projections and market growth) + Capital Spending, depreciation and revenues will grow 30% a year during this period (based upon past growth) ‘Working capital will remain at 15% of reveres # Approximately 10% of external financing will come from debt. The beta forthe high growth period is 1.20 ransition period Length of the transition period ~ $ years # Growth cate in earnings will decline fav 35% in year 5 to 12% in year LO linealy + Capital Spending will grow 10% a year in this period, while depreciation will continue to grow 15% a yearRevenues will increase 15% a year during this period; working capital will remain 15% of revenues, The debt ratio will remain at 10% during this period © Thebota will decline linearly from 1.20 in year $ to 1,00 in year 10 © Phase 3 Stable Growth Phase + Parnings will gross 12% a year in pempotuity * Capital expenditures will be ellsot by depreciation, Revenues will also grow 12% a y Working capital will remain 15% of revenues #Thedobt ratio will emain at 10% during this period © Thebota for the stock will be 1.00 Ro rshico rare for the Dadam maThor Fs Tada TSO Tsk promnum is emp Yor [Tigh Growth Perfod (= years) Famings PT Cape Depreciationy ayTransition period ear z r T T row Tae Ta SRO | Ta | Te | TE [Cumulated Growth es ON es Se Fam RSTOIS | RAS OT |RSS IT | RSIS | STEIN (CapENDepreciationC1-a) | RSILS2 | ROIDST | RSITSD | RSISTT | Rs20IT Che. Working Capital (a) | RS6.77 [R778 RBS RSTTS4 TCTE RST RSIS 22 | RSET FESS Teta Te TIE TOR T Cost or Equiy TOTO [TIA | TITIES 3% Present Value RI | Rae | es | Te | se The five cashflow to equity in year 11, assuming that capital expenditures are of'Set by depreciation, is Rs 67.59, yiekding a terminal price of Rs 112.94, FCFE in year = (Rs, 72,181.12) Rs. 14.73 (1-10) ~ Rs 67.59 Cost of Equity in stable phase ~ 1161 1,00 (7.50%) — 18.50% Terminal price ~ Rts 67.59 (.185=.12) — Rs, 1039.85 The present value of free cashflows to equity andthe terminal price is as follows, Present Vali of FTE tn high prowih pase Ties Ty [Rrser Vane PCP tiansiion phase TENT] Tresont Valier Terminal Price RST TS.35] [Saneatte tock] Titan Watches was trading at Rs 125 at the time of this analysis. S11 = (Revy1-Revya)*Working Capital as % of Revenues ® (1+ Debt RatioEstimation Issues for Emerging Market Companies 1. Estimating Risk Parameters Opto Taaiions Simave the Datars) by Tegressmng TouumTS OM Te sto Tigh nat have hoon ted Tone returns on the market index. Estimates might be very noisy ss returns on Titan against Bombay Stock Exe Sate The etary hy sector Taher Than by company, WaT Might not be many finns in the sector, the local market Teg, Estimate Me Betas for ware eTerronie Companies, ard TARE Too many differences across fimsin each sector average across the secto Use the bata Trom anther market Tora Silay company ° hr be different across countries because i. Use the beta ofa (U.S. company or companies manufacturing differences in operating and regulatory risk. watches. Use accounting earnings 1 csiimare bolas TsteaT oT MTR! —[-« Acgounting earnings may be even more volatile than stock vession of Titan earnings against overall earnings © There might not be a long enough historyEstima I. Estimating Risk Parameters n Issues for Emerging Market Companies STs wa ectiv sk Measures CTaseTTy Tis Tala Ak oT ‘+ Subjective judgment might be erroneous and calculate expected retums by risk class, This approach mixes finespecifie and marke risk Fg. Classify Tian as high, average or low sk and demand T-Makowo risk adjustment, ATs have the same required we Ly Wilf be disastrous if Tims are oF very different risk clawes of reurn, HL. Estimating Cash Flows © There is not much historical data © The data is unreliable. ‘+The company and the economy are changing too fast While all the partially the result of Factors increase the uncertainty associated with the estimates, this noise is partially the result of poor infomation andfats wrong with this valuation? TSize J+ IFyou gota extremely low value from the 3-siage FCFE, the likely culprits are - capital expenditures are significantly higher than depreciation in Ofiket capital expenciitures by depreciation (or) stable growth phase Cap Ex grows slower than depreciation during transition period - the beta in the siable period is too high fora stable finn Use a beta closerto one - working capital as % of revenue is too high to sustain Use a working capital ratio closer to industry J+ Iryou get an extremely high value, - capital expenditures offset depreciation during high growth period Capital expenditures should e sot higher - capital expenditures are fess than depreciation Set capital expenditures equal to depreciation = Growth Period (High growth + transition) is too lo Use a shorter ad sowth pe + the growth rate in the stable growth period is too high forstable firm Use a growth rate closer to GNP growtha FCFE Valuation versus Dividend Discount Model Valuation When they are similar where the diviclends are oqual to the FCFE where the FCFE is greater than dividends, but the excess cash is invested in projects with net present value of zero, . When they are different when the FCFE is greater than the dividend and the excess cash either exrns below-market interest rates or is invested in negative net present value projects the payment of sinaller dividend than can be afforded to be paid out by « firm, lowers debt-equity ratios and may lead the fim 6 become underleveraged, causing @ loss in value, Inthe cases where dividends ar ter than FCFE, the frm will have to issue either new stock or new debt to pay these dividends sading to atleast three 1 ative consequences for value Ones the flotation cost on these security issues, which eam be substantial for equity issues, creates an unecessary expenditure which decreases value ‘© Socond, ifthe frm borrows the money to pay the dividends, the firm may become overleveraged (relative to the optimal) leading to losin valueECFE Valuation versus Dividend Discount Model Valuation ‘© Finally, paying too mnch in dividends can lead to capital rationing consraints where good projects are rejected, resulting in & loss of wealth, 3. What does it mean when they are different? + The difference between the value from the PCFE model and the value using the dividend discount model ean be considered one component of the value of controlling a firm - if measures the value of eontrolling dividend policy + In the more infrequent case, where the value from the dividend discount model exceeds the value from the FCFE, the difference has Jess economie meaning but can be considered a warning on the sustainability of expected dividends.GROWTH IN FCFE VERSUS GROWTH IN FCFF ‘+ Leverage generally increases the growth rate in the FCFE, relative to the growth rate in the FCFF. ‘©The growth rate in eamings per share is defined to be: geps=b ROC +DE ROC 4i (1-4) where, ‘geps = Growth rate in Eamings per share ‘b= Retention ratio= 1 - Payoutratio ROC =Retum on Assets = (Net Income + Interest Expense (1-)V(BV of Debt + BV of Equity) DE=Debt/ Equity it Interest Expense! Book Value of Debt ‘+ The growth rate in EBIT will be a fimction of only the retention ratio and the retum on assets and will generally be Lower: gearr=b ROC) lustration 12: Growth rate in FCFE and FCFF: Home Depot Inc. Home Depot Inc. had earnings per share in 1992 of $0.82, and had registered growth in eamings per share of 45% in the prior five years. The firm had retumn on assets of 12.82 %, a pre-tax interest rate of 7.7%, a debt-equity ratio of 36.59% and a retention ratioof 91% in 1992 (The tax rate was 36%). Assuming that these levels will be sustained im the fixture. the growth rates in FCFE and FCFF will be as follows Expected growth miein FFE =b ROC +DE ROC i149) = 0.91 (12.82% + 0.3659 (12.82% - 7.7% (1-0.36)) = 14.29% ExpectedGrowth miein FCF =b ROC) = 0.91 * 12.82% 1.67% ‘The growth rate in free cashflows to equity is greater than the growth rate inthe fie cashflow to the firm because of the leverage effect.‘VIL. FCFF STABLE GROWTH FIRM The Model A fim with free cashflows to the firm growing at a stable growth rate can be valued using the following model: Value of fim = ECF; /(WACC- ga) Where, ‘FCFF | = Expected FCFF next year WACC = Weighted average cost of capital = Growth rate in the FCFF (forever) The Caveats ‘© the growth rate used inthe model has to be reasonable, relative to the nominal growth rate in the economy. ‘+ the relationship between capital expenditures and depreciation has to be consistent with assumptions of stable growth. lustration 13: Valuing the Food Product Division at RJR Nabisco 4 Rationale for using the Stable FCFF Model ‘+The division is im steady state; Itisa large player in a stable market with strong competition. It camnot be expected to sustain high ‘growth for any length of time.‘The division does not carry its own debt (though its parent company, RJR Nabisco, carries plenty). Thus, only the FCFF can be ‘computed for the division. The entire division is up for sale, not just RIR’s equity stake in the division. Background Information In 1995, the food products division had revemues of $ 7 billion on which it eamed $1.5 billion before interest and taxes. ‘The division had capital expenditures of $660 million and depreciation of $550 million in 1994 ‘The working capital as a percent of revenues has averaged 5% between 1993 and 1994. (Working capital increased $350 million in 1994) ‘The beta of comparable firms in the food products business is 1.05 and the average debt rato at these firms is 23.67%. (The cost of debt at the largest of these firms is approximately 8 50%). ‘The tax rate is assumed to be 36% ‘The cash flows to the firm are expected to grow 5% a year in the long term Valuing the Division ‘The estimated free cash flows to the firm (division) are as follows — 32 Curent | Nest Year~Wap Ex-Depreciationy —] STOW S—TIS50 ~ Change in Working Capital |S 130000] 1730] =FCFF STOW |S BIST ‘+ The cost of capital is computed, based upon comparable firms (in the food products business) + Beta (based upon comparable firms) = 1.05 + Cost of Equity (based upen comparable firms) = 7.5% + 1.05 (5.50%)= 13.275% + Pretax Cost of Debt= 8.50%: After-tax cost of debt = 8.50% (1-036)= 5.44% + Debt Ratio (based upon comparable firms) = 23.67% ‘© Cost of Capital (based upon comparable firms) 3.275% (0.7633) + 5.44% (0.2367) = 11.42% ‘+ The value of the division, using this cost of capital and an expected growth rate of 5%, were estimated as follows ~ ‘Value af Food Prodacts Division = 3 875 (1142 - 05) = $15 615 billowsVIII & IX. TWO AND THREE STAGE VERSIONS OF THE FCFF MODEL The Medel The value ofthe firm, in the most general case, can be writen as the present value of expected free cashflows to the fim: ‘Se FCFF, Value of Frm = le WACCY a where, *CFF,, = Free Cashflow to fim in year t WACC= Weighted average cost of capital If the firm reaches steady state after n years, and starts growing ata stable growth rate gq after that, the value of the firm can be written 2 FCEF, _[FCFF,. /(WACC-g,)] Value ofFim= 7S Wwacoye” d= WACO® Firm Valuation versus Equity Valeatton ‘+The value of equity, however, canbe extracted from the value of the firm by subtracting out the market value of outstanding debt+ The advantage of using the firm valuation approach is that cashflows relating to debt do not have to be considered. In cases where the leverage is expected to change significantly over time, this isa significant saving, The firm valuation approach does, however, require information about debt ratios and interest rates to estimate the weighted average cost of capital ‘+ Thevalue for equity obtained from the firm valuation and equity valuation approaches will be the same if (@ Consistent assumptions are made about growth in the two approaches () Bonds are correctly priced Best suited for: ‘+ Fis which have very high leverage and are in the process of lowering their leverage or vice versa. + Fimms which have negative FCFE, but have positive FCFF. ustration 14: Federated Department Stores: Valuing an over- leveraged firm using the FCFF approach 4 Rationale for using the Two-Stage FCFF Model ‘+ The eamings before interest and taxes at Federated in 1994, which amounted to $531 million, were still well below EBIT in 1988 of $628 million. The earnings are expected to grow at rates slightly above-stable for the next five years as the firm recovers. + The leverage in 1994 was still significantly above desirable levels, largely as a consequence of the leveraged buyout in the late ‘eighties, It was anticipated that this debt zatio would be lowered gradually over the nent five years to acceptable levels. Background Information© Base Year Information Earnings before interest and taxes in 1994 = 532 million (Capital Expenditures in 1994 =$310 million Depreciation in 1994 = $207 million Revennes in 1994, 7230 million ‘Working Capital as percent of revenues = 25.00% Tax rate: High Growth Phase Length of High Growth Phase = 5 years Expected Growth Rate in FCFF = 8% Financing Details «Beta during high growth phase = 1.25 * Cost of Debt during high growth phase = 9.50% (pre-tax) + Debt Ratio during high growth phase 0% © Stable Growth Phase+ Expected growth rate in FCFF = 5% + Financing Details + Beta during stable growth phase = 1.00 © Cost of Debt during stable growth phase =8.50% ‘© Debt Ratio during stable growth phase = 25% + Capital expenditures are offset by depreciation. Valuation ‘The forecasted fiee cashflows to the firm over the next five years are provided below: T t 7 remminal year EBIT SSTAAS | SOROAT | SOTOOT | S7DS.GF [STBT SE | $820.6 [-PEBITY ¥WERO | SIFTS | SAT AT | SIOUST | SIBTSS | SISAL = CapEx- Depreciation) | SITT24 | SIXOIT | STINTS | SHADTS | SISTSE | — $000 ~Ch Working Capital [STS | SISEIS | SIGEGT | SISLIS | $196.70 [SSI = FCF SOLES | S1BOTT | S1304S | STAO.BT | SISDIS | $5947 ‘Cost oF Equity during high growth phase = 73% 7 115 OS%)= 14 38% Cost of Capital during high-growth phase = 14.38 % (0.5) +9.50 % (1-0.36) (0.5) = 10.23%‘The free cashflow to the firm inthe terminal year is estimated to be $392.42 million FCFF in terminal year = EBITs (1-1) - (Revg-Revs)*Working Capital as % of Revenue =$ 820,61 (1-036) -§ 132.77 =$ 392.42 millions ‘Cost of Equity during stable growth phase = 7.50% ~ 1.00 (5.50%) = 13.00% ‘Cost of Capital in stable growth phase = 13.00% (0.75) + 8.50% (1-0.36) 0.25)= 11.11% ‘Terminal value of the firm = § 392.42 / (1111 - 05) =$ 6,422 millions ‘The value ofthe fim is then the present walue ofthe expected fiee cashflows to the firm and the present value of the terminal value: [PVOFCEF 7 S871] [PV of Terminal Value= | S3.94693 [VaieorFinma= | S4.454.17] [Value of Debt SI OSE [Value of Equity= STBOSST "a Share= | SIs38—] Federated Department Stores was trading at $21 per share in March 1995,am pew Financing Investment Decisions Payout 0.78 sbi Eatio] - ROA-Assets]ROA Future % of EBIT s ka Place [Projects paid out | Puce Proves mai Cost of E (ost of Dest : SRE, fat rate(1-t) Li fer Capita 4% [7-5 9%(1-32): fares: 1 [69-9 million Cost of Capital = [Current Expected Growth Cost of Eguits Eee) BITC) 1-Payout)(ROA)-0.59(13.5%) = 7.94 ° @I@+E)) l139.94 ml 11.4996 8)-8.1%662 1 7 it Cap Ex=0 Future EBIT (1-t Working Capital ler 139.9 mil growing 7, 280 of Revenues TS sone T 1 Eee cot v y FCF) FCER) FCF FCEF, CIF foreve ja——Toss 710. a7—s—i‘i SCC 2183.6 Yearl Year? «= Year3. = -Year$. Year ‘VALUING REPSOL: FCFF Model 313 = 1,290 mllustration 15 = Valuing with the Threesstage FCFF model: LIN Broadcasting ‘+ 4 Rationale for using the Three-Stage FCFF Model ‘+ My three-stage? LIN Broadcasting in a fast growing firm in a fast growing industry segement. Revenues are expected to grow 30% a year for the next few years, + WhyFCFF? LIN Broadcasting has never made a profit after taxes, even though it has posted high growth, because ithas had. high leverage and non-operating expenses. Prior to these charges, however, it eamed a healthy operating income of $128 million in 1994. Thus, though FCFE are negative, FCFF are positive. ‘+ The financial leverage is high but can be expected to decline as the industry stabilizes, Background Information + Curent Earnings + EBITin 1994=$ 128.3 million ‘= Capital Expenditures in 1994= § 150.5 million ‘© Depreciation & Amortization in 1994 = § 125.1 million ‘+ Working Capital was about 10% of revenues in 1994, ‘© Inputs for the High Growth Period ‘* Length of the High Growth Period = 5 yearsExpected growth rate in Revemies /EBIT = 30.00% Financing Details 60 + Beta during High Growth Period * Cost of Equity during High Growth Period = ‘+ The firm will continne to use debt heavily curing this period (Debt Ratio = 60%.),at a pre-tax cost of debt of 10%. (Capital Expenditures and Depreciation are expected to grow at the same rate as revennes and EBIT. ‘Working Capital will remain at 10% of revenues during this period. ‘Weighted Average Cost of Capital = 16 30% (0.40) + 10% (0.64) (0.60) = 10.36% ‘+ Inputs for the transition period Length of the transition period = 5 years Growth rate in EBIT will decline from 30% in year 5 to 5% in year 10 in linear increments, Capital expenditures will grow 8% a year and depreciation will grow at 12% a year during the transition period. Financing Details, + Beta will drop to 1.25 for the entire transtion period + The debt ratio during this phase will drop to 50%, and the pre-tax cost of debt will be 9%.‘Working Capital will remain at 10% of revenues during the period. ‘Weighted Average Cost of Capital = 14.38 % (0.50) + 9% (0.64) (0.50)= 10.07% + Inputs for the Stable Growth Expected Growth Rate in revenues and EBIT= 5% (Captial expenditures and depreciation will grow at the same rate as EBIT. Beta during stable growth phase = 1.00 : Cost of Equity = 7.50% + 1.0 (5.5%) = 13% Debt Ratio during stable phase = 40%; Pre-tax cost of debt will be 8.5%. Estimating the Value + These inputs are used to estimated fre cash flows to the firm, the cost of capital and the present values during the high growth and ‘ransition period — | Period] EBITCI-1)] Cap Exp | Depreciation] Chg. WC] FCFF [Debt Ratio] Beta; WACC jPresent Value TP SIE TS] SISSES | STOLE] SIOSE | SST | SOVIET TO 38% | — SET] T_[SISETT | SISESS | SET AL | SIS RS | ORT | BOWI | THO PTO 38% | S56ET | SISOIT | SSUES | —SITERT | SES SOOT SOOO | TBO] TO 38% | —SEETI—] F_|SUBESY [SORT | SSSTIO_ | S4S39 | SITES | GOOO% THO] 10 36%] STRET POL] FSSC | SASLAT | SHV SISTST | SOOO | TSO 038% | SST]VIELY [SOUS | SSIS | METS [SII] SOON [LIST] STAT SESTST [SESS | SSRLGS | SES OY PSS IT | SOOO TIS | TOOT] SBS SO | SSISST [SOS | SESIST | SST SS SATUS | SU0O% [TIS | TOOT] SISTOS | SSTESV | STOO | STORE| LTO ESOS OT | SOO TIS | TOOT] SIO IO | TO | $607 a3 |SEIL05 | S81S59_| $2426 | SSRO7O | S000 TIS |) STIOSE ‘The terminal valhe at the end of year 10 can be cs ‘based upon the FCFF in year TI, the stable growth rate of 5% and the cost of capital in the stable growth phase — FCEF in year 11 = FCFF in year 10 * 1.05 = $ 580.70 (1.05) = $609.73 i of ~{ of (Cost of Capital in stable period = 13.00% (0.6) + 8.5% (1-36) (0.4) = 9.98% ‘Terminal price = $ 609.73 / (0998 - .05)=$ 12,253.55 millions ‘The components of value are as follows: Present Value of FCFF in high growth phase: $342.64 Present Value of FCFF in transition phase: S914.15 ‘Present Value of terminal firm value at end of transition: $4,633.49 Value of LIN Broadcasting $5,890.27 ‘Less: Value of Outstanding Debt $1,806.60 ‘Value of Equity in LIN Broadcasting: $4,083.67 ‘Value per share $79.29What is wrong wit The issues are the same as in the FCFE Models. (See end of sections on two-stage and three-stage FCFE Models) In addition, his model? (All FCFF Models) the value of the firm may be less than value of debt In some cases, this is entirely feasible. The firm is bankrupt. = In other cases, this may be because the EBIT is depressed. If this 4s the case, nommalize the EBIT.Beyond Inputs: Choosing and Using the Right Model Discounted Cashflow ValuationSummarizing the Inputs @ Insummary, at this stage in the process, we should have an estimate of the * the current cash flows on the investment, either to equity investors (dividends or free cash flows to equity) or to the firm (cash flow to the firm) the current cost of equity and/or capital on the investment the expected growth rate in earnings, based upon historical growth, analysts forecasts and/or fundamentals @ = The next step in the process is deciding * which cash flow to discount, which should indicate + which discount rate needs to be estimated and © what pattern we will assume growth to followWhich cash flow should I discount? @ Use Equity Valuation (a) for firms which have stable leverage, whether high or not, and (b) if equity (stock) is being valued @ Use Firm Valuation (a) for firms which have leverage which is too high or too low, and expect to change the leverage over time, because debt payments and issues do not have to be factored in the cash flows and the discount rate (cost of capital) does not change dramatically over time. (b) for firms for which you have partial information on leverage (eg: interest expenses are missing.) (c) in all other cases, where you are more interested in valuing the firm than the equity. (Value Consulting?)Given cash flows to equity, should I discount dividends or FCFE? @ Use the Dividend Discount Model * (a) For firms which pay dividends (and repurchase stock) which are close to the Free Cash Flow to Equity (over a extended period) * (b)For firms where FCFE are difficult to estimate (Example: Banks and Financial Service companies) m@ Use the FCFE Model * (a) For firms which pay dividends which are significantly higher or lower than the Free Cash Flow to Equity. (What is significant? ... As a rule of thumb, if dividends are less than 80% of FCFE or dividends are greater than 110% of FCFE over a 5- year period, use the FCFE model) * (b) For firms where dividends are not available (Example: Private Companies, IPOs)What discount rate should | use? @ Cost of Equity versus Cost of Capital If discounting cash flows to equity -> Cost of Equity If discounting cash flows to the firm > Cost of Capital @ What currency should the discount rate (risk free rate) be in? Match the currency in which you estimate the risk free rate to the currency of your cash flows m@ Should I use real or nominal cash flows? If discounting real cash flows => real cost of capital If nominal cash flows -> nominal cost of capital If inflation is low (<10%), stick with nominal cash flows since taxes are based upon nominal income If inflation is high (>10%) switch to real cash flowsWhich Growth Pattern Should I use? @ If your firm is * large and growing at a rate close to or less than growth rate of the economy, or * constrained by regulation from growing at rate faster than the economy * has the characteristics of a stable firm (average risk & reinvestment rates) Use a Stable Growth Model @ If your firm * is large & growing at a moderate rate (< Overall growth rate + 10%) or + hasa single product & barriers to entry with a finite life (e.g. patents) Use a 2-Stage Growth Model @ If your firm * is small and growing at a very high rate (> Overall growth rate + 10%) or «has significant barriers to entry into the business * has firm characteristics that are very different from the norm Use a 3-Stage or n-stage Model