Equity Valuation and Analysis Manual

ILPIP Members
Course Manual
Equity
Valuation and Analysis
Copyright © 2008
2008, AZEK/ILPIP
AZEK/ILPIP,
/ILPIP, Geneva
EQUITY VALUATION AND ANALYSIS
COURSE MANUAL
Copyright © 2008, AZEK/ILPIP

Copyright  2008, AZEK/ILPIP

All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, in any form or by any means, electronic, mechanical, photocopying,
recording, or otherwise, without the prior written permission of AZEK/ILPIP.
1) Equity Markets and Structures
2) Understanding the Industry Life Cycle
3) Analysing the Industry Sector and its

Constituent Companies
4) Valuation Model of Common Stock
5) Exercises: Questions
6) Exercises: Solutions
Chapter 1
EQUITY MARKETS AND STRUCTURES


Table of contents
1. Equity Markets and Structure 1
1 .1 Types of equity securities ................................................................................................................... 1

1.1.1 Common shareholders’ rights ........................................................................................................... 1
1.1.1.1 Control......................................................................................................................................... 1
1.1.1.2 Dividend Income ......................................................................................................................... 3
1.1.1.3 Limited Liability.......................................................................................................................... 3
1.1.1.4 Asset rights .................................................................................................................................. 3
1.1.1.5 Pre-emptive rights ....................................................................................................................... 3
1.1.1.6 Right of transfer........................................................................................................................... 4
1.1.2 Authorised and outstanding shares .................................................................................................... 4
1.1.3 Issuing Equity ................................................................................................................................... 4
1.1.3.1 Approval from the Board of Directors ........................................................................................ 5
1.1.3.2 The role of an investment banker ................................................................................................ 5
1 .2 Indices .................................................................................................................................................. 6
1.2.1 The uses of stock indexes.................................................................................................................. 6
1.2.2 How stock indexes are calculated ..................................................................................................... 6
1.2.2.1 Number of stocks in an index ...................................................................................................... 6
1.2.2.2 Method of calculating an index ................................................................................................... 7
1. Equity Markets and Structure
1.1 Types of equity securities

The most popular securities among investors throughout the world are the shares of common
stock or equity of a firm. These shares represent the residual claim on the firm’s earnings. The
term residual claim implies that the earnings of the firm belong to the common shareholders
of the firm after satisfying all other claims. These claims are employees’ wages/salaries,
interest and principal payments to creditors who have advanced short- and long-term loans to
the firm, taxes, and claims of preferred shareholders. Thus, common shares are junior to all
other corporate securities. Common share capital (or common stock) represents the risk
capital provided by the owners of the firm. Because of the risk borne by common shareholders
through their investment in the firm, they enjoy certain rights that are not available to owners
of corporate debt or preferred stock.
1.1.1 Common shareholders’ rights
1.1.1.1 Control
Since the common shareholders own the firm, they enjoy the right to manage the firm.
Typically, the majority of a firm’s shares are held by tens of thousands of small shareholders.
Therefore, day-to-day management of the firm is entrusted to professional managers, who, in
turn, report to the board of directors. The firm’s stockholders elect the members of the board
of directors every year.
The elections for the membership of the board of directors can be made either by the system
of majority voting or by cumulative voting. Under the majority voting system each share
represents the right to cast one vote for each position on the board. Any candidate receiving
more than 50% of the votes cast will get elected to the board. This system gives the majority
shareholder absolute control over the board as he can elect all the members of the board.
A number of state and local governments frown upon the practice of majority voting because
the majority shareholder will usually pack the board with his supporters thus denying the
minority shareholders any voice in the running of the firm. These governments may require
that the election of the board be organised under the cumulative voting system, wherein each
share represents as many votes as the number of directors to be elected. In the majority voting,
only one vote per share can be assigned to one candidate. But in the cumulative voting system,
all the votes per share (i.e., number of directors to be elected) can be assigned to a single
candidate. This increases the chances that minority shareholders may be able to elect a few
directors on the board. One can, in fact, calculate the number of shares needed to elect one
member of the board, as follows:
T
S min = +1
N +1
where.
Smin minimum number of shares needed
T total number of shares outstanding
N total Number of directors to be elected
chapter 1 / page 1
The following example will make the concept clear:
Example
The Zodiac Corp. has 10 million shares outstanding. If Zodiac has nine members on the board of
directors who get re-elected every year, calculate the number of shares needed to elect one member
on the board of directors.
In Zodiac’s case, each share has nine votes and these can be assigned to the member the minority
shareholders wish to elect. The minimum number of shares so that one member of your choice can
be elected will be
10'000'000
S = + 1 = 1'000'001shares
min 9 +1
Thus, even a shareholder who only owns 10% of the firm’s stock can get a member of his/her
choice elected to the board. Under the majority-voting scheme, this will not be possible.
Alternatively, the following formula will allow one to determine how many members on the
board can be elected with a given number of shares.
(S − 1)( N + 1)
n=
T
where:
n number of directors who can be elected
S given number of shares
N total number of directors to be elected
T total number of shares outstanding
Example:
If Walter Hadlee owns 2.5 million shares of Zodiac Corp. (see above), how many directors can he
hope to elect?
The total number of votes available with Walter will be 2.5 million x 9 directors to be elected =
22.5 million votes. He must use these votes judiciously to maximise the number of directors he can
elect.
n=
(2'500'000 − 1)⋅ (9 + 1) = 2.5
10'000'000
(rounding down, as fractional directors are meaningless)
Thus, Walter can hope to elect two directors. Walter should therefore distribute his votes to two
candidates of his choice.
Sometimes, a group of shareholders that is unhappy with the way the firm is being managed
may challenge the existing management. This “dissident” group will try to wrest control of the
firm by challenging the controlling group of shareholders. These challenges are usually in the
form of proxy fights. Proxy fights will involve the existing management and the challenger
group both appealing to the shareholders of the firm to vote in their favour so that the firm can
be managed better.
Mergers and acquisition are other methods of taking over the control of a firm. The strategies
involved in mergers and acquisition are discussed in detail in a subsequent chapter.
chapter 1 / page 2
1.1.1.2 Dividend Income
As mentioned above, common shareholders have the residual right to the earnings of the firm.
Residual earnings are earnings of the company after meeting the claims of all other security
holders, the government, and the employees of the firm. Each share is entitled to receive an
equal amount in cash dividends. The shareholders of a profitable firm expect the firm to pay
dividends to its shareholders. However, shareholders have no legal rights to dividends and
firms occasionally skip cash dividends. The cash not paid out as dividends still belongs to the
shareholders and will therefore be treated as capital reinvested by them in the firm. This
reinvestment is reflected in the balance sheet of the firm as additions to Retained Earnings (or
Reserves, as they may be called in some countries).
Some companies resort to paying stock dividends to conserve cash, or when they are in
financial difficulties, or if they face contractual restrictions. Stock dividend payment involves
issuing additional shares to the existing shareholders of the firm. A 2% stock dividend will
require the firm to give 2 additional shares for every 100 shares owned by a shareholder.
When the stock dividend percentage exceeds 25%, it is called a stock split under NYSE
guidelines.
1.1.1.3 Limited Liability

The reason why shares of corporations are very attractive investments for the public at large is
that the investors’ liability with regard to the firm is limited to their investment in the firm.
This feature is called the limited liability. Unlike the common shareholders who own assets of
a corporation, the owners of sole proprietorship and partnerships do not enjoy the benefit of
limited liability. If a sole proprietorship or a partnership ends up owing more than the value of
its assets, the creditors of the firm have the right to recover the difference between the amount
of debt and the value of the firm’s assets from the owners of the firm. Thus, the owners of a
sole proprietorship or partnership have unlimited liability.
The limited liability enjoyed by common shareholders is more like a call option owned by
shareholders. If the company is profitable and growing, the shareholders participate in the
profits and the growth of the firm after all the fixed claims are met. On the other hand, if the
firm keeps on making losses and has debts larger than the value of the assets, the shareholders
can simply walk away from the firm leaving the assets for other claimants.
1.1.1.4 Asset rights

Just as in the case of earnings, shareholders also have the residual claims on the assets of the
firm. If the firm goes bankrupt, the firm’s assets have to be liquidated and the claims on the
firm’s assets have to be paid off. Since the common shareholders’ claims are the most junior,
all other claimants such as creditors, governments, bondholders and preferred stockholders
have to be paid off first. If any funds are left after all other claims are settled, the common
shareholders will share equally in the same. The residual nature of shareholders’ claim makes
common shares the most risky among all securities issued by corporations.
1.1.1.5 Pre-emptive rights

The pre-emptive right is a provision that entitles shareholders to maintain their fraction of
ownership in the firm. Thus, if the firm issues any new shares of common stock, the existing
shareholders will have the right to purchase new shares in the same proportion as their current
holding. Firms may eliminate this right by amending their charters so that they may be able to
issue new shares for the purpose of mergers, acquisition or to meet the needs of ESOPs
(Employee Stock Ownership Plans).
chapter 1 / page 3
The pre-emptive right necessitates what is called the rights offering. A rights offering is the
issue of new shares of the firm, which is open for subscription only to the existing
shareholders. Usually, shares are offered for subscription in a rights offering at a substantial
discount to the market price. Each existing share will receive one right. The number of rights
needed to purchase a share depends upon the ratio of new shares issued to currently
outstanding number of shares. Assume that a company, which has 10 million shares
outstanding at present wishes to issue 1 million new shares through a rights offering. Since
each existing share receives one right, ten million rights will be created. These ten million
rights are created to purchase one million new shares. Therefore, ten of these rights will be
needed to purchase one share in the new issue.
Because the share price in the rights offering is below the market price of the common stock,
the rights have a value by themselves. Investors who may not wish to exercise their right
benefit by simply selling it to an investor who wishes to buy the shares in the offering. The
valuation of rights is discussed elsewhere in the course material.
1.1.1.6 Right of transfer

Common shareholders can easily transfer their ownership in the firm to another investor. In
publicly traded companies, the owner may seek help from a registered securities broker to sell
the stock. In countries where securities markets are well developed, the transfer is affected
within a few working days and the purchaser of the shares is registered with the firm as the
owner of the shares. He will receive cash dividends from the firm that day onwards.
1.1.2 Authorised and outstanding shares

In reading the financial statements of a firm, one comes across the terms “authorised,” and
“outstanding” shares. The firm’s charter specifies the maximum number of shares the
company is legally entitled to issue. If the firm needs to issue more than this number of shares,
it has to amend the charter to do so. Most firms will have a very large number of shares as
authorised shares, while they may initially issue a much smaller number of shares. This allows
them to raise additional funds through common stock issues without amending the charter.
The shares in the hands of public are called outstanding shares.
In some cases, the number of shares issued and shares outstanding may not be the same. The
difference between the two arises due to the stock repurchase (or stock buyback, as it is called
in some countries) wherein the issuing firm may repurchase its own stock on the open market.
The number of shares repurchased will make up a block of shares called treasury shares.
Thus, the number of shares issued will be equal to the sum of the number of shares
outstanding and treasury shares.
1.1.3 Issuing Equity

Established companies sparingly use common stock as a source of external financing. But
smaller firms, start-ups and high-growth firms use equity to raise funds needed for their
growth. It is therefore important for an analyst to understand the mechanism of issuing equity
to raise funds.
The steps in the process of issuing equity will vary from country to country. The following
discussion is based on the practices used by firms to issue equity.
chapter 1 / page 4
1.1.3.1 Approval from the Board of Directors
The issue of new equity to public will require the approval of the board of directors.
1.1.3.2 The role of an investment banker

Once the approval of board of directors is obtained, the firm selects an investment banker (or
a merchant banker, as they are called in some countries) to manage the issue. If the issue size
is small, one investment-banking firm will be retained to undertake the issue. If the issue size
is large, a syndicate of investment bankers may perform the task.
The investment banker is retained by the issuing firm to advise and counsel the issuing firm
about the regulations regarding equity issue. The investment banker is also expected to
evaluate the market conditions to determine the timing of the issue and at what price the
security should be issued.
Depending on the reputation of the issuing firm, the issue may be underwritten. When an
equity issue is underwritten, the investment banker or bankers will guarantee the sale of the
issue. If the public does not subscribe the entire issue then the underwriter will purchase the
balance of the issue. This guarantees the issuing firm that the entire issue will be sold out and
the necessary funds raised. However, this guarantee will be available only to the most
reputable firms whose shares will be sought after by the public. Lesser known firms will not
be able to get their equity issue underwritten, but will have to be satisfied with a best-efforts
deal from the investment banker.
The investment banker also undertakes the distribution of the shares. To do this, the
investment banker must first register the issue with the regulatory authorities. The registration
will require that the issuing firm provides information about itself, the type and the amount of
security being offered and the purpose for which the funds are being raised.
To inform the public about the issue of equity, the investment banker will then publish a
Prospectus, which outlines the price of the share, offering date and the financial information
about the issuing firm. The investor is expected to decide to subscribe to the share issue only
upon receiving the information contained in the prospectus.
After the issue of the shares, they are generally listed on a stock exchange (a marketplace
where shares are traded). Each stock exchange has its own listing requirements.
The issue of shares by a firm entering the capital market for the first time is called an initial
public offering (IPO). The question of pricing IPOs is particularly interesting for analysts.
When a company issues shares for the first time, the correct value of the shares can only be
guessed. The investment bankers usually err on the conservative side when pricing IPOs, i.e.,
IPOs are usually under priced. It is not uncommon for the IPOs to experience huge price
increases during the first few sessions of trading after listing. This phenomenon ensures that
the investment bankers will have a strong demand for IPOs.
chapter 1 / page 5
1.2 Indices
Stock indexes (or indices) are created to provide investors with the information regarding the
average share price on the stock market. Since shares of thousands of companies (around
2,000 on NYSE and 3,300 on NASDAQ) are traded on any given day in the stock market, it is
impossible to keep track of all the price movements and discern the direction in which the
market is going. A stock index represents the average price of shares trading on a stock
exchange. The average is computed using the prices of only a handful of stocks that are
deemed to be the most representative of the market as a whole.
1.2.1 The uses of stock indexes

The first and foremost use of a stock index is as a measure of performance of the market.
Since the index is based on representative stocks, an increase in the index signifies an increase
in prices of a majority of stocks.
Investment analysts find the stock index a useful tool in determining the factors underlying
stock price movements. Historical information about the index and macro-economic variables
can be correlated to analyse factors related to share price movements.
A number of analysts (“Technical analysts”) believe that historical share price movements can
help one to predict future price movements. These analysts use the stock index data to forecast
the direction of the market.
Stock indexes have been very useful in portfolio management. A broad-based stock index is
normally used as a proxy for the “market” portfolio and used in determining the systematic
risk of portfolio being managed. This helps portfolio managers make investment decisions.
Free market economies are subject to business cycles; thus, the economic growth varies from
one period to another. It is extremely important for businesses to predict when the economy
will start expanding or when it will slide into a recession. Stock prices have been found to be
leading indicators (i.e., stock prices rise/fall before the economic expansion/recession) of the
economy. Thus, the changes in stock indexes can be used as an indicator of the direction of
the economy.
1.2.2 How stock indexes are calculated

There are two important factors in determining the utility of a stock index: the number of
stocks to be included in the index and the method of calculating the average price.
1.2.2.1 Number of stocks in an index

Ideally, a stock index should be based on as many stocks in a given market as possible. This
index will then be truly representative of the market. However, in the past, the cost of
calculating such an index on a continuous basis was found to be too much. Thus, most stock
indexes created prior to the computer age included very few stocks. A prime example of this
is the best-known stock index in the world: the Dow-Jones Industrial Average (DJIA). DJIA
was created in the year 1896 with only 12 stocks. Over the years, more stocks have been
added to it and now it is based on 30 stocks. On the other hand, more modern Standard and
Poor’s 500 index consists of 500 stocks, while NYSE Composite Index is based on the prices
of all stocks traded on the New York Stock Exchange.
chapter 1 / page 6
The following table shows how many stocks are included in some of the indexes on the most
important stock exchanges in the world:
Stock Market Index Name No. of Shares

New York SE DJIA, S&P 500, NYSE Comp. Index 30, 500, around 2000
NASDAQ NASDAQ Composite Around 3300
London Financial Times 100
Paris CAC40 40
Frankfurt DAX 30
Zurich SMI 27
Milan MIB30 30
Tokyo TOPIX100 100
Toronto Toronto Composite 223
Singapore Straits Times 45
Hong-Kong Hang Seng 33
1.2.2.2 Method of calculating an index

Stock indexes are calculated using different methods of determining the average price of
shares. The two most widely used methods are: 1) Price-weighting and 2) Value-weighting.
Price-weighted indexes
Price-weighted indexes are calculated simply as the average share price of stocks included in
the index on a given day. Thus, on the very first day the DJIA was calculated, the share prices
of all the 12 stocks were added and then divided by 12 (called the divisor) to calculate the
value of the index. Over the long run, however, this calculation method will introduce errors
in the value of the index due to stock splits and stock dividends. To eliminate these errors, the
divisor has to be continuously adjusted. Thus, even though the index is now based on 30
stocks, the divisor used in calculating the index is closer to 2 and is continually adjusted to
reflect the changes in the number of shares outstanding of the member firms due to stock
splits and stock dividends.
The price-weighting scheme suffers from a number of drawbacks. High-priced stocks affect
the index much more than low-priced stocks. The divisor is usually not adjusted for stock
dividends of less than 10%. This creates another error in computing the index. The DJIA in
particular is based on a very small sample (30) chosen from the 2,000 or so stocks trading on
the NYSE. These stocks represent mainly large industrial firms. Thus, the DJIA cannot be
truly representative of the market as a whole.
Value-weighted indexes
The alternative method of index calculation is the value-weighting scheme. Here the market
values of all the firms included in the index are added and divided by the market value of the
firms on the day the index was first calculated. The Standard and Poor’s 500 index is
calculated using the following formula:
chapter 1 / page 7
500
∑p j
t ⋅ q tj
j−1
Index = 500
⋅ 10
∑p j
0 ⋅q j
0
j=1
where:
p tj , p 0j share price of stock j on day t and 0, respectively.
q tj , q 0j number of shares outstanding of stock j on day t and 0, respectively.
This method of calculation eliminates some problems inherent in the price-weighting method.
Stock splits and stock dividends do not affect the index as the index accounts for the market
value of equity rather than the price of a share. High-priced stocks do not necessarily have a
bigger impact on the index. It is market value that matters. Large market value firms will
affect the index more than small market value firms. Finally, as it is based on a sample of 500
stocks, S&P 500 is more broad-based and thus more representative of the market as a whole.
An exception to the above two types of stock indexes is the Value Line Index that is
calculated as the geometric mean of share prices of all stocks included in the index.
chapter 1 / page 8
Chapter 2
UNDERSTANDING THE
INDUSTRY LIFE CYCLE


Table of contents
2. Understanding the industry life cycle* 1
2 .1 The top-down approach* ................................................................................................................... 1
2 .2 The bottom-up approach* ................................................................................................................. 1
2 .3 The “new” top-down approach* ....................................................................................................... 3
* final level
2. Understanding the industry life cycle*
The top-down approach (see below) is an institution. Almost every international investment
strategy relies on it. A large number of studies have proved that the behavior of the major
economic aggregates determines the performances of financial assets, i.e. stocks and bonds. In
the case of stocks, the top-down process most often involves two successive decisions:
allocation by country and/or region and then, within each country and/or region, individual
stock selection.
2.1 The top-down approach*

Basic assumption
The performance of an equity portfolio depends primarily on the asset allocation by
country/region.
Process
1. Each country's economic aggregates, e.g. GDP, inflation, interest rates and exchange
rates are analyzed.
2. Forecasts of those aggregates are then made.
3. Market valuations are assessed.
4. Each market’s upside potential is estimated.
5. Assets are allocated by market.
6. Individual stocks are then selected within each market.
Conversely, most individual investors follow a bottom-up approach in selecting their stocks
(although they quite often skip the first five stages of the following process).
2.2 The bottom-up approach*

Basic assumption
The performance of an equity portfolio depends primarily on the selection of individual
stocks.
Process
1. Variables (business, management, financing, etc.) for each company are analyzed.
2. Company forecasts are made (earnings, free cash flows, etc.).
3. The risk associated with those forecasts is estimated.
4. The company is valued on the basis of its asset value and its return value (for instance
by using a DCF model).
5. The upside potential of each stock is estimated (for various time horizons).
6. Individual stocks are then selected.
Some famous asset managers, in particular Peter Lynch and Warren Buffet, also favour the
bottom-up approach. But as professionals, they would for surely strongly suggest that you
spend most of your time on the first 5 steps of the above process.
chapter 2 / page 1
Understanding the industry life cycle has always been considered as a central issue by
corporate analysts, because there is a close correlation between the company-specific product
cycle and the corresponding industry cycle.
Most economists and strategists, on the other hand, have neglected this factor for a long time,
for both good and bad reasons:
The good reasons

Until recent years, diversifying an international equity portfolio by region proved much
more effective than diversifying it by industry.
The industry cycle is supposed to be captured by the equity analysts, who should take it
into account at the last stage of the top-down process, i.e. when selecting individual
stocks.
The bad reasons

Country economic aggregates, e.g. the United States’s GDP, are available, whereas useful
industry aggregates are still missing. Admittedly, however, that does not mean that
spending time analyzing industry cycles is not a key factor in successful asset allocation.
There is no widely-accepted classification as regards industries, whereas everyone (with
the exception of nations claiming their independence) acknowledges the official country
“classification”. We all agree that the United States and the United Kingdom are different
countries, even though they share the same language. What about the software and the
semiconductor industries? Are they really different, or just “sub-industries” belonging to
the same sector, i.e. technology? Once again, that does not mean that spending time
analyzing industry cycles is not a key factor in successful asset allocation.
Recently, a new body of research has focused on assessing a strategy aimed at optimally
shifting exposure among global industry sectors. It had become increasingly obvious that
more value could be added by selecting the right industries at the right time than before,
because of:
1. The emergence of new industries (particularly those related to the Internet). Emerging
industries are similar to emerging countries. Because of their low correlation with
more mature industries, they offer a good way to improve the expected return of a
portfolio while reducing its risk. After the Case for International Diversification, here
comes the Case for Interindustry Diversification.
2. The increasing correlation between the most developed equity markets, which can be
explained by several factors:
- the convergence of European monetary, fiscal and economic policies
- the ongoing expansion of large, multinational companies
- the gradual reduction of barriers to international trade and investment.
In other words, diversifying assets by country has become less and less effective over the past
few years, whereas allocating money by industry has proved increasingly attractive, so much
so that the authors of some recent articles have suggested that strategists implement a “new”
top-down approach.
chapter 2 / page 2
2.3 The “new” top-down approach*
Basic assumption
The performance of an equity portfolio depends primarily on the asset allocation by industry.
Process
1. Each industry's aggregates are analyzed.
2. Forecasts of those aggregates are then made.
3. Sector valuations are assessed.
4. Each sector’s upside potential is estimated.
5. Assets are allocated by industry.
6. Individual stocks are selected within each industry.
Whatever the investment process, understanding industry cycles is key to building an equity
portfolio. The life cycle (or long-term cycle) can be distinguished from the business cycle (or
short-term cycle).
The first is very similar to a product life cycle. Like Bodie, Kane and Marcus, and other
authors, we can highlight four successive stages in any industry life cycle:
Sales
Maturity
Decline
Consolidation
Start-up
Time
Start-up stage
The first stage is characterized by the emergence of a new product, technology and/or business
model. Internet-related services, such as on-line investment research dedicated to individuals,
are typical examples. It is very difficult to predict which firms will survive and potentially
become industry leaders. Selecting the right stocks is not an easy task, to say the least.
Therefore, individual investors, and also most investment professionals, are strongly advised
to play the industry through mutual funds managed by true experts.
Consolidation stage
The second stage is characterized by the appearance of industry leaders. The mobile phone
sector is a quite obvious example. The product has become established. Sales and earnings
growth – although higher than average – are easier to forecast. Hence, selecting stocks is less
risky, and well-informed investors may start buying individual stocks. But those who do not
have enough time to closely monitor their investments should stick to mutual funds.
chapter 2 / page 3
Maturity stage
The third stage is characterized by greater price competition. TV sets are in this stage. The
product has reached its full potential for use by consumers, and it has become more or less
standardized. Profit margins are gradually coming under pressure and cost-cutting programs
may already be necessary. Companies are much more exposed to the business cycle (see
below). Selecting individual stocks can nevertheless be quite safe (if the industry – such as
food & drinks – is not cyclical and the maturity stage is due to last for a long time). But it can
also be much riskier (if the industry – such as car makers – is cyclical, and/or if the product –
such as video cassettes – is about to be replaced by a new one).
Decline stage
The fourth stage is, after lower-than-average growth, characterized by shrinking sales. This is
often due to the obsolescence of the product. Selecting individual stocks here – as in the start-
up phase, ironically – is a difficult task. The focus should be on turnaround situations and
asset plays. Once again, individual investors and most investment professionals would be wise
to play such industries through mutual funds managed by true specialists, instead of trying to
do the job themselves.
Peter Lynch uses another – although related – industry classification system. He divides firms
into the following six groups:
Slow growers
Large and aging companies that will grow only slightly faster than the broad economy. This
category corresponds to the beginning of the maturity stage described above.
Stalwarts
Large, well-known firms like Coca-Cola. They grow faster than the slow growers, but are not
in the very rapid growth start-up phase. This category corresponds to the end of the
consolidation stage described above.
Fast Growers
Small and aggressive new firms with annual growth rates in the neighbourhood of 20% to
25%. This category corresponds to both the start-up stage and the beginning of the
consolidation stage described above.
Cyclicals
These are firms with sales and profits that regularly expand and contract along with the
business cycle. This category does not correspond to any of the stages described above,
because it refers to the short-term cycle, i.e. the business cycle, not to the long-term cycle, i.e.
the life cycle. In fact, cyclical firms can be either in the start-up stage (digital books), in the
consolidation stage (mobile phones), in the maturity stage (TV sets) or in the decline stage
(turntables).
Turnarounds
These are firms that are in bankruptcy or soon might be. That can be due to a continuous sales
drop, i.e. the company is in the decline stage. But it may also be the result of a cash squeeze,
and in this case, the company could be in any of the stages described above. We might, for
instance, be faced with a start-up that was not able to raise new funds because of troubled
stock markets. In other words, this category does not strictly correspond to any of the stages
described above.
chapter 2 / page 4
Asset plays
These are firms that have valuable assets not currently reflected in the market prices of their
stocks. Like cyclicals, this category does not correspond to any particular life-cycle stage. You
may find asset plays – usually companies with sizable tangible assets, for instance real estate –
in all four stages.
As regards industry classifications, we would suggest that you forget about special situations
like turnarounds and asset plays, which are stock-specific, and not industry-specific concepts.
As we have already said, the slow-grower, the stalwart and the fast-grower categories can be
viewed as life-cycle stages.
The cyclical companies category, for its part, refers to the business cycle, not to the life cycle.
So does another category, that of the so-called “defensive” firms. These companies are not –
or less – affected by economic downturns, and they do not benefit – or benefit less – from
economic recoveries. The following table provides examples for both the life cycle and the
business cycle:
Defensive Cyclicals
Start-up Health-promoting nutrients Digital books
Consolidation Diet food Mobile phones
Maturity Washing powder TV sets
Decline High-tar cigarettes Turntables
Paul and Carole Huebotter have suggested dividing the business cycle into four phases, with
the objective of optimizing industry allocation. Their theory applied to the U.S. equity market,
but it could well be extended to all the developed markets.
Phase 1
This phase starts at the bottom of a recession. People who are still working – probably 90% to
93% of those who want to – are not much afraid of losing their jobs. Family purchases
deferred during times of uncertainty start being made again. Sales of big-ticket items such as
cars and major appliances pick up. Interest rates are at their lowest, so it's a good time to buy
or build a house. With growing confidence, families go out more, travel more, and indulge in
entertainment more. For different reasons, the energy industries are also doing well. It is clear
to business leaders that a new cycle has begun, and that the energy needs for the new cycle
will exceed those of the previous one.
Phase 2
The economy is growing too fast. At this point, the Federal Reserve begins to raise interest
rates to prevent overheating and an upsurge of inflation. During such periods, interest-
sensitive industries such as utilities and financials do poorly, as does the bond market. The
consumer cyclical group falls out of investor favour as higher interest rates start putting
pressure on housing starts and big-ticket purchases. At this stage of the economic recovery,
manufacturing is operating at close to full capacity and raw-material inventories are low. The
metals, chemicals, paper and forest products industries are now producing flat-out to restock
the finished-goods industries. Higher prices start appearing on these building-block materials,
and their producers have the best of all possible worlds – strong demand and higher prices. As
full-capacity utilization nears, efficiency and productivity begin to be emphasized. At that
chapter 2 / page 5
point, the industry invests in computers, software, automation equipment and communications
in an effort to meet demand with existing plant capacity.
Phase 3
Interest-rate hikes during phase 2 finally have their intended effect on the economy, and the
desired soft landing is achieved. GDP growth declines, though it remains strongly positive.
Transport industries thrive due to the brisk pace of commerce and the large volume of goods
being shipped. Capacity expansion benefits the capital-goods industry. Interest rates, though
high, are now stable. This helps the financial industries, which cash in on strong loan demand
and reliable margins.
Phase 4
This phase begins with a sharp decline of the growth rate. Inflation fears are now subordinate
to fears of recession. At this stage, the Fed tries to stimulate the economy with a series of
interest-rate cuts. Despite layoffs and less job security, the demand for utility services and
food and other consumer noncyclicals is relatively unaffected.
chapter 2 / page 6
Chapter 3
ANALYSING A SECTOR OR INDUSTRY

AND ITS CONSTITUENT COMPANIES


Table of contents
3. Analysing a Sector or Industry and its Constituent Companies* 1
3 .1 The sector or industry* ...................................................................................................................... 1

3.1.1 The U.S. Census Bureau classification*............................................................................................ 1
3.1.2 The MSCI/S&P classification* ......................................................................................................... 2
3.1.3 The Dow Jones classification* .......................................................................................................... 3
3 .2 Characteristics of the industry* ........................................................................................................ 4
3 .2 .1 Characteristics of the products and services*.................................................................................... 4
3 .2 .2 Characteristics of the clients* ........................................................................................................... 5
3 .2 .3 Characteristics of the suppliers* ....................................................................................................... 5
3 .2 .4 Characteristics of the labor force* .................................................................................................... 6
3 .2 .5 Characteristics of shareholders (and of other capital suppliers)* ...................................................... 6
3 .2 .6 Characteristics of the environment* .................................................................................................. 7
3 .3 Macro factors* .................................................................................................................................... 8
3 .4 Forecasting for companies in the industry* ................................................................................... 15
3 .5 Balance-sheet factors* ...................................................................................................................... 17
3 .6 Corporate strategy* ......................................................................................................................... 19
3 .7 Valuations* ....................................................................................................................................... 21
* final level
3. Analysing a Sector or Industry and its Constituent Companies*
3.1 The sector or industry*

How to define a sector and/or an industry? We have said in chapter 2.2 that there is no widely
-accepted classification as regards industries, whereas everyone acknowledges the official
country “classifications”. In fact, as regards industries, there are several classifications
competing with one another. Which one is going to win? Nobody knows.
3.1.1 The U.S. Census Bureau classification*

The U.S. Census Bureau is part of the U.S. Department of Commerce. Its mission is to be the
pre-eminent collector and provider of timely, relevant and quality data about the people and
the economy of the United States.
The North American Industry Classification System (NAICS) was developed jointly by the
U.S., Canada and Mexico in 1997 to provide new comparability in statistics on businesses
across North America. This new system is replacing the U.S. Standard Industrial
Classification (SIC) system.
It recognizes the following 20 broad sectors:
Code NAICS Sectors

11 Agriculture, Forestry, Fishing and Hunting
21 Mining
22 Utilities
23 Construction
31-33 Manufacturing
42 Wholesale Trade
44-45 Retail Trade
48-49 Transportation and Warehousing
51 Information
52 Finance and Insurance
53 Real Estate and Rental and Leasing
54 Professional, Scientific, and Technical Services
55 Management of Companies and Enterprises
56 Administrative and Support and Waste Management and Remediation Services
61 Education Services
62 Health Care and Social Assistance
71 Arts, Entertainment, and Recreation
72 Accommodation and Food Services
81 Other Services (except Public Administration)
92 Public Administration
The previous classification (SIC) recognized only 10 divisions (i.e. Agriculture, Forestry and
Fishing; Mining; Construction; Manufacturing; Transportation, Communication and Public
Utilities; Wholesale Trade; Finance, Insurance and Real Estate; Services; Public
Administration). You will note that a great deal of improvement has been made in the field of
services, which have now been divided into 7 new categories.
chapter 3 / page 1
NAICS industries are identified by a 6-digit code, in contrast to the 4-digit SIC code. The
longer code accommodates the larger number of industries and allows more flexibility in
designating sub-industries. It also provides for additional detail not necessarily appropriate for
all three NAICS countries. The international NAICS agreement sets only the first five digits of
the code. The sixth digit, where used, identifies subdivisions of NAICS industries that
accommodate user needs in individual countries. Thus, 6-digit U.S. codes may differ from
their counterparts in Canada or Mexico, but at the 5-digit level they are standardized.
Example of NAICS Hierarchy

Sector 51 Information
Subsector 513 Broadcasting and telecommunications
Industry group 5133 Telecommunications
Industry 51332 Wireless telecommunications carriers, except satellite
U.S. Industry 513321 Paging
350 new industries were separately recognized for the first time with NAICS. A few of those
industries reflect “high tech” developments such as fiber optic cable manufacturing, satellite
communications and the reproduction of computer software. More of them recognize less
technological changes in the way business is done: bed and breakfast inns, environmental
consulting, warehouse clubs, pet supply stores, credit card issuing, diet and weight reduction
centers.
Note that the U.S. Office of Management and Budget (OMB) has already made proposals as
regards the North American Industry Classification System (NAICS) updates to be adopted in
2002. The OMB's Economic Classification Policy Committee (ECPC) recommends an update
of the industry classification system to extend the harmonized three-country classification
structure to construction and to recognize important changes in retailing and information.
3.1.2 The MSCI/S&P classification*

The world's two premier providers of index services, Morgan Stanley Capital International
(MSCI) and Standard & Poor's (S&P), together have launched a new global industry
classification standard aimed at making the investment research and management process
easier for financial professionals worldwide.
The classification standard consists of 10 Sectors aggregated from 23 Industry Groups,

59 Industries, and 123 Sub-industries covering almost 6’000 companies in all.
Code MSCI Sectors

10 Energy
15 Materials
20 Industrials
25 Consumer Discretionary
30 Consumer Staples
35 Health Care
40 Financials
45 Information Technology
50 Telecommunications Services
55 Utilities
chapter 3 / page 2
Example of MSCI Hierarchy
Sector 45 Information Technology
Industry group 4520 Technology Hardware & Equipment
Industry 452010 Communications Equipment
Sub-industry 45201010 Networking Equipment
3.1.3 The Dow Jones and FTSE classification - ICB *

Dow Jones Indexes and FTSE have created a classification system called the Industry
Classification Benchmark (ICB). The system is supported by the ICB Universe Database,
which contains over 40,000 companies and 45,000 securities worldwide from the FTSE and
Dow Jones universes.
SWX indices have adopted the Industry Classification Benchmark (ICB) sector definitions
since January 2006. The ICB structure is also used by the NASDAQ, NYSE, London Stock
Exchange, Euronext, STOXX, Hang Seng, Russell, Dow Jones Wilshire, the Financial Times,
The Wall Street Journal, CNBC and SmartMoney.
ICB is a detailed and comprehensive structure for sector and industry analysis, facilitating the
comparison of companies across four levels of classification and national boundaries. The
system allocates companies to the Subsector whose definition most closely describes the
nature of its business. The nature of a company's business is determined by its source of
revenue or where it constitutes the majority of revenue.
10 Industries help investors monitor broad industry trends

18 Supersectors can be used for identifying macroeconomic opportunities for
investment and trading decisions
39 Sectors provide a broad benchmark for investment managers
104 Subsectors allow for more detailed quantitative and qualitative analysis
The 10 Industries are

Oil & Gas
Basic Materials
Industrials
Consumer Goods
Health Care
Consumer Services
Telecommunications
Utilities
Financials
Technology
Example of ICB Hierarchy for the company 'Puma AG':

Industry 3000 Consumer Goods
Supersector 3700 Personal & Household Goods
Sector 3760 Personal Goods
Subsector 3765 Footwear
Description: Manufacturers and distributors of shoes, boots, sandals, sneakers and other
types of footwear.
chapter 3 / page 3
3.2 Characteristics of the industry*
In order to assess both the growth potential and the risk of a specific industry, we might go
through the following checklist, and answer the questions as precisely as possible. Note that
these same questions may also be useful for analyzing a specific company.
3.2.1 Characteristics of the products and services*

Which life-cycle stages are the products/services in?
Start-up-stage industries usually exhibit the highest sales growth. But they are faced with
losses and negative cash flows. As we highlighted in Chapter 2.2, those industries are much
riskier than average.
Consolidation-stage industries usually exhibit the highest earnings growth. Those industries
are less risky than start-up-stage industries, since the products/services have become
established.
Maturity-stage industries usually exhibit low sales and earnings growth, but they generate a lot
of cash. Those industries are normally the least risky of the four life-cycle categories, provided
that 1) competition within the industry is not too intense (slow industry growth contributes to
competition) and 2) they are not near the decline stage yet.
Decline-stage industries exhibit – by definition – a decrease in sales and/or profits. They may
still be cash cows, but this cannot last for long unless, for whatever reason, they enter a revival
phase (which happens sometimes). They are riskier than maturity-stage industries, and
sometimes even riskier than start-ups (for instance, when most companies of the industry are
close to bankruptcy).
To what extent do the products/ services fulfill basic needs?

Industries corresponding to basic need are usually less sensitive to changing market
conditions, i.e. to the business cycle. In other words, they are less risky. Note that this factor
has nothing to do with profitability and/or long-term earnings prospects. Cyclical industries
may be just as profitable, and grow just as fast as defensive ones.
How uniform are the products/services?

Industries selling very uniform products/services are usually riskier than the ones providing
relatively complementary ones. If something goes wrong in the first case – say, for instance,
volumes are under pressure because the industry is faced with an economic downturn – all the
companies in the industry are affected in the same way. In addition, as competition is often
higher in the uniform industries, margins may be under pressure.
How transportable are the products/services?

As competition from abroad is potentially higher, industries selling easily-transportable
products/services are usually riskier than average. Internet services, for instance, are much
more exposed to international competition than voluminous, heavy, and/or perishable goods.
In addition, because of competition, margins may be under pressure.
chapter 3 / page 4
To what extent can the products/services be legally protected?
Industries that can protect their products – and/or their production processes – through patents
are usually less risky and more profitable than the ones that cannot. Trademarks and
copyrights are also useful protections. Generally speaking, physical goods can be protected
better than services.
How intense is the pressure from substitute products/services?

Industries facing competition from firms in related industries are usually less profitable than
average. The availability of substitutes limits the price that can be charged to customers.
Furthermore, those industries are riskier because their clients may – more or less easily –
switch from their products/services to the ones offered by the related industries.
In addition to existing substitutes, potential substitutes must also be addressed. What about
new products/services that may emerge and threaten the industry? This factor is obviously
most important in technology-related industries.
3.2.2 Characteristics of the clients*

What is the bargaining power of clients?
Industries with a large number of small clients are usually less risky than ones with a small
number of large clients. As they do not face price concessions demanded by their buyers, they
are also more profitable.
Both the end users (who are the final buyers) and the intermediaries (who are the actual
clients) should be considered. If there are only a few intermediaries distributing the
products/services, the industry may well be under pressure, in spite of the large number of end
users.
In other words, the distribution channels of the products/services should be carefully analyzed.
Industries that sell their output in different countries with different types of distribution are
usually less risky than average. That does not mean that they are more profitable, because a
larger number of markets and/or types of distribution implies higher costs.
Last but not least, the bargaining power of clients also depends upon the intensity of
competition within the industry.
How loyal are the clients?

As keeping existing clients is often more profitable than trying to attract new ones, industries
that benefit from strong client loyalty usually achieve higher profits with less risk.
3.2.3 Characteristics of the suppliers*

What is the bargaining power of suppliers?
Industries with a large number of small suppliers are usually less risky than ones with a small
number of large suppliers. As they can impose price concession to the suppliers, they are also
more profitable.
More generally, the degree of rivalry between suppliers should be assessed. Intense
competition benefits the industry, through lower purchasing prices.
chapter 3 / page 5
How loyal are the suppliers?
As keeping existing suppliers is often more profitable than regularly switching from one to
another, industries that benefit from strong supplier loyalty usually achieve higher profits with
less risk.
It might be argued that this factor is much less important than client loyalty. That may be right
for growth industries that need to finance their expansion. But note that the management of
production tools – plant, computers, furniture etc. – has become a true challenge for most
industries, probably as important as product innovation and client satisfaction. Here, products,
clients and logistics are the three keys. And since the above production tools are quite often
provided by suppliers (and not built by the industry itself), securing their loyalty – for instance
by treating them as partners and not simply as providers – may well prove very helpful in the
long run.
3.2.4 Characteristics of the labor force*

What is the bargaining power of workers?
Industries where the labor market is highly unionized are usually considered as riskier and less
profitable than others, because labor unions can engage in collective bargaining to increase the
wages paid to workers. In other words, a significant share of the potential profits can be
captured by the workforce at the expense of the shareholders.
However, it should be acknowledged that industries (or countries) where labor unions hardly
exist can, at the end of the day, prove riskier and less profitable than average because workers,
being treated as nonentities, suffer from a lack of motivation. This could even lead, in some
cases, to substantial social unrest.
Another important element is the phase of the business cycle. How tight is the labor market?
This also determines the bargaining power of workers.
How loyal are the employees?

As keeping existing employees is often more profitable than hiring new ones, industries that
benefit from strong employee loyalty usually achieve higher profits with less risk.
3.2.5 Characteristics of shareholders (and of other capital suppliers)*

How loyal are the shareholders?
Keeping existing shareholders is also more profitable and less risky than trying to attract new
ones. Shareholder “volatility” tends to increase the cost of capital, which is really bad news
for growth industries that need to finance their expansion.
But it is also negative for more mature industries, even though they do not need to raise new
funds. As you know, any increase in the return required by the shareholders translates into
lower stock prices. Therefore, stock-option plans prove less effective, and company
managements and employees must be compensated by higher wages, which decrease reported
profits.
chapter 3 / page 6
3.2.6 Characteristics of the environment*
What are the side-effects of the business on the environment?
Industries selling products that can be dangerous to human and/or animal health are obviously
riskier than average. The ones that potentially or actually pollute the air, the ground and/or the
water are also under pressure. In the long run, those industries may also prove less profitable,
because they will be required to pay for the risk to the environment.
Industries operating in regulated markets are usually riskier as well. Because they have been
protected for a long time, they may be hit hard when the markets get liberalized. These
industries are often more profitable than average, but their returns are likely to prove
unsustainable.
chapter 3 / page 7
3.3 Macro factors*
The departure point for assessing the dynamics of the business cycle is the long-run
sustainable real growth rate of the economy. Economies are constrained by the capital and
labour available for production. The availability and growth, over time, of these production
factors determine the long-term potential growth rate of the economy.
Deviations in GDP growth from its potential rate are either unsustainable or suboptimal.
Deviations from the potential rate build an output gap. The existence of an output gap in an
economy, by definition, indicates disequilibrium within that economy and implies inflationary
or deflationary forces within the system.
Jon Gregory Taylor, Chief Investment Officer at Commonwealth Funds Management, an

international investment firm based in Melbourne, Australia, has suggested – like Paul and
Carole Huebotter – dividing the business cycle into four successive phases.
Phase I: Expansion to Potential

The beginning of phase I is identified by a trough in economic activity. The trough and
subsequent upturn are normally heralded by the end of an inventory rundown, i.e. excess
inventories have been worked off, and production has returned to near-normal levels. A
resumption of normal production results in an increase in hours worked, incremental job
creation and commensurate increases in disposable income and consumption.
Depending on the severity of the downturn, monetary policy is often very accommodating at
this stage of the cycle and characterized by a steep yield curve with short-term rates
substantially below long-term rates.
Phase I features the absorption of existing capacity in the system, but it is not associated with
inflationary pressures because excess capacity exists in both the labour and capital markets at
this juncture.
In this phase of the cycle, corporate margins tend to expand sharply because greater utilization
of fixed capacity results in lower marginal costs. Strong corporate profitability and sharply
increasing earnings per share translate into strong stock market performance.
Phase II: Growth above Potential

When growth accelerates above a sustainable level, the output gap turns negative, capacity
constraints begin to emerge and inflationary pressures begin to build within the system.
Growth above potential generates inflationary concerns, which, if borne out by statistical
evidence, causes weakness in the bond market as it begins to anticipate a policy response in
the form of higher interest rates from the Federal Reserve Open Market Committee (FOMC).
Early in this phase, a tug-of-war develops between earnings growth and expectations of higher
inflation and higher interest rates.
The emergence of capacity constraints does, however, lead to increased capacity. Investment
in capital equipment accelerates as businesses endeavour to keep up with surging demand.
During this phase of the growth cycle, capital goods producers tend to perform well.
At the peak of the cycle, interest and inflation fears clearly win out over earnings growth, with
the stock market being weak to falling.
chapter 3 / page 8
Phase III: Contracting Growth from Unsustainable Levels
Even after growth or the business cycle has peaked, inflationary pressures persist. Firms
continue to face capacity constraints that prompt upward pressure on the costs of production.
In this phase, monetary policy is generally restrictive. A flat to inverted yield curve in the U.S.
means repeated increases in the Fed funds rate during the period. Yet growth remains above
its potential rate. In addition, long-term bond rates increase in response to higher inflationary
expectations which are, in part, validated by the Fed raising the Fed funds rate.
The environment of a tight monetary and credit policy will induce a pronounced downturn in
the interest-sensitive segments of the economy, such as housing and capital spending. These
two areas will lead the economy down.
Phase IV: Contracting Growth to below Potential

Often, growth cycles in the United States have been determined by inventory cycles.
Downturns are precipitated by inventory imbalances with excess inventories prompting
manufacturing slowdowns. The slowdowns are normally accompanied with declines or
sluggishness in business capital investment as excess capacity increases and the need for and
profitability of capital investment diminish. The resulting impact on employment and
consumer and business confidence precipitates a widespread slowdown.
From the four phases described above it can be derived that there are two major macro factors
determining short-term business performance: GDP growth (or decline) and changes in
interest rates.
Jon Gregory Taylor has classified the various industries according to their sensitivity to these
two factors.
GDP Growth-Sensitive Sectors

Basic and Industrial Materials
Basic and industrial materials companies, as primary and intermediate producers, immediately
benefit from a pickup in economic activity given their high fixed costs and long lead times in
adding new or expanded capacity. Increases in activity and material demand are generally met
out of existing production capacity with only marginal changes in variable costs. This
improvement in asset utilization translates directly into earnings growth.
Energy
The performances of energy companies relative to the broader market are directly related to
changes in energy prices and, to a lesser extent, to the performance of the economy. Energy
companies tend to have high operating leverage – high fixed costs and relatively low variable
costs – and they benefit directly from increased demand or higher energy prices.
Industrial Cyclicals
The S&P industrials index closely tracks the broader S&P index and shows minimal variation,
as might be expected. Industries such as computers, technology, electronics,
telecommunications and conglomerates are all sensitive to economic downturns when the
economy dips below trend-growth levels.
chapter 3 / page 9
Transportation
As might be expected, transportation companies are quite sensitive to changes in economic
activity, given their high fixed capital costs and fixed capacity. As freight increases and idle
capacity is utilized, a reduction in average costs will show up immediately. Conversely, a
downturn in volume, caused by a decline in activity, immediately pushes up average costs
because transport fleets must operate below capacity or stand idle.
Capital Goods
Capital goods spending is heavily influenced by actual orders as well as by changes in the
level of capacity utilization. Rising rates of capacity utilization trigger investment in capital
equipment while falling levels of capacity utilization result in a pronounced slowdown in
business investment.
Consumer Cyclicals
The auto industry is extremely sensitive to changes in the economy and to disposable income.
In large part, this is because of the leads and lags involved in production and the inventory
control problem that constantly looms so large for the industry.
Other consumer cyclical industries, such as household furnishings and appliances, are also
sensitive to the economy in general, and to interest rates in particular given their impact on
residential construction and new home purchases.
Growth and Interest-Sensitive Industries

Construction and Housing
Residential construction is sensitive to both economic growth and the interest-rate
environment. Growth, however, appears to exert the dominant influence.
Interest-Sensitive Industries
Banking and Financial Services
Banks and thrifts are sensitive to both the level of interest rates and the shape of the yield
curve, or the spread between short- and long-term interest rates. Loan demand is obviously
influenced by the level of interest rates. Consequently, banks and thrifts tend to perform well
in declining interest-rate environments.
Insurance
Insurance companies – both life and property/casualty insurers – are highly sensitive to both
the growth and the interest-rate environment. Insurance companies, on average, have
outperformed the market during periods of declining growth and have underperformed during
periods of accelerating growth.
Investment Banking and Brokers

Investment banks and brokerage firms significantly outperform the market during periods of
growth while underperforming, on average, during periods of declining growth. Robust
economic performance underpins financial markets and corporate activity, providing a
lucrative environment for these firms. The direction of interest rates, although important, is
secondary to the overall performance of the economy and is exhibited the most in the relative
performance of financial assets.
chapter 3 / page 10
Stable Growth/Defensive Stocks
Stable or defensive stocks are stocks that tend to have a low sensitivity to changes in the
overall economy. These stocks tend to underperform during periods of strong economic
growth and to outperform during economic downturns. In general, the underlying companies
have limited pricing power and incur margin erosion during inflationary periods, but they fare
relatively well when inflation is low. This is because of the considerable resistance of
consumers to price increases.
Healthcare, Drugs and Cosmetics

Healthcare, drugs and cosmetics stocks are classic defensive stocks in that they tend to
outperform in a declining market. Healthcare stocks performed exceptionally well in both
rising and falling macroeconomic environments.
Defensive Consumer Industries

Defensive consumer industries comprise stocks that have had steady performances with
minimal swings in response to changes in the economy. Food, beverages, alcohol, tobacco and
the companies that distribute these goods tend to outperform the market during downturns
because consumer expenditures on those categories are income-inelastic.
Utilities
As regulated entities, utilities encounter serious resistance to rate increases and, consequently,
underperform in growth and inflationary environments. That is, utilities find it difficult to pass
on input cost increases because of regulatory constraints and the inherent time delays in price
changes. Utilities therefore tend to underperform the broad market during periods of economic
growth.
As you may conclude from Taylor's analysis, all industries – perhaps with the exception of
pharmaceuticals – are more or less sensitive to the state of the broad economy. Even the so-
called “interest-sensitive” industries are in fact both growth and interest-sensitive. Banks, for
instance, are faced with bad loans during recessions, which can offset the benefits of declining
interest rates. And the so-called “GDP-sensitive” industries are also interest-sensitive.
As regards nonfinancial industries, answering the following three questions should help you
assess their sensitivity to the business cycle.
Sales sensitivity
What is the sensitivity of sales to GDP growth?
This question is related to the characteristics of the products/services. Do they fulfil basic
needs, like eating? Or do they correspond to investments that can be postponed, like buying a
car? In the first case, sales sensitivity is low. In the second, it is much higher.
Note that sales volatility can be due to changing volumes and/or changing prices. Once again,
it depends upon industry characteristics. When the products/services are very uniform – if not
identical – prices tend to react strongly to new market conditions. As the companies in the
industry cannot differentiate themselves through their products, they are forced to compete
with one other through price cuts.
chapter 3 / page 11
When the products/services are less uniform, price competition is also less intense. Some
companies will gain market share thanks to the quality of their output, but at the industry
level, volumes are likely to go down.
Operating income sensitivity

What is the sensitivity of operating income to sales growth?
Operating income can be defined as sales less operating costs, which include all costs with the
exception of interest paid and income taxes (and possibly other non-operating costs like
exceptional losses incurred through the disposal of assets).
Operating leverage refers to the level of fixed costs as a percentage of operating costs.
Variable costs are those that rise or fall along with the production level. Fixed costs are those
the firm incurs regardless of its production level. Note that non-operating costs such as
exceptional gains and losses (due, for instance, to asset disposals), interest paid and income
taxes are not taken into account at this level of the analysis.
Operating leverage can be considered as an industry-specific factor, more than a company-

specific one. Imagine you were an independent taxi driver. You could then not afford not to
buy a car, or at least not to lease it. Your fixed costs – whatever your decision, to buy or to
lease – would in any case be higher than the ones you would be faced with if you had chosen
to become a writer.
The relationship between operating income growth and sales growth can be formalized as
follows:
Operating income growth in % = DOL · Sales growth in %
Fixed operating costs

where DOL = Degree of Operating Leverage = 1 + Operating income
Example
Year 1 Year 2 Growth
Sales 100’000 110’000 10%
Variable costs 25’000 27’500 10%
Fixed costs 45’000 45’000 0%
Operating income 30’000 37’500 25%
45,000
DOL = 1 + = 1 + 1.5 = 2.5
30,000
Operating income growth = 2.5 · 10% = 25%
Net income sensitivity

What is the sensitivity of net income to operating income growth?
Net income can be defined – when ignoring exceptional gains and losses – as operating
income less interest paid, and less income taxes.
The level of indebtedness is, in principle, a company-specific decision. So we will address this
issue in the section dedicated to balance-sheet factors (Part 3.5). Note, however, that the
pressure exerted by the capital suppliers (the shareholders and the lenders) for optimising their
risk/return leads – within a particular industry – to much more uniform debt-to-equity ratios
chapter 3 / page 12
than theory would suggest. It is a matter of profitability – some industries would never make
enough money if they did not resort to high borrowing.
High indebtedness means higher risk for two reasons:

The sensitivity of net income to GDP changes depends upon 1) the sensitivity of sales to
GDP changes and 2) the proportion of total fixed costs (operating fixed costs and interest
paid). So the higher the level of indebtedness, the higher the sensitivity of net income to
GDP changes.
Interest paid, a cost that reduces earnings, depends on 1) the level of indebtedness and 2)
the level of interest rates. So the higher the level of indebtedness, the higher the sensitivity
of net income to interest-rate changes.
Companies – or industries – with high debt-to-equity ratios are very vulnerable when the
economy starts slowing down from its peak, while interest rates are still high. On the other
hand, they achieve impressive earnings growth when the economy starts recovering from a
trough, while interest rates are still low.
Do not forget that, in addition to the fundamental effect (increase or decrease of the cost of
debt, along with interest-rate rises or drops), interest-rate changes impact company valuations.
This second effect is even more important than the first from the investor’s standpoint. A
surge in interest rates would hit share prices much more because of the valuation effect than
because of the fundamental effect.
Income taxes have nothing to do with the industry-related factors. Basically, the tax rate
depends upon the mix of countries in which a specific company operates and the tax
optimisation system that it uses.
In addition to GDP and interest rates, a third macro factor must be addressed, i.e. exchange
rates. The major U.S. and European indices are dominated by multinationals, selling their
products/services worldwide. Although these companies are international from an economic
standpoint, they are still considered as American, British, German, French or Swiss depending
on the location of their head office.
This would have no impact if all the countries around the world had adopted the same
currency. Although the trend is very clear (there are fewer and fewer currencies in use, and it
may be imagined that sooner or later, the major currency blocs – the dollar, the euro and the
yen – will enter a common currency system), companies are still faced with exchange-rate
risks.
There are basically two types of currency risk:
Operating risk
Most companies – whatever the industry – do business in more than one currency. As orders,
deliveries, and payments usually do not occur at the same time, firms are exposed to the
exchange risk if they bill their products in foreign currencies.
chapter 3 / page 13
Example
Company X (reference currency = euro) gets an order from one of its American clients. The selling
price of the product is EUR 10’000. At that time, the exchange rate of the U.S. dollar against the
euro is just 1.00. So, Company X sets the price in dollars at USD 10’000. The delivery and billing
is done one month later. Company X is glad because the dollar now trades at 1.05 against the euro.
Which means that the value of the sale in euros has increased to EUR 10’500. This is the figure
that Company X captures in its accounting system. The payment is received after two months.
Company X gets USD 10’000 and converts this amount into euros. Unfortunately, the dollar has
slumped to 0.95. So, the bank credits Company X’s account with only EUR 9’500. From an
economic standpoint, Company X has lost EUR 500 (the difference between the price wanted,
EUR 10’000, and the amount received, EUR 9’500). But from an accounting standpoint, it has lost
more money, namely EUR 1’000 (the difference between the value of the bill, EUR 10’500, and
the amount received, EUR 9’500). Those EUR 1’000 will appear as a loss in Company X’s income
statement.
Conversion risk
Many companies – whatever the industry – own assets (e.g. subsidiaries) abroad. Once, twice
or four times a year, they must draw up their balance sheets. Consequently, they must convert
the value of all their foreign assets (which are not for sale, it must be emphasized) into their
reference currency. Since exchange rates are not fixed, even though the local-currency value
of these assets would be unchanged, their value translated into the reference currency changes
with time.
Example
Company Y (reference currency = euro) owns a subsidiary in the U.S. At the end of last year, the
value of this subsidiary was USD 1 million. The U.S. dollar was 1.10 against the euro. Hence, the
value of the subsidiary in euros was EUR 1.1 million. This is the figure that Company Y reported
in its last annual report. One year later, nothing has changed as regards the U.S. subsidiary. Its
value in local currency is still USD 1 million. But the dollar has plummeted against the euro. It
now trades at 0.85. Therefore, the value of the subsidiary in euros is down to EUR 850’000. Has
Company Y really lost EUR 250’000? From the operating standpoint no, because 1) the value of
the subsidiary in local currency has not changed and 2) the subsidiary has not been sold, and will
not be sold in the near future. Hence, those EUR 250’000 will not appear as a loss in the income
statement. However, since the total asset value of Company Y (with its subsidiary) has come down,
this amount will be deducted from the shareholders’ equity.
As we have already highlighted, currency risk is not an industry-specific factor. There are
local and multinational companies in all industries.
chapter 3 / page 14
3.4 Forecasting for companies in the industry*
Forecasting companies’ future results is a challenge, to say the least. So much so that many
investment professionals have given up the idea of making earnings or cash flow estimates
beyond the current year, or possibly the next year.
Is it easier to make forecasts in some industries than others? Definitely yes. In fact, this issue
is closely related to the industry characteristics described above.
Characteristics of the products/services

Forecasting the results of maturity-stage companies is easier than predicting the ones of
start-ups or declining firms.
Forecasting the results of defensive companies (those which sell products/services
fulfilling basic needs) is easier than predicting the ones of cyclicals.
Predicting the results of companies active in a uniform industry is more difficult than
forecasting those of the ones selling more differentiated products/services.
Predicting the results of companies offering easily-transportable products/services is more
difficult than forecasting the ones of firms less exposed to international competition.
Forecasting the results of companies that can protect their products/services through
patents is easier than predicting the ones of firms that cannot.
Predicting the results of companies that face competition from substitute products/services
is more difficult than forecasting the ones of firms that do not.
Characteristics of the clients

Forecasting the results of companies with a large number of small clients is easier than
predicting the ones of firms with a small number of large clients.
Forecasting the results of companies that benefit from client loyalty is easier than
predicting the ones of firms that suffer from high client turnover.
Characteristics of the suppliers

Forecasting the results of companies with a large number of small suppliers is easier than
predicting the ones of firms with a small number of large suppliers.
Forecasting the results of companies that benefit from supplier loyalty is easier than
predicting the ones of firms suffering from high supplier turnover.
Characteristics of the labour force

Predicting the results of companies in highly unionized industries is, in the short run at
least, more difficult than forecasting the ones of firms in less unionized industries.
Forecasting the results of companies that benefit from employee loyalty is easier than
predicting the ones of firms suffering from high employee turnover.
Characteristics of the shareholders (and of other capital suppliers)

Forecasting the results of companies that benefit from shareholder loyalty is easier than
predicting the ones of firms suffering from high shareholder turnover.
chapter 3 / page 15
Note that shareholder loyalty depends a lot upon all the other company characteristics
mentioned above. Moral of the story? “The riskier the company, the less loyal the
shareholders. And the less loyal the shareholders, the riskier the company”. It sometimes
becomes a true vicious circle.
What about specific companies within the industry? Not surprisingly, their results tend to
evolve in the same way, at the same time. All car makers benefit from an improvement in
consumer confidence. All investment brokers get hit when investor sentiment turns negative.
The more uniform the products/services offered by the companies in the industry, the more
similar their earnings and cash flow growth. And conversely. Drug companies, for instance,
may achieve quite distinct results, because their products are not identical. Which means that a
better knowledge of company-specific fundamentals can add value. Furthermore,
understanding individual firms’ characteristics is even more important if they are in the start-
up phase, like most biotech companies. This is mainly because their current portfolio of
products is not diversified, which means that the impact of new drug development is
spectacular.
As regards company-specific factors, you should try to identify the barriers to entry from
which the firm benefits. Here are a few ideas, some of them being close to what has already
been said.
To what extent is the product/service different from the competition’s?

To what extent does it fulfill proven customer needs?
How well known is it (brand awareness and brand loyalty)?
What is its market share?
What is the amount of capital required to replicate it?
To what extent is it protected by proprietary knowledge?
To what extent is it protected by patents, copyrights, etc.?
What is the critical mass necessary to have a competitive edge?
To what extent does the company control its distribution channels?
Last but not least, we should not forget, as regards specific companies, the degree of risk
arising from regulations, anti-trust laws, protectionism, litigation, fair competition issues,
political instability and specific environmental and social aspects.
chapter 3 / page 16
3.5 Balance-sheet factors*
There are two major factors to be highlighted. The first is financial leverage, i.e. the interest-
bearing debt to equity ratio. The higher the ratio, the higher the sensitivity of earnings to GDP
changes. Let’s come back to the example we used in the macro factors section (2.3.3), and
make an assumption regarding the level of interest paid (15’000) and the tax rate (40%).

Sales 100’000 110’000 10%
Fixed operating costs 45’000 45’000 0%
Operating income 30’000 37’500 25%
Interest paid 15’000 15’000 0%
Income before taxes 15’000 22’500 50%
Income taxes 6’000 9’000 50%
Net income 9’000 13’500 50%
The relationship between net income growth and operating income growth can be formalized
as follows:
Income before taxes growth in % = DFL · Operating income growth in %
As net income growth = Income before taxes growth, then:
Net income growth in % = DFL · Operating income growth in %
Interest paid
where DFL = Degree of Financial Leverage = 1 + Income before taxes
As regards our example:
15'000
DFL = 1 + =1+1=2
15'000
Net income growth = 2 · 25% = 50%
We could combine the degree of operating leverage and the degree of financial leverage into a
single factor, to assess the sensitivity of net income to sales changes.

Sales 100’000 110’000 10%
Fixed costs* 60’000 60’000 0%
Income before taxes 15’000 22’500 50%
Income taxes 6’000 9’000 50%
Net income 9’000 13’500 50%
* fixed operating costs + interest paid
chapter 3 / page 17
The relationship between net income growth and sales growth can be formalized as follows:
Income before taxes growth in % = DL · Sales growth in %
As net income growth = Income before taxes growth, then:
Net income growth in % = DL · Sales growth in %
Fixed costs
where DL = Degree of Leverage = 1 +
Income before taxes
As regards our example:
60'000
DL = 1 + =1+4=5
15'000
Net income growth = 5 · 10% = 50%
The second factor to be highlighted is working capital and cash flow. The company's
solvency, i.e. its ability to pay back its short-term debt, must be assessed. Two ratios are
widely used for assessing the risk of a cash squeeze:
Short-term assets
Current ratio =
Short-term debt
Short-term assets less inventories

Quick ratio =
Short-term debt
chapter 3 / page 18
3.6 Corporate strategy*
Assessing a corporate strategy is one of the most difficult tasks for investment professionals.
First, most companies do not want to reveal their strategy in detail. That is understandable,
since this factor is absolutely key to success. Why offer your business objectives to your main
competitors? Nevertheless, since it is a key factor, analysts and portfolio managers must spend
most of their time on this issue.
Second, corporate strategy refers to management quality. As a capital supplier, when investing
in a company, you implicitly give the company executives the power of investing your money
in a discretionary way. So, before empowering the management, you had better check whether
it is capable or not. But how to assess the competence of people whom you have probably
never met?
The best possible answer would be to make appointments with them. As they are likely not to
accept (who, apart from investment banks, has ever met all the members of a management
team?), and as you may not have enough time to investigate the company in so much depth,
you will have to assess the management's quality through its past decisions and the
information it passes on to its shareholders.
Whatever your degree of access to the board of directors, you should address the following
issues. To get answers to your questions, you might start by viewing the company's Website,
before visiting the CEO, the CFO or, failing that, the Investor Relations Officer.
Strategy
Does management seem capable of working out a coherent strategy and achieving sustainable
long-term growth?
Consistency of the company's vision and mission statement. Do they fit with your own
long-term view on the industry?
Accuracy of the company's financial objectives. Are they measurable, i.e. are they
expressed in figures, with a clear deadline?
Adequacy of the company's values. Do they correspond to your own values and to your
view on the way any business should be run to be successful in the long term? Does
management take social and environmental aspects into account?
Decision-making process
Does management seem capable of making suitable decisions, and implementing them in an
effective way?
Consistency of decisions. Do they fit with the company's vision, mission and values?
Timeliness of the decisions. Is their timing appropriate?
Communication of the decisions. Are they widely known and supported by staff?
Implementation of the decisions. Do they materialize almost naturally thanks to clear
operating procedures?
Outcome of the decisions. Do they actually help improve the company's resource
allocation?
chapter 3 / page 19
Monitoring
Does management seem capable of closely monitoring its operations? Furthermore, does it
seem capable of adapting to changing market conditions?
Management information system. Is it effective? In other words, is management well
informed about its own business (feedback from operating units) and about market
developments (surveys conducted by the company's market research team)?
Corrective action. Is it prompt and effective? In other words, after detecting gaps between
its expectations and actual outcomes, does it rapidly make new – and suitable – decisions
to take that information into account?
Media and investor relations

Does management seem capable of keeping the press and the financial community informed
of the company's developments?
Press releases. Are they frequent and detailed? Does the company also communicate bad
news in a transparent way? Does management willingly answer journalists' questions?
Financial reporting. Is it frequent and reliable? Does management willingly answer the
analysts', portfolio managers' and investors' questions?
chapter 3 / page 20
3.7 Valuations*
Here comes the dilemma. Should this section be the longest or the shortest of chapter 3? Many
investment professionals argue that you should not use the same valuation techniques for
assessing the fair price of companies operating in different industries. In other words, that you
should use industry-specific tools for valuing banks, pharmaceuticals or technology stocks. If
they are right, this section should be the longest of the chapter.
But do analysts really use specific models for each industry? Definitely no. Admittedly,
particular tools have been developed for valuing certain sectors, such as financials or high-
growth stocks. But those tools are all based on the approaches developed in chapter 4.
And anyway, are there theoretical foundations justifying differentiated approaches? No again.
All shareholders – whatever the industry – own, by definition, a certain percentage of the
firm's net assets.
What is, from the theoretical standpoint, the most straightforward way to assess the value of
the shareholders’ equity? Simply draw up a list of the firm's assets, and deduct the amount of
debt from their total current value. Quite simple, isn’t it?
The problem is that the value of some assets – especially intangibles – is very difficult to
estimate, because there is no market for them. Consequently, investors are generally forced to
appraise the value of their equity through the flow of funds the company is expected to
generate over the years.
Flows of funds can be analyzed from two standpoints. The first is the shareholders’
standpoint. Which operations lead to cash transfers between the company and them?
Dividend payments
New issues
Share buybacks
Therefore, the value of the shareholders’ equity should be appraised by 1) assessing the level
of those cash flows in the future and 2) discount them back to their present value. If you
ignore new issues and share buybacks, you get the well-known dividend discount model
(DDM).
The DDM has been criticized because it cannot deal with companies which do not pay any
dividends. That is right if you suppose that these firms will never pay any dividends.
However, if you think that Company X may start paying dividends from Year 5 (i.e. five years
from now), then the DDM can be used to appraise the company's value.
What about companies which will never pay any dividends? There are two possibilities. The
first is that they will never pay any dividends, and never buy back any shares. In other words,
they will never give any money back to shareholders. Why invest in such firms? These are
probably start-ups that will never enter the consolidation stage, and go bankrupt before then.
chapter 3 / page 21
The second is that they will never pay any dividends, but buy back shares for tax purposes.
Depending on the country, share buybacks may be a more effective way of returning money to
shareholders than paying dividends. Some firms also combine the two ways of compensating
their shareholders.
Provided the firm keeps up – or will keep up, starting in 5 or 10 years – with a share buyback
program (meaning that share buybacks are more or less predictable, which is actually more
and more the case, especially in the U.S.), the dividend discount model could be adapted and
converted into a “dividend and share buyback discount model” that would be usable for
almost any stock. As regards new issues, you may forget them, because they can be considered
as purely random.
The second possible standpoint is the company's (or management's). Which operations –
regardless of those concerning the shareholders and the lenders – lead to cash transfers
between the company and its clients, suppliers, employees, and the tax authorities?
Capital expenditures
Working capital changes
Cash flow from operations
Using those flows of funds, instead of dividends, new issues and share buybacks, leads you
automatically to the DCF model (and its variants, the EVA model and the CFROI model).
Once again, from a theoretical point of view, there is no reason not to use the DCF model for
all industries. Cash inflows and outflows are cash flows, whatever the sector.
Therefore, the issue is not to know whether the DDM and the DCF models – which are just
tools – are valid for valuing stocks in all industries. They are. The question is rather to know
which valuation model is the easiest to implement for assessing the fair price of high-growth
companies versus low-growth companies, or cyclicals versus defensive stocks, or financials
versus nonfinancials.
High-growth versus low-growth companies

It is easier to appraise the value of start-ups and consolidation-stage companies through the
DCF model than through the DDM, which applies better to maturity-stage firms. For single-
product start-ups and troubled firms that may go bankrupt, option pricing models may be
helpful.
Cyclicals versus defensive stocks

As for cyclicals, you should first normalize future dividends and cash flows, because business
cycles are almost impossible to predict. You can then compute the present value of those
normalized dividends (DDM) and cash flows (DCF), exactly in the same way as you would
discount the forecasted results of a defensive stock. Apart from the normalization process, the
methods to be used for both categories are the same.
Financial versus nonfinancial firms

The DDM model applies to both financial and nonfinancial firms. As regards the DCF model,
it should be stressed that the use of the DCF model, as defined above, may be quite risky for
valuing financials, because the cost of debt (one of the components of the discount factor, i.e.
the WACC) is very likely to be underestimated (banks’ main source of financing is low-cost
customer deposits raised through the retail bank, not borrowing in capital markets; in the case
chapter 3 / page 22
of insurance companies, very high provisions tend to distort the cost of debt downward). It
would be better to forecast free cash flows to equity (i.e. free cash flow to the firm, as defined
above, adjusted for the cash transfers between the shareholders and the lenders) and calculate
their present value, so as to use the cost of equity instead of the WACC as the discount factor.
There are a few specific methods for valuing banks and insurance companies, but it should be
stressed, once again, that these particular techniques are just extensions of the standard ones.
Last but not least, note that “the most straightforward way to assess the value of shareholders'
equity”, i.e. the net asset value, is – generally speaking – a more reliable tool for valuing
financial (banks, insurance firms, and also real estate and holding companies) than
nonfinancial stocks.
chapter 3 / page 23
Chapter 4
VALUATION MODEL OF COMMON STOCK


Table of contents
4. Valuation model of common stock 1
4 .1 Dividend discount models .................................................................................................................. 1

4.1.1 Zero growth model ............................................................................................................................ 2
4.1.2 Constant growth model ..................................................................................................................... 3
4.1.3 Multiple growth model ...................................................................................................................... 6
4 .2 Free cash flow model .......................................................................................................................... 7
4.2.1 The recommended discounted cash flow framework ........................................................................ 7
4.2.2 Other discounted cash flow frameworks ........................................................................................... 8
4.2.3 Forecasting free cash flows ............................................................................................................... 9
4.2.3.1 Definition of free cash flow....................................................................................................... 10
4.2.3.2 Introductory examples ............................................................................................................... 11
4.2.3.3 Estimating the initial investment ............................................................................................... 12
4.2.3.4 The importance of tax deductions ............................................................................................. 12
4.2.3.5 Estimating residual value........................................................................................................... 13
4 .3 EVA, MVA, CFROI, Abnormal earnings discount model* .......................................................... 14
4.3.1 Economic Value Added and Market Value Added* ....................................................................... 14
4.3.1.1 Introduction* ............................................................................................................................. 14
4.3.1.2 Definitions* ............................................................................................................................... 14
4.3.1.3 Valuation with EVA* ................................................................................................................ 16
4.3.1.4 Performance Measurement with EVA* ..................................................................................... 23
4.3.1.5 Conclusions* ............................................................................................................................. 24
4.3.2 Cash Flow Return on Investment* .................................................................................................. 24
4.3.2.1 Definition*................................................................................................................................. 24
4.3.2.2 Valuing a firm*.......................................................................................................................... 27
4.3.3 Abnormal earnings discount model* ............................................................................................... 29
4.3.3.1 Valuing cyclical companies*..................................................................................................... 29
4.3.3.2 Valuing start-ups* ..................................................................................................................... 30
4 .4 Measures of relative value ............................................................................................................... 32
4.4.1 Price/Earning ratio and valuation .................................................................................................... 32
4.4.1.1 General considerations .............................................................................................................. 32
4.4.1.2 Interpretation ............................................................................................................................. 33
4.4.1.3 Empirical accuracy of the method ............................................................................................. 34
4.4.1.4 Problems of the P/E ratio valuation method .............................................................................. 36
4.4.2 Price/ book value ratio .................................................................................................................... 37
4.4.3 Price/ cash flow ratio....................................................................................................................... 37
4.4.4 Price / sales ratio ............................................................................................................................. 38
* final level
4. Valuation model of common stock
Firms finance new projects, acquisitions, and working capital requirements by issuing claims
against the income generated by these investments. These claims include, among others,
bonds and common stocks. The return on these claims is in the form of dividends, interest,
and principal repayments. These future cash flows determine the value of the securities.
Knowing how to value corporate securities is important for both the firm's management and
investors. Current and prospective shareholders may want to compare their valuation of a
firm's securities with actual market prices. Equally important, managers need to understand
how their investment and financing decisions are likely to affect security prices. Furthermore,
firms can be valued by separately estimating the values of their debt and their equity.
4.1 Dividend discount models

When an investor acquires a share of common stock, he/she receives two types of return:
1. all the future cash dividends, and
2. the price at which he/she sells the share at the end of the holding period.
The current price of a share is thus the present value of these cash flows added together, or
P0 = sum of discounted, expected future dividends + discounted, expected future sale price
T
E(Div t ) E(PT )
P0 = ∑ (1 + k ) +
t =1
t
(1 + k ) T
where:
P0 stock price in period t = 0
E(.) expectations operator
Divt dividend in period t
PT future proceeds from stock sale
kE discount rate (assumed here to be constant over time)
The maturity of shares is not fixed. At its limit, T will be infinity, in which case the present
value of the proceeds from the sale of the stock will approach zero. Thus, the present price of
a stock is determined exclusively by its discounted, expected future dividends, i.e. the present
value of the expected future dividend stream. This leads us directly to the following general
pricing formula
∞
E (Div t )
P0 = ∑ (1 + k ) t
t =1
The above expression is the dividend discount model. In this form, the pricing formula for
shares is correct, but not very practical. To make it more useful, some additional restrictions
need to be imposed.
chapter 4 / page 1
4.1.1 Zero growth model
Suppose dividends are not expected to grow at all, but to remain constant forever. Assume
that dividends expected in future years are equal to some constant amount - that is,
Div1 = Div2 = ... = Div
The dividends of a zero growth stock therefore may be thought of as a perpetuity. By

rearranging the above formula, we get
Div
P0 =
k
Example: Jelmoli
Jelmoli bearer share paid the following (non-adjusted) dividends in 1987-1989 (on the 30th of
March of each year):
Year 1987 1988 1989

Dividend 35 CHF 35 CHF 35 CHF
Assume the discount rate of 10%. Immediately after the stock went ex-dividend in 1989, the
theoretical price would have been:
35
P0 = = 350 CHF
0.1
In fact, the stock sold for 2'350 CHF at the time.
One problem in our calculation might be that we simply assumed the discount rate. To avoid this
assumption, we can use the 1988 figures to calculate an appropriate discount rate.
Since we know that
PApril 1988 = 2'300 CHF
Div = 35 CHF
we can use the pricing formula to calculate the discount rate
Div
kE= = 35 CHF / 2'300 CHF = 1.5%
P0
If this is the appropriate discount rate, then the theoretical price of the stock in 1989 should be
35 CHF / 0.015 = 2'300 CHF. (As it turns out, there was no need to compute anything. The model
predicts that, if discount rates and dividends do not change, the price will not change either: the
1989 price will equal the 1988 price).
Our computation of the implied discount rate shows that the zero growth model does not do well in
the case of Jelmoli. It yields a discount rate that is far below the yield to maturity on Swiss
government bonds at the time.
chapter 4 / page 2
In principle, this model has the following implications:
• If discount rates do not change, than the predicted price equals previous year's price;
• If discount rates change, than the predicted price will differ from the previous year's price,
but there is need to calculate the appropriate discount rate to compute it;
• The model is applicable even if previous years price is not available (in other words, if the
stock is not traded), provided the appropriate discount rate is known or calculated. The
model can be used as shown above to calculate the discount rate for traded stocks in similar
risk classes and apply that rate to the dividend stream to be valued. The following example
illustrates this case.
Example: Grands Magasins

Suppose you want to compute the stock price of “Grands Magasins”, a privately held corporation.
The firm has paid a constant dividend of 40 CHF over the past several years. We can make this
calculation by taking the example of “Loeb”, assuming that Loeb pays a constant dividend and is in
the same business as Grands Magasins. We apply the zero growth model to Loeb and get a
discount rate of 8%, which means that the theoretical value of Grands Magasins' stock is
40 CHF / 0.08 = 500 CHF.
4.1.2 Constant growth model

Empirically, almost all firms pay a dividend each year. In fact, firms go to great pains to
prevent having to cut that dividend. If anything, they strive to increase it every year. The zero
growth model loses a lot of its appeal. As an alternative, we can derive a pricing model under
the assumption that dividends increase at a constant growth rate every year.
If the dividend grows at a constant rate of g, we get
Div1 = Div0 ⋅ (1+g)

Div2 = Div1 ⋅ (1+g) = Div0 ⋅ (1+g)2
...
Divt = Div0 ⋅ (1+g)t
Using this method of estimating future dividends in the general valuation formula
∞
E (Div t )
P0 = ∑ (1 + k ) t
t =1
we get
Div 0 ⋅ (1 + g)
∞ t
P0 = ∑
t =1 (1 + k E ) t
With the help of some simple algebraic transformations, we can rearrange this formula as
written below. This is the so-called constant dividend growth model (or J.B. Williams model).
Div 0 ⋅ (1 + g) Div1
P0 = =
( k E − g) ( k E − g)
chapter 4 / page 3
Since
Div1 = EPS1 ⋅ π
where
Div1 Dividend in period 1
EPS1 Earnings per share in period 1 (earnings are cash earnings)
π Payout ratio
1–π Earnings retention rate
we can substitute
EPS1 ⋅ π
P0 =
( k E − g)
Note that, if the return-on-equity is r, we can write
EPS1 = EPS0 + r ⋅ (1 − π) ⋅ EPS0
since (1 − π ) ⋅ EPS0 are the reinvested earnings. Consequently
EPS1
= (1 + g) = 1 + r ⋅ (1 − π )
EPS0
which implies
g = r ⋅ (1 − π)
We can therefore substitute for g in the valuation expression and write
EPS1 ⋅ π
P0 =
k E − (1 − π ) ⋅ r
This is commonly referred to as the Gordon-Shapiro model.
Example: Nestlé Bearer Share (1989)

The following table shows the adjusted dividends Nestlé paid on its bearer shares (in CHF):
Year 1984 1985 1986 1987 1988 1989

Dividend 133.29 142.32 142.32 147.23 171.76 175
On the basis of the J.B. Williams model, what is the theoretical stock price of Nestlé bearer share
1989?
a) To estimate the historical growth rate of Nestlé's bearer share dividends, we calculate the
arithmetic average of the one-year growth rates. We know that
Div1 = Div0 ⋅ (1+g)
The dividend growth rate between 1984 and 1985 can be calculated as
142.32
g= − 1 = 6.77%
133.29
chapter 4 / page 4
If we do this for every year, in the end, we get 5 one-year growth rates for which we can calculate
the arithmetic average ( g )
6.77 + 0.00 + 3.45 + 16.66 + 1.89

g= = 5.75%
5
b) To estimate the appropriate discount rate, we can use the formula for the year 1988 (Nestlé
pays its dividends at the end of May). Since
• Share price Nestlé June 1988 = 8'445 CHF (historical data)

• dividend growth rate g = 5.75% (from above)
Div 0 (1 + g )
P0 = or
(k − g )
171.76 ⋅ 1.0575
8445 = which yields
(k − 0.0575)
171.76 ⋅ 1.0575
k= + 0.0575 = 7.9%
8445
c) Now we can use these figures to estimate the theoretical stock price for 1989:
175 ⋅ 1.0575
P0 = = 8'607 CHF
(0.079 − 0.0575)
In fact, the stock price in June 1989 was about 7'150 CHF.
As before, we could have reached this conclusion with less effort and more thought.
Remember:
Div 0 ⋅ (1 + g)
P0 = and
( k E − g)
Div1 ⋅ (1 + g) Div 0 ⋅ (1 + g)
2
P1 = = or, in other words,
kE − g kE − g
P1 = P0 ⋅ (1 + g)
In the case of Nestlé (denoted here by P-1, Nestlé's 1988 bearer price of 8'445 CHF), we could have
computed
P0 = P-1 ⋅ (1 + g) = 8'445 ⋅ 1.0575 = 8'931 CHF.
Note that 8'931 CHF does not correspond exactly to the 8'607 CHF we found above. The
difference in the two results is due to the fact that the 1989 dividend payment of 175 CHF is not
exactly equal to the 1988 dividend payment times 1.0575 (171.76 ⋅ 1.0575 = 181.64 CHF). If the
dividend actually increased by 5.75% from 1988 to 1989, we would have obtained
171.76 ⋅ 1.0575 2
P0 = = 8'934 CHF
(0.079 − 0.0575)
chapter 4 / page 5
The constant growth model can be used in the following situations:
• to identify mispriced stocks (if you believe in the model)
• to value non-traded stocks.
If you are going to use it, keep the following guidelines in mind:
• If you think dividend growth and discount rates have not changed, the predicted price equals
last year's price times one plus the rate of growth of dividends;
• If you think discount rates have changed, you can use the model, but you need to determine
both the appropriate discount rate and the appropriate rate of growth of dividends;
• If you don't have last year’s price (in other words, if the stock is not traded), you can use the
model the way we did to infer the discount rate for traded stocks in similar risk classes and
apply that to the dividend stream under analysis.
4.1.3 Multiple growth model

Firms typically go through life cycles, with growth varying with the age of the firm. As
growth varies, so do dividends. The multiple growth model allows dividends to follow
different growth patterns. The analyst could for instance forecast the first T dividends
separately and assume a constant dividend growth model thereafter. He might be able to
forecast individual near-term dividends with some precision; for later dividends, he might just
be able to make an average prediction. The model is best demonstrated with an example.
Example: Nestlé (1993)

The following table lines up (in CHF) four historical dividends figures (1990-1993), along with an
analyst's expectations of Nestlé's dividends per share of registered stock for the next three years
(1994-1996).
Year 1990 1991 1992 1993 1994 1995 1996

Dividend 20 21.5 23.5 25 27 30 33
Using the four historical dividends, we calculate the most recent dividend growth rate g. (As in the
example before, we calculate average one-year dividend growth).
7.50% + 9.30% + 6.38%

g= = 7.73%
3
Here, we assume that the dividend will keep growing at a constant rate of 7.73% after year 1996.
Therefore, the expected dividend in 1997 is 33 CHF · 1.0773 = 35.5 CHF.
To calculate the discount rate, we rely on the 1993 data, and arrive at a stock price at the end of
1993 of approximately 1'320 CHF. Employing the constant growth model, we get
CHF 25 ⋅ (1 + 0.0773)
1320 CHF = or
(k − 0.0773)
kE = 9.77%
With these figures, we can now calculate the theoretical price of Nestlé registered stock as follows
27 30 33 35.5
P0 = + + + = 1'390 CHF
1.0977 1.09772 1.09773 1.09773 ⋅ ( 0.0977 − 0.0773)
Note that the stock price of Nestlé registered stock in mid 1994 was approximately 1'200 CHF.
There are alternative methods for computing stock values - one of them entails computing firm
values (via the cash flows the firm can be expected to generate) and deducting the market value of
debt.
chapter 4 / page 6
4.2 Free cash flow model
4.2.1 The recommended discounted cash flow framework

To use discounted cash flow (DCF) analysis to value a stock is just the same as it is for
calculating the present value of any other asset. We discount the cash flows by the return that
can be earned in the capital market on securities of comparable risk.
Therefore, we need a framework that answers the following questions:

• How are the cash flows defined?
• What are the relevant cash flows?
• What is the appropriate discount rate?
• What is the most appropriate method of forecasting the future cash flows?
• What is the appropriate period for which the cash flows can be forecasted?
• How can we compute the market values?
To estimate the firm value, we can either estimate the market value of the debt and the market
value of the equity separately and add them up. Alternatively, we can estimate the firm value
directly by discounting the firm's future cash flows. To estimate the value of equity, we can
simply discount the cash flows accruing to equity-holders (dividends and share repurchases).
The problem is that this procedure involves less explicit information about the sources which
lead to value creation, making a sensible sensitivity analysis more difficult. Consequently, we
prefer to value the firm by discounting its forecasted future cash flows. The market value of
the equity can then be computed by subtracting the market value of the debt from the market
value of the firm.
The three basic steps of the DCF valuation approach are the following:
a) Estimating free cash flows (FCFs)

FCF is equal to the after-tax operating earnings of the company plus non-cash charges, less
investments in net working capital, property, plant and equipment, and other assets. It does
not include any financing-related cash flows such as interest expense or dividends. It
reflects the cash flow available to all providers of capital (debt and equity). A more formal
definition is provided below.
One may ask the question why we have been talking about ‘cash flows’ so far and are now
suddenly using the term ‘free cash flows.' The question is legitimate. The reason is that up
to now we have been talking about the discounted cash flow approach in general. The
emphasis was on the general principles, not on the technical details. To do the actual
valuations, one cannot ignore these details. As we will show directly, with the discounted
cash flow approach, we always use the same specific definition of cash flow: free cash
flow.
b) Estimating the appropriate discount rate

To be consistent with the cash flow definition, the discount rate reflects the opportunity
costs of all providers of capital weighted by their relative contribution to the total capital of
the company (Weighted Average Cost of Capital: WACC).
chapter 4 / page 7
c) Determining forecast horizon and terminal value
The value of the business is separated into two components, during the explicit forecast
period and after the explicit forecast period. It is usually possible to make accurate cash
flow forecasts during the explicit forecast period. Thereafter, this task becomes
increasingly difficult or completely impossible. Nevertheless, we have to find ways to
determine the firm's value after the explicit forecast horizon. This value is called terminal
value or continuing value.
d) Treat inflation consistently

Competition tends to depress output prices over the life of a product. Variable costs tend
to increase in time. Free cash flow projections should reflect these considerations. Care
should be taken, however, that, if these projections are in nominal terms, they should also
be discounted with nominal rather than real (= nominal rates net of expected inflation rates
for the period under consideration) rates. Working with nominal values is generally
simpler. First, interest rates are quoted in nominal terms. Second, management is
accustomed to thinking in nominal terms.
Table 2-1 shows an example of the principles of the DCF valuation approach.
Free Discount factor Present value

Year Cash Flow @ 20% of free cash flow
1998 15 CHF 0.8333 12.5 CHF

1999 22 CHF 0.6944 15.3 CHF
2000 31 CHF 0.5787 17.9 CHF
2001 35 CHF 0.4823 16.9 CHF
2002 42 CHF 0.4019 16.9 CHF
Continuing value* 210 CHF 0.4019 84.4 CHF
Value of operations 163.9 CHF
– Debt value** –50.0 CHF
Equity value 113.9 CHF
* calculated as 42 CHF / 0.2 = 210 CHF

** assumed
Table 4-1: DCF approach: an example
4.2.2 Other discounted cash flow frameworks

There are valuation principles other than the DCF framework. One approach is to work with
pre-tax instead of after-tax cash flows. Working with pre-tax cash flows involves discounting
cash flows with a pre-tax discount rate (which is higher than the corresponding after-tax
discount rate). However, after-tax cash flows are not simply pre-tax cash flows adjusted by the
tax rate. This is because taxes are based on accounting figures. For example, the tax benefit of
purchasing a machine is received in a different period from when the machine is paid for. So it
is virtually impossible to perform a valid discounted cash flow analysis using the pre-tax
approach.
chapter 4 / page 8
Second, some people recommend the use of an option-pricing framework to estimate the
value of a firm. The justification for this approach is that investment policy is not fixed and
unchangeable. Managers revise their investment strategy as they learn about the market, as
new technologies become available, as uncertainty about input and output prices is resolved,
etc. Ex-ante, the possibility of adjusting one's investment policy (the possibility of expanding
or contracting, postponing investment decisions, switching from one technology to another,
etc.) represents options that cannot be valued with the standard DCF approach. To handle this
valuation problem, option pricing models are necessary. In what follows, we will ignore this
interesting aspect of investment policy and focus instead on investment activities without
option characteristics. To value these simpler activities, we strongly recommend using the
DCF approach.
So far, we have talked about the appropriate valuation framework in general. This is, however,
not sufficient for actual valuation problems. We will therefore now deal with the technical
details of real-world valuation problems. In the next section, we start by determining the
relevant free cash flows.
4.2.3 Forecasting free cash flows

Forecasting free cash flows involves two different aspects. First, free cash flows have to be
defined so that everybody is talking exactly about the same thing. We will provide you with
the definition of free cash flows in the next section. In section 4.2.3.2 we will give you a few
very simple examples of how free cash flows have to be computed. The second, and probably
more difficult aspect of forecasting free cash flows is to determine which cash flows are
relevant to the valuation at all.
chapter 4 / page 9
4.2.3.1 Definition of free cash flow
Free cash flows (FCF) are defined in the following table:
Earnings from operations before interest and taxes (EBIT)

– Taxes (calculated as EBIT ⋅ marginal tax rate)
+ non cash relevant expenses (depreciation, provisions for doubtful debt, etc.)
– non cash relevant revenues (adjustments for currency changes, etc.)
= Gross cash flow1
– Changes in net working capital2,3
– Investment outlays (buildings, equipment, etc.)4,5
= Free cash flow from operations6
Table 4-2: Definition of free cash flows
Net working capital is defined as current assets (cash + receivables + inventories) minus
payables.
Financing considerations (interest and dividend payments, debt and equity issues, debt
repayments, equity repurchases, etc.) should not be taken into consideration since they
represent the use of free cash flow.
Given its definition, free cash flow is the amount of money available to the providers of
capital to the firm. Firm value (the value of the firm’s total capital) can therefore be computed
by discounting projected future free cash flows with the cost of total capital. If we were
interested in valuing only equity, instead, we could compute residual cash flows (i.e., free
cash flows minus all net payments to the providers of capital other than equityholders) and
discount them at the cost of equity.
1 Source: COPELAND Th., KOLLER T. and MURRIN J., 1991, “Valuation: Measuring and Managing
the Value of Companies”, John Wiley.
2 These changes can be positive or negative. Increases in net working capital represent cash drains and
should be deducted; decreases represent liquidations, or cash inflows, and should be added.
3 The item (Gross cash flow – Changes in net working capital) is occasionally defined as “Cash flow from
operations ”, (Working capital exclusive of cash balances), see STICKNEY C.P. and WEIL R.L., 1994,
“Financial Accounting”, p. 229.
4 Also known as “Cash flow from investing”, see STICKNEY C.P. and WEIL R.L., 1994, “Financial
Accounting”, p. 217.
5 Again, investments can be positive or negative. Positive investments are increases in fixed assets (and
should therefore be deducted), negative investments are liquidations of assets (and should therefore be
added).
6 Also known as “Operating free cash flow”.
chapter 4 / page 10
4.2.3.2 Introductory examples
Example: Paintball Company
Consider the following investment opportunity for Paintball Co.
Initial Investment 100'000 CHF

Annual Cash Revenues 50'000 CHF
Annual Operating Costs (incl. depreciation) 35'000 CHF
Life 10 years
Salvage Value 0 CHF
Depreciation for Tax Purposes 10'000 CHF a year
Tax Rate 40%
Cost of Capital 10%
How can we calculate the value of this investment project?
Solution:
In a first step, we calculate the relevant free cash flows (FCF) of the project. They are the same for
years 1 to 10. We have
FCF = Revenues – costs (incl. depreciation) – taxes + depreciation
FCF = 50'000 – 35'000 – taxes + 10'000

= 50'000 – 35'000 – (50'000 – 35'000) · 0.4 + 10'000
= (50'000 – 25'000) · (1–0.4) + 10'000 · 0.4 = 19'000 CHF.
Hence, the NPV of the project is:
NPV = –100'000 + 19'000 ⋅ PVIFA10,10

= –100'000 + 19'000 ⋅ 6.1446 = 16'747 CHF
where: PVIFA 10,10 (=Present Value Interest Factor of a ten-year Annuity at 10%) is the factor
typically used to value annuities. PVIFA is available from tables.
Example: Black versus Greene

Mr. Black and Mr. Greene are planning to manufacture a new product. The initial investment is
3'000'000 CHF. Mr. Black, an accounting expert, has prepared the following cash flow projections
for the project (in 1'000 CHF):
1998 1999 2000 2001
Net Sales 5'500 6'400 7'000 7'000

./. Cost of Goods Sold –3'000 –3'300 –3'500 –3'500
./. Depreciation –800 –700 –600 –500
= Gross Profit 1'700 2'400 2'900 3'000
./. Selling and Administrative Expenses –700 –690 –680 –680
= Net Income before Taxes 1'000 1'710 2'220 2'320
./. Taxes –400 –710 –820 –820
= Net Income 600 1'000 1'400 1'500
Bills and taxes are paid promptly. Sales are all on credit; payments for 50% of sales will be
received the same year, the remaining the following year. The appropriate discount rate for the
project is 20%. After 2001, the project is worthless.
Having considered these figures carefully, Mr. Black concludes that the investment is unprofitable,
because it has a negative net present value (NPV):
600' 000 1' 000' 000 1' 400' 000 1' 500' 000
NPV (Black) = −3' 000' 000 + + + + = −271' 990.7 CHF
1.2 1.2 2 1.2 3 1.2 4
chapter 4 / page 11
Mr. Greene disagrees. Unable to reconcile their differences, the two gentlemen hire you as a
consultant. What do you recommend?
Solution:
As in the example of Paintball, we first have to identify the relevant free cash flows. Cash inflows
have to be computed according to the historical pattern. Since 50% of the sales are paid one year
later, we will have some cash inflows in the year 2002 (50% of the 2001 sales, or 3.5 Mio. CHF).
Second, since we do not have any information to the contrary, we have to assume that the stated tax
figures are correct. The following table shows the estimated free cash flows (in 1'000 CHF):
1998 1999 2000 2001 2002
Cash Receipts 2'750 5'950 6'700 7'000 3'500

./. Cost of goods sold –3'000 –3'300 –3'500 –3'500
./. Selling and adm. expenses –700 –690 –680 –680
./. Taxes –400 –710 –820 –820
= Free Cash Flows -1'350 1'250 1'700 2'000 3'500
Given the initial outlay of 3 Mio. CHF, the net present value of the project is
1350000
' ' 1250000
' ' 1700000
' ' 2000000
' ' 3500000
' '
NPV = −3000000
' ' − + + + + = 97’929.5 CHF
12
. .2
12 .3
12 .4
12 .5
12
Consequently, the project is worth undertaking.
4.2.3.3 Estimating the initial investment

Make sure that you take the initial investment into account, the cost of placing the necessary
assets into service, any increase in net working capital, the net proceeds from the sale of
existing assets, and any tax considerations (investment tax credits, taxes on recapture of
depreciation, capital gains taxes, etc.).
4.2.3.4 The importance of tax deductions

Tax deductions can be important considerations in valuing acquisition targets. What follows
shows an example, although it would not be acceptable under most current tax codes.
Example: MP Inc.
You own a company, ABC Inc., which is expected to earn a taxable income of 60'000 CHF for the
foreseeable future. The tax rate is 48%. You are considering buying another company, MP Inc.,
with the following projected cash earnings before taxes:
Year 1 –20'000 CHF

Year 2 –20'000 CHF
Year 3 40'000 CHF
After 3 years, MP Inc. is worthless. MP Inc. also has an accumulated loss of 30'000 CHF which it
can deduct from taxable income in year one or any subsequent year for a maximum of 7 years. The
cost of capital of MP Inc. is 10%. What is the maximum amount of money you are willing to pay to
take over MP?
Solution:
The value of the MP Inc. stems primarily from the tax savings it generates for your own firm. In
the first year, you don't have to pay full taxes on your taxable income of 60'000 CHF since you can
deduct MP's operating loss (20'000 CHF) as well as the accumulated loss of 30'000 CHF. Overall,
you don't have to pay taxes on the combined total of 50'000 CHF. This yields tax savings of:
Tax savings by ABC (1) = 50'000 ⋅ 0.48 = 24'000 CHF
chapter 4 / page 12
At the same time, MP incurs an operating loss of 20'000 CHF. The net cash flow in year 1 to the
acquirer, ABC Inc., therefore equals 24'000 – 20'000 = 4'000 CHF.
In year two, ABC Inc. can again save taxes of 20'000 ⋅ 0.48 = 9'600 CHF. Nevertheless, MP Inc.
incurs an operating loss of 20'000 CHF. Taken together, the net cash flow of year two to the
acquirer, ABC. Inc., is 9'600 – 20'000 = –10'400 CHF. And finally in year 3, MP Inc. generates an
after-tax cash flow of 40'000 ⋅ (1 – 0.48) = 20'800 CHF.
The maximum you should therefore be willing to pay is:
NPV = 4'000 ⋅ 1.1 –10'400 ⋅ 1.1 + 20'800 ⋅ 1.1 = 10'668.7 CHF

-1 -2 -3
4.2.3.5 Estimating residual value

Residual value is either the residual cash flow from the project, a salvage value, or the value
of the cash flow we could obtain from investing the project's resources in alternative uses.
chapter 4 / page 13
4.3 EVA, MVA, CFROI, Abnormal earnings discount model*
4.3.1 Economic Value Added and Market Value Added*
4.3.1.1 Introduction*
The EVA Financial Management System was pioneered by Stern Stewart & Co., a global
consulting firm that specializes in helping client companies to measure and create shareholder
wealth. It is a consistent performance measurement and valuation tool and is also the basis for
a value based incentive plan.
Every value-based management intends to increase the wealth of its shareholders. This wealth
can be seen as the difference between the actual market value of a company minus the money
the providers of capital have paid in historically. Stern Stewart calls this difference Market
Value Added, or MVA.
MVA, though, is not a manageable measure. It depends on the market expectations and
fluctuates daily. Operating managers need a day-to-day periodic measure that guides them to
maximize MVA. This is where EVA comes into play. Mathematically, MVA can be
expressed as the present value of all future EVA. Managing for a higher sustainable EVA is
therefore managing for a higher MVA and, ultimately, for a higher share price.
EVA, or Economic Value Added, is nothing else than a periodic profit after taking into
account the opportunity cost of the capital invested in the operating business.
This section demonstrates the two major applications of EVA: Valuation (ex ante view, see
4.3.1.3) and performance measurement (ex post view, see 4.3.1.4). But before discussing
valuation and performance measurement, we will define a few important terms.
4.3.1.2 Definitions*
MVA is defined as follows:
Market Value of the Firm (market value of debt + equity)

– Invested Capital
= Market Value Added (MVA)
= Present Value of future EVA
The market value is the observable market capitalization of the firm (if the firm is traded) plus
the actual value of any interest bearing debt plus the market value of any financing vehicles
that are hybrid forms of debt and equity, such as preferred stock or convertibles. Invested
capital is an accounting number. It corresponds to the amount of money all investors (debt and
equity investors) have historically invested in this company (net of depreciation). For equity,
this investment can take the explicit form of an IPO or a seasoned equity offering or the
implicit form, where net income will be reinvested in the company that otherwise could be
paid out as dividends.
chapter 4 / page 14
EVA is defined as a Net Operating Profit After Tax (called NOPAT) minus a charge for the
invested capital (called capital charge).
Earnings before interest and tax (EBIT)

– Taxes (tax rate x EBIT)
= Net Operating Profit After Taxes (NOPAT)
Invested Capital (book value of debt + equity)

x Weighted Average Cost of Capital (WACC)
= Capital Charge
Net Operating Profit After Taxes (NOPAT)

– Capital Charge
= Economic Value Added (EVA)
In determining NOPAT, all financing related line items (such as interest expense) are ignored.
It is therefore a pure operating profit that is not influenced by the capital structure choice.
The invested capital is usually determined by the book value of net assets, i.e. fixed assets
plus net working capital (net working capital is defined as current assets minus current
liabilities). Of course, this is equivalent to book equity plus interest bearing debt.
The cost of capital is defined as the Weighted Average Cost of Capital (WACC). Since capital
is defined as debt plus equity, the corresponding cost of capital has to incorporate both sources
of capital. WACC is therefore defined as:
D E
WACC = Cost of Debt × (1 − Tax Rate) × + Cost of Equity ×
D+E D+E
It is important to note that the weights (D stands for Debt, E stands for Equity) should
correspond to market values of debt and equity. The market value of debt can usually be
approximated with its book value. The book value of equity, on the other hand, is typically
much different from its market value. Here, we run into a problem of circularity. We need a
market value based WACC as the discount rate to estimate the market value itself. This is not
only an EVA problem but it’s the same circularity if you value firms with the DCF approach
(Discounted Cash Flow approach). The typical solution to that is to use a target capital
structure for the weights (still, the target has to be expressed in market value terms).
The cost of equity is an opportunity cost. It is estimated with a capital market model such as
the Capital Asset Pricing Model (CAPM) or the Arbitrage Pricing Theory (APT).
The cost of debt is an opportunity cost as well. It can be approximated either by the CAPM, by
the yield to maturity on the outstanding loans or alternatively, especially if the debt is not
traded, by the sum of the risk free rate plus a risk premium based on the rating of the firm.
Because of the tax deductibility of interest payments, the cost of debt is taken after tax.
chapter 4 / page 15
4.3.1.3 Valuation with EVA*
4.3.1.3.1 Valuation of an investment project*

As stated above, the capitalized future EVA of a given investment project corresponds to the
MVA, which is exactly the net present value. We want to show this with an example:
Consider the following investment opportunity: Initial investment is 100. The project
generates after-tax free cash flows in the following two years in the amount of 100 each.
There will be no salvage value left after two years. What is the NPV of this project with a
discount rate of 10%?
NPV = - 100 + 100 / 1.1 + 100 / 1.12 = 73.55
To use the EVA approach we need NOPAT and a balance sheet to calculate the yearly EVA.
NOPAT is nothing else than free cash flow minus depreciation. Since the acquired asset has
no salvage value, it has to be depreciated over the two years (linear, by assumption). Based on
these assumptions, we get the following numbers:
Year 1 Year 2
Free Cash Flow 100 100
– Depreciation 50 50
= NOPAT 50 50
Invested Capital
100 50
(at the beginning of the year)
× Weighted Average Cost of Capital 10% 10%
= Capital Charge 10 5
NOPAT 50 50
– Capital Charge 10 5
= Economic Value Added 40 45
The present value of the future EVA (or MVA) is equal to:
PVEVA = 40 / 1.1 + 45 / 1.12 = 73.55
We see that we get the net present value of the project.
Note that ‘Invested Capital’ is clearly defined. Since a valuation is forward looking, the
amount of invested capital at the beginning of the project is equal to the cash outlay for the
initial investment.
We can also look at the difference between free cash flow and EVA to investigate where this
equality comes from. Free cash flow is defined as follows:
Free Cash Flow = EBIT – Tax + Depreciation – Incremental Investments

NPV of project = – Initial Investment + PV of Free Cash Flows
EVA = EBIT – Tax – Capital Charge

NPV of project = PV of EVA
chapter 4 / page 16
To test for the conditions, under which both approaches lead to the same result, we can write:
PV of EVA = PV of Free Cash Flows
PVEBIT – PVTax – PVCapital Charge = PVEBIT – PVTax + PVDepreciation – PVIncremental Investments
Since all investments are made up front, PVIncremental Investments is equal to the initial investment
and also equal to the invested capital. We can simplify the last equation to:
– PVCapital Charge = + PVDepreciation – PVIncremental Investments
PVIncremental Investments = PVDepreciation + PVCapital Charge
If the present value of any initial and future investments is equal to the present value of all
future depreciation plus the present value of all future charges on the invested capital (net of
depreciation), then both approaches lead to the same result. In fact, this equality is always
true.7
This also shows us the reason for a measure like EVA. Whereas in a DCF approach, all
investments occur in the period where the cash is spent, the EVA approach divides this capital
spending over its useful life in the form of depreciation. The capital charge is necessary to
make both approaches equal in their present values.
Although the example here is a very simple one, the general insight remains the same. An ex
ante valuation in terms of free cash flow is always identical to an EVA based valuation.
4.3.1.3.2 Valuation of a firm*

In a firm valuation context, MVA corresponds to the NPV of all investment projects the firm
currently has or is expected to initiate in the future. Since a firm is nothing else than a
portfolio of projects and from the MVA definition above, we can say that:
Firm Value = Invested Capital + Market Value Added

= Invested Capital + PV of future EVA
= PV of future Free Cash Flows
Let’s consider an example to illustrate this equivalence:
Year 1 Year 2 Year 3 Year 4 Year 5

Free Cash Flow (FCF) USD 30.0 USD 25.0 USD 20.0 USD 15.0 USD 10.0
Invested Capital
40.0 32.0 24.0 16.0 8.0
Depreciation 8.0 8.0 8.0 8.0 8.0
Invested Capital
32.0 24.0 16.0 8.0 -
(at the end of the year)
NOPAT (FCF – Depreciation) 22.0 17.0 12.0 7.0 2.0

Capital Charge (@ 10%) 4.0 3.2 2.4 1.6 0.8
EVA 18.0 13.8 9.6 5.4 1.2
7 See Loderer et al (2000) for a numerical illustration of this fact.
chapter 4 / page 17
The free cash flows are as given in the table. They – and nothing else – determine the value of
the firm (we assume no terminal value in this example), which is:
30 25 20 15 10
V0 = + 2 + 3 + 4 + 5 = 79.41
1 .1 1 .1 1 .1 1 .1 1 .1
How do we apply the EVA approach? EVA is calculated as the difference between NOPAT,
which is equal to free cash flow minus depreciation (linear, 20% per year), and the capital
charge, which is the cost of capital (10%) multiplied by the invested capital at the beginning
of the period8, i.e. in year 1, the capital charge corresponds to 4 (10% of USD 40). EVA for
year 1 is therefore 30–8–4 = 18.
If we capitalize the future expected EVA, we get:
18 13.8 9.6 5.4 1.2

PV of EVA = + + + + = 39.41
1.1 1.12 1.13 1.14 1.15
To get the firm value, we have to add the invested capital as of today:
Firm Value = PV of EVA + Invested Capital = 39.41 + 40 = 79.41
As we see, we get the same result under both approaches, not only for new investment
projects, but also for firm valuation purposes.
A question that often arises is the following: How can both approaches always lead to the
same result, if EVA uses a book value of capital in the valuation that can be influenced by
accounting rules? The answer is: Invested capital is irrelevant in the valuation of the firm, as
we see in the next example.
In this example, we present a different firm, but one that promises to generate exactly the
same future free cash flows as before.

Invested Capital
100.0 80.0 60.0 40.0 20.0
Depreciation 20.0 20.0 20.0 20.0 20.0
Invested Capital
80.0 60.0 40.0 20.0 -
NOPAT (FCF - Depreciation) 10.0 5.0 - (5.0) (10.0)

Capital Charge (@ 10%) 10.0 8.0 6.0 4.0 2.0
EVA - (3.0) (6.0) (9.0) (12.0)
8 It is important that we take the capital charge based on the invested capital at the beginning of the
period. We have to make sure, that in both approaches, we make the same assumptions. In the DCF
approach, we assume that all cash flows occur at the end of the year. This has to be true for the cash
flows from investments as well. This means, that the invested capital over the whole year corresponds to
the number at the beginning of the year.
chapter 4 / page 18
Since firm value is determined solely by the future free cash flows, the value has to be 79.41
as well.
What do we get with the EVA approach?
0 3 6 9 12
PV of EVA = − 2 − 3 − 4 − 5 = −20.59
1 .1 1 .1 1 .1 1 .1 1 .1
All future EVA will be negative, since depreciation and capital charge are much higher for
this firm. But as we have seen above, the present value of these two line items are equal to the
invested capital as of today. Since invested capital is added to the present value of EVA, the
whole thing is a wash.
Firm Value = PV of EVA + Invested Capital = –20.59 + 100 = 79.41
The interested reader might have realized that depreciation has changed and one might assume
that this is the reason why both approaches yield the same result. But even if we do not
depreciate the invested capital to zero, we arrive at the same result under both approaches.

Invested Capital
100.0 92.0 84.0 76.0 68.0
Depreciation 8.0 8.0 8.0 8.0 8.0
Invested Capital
92.0 84.0 76.0 68.0 60.0
Salvage Value 60.0
NOPAT (FCF - Depreciation) 22.0 17.0 12.0 7.0 2.0

Capital Charge (@ 10%) 10.0 9.2 8.4 7.6 6.8
EVA 12.0 7.8 3.6 (0.6) (4.8)
In this example, the depreciation schedule is the same as in the initial example. Capital though
is 100. What is important to note, is that the depreciation should reflect a true economic
reduction in the value of the invested capital. So, if capital is not depreciated to zero, it can be
sold for a positive salvage value at the end of the forecast horizon. Therefore the last free cash
flow has to include any cash inflows resulting from liquidating the firm, in our case USD 60.
The firm value based on the DCF approach is then:
30 25 20 15 10 + 60
V0 = + 2+ 3+ 4+ = 116.67
1 .1 1 .1 1 .1 1 .1 1.15
With the EVA approach, we get:
12 7.8 3.6 0.6 4.8

PV of EVA = + + − − = 16.67
1.1 1.12 1.13 1.14 1.15
Firm Value = PV of EVA + Invested Capital = 16.67 + 100 = 116.67
chapter 4 / page 19
So far, we have neglected any terminal value assumptions. Terminal values are calculated
after explicit forecast periods to capture the value impact in the long run of a firm’s life. To
focus on the important issues, we now look at firm valuations using only terminal value
formulas.
Let’s take a look at the following two firms: Company B is a firm that is not growing,
company D is a firm that is growing. Let’s start with company B first. It’s invested capital
today is 1’000’000. That capital is maintained over the years, i.e. investments replace the
depreciation. In this specific case, where investments are equal to depreciation, free cash flow
is equal to NOPAT. The return on the invested capital (NOPAT / Invested Capital) is equal to
10% and so equal to WACC. This means that all future EVA are exactly zero and that firm
value is equal to invested capital (1’000’000). This has to be equal to the DCF approach,
which is just an annual free cash flow of 100’000 capitalized as a perpetuity at a discount rate
of 10% (100’000 / 10% = 1’000’000).
In one year from now, everything stays constant. The company B has still an invested capital
of 1’000’000 and no future EVA, meaning: it still has a value of 1’000’000. How did the
investors in company B get their required rate of return of 10%. Because there are no
incremental investments, the free cash flows can be paid out, therefore, investors get 100’000
every year on an investment worth one million, i.e. exactly 10% (= 100’000 / 1’000’000).
Company B Year 1 Year 2 Year 3

Free Cash Flow USD 100’000 USD 100’000 USD 100’000
Invested Capital
1’000’000 1’000’000 1’000’000
Depreciation 50’000 50’000 50’000

Incremental Investments - - -
Total Investments 50’000 50’000 50’000
NOPAT 100’000 100’000 100’000

Capital Charge (WACC = 10%) 100’000 100’000 100’000
EVA - - -
Company D Year 1 Year 2 Year 3

Free Cash Flow USD 50’000 USD 52’500 USD 55’125
Invested Capital
1’000’000 1’050’000 1’102’500
Depreciation 50’000 52’500 55’125

Incremental Investments 50’000 52’500 55’125
Total Investments 100’000 105’000 110’250
NOPAT 100’000 105’000 110’250

Capital Charge (WACC = 10%) 100’000 105’000 110’250
EVA - - -
chapter 4 / page 20
Let’s now look at company D. This company is growing at 5% p.a. At the end of year 1, it
invests 50’000 in additional growth (the total investment is 100’000 from which 50’000 is to
offset depreciation and 50’000 is an incremental investment). Using the DCF approach, the
value of the firm, as of today, is:
V0 = FCF1 / (WACC – g) = 50’000 / (0.1 – 0.05) = 1’000’000
What do we get with the EVA approach? Invested capital today is 1’000’000. Because all
future EVA are zero, their present value is zero as well. Therefore, the fair value of the firm is
equal to its invested capital at the beginning of the year, 1’000’000 and equal to the DCF
value.
What is the value of company D in one year from now (at the end of year 1)? The first
incoming free cash flow will then be 52’500. It has grown by 5% because it is assumed that
the incremental investment yields a return on investment of 10%9.
The value of company D one year from now is:
V1 = FCF2 / (WACC – g) = 52’500 / (0.1 – 0.05) = 1’050’000
With the EVA approach, future EVA and also their present value are zero. Therefore, the fair
value of the firm is still equal to its invested capital. In one year from now, the invested capital
and the fair value of the company D is 1’050’000, the same as with the DCF approach.
In company D, the investors get their required rate of return of 100’000 in the form of free
cash flow (50’000) and a capital gain, since the firm value increases by 50’000 over that year.
In the second year, investors require still a 10% return on the market value, i.e. 105’000 =
10% of 1’050’000. They get half of it in free cash flow (52’500) and half of it in a capital
gain.
How can it be possible, that both firms (B and D) have the same value if one is growing and
the other not? The EVA approach gives us an intuitive view. Because future EVA are still
zero, it must be that the incremental investment does not add anything to the value of the firm.
If we look at our assumptions, it’s clear why this is the case. The incremental investments
promise a return of 10% which is equal to the required rate of return. Therefore, the
incremental investments have a zero net present value and the firm value is not increased by
these investments. It is important to note, that growth is not equal to wealth creation. EVA
does a much better job in the indication of future wealth creation and/or destruction and is
therefore helpful in finding reasonable assumptions about future investment behavior and its
outcome.
It is important to note that the growth rate g, that is used in terminal value assumptions is not
equal under the EVA and the DCF approach. The growth rate g, generally, corresponds to the
annual growth in NOPAT. Under constant growth assumptions, this means, that the annual
investment and depreciation also have to grow with g. If this is the case, then FCF also grows
with g (this is the typical assumption in the terminal value calculation with the DCF
9 In fact, if we assume a 10% return on incremental investment, there will be an addition to NOPAT of
10% of the investment. Since we assume a constant perpetual growth, depreciation, incremental
investments, and ultimately, free cash flow will grow with 5% as well.
chapter 4 / page 21
approach). In the EVA approach, if NOPAT grows with g, EVA does not. Therefore, the
terminal value calculation with the EVA approach cannot simply be defined as: Capital +
EVA / (WACC-g). The EVA valuation formula for perpetual growth is as follows:
EVA T + 1 I ROIC − WACC

Firm Value T = Capital T + + T +1 ×
WACC WACC WACC − g
In the formula, CapitalT is the invested capital at the beginning, EVAT+1 the first EVA, one
year from now, IT+1 the incremental investment and ROIC is the return on the incrementally
invested capital.
Let’s look at the application of this formula with a specific example:
Company X Year 1 Year 2 Year 3

Free Cash Flow USD 50’000 USD 51’250 USD 52’531.25
Invested Capital
1’000’000 1’050’000 1’101,250.00
Depreciation 50’000 51’250 52’531.25

Incremental Investments 50’000 51’250 52’531.25
Total Investments 100’000 102’500 105’062.50
NOPAT 100’000 102’500 105’062.50

Capital Charge (WACC = 10%) 100’000 105’000 110’125.00
EVA - (2’500) (5’062.50)
Company X is a growing company as well. We show only the first three years and assume a
perpetual growth afterwards. The growth rate (FCF, NOPAT) is 2.5% (e.g. 51’250 / 50’000 –
1 = 102’500 / 100’000 – 1 = 2.5%). The value of the firm with the DCF approach is therefore:
V0 = 50’000 / (0.1 – 0.025) = 666’667
Doing this valuation provides no information about where this value comes from. If we look
at the EVA approach instead, we gain further insights. As can be seen in the table, future EVA
are negative. In the beginning, the firm has an invested capital of 1’000’000 and creates
NOPAT in the amount of 100’000. So it breaks even on the actual investment, resulting in a
zero EVA (100’000/1’000’000 = 10% = WACC). But then, the firm invests even more
money. In the first year, 50’000 will be incrementally invested. But this incremental
investment only adds 2,500 to NOPAT in the following years. Although the firm is growing
(in the sense that its operating profit is growing), it actually destroys value: The incremental
investment has only a ROIC10 of 2’500 / 50’000 = 5%, whereas the required rate of return
(WACC) is 10%. This incremental investment is therefore value destroying, which is shown
in the negative EVA in year 2.
If we want to value the firm with the EVA approach, we use the above mentioned formula:
10 ROIC is the abbreviation of Return On Incremental invested Capital. It is defined as Incremental

NOPAT / Incremental Investment.
chapter 4 / page 22
0 50'000 0.05 − 0.1
V0 = 1'000'000 + + × = 666'667
0 .1 0 .1 0.1 − 0.025
We see again that we get the same value as under the DCF approach. But we have more
insights with this valuation procedure. First of all, the value is less than the actual invested
capital which automatically means that in the future, EVA will be negative, i.e. value will be
destroyed. We also see that ROIC lies below the required rate of return (WACC). From a
value based management perspective, this means, that management (and ultimately
shareholders) would be better off, if the company would not invest and not grow as assumed.
4.3.1.4 Performance Measurement with EVA*

As said in the introduction, EVA is not only a valuation tool it is also a tool to measure
managerial performance ex post. In fact, this is the major application of the concept.
Before, we have shown, that for valuation purposes, the choice of capital is irrelevant. But
how about measuring managerial performance? One could argue that market values are
typically higher than book values. If we then define EVA on book values instead of market
values, the required return in dollars would be typically underestimated and EVA would be
overestimated. Using EVA as the basis for determining executive compensation, so the
argument goes, would lead to an unjustified gift from the shareholders to the managers.
Book capital is the amount of money that has been historically invested in the company. This
is the amount of money, management received from the providers of capital to run the
business. Usually, and on purpose, EVA is measured based on this invested capital. The
reason for this can be found in the following table. We look at three companies, A, B and C.
Each company has a perpetual constant NOPAT of 90’000, 100’000 and 110’000,
respectively and each has the same invested capital of 1’000’000 (book value). The
opportunity cost of capital of these firms is 10%. The market values of the firms can be found
by capitalizing future free cash flows. Since there is no incremental investment, there is no
growth. Investments are only made to offset depreciation. Therefore free cash flow is equal to
NOPAT and the market values are 90’000 / 10% = 900’000 for company A, 100’000 / 10% =
1’000’000 for company B and 110’000 / 10% =1’100’000 for company C, respectively.
Company A Company B Company C

NOPAT (= FCF) USD 90’000 USD 100’000 USD 110’000
Invested Capital (Book Value)
1’000’000 1’000’000 1’000’000
Market Value
900’000 1’000’000 1’100’000
NOPAT 90’000 100’000 110’000

Capital Charge (on Book Value) 100’000 100’000 100’000
EVA (10’000) - 10’000
NOPAT 90’000 100’000 110’000

Capital Charge (on Market Value) 90’000 100’000 110’000
EVA - - -
Return on Invested Capital 9% 10% 11%

Return on Market Value 10% 10% 10%
chapter 4 / page 23
If we calculate EVA based on book values we find that company A is not able to generate a
NOPAT high enough to cover the charge for the capital in place, i.e. it has a negative EVA.
Company B is neutral whereas company C has “very good” managers. They are able to
generate NOPAT that are higher than the capital charge, i.e. they generate positive EVA.
If we use market values instead, and assume that market prices are fairly set, every company
has an EVA of zero in each year, by definition. Company A, with the “bad” managers (earning
a return on the book value of 90’000 / 1’000’000 = 9%) now has the same EVA as Company
C with the “good” managers (earning a return on the book value of 11%). The problem with
this approach is that market prices incorporate information about inferior or superior operating
performance. If the prices are fairly set, each company promises a return on market value (=
NOPAT / Market value of firm) of 10%, irrespective of the underlying operating performance.
Companies with a bad operating performance, such as Company A in our example, don’t
promise a lower return on its stocks but the stocks will just sell for a lower price.
Therefore, the right basis for measuring managerial performance is the money given to them
by the providers of capital and this amount of money is the book value. A “good”
management, where the market expects a superior performance, would otherwise never be
able to profit from its superior ability to generate positive EVA in the future.
4.3.1.5 Conclusions*
EVA is a measure for periodic economic profit. It is defined as an after tax operating profit
minus a charge for the invested capital.
For valuation purposes, and therefore, for evaluating future investment opportunities, it can be
shown that the EVA approach and the DCF approach are absolutely equivalent.
EVA is typically used to measure managerial performance ex post. The major advantage in
using EVA is that management is held accountable for the money they received from their
investors. If management decides to invest such money in the operating business, they have to
deliver returns high enough to offset the economic depreciation of the assets in place and also
the opportunity cost of the capital invested; only then, EVA will be positive. This
requirement, reinforced by an EVA based compensation system, generates strong incentives to
invest only in positive NPV investments and to manage projects to create the most possible
value for the shareholders.
4.3.2 Cash Flow Return on Investment*
4.3.2.1 Definition*
The Cash Flow Return on Investment (CFROI) model has been developed by another global
consulting firm, HOLT Value Associates. HOLT's basic premise is that the stock market sets
prices based on cash flows, not traditional accounting measures of corporate performance like
reported earnings. The CFROI model is, like the EVA model, its major competitor, rooted in
discounted cash flow principles (more cash is preferred to less, sooner is preferred to later,
less uncertainty is preferred to more). But it is supposed to be substantially more accurate than
EVA, because 1) it deals with inflation-adjusted figures and 2) it minimizes accounting
distortions. This means that CFROIs are more comparable over time and across companies in
different industries and different countries.
chapter 4 / page 24
From a theoretical standpoint, CFROI is a cross-sectional return measure of a portfolio of
ongoing projects. Each project a) has a life cycle, b) requires an initial outlay of depreciating
assets (plant, goodwill) and non-depreciating assets (net working capital, land), c) generates
cash flows over the life of the project and d) releases the non-depreciating assets at the end of
the project.
Individual projects cannot be identified by outside investors. But financial statements do

reveal the amount of total depreciating assets, total non-depreciating assets, and total cash
flow. Consequently, it is possible to compute the CFROI without knowing the specific returns
of all projects.
Asset life
Asset life can be defined as follows:
Adjusted gross plant

Asset life =
Depreciation of gross plant
The gross plant amount is the cost of all tangible fixed assets. However, land is excluded
because there is no associated depreciation expense.
Depreciating assets
Depreciating assets can be defined as follows:
Inflation-adjusted gross plant
+ Capitalized value of operating leases
+ Goodwill
= Depreciating assets
Gross plant assets must be adjusted for inflation. In other words, we should estimate the
current value of these assets, and not simply use reported figures, which are usually a mix of
different purchasing-power dollars.
Some operating assets are not mentioned in the balance sheet, because they are not owned but
leased by the company:
Annual rental expense
Capitalized value =
Real debt rate
In HOLT's database, the amount of intangibles (goodwill) is included in assets for measuring
CFROIs. This is basically a good decision, because the firm's capital suppliers paid for the
goodwill. Unfortunately, accounting standards differ between companies which purchase
intangible assets through acquisitions and companies which generate goodwill by increasing
the value of their own intangible assets (for instance by training their staff). In the first case,
goodwill is considered as an asset. In the second, it is not, and the CFROI may appear much
higher than it really is.
chapter 4 / page 25
Non-depreciating assets
Non-depreciating assets can be defined as follows:
Net monetary assets
+ Current-dollar inventory
+ Current-dollar land
= Non-depreciating assets
Net monetary assets (excluding inventories) are cash, short-term investments, receivables and
other current assets, less current liabilities (accounts payable, income taxes payable, other
current liabilities).
Inventory must be valued in current dollars, i.e. by using the FIFO (first-in, first-out) method.
As with plant, land is usually stated in historical dollars. This value should also be adjusted to
take inflation into account.
Gross cash flow

Gross cash flow (the amount of cash flow resulting from the company's business operations,
regardless of how they are financed) can be defined as follows (we have ignored the effects of
pension and tax accounting):
Net income
+ Depreciation & Amortization
+ Adjusted Interest Expense
+ Rental expense
+ Inflation adjustments
+ Minority interest
= Current-dollar gross cash flow
Depreciation and amortization are added to net income because they are non-cash operating
expenses.
Interest expense is added too, because it is viewed as a financing cost, not an operating cost.
Since in the depreciating assets calculation, leases were capitalized, rental expenses must be
added to net income as well.
Inflation adjustments come from:

- the restatement of LIFO inventories to their FIFO value
- the adjustment of nominal interest revenues and expenses to real values
A minority owner is treated as a supplier of capital in the CFROI model. Therefore, minority
interest is added back to net income.
chapter 4 / page 26
Example:
Company H
Asset life 5 years
Depreciating assets USD 500’000
Non-depreciating USD 50’000
assets
Annual gross cash USD 150’000
flow
Total investments in year 0 = USD 500’000 + USD 50’000 = USD 550’000

Total cash flow in years 1 to 4 = USD 150’000
Total cash flow in year 5 = USD 150’000 + USD 50’000* = USD 200’000
* non-depreciating assets are supposed to be released at the end of the asset life
CFROI = internal rate of return of the “project” =13.34%
4.3.2.2 Valuing a firm*

Theoretically, DCF valuation requires forecasting the entire stream of future net cash receipts
(i.e. gross cash flow less investment in depreciating and non-depreciating assets plus release
of non-depreciating assets) for the life of the firm.
The CFROI model separates the forecast net cash receipts (NCR) stream into two parts:
1. NCRs from existing assets
2. NCRs from future investments
Each of the NCR streams can be separately discounted, giving separate net present values for
existing assets and for future investments.
Value of existing assets

The stream of NCRs from existing assets depends on:
a) the current level of gross assets (depreciating assets + non-depreciating assets)
b) the current level of CFROI
c) the asset life
d) the age of existing plant
e) the fade rate of CFROI
It is assumed that the value of depreciating assets will come down to zero over the asset life.
Non-depreciating assets are supposed to be progressively released over the asset life.
The age of existing plant is an important factor. The older the plant, the more rapid the wind-
down of cash flows because of greater plant retirements in earlier years.
The fade rate of CFROI is even more important. HOLT has demonstrated that CFROIs tend to
fade over time, down (or up) toward the average. The magnitude of change depends on 1) the
CFROI level (the higher – or the lower – the CFROI, the quicker the move toward the
average), 2) the variability of past CFROIs (the higher the variability the quicker the move
toward the average) and 3) the dividend payout ratio (the lower the ratio – i.e. the higher the
reinvestment rate – the quicker the move toward the average; it is, however, worth noting that
as for below-average CFROI firms, the payout ratio is not significant). In other words, high-
growth companies with high and variable CFROIs exhibit the most rapid profitability
chapter 4 / page 27
declines, whereas firms with low and variable CFROIs (whatever their payout ratio) improve
their returns at the greatest pace.
The estimates of future NCRs from existing assets are then discounted so as to get their
present value. Interestingly, the discount rate is part of HOLT's model (which is not the case
in the EVA model). As in the case of deriving a bond's yield to maturity from its market price
and its expected stream of interest payments plus principal repayment, the discount rate
employed in the CFROI model is a real market discount rate derived from the market's price
for an aggregate of firms and a forecasted net cash receipts stream for the aggregate which is
consistent with the model itself.
The real debt rate is calculated as the nominal rate less inflation expectations. The CFROI
model – unlike the EVA model – employs a before-tax debt rate, since the tax deductibility
benefit is captured by higher CFROIs.
The real equity rate, for its part, can be derived from the real market discount rate (calculated
as explained above) and the real debt rate (remember that the real market discount rate is a
combination of the real debt rate and the real equity rate).
Firm-specific discount rates are computed as follows:

Market discount rate
+ Risk differential related to the firm's size
+ Risk differential related to the firm's financial leverage
= Firm-specific discount rate
Risk differentials (positive, negative or nil) appear because the effects of financial leverage
and size (i.e. equity market capitalisations) cannot be eliminated through portfolio
diversification. They are also derived from market observations.
Value of future investments

There are two basic steps in calculating the present value of the NCR stream generated by
future investments.
First, the incremental wealth created from each future investment is computed as the present
value of that investment in the year undertaken less the amount invested.
Second, that incremental wealth is discounted to a present value for “today”. The cumulative
amount of these present values represents the estimated value of the firm's future investments.
The fade-toward-average effect of competitive forces applies to both the wind-down of cash
flows from existing assets and the profitability of future investments. This means that sooner
or later, the CFROI will be equal to the discount rate. Consequently, from that date onward,
the incremental wealth from new investments is supposed to be nil. You may relate this effect
to the “competitive advantage period” defined in the EVA model.
chapter 4 / page 28
Value of the firm
Finally, the total value of the firm can be defined as follows:
Value of existing assets
+ Value of future investments
= Value of the firm
4.3.3 Abnormal earnings discount model*
4.3.3.1 Valuing cyclical companies*

The financial results of cyclical firms are, by definition, volatile and depend upon the state of
the economy. Their earnings explode in economic booms while they collapse in economic
downturns.
May we nevertheless use standard discount models (like the DCF) for valuing such
companies? The answer is definitely yes. But in order to do so, we first have to deal with the
following issues:
1. How can we predict the cash flows of cyclical firms?
2. What discount rate should we use to compute their present value?
Predicting the results of cyclical firms

Cyclical companies’ earnings volatility is basically due to sudden and often sharp changes in
sales volumes and/or selling prices. Above-average operating leverage (cyclical firms’ fixed
costs usually account for a large part of total costs) and financial leverage (cyclical firms’
debt-to-equity ratios are usually high) expand the impact of sales cyclicality on the companies’
profitability.
Suppose that you had perfect foresight about the industry cycle, and that you were able to
predict the future peaks and troughs of Company X’s earnings. It would then be easy to
compute its fair value by using the DCF model.
Because high cash flows mathematically cancel out low cash flows, the DCF value of
company X should theoretically prove to be much less volatile than earnings. And in practice,
it can be observed that the market values of cyclical firms are indeed not as volatile as their
results, although they are less stable than theory would suggest. This may well be due to the
fact that analysts tend to extrapolate the firms’ latest results, as if those results were going to
break out of their old cycle and establish a new trend.
As you – like all analysts – are not a seer, the best way to predict the performance of a cyclical
firm is to normalize its stream of expected cash flows. Depending upon at what stage of the
economic cycle a valuation is done, the current year’s earnings may be too low (if there is a
recession) or too high (if the economy is at a peak) to be used a base year. In order to avoid
significant errors in valuation, you should first adjust the current-year figures, as if you were
precisely at the middle point of the economic cycle. You would then apply an average growth
rate to the adjusted base earnings to assess the normalized stream of future cash flows. Just as
if you were dealing with a high-visibility firm, such as a food & drink company.
chapter 4 / page 29
Be aware that the implicit assumption in the use of normalized earnings as base-year earnings
is that cyclical firms will quickly revert back to this level when the economic cycle turns. This
may sometimes prove unrealistic, in particular if the firm’s fundamentals have changed.
You could use the following two-scenario approach to take this possible change into account:
1. Assess future cash flows as if the firm's fundamentals had not changed (in other
words, assess normalized cash flows on the basis of past cycles)
2. Assess future cash flows as if the firm's fundamentals had changed (in other words,
assess normalized cash flows on the basis of recent results)
You would then assign probabilities to the two scenarios and compute a weighted value of
future cash flows.
Calculating the present value of cash flows

Because we have given up the idea of predicting future recessions and recoveries, the stream
of future cash flows may well look too optimistic. The trend is fine, but the volatility of
earnings has been erased thanks to the normalization process. How can we then take the real
earnings visibility (which is low) into account? Simply by increasing the discount factor (the
cost of equity or the WACC, depending on the model used), which should be consistent with
the fact that normalized earnings are unlikely to turn out as actual earnings. In other words,
you must use a higher rate for discounting the normalized (and unrealistic) cash flows of a
cyclical firm than for discounting the non-normalized (and more realistic) cash flows of a food
& drink company.
However, should the discount rate be artificially increased? The answer is no. Do not forget
that over the entire economic cycle, high cash flows cancel out low cash flows (i.e. the present
value of a steady stream of cash flows discounted at 10% is more or less equal to the present
value of a volatile stream of cash flows discounted at 10%, provided that earnings trends are
similar). In other words, just assess the fundamental risk (sales volatility, operating leverage,
financial leverage, etc.) of investing in a cyclical company, convert that risk into the proper
discount rate – which is likely to be quite higher than the food & drink’s one – and apply that
discount rate to the normalized stream of cash flows, as if you had not gone through the
normalization process.
4.3.3.2 Valuing start-ups*

Assessing the value of start-ups is a difficult task, and this is no news. But it has now become
part of the day-to-day job of analysts, at least of those in charge of monitoring technology and
healthcare stocks.
Can you use standard models (like the DCF) to estimate the fair value of such companies?
Once again, the answer is definitely yes.
Valuing Internet companies

Most Internet companies make losses. Shorthand valuation approaches, in particular the well-
known price/earnings ratio, are meaningless. Some practitioners recommend using alternative
methods such as revenue multiples (when revenues are high enough) or market share
multiples. But these shortcuts are often misleading, since they do not take into account what
drives the company’s value in the long run, i.e. earnings and/or cash flows (depending on the
model you are referring to).
chapter 4 / page 30
The best way to value Internet companies is to return to economic fundamentals. The absence
of meaningful historical data doesn't matter, since the DCF model relies solely on forecasts. In
other words, this model can easily capture the worth of businesses which experience several
years of initial losses.
How to predict Internet firms’ future cash flows? You are not a seer, as we have already
noted. Does that prevent you from building scenarios on what those companies might look
like in a few years from now?
Provided they do not go bankrupt in the meantime, all high-growth companies are due to
become moderate-growth companies. Consequently, sooner or later, the usual measures such
as the penetration rate or the revenue per customer will apply. Although it requires some
imagination, you should be able to assess the “normalized” earnings that an Internet company
could achieve in, say, 15 years from now, as well as its long-term growth rate (the one that
will be valid from Year 15 onward).
What about the cash flows from Year 1 to Year 14? You could estimate them by
“extrapolating back” the Year 15 performance to ensure consistency with the company's
current figures.
As regards discount rates, don't miss the point! Internet firms are riskier than average, even
riskier than cyclical companies.
The DCF model can't eliminate the need to make difficult forecasts. But it does address the
issues of high growth rates and uncertainty in a coherent way. Don't be content with a single
scenario. You should draw up three or four of them, and then assign probabilities to them.
You will then get a more accurate result than by trying to compute a single fair value.
Valuing biotech companies

Valuing biotech companies is no more difficult than valuing Internet firms from a technical
standpoint. Here again, you should stick to standard models.
The main issue lies in the fact that developing a new drug takes much more time than creating
new software. In other words, biotech companies are likely to experience losses for more
years than dot.coms. In addition, assessing the potential sales of a drug that won't be on the
market before 5 or even 10 years is not an easy task, to say the least.
Although future cash flows are very difficult to predict, analysts with a good knowledge of the
healthcare industry can rely on the DCF model.
Theoretically, you could also use an option pricing model to value biotech companies, since
those firms look like out-of-the-money call options. But this approach is almost impossible to
implement in practice.
chapter 4 / page 31
4.4 Measures of relative value
4.4.1 Price/Earning ratio and valuation

An alternative and widely used method to value stock relies on P/E ratios. The P/E ratio
shows how much investors are willing to pay per unit (CHF, USD, etc.) of reported profits
(price/earnings). The method is very adaptable since it can be used for traded as well as for
non traded stocks. Moreover, it is simple and doesn't require time-consuming data analysis;
only two numbers need to be known to apply the method: the earnings of the firm to value and
the P/E ratio of the industry in which the firm does its business. After a short introduction to
the method, we'll discuss in detail an empirical investigation that considers the accuracy of
this valuation method before we take a look at its main weaknesses.
4.4.1.1 General considerations

The easiest way to start is with an example. Suppose you want to determine the value of Firm
Z's stock, which is not traded. To apply the P/E ratio pricing model, all you have to know is
Firm Z's earnings and the average P/E ratio of Firm Z's industry. For instance, if the industry
P/E ratio is 10.0 and Firm Z has current earnings of 100 CHF, the value of the firm can be
calculated by multiplying the firm's earnings with the firm's industry P/E ratio (the average of
the ratios of comparable firms). Of course, the implicit assumption is that the differences
among different P/E ratios in the industry are random.
Following this procedure for Firm Z, we arrive at the following equality
Value Firm Z = Firm Z's earnings ⋅ Firm Z's industry P/E ratio = 100 CHF ⋅ 10.0 = 1’000 CHF
One of the advantages of the P/E ratio method is that it can be used to value stocks for a
variety of situations: acquisitions, mergers, initial public offerings, valuation of non-traded
firms and securities, stock price forecasting or investment strategies.
Example: Use industry P/E ratios to impute the value of Novartis bearer stock
The following table shows average P/E ratios (January 2003 prices) for different Swiss industries:
Industry P/E ratio

Banks 13
Health Care 16
Food 15
Electronics 15
Insurance 8
To value the Novartis stock, we need to know the earnings per share (EPS) of Novartis. In 2002
they were 2.91 CHF. Using this estimate (the alternative would be to update it), in January 2003,
the implied bearer stock price could have been computed as
2.91 CHF ⋅ 16 = 46.6 CHF
The assumption is that Novartis is mostly in the health care industry. The actual bearer stock price
(January 2003) is 50 CHF.
chapter 4 / page 32
4.4.1.2 Interpretation
To interpret what we do when we compute equity values with this valuation method, assume
that the payout ratio is 1 (earnings are all paid out, i.e., dividends per share = earnings per
share = EPS) and that earnings are a constant perpetuity. Under these circumstances, stock
value can be computed using the constant dividend model as
EPS
P0 =
kE
where kE is the cost of equity capital.
Notice that we can use this expression to calculate the P/E ratio
P0 1
=
EPS k E
This result shows that in a world of constant earnings and full payout, P/E ratios can be
interpreted as the reciprocal of the cost of capital.
Consequently, in a world of constant earnings and full payout, the industry average P/E ratio
is a measure of the inverse of the cost of equity capital of the representative firm in the
industry. In the above example, a P/E ratio of 17 implies a discount rate of
1
kE = = 5.9%
17
Clearly, this figure is too low to be an average cost of equity capital.
A more realistic alternative is to assume a constant dividend growth model. In that case,
rearrangement of the Gordon-Shapiro model yields the following expression for the P/E ratio:
P0 π ⋅ (1 + g)
=
EPS0 kE − g
As one can see, the P/E ratio is now a function, among other things, of the rate of growth of
earnings (dividends), g, and of operating and financial risk (as reflected in the cost of equity
capital kE).
chapter 4 / page 33
4.4.1.3 Empirical accuracy of the method
In a paper, Loderer and Trunz11 analyse the performance of the P/E valuation method of
estimating the value of traded and non-traded firms. First, they compute the theoretical stock
price of a share with the P/E ratio method ( P$ ). Then, from this value, they subtract the
observed market price of the share (P) and divide the difference by P. Formally, this valuation
error, e, can be written as
P$ − P
e= ⋅ 100
P
Table 4-1 provides descriptive statistics of the valuation error for a sample of 88 traded firms
(188 stocks, respectively) on the Zurich Stock Exchange for the period 1983-199212. The
results are qualitatively identical for a sample of non-traded stock.
Valuation Error of Traded

Firms (1983-1992)
Number of observations 1123
Average 3.1%
Median –1.0%
Lower 25% of Cases ≤ –22.6%
Upper 25% of Cases ≥ 21.7%
Maximum 267%
Minimum –92.8%
Standard deviation 44.6%
Table 4-3: Descriptive statistics of the valuation error
These findings can be summarised as follows: the average as well as the median valuation
errors are almost zero. Nevertheless, the valuation errors are characterised by significant
variation. In 50% of all cases, the absolute valuation error is greater than 22%. To give an
intuitive idea for the minimum (maximum) errors reported in the study, consider a stock with
value of 100 CHF. A valuation error of –92.8% means an imputed value of 7 CHF instead of
100 CHF. Conversely, a valuation error of 267% implies a theoretical price of 367 CHF for a
stock that is worth only 100 CHF.
Figure 4-1 shows that the relative frequency distribution of the valuation error is not
symmetric, but skewed to the right. It is characterised by a large number of relatively small
negative valuation errors and a comparatively small number of relatively large positive
valuation errors.
11 See LODERER C. and TRUNZ R., 1993, “Das Price-Earnings Verfahren”, Der Schweizer Treuhänder,
Nr. 10, pp. 741.747.
12 From LODERER C. and TRUNZ R., 1993, “Das Price-Earnings Verfahren”, Der Schweizer
Treuhänder, Nr. 10, pp. 741.747.
chapter 4 / page 34
30% 28%
26%
25%
20%
15%
15%
11%
10%
7% 7%
5% 3%
2% 1% 1% 1% 0% 0% 0% 0%
0%
-75 bis -50%
-50 bis -25%

-100 bis 75%
-25 bis 0%
0 bis 25%
25 bis 50%
50 bis 75%
75 bis 100%
100 bis 125%
125 bis 150%
150 bis 175%
175 bis 200%
200 bis 225%
225 bis 250%
250 bis 275%

Percentage Valuation Error
Figure 4-1: Frequency distribution of valuation error full sample (1983-1992)13
Overall, Loderer and Trunz14 draw the following conclusions:

1. The average valuation error for quoted stocks is remarkably small. The variance of this
number, on the other hand, is rather large. When using the P/E valuation method, the true
value of our individual firm lies in the range between –84% to +91% with 95% confidence
(Relying on an approximately normal distribution, the 95% confidence interval can be
computed as 3.1% ± 1.96 ⋅ 44.6%).
2. The distribution of the valuation error is skewed to the right.
3. The results depend on the industry considered. The method seems to be especially effective
for valuing banks.
4. The results for a sample of non-quoted stocks are comparable to the ones for quoted stocks.
In practice, a financial analyst’s job is usually to value a single firm. The fact that the P/E
valuation method yields good estimates on average, i.e. when valuing a lot of firms, is not
particularly helpful here. In the case of a single firm, the variance of the value estimate is very
important. And clearly, a 95% confidence interval between –84% to +91% for traded stocks
(between –103% and +122% for non-traded stocks) is quite large. This should be kept in mind
when using the P/E valuation method as a tool for determining investment strategies.
13 Source: LODERER C. and TRUNZ R., 1993, “Das Price-Earnings Verfahren”, Der Schweizer
Treuhänder, Nr. 10, pp. 741.747.
14 See LODERER C. and TRUNZ R., 1993, “Das Price-Earnings Verfahren”, Der Schweizer Treuhänder,
Nr. 10, pp. 741.747.
chapter 4 / page 35
4.4.1.4 Problems of the P/E ratio valuation method
In principle, there are various reasons why the P/E valuation method should be fraught with
measurement error. This can be seen by referring to the Gordon-Shapiro model and noticing
that P/E-ratios can differ systematically across firms because of differential growth, and
differential financial and operating risk. As the following considerations will show, this is true
in general.
Problem 1: The method does not take differential growth into consideration
To see this, consider a specific industry. Table 3-2 below shows the average expected income
growth of the industry (“average income”). For simplicity, we assume a three-year horizon.
Given these figures, and assuming a 10% cost of equity capital, the value of the representative
stock at the beginning of year 1 is 249 CHF. That implies an industry P/E ratio of 249 / 100 =
2.49.
Firm Z does business in the same industry. In year 1, Firm Z's earnings are expected to grow
in line with the industry. Thereafter, they are expected to grow at a faster rate. Clearly, if we
price Firm Z's stock with the industry's P/E, we ignore this faster growth and obtain a stock
value that underestimates the true value 2.49 ⋅ 100 = 249 CHF instead of 482 CHF.
Average income Income of firm Z

Previous year 100 CHF 100 CHF
Year 1 100 CHF 100 CHF
Value (i = 10%) 249 CHF 482 CHF
Average P/E ratio in Year 1 2.49
Table 4-4: P/E ratio and earnings growth
Problem 2: Earnings depend systematically on financial and operating risk

Let us consider financial risk. We know that leverage (financial risk) has a systematic
influence on P/E ratios, i.e. that higher risk implies lower P/E ratios.
To see this effect, consider an industry in which all firms but one (Firm Z) are 100% equity
financed. The average industry P/E ratio is 10. Firm Z, however, is financed with 50% equity
and 50% debt. As shown earlier, higher financial leverage reduces P/E ratios. So the P/E ratio
for firm Z is lower than the industry average. Consequently, using the industry P/E ratio to
value the stock of Firm Z systematically overestimates the value of Z stock.
Problem 3: Earnings are accounting-based numbers

Since earnings are accounting-based figures, it is possible, at least in principle, to manipulate
earnings figures (depreciation, hidden reserves etc.). To the extent that a firm uses accounting
principles that differ from other firms in the industry, we cannot use the industry average P/E
ratio to compute its theoretical stock price.
chapter 4 / page 36
4.4.2 Price/ book value ratio
As we have seen in the previous section, price/earnings ratio is the most popular ratio of
relative valuation. However, it is not proper for an analyst to use only one ratio. So, we
recommend three more ratios. These are to be used along with the P/E ratio. These are:
• Price/ book value ratio
• Price/ cash flow ratio
• Price/ sales ratio
Let us look at the price/ book value ratio. This ratio is calculated by
PBV ratio = Market price / book value of the common stock
where
Book value = tangible net worth of the business / number of shares outstanding
Here, tangible net worth is calculated as,
Paid up capital + free reserves less intangibles
It must be noted that this ratio, is calculated net of depreciation. As this depends on the
balance sheet figures, it suffers from the same defect of dependence on accounting
information. As you might have read in the binder on financial statement analysis, the
accounting policies and treatment of different items will distort this ratio.
This ratio is useful in old economy stocks or companies which are in existence for some years.
This is not very useful in the case of new economy companies. Another drawback of this ratio
is that it can be used only for valuation of full firm. This cannot be used for valuation of parts
of business such a division or a product or a brand.
We also know that the book value is a substitute for retention policies of the past. Thus, if a
company keeps paying less dividends and ploughs the profits into business, its book value is
likely to be higher. Hence, a lower price/ book value ratio is a measure of market’s view about
the organization’s dividend policy as well as future growth. Thus, in association with
price/earnings ratio, this gives useful results.
4.4.3 Price/ cash flow ratio

The above two ratios, P/E ratio, as well as P/BV ratio are affected by the accounting policies
of the firm. To correct for the distortion, the analyst could also use two more ratios of relative
valuation. These are,
• Price/ cash flow ratio
• Price/ sales ratio
Price to cash flow ratio is an extremely important measure of relative valuation. This
eliminates the accounting treatment effect on profits. Another important aspect is that this
ratio can be used as a surrogate for Price / EBITDA ratio (earnings before interest, taxes,
chapter 4 / page 37
depreciation and amortization). This is one ratio which is becoming very popular in evaluating
fast growth, new economy stocks which do not have a long history.
Price to cash flow ratio is calculated as:
Market Price/ Free cash flow per share of ordinary stock outstanding.
Example:
a) ABC Co. had a profit of 100’000 CHF during the year N. Depreciation for the year was 20’000
CHF. Other intangibles charged to income statement were 25’000 CHF. At the end of the year,
number of common stock outstanding were 100’000. Market Price as at the closing of March 23,
N+1 was 100 CHF at the principal stock exchange. Calculate the P/CFW ratio as at March 23,
N+1.
b) Compare this with XYZ Co. with same profits, but with only a depreciation of 20’000 CHF.
There are no intangibles.
Solution:
a) Free cash flow = Net profits + depreciation + other intangibles
= 100’000 + 20’000 + 25’000 CHF
= 145’000 CHF
P/FCW ratio = 100/ (145’000 / 100’000)

= 100 / 1.45
= 69 (roughly)
b) Free cash flow = Net profits + depreciation + other intangibles

= 100’000 + 20’000 CHF
= 120’000 CHF
P/FCW ratio = 100/ (120’000 / 100’000)

= 100 / 1.20
= 83.3 (roughly)
Now, you can clearly see that Price/ Earnings ratio of both the firms will be the same. But, the
price to cash flow ratios are different. We find that the second firm enjoys a higher market
appeal. This may be due to various reasons. Perhaps, the intangibles in the first case are not
viewed as highly by the market. May be, the market values the dividend paying capacity of the
second firm higher.
The advantage of this ratio, is that it can be used for both new economy and old economy
stocks and can be used to value firms in different industries as well. It also can be used even
for valuation for mergers, corporate restructuring, valuation of different geographical
segments etc.
4.4.4 Price / sales ratio

Valuation is not only used for finding whether a stock is under- or overvalued, but also for
deciding the price to be paid if the business is to be purchased. The need for valuation of
different segments of business has grown in the last ten years. We value parts of business in
the case of mergers, restructuring, sale of a product or a brand or intangibles. Obviously, price
earnings ratio and price to book value ratio fail in this respect. So, we use price to cash flow
ratio to determine the value of parts of business. Apart from this, another quick and
chapter 4 / page 38
convenient ratio used for this purposes, is the price to sales ratio. This can be used even for
determining different segments of business separately. Say, we want to value a company like
3M or Hyundai or DUPONT or PCCW. These are large conglomerates. They are also into
many areas of business. To value the company, we may use a method called sum of the parts.
That is, we value each of the separate line of activity. Finally, we arrive at the final value by
adding the value of each of the lines of activity. For this, we may use Price/ Sales ratio.
Price/ Sales ratio = Market price / Sales of each of the lines of activities or the firm per share
outstanding.
Example
Let’s take ABC Co. which is in three lines of business and the details are given below:
Market price: 100 CHF per ordinary share

Number of ordinary shares outstanding: 100’000
Sales in CHF P/S ratio of industry

Division A 100’000 13
Division B 200’000 15
Division C 250’000 25
Calculate the value of each division. If the composite Price to sales ratio is 16 in the respective
country, then comment on the valuation of ABC Co.
Solution:
Sales in CHF P/S ratio of industry Valuation of parts*
Division A 100’000 13 1’300’000
Division B 200’000 15 3’000’000
Division C 250’000 25 6’250’000
Total 550’000 10’550’000
(Price per share / sales per share) * Sales = valuation of the part
Price/ sales ratio of ABC Co. = (10’550’000/550’000) = 19.18

Sum of parts = (10’550’000) / 100’000 = 105.5 CHF per share
Here, we find that the sum of the parts gives a market valuation of 105.5 CHF per share while the
actual market price is 100 CHF only. Other things being equal, we may conclude that market
values the conglomerate at a lower value or that this firm is undervalued marginally. For detailed
analysis, we need to look at other qualitative factors.
Main use of this ratio will be, for the sale of a division. If we want to sell one of the three
divisions, we have an idea of what the market price for that division should be. We can also
separately find out the cash flow generated by that division. Using similar technique, we can
calculate the market valuation using cash flow to price ratio. From these two ratios, we can
arrive at an average valuation of the division to be sold.
It can be seen that some of the problems associated with price/ earnings ratio exist here also.
But, the biggest advantage of the above two ratios is that they are fairly independent of
accounting policies, divisional distortions as well as independent of payout policies. Thus,
they are very useful in valuing conglomerates, segments and new economy stocks such as
internet, dotcom and biotech companies.
chapter 4 / page 39
Exercises: Questions
Level I


Q3 Sept 02: Equity valuation
Alpha Ltd has just paid a dividend of EUR 0.75 per share. It has a retention ratio of 40% and a
current market price of EUR 10. Dividends are paid annually and the CAPM holds for annual
returns. The expected annual return on the market is 11% and the riskless rate is 5%. Alpha’s
stock has a beta of 1.5. The expected return on book equity each year is a constant (ROE).
When appropriate, please use the constant growth model.
a) What is the expected annual return on Alpha’s stock?
b) What are the expected growth rate of dividends for Alpha's stock, the expected return on
book equity (ROE) and the book value per share as of today?
c) If you buy Alpha stock today and hold it for one year, what is your expected holding
period return?
d) What are the main points of strength and weakness of the constant growth model?
Q2 March 03: Equity valuation

Ms Clear is evaluating Petrol Asia Limited for potential inclusion in her investment portfolio.
She has gathered the following information about the company:
Expected net earnings for next year USD 1 million

Number of shares outstanding 500’000
Dividend payout ratio 30%
Dividend growth rate 10%
Risk-free rate 5%
Market risk premium 6%
Beta for Petrol Asia 1.2
Current stock price USD 25
a) Estimate the dividend per share for each of the next two years.
b) Using the dividend discount model, estimate the value of the stock. Should Ms Clear buy
the stock at the current market price? Explain your answer.
c) Assuming that the price-earnings ratio remains constant over time, calculate the rate of
return for a one-year holding period. Show how this return can be expressed in terms of
dividend yield and growth rate. Is your answer dependent on the hypothesis of a constant
P/E ratio and that of a constant growth rate?
d) Assume that Ms Clear bought the stock at the beginning of the first year (t=0) at 25. The
dividend for the first year was 0.8, the growth rate for the second year was 10% as
expected, but dropped to 5% the third year. The payout ratio remains constant at 30%. At
the end of the second year (t=2), when Ms Clear sold the stock, the P/E ratio was 8.
questions I / page 1
Calculate the internal rate of return (IRR) of the investment of Ms Clear over the two-year
period.
Company Alpha Income Statement Year N (in CHF ‘000)
Sales 600’000
Cost of goods sold 350’000
Gross operating profit 250’000
Selling, general and administrative expenses 100’000
EBITDA 150’000
Depreciation and amortization 75’000
EBIT 75’000
Interest expenses 20’000
Pre-tax income 55’000
Income taxes 19’250
Net income 35’750
Other Information
Shares outstanding 21’000

Earnings per share (EPS) 1.70
Dividend paid 14’300
Total assets 578’000
Current liabilities 162’000
Long term liabilities 250’000
a) Based on the data contained in the above table, compute the rate of sustainable growth,
i.e. the growth rate of the company that can be achieved through internal financing all
things being equal.
b) Estimate the value per share using the DDM (dividend discount model) with the
following hypotheses: a growth rate of 12% for the first three years, 6% for the
subsequent years, and a cost of equity of 9.5%.
c) One of your colleagues is suggesting that the value of equity should be computed by
determining first the present value of the WACC of free cash flows to firm and then
deducting debt. What do you think? Explain your answer.
d) Compute the free cash flow to firm for year N knowing that the investments in fixed
assets for the year amount to CHF 50 million and that the net working capital has
decreased by CHF 10 million.
e) Is it correct to say that the ratio EBITDA/Sales is a good indicator to rank companies
across industries?
You work for a fund management company and specialize in companies working in the metal
and mining sector. At the end of 2003, you have been asked to perform an analysis of
Australian Metal Company (AMC) for which you have collected the following information:
Financial Statements (in Australian $ - AUD - million, except if stated otherwise)
2000 2001 2002 2003 2004E
Total revenues 21'665 22'346 23'564 22'786 23'780

Operating expenses 20'456 21'983 21'980 21'800 22'009
Interest expense 340 348 347 498 440
Pre-tax income 869 15 1'237 488 1'331
Taxes 300 8 420 165 480
Net income 569 7 817 323 851
Tax rate (in %) 34.5% 53.3% 34.0% 33.8% 36.1%
Book value 9.75 11.31 13.18 15.25 15.91
Outstanding shares (in million) 240 240 242 251 251

Avg. stock price (in AUD) 37 39 35 35 *
EPS (in AUD) 2.37 0.03 3.38 1.29 3.39
Dividend per share (in AUD) 0.6 0.62 0.67 0.73 0.8
* today's share price
2000 2001 2002 2003 2004E

Current assets 3'230 3'454 3'857 4'400 4'645
Fixed assets 4'657 4'898 5'243 6'001 6'100
Total assets 7'887 8'352 9'100 10'401 10'745
Current liabilities 2'658 2'727 2'900 3'121 3'300

Long-term debt 2'890 2'911 3'011 3'453 3'452
Shareholders' equity 2'339 2'714 3'189 3'827 3'993
Total liabilities & SE 7'887 8'352 9'100 10'401 10'745
In addition to the data in the table above, you downloaded from Bloomberg the following
information:
Depreciation in 2003: AUD 408m
Depreciation estimated for 2004: AUD 420m
Coupon rate on long-term debt 8%
(Debt trades at par value)
Market risk premium: 6.5%
Beta: 1.2
Risk-free rate: 5%
a) Based on the above information, compute the firm’s weighted average cost of capital (for
the market value of debt, only consider the long-term debt) as of today. What assumption
is made by the suggestion to discard short term liabilities when computing the market
value of debt?
b) Compute the free cash flow to firm for year 2004 and show the details of your
computation.
c)
c1) A friend of yours estimates the free cash flows to firm (FCFF) of AMC for years 2004
to 2006 as follows:
FCFF 2004 = 1’000

FCFF 2005 = 1’050
FCFF 2006 = 1’080
Furthermore, your friend calculated a WACC of 13% and assumed that the company
will grow at 8% per year after 2006. Compute AMC’s value as of the beginning of
2004 using your friend’s estimates.
c2) In the above calculation of the value of the firm, assume that AMC had in addition
financial assets amounting to AUD 500m and a financial revenue of AUD 30m. How
would you have taken into account these figures in computing the total value of the
firm? (no computations are required)
c3) Assuming that the total value of the firm is 16’000m, estimate the value per share of
AMC’s common stock. Discuss the current share price level.

Cabernet Inc. and Merlot Inc. are two US companies in the same business risk class. Cabernet
is a quoted company with a debt/equity ratio of 1/3. The company’s equity beta is 1.6 and the
debt capital can be assumed to be riskless. Merlot is an unquoted and all equity-financed
company. The expected return on the S&P Index is 16%. The return on Treasury Bills (and
also the return on Cabernet’s debt) is 10%. Assume that both Cabernet and Merlot pay out
constant annual dividends. Cabernet’s debt is irredeemable. Ignore taxation.
a) Explain what is meant by the term “same business risk class”. What will be the
consequence as far as the betas are concerned? Estimate the equity beta of Merlot.
b) Estimate the weighted average cost of capital (WACC) of each company and comment
briefly on the significance of your figures in the Modigliani and Miller's capital structure
framework with no tax.
c) A small shareholder of Merlot just received his regular dividend of USD 150 and, at the
same time, an investor offered him USD 1,000 per share. However, he does not know
whether or not to sell his shares as he relies heavily on his annual dividend. Knowing that
the payout ratio is 100%, a financial analyst correctly computes the theoretical price of his
shares as USD 872.0. He therefore tells the shareholder that he should accept the offer and
use the proceeds of the sale to buy Cabernet's securities. Explain how this shareholder can
make a profit from this arbitrage suggestion. What would be his resulting gain?
You are asked to evaluate a privatization candidate - DNIPROTUBE, a Ukrainian tube
producer for the State Property Fund of Ukraine. You are provided with the following
simplified information on DNIPROTUBE assets (in Ukrainian Hryvnias, UAH):
Total assets UAH 650 billion

Liabilities UAH 250 billion
Common shareholders’ equity UAH 400 billion
The Company is expected to generate revenues of UAH 510 billion next year and earnings
before interest and taxes (EBIT) of UAH 160 billion. The interest expenses amount to UAH
80 billion and the corporate tax rate in Ukraine is 28%.
DNIPROTUBE is expected to maintain sales in its niche product, oil country tubular goods,
and grow at 5% a year in the foreseeable future, primarily by expanding exports to Russia and
Asian markets. In addition to the above data you downloaded from the Internet the following
information:
- The average beta, based upon metallurgical counterparts from Eastern European and CIS
countries, equals 1.1
- The government bond rate in Ukraine (risk-free rate) is 8.5%
- The risk premium for Ukrainian stocks over bonds is assumed to be 4.0%.
a) Calculate the required rate of return on DNIPROTUBE’s equity.
b) The formula: P/BV = (ROE - g)/(r - g)

is derived from the Gordon growth model, using g = ROE · Retention Ratio, where
P value of equity
BV book value of equity
g growth rate
ROE return on equity (based upon expected earnings in the next time period)
r required rate of return on equity.
Compute the P/BV ratio for DNIPROTUBE and estimate the Company’s Value of Equity.
c) State two major advantages and two major disadvantages of the price-to-book value ratio
valuation methodology.
d) Explain how changes in the return on equity of a company influence its price-to-book
value ratio.
e) Is it correct to say that the market value of a company might deviate significantly from its
book value? If you agree with the statement, specify the fundamental reason for this
deviation. If you disagree, explain with reasons.
You are working for an investment firm and are currently involved in the valuation of an IPO
by Interlink, an internet company. The company was founded three years ago and still has no
debt. As a first step, conduct an analysis on the following data:
Sales (for t = 0): USD 25 million

Expected annual growth in sales: 20% (for the first 5 years)
Net operating profit margin: 10% of sales
Marginal tax rate: 35%
Net working capital: 5% of the sales
Capex (capital expenditure) 10% of the sales increase
Risk free rate: 4%
Return on market: 11%
Interlink’s beta: 1.2
The company has no non-operating incomes / expenses.
a) Estimate the gross cash flows (i.e. annual after-tax cash flows before taking into account
the changes in working capital and Capex) for the first 5 years (from t=1 to t=5). Assume
that that the annual depreciation is USD 0.75 million and that there are no other relevant
non-cash expenses or incomes.
b) Estimate the annual fixed capital expenses (capex) and the changes in working capital
needs. For the sake of simplicity, assume they occur at the end of the years. Then calculate
the annual free cash flow from t=1 to t=5.
c) What would be the appropriate discount rate for Interlink’s free cash flows?
d) Assume that a firm value at the end of the fifth year is estimated by applying the Gordon-
Shapiro formula. A colleague of yours argues that the use of the cost of capital found
above is not appropriate for this calculation. What do you think? Motivate your answer.
The income statement and balance sheet for the years 2004 and 2005 of SE Company are
given under Tables 1 and 2. All figures are in USD million.
Table 1: Income statement

2005 2004
Net sales 310.3 208.9
Cost of goods sold 71.6 52.9
Selling and administrative expenses 17.8 14.1
Income before depreciation and amortization 220.9 141.9
Depreciation and amortization 81.6 63.1
Interest expenses 27.6 27.3
Non-operating income -10.2 -0.9
Income before tax 101.4 50.7
Provision for income tax 33 16.5
Income after tax 68.5 34.3
Net income before extra items 68.5 34.3
Extra items - -4.4
Net income 68.5 29.9
Table 2: Balance sheet (as of 31/12)

2005 2004
Cash 4.9 1.1
Receivables 39 27.4
Other current assets 10.4 5
Total current assets 54.4 33.5
Property, plant, and equipment, gross 1,572.60 1,383.30
Accumulated depreciation 649.2 567.5
Property, plant, and equipment, net 923.4 815.8
Deferred charges 12.7 10.5
Total non-current assets 936.2 826.4
Total assets 990.6 859.8
Accounts payable 29.4 26.2
Accrued expenses 31.7 38.2
Other current liabilities 7.5 4.9
Total current liabilities 68.6 69.4
Deferred charges to income 73.1 43.5
Long term debt 357.5 340.3
Other long term liabilities 17.2 9.3
Total non-current liabilities 447.8 393.1
Total liabilities 516.4 462.4
Common stock, net 0.3 0.3
Capital surplus 343.5 334.9
Retained earnings 138.5 70.1
Treasury stock 6.9 7.6
Other comprehensive income (loss) -1.3 -0.3
Total shareholders' equity 474.2 397.4
Total liabilities and shareholders' equity 990.6 859.8
Additional information:
2005 2004
Weighted average shares outstanding (million) 27.8 27.3
Exercisable share options (million) 1.71 1.48
Exercise price (in USD) 15.00 13.71
Average stock price (in USD) 21.62 15.89
a) Calculate the basic EPS for 2004 and 2005 and the diluted EPS for 2005 only.
b) State two drawbacks of using EPS for valuing firms. Discuss the idea that cash flow per
share is a better criterion than EPS when comparing and ranking companies across
industries.
c) The analysts predict that SE Company is at the end of a supernormal growth period and
estimate that the EPS would grow at a rate of 25% p.a. for the next 5 years before settling
down to a normal growth rate of 10% p.a. The company is not expected to pay any
dividends for the next 5 years after which the payout ratio is estimated to be 30%. The
company’s beta is 1.36, market risk premium is 7.35% and risk free rate is 5%. What is
the estimated share price of SE Company’s stock? Assume the current EPS of SE
Company to be USD 2.46.

The details of the dividends per share paid by company ABC during the last three years and
this year (assume today is t = 0 ) are:
t=-3 t=-2 t=-1 t=0

Dividend (in CU) 12 14 15 16
a) Determine the yearly average rate of growth g of the dividends from year t = -3 to t = 0.
b) Assume that the company ABC has a beta of 1.3, that the expected rate of return of the
market is E[rmkt ] = 0.1 and that the risk-free rate of return is rf = 0.04 . Determine the
price in t = 0 of company’s ABC share if you assume that the average rate of growth g
computed in a) remains the same for the future.
c) Using Gordon-Shapiro’s formula, explain the relationship between the discount rate k
estimated with CAPM formula and the price/earnings ratio. What is the effect on the
price/earnings ratio of an increase in the discount rate k ? Explain.
d) With the objective of an acquisition, Company ABC is evaluating a competitor that shows
lower growth and similar pre-tax margin. The acquisition would be completely financed
by a bond issue of CU 500 million. With this acquisition, the total revenues of company
ABC will increase significantly.
d1) Discuss the effect of this acquisition on the value of the three parameters of the
constant-growth dividend discount model used to valuate company ABC.
d2) Discuss the effect of this acquisition on the P/E multiple of company ABC.

a) In mid May 2006, immediately after the release of the new earnings-per-share figures of
Company A of 174 CHF and a dividend per share of 42 CHF, you buy A shares at a price
of 2,058 CHF. You believe that earnings and dividends will increase at a rate of 7.8% per
year. You require a rate of return of 10% on this investment.
a1) What will be the required selling price that will satisfy your expectations when you
sell your shares in May 2008?
a2) Does this result imply a change in the P/E ratio? Explain your answer.
Last year, Company B paid out dividends of 0.75 USD per share. The market expects a
constant growth rate of earnings and dividends of 10%. Last year, 25% of the earnings have
been paid out as dividends. It is commonly expected that this payout ratio stays constant. The
firm’s expected cost of equity is 15%. Based on this information, answer the following
questions (Assume we are at the beginning of the year and that both dividends and earnings
accrue at the end of the year).
b) What is the theoretical P/E ratio of the firm based on the expected earnings for the current
year?
c) Assume that Company C operates in the same industry as Company B. Both firms use the
same product technology, have the same capital structure, have the same expected
earnings per share (EPS) for this year and the same constant payout ratio. The P/E ratio of
Company C (based on expected earnings for the current year) is 10. Would you conclude
from the P/E ratio (which is higher than that of Company B) that Company C is
overvalued? What could explain the differences between the P/E ratios? Justify your
answer with calculations.
d) The P/E ratio has often been proposed to estimate share prices. For this calculation, you
simply have to multiply the adequate P/E ratio with the equivalent estimate of earnings per
share (EPS). Is there any relation between this valuation method and the dividend discount
model? Answer this question generally.
e) Is there any relation between P/E ratios and the cost of equity of a firm? Answer this
question under the assumption that a firm has a P/E ratio of 20, a constant payout ratio of
40% and an expected constant dividend growth rate of 10%. What is the cost of equity kE
of the firm?
Exercises: Questions
Level II


Q3 March 03: Equity Valuation and Analysis
In early 2002, Steve Larson, Senior Portfolio Manager of a London based group of mutual
funds, was considering whether to add shares of Glamour Woman, Inc. (GW) in their small-
capitalization equity portfolio. GW is a cosmetic marketing company that sells its products
exclusively through catalog mail order. Steve believes that the mail order and catalog business
will steadily increase over time.
Steve wants to evaluate the recent performance and suitability of acquiring GW stock.
Recently, he received the 2001 annual report from GW.
Use the data provided in Table 1 to answer the following questions.
a) Compute the sustainable growth rate and actual growth rate in sales for the years 2000 and
2001.
Note: Sustainable growth rate is defined as a maximum rate of growth a firm can sustain without increasing
financial leverage. You may assume that sustainable growth rate is equal to the product of return-on-equity and
retention ratio.
b) GW's actual sales growth rate in 2001 is more than the sustainable growth rate. Describe
and briefly discuss two courses of action GW could take if the actual growth rate
continues to exceed its sustainable growth rate.
c) Briefly discuss how an increase in the dividend payout ratio will affect the stock price.
d) Assuming that GW will be able to maintain a constant growth rate of 9 percent forever,
calculate the required rate of return on equity and theoretical value of the stock at the
beginning of 2002. Based on your result, would you recommend Steve to purchase this
stock?
e) After a meeting with GW’s Chief Financial Officer (CFO), Steve informs you that in the
CFO’s opinion, the long-term growth rate you assumed above may not be sustainable. The
CFO believes that dividends could grow at a rate of 7 percent a year for the next four
years, after which they are more likely grow at a constant rate of 5 percent per year
indefinitely. Recalculate your estimate for GW’s stock value and discuss whether your
recommendation about acquiring GW stock has changed in light of your new estimate?
questions II / page 1
Table 1.
Glamour Woman, Inc.
Income Statement (USD million, except per share data)
for the years 1999, 2000, and 2001
1999 2000 2001
Sales 48 976 47 171 54 597
Cost of Goods sold 23 808 21 085 24 855
Gross Profit 25 168 26 086 29 742
Operating Expenses 20 578 18 408 21 279
Operating Income 4 590 7 678 8 463
Interest Expense 714 837 940
Earnings before taxes 3 876 6 841 7 523
Income Tax 1 527 2 531 2 633
Net Income 2 349 4 310 4 890
Glamour Woman, Inc.
Balance Sheet (USD million, except per share data)
for the years ended December 31, 1999, 2000, and 2001
1999 2000 2001
Assets
Current assets 22 556 25 776 30 964
Property plant and equipment 17 446 17 455 19 220
Other fixed assets 382 544 485
Total assets 40 384 43 775 50 669
Liabilities and Stockholder Equity

Current Liabilities 10 290 11 644 14 073
Long-term debt 9 243 9 734 11 655
Deferred taxes 844 1 316 1 395
Other non-current liabilities 734 844 1 002
Stockholders' equity 19 273 20 237 22 544
Total Liabilities and Stockholder Equity 40 384 43 775 50 669
Other Information:
Common Dividends (USD million) 1 582 2 474 2 979
Number of shares outstanding (million) 3 955 4 123 4 255
Closing price per share 15.25 22.75 24.30
Risk free rate of return 3.0%
Expected return of S&P500 10.5%
GW's Beta 1.22
Q4 March 04: Equity Valuation and Analysis / Corporate finance
Company ABC is reportedly considering acquisition of Company XYZ. Company ABC has
net earnings of EUR 1 million, outstanding shares of 250,000, and a share price of EUR 100.
Company XYZ has net earnings of EUR 400,000, outstanding shares of 100,000, and a share
price of EUR 40. Neither company has any debt.
Status of ABC and XYZ

Company ABC Company XYZ
Net earnings (EUR) 1,000,000 400,000
Number of outstanding shares 250,000 100,000
Earnings per share (EUR) 4 4
Price-to-earnings ratio 25 10
Share price (EUR) 100 40
a) Bob Sapp, an analyst, estimates that the synergy resulting from Company ABC acquiring
Company XYZ has a present value of EUR 1.5 million. If Company ABC acquires
Company XYZ for EUR 5 million cash, what will be the total profit to the shareholders of
Company ABC from the acquisition? (In other words, how much will Company ABC's
value increase?)
b) Mr. Sapp's investment guideline is that a company considering a merger or acquisition is a

potential ‘buy’ if its earnings per share will increase as a result of the merger/acquisition.
Evaluate this valuation method.
c) Company ABC decides to attach a premium of EUR 10 to Company XYZ’s share price,
valuing XYZ at EUR 50. It proposes to acquire XYZ by exchanging one newly issued
ABC share for two shares in XYZ. Given Mr. Sapp's estimate for the present value of the
synergy effect from the acquisition of EUR 1.5 million, calculate the total profits brought
to the shareholders of the old ABC.
d) Given Mr. Sapp's estimate of the synergy effect, which would be more advantageous for
the shareholders of Company XYZ, a cash tender offer for EUR 5 million or a stock offer
at one ABC share for two shares of XYZ?
e) Several papers have been published showing that acquiring companies’ share prices rise
slightly after the announcement of a cash acquisition, but that share prices decline after the
announcement of a stock offer. Discuss two reasons that can help explain this result
utilizing the “asymmetric information” concept.
Q2 Sept 04: Equity Valuation and Analysis
Apex Heavy Vehicles Ltd is evaluating a proposal to manufacture commercial vehicles. The
project will require an initial investment (in year 0) of CU 500,000 in plant and equipment.
This initial investment will be depreciated on a straight-line basis, down to a salvage value of
CU 100,000 at the end of the fourth year. During the first year, the investment is expected to
generate revenues of CU 300,000 and operational expenses of CU 100,000. The CFO of
Apex, who analyzed the project in detail, estimates that the revenues and expenses can be
expected to grow at an annual rate of 5%, from the first to the fourth year. The marginal
income tax rate applicable to the company is 36%. The cost of capital of the company after tax
is 10% (see below for definition).
The CFO discussed at length the treatment of inflation in evaluating the project and finally
decided to completely ignore inflation in estimating the cash flows. He also considers that the
cost of capital should be calculated after tax, but without any adjustment for inflation. He used
the CAPM to estimate the cost of equity capital. As no reliable information on the risk-free
rate suitable for the project's time horizon was available, he used the 90-day Treasury bill rate
as proxy. He was also concerned about the possibility of a change of the income tax rate and
was wondering how it will impact the net present value of the project.
a) For years 1 to 4, calculate the cash flows from operations of the investment project.
b) Based on the net present value (NPV) criterion, is this project acceptable? What will be
the impact on the shareholders' wealth if the project is accepted?
c) Discuss the main assumption made when ignoring inflation in the free cash flow
estimation process. How should one treat inflation in (i) estimating the free cash flows and
(ii) calculating the net present value?
d) Discuss the impact of a higher income tax rate on the net present value of the project.
Then compute the impact on the NPV of the depreciation tax shield using a tax rate of
40% instead of 36%.
e) Discuss the use of the interest rate on 90-day Treasury bills as a proxy for the risk-free
rate. What could be the impact of a wrong estimation of the cost of capital on the decision
to accept or reject an investment proposal? As an illustration, consider two projects with
differing cash flow profiles but whose NPVs are equal when using the appropriate cost of
capital. What will be the effect of using incorrect cost of capital?
At the beginning of 2005, you are analyzing the three following manufacturing companies:
• Alpha Electric (US) is one of the largest and most diversified industrial companies in the
world. Business segments include aircraft engines, appliances, locomotives engines,
industrial systems, power generation and turbine generators, as well as consumer finance
and insurance.
• Beta Computer (US) is the world’s largest computer manufacturing and direct marketing
company. The company makes notebooks and desktop computers, workstations, servers
and storage products.
• Gamma Motor (US) is a large automobile manufacturer with foreign sales accounting for
about 40% of the business. The company also operates in the vehicle leasing and rentals as
well as financial services.
a) Using the financial data in appendix 1 and considering the highest price and relevant
financial data of the year 2003, complete the following table for 2003:
Alpha Beta Gamma MFG 500

P/CF (Price/Cash flow)
P/E (Price/Earning)
Dividend yield in %
Compare the results of the three companies to those obtained for the MFG 500 Index,
which represents the benchmark. Explain the reasons for the observed differences. Are the
reasons you gave confirmed by the four-year data history of the three companies?
b) A colleague applied the discounted cash flow model (DCF) to estimate the value of the
three firms as of end 2004 by using a discount rate of 10%. For the next five years, he
assumed that Alpha and Beta maintain the growth rate of the year 2004, and assumed a 7%
growth rate for Gamma. The perpetual rate after five years is supposed to be equal to the
expected market growth of 5%. He obtained the followings results:
• Estimated value of Alpha stock = 47.60
• Estimated value of Beta stock = 70.77
• Estimated value of Gamma stock = 170.79
Comment upon the results obtained by your colleague and compare them to the 2004 price
range. Why is the estimated value of Gamma Motor so far above the highest price
observed in 2004? Using the same hypotheses as your colleague, estimate the share price
of Gamma by applying the dividend discount model (DDM) (show all your data and
calculations). Which discounting method is more appropriate for Gamma Motor and why?
c) Assume that currently the world economy is in a recession with two quarters of negative
growth. Elaborate on the possible implications for the three companies by referring to the
ratios calculated above in a) and the estimated stock prices calculated in b). Then, discuss
the implications of a strong economic recovery (after the recession). Are there different
implications?
APPENDIX 1
Financial Data (all numbers in US Dollars)

2001 2002 2003 2004
Alpha Electric
Stock price range (max/min) 25/16 34/23 53/31 60/41
Sales per share 5 5,25 5,65 6,42
Cash flow (CF) per share 1 1,18 1,32 1,51
CF growth rate % 18 12 14,67
Earnings per share 0,83 0,93 1,07 1,27
Dividends per share 0,36 0,42 0,49 0,57
Book value per share 3,52 3,96 4,32 5,08
Operating margin % 19 21,2 21,4 21,8
Return on equity % 23,8 23,9 25,2 25,2
Beta Computer
Sales per share 4,79 7,17 9,81 12,26
Cash flow (CF) per share 0,39 0,61 0,72 0,98
CF growth rate % 56 18 36,67
Dividends per share nil
Operating margin % 11,2 11,8 10,3 9,4
Return on equity % 73 62 35 41
Gamma Motor
Sales per share 126 126 133 90
Cash flow (CF) per share 11,9 13,2 13,5 7,46
CF growth rate % 11 2 -45
Dividends per share 1,65 1,72 1,88 1,8
Operating margin % 25 25 23,7 22,6
Return on equity % 22,5 28,1 26,3 25,9
MFG 500
Price range (max/min) 1470/1212
Cash flow (CF) per share 82,2
Earnings per share 48,17
Dividends per share 16,7
Price to book 7,2
Return on equity 18
The JUN Corporation's share price is currently 95 euros, and its book value per share was 100
euros at the end of last year. The Research Department at MKI Asset Management has
published an investment opinion on JUN's stock, forecasting a return on equity (ROE) of 10%
and a payout ratio of 30% into perpetuity. The risk-free rate is 3%, the stock market risk
premium 7% and JUN's estimated beta is 1.1.
Assumptions used in the JUN Corporation investment opinion:
Return on shareholders' equity (ROE) 10%

Payout ratio 30%
Book value per share (BVPS) at the end of last year 100 euros
Risk-free rate 3%
Stock market risk premium 7%
JUN's beta 1.1
JUN's share price 95 euros
a) Based on the forecasts from the MKI Asset Management Research Department, calculate
the expected rate of return (implied return) on JUN’s shares at the current share price, by
using the constant growth dividend discount model. Then, discuss whether JUN’s shares
are trading at a discount or at a premium if the CAPM holds.
b) Mr. White, an analyst at MKI Asset Management, uses a different approach. He calculates
the theoretical share price by adding the present value (PV) of the future residual income
per share to the current book value per share (BVPS) using the following formulae:
Theoretical share price =

(BVPS at end of last year) + (PV of residual income per share in and after this year)
Residual income per share =

EPS – (BVPS at end of last year) · (Required rate of return on equity)
Show the calculations following Mr. White’s approach. Then, discuss whether JUN’s
shares are trading at a discount or at a premium.
c) Mr. Field, a fund manager at MKI Asset Management, aggressively includes in his
portfolio shares with a price-to-book ratio (PBR) below 1, based on the rationale that such
shares are trading at a discount, as they are cheaper than liquidation value. Based on this
philosophy, he has decided to invest in JUN’s shares. Explain what is wrong with Mr.
Field's investment decision.
d) Provide two arguments that could support Mr. Field's investment philosophy mentioned
above.
You are at the end of Year 2005. Company X operates a major portal site on the Internet that
provides a full range of services, including an online shopping mall and a search engine. It is
considering acquiring Company Y, a game software developer. The acquisition would take the
form of a stock-for-stock exchange, with 2 stocks in Company X allotted per 1 stock in
Company Y. Answer questions a) through d) referring to the information in Tables 1 through
3. Assume that the risk-free rate is 2% and the market risk premium is 4%.
a) Calculate the cost of equity capital for Company X and Company Y based on the CAPM.
Then, calculate the dividend growth rate for Company X and Company Y by using the
constant-growth dividend discount model. You may assume that current stock prices are at
theoretically appropriate levels.
b) At the beginning of Year 2006, the merger is processed as planned above. The market
welcomes the acquisition of Company Y by Company X, and the merged Company XY's
stock price rises by JPY 40 to JPY 540. Company XY has a payout ratio of 50% and cost
of equity capital of 5.2%. Analyst A postulates that there will be no immediate effect on
sales and net income after the merger between Company X and Company Y. Analyst A
therefore judges the rise in the post-merger stock price to be driven by investor
expectations of a long-term rise in the dividend growth rate only. Assuming it is possible
to use the constant-growth dividend discount model to evaluate the stock value and that
Analyst A's judgment is correct, calculate the dividend growth rate. Then discuss whether
you support Analyst A's judgment.
c) Analyst B anticipates a synergy effect from the merger and says that if the acquisition
succeeds, Company XY's sales will be 5% higher in the future than the total sales of
Company X and Company Y on their own. Analyst B also makes the following
assumptions about the post-merger Company XY.
Payout ratio = 50%
Ratio of EBIT to sales = 7.9%
Ratio of interest payments to sales = 2.5%
Corporate tax rate = 40%
Dividend growth rate = 3.2%
Analyst B uses the results of the regression analysis shown in Table 3 to conclude that
Company XY's cost of equity capital will be 5.2%. By using the constant growth dividend
model, calculate Company XY's theoretical price per stock based on Analyst B's
assumptions.
d) Analyst C agrees with Analyst B that Company XY will see a 5% increase in sales.
However, Analyst C thinks that if the acquisition succeeds Company XY's fundamental
value will be even higher than Analyst B says. There are two reasons for this. Analyst C
has different expectations than Analyst B about the merger effect, and Analyst C estimates
post-merger Company XY's cost of equity capital to be lower than Analyst B.
d1) Show how Analyst B presumably estimated Company XY’s cost of equity capital at
5.2%.
d2) Using the figures in Table 2, discuss factors that would support Analyst C's judgment
(in contrast to Analyst B’s assumptions) about the merger effect.
d3) Discuss problem areas that would account for the different estimations of the cost of
equity capital by Analyst B and Analyst C and describe alternative estimation
methods.
Table 1: Next year's (2006) results forecasts, current stock prices, and stocks issued
and outstanding for Company X and Company Y
Sales, net income and dividends are forecasts for next year (2006; in million JPY). Stock
prices are in JPY. Issued and outstanding stocks are in million stocks. Net assets are in
million JPY.
Company X Company Y
Sales 135,000 4,200
Net income 4,000 200
Dividends 2,000 60
Stock price 500 1,000
Number of shares 200 10
Net assets 71,500 1,600
Table 2: Results for the past 3 years (million JPY)
Company X Company Y
2003 2004 2005 Past 3 year 2003 2004 2005 Past 3 year
average average
Sales 123,339 124,598 131,952 126,630 3,022 2,043 4,905 3,323
Cost of sales 80,069 81,290 85,164 82,174 1,953 1,335 3,214 2,167
Selling, general & 27,344 27,402 29,037 27,928 743 518 1,207 823
administrative
expenses
Depreciation 6,339 6,456 6,443 6,413 101 102 98 100
charges
EBIT 9,587 9,450 11,308 10,115 225 88 386 233
Interest expense 2,733 2,739 2,748 2,740 202 194 199 198
EBT 6,854 6,711 8,560 7,375 23 -106 187 35
Corporate taxes 2,776 2,678 3,475 2,976 8 0 76 28
Net income 4,078 4,033 5,085 4,399 15 -106 111 7
EBIT/Sales 7.77% 7.58% 8.57% 7.99% 7.45% 4.31% 7.87% 7.01%
Interest expense/ 2.22% 2.20% 2.08% 2.16% 6.68% 9.50% 4.06% 5.97%
Sales
Table 3: Results of regression analysis
The regression analysis was conducted by using monthly rate of return for the latest
36 months. rX ,t ( rY ,t ) is the excess return over risk-free assets for Company X (Company
Y); rM ,t denotes the excess return of the value weighted stock index. Numbers in
parentheses are t values of regression coefficients.
Company X rX , t = − 0.001 + 0.700 ⋅ rM , t + ε X , t

(-3.265) (5.354)
R-squared = 0.456
Company Y rY , t = − 0.002 + 1.800 ⋅ rM , t + ε Y ,t

(-6.265) (2.537)
R-squared = 0.246

IT Corporation was established just a year ago and is planning a EUR 5 million equity
financing so that it can begin fully-fledged operations. Mr. Young, a venture capitalist, is
considering purchasing newly issued shares of IT and then selling his equity when the
company goes public. According to the business plan submitted by the IT management team,
IT Corporation plans to go public in five years time with net income of EUR 20 million. It
anticipates a price earnings ratio (PER) at the time of the IPO of 30, which is the industry
average. IT currently has 1 million shares issued and outstanding and no plans for further
stock issues or dividend payments until the IPO. Mr. Young thinks that the required rate of
return on IT equity should be 50%.
a) Calculate the total market capitalization (theoretical price) after the equity financing of IT
from Mr. Young’s perspective.
b) Calculate the share price at which Mr. Young should purchase new shares of IT.
c) It is common for venture capitalists to employ extremely high required rates of return of
between 40% and 100% when making equity investments in new startups. Discuss two
reasons why privately-held startups are required to have far higher rates of return than
publicly-traded companies.
d) “Real options” are the options, inherent in corporate management and business operations,
to modify, cancel and defer investment projects as conditions warrant. It is possible to use
option valuation theory to calculate the impact of this inherent flexibility in corporate
management on the value of an investment project or a company as a whole.
d1) Mr. Young is considering applying the “real option” approach to evaluate venture
capital investments. Discuss why the real option approach is considered to be a
suitable evaluation method for venture capital investments.
d2) Briefly explain, in general, under which circumstances it might be better to use real
options to valuate projects and list three examples you can think of.
Exercises: Solutions
Level I


SQ3 Sept 02: Equity valuation
a) From the CAPM: E[R] = 5% + 1.5 · (11% - 5%) = 14%.
D1
b) From the constant growth dividend discount model: P0 =
kE − g
0.75 ⋅ (1 + g )
And so 10 =
0.14 − g
1.4 – 10 · g = 0.75 + 0.75 · g
Therefore the growth rate g = 0.65/10.75 = 0.060465
and ROE = g/(1-π) = 0.060465/0.4 = 0.15116
Since the expected dividends in one year’s time are:

E(D1) = D0 · [1+g] = 0.75 · [1+0.060465] = 0.79535
and E1 = E(D1)/π = 0.79535/0.6 = 1.3256
then the book value of equity per share today is:
K0 = E(E1)/ROE = 1.3256/0.15116 = 8.7692
c) We know that the expected holding period return is 14%. So the answer is exactly 14%.
d) The principal advantage of the model is its simplicity.
However, some assumptions are needed for the model to hold (stable growth rates, stable
leverage.
Furthermore, the "constant" and "stable" growth rate cannot be higher than the growth rate
of the economy in which the firm operates.
SQ2 March 03: Equity valuation

a)
Dividend per share1 = EPS1 · π = USD 1 million/0.5 million · 0.3 = USD 0.6 per share
Dividend per share2 = USD 0.6 · 1.1 USD = USD 0.66 per share
b)
kE = rf + β · (risk premium) = 5% + 1.2 · 6 = 12.2%
Using the constant growth model, the value of the stock is determined as follows:
Div1 0.60
P0 = = = 27.27
k − g 0.122 − 0.1
Since the resulting value is greater than the current stock price, we conclude that the stock is
underpriced and she should buy the stock (2 points). However, the difference is small, and a
slight change in the value of the parameters could change the decision. (2 points)
solutions I / page 1
c)
The current P/E ratio is 12.5 (= 25/2). The expected EPS is 2.2 for year 2. Therefore, the
expected stock price at the beginning of next year is 12.5 ⋅ 2.2 = 27.5 . A simpler way of
finding this is to multiply the current price (25) by one plus the growth rate (10%): 25 · 1.1 =
27.5.
The return is: ((27.5 + 0.6)/25) - 1 = 12.4%.
Yes, this return can be expressed as 0.6/25 + 10% = 2.4% + 10% = 12.4%
Yes, if the P/E declines for instance, the return will drop (and vice versa). The same
explanation applies with the growth rate.
d)
The dividend of the first year is 0.8, that of the second year = 0.8 · 1.1 = 0.88, and that of the
third year = 0.88 · 1.05 = 0.924. The earnings of the third year = 0.924/0.3 = 3.08. The selling
price at the end of the second year will be 3.08 · 8 = 24.64.
The cash flow at t=0 is –25, that at t=1 is 0.8, and that at t=2 is 0.88 + 24.64 = 25.52. The IRR
amounts to 2.65%.

a)
Sustainable growth rate = return on equity earnings retention rate
35'750 14'300
=( ) ⋅ (1 − ( )) = 0.21536 ⋅ 0.6 = 12.9%
166'000 35'750
or = (net profit – dividend)/equity

= (35’750 – 14’300)/166’000 = 12.9%
b)
Cash Dividends 14'300
DPS 0 = = = 0.68095
Outstanding Shares 21'000
DPS1 = DPS0 1.12 = 0.76267

DPS2 = DPS1 1.12 = 0.85419
DPS3 = DPS2 1.12 = 0.95669
DPS4 = DPS3 1.06 = 1.01409
Terminal value = 28.97
DPS 4
DPS1 DPS 2 DPS3 (k e − g)
Value per share = + + +
(1 + k e ) (1 + k e ) 2 (1 + k e ) 3 (1 + k e ) 3
1.01409
0.76267 0.85419 0.95669 (0.095 − 0.06)
Estimated value per share = + + + = 24.21
1.095 1.0952 1.0953 1.0953
c) Your colleague is right because the value of equity is primarily determined by the cash
generated by the assets. The FCFF approach is more appropriate when doing scenarios
concerning operating activities as well as debt policies.
d) Tax rate = 19'250/55'000 = 35%
NOPAT = 75'000 x (1- 0.35) = 48'750
Operating cash flow = 48'750 + 75'000 = 123'750
FCFF = 123'750 – 50'000 + 10'000 = 83'750
e) No, because this ratio is very dependent upon the industry. Capital intensive companies will
appear on the top of the rankings, though they may not be very profitable. Across industries,
the ratio EBIT/Sales is a better measure, even though depreciation is not necessarily a good
proxy for required investments. In any case, a ranking is always much better if it is based on
returns rather than margins.

a)
Cost of equity = 5% + 1.2 · 6.5 = 12.8%
Debt and equity weights (based on market values):

Equity: 35 · AUD 251m = AUD 8’785m
Since the firm’s debt is trading at par value, the market value is equal to the book value:
AUD 3’453m
Weight of equity = 8785/(8785 + 3453) = 71.8%

Weight of debt = 1 - 71.8% = 28.2%
WACC computation: 0.718 · 12.8% + 0.282 · 8% · (1 - 0.34) = 10.7%
The assumption is that the short term liabilities are non-financial debt. Even if short-term
liabilities include bank accounts, these are usually also discarded as the leverage policy is best
assessed by long-term debt.
b)
EBIT = 1’331 + 440 = 1’771
NOPLAT = EBIT · (1-t) = 1’771 · (1 - 0.361) = 1’131.7
After tax operating cash flow = NOPLAT + Depreciation = 1’131.7 + 420 = 1’551.7
Change in net working capital = Est. NWC2004 – NWC2003

= (4’645 - 3’300) - (4’400 - 3’121) = 1’345 - 1’279 = 66
Capital Expenditures (CAPEX) = change in fixed assets + depreciation

= (6’100 - 6’001) + 420 = 519
Free cash flow to firm = 1551.7 – 66 – 519 = 966.7
c)
c1)
1’000/1.13 = 884.96
1’050/1.132 = 822.30
1’080/1.133 = 748.49
[(1’080 · 1.08)/(0.13 - 0.08)]/1.133 = 23’328/1.133 = 16’167.47
Therefore, 884.96 + 822.30 + 748.49 + 16’167.47 = 18’623
c2)
The amount of financial assets should have been added to the above figure. This is because
when computing the present value of free cash flows, we only consider operating items.
c3)
16’000 - (long-term debt 2003 = 3’453)/251 = 12’547/251 = 49.99
We only consider long-term debt because we assume that there is no interest-bearing item in
the current liabilities. Note to correctors: also consider that the answer is correct if total
liabilities are subtracted (the share price is then 37.55, which is very close to the current price
of 35).
49.99 is higher than the current share price of 35 therefore the stock is undervalued.

a)
If two companies are in the same business risk class, the volatility of their operating earnings
is the same and their asset betas will be identical.
Given that our two companies are in the same business risk class, their asset beta should be
the same. As Merlot is all-equity financed, its equity beta will equal its asset beta. Hence,
Merlot's equity beta can be estimated with Cabernet’s asset beta. We have:
βMerlot equity = βCabernet assets = 0 x 1/4 + 1.6 · 3/4 = 1.2
(Note that a D/E ratio of 1/3 is equivalent to a D/V of 1/4. Indeed, one can write: (D/E) + 1 = 1/3 + 1, which
gives V/E = 4/3. Therefore E/V = 3/4 and D/V = 1/4).
b)
For Cabernet, the cost of debt is 10% and the cost of equity, using the CAPM formula, is
equal to 10% + 6% x 1.6 = 19.6%. Therefore, we have:
WACC = 19.6% x 0.75 + 10% x 0.25 = 17.2%
For Merlot, the WACC is equal to the cost of equity, as the firm is all-equity financed. We
have:
KE = 10% + 6% x 1.2 = 17.2% = WACC
This result is the one we would expect in the Modigliani and Miller's capital structure
framework with no tax: firms in the same business risk class have the same weighted average
cost of capital.
c)
For information: the financial analyst correctly obtained the theoretical price of USD 872.09 =
USD 150 / 0.172, where 17.2% is the cost of equity calculated above in question b).
In the Modigliani and Miller's capital structure framework, there is a disequilibrium that
should lead to an arbitrage. In our case, the shareholder will realise a gain by selling his
Merlot's shares and buying Cabernet's shares with the proceeds of the sale. The arbitrage can
be achieved as follows:
(i) Sell Merlot's shares for USD 1,000 per share.
(ii) Use the proceeds of the sale to buy debt and equity of Cabernet in the same proportion as
Cabernet’s own debt/equity ratio of 1/3.
Thus, per share sold, the investor should purchase for USD 250 of Cabernet' debt and for
USD 750 of Cabernet's equity. This would have the effect of maintaining the same average
cost of capital.
The annual income after the arbitrage will be:
USD 250 x 0.10 = USD 25
USD 750 x 0.196 = USD 147
USD 172/year
Thus, the investor's gain is USD 172 – USD 150 = USD 22/year, with no change in risk.

a)
r = rf + β · premium = 8.5% + 1.1 · 4.0% = 12.9%
b)
EPS1 = (EBIT - Interest Expenses) · (1 - Tax Rate)
= (160 - 80) · (1 - 0.28) = UAH 57.6 billion.
ROE = EPS1/BV = 57.6/400 = 14.4%.
P/BV = (ROE - g)/(r - g) = (0.144 - 0.05)/(0.129 - 0.05) = 1.19.
VEq = BVEq · (P/BV) = 400 · 1.19 = UAH 476 billion.
c)
Advantages:
1. Incorporates some concept of asset values.
2. Easy to compute even for companies with negative (volatile) earnings.
3. Easy to compare with market and specific industries.
Disadvantages:
1. Book value may be poor guide to actual asset values.
2. Subject to differing accounting rules.
3. Affected by non-recurring items.
4. Subject to historical costs.
5. Ignores future earnings perspectives as well as growth potential.
d)
The price-to-book value ratio is an increasing function of the return on equity. The larger the
return on equity relative to the required rate of return, the greater the price-to-book value ratio.
e)
The statement is correct. The market value will deviate from the book value when the earning
power of company’s assets has increased or declined significantly since their acquisition.

a)
(All figures in USD million)
Year 0 1 2 3 4 5
Sales 25.00 30.00 36.00 43.20 51.84 62.21
Net operating profit margin 3.00 3.60 4.32 5.18 6.22
- Taxes 1.05 1.26 1.51 1.81 2.18
+ Non cash relevant expenses 0.75 0.75 0.75 0.75 0.75
- Non cash relevant income 0 0 0 0 0
Gross cash flow 2.70 3.09 3.56 4.12 4.79
b)
Gross cash flow 2.70 3.09 3.56 4.12 4.79
- Changes in NWC -0.25 -0.30 -0.36 -0.43 -0.52
- Capex -0.50 -0.60 -0.72 -0.86 -1.04
Free cash flow 1.95 2.19 2.48 2.83 3.23
c)
Applying CAPM we get k e = R f + β ⋅ (R m − R f ) = 4% + 1.2 ⋅ (11% − 4%) = 12.4%
d)
The colleague of yours is right. Indeed, your are implicitly making two strong hypotheses in
using the cost of capital found above: 1) the cost of equity stays at the same level, which
implies, other things being equal, that the beta remains at 1.2; 2) the company will have no
debt for infinity, which is quite a strong hypothesis. In addition "others things" are not equal.

a)
net income attributable to ordinary shareholders
Basic EPS =
weighted average number of ordinary shares
2005 2004
Net income 68.5 29.9
Outstanding shares 27.8 27.3
Basic EPS 2.46 1.095
Net income attributable to ordinary shareholders +
After tax int erest on dilutive potential ordinary shares
Diluted EPS =
Weighted average shares outs tan ding + number of ordinary
shares resulting from the conversion of all dilutive potential ordinary shares
2005
Options exercisable (million) 1.71
Exercise price (in USD) 15.00
Shares outstanding (million) 27.8
Average stock price (in USD) 21.62
1. Proceeds from the exercise of options (in USD million) 1.71 · 15 = 25.65
2. Assumed share purchases (million) 25.65/21.62 = 1.19
3. Dilutive effect (theoretical number of options exercised at 1.71 – 1.19 = 0.52
an exercise price of zero, in million)
4. Change in the numerator (no interest, so no change) 0
5. Denominator for calculating diluted EPS 27.8 + 0.52 = 28.32
6. Diluted EPS 2.42
b)
Four drawbacks of EPS for valuation of firms are:
• It does not take into account the possibility of some conversions not taking place.
Similarly the adjustment for options is also not realistic.
• It contradicts the Modigliani-Miller hypothesis about indifference between retained
earnings and dividends as well as indifference to debt-equity ratios.
• It does not take into account multiple classes of common stock.
• There may be graded rights and claims for preferred share holders under which case this
method may not be applicable.
To compare companies across industries, the cash flow per share is not a good criterion.
Indeed, for a given ROA, capital-intensive companies (in capital intensive industries) will
necessarily show higher cash flow per share, i.e. a higher cash flow to sales ratio, than
companies in labor intensives industries. We cannot conclude they are “better”.
c)
The cost of equity for SE Company is 15%.
Using the formula k e = R f + β ⋅ (R m − R f ) = 0.05 + 1.36 ⋅ 0.0735 = 15%
Year EPS Div

0.00 2.46 -
1.00 3.08 -
2.00 3.84 -
3.00 4.80 -
4.00 6.01 -
5.00 7.51 -
6.00 8.26 2.48
7.00 9.08 2.73
8.00 9.99 3.00
9.00 10.99 3.30
As the payout ratio is 0% for the first 5 years, there are no dividends. Dividends start from the
2.48 ⋅ (1 + 0.10)
6th year onwards. The PV at the end of the 5th year is = 54.56
0.15 − 0.10
54.56
Share price of SE Company’s stock = = 27.13
(1.15) 5

a)
g is calculated by solving 12 ⋅ (1 + g ) = 16 , i.e. g = 0.100642
3
b)
16 ⋅ 1.100642
As k = 0.04 + 1.3 ⋅ (0.1 − 0.04) = 0.118 the price is P0 = = 1 014.53
0.118 − 0.100642
c)
The link between the discount rate k and the price/earning ratio can be seen by applying the
Gordon and Shapiro model:
EPS0 ⋅ (1 + g ) ⋅ π
P0
=
k−g
=
(1 + g ) ⋅ π
EPS0 EPS0 k −g
As k increases (i.e. the company becomes riskier) the price/earnings ratio, ceteris paribus,
decreases.
d)
d1)
Growth (g): the acquisition of a slower growth company reduces company ABC’s long-term
growth rate
Dividend (Div1): the new bond issue and related higher interest expenses may reduce the
chance that the dividend will be increased next year. On the hand, as the acquired firm has
less growth, maybe less risk consequently in the short term, and will increase the financial
leverage, more profit per share can be distributed. (either answer)
Cost of equity (ke): higher leverage will increase the risk for company ABC and therefore the
required rate of return for the shareholders.
d2)
- If there are no synergies, the P/E ratio should decrease if we do not consider the effect of
financial leverage. Indeed, the new P/E should be somewhere between the P/E of ABC
before the acquisition and the P/E of the acquired company.
- Synergies (reducing costs, economies of scale,…) and higher leverage will have a positive
effect on the P/E.
- Other possible considerations that could have a positive effect on the P/E: higher sales
potential due to reduced competition and bundled forces; market considers leverage as
optimised if combined; riskiness could be considered lower for the combined company
than for company ABC alone

a)
a1)
Assume earnings and dividends grow at a constant rate of growth of 7.8%. We get
2006 2007 2008 2009

Earnings per share 187.57 202.20 217.97
Dividend per share 45.28 48.81
Purchase price –2058
Selling price (SP) SP
Implied cash flow –2058 45.28 48.81+SP
At a discount rate of 10% we obtain

2058 = 45.28 / 1.1 + 48.81 / (1.1)2 + SP / (1.1)2
SP = 2391.55 (required selling price in May 1994)
a2)
In mid-May 2006, we observe
P0 / E0 = 2058 / 174 = 11.82
P0 / E1 = 2058 / 187.57 = 10.97
In mid-May 2008, the calculations are as follows

P0 / E0 = 2391.55 / 202.2 = 11.82
P0 / E1 = 2391.55 / 217.97 = 10.97
Therefore, if earnings and dividends grow at a constant rate of 7.8%, share prices will grow at
this rate as well.
Check:
2391. 55
− 1 = 7.8%
2058
Obviously, to get the total return on the investment, we have to add the dividend yield:
45. 28
Dividend yield = = 2.2%
2058
Taken together, we get a total return of 7.8% + 2.2% = 10%
b)
Constant dividend growth model
0.75 ⋅ 11
. 0.825
Current share price = = = 16.5 USD
0.15 − 0.1 0.05
For the end of the year, assuming the same payout ratio as last year, we expect:
Earnings per share (EPS) ⋅ Payout ratio = Dividends per share
Dividends per share = EPS ⋅ 0.25 = 0.825 USD

0.825
EPS = = 3.3 USD
0.25
16.50
which implies that price-earnings ratio = =5
3.3
c)
In competitive capital markets, it is unlikely that Company C is overvalued. More likely, its
earnings (and therefore its dividends) are expected to grow faster than those of Company B.
This can be shown by the following calculation:
By definition
Current stock price of Company C = P/E ratio ⋅ EPS = 10 ⋅ 3.3 USD = 33 USD
The constant-dividend-growth formula can be used to infer the expected EPS growth for
Company C:
D1 0.825
From: P0 = = = 33 USD
k − g 0.15 − g
0.825
we can compute g = 0.15 − = 0.15 − 0.025 = 12.5% > 10%
33
d)
P0
Price earnings formula: P/E ratio =
EPS1
Constant growth model formula (dividend discount model):

D1 EPS1 ⋅ Payout ratio P0 Payout ratio
P0 = = → =
kE − g kE − g EPS1 kE - g
There is a direct relationship between these formulas if you assume that the earnings of the P/E
ratio are growing constantly for ever and that the firm maintains a stable payout ratio. In that
case the only difference is in the question whether you look at earnings or dividends (which are
directly linked to earnings).
e)
Yes, there is a relation when you assume that the earnings and dividends are stable (or
P Payout ratio 0.40
constantly growing): = = = 20
EPS kE − g kE − 1
Therefore the cost of equity amounts to kE = 0.40 / 20 + 0.1 = 12%
Exercises: Solutions
Level II


S3 March 03: Equity Valuation and Analysis
a)
2000 2001
4310/19273 4890/20237
ROE = Net Incomet /Common Equityt-1
= 22.36% = 24.16%
Retention ratio (RR) = (1 - payout ratio)
= (1 - Common Dividend/Net Income) 42.60% 39.08%
22.36 · 42.60 24.16 · 39.08

Sustainable growth rate = ROE · RR = 9.53% = 9.44%
Actual growth rates = % change in sales

from prior year -3.68% 15.74%
b) If the actual growth rate continues to exceed the sustainable growth rate, the management
can take one or more of the following actions:
1. Increase leverage:
Management can increase financial leverage by issuing new debt to finance the
growth. This will increase GW’s total-assets-to-common-equity ratio, and thus, its
sustainable growth rate. However, increase in debt has a limit. Creditors impose a debt
limit on firms by demanding increasingly higher returns for higher levels of debt.
Higher debt ratio also increases the cost of equity and the WACC may also increase.
2. Reduce payout ratio

Reducing payout ratio will result in the firm retaining a larger proportion of its
earnings. This will cause the sustainable growth rate to increase. Reduction in payout
ratio is a good way to increase sustainable growth. However, this too has a limit. A
firm can only reduce the payout ratio to zero.
3. Profitable pruning:
Profitable pruning involves selling-off either businesses that are not part of the firm’s
core business or are marginal businesses. Businesses that are different than the core
business of the firm divide management attention and reduce management
effectiveness, and consequently, profitability. A firm can sell off marginal or otherwise
low performing businesses. This would result in an increase in profit margin and
sustainable growth.
Profitable pruning can also be done in a single-product company by eliminating slow-

paying customers or slow-moving inventory. The freed up cash can support new
growth. Asset turnover will increase with fewer assets tied in low profit margin assets.
solutions II / page 1
4. Merge with other firms:
A firm, unable to finance its growth from internally generated funds, can look for a
partner. A firm that has excess cash flows (is a cash cow) and is looking to merge with
a high growth business would be an ideal merger partner. Such a firm could provide
the cash flows needed to support high growth.
c) According to Miller and Modigliani, an increase in dividend payout should not have any
impact on the market value of the equity. This is especially true if the firm does not have
new investment opportunities that earn a rate of return which equals (or exceeds) the
required rate of return of the shareholders. In such cases, the firm should return cash to
shareholders who can invest themselves at a higher rate. However, the share price may
actually increase if the higher dividends signal the market of management’s optimism
about GW’s prospects.
d) Required Rate of Return on Equity:

Re = rf + b(RM – rf) = 3.0 + (10.5 – 3.0) · 1.22 = 12.15%
D2001 = Dividend per share in 2001 = Com.Div./# of shares = 0.7
Value of the stock:

D2002 = D2001 · (1 + g) = 0.70 · (1+0.09) = 0.763
Value of the stock on 1/1/2002 = D2002 / (Re - g) = 763 / (0.1215-0.09) = USD 24.22
The market price at the beginning of 2002 (end of 2001), USD24.60, is almost equal to the
theoretical price of USD 24.22. Therefore, if you feel at ease with the various hypotheses
you made, you can say that the stock is fairly priced and can be purchased.
e)
2002 2003 2004 2005 2006

Growth rates of dividends 0.07 0.07 0.07 0.07 0.05
Dividends at the end of year D2002 D2003 D2004 D2005 D2006
Dt = Dt-1(1+g) 0.749 0.801 0.858 0.918 0.963
Value of the stock at the end of year 2005
V2005 = D2006/(k-g) = 0.964/(0.1215-0.05) V4=13.47
PV of future cash flows (discounted at 12.15%) 0.668 0.637 0.607 0.580 8.52
Value of the Stock = ΣPV of all CFs USD 11.01
According to the CFO’s scenario, GW stock has an intrinsic value of USD11.01. It is

over- priced (market price is USD 24.60) and should not be acquired.
S4 March 04: Equity Valuation and Analysis / Corporate finance
a) Present value of synergy = EUR 1.5 million

Acquisition premium
= Cash paid - XYZ's market capitalization prior to acquisition
= 5,000,000 - 40 · 100,000 = EUR 1,000,000
NPV of acquisition
= Present value of synergy - Acquisition premium
=1,500,000 – 1,000,000 = EUR 500,000
b) This is not a good method. Generally, when a company with a high price-earnings ratio
issues new shares to acquire a company with a lower price-earnings ratio, its earnings per
share increase after the acquisition. This happens even when there is no synergy effect
from the merger/acquisition. It is therefore impossible to judge the economic merits of a
merger or acquisition from the change in earnings per share.
c) If the stock offer is affected, Company ABC will have a market capitalization after the
acquisition of:
ABC's market capitalization prior to the acquisition + XYZ's market capitalization prior to
the acquisition + synergy effect
= 25,000,000 + 4,000,000 + 1,500,000 = EUR 30,500,000
There will be 300,000 outstanding shares after the acquisition (250,000+100,000/2),
250,000 of which will be in the hands of the old ABC shareholders. The proportion of the
company belonging to the former shareholders of ABC is therefore 250/300 = 0.833.
Therefore, they own:
250,000
30,500,000 ⋅ = EUR 25,416,667
300,000
As the market capitalization of ABC prior to the acquisition was EUR 25 million, total
profits to the old ABC shareholders are:
25,416,667 - 25,000,000 = EUR 416,667
d) There will be 300,000 outstanding shares after the acquisition, of which 50,000 will be
held by the old XYZ shareholders. They therefore own 0.167 (= 50/300) of the new ABC
(2 points). The value of the shares held by the old XYZ shareholders will be:
50,000
30,500,000 ⋅ = EUR 5,083,333
300,000
Therefore, the stock offer is more advantageous than receiving EUR 5 million in cash.
e) When the acquiring company uses a stock offer, it is possible that it is doing so because its
shares are overvalued. If this is the perception of outside investors, the company's share
price will fall after the acquisition is announced. This has to do with asymmetric
information between the management of the acquiring company and outsiders.
Also, if the acquiring company suspects that the company to be acquired may have some
hidden debts, a stock offer may be chosen by the acquiring company as a preferable way
because shareholders of the acquired company will have to share the losses from these
debts. In this case, the share price could decline if the problem does exist and comes to
light after the announcement of the acquisition. This is asymmetric information between
the management of the acquiring company and the management of the company to be
acquired.
S2 Sept 04: Equity Valuation and Analysis

a)
The yearly after-tax operating cash flows of the project can be estimated as follows:
1 2 3 4
Revenues 300,000 315,000 330,750 347,288
Less: Operating expenses 100,000 105,000 110,250 115,763
Less: Depreciation 100,000 100,000 100,000 100,000
= EBIT 100,000 110,000 120,500 131,525
EBIT(1 – t) [t = 36%] 64,000 70,400 77,120 84,176
Add: Depreciation 100,000 100,000 100,000 100,000
After-tax cash flow 164,000 170,400 177,120 184,176
One can also use the following procedure:

Revenues of the first year 300,000
Less: Operating expenses of the first year 100,000
= (Revenues) – (Operating expenses) 200,000
[(Revenues) – (Operating expenses)](1-t) = (REV-OEX)(1-t) 128,000
We apply the 5% yearly rate of growth on this amount and then add the tax shield:
1 2 3 4
(REV – OEX) (1-t) 128,000 134,400 141,120 148,176
Add : (Depreciation)t 36,000 36,000 36,000 36,000
After-tax cash flow 164,000 170,400 177,120 184,176
b)
The net present value of the project can be calculated as follows:
Cash Flow PV Factor (10%) Present Value

164’000 0.90909 149’090
170’400 0.82645 140’826
177’120 0.75131 133’073
184’176 + 100’000 0.68301 194’096
PV of the Cash Inflows 617’086
The NPV is therefore: 617,086 - 500,000 = 117,086 and the project is acceptable. The wealth
of the shareholders will increase by CU 117,086
c)
The implicit assumption made is that inflation has the same impact on both revenues and
expenses. This assumption does not always hold. Prices of raw materials, for instance, may
increase or decrease by a different percentage than the personnel expenses, land or buildings.
When calculating the net present value, the treatment of inflation should be consistent
between the cash flows and the cost of capital, i.e. it should be either considered or ignored in
both calculations. If cash flows are estimated using nominal values of revenues and expenses,
the cost of capital should also be nominal. In most cases, the cost of capital is nominal, and for
sake of simplification, the cash flows are often supposed to be constant. That solution must be
avoided, as it is incoherent.
d)
An increase in the tax rate has an effect on the NPV at least in two ways. First, the after tax
cash flows related to cash income and cash expenses will decrease.
Second, the depreciation tax shield will increase.
For profitable projects, the net effect will necessarily be negative.
Tax may also have an effect on the residual asset values. It is difficult to forecast the effect on
the cost of capital, as it will be nil if the investors consider their after-tax return.
If the tax rate is 40% instead of 36%, the effect on the NPV of the depreciation tax shield will
be:
- PV of the tax shield with a tax rate of 36% : 100,000 x 0.36 x 3.170 = 114,120
- PV of the tax shield with a tax rate of 40% : 100,000 x 0.40 x 3.170 = 126,800
The effect will be a positive impact on the NPV of 12,680. A shorter calculation is:
(100,000 x (0.40 – 0.36) x 3.170 = 12,680
e)
The 90-day T-bill is not a good proxy except when the term structure of interest rates is flat.
The net present value is highly sensitive to the value of the cost of capital. If the cost of capital
used is not correct, the value of the NPV obtained and thus the decision to accept or reject the
project may be wrong.
If the cost of capital used is higher than it is supposed be, the project whose cash flows are
farther in the future will have a lower NPV, and vice-versa.
Indeed, the farther the cash flows are in the future, the larger the impact of an error in
estimating the cost of capital.
a)
Using 2003 data and the highest prices of the year, we obtain:
Alpha Beta Gamma MFG 500

Highest price 53.0 55.0 68.0 1470.0
P/CF 40.2 76.4 5.0 17.9
P/E 49.5 80.9 11.6 30.5
Dividend yield (%) 0.92 none 2.76 1.14
At the market high, base on P/E and P/CF, Beta traded with a very high premium relative to
the market, and Alpha was also expensive. Obviously investors paid for expected high growth
rates. Gamma is attractive on dividend yield, but as a mature company it compensates for
slower growth with a higher dividend yield.
Alpha has managed to generate continuously high growth rates and has paid dividends close
to market average. The market premium for Alpha could be justified by the outstanding
stability of growth rates over time. The very fast growing Beta Computer is expensive and
pays no dividend, but this strategy is successful only if growth rates persist.
b)
Using the discounted cash flows, we obtain
Growth Cash 2005 2006 2007 2008 2009 PV of PV Total

rate % Flow annual terminal value
2004 CF value
Alpha:
CFM 14.67 1.51 1.73 1.99 2.28 2.61 2.99 8.57 39.03 47.60
Beta:
CFM 36.67 0.98 1.34 1.83 2.50 3.42 4.67 9.85 60.92 70.77
Gamma:
DDM 7.00 1.80 1.93 2.06 2.21 2.36 2.53 8.29 32.92 41.21
CFM 7.00 7.46 7.98 8.54 9.14 9.7810.46 34.36 136.43 170.79
Using the cash flow model, the values of the three companies' shares are within the Hi/Low
range for 2004 in case of Alpha. Beta seems to be undervalued a little. However Gamma
seems to be totally undervalued, but the result is due to the assumption of 7% growth rate as
opposed to the actual negative growth shown in the past years. The CFM does not make sense
to evaluating Gamma, which is a low growth firm. We can value Gamma using the DDM,
which gives more sensible results.
Discounted Cash Flow is not appropriate for low growth and high dividend companies. A
DDM gives better results.
c)
In recession periods, growth rates become very questionable with significant implications for
growth companies. Technology companies like Beta face problems because growth rates
appear to be unsustainable, and stock prices fall. Value cyclical companies like Gamma are
protected by the dividend and become more attractive in recession times. Usually these
companies are the first to recover in the market.
In a second stage after recession investors pay for stable growth if the price is right, Alpha is
an example. For aggressive growth companies, investors have to become very confident on
future growth and need the confirmation for rising growth rates. They profit the most when a
new period of economic recovery is confirmed. Price/Earnings ratios contract in recession
times and expand in periods of long growth. A problem for all manufacturing companies in
recession times are falling prices and higher marketing costs (incentives).

a)
Forecast earnings per share this year = E(EPS) = (BVPS of last year) · ROE
= 100 · 0.1 = 10 euros
Forecast dividends per share this year = E(DPS) = E(EPS) · (Payout ratio)
= 10 · 0.3 = 3 euros
Sustainable growth rate = g = ROE · (1 – Payout ratio)

= 0.1 · (1 - 0.3) = 0.07
Using the constant growth dividend discount model, the implied return (implied kE) of JUN’s
shares is:
E (DPS) 3
Implied kE = +g = + 0.07 = 0.1015
Share price 95
Required rate of return under the capital asset pricing model (CAPM) = kE
= Risk-free rate + Stock market risk premium · beta
= 0.03 + 0.07 · 1.1 = 0.107
The implied return of 10.15% is less than the required return of 10.70% under the CAPM, so
JUN's shares are at a premium.
b)
Forecast residual income per share this year:
= E(EPS) – BVPS · RE = 10 – 100 · 0.107 = -0.7 euros
Earnings per share and book value per share will grow at the sustainable growth rate of 7%
from next year onwards, so the residual income per share (or in this case, residual loss) will
also increase by the sustainable growth rate of 7%.
Theoretical share price =

(BVPS at end of last year) + (PV of residual income per share in and after this year)
− 0 .7
= 100 + = 81.08 euros
0.107 − 0.07
The theoretical price for JUN's shares is thus 81.08 euros, and the current price of 95 euros is
at a premium.
With this approach, one obtains the same result as with the constant growth dividend discount
model:
E (DPS) 3
Theoretical price for JUN shares = = = 81.08 euros
kE − g 0.107 − 0.07
c)
Even if the share price is below the liquidation value, JUN's shares are still at a premium to
the theoretical price calculated from forecast earnings and dividends. Therefore, JUN’shares
should not be considered as an investment.
d)
• Assuming the balance sheet accurately reflects the company's asset values, a PBR below 1
indicates that the shares are trading for less than the company's liquidation value, which
makes the company a potential take-over target. If the company becomes a take-over
target, the share price is likely to rise above the liquidation value, which would make it a
good investment.
• Empirical evidence suggests that in most countries stocks with low PBRs have high risk-
adjusted returns. Therefore, as a general rule a stock with a low PBR could be a promising
investment.

a)
Calculation of the cost of equity for Company X and Company Y by using the results of the
regression analysis shown in Table 3. Let us denote Company X's cost of equity as rX and
Company Y's cost of equity as rY . Then,
rX = 0.02 + 0.7 ⋅ 0.04 = 0.048 = 4.8%, rY = 0.02 + 1.8 ⋅ 0.04 = 0.092 = 9.2%
Table 1 indicates dividend per stock of JPY 10 and JPY 6 for Company X and Company Y in
2006 respectively.
The following relationship holds true under the constant-growth dividend discount model:
Div1 Div1
P0 = ⇒ g =r−
r−g P0
The stock prices of Company X and Company Y are currently JPY 500 and JPY 1000
respectively, so using the formula, Company X's dividend growth rate g X and Company Y's
g Y are calculated as follows:
g X = 0.048 − (10 / 500) = 0.028 = 2.8%, g Y = 0.092 − (6 / 1,000) = 0.086 = 8.6%
b)
Company XY will use a stock-for-stock exchange to complete the merger, swapping 1 stock
in Company Y for 2 stocks in Company X. Therefore, Company XY's total stocks issued and
outstanding will be 200 + 10 x 2 = 220 million stocks. Analyst A does not think the merger
will have any impact on next year's results, so net income will be the same as total net income
for pre-merger Company X and Company Y, or 4,200 (= 4,000 + 200) million. Therefore,
with a payout ratio of 50%, Company XY's dividends per stock will be (4,200/220) x 0.5. If
the cost of equity capital is 5.2% and the stock price is JPY 540, the dividend growth rate is
3.43%, as shown by the following formula:
Div1 4,200 / 220 ⋅ 0.5
g=r− = 0.052 − = 0.0343 = 3.43%
P0 540
However, Analyst A's opinion cannot be supported. Company XY's sustainable growth rate
can be calculated from post-merger Company XY's net assets of 73,100 (= 71,500 + 1,600)
and retained earnings ratio of 50%. The results are 4,200/73,100 x 0.5 = 0.0287 = 2.87%.
Therefore, the dividend growth rate of 3.43% is unachievable unless the company engages in
further equity financing. One must therefore conclude that the rise in the stock price was due
to the market reflecting other factors than the dividend growth rate, for example, forecast net
income, dividend amounts, or cost of equity capital.
c)
Table 1 indicates Company X will have sales of 135,000 in 2006; Company Y, 4,200. If after
the merger sales increase by 5%, the ratio of EBIT to sales is 7.9% and the ratio of interest
payments to sales is 2.5%, then EBT will be 5.4% of sales. The corporate tax rate is 40% and
payout ratio 50%, so Company XY will have dividend per stock in 2006 of:
((135000 +4200) · 1.05 · 0.054 · 0.6 · 0.5)/220 = JPY 10.7627
Using the dividend discount model, Company XY's stock price PXY is calculated at:
10.7627
PXY = = JPY 538.135 ≅ JPY538.14
(0.052 − 0.032)
d)
It is possible that Analyst B and Analyst C hold the following different views that would
account for the under-valuation of the merger effect and the estimations of cost of equity
capital.
d1) Estimation of cost of equity capital

Since Company X has a beta of 0.7 and Company Y a beta of 1.8, and since market
capitalization at the time of merger will be JPY 10 billion for Company X and JPY 1 billion
for Company Y, Company XY will have a beta of:
0.7 · (10000/11000) + 1.8 · (1000/11000) = 0.8.
So Analyst B presumably estimated Company XY's cost of equity capital at:
0.02 + 0.8 · 0.04 = 0.052 = 5.2%.
d2) Under-valuation of the impact of the merger on net income

Analyst B postulates that after the merger the ratio of EBIT to sales will be 7.9% and the ratio
of interest payments to sales will be 2.5%. This is roughly equivalent to an average (weighted
by market capitalization) of the pre-merger results of Company X and Company Y for the
latest 3 years. Therefore, the rise in the stock price in c) can be explained entirely in terms of
higher sales.
If it can be expected that the merger will bring reductions in the cost of sales or selling,
general and administrative expenses, then the market could value it even higher. Company Y
has a fairly high ratio of interest payments to sales of 6.0% (average over 3 years). It could
conceivably be able to raise funds after the merger by making use of Company XY's retained
earnings or issuing bonds at lower rates. When these financial benefits are taken into account,
it will be possible to value Company XY higher.
d3) Even if CAPM is used to estimate cost of equity capital, when the estimation is based on
historical betas as in Table 3, the results will greatly depend on the size and frequency of the
data's sample. It is therefore completely conceivable for Analyst C to arrive at a different
estimation from Analyst B even if Analyst C was using historical betas. Or it is conceivable
that Analyst C used a fundamental beta based on the corporate financial profile.
Looking at the results of Table 3, CAPM has low explanatory power for Company Y, and the
intercept has a significant negative value. It is therefore uncertain whether CAPM is an
appropriate model for estimating cost of equity capital. In addition, the scale effects of the
merger may mean that investors are happy with a lower rate of return than 5.2% from
Company XY. In cases such as this, what is needed is a cost of equity capital estimation
model that takes account of corporate scale, debt ratios and other aspects of the financial
profile.

a)
The expected market capitalization of IT Corporation at the time of an IPO 5 years hence
= Projected net profits five years hence · Projected PER
= EUR 20 million · 30 = EUR 600 million
The value of IT’s shares after the equity finance can be calculated by discounting this value by
the 50% required rate of return on IT shares:
EUR 600,000,000
= EUR 79,012,346
1 .5 5
b)
The value of existing shares at the time of the equity finance is found by subtracting the
amount of the capital increase from market capitalization after the equity finance:
EUR 79,012,346 – EUR 5,000,000 = EUR 74,012,346
The theoretical share price at the time of the equity finance is obtained by dividing this
amount by the number of issued and outstanding shares:
EUR 74,012,346 ÷ 1,000,000 shares = EUR 74.01
Alternative answer:
Most venture capitalists use the following calculation.
The percentage ownership required by venture capitalists can be found by dividing the amount
of the capital increase by market capitalization after the equity finance:
Required percentage ownership = EUR 5,000,000 ÷ EUR 79,012,346 = 6.328%
The number of newly issued shares and the share price can be found with the following
formula:
Number of newly issued shares

= (Required percentage ownership/(1-Required Percentage Ownership)) · Number of existing
shares
= (0.06328/(1-0.06328)) · 1’000’000 shares = 67’555 shares
Share price
= Investment/Number of newly issued shares
= EUR 5’000'000 / 67’555 shares = EUR 74.01
c)
The following are conceivable reasons:
• Private equity shares have low liquidity and are difficult to sell. Higher required rates of
return include a liquidity premium that reflects this liquidity risk (liquidity)
• New startups have an extremely high risk of bankruptcy. Higher required rates of return
include a premium that reflects this bankruptcy risk (risk)
• Unlike investments in listed companies, investments in private equities require that
venture capitalists commit to their management if they are to succeed. Higher required
rates of return include the reward to the services provided by venture capitalists (services)
• The business plans and profit forecasts of new startups tend to be optimistic and often are
not achieved. Higher required rates of return can be interpreted as adjustment to the
overly-optimistic figures provided by management (forecast adjustments)
d)
d1)
Generally, when an option is purchased, its value is higher the higher the volatility in the price
of the underlying asset because if the transaction does not go in one’s favor losses are limited
to be option premium, while if it does go in one’s favor, capital gains are unlimited. Startup
companies contain a great deal of uncertainty regarding future potential and directions and
have many different options for developing the business depending on circumstances and are
therefore suitable to valuation using the “real option” approach.
d2)
The current set of valuation and decision making tools aren't sufficient for the new business
realities:
- strategic investments with lots of uncertainty and huge capital requirements.
- projects that must adapt to evolving conditions.
- complex asset structures through partnerships, licenses, and joint ventures.
REFERENCES
BODIE Zvi, KANE Alex & MARCUS Alan J., “Investments”, Fifth edition, McGraw-Hill,
New York, 2002.
BREALEY Richard A. & MYERS Stewart C., “Principles of Corporate Finance”, Sixth
edition, McGraw Hill, 2000.
SHARPE William F., ALEXANDER Gordon J. & BAILEY Jeffery V., “Investments”,
6th edition, Prentice-Hal, Upper Saddle River, NJ 1996.
SOLNIK Bruno, “International Investments”, 4th edition, Addision-Wesley, Reading, MA,

1999.
LODERER Claudio, JÖRG Petra, PICHLER Karl & ZGRAGGEN Pius, “Handbuch der
Bewertung”, NZZ Verlag.
ROSS Stephen A., WESTERFIELD Randolph W., JAFFE Jeffrey, “Corporate Finance”,
6th edition, McGraw-Hill, 1999.
MADDEN Bartley J., “CFROI Valuation”, Butterworth-Heinemann, 1999.
DAMODARAN Aswath, “Investment Valuation”, 2nd edition, John Wiley & Sons, 2002.
McKinsey & Company, “Valuation: Measuring and Managing the Value of Companies”,
3rd edition, John Wiley & Sons, 2000.

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2) Understanding the Industry Life Cycle

3) Analysing the Industry Sector and its

4) Valuation Model of Common Stock

EQUITY MARKETS AND STRUCTURES

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1. Equity Markets and Structure 1

1 .1 Types of equity securities ................................................................................................................... 1

1.1 Types of equity securities

1.1.1 Common shareholders’ rights

1.1.1.3 Limited Liability

1.1.1.4 Asset rights

1.1.1.5 Pre-emptive rights

1.1.1.6 Right of transfer

1.1.2 Authorised and outstanding shares

1.1.3 Issuing Equity

1.1.3.2 The role of an investment banker

1.2.1 The uses of stock indexes

1.2.2 How stock indexes are calculated

1.2.2.1 Number of stocks in an index

Stock Market Index Name No. of Shares

1.2.2.2 Method of calculating an index

Copyright © 2008, AZEK/ILPIP

Copyright  2008, AZEK/ILPIP

2. Understanding the industry life cycle* 1

2 .1 The top-down approach* ................................................................................................................... 1

2 .2 The bottom-up approach* ................................................................................................................. 1

2 .3 The “new” top-down approach* ....................................................................................................... 3

2.1 The top-down approach*

2.2 The bottom-up approach*

The good reasons

The bad reasons

ANALYSING A SECTOR OR INDUSTRY

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Copyright  2008, AZEK/ILPIP

3. Analysing a Sector or Industry and its Constituent Companies* 1

3 .1 The sector or industry* ...................................................................................................................... 1

3 .4 Forecasting for companies in the industry* ................................................................................... 15

3 .5 Balance-sheet factors* ...................................................................................................................... 17

3 .6 Corporate strategy* ......................................................................................................................... 19

3.1 The sector or industry*

3.1.1 The U.S. Census Bureau classification*

It recognizes the following 20 broad sectors:

Code NAICS Sectors

Example of NAICS Hierarchy

3.1.2 The MSCI/S&P classification*

The classification standard consists of 10 Sectors aggregated from 23 Industry Groups,

Code MSCI Sectors

3.1.3 The Dow Jones and FTSE classification - ICB *

10 Industries help investors monitor broad industry trends

The 10 Industries are

Example of ICB Hierarchy for the company 'Puma AG':

3.2.1 Characteristics of the products and services*

To what extent do the products/ services fulfill basic needs?

How uniform are the products/services?

How transportable are the products/services?

How intense is the pressure from substitute products/services?

3.2.2 Characteristics of the clients*

How loyal are the clients?