NISM Fundamental Analysis (FA): Ch.

2
Learning Objectives
 To understand how to use the Discounted Cash Flows
(DCF) Models to estimate the Intrinsic Value of an Equity
Stock.
◼ Using the Dividend Discount Model (DDM) to estimate the
Intrinsic Value of a stock.
◼ Using the Free Cash Flow (FCF) model to estimate the Intrinsic
Value of a stock.
 To understand how to use the Relative Valuation Models to
estimate the Intrinsic Value of an Equity Stock.
◼ Using the Price-to-Book Value (P/B) Ratio model to estimate the
Intrinsic Value of a stock.
◼ Using the Price-to-Earnings (P/E) Ratio model to estimate the
Intrinsic Value of a stock.
A Misconception about Valuation

There is no such thing as “Intrinsic Value”!

 We are concerned with the Intrinsic Value of the security and

more particularly with the discovery of the discrepancies between
intrinsic value and price. We must recognize, however, that
intrinsic value is an elusive concept. In general terms it is
understood to be that value which is justified by the facts, e.g.,
the assets, earnings, dividends, definite prospects – as distinct, let
us say, from market quotations established by artificial
manipulation or distorted by psychological excesses. But it is a
great mistake to imagine that intrinsic value is as definite and as
determinable as is the market price.

….Benjamin Graham and David Dodd, Security Analysis, 1934, p. 17

The Warren Buffett Way
Key Points in Valuation
 Valuation is a matter of Accounting.
 The investor is "negotiating with Mr. Market" (in
Benjamin Graham's words) and, in those negotiations,
the onus is not on the investor to produce a valuation,
but rather to understand Mr. Market's valuation, in
order to accept it or reject his asking price.
 As a valuation is based on forecasts, valuation models
are appropriately applied to understand Mr. Market's
forecasts:
 What forecasts are behind Mr. Market's price? Are those
forecasts reasonable?
Applying Fundamental Principles in Valuation

1) Understand what you know and don’t mix what you know
with speculation
❑ Don'tbuild speculation about the required return (Ko) or a
growth rate (g) into a valuation.
❑ We really don't know these numbers, so don't mix them with
what we do know.
❑ Usevaluation models to challenge the market price with value
based on what we do know.
2) Anchor a valuation on what you know rather than on
speculation
3) Beware of paying too much for growth (speculative value
from growth where our uncertainty lies)
The primary risk in investing is the risk of paying too
much (or selling for too little).
Anchoring Valuation
 Anchor a valuation on what you know rather than on
speculation (separate what you know from speculation)

 Identify the value indicated by what we know - "value

justified by the facts" in Graham's words i.e. implied
by the fundamentals and then go about adding value
for speculation/speculative growth.
Value = Minimum True Value + Speculative Value
 Minimum true value is value that can be accounted for
("value justified by the facts”);
 Speculative value is where our uncertainty lies.
Equity Valuation Models
 Selecting an appropriate valuation model depends on the
characteristics of the company and the context of valuation.
 The valuation models that incorporate a Going-concern
Assumption are:
1. Absolute Valuation Models

2. Relative Valuation Models

 In practice, an analyst may use a variety of models to

estimate the value of a company or its common stock.
Equity Valuation: Absolute Valuation Models
Equity Valuation: Absolute Valuation Models

 They estimate an asset’s intrinsic value, which is its value arising

from its investment characteristics without regard to the value of
other firms.
 They are used to produce an estimate of value that can be
compared with the asset’s market price.
 Types of absolute equity valuation models:
 Discounted/Present Value models
◼ They determine the value of a firm today as the discounted or present value of all
the cash flows expected in the future.
 Asset-based Valuation
◼ This approach estimates a firm’s value as the sum of the market value of the assets
it owns or controls. This approach is commonly used to value firms that own or
control natural resources, such as oil fields, coal deposits, and other mineral
claims.
Equity Valuation: Relative Valuation Models

 A relative valuation model estimates an asset’s value

relative to that of another asset.
 The idea underlying relative valuation is that similar
assets should sell at similar prices.
 Relative valuation is typically implemented using price
multiples such as the price-to-earnings (P/E) ratio, price-
to-book value (P/B) ratio, price-to-cash flow per share
(P/CFP) ratio, or enterprise multiples (EV/EBITDA).
DCF Techniques: An Introduction

 Discounted Cash Flow (DCF) techniques attempt to

estimate the value of a stock today (its Intrinsic Value)
using a Present Value (PV) analysis.
 The DCF model estimates the value of a security by
discounting its expected future cash flows back to the
present and adding them together.
 The estimated value of a security is equal to the discounted
(present) value of the future stream of cash flows that an
investor expects to receive from the security.
Discounted Cash Flow (DCF) Techniques

 Steps in applying DCF analysis to Equity valuation:

 Choosing the class of DCF model—equivalently, selecting
a specific definition of cash flow and forecasting the cash
flows.
◼ Definitions of future cash flows:
◼ Dividends,
◼ Free Cash Flow, and
◼ Residual Income.
 Choosing a discount rate methodology and estimating
the discount rate.
Dividend Discount Model
Dividend Discount Model
 Dividend discount models (DDMs) define cash flow as the
dividends to be received by the shareholders.
 According to the DDM, the value of an equity share is equal
to the present value of expected dividends from its
ownership plus the present value of the sale price expected
when the equity share is sold.
 In a broad sense, DDM would typically be a discounted cash
flow using dividend forecasts over several stages.
Continued…
Assumptions of DDM
 Dividends are paid annually
 The first dividend is received one year after the
equity share is bought
 Dividends are the only way of cash flows to the
investors from the company.
◼ This implies that any share buyback would be ignored
 Investor is expected to hold the share for an
infinite period: he/she will not sell.
DDM: General Model
 Single-period Valuation Model
 Multi-period Valuation Model
DDM: Single-period Valuation Model

 When an investor buys stock, he/she generally expects to get two types
of cash flows - dividends during the period he/she holds the stock and
an expected price at the end of the holding period.
𝑫𝟏 𝑷𝟏
𝑽𝟎 = +
𝟏 + 𝑲𝒆 𝟏 + 𝑲𝒆

 Where 𝑷𝟎 is the current price of the equity share, 𝑫𝟏 is the expected dividend a
year hence, 𝑷𝟏 is the price of the share expected a year hence, and 𝑲𝒆 is the rate
of return required on equity share.
 What happens if the price of the equity share is expected to grow at a
rate of ‘g%’ annually?
𝑫𝟏 𝑷𝟎 𝟏 + 𝒈
𝑽𝟎 = +
𝟏 + 𝑲𝒆 𝟏 + 𝑲𝒆
or
𝑫𝟏
𝑽𝟎 =
𝑲𝒆 − 𝒈
DDM: Multi-period Valuation Model

 Since equity shares have no maturity period and the expected selling
price is itself determined by future dividends, the value of a stock is
the present value of dividends through infinity.
∞
𝑫𝟏 𝑫𝟐 𝑫∞ 𝑫𝒕
𝑽𝟎 = + + … … . + =
(𝟏 + 𝑲𝒆 ) (𝟏 + 𝑲𝒆 )𝟐 (𝟏 + 𝑲𝒆 )∞ (𝟏 + 𝑲𝒆 )𝒕
𝒕=𝟏
𝑫𝟏 𝑫𝟐 𝑫𝒏 𝑷𝒏
𝑽𝟎 = + + … … . + +
(𝟏 + 𝑲𝒆 ) (𝟏 + 𝑲𝒆 )𝟐 (𝟏 + 𝑲𝒆 )𝒏 (𝟏 + 𝑲𝒆 )𝒏
∞
𝑫𝒕 𝑷𝒏
𝑽𝟎 = +
(𝟏 + 𝑲𝒆 )𝒕 (𝟏 + 𝑲𝒆 )𝒏
𝒕=𝟏
𝑫𝒏+𝟏 𝑫𝒏+𝟐 𝑫∞
𝑷𝒏 = + + … … . +
(𝟏 + 𝑲𝒆 ) (𝟏 + 𝑲𝒆 )𝟐 (𝟏 + 𝑲𝒆 )∞−𝒏
∞
𝑫𝒕
𝑽𝟎 =
(𝟏 + 𝑲𝒆 )𝒕
𝒕=𝟏

Where V0 is the price of the equity share today, Dt is the expected dividend per share at the end
of infinity, and Ke is the cost of equity, and Pn is the price at the end of n years.
Continued….
 For practical applications, it is helpful to make
simplifying assumptions about the pattern of dividend
growth. The more commonly used assumptions are as
follows:
 The dividend per share (DPS) remains constant forever,
implying that the growth rate is nil (the Zero growth model).
 The DPS grows at a constant rate per year forever (the Constant
growth model or Gordon Growth Model).
 The DPS grows at a constant extraordinary rate for a finite
period (g1), followed by a constant normal rate of growth (g2)
forever thereafter (the Variable growth model - Two-stage or
Three-stage Model).
 The DPS, currently growing at an above-normal rate,
experiences a gradually declining rate of growth for a while
and, thereafter, it grows at a constant normal rate (the H
Model)
Continued….
 Zero Growth Model
 If we assume that the DPS remains constant year after year at a value of
D, it becomes:
𝑫 𝑫 𝑫 𝑫
𝑽𝟎 = + 𝟐
+ …….+ ∞
=
(𝟏 + 𝑲𝒆 ) (𝟏 + 𝑲𝒆 ) (𝟏 + 𝑲𝒆 ) 𝑲𝒆

 Constant Growth Model or Gordon Growth Model

 It assumes that DPS grows at a constant rate (g). the value of a share,
under this assumption, is:
𝑫𝟎 (𝟏 + 𝒈) 𝑫𝟏
𝑽𝟎 = =
𝑲𝒆 − 𝒈 𝑲𝒆 − 𝒈
𝑫𝒕
𝑽𝟎 =
𝑲𝒆 − 𝒈
◼ Where g = plough back ratio (b) × Return on Equity (Ke)
Continued….
 Variable Growth (Two-stage) model
 It assumes that the extraordinary growth (good or bad) will
continue for a finite number of years and thereafter the normal
growth rate will prevail indefinitely.
 Since the two-stage growth model assumes that the growth rate
after n years remains constant, V0 will be:
𝟏 + 𝒈𝟏 𝒏
𝟏−( ) 𝑫 (𝟏 + 𝒈 ) 𝒏−𝟏
(𝟏 + 𝒈𝟐 ) 𝟏
𝑽𝟎 = 𝑫𝟏 𝟏+𝒓 +
𝟏 𝟏
𝑲𝒆 − 𝒈𝟏 𝑲𝒆 − 𝒈𝟐 (𝟏 + 𝑲𝒆 )𝒏

OR
Continued….
 H-Model
 Fuller and Hsia (1984) developed a variant of the two-stage model in
which growth begins at a high rate and declines linearly throughout the
supernormal growth period until it reaches a normal rate at the end.
 The value of the dividend stream in the H-model is
The Financial Determinants of Growth Rates

Sustainable Growth Rate (g)

 It is defined as the rate of dividend (and earnings) growth that
can be sustained for a given level of return on equity, assuming
that the capital structure is constant through time and that
additional common stock is not issued.
 The reason for studying this concept is that it can help in
estimating the stable growth rate in a Gordon growth model
valuation, or the mature growth rate in a multistage DDM in
which the Gordon growth formula is used to find the terminal
value of the stock.
𝑔 = 𝑏 × 𝑅𝑂𝐸
 where
g = dividend growth rate
b = earnings retention rate i.e. (1 – Dividend payout ratio)
ROE = return on equity
Continued….
Advantage of DDM
 Dividends are less volatile than other measures (earnings or
free cash flow), and therefore the value estimates derived
from DDMs are less volatile and reflect the long-term
earning potential of the company.
Disadvantages of DDM
 It is difficult to implement DDM for firms that don’t
currently pay dividends.
 It takes the perspective of an investor who owns a minority
stake in the firm and cannot control the dividend policy.
 If the dividend policy is not related to the firm’s ability to
create value, then dividends are not an appropriate measure
of expected future cash flow to shareholders.
Suitability of DDM
 Dividends are appropriate as a measure of cash
flow in the following cases:
 The company has a history of dividend payments.
 The dividend policy is clear and related to the earnings
of the firm.
 The perspective is that of a minority shareholder.

 Firms in the mature stage of the industry life cycle

are most likely to meet the first two criteria.
 :

Free Cash Flow (FCF) Model

Free Cash Flows Model
 Many analysts consider free cash flow models to be more
useful than DDMs in practice.
 Free cash flows provide an economically sound basis for
valuation.
 The value of a firm’s stock is calculated by forecasting free
cash flow to the firm (FCFF) or free cash flow to equity
(FCFE) and discounting these cash flows back to the
present at the appropriate required rate of return.
 FCFF or FCFE are the appropriate models to use when
 the firm doesn’t pay dividends at all or pays out fewer dividends
than dictated by its cash flow,
 free cash flow tracks profitability,
 the analyst takes a corporate control perspective.
FCF Model
 FCF is the cash flow available to all investors in the
company – both shareholders and bondholders
after consideration for taxes, capital expenditure,
and working capital investment.
𝐹𝐶𝐹 = 𝐶 − 𝐼 = 𝐹 + 𝑑
 A firm can be analyzed from the perspective of all
investors or just equity investors.
 Measuring Cash Flows (CF):
 FCF to the Firm i.e. all Investors (FCFF)
 FCF to the Equity Investors (FCFE)
Continued…
Measuring FCF to the Firm (FCFF)
 It involves determining the value of the Firm as a whole i.e.
the Enterprise Value (EV) by discounting the Free Cash
Flow (FCF) to investors and then subtracting the value of
Preference and Debt to obtain the Value of Equity.
 𝐹𝐶𝐹 = 𝐶 − 𝐼
 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 𝐶 = 𝑅𝑒𝑝𝑜𝑟𝑡𝑒𝑑 𝐶𝐹 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠
 𝐶𝑎𝑠ℎ 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 𝐼 = 𝑅𝑒𝑝𝑜𝑟𝑡𝑒𝑑 𝐶𝐹 𝑢𝑠𝑒𝑑 𝑖𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑖𝑛𝑔 −
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
Or
 𝐹𝐶𝐹 = 𝑁𝑂𝑃𝐴𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 & 𝐴𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛 −
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 ± ∆ 𝑊𝐶 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Where
◼ NOPAT = EBIT (1 – Tax rate) Or
◼ NOPAT = PAT + Interest (1-Tax Rate)
Measuring FCF to Equity (FCFE)

 Cash flow to equity (FCFE) is the residual cash flow after

meeting investment requirements and contractual
payments.
 It should be noted that cash flow to equity is more
meaningful for a growing firm that borrows all the time to
invest.
 For a typical growing firm cash flow from operations would be
negative.

𝑭𝑪𝑭𝑬
= 𝑁𝑂𝑃𝐴𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 & 𝐴𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
± ∆ 𝑊𝐶 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
− 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑁𝑒𝑤 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
DCF Valuation
 Value of Firm = Present Value of Expected FCF

𝑭𝑪𝑭𝟏 𝑭𝑪𝑭𝟐 𝑭𝑪𝑭𝒏 𝑪𝑽𝒏

 𝑬𝑽𝟎 = + + …….+ +
𝟏+𝑲𝒐 𝟏+𝑲𝒐 𝟐 𝟏+𝑲𝒐 𝒏 𝟏+𝑲𝒐 𝒏
Where
𝑭𝑪𝑭𝒏+𝟏
𝑪𝑽𝒏 =
𝑲𝒐 − 𝒈
 But --- what is Ko?
--- what is g?
--- does free cash flow capture value added?
Steps for a DCF Valuation
1. Forecast Free Cash Flow (FCF) to a horizon
2. Discount the FCF to present value (i.e. PV of FCF)
3. Calculate a Continuing Value (CV) at the horizon
with an estimated growth rate
4. Discount the CV to the present (i.e. PV of CV)
5. Add 2 and 4 (i.e. PV of FCF + PV of CV) to get the
Value of the Firm i.e. EV
6. Subtract Net Debt from EV to get Value of Equity.
Continued….
Continued….
Solution:
Critical Evaluation of DCF Model

 Advantages
 Easy concept:
◼ Cash flows are "real" and easy to think about; they are not
affected by accounting rules.
 Familiarity:
◼ Cash flow valuation is a straightforward application of familiar
present value techniques.
 If good investors buy businesses, rather than stocks (the
Warren Buffet adage), discounted cash flow valuation is
the right way to think about what you are getting when
you buy an asset.
Critical Evaluation of DCF Model
 Disadvantages
 Suspect concept:
◼ Free cash flow does not measure value added in the short run; value
gained is not matched with value given up.
◼ Investment is treated as a loss of value.
◼ Free cash flow is partly a liquidation concept; firms increase free cash
flow by cutting back on investments.
 Forecast horizons:
◼ Typically, long forecast horizons are required to recognize cash inflows
from investments, particularly when investments are growing.
Continuing values have a high weight in the valuation.
 Not aligned with what people forecast:
◼ Analysts forecast earnings, not free cash flow.
◼ These inputs and information are not only noisy (and difficult to
estimate), but can be manipulated by the savvy analyst to provide the
conclusion he or she wants.
Continued….
 When it works Best?
 When the investment pattern produces positive constant free cash
flow or free cash flow growing at a constant rate; a "cash cow"
business.
 It works best for investors who either
◼ have a long time horizon, allowing the market time to correct its valuation
mistakes and for price to revert to “true” value or
◼ are capable of providing the catalyst needed to move price to value, as would
be the case if you were an activist investor or a potential acquirer of the
whole firm
 DCF is useful when equity investments are terminal or the investor
needs to "cash out," as in leverage buyout situations and private
equity investment where debt must be paid down or investors must
be paid out within a certain time frame, so the ability to generate
cash is important.
Summery of Learning

Questions & Answers

Thank you