CHAPTER 5: The art and Science of Valuation

• Valuation is a subject, it´s an art, not a science

• The two most important valuation methods are multiples and discounted cash flow.
1. Multiples
- A ratio that compares the value of an asset to an operating metric associated
with that asset.
- A common multiple used in valuation is the price-to-earnings or P/E ratio →
divides a company´s stock price by its earnings per share. The value of a
company´s equity divided by its net profit.
- The ratio will be “15X” → you are willing to pay 15 dollars for every dollar of
earnings that a company generates, you are paying for a stream of future
earnings that are expected to grow.
- EV (the sum of the market value of debt and equity)/EBITDA → helps us
compare companies of varying capital structures

The pros and cons of multiples

- Simple to communicate (+)

- Based on current market prices, means that someone actually valued a
company and put their money on it (+)
- Comparison between companies are quick
- Comparability is not always so straightforward, this measure ignores many
factors (-)
- Many decisions associated with calculating earnings might differ across
companies, they can be incomparable for multiple purposes (-)}

2. Payback periods
- The amount of time it would take for investors to get their money back.
- Compare the initial outflow of the funds with subsequent inflows and ask in
what year do I get my money back?
- The time value of time is ignored (-)
- The answer to payback analysis is a number of years but we are interested in
creating value (-)

3. Internal rates of return (IRR)

- The rate of return that will be experienced if the forecast is realized for a
project. The internal rate of return (IRR) is the annual rate of growth that an
investment is expected to generate.
- Takes forecasted future cash flows and finds the discount rate that makes the
present value 0
- They are focused on returns and not value creation (-)
- Inflows can give wrong answer. (-)

4. Discounted cash flow (best method)

- Assets derive their value from their ability to generate future cash flows, these
cashflows require discounting to translate them to today´s numbers
- Free cash flows: flows that assets generate that are truly cash, after
discounting costs and expenses. It can be invested or distributed to capital
providers
- Steps: (projected EBIT – taxes) + depreciation and amortization and then
accommodate the capital intensity of the business by penalizing for its
investments in its working capital and fixed assets

STEP 1: Forecast future cash flows

- Like initial capital expenditure, expected EBIT, depreciation, and amortization

- Following the timing of the project is critical, the working capital calculation is
not the level of working capital, but it is the change in the level of working
capital. Also, it is important to settle a system to keep track of the inflows and
outflows

STEP 2: APPLY WACC

- This model helps us to understand where the costs of equity come from, and
betas capture the measure of risk.

➔ Return to the forecasted free cash flows and determine net present value.
Discount factors are 1/(1+WACC). Multiply all the free cash flows by the
discount factor and sum them to determine the net preset value.

STEP 3: CALCULATE TERMINAL VALUES

- Many investments are expected to continue indefinitely and in this situations

is typical to set a year when you expect the company´s growth to stabilize →
“terminal value”: sum of the values of the investment at the end of the
forecasted cash flows
- Two ways to get terminal values
1. Multiples
2. Perpetuity formula: calculates today´s value for a stable set of cash
flows
 If someone promises growing perpetuity of 3% use this formula

STEP 4: COMPARE ENTERPRISE VALUES VERSUS MARKET VALUES

- Through valuation, you have determined the value of the business, not its
equity. The value of the business is called enterprise value.

STEP 5: ANALYZE SCENARIOS, EXPECTED VALUES AND BIDDING STRATEGIES

- It is important to calculate best case, base case and worst case or fraud
scenario
- Expected value= 10% PV (best case), + 70% PV (Base case) + 20% PV (worst
case)
- In case of bidding, the expected value should be the final offer. You opening
bid should be something considerably lower.

VALUATION MISTAKES

1. Ignoring incentives: asymmetric information. Everyone involved in the

transaction wants the transaction to happen and may subtly change
assumptions or forecasts to help make the outcome a reality.
2. Exaggerating synergies and ignoring integration costs: Synergy is the idea that
once merged, the value of the two companies will be greater than the sum of
the values of each individual company. People tend to overestimate how
quickly those synergies will work and overestimate the magnitude of their
effects. Changing cultures and changing workforces take time.
3. Underestimating Capital Intensity: Understate the capital intensity of the
business.

Lecture 2: INTRODUCTION TO VALUATION

- Stock valuation is important to a firm´s managers because (1) it affects

whether issuing new equity is an attractive source of financing and (2) the
board of directors often use stock price to evaluate and reward the managers’
performance

Valuation principles

1. Investors purchase securities for their future cash flows: Investors acquire and value
stocks for the future cash flows they generate. Future cash flows to debt investors are
relatively predictable, but cashflows to equity investors are more difficult to forecast
because they are paid only after commitments to the firms’ creditors have been met.
2. Investors require higher expected payoffs for riskier investments: By investing,
investors are forgoing their cash for current consumption. Some investments are
riskier than others, but they expect higher returns: governments bonds, corporate
 debt (some firms default on their debt) and stocks (if a firm loses money or goes out of
business it may have insufficient cash to pay its creditors)

Challenges in Valuing Stocks

- To estimate future cash flows investors are forced to rely heavily on historical
data from financial reports but the historical data might be unavailable or
incomplete → historical measures of a stock relative risk are imperfect guides
to its future risk
- Two approaches have been addressed to control de limitation of using historial
data information.

1. Valuation using Multiples: a firm´s value is determined by applying an

appropriate price multiple on a current measure of performance or forecasted
performance
1.1. Price-to-earnings Multiples (P/E or PE)
Earnings are a measure of financial performance, they reflect industry
growth, firm’s competitive position and que quality of management and
they represent the amount of new value generated for shareholders

*Earning per share (EPS): net income / number of shares of stock

outstanding
“Investors were willing to pay 20 dollars for every 1 dollar that the
company generates”
- Seems that the three companies analyzed have relatively conservative
financial leverage
- They are highly sensitive to the current earnings number (-) that’s because
many analysts use earnings from continuing operations or earnings excluding
one-time gains or losses as the denominator in PE.

1.2 Price-to-Book Equity Multiples

“Investors were willing to pay 5 dollars for every 1 dollar of book value or book
equity that the company reported”

- Book value:
 - Future earnings from its book equity than its competitors, leads to a higher
return on equity (ROE)

1.3 Using multiples to Value Stocks

- Step 1: Identify a stock or set of stocks that are comparable to the one
being valued to use as a benchmark
- Step 2: Calculate the multiple of interest like PE or PB for the stocks. If
there are multiple benchmark stocks, use weighted average multiple
- Step 3: Multiply the multiple by the relevant performance measure of the
stock to be valued.

Limitations of multiples valuation

- They are only effective if the benchmark stocks are truly comparable to
the stock being valued
- They are underdefined if the denominator is nonpositive. During the dot-
com bubble, some analysts resorted to using revenues as the denominator
because even gross profit were negative.

2. Valuation using discounted future earnings

- It values a stock as the present value of its expected future dividends, applying a
discount rate (r) that reflects the riskiness of those dividends

-
- The dividend discount model makes up for many of the limitations of valuing stocks
using multiples, it does not require the identification of benchmark companies.
- Works for companies that have negative earnings (+)
- Firms that pay no or very low dividends will have little historical data to aid in
forecasting future dividends (-)

2.1 Reframing discounted future dividends in terms of earnings and book equity
 - Dividends can be rewritten in terms of earnings and book values using the
accounting book equity identity

- Assumptions: (1) all equity transactions flow through the income

statement (2) any future new capital issues occur at a fair price and hence
will not affect today´s stock price (3) dividends represent all distributions
to shareholders, including share buybacks or repurchases.

- Then the equity formula becomes

- Abnormal earnings are defined as net income less the normal earnings
that shareholders expect the firm to generate on its book equity capital.
Reflect the firms ability to generate rates of return on book equity that
exceed shareholders’ required return. They could arise because the firm
owns superior technology, patents or know-how
- Normal earnings are the beginning book equity for the firm multiplied by
the expected return that investors require to compensate them for
deferring consumption and bearing risk

-
- Investors are willing to pay more than its book value → if the firm is able
to generate abnormal earnings (book equity >shareholders required
return)
- Investors are willing to pay less than its book value → book equity < than
shareholders required return

2.2 Terminal values

- One challenge when implementing the future abnormal earnings approach
is that most firms have an indefinite life, requiring the valuation to
incorporate abnormal earnings into the indefinite future
- The common approach is called terminal value for abnormal earnings. To
do this we use the formula for the present value of an indefinite annuity,
called perpetuity.
 - AE → abnormal earnings
- r → discount rate
- g → growth rate
- To continue to generate big positive abnormal earnings, a firm has to
continue to outperform its competitors by the remaining leader in
technology, patents or knowhow
- It is very challenging for firms to continue generating strong abnormal
earnings indefinitely, there is rapid mean reversion in abnormal earnings

2.3 The Price to Book Equity Multiple Revisited

- Rates of growth are driven by several factors including firm size (small
firms can sustain high rates of growth) and competitive advantages
- Average rates of growth in book equity are likely to be similar to rates of
growth to the overall economy.
- Firms with a PB multiple greater than 1 are expected to generate ROEs
greater than investors required return
- If a firm is expected to generate an ROE that is identical to its cost of
equity, growth is irrelevant. If a firms future ROE is expected to be lower
than the required return, growth destroys shareholder value

Lecture 3: Shareholders equity

- Articles of incorporation: rules by which the company will be

administrated
- Shareholders equity: the financing the shareholders provide combined
with the firms cumulative gains or losses are referred to as shareholders’
equity or stockholders equity
- The assets are equal to the sum of the total financing by external parties
(liabilities) and the owners financing and cumulative earnings or losses
(shareholders equity)
 - Shareholders equity is the residual interest in the assets of an entity that
remains after deducting its liabilities
- The book value per share is the per-share value of shareholders’ equity
- Capital contributions: Funds or assets that shareholders provide through
the issuance of different types of equity securities
- Distributions: shares of earnings that are distributed in various forms like
dividends, stocks dividends, stock splits, stock buybacks, or stock options
- Retained earnings: net income or earnings that are not paid out as
distributions but are retained by the company to be reinvested
- Accumulated other comprehensive income (AOCI): Changes in the equity
section that are not reported as net income, capital contributions or
distributions.
- JP Morgans balance sheet, shareholders’ equity is broken intro two basic
categories: capital that shareholders contributed and the amounts that
the company retained from prior earnings or earned capital

3. Capital Contributions

- Increase in assets means an increase in contributed capital.

- All the transactions between the company and shareholders such as the
payment of dividends have no impact on the income statements of the
company.
- If a company buys back its shares, the gain is recorded as an increase in
contributed capital, not a as gain on the income statement.
- Two types of stocks: common stocks and preferred stocks. The combined
amount of common stock, preferred stock, and additional paid-in capital is
called the company´s capital stock.
- Common Stock: grants its holders ownership in the corporation in
proportion to the number of shares
1. The right to vote on corporate issues
2. A share in profits through a dividend or appreciation in the value and
appreciation in value of the stock
3. A right to the corporation´s assets in the event of liquidation, but they
are the last priority
- Authorized shares: a maximum number of shares that the company allows
to be issued. Provides an upper limit on the extent of dilution possible in
the ownership share of any investor
- Issued shares: authorized shares that have been sold to shareholders
- Initial public offering (IPO)
- Outstanding shares: the number of shares that have been issued less the
ones that the issuing company has repurchased
- Treasury shares: Shares that the issuing company has repurchased
- Par value: minimum dollar amount at which a share may be issued.
Companies often issue shares with very small par values.
 Additional Paid-In Capital

- The amount the company issues more than the par value is commonly
referred to as APIC.
Accounting for the stock issuance:

An issuance of common stock, the cash or assets received are recorded as

an asset.

4. Preferred stock
- It offers its holders some preference over the owners of common stock
- Commonly they receive a guaranteed dividend at a predetermined rate
when the company pays dividends to common shareholders
- If liquidation, preferred shareholders have a higher priority
- No voting rights

5. Distributions
Companies distribute their earnings to shareholders in the form of dividends,
cash, additional stocks, reacquiring shares, or treasury stocks
a) Dividends
- Paid in cash, property, or stock. Commonly expressed as a dollar amount
per share.
- Do not affect the income statement
- Record date: when the shareholders recorded in the share register
become eligible for the dividend payment
- Declaration date: indicates when the company´s board of directors
announces the dividend to be paid on the payment date.
b) Stock dividend
- Distribution of an entity’s own common shares to its common
shareholders with the issuer receiving no consideration in cash or assets
- Not enough cash in the company or does not wish to use its cash to
declare and pay a cash dividend
- Stock dividends are typically tax-free
c) Stock split
- Issuance of additional shares to common shareholders
- Greater number of shares for the same level of shareholders equity
- The per-share price reduces proportionately, appeal to a broader audience
d) Treasury stock
- When a company repurchases its common stock from the shareholders,
the reacquired stock before it is formally retired
- Holdings of treasury stock do not have voting rights and these stocks are
not counted in the calculation of earnings per share
- Reasons: return capital to shareholders, reduce the extent of free cash
available to managers to invest so it makes it more difficult for managers
to waste corporate resources (reduction in agency costs), increases the
per-share price, tax-efficient way of returning capital to shareholders,
compensation for employees, prevention of dilution of share ownership
- Cost method is used to account for stock buybacks
e) Restricted stock
- Shares of stock for which sale is contractually prohibited for a specified
period of time
- Usually granted to employees
- Restricted stocks units (RSUs) is a contract under which the firm grants the
holder the right to convert each unit into a specified number of shares of
the issuing company

Share-based arrangements

Companies often offer their employees share-based compensation such as

stock options or other instruments

a) Stock Options
Is a contract that gives an employee the right to purchase a certain
number of shares of the company at a predetermined price at a specified
period of time. Employee compensation, but he employee has no
obligation to buy. Fair value-based method
b) Stock rights
Offer that gives the holder the right to purchase a certain number of
common shares of the company at a predetermined price in a given period
c) Stocks warrants
Security or a certificate that gives the holder the right to purchase shares
of common stock according to the terms specified on the instruments,
usually upon payment of a specified amount

Retained earnings

- Cumulative earnings that the company has not distributed as dividends to

shareholders. It its negative its called accumulated deficit or accumulated
losses account
- Ending retained earnings = beginning retained earnings + current period
earnings (net income) – distributed earnings (dividends)
- Sustainable earnings help define the sustainable growth rate of a
company, a company does not have to increase its debt in order to
sustain.

Comprehensive Income

- Gives a more complete indication of the change in owners equity than net
income. Includes all changes in equity during a period except those
resulting from investments by owners and distribution to owners
- Net income does not provide full measure, several transactions that
increase equity are not recorded in the income statement, they are
recorded in the shareholders’ equity account
- Consists of two parts; net income and the portion of comprehensive
income that is not part of the net income (other comprehensive income or
OCI)
- Recorded in two ways: one statement format or a two-statement format
- OCI → captures all changes to shareholders equity other than those
included in net income. Typical elements are; unrealized gains or losses on
 available-for-sale debt securities, pension adjustments, gains or losses on
foreign currency translations

AOCI

- Accumulated other comprehensive income → OCI added to a cumulative

account

Noncontrolling interest

- An entity may invest a controlling portions (more than 50% but less than
100%) of the equity in a subsidiary. The value of the shares that the parent
firm does not own is called the minority interest or noncontrolling interest.
- Holders of the minority interest have legal claims to shares of the
subsidiary’s net assets and earnings

Market value

- When investors value a company, they also consider the business future
prospects, so they pay for the present value of future profits
- Market capitalization: firm´s market value, the price per share in market
multiplied by the number of shares outstanding

Earnings per share (EPS)

- EPS is net income standardized by the number of shares outstanding

- Another metric is the diluted earnings per share and considers all
outstanding securities that can be converted to equity including options
warrants, convertible preferred shares and convertible bonds