Valuation Methods

You can estimate market values of companies using

DCF, Economic Value Added or Residual Income

Em via DCF = [FCFi/(1+Rwacc)i] Dm

Em via EVA = IK0 + [EBITix(1-T)-IKixRwacc] - Dm

____________________(1+Rwacc)I

Em via Residual Income = EB0+[(NIi-EBixRe)/(1+Re)i

Dividend Discount Model also works!!!

Although less often used, the Dividend

Discount Model can help you find Em

Em = Divi/(1+Re)I

It is a deceivingly simple method, but may

not work well in real sector companies as

these may not pay regular dividends

Is there a way to check DDM ~ DCF et al?

Valuing Coke using DDM

Question to ask when valuing Coke with the DDM method is What is the maximum dividend Coke can afford to pay while still allowing it to grow at its trend growth of 1.5% without new equity?

To answer the above question, we know this:

SGR = RxROE/(1-RxROE), where R=[NI-Divs]/NI

Set SGR=2%, and take ROEKO=25%. If we know that last 12 mos of NI = $8.37B, then Div=$7.7B

Note: SGR stands for sustainable growth rate (the maximum growth level a company can self-fund without additional equity issues). This SGR can be found by either of thefollowing two equations: SGR = RxROE/(1-RxROE) or SGR = ROICxFLx(1-d)/(1-ROICxFLx(1-d)), where ROIC=EBITx(1-T)/IK, FL = (Eb+Db)/Eb and d=1-(NI-Divs)/(EBIT(1-T))

Valuing Coke using DDM If we assume Dividends grow at 1.5% and that Re,

based on current data, is 6% (from Rf+Be x (Rm-Rf) =

2.4%+0.6x6%), then:

Em = $7.7Bx(1+1.5%)/(6%-1.5%)+Excess Cash

Em = $187.65B (Ps=$42)

As of Aug 7th, 14, Cokes MarketCap = $173B (Ps=$39)

Note that Cokes 12mo trailing DIVs are $5.27B but

we used $7.7B (from SGR formula). Why?

Because $7.7B is the highest Coke can pay and still be able to grow

at its trend of 1.5% without requiring additional equity

If we had used $5.27B, we wouldve undervalued Coke using DDM

Valuing Coke using DDMHow did we find the expected growth? We assumed it would be the growth priced in the stock price

ROE 25%

EBIT 7,000,200$ R 7.994%

Dep 1,997,000$ g* 2.04%

CAPex (2,511,000)$

-Inc WK (352,000)$ NI 8.37$

DIV 7.70$

FCF 6,134,200$ R 7.994%

Rdx(1-T) 1.56% 18.64$

Re 6.00% 173.00$

Rwacc 5.57%

EC 9,307,000$ EC 9,307,000$

Em 173,000,000$ Em 187,655,228$

gimp 1.61%

Ps 39.41$ Ps 42.75$

Note: See Appendix for an expanded view of this exercise

DDM needs some tweaks, so why use it?

Is best to use DCF or EVA before relying on DDM,specially for Real Sector companies that dont paydividends

Whether companies pay or not pay dividends, we must finda level of dividends based on growth trends and SGR. This isdue to the fact that even what companies pay might not besuited for use in DDM valuations (as was the case with Coke)

However, DDM is most helpful to value commercialand investment banks. For these type of companies(Financial Institutions), DDM works like a charm

More on why DDM is good for FIs DDM is well suited to value banks because:

Banks operate under very tight regulations

Banks have stable dividend policies. That allows us to lookback and, just as easy, project dividends forward

Unlike real sector companies (which buy raw inputs tomanufacture products which then are sold for money), banksraw inputs are money. Banks then use that capital to createmoney-like products and sell these, again, for money.Concepts of working capital needs are thus very different.

Banks also invest more on IT technology than on CAPex andthose IT investments are expensed as they occur. As such, NetIncome (from which Divs come) includes good info about it.

Banks pool all funds (a dollar from deposits might end upexactly where another dollar in Long Term Debt ended up) toinvest in various projects (whether it be lending to people orinvesting in companies). As a result, as Banks even use itsDeposits (a short term liability), is not as easy to estimate areasonable Em% and Dm% to weigh Rd and Re in WACC

Using DDM to value Banks

See Damodaran article on valuing Banks using DDM

http://tinyurl.com/d9gghzo

What is the alternative to DDM in FIs?

An alternative to DDM is to value Banks via their

fundamentals

Valuing the bank via its fundamentals requires

another set of tools that is different to those used

for real sector companies

Well expand more on banks fundamental

valuation towards the end of the course because

DDM is only a rough approximation. For ex, what

would we say are the right dividends when

projected growth >> SGR? Or, what would we do

if Net Income is biased by accounting gimmicks?

But lets return to Divs for Real Sector companies We can still ask Why should companies return capital to their

shareholders? Why not keep Excess Capital for extreme situations?

Well lets start by saying that such Excess Capital belongs toshareholders if they so like (Managers have to convince shareholdersthat they have good use for the Excess Cash, or else dividend it out)

Excess Cash in a company belongs to those who invested in the companyassets that generated it, not to agents managing these assets. By contrast,your parents earned excess cash by way of labor and own the rights to it.They are simultaneously shareholders and managers of their assets.

That said (that Shareholders, not managers, own the rights to theExcess Cash), there is also a value-conservation rationale to divestingExcess Cash when good corporate opportunities are hard to come by

If IKi (invested capital on ith year) is larger than needed (as when

Excess Cash is there), the right side term of IKi x Rwacc (a.k.a. capital

charge) will make the value in between brackets smaller!!!

But lets return to Divs for Real Sector companies

Moreover, paying dividends to shareholders

provides some added benefit to stock owners:

Shareholders pay lower capital gain tax on dividends

Shareholders can then reinvest cash where they want

So when do companies accumulate Excess Cash?

Cash increases when projected growth (gp)

But, I hear that Cash is King

We wrap up by questioning the wisdom of the Cash is King

idiom in corporate settings

Is not that Cash does not serve us well at times of need, but

rather that if it can not be invested above the companys

opportunity cost (Rwacc), too much of it destroys value

In spite of the above, there may be times when you, as a

manager, convince shareholders to hold some or most of the

Excess Cash for valid purposes (i.e. buy a competitor using cash,

guarantee solvency during potential bank system crisis )

Lastly, think of it this way: Would you prefer holding cash at the

expense of growth, even when economically profitable growth

can be attained by putting that Excess Cash to work?

Returning to valuing Banks

Fundamental

Valuation

Valuation

shortcuts

(1) Damiodarans article

proposes DDM as way to value

banks but that is somewhere

between a valuation shortcut

and a fundamental valuation

(2) Now, to have a more

precise valuation (closer to the

real sector company technique

DCF but for banks), we need a

new valuation paradigm for FIs

(3) An interesting thing on valuation

shortcuts: What works for real sector

companies does NOT work for FIs

To understand the FIs Fundamental

Valuation model, we need to delve

deeper into the topology of banks

- Separates FIs into fee and Fin Instrs side

- Values fee side discounting FCFEs by Re

- Values Financial Instruments side using:

PVLiquidationValue + PVFranchise Value -PVOPEX-PVTaxpenaltyThis technique is sometimes referred to as the Balance Sheet approach

The FIs Fundamental Valuation model

Lets focus on the traditional side, the least understood

The FIs Fundamental Valuation model

Liabs+Equity

0 1 2

DIVi = NIi-(TEi-TEi-1) because: NIi+Tei-1 DIVi =TEi

Value of Taxable Bond

Single Component

Value of Taxable Bond

Two Components

TB

TB

ETFB

ETFBTB

PV taxable bond = PV tax-free bond + (Addnl Cap Gains on taxable bond) x T

ETFB