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189 Cards in this Set

  • Front
  • Back
Graham and Dodd
the pioneers of security analysis and the concept of “intrinsic value” – which should be determined independent of the market price, and primarily predicated on the earnings power of an investment or company; the use of the market multiple
John Burr Williams
developed “discounting” techniques, and calculated intrinsic value by finding the PV of all future dividends per share
the estimation of an asset’s value based on variables perceived to be related to future investment returns , based on comparables, liquidation proceeds
Intrinsic Value
the value of the asset given a hypothetically complete understanding of the asset’s investment characteristics – an investor’s view of the “true” or “real” value of an asset
market price is not = to “true,” intrinsic value
Reasons for mispricings
Rational efficient markets formulation: analysts won’t do the work, unless there is a sizable gain on potential returns, or when the expense to gather info is too great for the return

For analysts to have jobs the market must not be efficient – otherwise abnormal returns (or alpha) would not exist – the excess risk-adjusted return, the return beyond just mispricing

Investors may look to catalysts that would cause the market to re-evaluate a company’s prospects, and “fix” mispricing, potential earn risk-adjusted return/alpha
Going concern assumption
the assumption that the company will continue its business activities into the foreseeable future
Going concern value
a company’s value under a going concern assumption
Liquidation value
a company’s value if it were dissolved and its assets sold individually
Fair market value
representing the price at which an asset (or liability) would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell
Investment value
would take into account potential synergies and is based on the investor’s requirement and expectations
Applications of equity valuation
Selecting stocks – determining if a stock is fairly priced, overpriced, underpriced relative to its current estimated intrinsic value and relative to the prices of comparable securities

Inferring (extracting) market expectations – determining if fundamentals are reflected in a stock and the reasonableness of expectations in the market

Evaluating corporate events – post M&A, a divestiture, spin-off, leveraged buyout, etc.

Rendering fairness opinions via a third party (like an investment bank)

Evaluating business strategies and models – alternatives and the effect on stock price

Communicating with analysts and shareholders – discuss to determine company value

Appraising private business – perhaps via an IPO

Share-based payment (compensation) – special valuation models typically accomplish this
the Valuation process
Understanding the business

Forecasting company performance

Selecting the appropriate valuation model

Converting forecasts to a valuation

Applying the valuation conclusions
the elements of industry and competitive analysis
having a framework to organize thoughts about the industry and to better understand a company’s prospect

should highlight which aspects of a company’s business present the greatest challenges and opportunities, and should be further investigated/monitored, or undergo sensitivity analysis
Porter's five forces
i. Intra-industry rivalry
ii. New entrants
iii. Substitutes
iv. Supplier power
v. Buyer power
Porter’s three strategies for above average returns
i. Cost leadership
ii. Differentiation
iii. Focus/Targeted
Absolute valuation models
specifies an asset’s intrinsic value – most important type are present value models (specifies that the value of an asset must be related to the returns that investor expects to receive from holding that asset); dividend discount model, FCFE model, FCFF model (cash flows before debt payments), residual income models (based on accrual accounting in excess of opportunity cost of generating through earnings); asset-based valuation
Relative valuation model
estimates an asset’s value relative to another asset (typically within the industry)– includes very popular multiples methods: P/E
Broad criteria needed for choosing an appropriate valuation approach
Consistent with the characteristics of the company being valued

Appropriate given the availability and quality of data

Consistent with the purpose of valuation, including the analyst’s perspective
Holding period return
the return earned from investing in an asset over a specified time period

HPR = price appreciation + dividend yield -or- for expected HPR = expected price appreciation + dividend yield
Required alpha = actual return - required return

Expected alpha = expected return - required return
Realized holding period return
for returns in the past, the actual realized holding period return (HPR)
Required rate of return
is the minimum level of expected return that an investor requires in order to invest in the asset over a specified time period, given the asset’s riskiness
Return from convergence of price to intrinsic value
when a mispricing converges to its intrinsic value; or the equilibrium and anticipated outcome when the investor’s value estimate is more accurate than the market’s, as reflected in the market price
Investor’s expected rate of return
the required return + a return from convergence of price to value

E(R) = Rr + (Vo – Po)/Po
Discount rate
reflects the compensation required by investors for delaying consumption

RFR + risk premium (of the required compensation for the risk of the CF)
Internal rate of return (IRR)
the hurdle rate, the point at which NPV = 0, or the breakeven point


the market is efficient and the appropriate ‘g’ is used

Intrinsic value = year ahead dividend / required return – expected dividend growth rate

Required return estimate = year ahead dividend / market price + dividend growth rate
Equity risk premium
is the incremental return (premium) that investors require for holding equities rather than a risk-free asset

Used to determine the required return, which is found via CAPM or the build-up method
Historical estimation approach to find ERP
found by calculating the mean value of the differences between broad-based equity-market-index returns and government debt returns over the same period

Must determine the most appropriate equity index to represent equity market returns, the time period for computing the estimate (longer time period = more precision, but may have issues with consistent stationarity), the type of mean calculated (arithmetic or geometric (compounded), the proxy for the risk-free return (long term government bond return, or short-term government debt instrument returns – T-bills

Geometric mean is always less than the arithmetic mean, expect when the returns for all periods are equal
Survivorship bias in finding ERP
eliminating poorly performing or defunct companies from the membership index

causes the historical estimates to inflate the equity risk premium
Forward-looking estimation approach (or ex ante estimates) for finding ERP
using forward estimates to determine equity risk premium

eliminates the issue of nonstationarity or data biases, but also is subject to estimation errors and potential “behavioral biases”

Gordon growth model – GGM equity risk premium estimate = dividend yield on the index based on a year-ahead aggregate forecast on dividends and market value + consensus long-term earnings growth rate – current long-term government bond yield

Macroeconomic model estimates: finding ERP with forward financial and economic estimates
Capital asset pricing model (CAPM)
assumes investors are risk averse and that they make investment decisions based on the mean return and variance of returns of their total portfolio

Investors evaluate the risk of an asset in terms of the asset’s contribution to the systematic risk (risk that cannot be diversified away, or Beta here) of their total portfolio

Under CAPM r = RFR + Beta(Equity Risk Premium)
Multifactor Model
Required return is determined by RFR + multiple risk premiums, not just one within CAPM

where Risk Premium = Factor Sensitivity X Factor Risk Premium
Fama-French model (FFM)
is a multifactor model using three factors: the market risk premium (Rm – RFR), the market cap factor (small cap – large cap premium), and the value return premium (high – low P/B premium) – high P/B is a value bias vs. low P/B is a growth bias

Under Fama-French, r = RFR + Bmrkt(RMRF) + Bsize(SMB) + Bvalue(HML)
Pastor-Stambaugh model (PSM)
taking FFM one step further and adjusting for illiquidity

Under PSM, r = RFR + Bmrkt(RMRF) + Bsize(SMB) + Bvalue(HML) + Bliq(LIQ)
Five-factor macroeconomic model
adjusts required return after RFR for confidence risk, time horizon risk, inflation risk, business cycle risk, market timing risk

where Risk Premium = Factor Sensitivity X Factor Risk Premium

Macroeconomic multifactor models include economic variables that affect the expected future cash flows of companies and/or the discount rate that is appropriate to determining their PV
The build-up method
"bond yield plus risk premium"

more commonly used among closely held businesses, private businesses (less/not exposed to market risks, aka no beta)

Under build-up method, r = RFR + Equity risk premium +/- one of more premia (discounts)

Here premia/discounts do not apply beta adjustments, and often pertain to size and perceived company-specific risks, so r = RFR + ERP + Size premium + Co-specific premium

Adjustments for control or minority interest are often NOT included in the r calculation

Under bond yield plus risk premium (for companies with publicly traded debt, r = YTM of co’s l-t debt + risk premium (equity related risk), where the YTM of debt includes the real interest rate and a premium for expected inflation and a default risk premium
Beta estimation for public companies
Beta is determined by the least squares regression of an asset’s return on the index’s returns – often termed unadjusted or raw historical beta

Actual beta is influenced by your choice of index, time period, and the frequency of observations

Adjusted beta = (2/3)(unadjusted or “raw” beta) + (1/3)(1.0)
Beta estimation for thinly traded public companies and non-public companies:
Use a public company comparable and adjust for leverage by first unleveraging the found equity beta from the public company comparable, and then leveraging consistent with the non-public company
strengths and weaknesses of methods used to estimate the required return on an equity investment
Beta can be a poor predictor of future average return, due to idiosyncratic risk in the market

Multifactor models bring in additional factors, but these are estimates that can increase error

FFM neglects the illiquidity factor

Build up methods are more for private companies, as it removes beta
factoring in International considerations in required return estimation
Exchange rates impact historical means, best to use the local currency historical records

Data and model issues in emerging markets – use a country spread model for the equity risk premium where ERP estimate = ERP for a developed market + country premium

Where country risk premium is typically the sovereign bond yield spread
Weighted average cost of capital (WACC)
the company’s weighted after tax cost of debt + its weighted cost of equity

WACC = (MVD/(MVD + MVE)) * rd * (1 – T) + (MVE/(MVD + MVE)) * re
Evaluating the appropriateness of using a particular rate of return as a discount rate, in terms of CF
Returns used as discount rates must match the type of cash flows being discounted

Nominal cash flows must be discounted by nominal rates

Cash flow to equity is discounted at Re, while cash flow to the firm is discounted by the firm’s cost of capital, usually WACC, because this would include debt holders
Threat of new entrants
puts a cap on the profit potential, because industry participants will keep prices low or boost investments to deter new competitors (and increase barriers to entry)

Seven main barriers to entry: supply-side economies of scale, demand-side economies of scale, customer switching costs, capital requirements, incumbency advantages independent of size, unequal access to distribution channels, restrictive government policy
Bargaining power of suppliers
powerful suppliers can often capture more of the value for themselves by charging higher prices, limiting quality or services, or shifting costs to industry participants (includes raw materials, but also labor)

Powerful suppliers come in different forms:
a. Suppliers are more concentrated than the industry it sells to
b. Supplier group does not depend heavily on the industry for its revenues
c. Industry participants face switching costs in changing suppliers
d. Suppliers offer differentiated product
e. There is no substitute for what the supplier group provides
f. Supplier group can credibly threaten to integrate forward into the industry
Bargaining power of buyers
powerful customers can capture more value by forcing down prices, demanding better quality or more service (increasing costs), and generally play industry participants off one another

Powerful customers come in different forms:
a. There are few buyers, and/or volume of purchases exceed the size of a single vendor
b. Industry products are standardized or undifferentiated
c. Buyers have few switching costs in changing vendors
d. Buyers can credibly threaten to integrate backward and produce/service themselves

Price sensitivity of buyers occurs when:
a. The product needed is a significant portion of its cost structure or procurement budget
b. Buyer group earns low profits, is cash-strapped, or under pressure to cut costs
c. Quality of buyers’ products/services is little affected by an industry’s product
d. Industry’s product has little to no effect on buyer’s other costs
Threat of substitute products or services
when a substitute performs the same or a similar function as an industry’s product by a different means

Threat of substitute is high when:
a. it offers an attractive price-performance trade-off
b. the buyer’s cost of switching to the substitute is low
Rivalry among existing competitors
in the form of: price discounting, new product introductions, advertising campaigns, and service improvements – the degree to which a rivalry reduces industry profitability depends on intensity and the basis on which they compete

Intensity of a rivalry is greatest when:
a. Competitors are numerous and have equal market shares
b. Industry growth is slow
c. Exit barriers are high
d. Rivals are highly committed to the business and have leadership aspirations
e. Firms cannot read each others' signals well due to a lack of familiarity, different approaches, or different goals

Price Wars are more likely to occur when:
a. Products or services of rivals are nearly identical and low switching costs for buyers
b. Fixed costs are high and marginal costs are low
c. Capacity must be expanded in large increments to be efficient
d. The product is perishable
How competitive forces drive industry profitability
Industries with benign competitive forces will be able to achieve higher profitability, while industries with fierce competitive forces will not be as profitable

Determines how much profitability is retained by companies in the industry versus bargained away by customers and suppliers, limited by substitutes, or constrained by potential new entrants
Industry growth rate: a fleeting factor
growth does not tend to mute rivalry, because an expanding pie offers opportunities to all competitors. Fast growth can put suppliers at an advantage, or low barriers to entry will attract new entrants. Even high growth cannot guarantee profitability if there are powerful customers or suppliers, or substitutes are attractive
Technology and innovation: a fleeting factor
advanced technology or innovations do not by themselves make an industry attractive; low tech industries with price-insensitive buyers, high switching costs, or high entry barriers are often more profitable
Government: a fleeting factor
involvement is neither good or bad, its more about how specific policies impact the five forces
Complementary products and services: a fleeting factor
when the customer benefits from two products combined vs. each product in isolation (computer hardware and software, worthless separated) – similar to government in that it impacts profitability by how it affects the five forces
how can positioning a company, exploiting industry change, and shaping industry structure be used to achieve a competitive advantage?
Know what the average profitability of its industry is and how that has been changing over time

Positioning the company – or building defense against the competitive forces or finding a position in the industry where the forces are weakest

Exploiting industry change – claim a new strategic position with an understanding of the competitive forces and their underpinnings

Shaping industry structure – when a company exploits industry change by recognizing and reacting to the inevitable: leading an industry towards new ways of competing that alter the five forces for the better. You want competition to follow your lead in this scenario – it may cause re-dividing of profitability (reducing the share of profits that go to buyers, suppliers, and substitutes), expanding profit pool (the expanding pie benefits all)

Defining the industry – by the five competitive forces, drawing correct industry boundaries, a separate strategy for each distinct industry
Key components for an industry analysis model
a. Industry classification: life cycle position, business cycle

b. External factors: technology, government, social, demographic, foreign

c. Demand analysis: end users, real and nominal growth, trends and cyclical variation around trends

d. Supply analysis: degree of concentration, ease of entry, industry capacity

e. Profitability: supply/demand analysis, cost factors, pricing

f. International competition and markets
Life Cycle Stage: Pioneer
product acceptance is questionable and implementation of business strategy is unclear; high risk and many failures
Life Cycle Stage: Growth
product acceptance is established; roll-out begins and growth accelerates in sales and earnings; proper execution of strategy remains an issue
Life Cycle Stage: Mature
industry trend line corresponds to general economy; participants compete for share in a stable industry
Life Cycle Stage: Decline
shifting tastes or technologies have overtaken the industry, and demand for products steadily decreases
Industry Classification: Growth
above-normal expansion in sales and profits occurs independent of the business cycle
Industry Classification: Defensive
stable performance during both ups and downs of the business cycle
Industry Classification: Cyclical
profitability tracks the business cycle, often in an exaggerated manner
Impact of external factor: Technology
the focus is first on survival – new technology can be a blessing and a curse – responses often come in two forms: copy the competition or buy the competition
Impact of external factor: Government
regulation plays a valuable role in promoting worker safety, consumer protection, and fair play. Government influence cuts both ways – harming industries with too much oversight, or supporting industries to prosper
Impact of external factor: Social changes
flexing to lifestyle and fashion changes – fashion being less predictable, and lifestyle changes having greater longevity
Impact of external factor: Demography
the science that studies the vital statistics of population: distribution, age, and income – keeping tabs on shifts here can prepare a company for industry shifts based on changing demographics, typically over long periods of time
Impact of external factor: Foreign Influences
our dependence on foreign goods, and its impact on industries when supply is disrupted (oil), and our dependence on foreign buyers for our exports
Top-down economic analysis
determining macroeconomic variables that affect sales
Determining industry demand by:
Top-down economic analysis

Categorizing where an industry is in the life cycle to provide a framework for demand forecasts

Determining the impact of external factors: by studying customers and supply analysis (determining whether supply can meet demand and at what cost, both in $s and time)
Factors that affect industry price practices:
a. Product segmentation (by brand name, reputation, or service)

b. Degree of industry competition (high concentration limits price movements)

c. Ease of industry entry (high barriers to entry keep pricing fluctuations or erosion limited)

d. Price changes in key supply inputs (depends on whether an industry can pass on pricing)
How inflation affects the estimation of cash flows for a company domiciled in an emerging market
Inflation distorts the financial statements, making it hard to make y/y historical comparisons, perform ratio analysis, or forecast performance

For emerging markets with high-inflation environments, historical analysis and forecasting should be done in both nominal and real terms when possible

1) In some situations nominal indicators are meaningless (e.g. capital turnover)
2) In some situations real indicators are problematic (e.g. to determine corporate income taxes)
3) Financial projections can be done in either real or nominal terms, and if done correctly, they should yield the same value

While some adjustments are made in hyperinflationary countries, to their financial statements, the following should be addressed:
i. Deflate growth into real terms, using an annual inflation index
ii. Capital turnover is often overstated, because fixed assets are carried at historical costs, either approximate the current costs of those long-term assets, or develop your own ratios based on capacity utilization and sales
iii. Operating margins can be overstated if depreciation is too low (based on those fixed assets) or large holding gains on slow-moving inventories
iv. Credit ratios and other capital structure health indicators may be distorted due to understated long-lived assets and floating rate debt at current currency units
Steps for forecasting the cash flow model to evaluate an emerging market company:
Accounting adjustments cannot affect free cash flow, thus you should project financial statements without any adjustments for inflation

Steps include:
1) Forecast operating performance in real terms (convert nominal BS and IS into real terms)

2) Build financial statements in nominal terms

3) Build financial statements in real terms

4) Forecast the future FCFs in real and nominal terms from the projected IS and BS

5) Estimate DCF Value in Real and Nominal terms
a. Ensure that the WACC estimates in real terms (WACCreal) and nominal terms (WACCnom) are defined consistently with the inflation assumptions in each year
Arguments for adjusting cash flows, rather than adjusting the discount rate, to account for emerging market risks (e.g. inflation, macroeconomic volatility, capital control, and political risk) in a scenario analysis
DCF approach simulates alternative trajectories for future cash flows – either business as usual of emerging market risks materialize

Adding country risk premium to the discount rate – simple, but there is no objective way to establish the country risk premium:
1) can historically obtain it, after the fact (once the new value is known, backing into it)
2) and adding the country risk premium to the discount rate when discounting expected value of future cash flows vs. the promised cash flows, essentially double counts the distress scenario (in cash flows and the discount rate)

DCF approach is recommended as it provides a more solid analytical foundation and more robust understanding of the value than incorporating country risk in the discount rate

Also most country risks can be diversified away – the discount rate should not reflect diversifiable risk (systematic risk) + country risk has different weight depending on the industry
Estimating the cost of capital (WACC) for emerging market companies
Use CAPM to calculate the cost of equity:

1) determine RFR – most emerging market government debt is not risk free, is often below investment grade, are not actively traded, and when it is traded its often in another currency – so start with 10-yr US government bond yield, adjust for inflation with the spread between emerging and developed inflation = a nominal RFR

2) determine Beta – relative to a well-diversified or global market index, and use international comparables

3) Determine MRP – excess returns between local equity markets and local bond returns are not a good proxy, so use a global estimate of 4.5-5.5%

Estimate the after-tax cost of debt: since the bond markets are unreliable and inconsistent in emerging markets use – developed market RFR + systematic part of the credit spread + inflation differential between local currency and developed currecy

Only taxes (or the tax rate) that are applied to interest expense should be considered with WACC

Calculating and interpreting the country risk premium:
1) don’t just use the sovereign risk premium, consider all estimates, avoid setting it too high (adjust for common sense, of what you know of the country)
2) Only apply the country risk premium to WACC if you are using “business as usual” cash flows
Dividend discount model valuation
defines cash flows as dividends, as this is the only cash flow for a stock holder with dividends, less volatile than earnings

when to use – the company should be dividend-paying, there should be a consistent dividend policy tied to the company’s profitability (consistent payout ratio), and investor takes a non-control perspective
Free cash flow valuation
returns to ownership (equity), the cash flows that are “free” from reinvestment needs, and if FCFF (to the firm) – also “free” from debt holders

when to use – applicable to any company, even dividend paying companies (especially if dividends fall short of FCFE by a significant spread), appropriate for investors looking to take a control perspective, and when FCF aligns with the company’s profitability, but negative FCFs due to unprofitable companies, or intense capex requirements make this method illogical
Residual income valuation
earnings for a period in excess of the investor’s required return on beginning of the period investment (common stockholder’s equity), is essentially the economic gain; calculated by taking the company’s book value per share + PV of expected future retained earnings; can be viewed as a restatement of the dividend discount model

when to use – can be used regardless of the company’s dividend policy and even if FCFs are negative, is an attractive focus on profitability in relation to opportunity costs, but depends on the quality of accounting, which may result in potential distortions
Gordon growth model
used to find the terminal value of an asset (stock), based on indefinitely extending future dividends, a required rate of return, and a constant growth rate

Very sensitive to small changes in ‘r’ or ‘g’, as well as, the spread between ‘r’ and ‘g’

Vo = Do * (1 + g) / (r – g)

i. r must be > g, if = g or r<g, the equation is invalid
ii. g normally uses GDP as a basis

With a declining dividend (i.e. negative ‘g’) apply the same GGM formula

If dividends are growing at a constant rate, the stock value also grows at ‘g’ – total return = dividend yield + capital gains yield
Present value of growth opportunities (PVGO)
the “value of growth”

is used to determine whether to pay out earnings as a dividend or to reinvest them with a required return on equity of ‘x’ and distribute the ending value as a dividend in one year – any reinvestment at a rate below the required return on equity would not be in shareholder interests
Strengths of GGM
offers a simple, practical approach to valuation and is appropriate when dividend paying companies have a staple dividend growth policy in line with earnings growth expectations
Limitations of GGM
if g > r or g = r the equation is invalid; is also very sensitive to changes in ‘r’ and ‘g’, as well as, the spread between ‘r’ and ‘g’; only applicable to single-sage

Limitation to multi-stage DDM is that often the PV of the terminal stage represents a major portion (or more than 3/4) of the total value of shares
Circumstance that requires spreadsheet modeling vs. DDM or GGM
a. Would need to move beyond DDM and the GGM when a stable, indefinite dividend growth rate is not realistic, and progressive phases are more align with the company’s expectations
Characteristics of a growth phase
when the company enjoys rapidly expanding markets, high profit margins, and an abnormally high growth rate in EPS – is often coupled with negative FCFE, a low dividend payout ratio due to reinvestment, and prone to increased competition over time
Characteristics of a transitional phase
the transition to maturity, when EPS growth slows with competitive pressures, reducing profit margins and/or sales growth

EPS growth may be above average, but declining towards GDP

Meanwhile capex requirements also typically diminish enabling positive FCFE and increasing dividend payout ratios
Characteristics of a maturity phase
the company reaches equilibrium when investment opportunities each their opportunity cost of capital and ROE approaches the required return on equity

EPS and dividend growth reach their mature growth rate, and the company reaches a point where GGM can be applied to find “terminal value”
Finding "terminal value"
is often obtained with price multiples, but can also be found with DDM – in one or multi-stages of growth and applying one discount rate

Even if a company does not pay a dividend, but is profitable, can use DDM through finding a terminal value at some point in time when the company may pay a dividend or target a payout ratio: the first stage is = 0, second stage is <Dt / (r-g)> / (1 + r)^(t-1)
Two-stage DDM implication
abnormal growth + an abrupt shift to the mature stage
H-model DDM implication
abnormal growth + transition/declining period to mature growth
Three-stage DDM implication
abnormal growth + consistent slower 2nd growth phase + mature OR abnormal growth + linear decline in growth (H-Model takes over 2nd and 3rd phases to mature)
Sustainable growth rate
is the rate of dividend (and earnings) growth that can be sustained for a given level of ROE, assuming that the capital structure is constant through time and that additional common stock is not issued
Implications of g = ROE x b equation
suggests that ROE is = to r, or the required return on equity, at maturity, because in a mature phase a company can do no more than earn investor’s opportunity cost of capital

can assume that the higher ROE, the higher g
PRAT equation = ?
= profit margin * retention rate * asset turnover * financial leverage

= g
When spreadsheet modeling is used?
Spreadsheet modeling is used when there are complicated situations with varying expectations for growth and dividend payout progressions – often used when multi-stage is too timely to compute manually
Evaluation of whether a stock is over, fairly, or under-valued based on DDM estimate of value
If DDM values a stock above the market price, it would be deemed undervalued

If DDM values a stock at the market price, fairly price

If DDM values a stock below the market price, it would be deemed overvalued (it’s not worth as much as the market thinks based on your DDM analysis)
Free cash flow to the firm (FCFF)
is all cash available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital (e.g. Inventory) and fixed capital (e.g. equipment) have been made.

Essentially FCFF = CFFO – capex (and is available cash to common stockholders, bondholders, and sometime preferred stockholders)

Discounted by WACC, since available to all suppliers of capital

If a company is levered with negative FCFE, or if the company is changing its capital structure, better to use FCFF to reflect those changes

Firm Value = FCFFt / (1 + WACC)^t this gives us the total firm value, to find equity value subtract market value of debt
Free cash flow to equity (FCFE)
is the cash flow available to the company’s holders of common equity after all opex, interest, and principal payments have been paid and necessary investments in WC and fixed capital have been made

Essentially FCFE = CFFO – capex – payments to debt holders

Discounted at required return for equity, because only available to equity holders

If capital structure is stable, it’s easier to use FCFE and more direct

Firm Value = FCFEt / (1 + re)^t
Contrast the ownership perspective implicit in the FCFE approach to the ownership perspective implicit in the dividend discount approach
FCFE approach takes the perspective of control, as FCFE is the cash flow available to the equity holder, compared to DDM, which is passive – investor is only concerned about dividend payout
Computing FCFF from Net Income
NI + net non-cash charges + interest expense * (1- T) – investment in fixed capital – investment in working capital (or current assets – current liabilities, ex cash, notes payable, and s-t debt)

FCFF = NI + NCC + Int(1 – T) – FCInv – WCInv

Note FCInv and WCInv will be the change in these balances on the BS

Typical NCC include: D&A, restructuring expenses (income is subtracted), losses or gains on assets, amortization of bond discounts or (premiums), deferred taxes added back but unique

Deferred tax assets arise when tax payments are higher than taxes reported on the IS, if this situation, however is expected to reverse in the near future, deferred tax assets should not be subtracted to avoid underestimating future FCFs
Computing FCFE from Net Income
FCFE = NI + NCC – FCInv – WCInv + Net Borrowing

Note FCInv and WCInv will be the change in these balances on the BS; WCInv = current assets – current liabilities, ex cash, notes payable, and s-t debt

Typical NCC include: D&A, restructuring expenses (income is subtracted), losses or gains on assets, amortization of bond discounts or (premiums), deferred taxes added back but unique

Deferred tax assets arise when tax payments are higher than taxes reported on the IS, if this situation, however is expected to reverse in the near future, deferred tax assets should not be subtracted to avoid underestimating future FCFs
Approaches to forecasting FCFF and FCFE
Apply a constant growth rate to the current level of FCF (often based on history)

Forecast components of FCF – e.g. EBIT derived from sales forecasts, and then an appropriate EBIT margin, and determining capital needs – WCInv and FCInv – based on sales growth
1) Incremental FCInv = Capex – depreciation / increase in sales
2) Incremental WCInv = increase in WC / increase in sales

For FCFE forecasting, assuming the debt ratio remains constant – i.e. each new investment will be funded by debt, the same % that has been applied in the past
FCFE model value recognition vs. DDM
FCFE requires no dividend payment or an expectation for when dividends will be paid

Dividends are a discretionary decision of the board, so they may differ dramatically from FCFE

Dividends are cash flow actually going to shareholders whereas FCFE is the cash flow available to be distributed to shareholders without impairing the company’s value

FCF is appropriate to use in a change of control, because new owners will have discretion over the uses of FCF (including a dividend policy)
How dividends, share repurchases, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE
Potentially not much of a role, BUT…

Uses of cash and their portion of FCFF and/or FCFE could affect future FCFs – if dividend payout exceeds FCF, reinvestment for future NI growth may be limited, same as if share repurchase or leverage limited NI of CFFO in the future

Share issuance has no effect on FCFF or FCFE
Net income and EBITDA as proxies for cash flow in valuation
NI, EBITDA, EBIT, or CFO are poor proxies for cash flows in a DCF valuation, because FCF analysis requires considerable care and understanding, often “missed” in these metrics

This formula: FCFF = EBITDA*(1-T) + Dep *T – FCInv – WCInv; demonstrates what a poor proxy it is with all the adjustments made to EBITDA –

Doesn’t account for the Dep tax shield, and investments in fixed and working capital, and worse for FCFE, excluding net borrowings
Sensitivity analysis in FCFF and FCFE valuations
FCF is sensitive to the company’s future profitability - sales growth and profit margins – to determine just how sensitive a company’s value is to these metrics, can adjust input variables for bear, base, and bull cases for: beta, RFR, ERP, and FCFE growth rate
Value of the firm
= value of operating assets + value of non-operating assets

non-operating assets may be excess cash, marketable securities, land held for investment – especially if these balances are substantial, should be included in market value calculation
Method of comparables
refers to the valuation of an asset based on multiples of comparable (or similar) assets; this keeps an asset from being valued in isolation, and sets a comparable “multiple measure” to determine if a company is fairly, over, or under-valued

P/E just values equity, while EV/EBITDA – or specifically EV values the entire company
Method based on forecasted fundamentals
the use of multiples that are derived from forecasted fundamentals – i.e. business metrics like: profitability, growth, or financial strength and found via a DCF where value is determined and then divided over earnings for forward P/E, or whichever multiple needed

Comments that the multiple of an asset should be related to its expected future cash flows
justified price multiple interpretation
it is the estimated fair value of that multiple, which can be justified on the basis of the method of comparable sot the method of forecasted fundamentals
P/E rationales
earning power is a chief driver of investment value, and EPS, the chief focus of the market

widely used and accepted by investors

differences in stocks’ P/Es may be related to differences in long-run average ROI
P/E drawbacks
EPS can be zero, negative, or insignificantly small relative to price, giving little value to P/E

Recurring components of earnings can be tough to decipher from transient components

Accounting can be manipulated by management
P/B rationales
Book value = shareholder equity or assets – liabilities (also less preferred stock is applicable)

BV as a balance sheet value, is typically positive even when EPS is zero or negative

BV/share is more stable than EPS – may be more meaningful for cyclical stocks

As a measure of NAV, BV is appropriate for valuing companies composed chiefly of liquid assets (i.e. finance, investment, insurance, and banks) – where BV approximates MV

Can be used for companies that are not expected to continue as a going concern

Differences in P/B may be related to differences in long-run average returns
P/B drawbacks
Assets not listed on the BS may have critical value – i.e. human capital, or brand equity

P/B may be misleading as a valuation indicator when the levels of assets used by the companies under examination differ significantly

Accounting effects on BV may compromise its usefulness – capitalized R&D, brand equity supported by ad spend

BV often reflects purchase cost of assets, net of depreciation – inflation and technological change is therefore not reflected as it would be in market value

Share repurchase or issuance may distort historical comparisons – when a company repurchases share at a price higher than the current book value per share, it lowers the overall book value per share of the company, and would cause P/B to appear more expensive

Trailing BV is mostly used, as BV is rarely forecasted
P/S rationales
Sales are generally less subject to distortion or manipulation by management than EPS or BV

Sales are positive even when EPS is negative

Sales are generally more stable than EPS, which reflects operating and financial leverage, P/S is generally more stable than P/E and may be more meaningful when E is abnormally high or low

Is viewed as being appropriate for valuing the stock of mature, cyclical, and zero-income cos

Differences in P/S multiples may be related to differences in long-run average returns
P/S drawbacks
a business may have high growth in sales even when it is not operating profitably as judged by earnings and CFFO – to be a going concern, you must have earnings

share price reflects debt, while sales do not – a mismatch – some use EV instead which incorporates the value of debt, but doesn’t “ding” the company for it as a stock price would

does not reflect differences in cost structures among different companies

relatively robust with respect to manipulation, but revenue recognition practices have the potential to distort
P/CF rationales
Cash flow is less subject to manipulation by management than earnings

Cash flow is more stable than earnings, therefore P/CF is more stable than P/E

P/CF addresses the issues of differences in accounting conservatism vs. P/E

Differences in CF may be related to differences in long-run average returns
P/CF drawbacks
When CFFO is defined as EPS + non-cash charges, important “other” items are ignored (i.e. WC)

FCFE rather than CF is the preferred variable for price-based multiples, but is also more prone to volatility, and can often be negative

As CF becomes more widely used by analysts, management can be opportunistic with accounting methodology to distort for a period of time (specifically CFFO)
Dividend yield rationales
Dividend yield is a component of total return

Dividends are a less risky component of total return than capital appreciation
Dividend yield drawbacks
Is only ONE component of total return – not using all information

Investors may trade off future earnings growth to receive higher current dividends – holding ROE constant, dividends paid now displace earnings in all future periods (dividend displacement of earnings)

Relative safety of dividends presupposes that market prices reflect in a biased way differences in the relative risk of the components of return
Alternative P/Es
difference in earnings’ time horizon, and accounting adjustments lead to alternative P/Es

1) Trailing P/E (or current P/E) is calculated with 12 month trailing EPS and current Price

2) Forward P/E (or leading, or prospective P/E) is calculated with next year’s EPS and current Price

3) Normalized P/E, uses an average EPS due to a company’s cyclicality
Alternative P/Bs
For P/B there is tangible BV/share, which subtracts reported intangible assets from SE (may not be warranted for things like patents, but is for goodwill (as it is just the excess price paid over fair value on an acquisition)

Adjusting P/B has two purposes – to make sure BV/share accurately reflects the value of shareholders’ investment; and that P/B is useful for making comparisons among different stocks
Underlying earnings
are earnings that exclude non-recurring items (also called persistent, continuing, or core earnings)
Normalizing earnings
often adjusts for cyclical business with high sensitivity to business- or industry-cycle influences (often causes volatile multiples due to volatile earnings)

Normalized EPS is an analyst estimating the level of EPS that the business could be expected to achieve under mid-cyclical conditions via:

1) Historical average EPS – average EPS calculated over the most recent cycle (does not adjust for business size)

2) Average ROE method – where normalized EPS is the average ROE for the most recent full cycle, multiplied by current book value per share (preferred, more accurate, factors in co size)
Earnings yield applicability
E/P (inverse price ratio), is effective when earnings are negative and the analyst is looking to rank companies by their current valuation

1) Ranked by highest to lowest E/P, the cheapest securities have the higher E/P % yield

2) E/P is commonly used, as is the inverse of P/CF, or CF/P, while S/P and B/P are less common

3) D/P is more commonly used than P/D
Fundamental factors that influence alternative price multiples and dividend yield
volatile earnings

the need for normalizing due to cyclicality

negative earnings
Justified price-to-earnings ratio (P/E)
is inversely related to the stock’s required rate of return, and positively related to the growth rate(s) of future expected cash flows, however defined
Justified price-to-book ratio (P/B)
the formula references that justified P/B is an increasing function of ROE, all else equal, the larger ROE is in relation to r, the higher is the justified P/B
Justified price-to-sales ratio (P/S)
based on forecasted fundamentals: states that P/S is an increasing function of the profit margin and earnings growth rate
Justified price-to-cash flows (P/CF)
is inversely related to the stock’s required rate of return and positively related to the growth rate of expected future cash flows
Justified dividend yield
demonstrates that the dividend yield is negatively related to the expected rate of growth in dividends and positively related to the stock’s required rate of return – suggests that the selection of stocks with relatively high dividend yields is consistent with value rather than growth investment style
Predicted P/E
estimated from cross-sectional regressions of P/E on the fundamentals believed to drive security valuation, given a cross-sectional regression on fundamentals:

Fundamentals include: growth rate in earnings, payout ratio, volatility measures such as the standard deviation of earnings changes or beta
Limitations of cross-sectional regressions
potential distortion from multi-collinearity among independent variables, make interpreting individual regression coefficients difficult

captures valuation relationships only for the specific stock over a particular time period

regression coefficients and explanatory power of the regressions tend to change substantially over a number of years – the relationships between fundamentals are also not stable
The importance of fundamentals in using the method of comparables
Company’s ability to meet short-term financial obligations (liquidity ratios)

Efficiency with which assets are being used to generate sales (asset turnover ratio)

The use of debt in financing the business (leverage ratios)

The degree to which fixed charges – like interest payments – are being met by earnings or cash flow (coverage ratios)

Profitability (profitability ratios)
the P/E-to-growth ratio (PEG)
is the stock’s P/E divided by the expected earnings growth rate in percent (P/E per percentage point of growth)

Lower PEGs are more attractive than higher PEGs in terms of valuation – less than 1 is an indicator of an attractive value level
Shortcomings of PEG
Assumes a linear relationship between P/E and growth

Does not factor in differences in risk

Does not account for differences in the duration of growth (i.e. P/E over gs vs. P/E over gl)
Justified P/E and inflation
justified Po/E1 = 1/(re +(1 – pass-through%)*Inflation %)

when pass-through is less than 100%, justified P/E is inversely related to the inflation rate

for equal inflation rates, company with the higher pass-through rate has the higher justified P/E
Using price multiples in determining terminal value
Terminal value “key” is that it reflects earnings growth that the company can sustain in the long run – terminal price multiples are often used to determine terminal value within DDM

Terminal price multiples are often based on comparables: median industry P/E, average industry P/E, and average of own past P/Es

Strong substitute for GGM traditional process, as it eliminates the need to estimate the required rate of return, the dividend payout ratio, and the expected mature growth rate

Disadvantage if the benchmark multiple reflects mispricing
Alternative definitions of cash flow used in price and enterprise value multiples
Using EPS + D&A + Depletion as a proxy for CF –or—“earnings + noncash charges” – not an accurate accounting method, but simplistic

More accurate CF proxies include: CFFO, FCFE, EBITDA

EV/EBITDA is a preferred multiple, because EV includes the value of debt, and EBITDA reflects pre-interest earnings (a flow to both debt and equity)
Enterprise value multiples
relate the enterprise value of a company to some measure of value (typically, a pre-interest income measure, because EV is less sensitive to the effects of financial leverage than price multiples when one is comparing companies that use differing amounts of leverage); EV also takes a control perspective
EV/EBITDA rationales
More appropriate than P/E alone when comparing companies with differing financial leverage – EBITDA is pre-interest, EPS is post-interest

Factoring in D&A through EBITDA, provides for an even playing field for capital intense businesses compared to those with limited D&A vs. the use of NI after D&A

EBITDA is frequently positive when EPS is negative
EV/EBITDA drawbacks
EBITDA will overestimate CFFO if WC is growing; it also ignores the effects of differences in revenue recognition policy on CFFO

FCFF has a stronger link to valuation than EBITDA (in theory), only if D&A match capex would EBITDA reflect differences in businesses’ capital programs
Justified EV/EBITDA
EBITDA should be positively related to the expected growth rate in FCFF, expected profitability (as measured by ROIC), and negatively related to business’ WACC
Sources of differences in cross-border valuation comparisons
Differences in accounting methods, cultural differences, economic differences, and resulting differences in risk and growth opportunities must be considered

All price multiples are impacted by international accounting differences, but P/CFO and P/FCFE are lease affected when compared to P/B, P/E, and multiples based on EBITDA
Momentum indicators
related to either price or a fundamental like earnings, to the time series of their own past values, or to the fundamental’s expected value
Earnings surprise
the difference between reported earnings and expected earnings

Scaled earnings surprise – divide unexpected earnings by standard deviation
Relative strength
compares a stock’s performance during a particular period either with its own past performance or with the performance of some group of stocks (often referred to as price momentum) – technical indicators like moving-average oscillator and a trading-range break full into this category

Technical indicators are vulnerable to data snooping and hindsight biases, but are also inherently self-destructing – “once its discovered, its often invalidated/”over” by traders
Residual Income
NI adjusts for a debt charge (i.e. interest expense), but does not factor in the cost of equity, or RI = NI – (SE * required rate of return on equity)

all of this is meant to reflect earnings available to owners, determining profitability not just in an accounting sense, but in an economic sense as well with RI calculation

Another form of RI is NOPAT – capital charge or total capital (debt + equity)*(total cost of capital), and since NOPAT is before interest expense, but factors in taxes, no double counting occurs with respect to debt charges within the total capital charge

BOTH METHODS SHOULD YIELD THE SAME RESULTS, as long as the marginal cost of debt = current cost of debt, and that the weights of debt and equity within the capital charge are derived from the book value of debt and equity
Economic Profit
RI is often called this, as it is an estimate of the profit of the company after deducting the cost of all capital: debt & equity
Abnormal earnings
is another form of RI

assumes that in the long term, the company is expected to earn its cost of capital (from all sources), therefore any earnings in excess of the cost of capital can be termed abnormal earnings
Economic value added
NOPAT – (C% X TC) where C% is the cost of capital, and TC is the total capital –TC and NOPAT are determined under GAAP and adjusted for the following:

R&D is capitalized, not expensed

strategic investments that will not have an immediate return (are not “charged”)

goodwill is capitalized and not amortized

deferred taxes are eliminated so taxes = cash taxes, and LIFO reserve is added back to capital and an increase in the LIFO reserve is added back when calculated NOPAT, operating leases are treated as capital leases, and nonrecurring items are adjusted
Market value added
economic profit must be generated to have an increase in market value

MVA = Market value of the company – accounting book value of total capital
Uses of the residual income models
for internal corporate performance and determining executive compensation

Companies that earn more than the cost of capital should sell for more than book value, and companies that earn less than the cost of capital should sell for less than book value
RI Model
analyzes the intrinsic value of equity as a sum of parts: current BV of equity + PV of expected future residual income

Vo = Bo + sum of RIt/((1 + r)^t)

Vo = Bo + sum of (Et – rBt-1)/((1 + r)^t) where Et is expected EPS for period t, and Bt is current per share book value of equity

The terminal value is “less important”, less prone to sensitivity in this analysis

Beg BV per share + EPS – Div per share = End BV per share; then RI = EPS – (Beg BV * re)
Fundamental determinants of residual income
ROE and BV are the main drivers

very similar to the DDM (will yield equivalent results with consistent assumptions); recognition of value typically occurs earlier in RI models compared to DDM

RI is based on clean surplus accounting – the relationship among earnings, dividends, and BV, or BVt = BVt-1 + Et - Dt
ROE and Re impact on BV valuation
If ROE was = to the cost of equity, the company would be value at book value

when ROE > re, the company is valued at greater than book and vice versa when ROE<re
Continuing residual income and its assumptions
RI after the forecast horizon, when ROE approaches the cost of equity, but here terminal value may not be a large component, Bo is instead the source of value

Assumptions made within continuing residual income:
i. RI continues indefinitely at a positive level
ii. RI is zero from the terminal year forward
iii. RI declines to zero as ROE reverts to re
iv. RI reflects the reversion of ROE to some mean level
Residual Income strengths
Terminal values do not make up a large portion of total PV, relative to other models

RI models use readily available accounting data

Can be readily applied to cos that do not pay dividends, or have near-term +FCFs

Can be used when CFs are unpredictable

An appealing focus on economic profitability
Residual Income weaknesses
Based on accounting data which is subject to management manipulation

Accounting data used as inputs may require significant adjustments

Requires the clean surplus relation holds, or that adjustments need to be made for it to hold

Assumes that the cost of debt capital is reflected in interest expense
Justification of why to use and why not-to-use RI model for valuation
The co doesn’t pay dividends, or dividends are not predictable

Expected FCFs are negative within the analyst’s comfortable forecast horizons

Forecasting is an art, not a science and great uncertainty exists

May not want RI model as departures from clean surplus accounting occurs

May not want RI model as determinants of RI (like BV and ROE) are not predictable
Accounting issues of RI models
Violations to the clean surplus relationship
i. May have to adjust BV for off-BS items and adjust NI to obtain comprehensive income – items like FX translation adjustments, certain pension adjustments, and fair value changes of some financial instruments

Comprehensive income = all changes in equity other than contributions by, and distributions to, owners

BS adjustments for fair value – determine if there are off BS items to factor in (SPEs, operating leases, LIFO adjustments, deferred tax A&L reserves and allowances, intangible assets) – all of these items and their impact on future earnings can be found in the footnotes

Intangible assets – require special attention, because they are often not recognized as an asset unless they are obtained in an acquisition (i.e. ad spend flows through to earnings, but the brand its supporting is not accounted for in BV); R&D costs related to software development as well

Nonrecurring items – only impact earnings, no adjustments to BV are needed

Aggressive accounting practices: RI is sensitive to accounting choices and aggressive accounting methods, which can result in valuation errors

International considerations – accounting standards differ internationally, and suggests that a valuation model based on accrual accounting may not be as accurate as other methods in the context of international comparisons

Other impeding factors: the availability of reliable earnings forecasts, systematic violations of the clean surplus accounting, and “poor quality” accounting rules that result in delayed recognition of value changes
Public vs. Private company valuation
Stage in lifecycle – private companies include those at the earliest stages of development, whereas public companies are typically more established, in later innings; private also have less access to capital – assets and employees

Size – private companies tend to be smaller, which has risk implications, may reduce growth prospects due to less access to capital

Overlap of shareholders and management – most private companies have managements with controlling interest in the company, but then agency issues may be mitigated at a private co, and because of this structure, management often can take a longer-term perspective

Quality/depth of management – small private companies have trouble attracting talent

Quality of financial and other information –while much in the way of timeliness and financial accuracy is required of public companies, this is not the case for private – an analyst may not even have access to the financials, which are not required to be disclosed

Pressure from short-term investors – public companies are more short-term focused and often motivated due to compensation plans, whereas private companies lack a stock price to “worry about”

Tax concerns – reduction of reportable taxable income and corporate tax payments are likely more important (or a specified goal) for private companies, as it benefits the owner

Liquidity of equity interest in business – stock of private companies is less liquid and typically only has a few shareholders – the limited # of buyers reduces the value of the shares in private co

Concentration of control – often concentrated between a few people within private companies, this may lead to actions by a corporation that benefits some shareholders at the cost of others; and often dilutive actions (additional investors) must be at a premium to compensate existing
j. Potential agreements restricting liquidity – current shareholders of private companies are often restricted in their ability to sell shares; reduces marketability of equity interests
Types of private business valuations
transaction-related: private financing (venture capital financing), IPO, acquisition, bankruptcy, share-based payment (ESOP plans) – often done by investment bankers

compliance-related: financial reporting (to determine goodwill for an acquisition of a private company), tax reporting – often done by professionals with accounting and tax regulations

litigation-related: to determine damages, lost profits, shareholder disputes, and divorce
Private Co - fair market value
the cash amount at which an asset would change hands between willing buyers and sellers, at “arm’s length” in an open and unrestricted market – neither buyer or seller is under compulsion to buy or sell and both parties have reasonable knowledge of the relevant facts – most often used with regard to tax reporting
Private Co - market value
the estimated amount for which an asset should exchange on the date of valuation between a willing buyer and seller in an arm’s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion – most often used with regard to real estate and tangible asset appraisal, when money is borrowed to buy the asset
Private Co - fair market value (reporting)
the definition of value used in financial reporting, similar to fair market value

under IFRS = the price that would be received for an asset or paid to transfer a liability in a current transaction between marketplace participants in the reference market for the asset or liability;

US GAAP = the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
Private Co - fair market value (litigation)
value set forth by state statutes and legal precedent in certain litigation matters; otherwise actual value definition is similar to financial reporting one
Private Company - Investment value
the value to a particular investor based on the investor’s investment requirements and expectations
Private Company - Intrinsic value
the value that an investor considers, on the basis of an evaluation or available facts, to be the “true” or “real” value that will become the market value when other investors reach the same conclusion
Income approach - private company valuation
values an asset as the present discounted value of the income expected from it – this approach has several variations depending on the assumptions the evaluator makes

Referred to as discount cash flow models or present value models, often used for established companies that may be in higher growth mode
Market approach - private company valuation
values an asset based on pricing multiples from sales of assets viewed as similar

referred to as a relative valuation model, using comparables

Most often used with mature, stable companies
Asset-based approach - private company valuation
values a private company based on the values of underlying assets of the entity less the value of any related liabilities

Good for companies in the early stages of development, because typically used when going concern premise of value may be uncertain and/or future CFs may be tough to predict
Normalized earnings - private company
are economic benefits adjusted for nonrecurring, non-economic, or other unusual items to eliminate anomalies and/or facilitate comparisons

Discretionary expenses that pertain more to the owners and its private structure often need to be adjusted to find normalized earnings – like compensation for the CEO (might be too high, in an effort to reduce taxable income), or personal use of company assets

Real estate should be evaluated when applicable – often separate from the operating company
Free cash flow method - private company valuation
values an asset based on estimate of future cash flows that are discounted to PV by using the discount rate reflective of the risks associated with the cash flows
Capitalized cash flow method - private company valuation
values a company using a single representative estimate of economic benefits and dividing that by an appropriate capitalization rate
Excess earnings method (or RI method) - private company valuation
valuing all the intangible assets of the business by capitalizing future earnings in excess of the estimated return requirements associated with working capital and fixed assets – the value of intangible is added to the values of WC and fixed assets to arrive at a value for the business enterprise
Factors that require adjustment when estimating the discount rate for private companies
Discount rate should reflect the risk of achieving the projected cash flows, will often need to adjust for a size premium

Beta is less applicable from CAPM if the company will remain private

Company-specific or industry risks should be considered, as well as, projection risk – the less you know, the more potential risk
Which required return models are most appropriate for private company equity?
Basic CAPM is often rejected if a company is not planning to ever go public (no beta application)

Expanded CAPM is an adaptation from CAPM, but adds a size premium and addresses company-specific risk

Build up approach eliminates the beta issue but has its own assumption risks with an industry risk premium, availability and cost of debt is often uncertain for private companies (tough to calculate WACC)

Discount rates in an acquisition context (use the target’s cost of capital, not your own when valuing the target company for an acquisition)
Guideline public company method
establishes a value estimate based on comparable public company trading multiples, which are adjusted to reflect relative risk and growth prospects of the subject, private company

Finding comparables is a challenge
Guideline transaction method
establishes a value estimate based on pricing multiples from acquisitions or public and private companies

Finding comparable transactions is often a challenge

Need to adjust for potential deal synergies, contingencies (potential future payments) structured within the acquisition, noncash considerations, changes between transaction and valuation date

Acquisition multiples reflect the value of total equity, therefore no control premium adjustment is needed
Prior transaction method
considers actual transactions in the sock of the subject private co – is obviously less meaningful if transactions are infrequent
Asset-based approach valuation to private company valuation
underlying principle, is that the fair value of the assets less the fair value of its liabilities is equivalent to the value of the enterprise

Asset-based approach is rarely used for the valuation of going concerns, due to limited market data on specific asset types compared to valuing the enterprise as a whole

May be appropriate for real estate companies and small companies with few assets
Controlling interest assumption - private company valuation
assumes that there is an optimal synergistic buyer – should reflect the highest potential value for the asset
As if freely traded/minority interest value - private company valuation
is the value of a non-controlling equity interest that is readily marketable (similar to the price you would pay for a public stock – small equity interest)
Non marketable/minority interest value - private company valuation
would reflect the lowest “value” as it has no control premium and no ready marketability
Discount/Premium applied to private company valuations based on control and marketability
The degree of discount is often dependent on whether an IPO or liquidity event is in the near future, or the opposite spectrum, an equity interest in a company that pays no dividends has no prospects for a liquidity event
Control premium - private company valuation
the amount or percentage by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest; are estimated based on public company transactions which are completed for varying reasons (strategic – looking for synergies, financially driven (no synergies, typically PE firms), industry factors (date to determine the control premium may be less obvious), all stock transactions are tough to decipher the control premium
Discount for lack of control (DLOC)
the amount or percentage deducted from the pro rata share of 100% of the value of an equity interest in a business to reflect the absence of some or all of the powers of control

DLOC = <1 – (1/(1 + control premium))>
Discount for lack of marketability (DLOM)
an amount of percentage deducted from the value of an ownership interest to reflect the relative absence of marketability

DLOM can be estimated based on 1) private sales of restricted stock in public companies relative to their freely traded share price; 2) private sales of stock in companies prior to an IPO; 3) the pricing of put options
Total discount due to DLOC and DLOM =
(1 – (1 – DLOC)*(1 – DLOM))
Role of valuation standards in valuing private companies
Valuation standards are meant to protect users of valuations and the community at large, but because buyers and sellers are not always aware of the “accepted” standards, compliance is at the option of the individual appraiser

Numerous organizations have released valuation standards, but no single set of valuation standards covers the valuation of private companies