The Determination of the True Value of a Company - Term Paper Example

More on Valuation Table of Contents Introduction 3 Methods of Valuation 3 Dividend and Equity Valuation 4 This method is also called the Gordon growth model and can value companies with a constant growth rate of dividends. Let us assume the growth rate to be 6%; cost of equity as 10.4%, the Earning per share (EPS) is $3.48 and a pay-out ratio of 60%. The expected DPS can be computed as $2.21. The value is then calculated as 2.21/ (0.104-0.06) = $50.23. If the share of the company is trading at more than the obtained value then the company is said to be overvalued (Damodaran, 2001). 5 Enterprise Discounted Cash Flow 5 Free Cash Flow for the Firm (FCFF) 7 Adjusted Present value (APV) 8 Relative Valuation approach 8 Valuation of Projects 9 Net Present Value (NPV) 9 Internal Rate of Return (IRR) 10 Payback method 10 Profitability index 10 Conclusion 11 Introduction Valuation is the estimation of the market value of an asset such as a company for the purpose of investment analysis, mergers or for other taxable events. The value of a company depends on the expected cash flows which in turn depend on the anticipated returns on the invested capital and the growth rate. The companies exhibiting a higher growth rate and higher returns on capital are given a higher value by the market participants. Methods of Valuation The main methods to value a company include Enterprise Discounted Cash Flow (DCF) and discounted economic profit. Although both the methods give the same results but each method has its own benefits. Of these methods Enterprise DCF is popular among the practitioners as it considers only the cash inflows and outflows and ignores the earnings. In discounted economic profit, the term ‘economic profit’ measures whether a company earns its cost of invested capital in a year. Under both the methods, future cash flows are discounted by the weighted average cost of capital (WACC). The WACC is used for companies with a stable debt structure. On the other hand, the companies with an unstable capital structure can adopt Adjusted Present value (APV) method which considers the tax shield associated with debt (Koller, Goedhart, Wessels, 2005). The cash flows that are discounted using this technique are dividend in the case of stocks and post-tax cash flows for real projects. Higher the risk of the cash flow, higher will be the discount rate for example projects which are safe are discounted with a lower rate. The advancement in financial sector has influenced the decision-making of the professionals who apply the DCF technique for the purpose of project analysis (Colorado School of mines, “Purpose and Scope of the course”). Dividend and Equity Valuation This method of valuation is most suited for companies with a stable track record of dividends. The value of the firm is measured by discounting the expected dividend with the cost of capital. This method is similar to bond pricing with dividends replacing the interest payments and the interest rate being replaced by the cost of equity. Stable or Constant growth rate of dividend- Depending on the rate of growth of dividends there can be a Stable growth scenario or a Constant growth scenario. In the Constant growth scenario, it is assumed that dividends will continue to grow at a fixed rate forever. The value of equity in this case can be measured as a cash flow that grows perpetually. The value of equity can thus be calculated as E (Dividend Next period)/ (k e – g n) Where, k e is the cost of equity g n is the growth rate of dividend. This method is also called the Gordon growth model and can value companies with a constant growth rate of dividends. Let us assume the growth rate to be 6%; cost of equity as 10.4%, the Earning per share (EPS) is $3.48 and a pay-out ratio of 60%. The expected DPS can be computed as $2.21. The value is then calculated as 2.21/ (0.104-0.06) = $50.23. If the share of the company is trading at more than the obtained value then the company is said to be overvalued (Damodaran, 2001). Enterprise Discounted Cash Flow The equity valuation is suited when valuing a firm from the investor’s perspective whereas if the firm has to be valued from the controlled perspective we have to use the Enterprise DCF or the Free Cash Flow approach (FCF). This is also used for valuing companies without a track record of dividend. This can again be of two types FCFE (Free cash flow for equity) and FCFF (Free cash flow for the firm). FCFE can be defined as the amount of cash left after meeting the operating expenditure, interest costs and the reinvestment requirements of the company. Constant growth FCFE model- In the case of Constant growth model, the value of equity is calculated as P0 = FCFE1 / (r – g n) where, P0 is the present value of the stock; FCFE1 is the Expected FCFE in the next year, r is the cost of equity and g n is the perpetual growth rate of the firm. This model is suitable for companies in a steady state i.e. the amount of capital expenditure is not much higher than the depreciation figure; with FCFE differing from the amount of dividends and a stable leverage position. The FCFE can be calculated as FCFE = EPS – (Capital Expenditure – Depreciation) (1- Debt ratio)-(Change in Working Capital) (1- Debt Ratio) Two stage FCFE model- The value of the stock is measured as the present value of the FCFE each year for the supernormal growth phase plus the present value of the horizon value at the end. Value = ∑ FCFE t / (1 + k e )t + P n / (1 + k e ) n Where, FCFE t is the free cash flow to the equity in the year‘t’; P n is the price at the end of the supernormal or extraordinary growth phase and k e is the cost of equity during such phase. The horizon value is calculated as P n = FCFE n+1 / (k e, n – g n) where, k e, n is the cost of equity during the stable period and g n is the perpetual growth rate. Three Stage FCFE model- This model is used when affirm has a three stage growth process i.e. there are three stages in the growth of the earnings. One is the high growth phase, where the growth rate remains fixed for a certain period; second is the Transition phase where the growth rate declines linearly for a specified period and third is the Stable growth period where the earnings are expected to grow in a perpetuity (New York University, “Why are dividends different from FCFE?”). Free Cash Flow for the Firm (FCFF) Free cash flow refers to the cash available to the investors including the shareholders and the bondholders after the firm has met all its investment needs. This method is best suited for firms with a high debt component and plan to lower the debt over the time. As the debt payments do not require to be factored, the cost of capital that is used as the discount rate need not be changed often. It is followed for the firms exhibiting partial information about the interest costs or where it is desired to value the firm rather than the equity. In similarity with the FCFE approach this method also has a Stable growth model, Two Stage model and Three stage model. The rate of growth of earnings is stable in the stable growth phase whereas it is moderate in the two stage model. The growth rate of a firm’s earnings is high in the three stage model (New York University, “The Fundamental Choices for DCF valuation”). Calculation of FCFF- FCFF represents the cash that is freely available with the business for uses like repayment of debt, dividend declaration or adding to the cash balance of the company. It is simply the cash generated by the company without considering the source of finance. The steps for the FCFF calculation are: The net profit given in the Income Statement is taken The non-cash expenses like amortization are added back to the net profit figure The amount of capital expenditure is deducted. If the amount of capital expenditure is not given it can be taken as the change in the value of gross fixed assets. Any changes in the “operational” balance sheet accounts are added or subtracted (ACTON, “Free Cash flow to the firm”). It is calculated as the Net Operating profit less adjusted taxes (NOPLAT) less the investment requirements of the company. FCFF = NOPLAT – (Capital Expenditure – Depreciation) – Change in the Working Capital. Adjusted Present value (APV) In the APV method of valuation of company, the value of the levered firm (VL) is the value of the unlevered firm (VU) plus the present value of the interest tax shield (PVTS). It can be also used in valuing the projects. It is stated as VL = VU + PVTS The firms adopting this method expect their debt-equity ratio to decline and can also forecast their future requirement of the debt funding. Under the changing capital structure scenario this method is more practical compared to the Weighted Average Cost of Capital (WACC) (Wharton University of Pennsylvania, “Introduction”). Relative Valuation approach In this method of valuation, the value of the firm is compared with the similar firms in the industry. Just like a prospective house buyer compares his payments with the prices charged for houses in the same area, an investor can assess the value of a stock by comparing it with the price of similar stocks in the market. In comparison with the DCF it is less time consuming but it is not without biases. It can be based upon the earnings, book values, cash flows or revenues of comparable firms (New York University, “Relative Valuation: First Principles”). Valuation of Projects The firm’s investment behavior is affected by the element of uncertainty embedded in the project and by the pressure of the competitors. A firm with limited resources has to identify the projects that can give a positive return. The methods used for this include Net Present Value (NPV), Internal rate of Return (IRR), Payback method and the Profitability Index. This involves the calculation of cash flows for a project. There can be three types of cash flows depending upon the time period of origin – Initial Investment, Operating Cash Flows and the Cash flows at the point of termination of the project. Net Present Value (NPV) The NPV method helps in finding out the value that is generated or added by undertaking a project. In this regard only projects with a positive NPV are considered for further investments. It is stated as – -II + (sum of) [OCF/ (1+R(r) )t ] + [TCF/ (1+R(r) )n] Where II is the amount of initial investment; OFC refers to the Operating Cash Flows in year ‘t’; ‘t’ is the year; ‘n’ is the life of the project and R(r) is the required rate of return from the project. NPV is the difference between the value of cash flows discounted at the present rate and the investment cost of the project. Internal Rate of Return (IRR) IRR is used as a substitute to the NPV method. It is the rate of return that gives a zero NPV. If the IRR is greater than the required rate of return a project is accepted. There is no mathematical formula to calculate IRR, it is found by trial and error method. An advantage of IRR is that it can be estimated without knowing the discount rate. But it can lead to faulty decisions in the case of mutually exclusive projects. Payback method This method considers the time period to recover the investment in a project. The time that is calculated is called the payback period. A specified time period is selected as the cut-off period for the realization of the initial investment made in the project. The payback period can be viewed as the time taken for the project to break even. This method is criticized on grounds of ignoring the time value of money as it does not consider the discounted cash flow. Profitability index The viability of a project can also be assessed by looking at its profitability index or the benefit cost ratio. It is stated as the Present Value of future Cash Flows/ Initial Investment. Of all the methods that have been mentioned NPV is the best as it actually calculates the value of the project. Also, in the case of multiple projects the project manger can sum up the NPV of all the projects (Mount Holyoke, “How do I value a Project?”). Conclusion The determination of the true value of a company is important as it helps a prospective investor in identifying the overvalued or undervalued stocks. Similarly, the scarcity of financial resources necessitates the valuation of projects. References Colorado School of mines. Purpose and Scope of the course. 2010. Using dynamic DCF and Real options to value and manage mining and petroleum projects. November 3, 2009. . New York University.Why are dividends different from FCFE?. No Date. November 3, 2009. . New York University. The Fundamental Choices for DCF valuation. No Date. Discounted Cash Flow Models: What they are and how to choose the right one. November 3, 2009. . ACTON. Free Cash flow to the firm. No Date. November 3, 2009. . Wharton University of Pennsylvania. Introduction. No Date.The Adjusted Present value approach to valuing Leveraged buyouts. November 3, 2009. . New York University. Relative Valuation: First Principles. No Date. Chapter 7. November 3, 2009. < http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch7.pdf>. Mount Holyoke. How do I value a Project?. No Date. Corporate Finance Basics. November 3, 2009. . Koller, T. Goedhart, M. Wessels, D. Valuation: Measuring and managing the value of companies. New Jersey: John Wiley and Sons Inc. 2005. Damodaran, A. The Dark side of valuation: Valuing Old Tech, New Tech, and New Economy Companies. Upper Saddle River, NJ: Prentice Hall, Inc. 2001. Read More