Class 8 Valuation Implementation 6-slide(1)

ACCT5910 –Business Analysis and Valuation Class 8: Valuation: Implementation

Financial Statement Analysis Class 8: Valuation Implementation

Valuation: Implementation

■Implementation of valuation models usually involves:

■Estimate discount rate

■Forecast earnings and cash flows

■Detailed performance for finite horizon ■Terminal value

■Valuation depends on forecasts

■“Garbage in, garbage out”

A. Estimate Discount Rate

■Discount rate = required rate of return

■Equity (capital) providers require a certain level of return as a compensation for taking risk.

■The higher the risk, the higher the discount rates.■To measure the cost of total capital in the company, we use Weighted Average Cost of Capital (WACC)

WACC = w d *r d *(1-T) + (1-w d )*r e

where: w d = weight of debt T = tax rate

r d = cost of debt r e = cost of equity

A1. Cost of Debt

■Cost of debt is determined by

■Nominal interest rate

■≈ real rate + expected inflation

■Default risk

■Probability that the debt will not be repaid

■Liquidity risk

■Probability that the bond will not be easily sold

■Credit rating indicates cost of debt

■How to find a company’s cost of debt?

■Yield to maturity for the publicly traded bond

■Interest rate charged by the bank for the latest bank loan

A1. Cost of Debt 1

■Credit rating

■Cost of debt from a comparable firm

A2. Cost of Equity

■Finance theory provides some models to estimate cost of equity, but none of them are perfect.

■Lack of understanding of risks

■Lack of understanding of price discovery

■Practitioners usually use some simple models

A2. Cost of Equity 1

■Capital Asset Pricing Model (CAPM)

r e = r f + β[E(r m ) –r f ]

■r f = risk free rate (nominal interest rate)■E(r m ) = expected market return

■β= Cov(r m , r e )/Var(r m ), a measure of systematic risk

■Expected return for a stock is determined by its systematic risk (β)and expected risk premium [E(r m ) –r f ].

■To use CAPM, we need to

■Estimate r f

■Using short-term treasure bill rate (risk free)

■Using intermediate (1 –3 years) treasure note rate to reflect expected inflation

A2. Cost of Equity 2

■Estimate r m

■Using survey date

■Using historical average

■Estimate β

■Using 60-month stock and market return data

■Constructing portfolios because portfolio beta is more stable ■Using estimates from data vendors.

■Academic research shows that CAPM does not work well, but practitioners love it ■Multi-factor model

=r +)–]+r i +r b +r A2. Cost of Equity 3

r e r f + β[E(r m ) r f ] + r size + r bm + r

mom ■To incorporate recent market anomalies

■Small firms yield higher returns than large firms ■Low market-to-book firms yield higher returns ■Past winners continue to yield higher returns

B. Performance Forecast

■Detailed forecast for a finite number of years

■Make sound assumptions based on strategy and accounting analysis

■Construct detailed pro forma financial statement An example by Wal Mart

■An example by Wal-Mart ■Estimate terminal value with valid assumptions

■Terminal value is less important in discounted abnormal earnings model

B1. Terminal Value

■Choose a terminal year

■How long can the firm sustain its competitive advantage?

■When will the firm’s return on new project reach the normal level?normal level?

■5 –10 years from historical evidence

B1. Terminal Value 1

■To choose sound long-term growth rate after terminal year

■Assume a “competitive equilibrium”

■Competition will drive NPV of new projects down to zero ■Firm value will not be affected since incremental NPV = 0

It implies that the future abnormal earnings will be zero or TV=0

■It implies that the future abnormal earnings will be zero or TV=0■Assume zero abnormal earnings for incremental sales

■Terminal year operation will persist

■The level of abnormal earnings will persist

■Assume a constant growth rate for sales

■Inflation rate or nominal GDP growth rate

■Use price multiples

■Use only “normal” multiples

Sensitivity Analysis

■Make different assumptions and re-do the

valuation

■Change key inputs by 5% or 10%

■How sensitive is the valuation to the assumptions

■Construct scenarios with different combination of assumptions

■Normal case, worst case and best case B2. Other Issues

■Accounting distortion

■Re-construct financial statements

■Correct it in Forecasting (core) earnings

■Negative earnings or book value

■Assume the firm will become profitable in near future; otherwise, it t b i

it may not be a going concern.

■Start with asset value

■Use real option valuation

■Excessive cash or free cash flow

■Cash earns low return

■Potential agency problem

■Potential target for take-over

Next Step

■What if your valuation is different from market price?

■Market price is correct –Efficient Market Hypothesis

■Market price is wrong –possible profit opportunity

■Price is supposed to move together with fundamentals in the long-run.

the long run.

■But for how long will price come back to intrinsic value?

■In the short-run, price is also affected by market sentiment.

■Is sentiment predicable?