Investment Banking
Internship Class
Equity Valuation I:
Basics
Objectives
A. Understand the relationship between
intrinsic value and market value
B. Understand the various types of valuation
models, including balance sheet, dividend
discount , free cash flow, relative value and PE
models
C. Understand other key metrics used in
valuing securities
A. The Relationship between
Intrinsic Value and Market Value

What is intrinsic value?
 The present value of a firm’s cash flows discounted
by the firm’s required rate of return
 What is the firm’s market value (or price)?
 The total value of a firm’s outstanding shares times
its market price
 In an efficient market, what should this relationship be?
 In a truly efficient market, the intrinsic value should
equal its market value
 What happens if it doesn’t?
Intrinsic Value (continued)

How do you identify mis-priced securities?
• Determine the intrinsic or fair value of the security.
This can be done by many methods:
• Models, i.e. CAPM, APT (E(rs) = rf + bs [E(rM) - rf ])
• Fundamental analysis
• Balance sheet methods
• Dividend Discount Models (DDMs)
• Then you compare the fair value to the current price
Intrinsic Value (continued)


Do all analysts look at companies the same way?
• No. If you have 30 analysts, you will generally
have more than 60 sets of intrinsic values.
How much is intrinsic value used in the real world?
• It is used a lot in terms of equity valuation and
financial analysis. These have a more solid
foundation and are not as affected by key
assumptions
• It is not used as much with DDM’s and PV models,
as slight changes in assumptions can have large
changes in a company’s intrinsic value. Also these
models assume a longer time frame generally.
Intrinsic Value (continued)

If DD and PV models are not used as much in
the real world, why do we include them in our
analysis?
• The concepts are critical to understanding
investments and finance
• They can add value with specific industries and
companies
• They can be used to support your recommendations
from other models if assumptions are stated clearly
Intrinsic Value (continued)

How do you determine Intrinsic Value?
• It is a value assigned by the analyst
• It is based on specific theories and assumptions
• Analysts use specific models for estimation
• Lots of models exist
• Remember, these models are proxies for
reality – they are not reality
Intrinsic Value (continued)

What happens if the calculated intrinsic value is greater
than the market price?
• Intrinsic Value > Market Price
• Buy
• Intrinsic Value < Market Price
• Sell or Short Sell
• Intrinsic Value = Market Price
• Hold or Fairly Priced or valued
• In this class, we use a 10% estimation factor. If the
IV > (<) MP by greater (less) than 10%, then buy
(sell)
• These models are not as accurate as most
students would like. Valuation is much more an
art than a science!
Questions

Do you understand the relationship between
intrinsic value and market value or price?
B. Understand Various Types of Equity
Valuation Models

Fundamental Stock Analysis: Models of Equity
Valuation
• Basic Types of Models
• 1. Balance Sheet Models
• 2. Dividend Discount Models
• 3. Discount Models, i.e. Free Cash Flow
• 4. Working Capital Models
• 5. Relative Valuation Models
• 6. Price/Earning Ratios
1.
•
Balance Sheet Models
Balance sheet models assume that the intrinsic
value of the firm is the value of its assets.
• What is the value of the firms assets?
• Is it the value on the books?
• Is it the value we could really get for the assets
(liquidation value)?
• Is it the value we could get to replace the
assets?
• What are the main types of models?
• Book Value, Liquidation Value, Replacement
Cost, and Tobin’s Q
Balance Sheet Models (continued)

Book Value (per share)
• The Book Value is Equity / shares outstanding
• Example: Ford
Assets
243,283 million
Liabilities
219,736 “
Owners Equity
23,547 “
Shares Outstanding
1,169 “
• What is the Book Value per share?
$23,547/1,169 = Book value of $20.14 per share
• Logic: the value of the assets should be equal to
their value on the books.
• Caution: Be careful as book value does not tell
you depreciation methods or the true value of
the assets (they may actually be worthless)
Balance Sheet Models (continued)

Liquidation Value (per share)
• Liquidation value is the value realized by breaking
up the firm, selling off assets and repaying debt
• Company A has a market value of $250 mn with
$50 mn in debt, cash of $150 mn and other
assets likely worth $200 mn if sold today.
• What is the liquidation value?
• Liquidation value is the cash on hand and what
they could liquidate the other assets for
• Logic: if price falls below liquidation value, the
firm becomes a takeover target as investors buy the
company and sell it in pieces
• Caution: Can they realize the value of the assets?
Balance Sheet Models (continued)

Replacement Cost (per share)
• Replace cost is the money necessary to replace the
tangible and intangible assets of a company
• Company B is a trucking company valued at $25
mn. Since Company C takes 60% of the
company’s business and is planning to expand, you
know that its CEO could replicate the trucking
company for $20 million and build her own
trucking division.
• What is the replacement cost? $20 million
• Logic: If the value gets too high above the
replacement cost, competitors would replicate the firm
and competition would drive down value of all firms.
• Concerns: Are all parts of the firm replicable?
Balance Sheet Models (continued)

Tobin’s Q
• Tobin’s Q is the ratio of a firm’s price to its estimated
replacement cost
• In the long run, the market price to replacement
cost will tend toward 1 as investors correctly
value the replacement cost of the assets
• Logic: Investors will be willing to purchase the
company as long as the company’s market price is
below the replacement cost. As soon as its price is
greater than the replacement cost, competition will
come in, dropping the price to close to its
replacement cost.
• Concerns: Differences may remain over time
Challenges of Balance Sheet Models
-
What are the major challenges of Balance
Sheet Models?
- It may be difficult to determine the real value of the
assets, i.e. depreciated cost versus real value
- It is uncertain how long it will take for replacement
cost to move toward unity. The time factor is a real
concern
- It may be difficult to determine the value of
intangible assets, which may be significant in some
companies
2. Dividend Discount Models

These are models which take into account
discounting expected future cash flows to gain
a reference for the value of a company
• These are the oldest and simplest present value
approach to valuing a stock
• Primary Dividend Discount Models
General Model
Constant Growth Model
Dividend Discount Models (continued)
General Dividend Discount Model
Vo= Sum [(Dt+ Pt) /(1+k)t ]
V0 = Value of Stock
Dt = Dividend at time t
Pt = Expected Price at time t
k = Required return on the stock
The value of a company is the discounted value of
dividends and the eventual sale of the company stock

( D1)
( Dt )
( Pt )
( Dt  Pt )
V
o

...


Vo  
1
t
t
t
(1  k )
(1  k ) (1  k )
t 1 (1  k )
Dividend Discount Models (continued)
Constant (or Gordon) Growth Rate Model
Vo = Do * (1+g)
(k - g)
• This is for stocks that are growing at a constant
growth rate (this rate is assumed in perpetuity)
g = constant perpetual growth rate
b = plowback or retention ratio (rr)
• Note: take out the g and the formula becomes the
no growth model
E1 = $5.00
b = 40%
k = 15%
(1-b) = 60% D1 = $3.00
g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
Dividend Discount Models (continued)

Estimating Dividend Growth Rates
g = ROE x b
• g = growth rate in dividends
• ROE = Return on Equity for the firm
• b = plowback or retention percentage rate
• (1- dividend payout percentage rate)
• Internal Growth Rate (ROE x (1-payout))
• This is the rate that the company can continue to
grow without any additional external financing
• Note: if the firm distributes all its earnings as
dividends, there is nothing to allow the firm to
continue to grow
Dividend Discount Models (continued)

More Changes to the DDM
• What about growth opportunities?
• Do those impact the value of the company?
• Does the DDM only look at dividends?
• What about earnings on specific projects?
• Can we fix the DDM to look at the value of new
projects?
• There are a number of different DDM models that
can handle each of these situations
Challenges of Dividend Discount Models
-
Major challenges to DDMs include:
- A slight change in the discount rate can have a huge
change in the result
- It is difficult to determine the terminal value of the
stock
- A small change in the termination value (i.e., the PE
multiple) can have a large change in the result
- Not all firms have dividends
3. Discounting Models

Discounting models assume the intrinsic value
of the company is the present value of the
firms’ expected future cash flows. It is useful
when:
• The company does not pay dividends
• Dividends paid differs from what the firm could pay
• Free cash flows align with profitability within a
specific forecast period
• The investor takes a control perspective
Discounting Models (continued)
 Free Cash Flow to the Firm (FCFF)
• FCFF is the cash flow available to the suppliers of
capital after all operating expenses (including taxes)
are paid and working and fixed capital investments
are made (i.e. less capital expenditures)
• FCFF = cash prior to the payment of interest to the
debt holders
FCFF = EBIT - taxes + depreciation (non-cash
costs) – capital spending – increase in net
working capital – change in other assets +
terminal value
• Discount this at the firm’s WACC
- Firm Value = Operating free cash flow
WACC – growth OFCF
Discounting Models (continued)

Free Cash Flows to Equity (FCFE)
• FCFE is the cash flow available after all operating
expenses, interest, and principle repayments have
been made and necessary investments in working
capital and fixed capital have been made
• FCFE = Adjusts operating cash flows for debt
repayments
• FCFE = EBIT – interest - taxes + depreciation
(non-cash costs) – capital expenditures – increase
in net working capital – principal debt
repayments + new debt issues + terminal value.
Discount at k = required return on equity
• Firm Value = Free CF to Equity/(k – growth FCFE)
Discounting Models (continued)

Calculation Methodology for Discounting:
•
•
•
•
Determine the appropriate discount rate
Set up each of the individual cash flows
Discount each of the individual cash flows
Discount the final cash flow assuming a constant
growth rate = cash flow / (k – g)
• The question remains whether the final cash
flow representative of all future cash flows
• Sum all the discounted cash flows
• Make adjustments as required
Challenges of Discounting Models
-
Major challenges of Discounting Models
include:
- A slight change in the discount rate can have a huge
change in the result
- A small change in the terminal growth rate can have
a large change in the result
- You must be very careful of your choice of discount
rates and capitalization rates
4. Working Capital Models

These models, based on historical experience,
state that most companies are worth some
multiple of EBITDA (Earnings before Interest,
Taxes, Depreciation and Amortization).
• Calculate their EBITDA for the past year, multiply
EBITDA by multiples of 6 and 9, and divide by
diluted shares outstanding
• Calculate working capital, subtract out long-term
debt, and divide by diluted shares outstanding
• Add EBITDA per share and working capital per
share to get a value for the firm
Working Capital Models

Benefits
• Easy to calculate
• Works for many different types of companies

Challenges
• Not all companies are worth a 7.5x EBITDA
multiple
5. Relative Value Models

Relative value models assume that companies
have a fair-value trading range versus the
market and versus their respective indices
• Companies that trade within their fair-value ranges
are correctly valued by the market
• When companies are outside their fair value ranges,
this gives information that the company should be
looked at, either to buy or sell
• The fair trading PE range times EPS times the
market PE gives the price per share.
Relative Value Models

Benefits
• Easy to calculate
• Identifies when stock appreciation is due to general
market movement versus the benchmark
• Works for many different types of companies
• Can be compared to the market and industry
benchmarks

Challenges
• Not all companies trade versus the market index in
the same way
• May not be useful if the market is at extreme
valuation levels
6. Price Earnings Ratios

P/E Ratios are a function of two factors
• Required Rates of Return (k)
• Expected growth in Dividends

Uses
• Valuation of new companies
• Relative valuation versus market and industry
• Note: this is used extensively in the industry.
Research has found that low PE stocks have
given a higher return to Investors than high PE
stocks over the last 70 years
Price Earnings Ratios (continued)
 Price
Earnings Key Terms
• Price Earnings = Price per share/Average Common
diluted Earnings Per Share
• Forward or Prospective PE = Current Price /
Forward EPS
• Historic PE = Year-end Price/Year-end EPS
• Normalized PE = Current Price/normalized earnings
(earnings adjusted to take into account the cycles in
the economy)
• Earnings Yield (E/P) = 1 / Price Earnings
Challenges of Price Earnings Models
• Benefits
• Used extensively in the industry
• Generally low PE firms outperform high PE firms
• Pitfalls
• Earnings are accounting earnings, which can be
manipulated through depreciation, inventory, etc.
• Earnings can fluctuate widely around a trend
• You cannot know if the PE is high or low unless you
compare it to a trend, to long-run growth prospects,
to an industry, or to the market
Questions

Any questions on methods of equity valuation?
C. Understand the Key Valuation
Metrics in Valuing Securities
 What are the key valuation metrics?
 PE, PBV, PS, DY, POCF, PEBIT, PEVITDA,
P/IGR, and P/EGR
 Why are they important?
 They relate the current market price to key
profitability variables
 They relate the company’s PE ratio to certain types
of growth
1. Price/Earnings (PE=P/EPS)
 PE Ratio
• The most common measures of a firm’s stock price
relative to its earnings--what you are paying for $1
of earnings.
 How is it analyzed?
• Versus its historical average
• If lower that than its history, it may indicate it is
moving into more attractive territory, i.e., growth
is increasing
• Versus the market.
• Gives a historical view. If it is trading at a lower
relative PE, it may be becoming more attractive.
• Versus the industry
• If the relative PE versus the Industry is
declining, it may indicate the stock is becoming
more attractive.
2. Price/Book (PB=P/BVS)


P/BV or PB or Market to Book
 Gives the relationship between the stock price and
the book value of the firm (i.e. owners equity).
How it is analyzed?
 If the PB ratio is high when compared to peer firms,
the stock may be overvalued, all else being equal.
 If the PB is negative, the firm is in serious trouble.
 Remember that owners’ equity is based on
accounting depreciation and may not have
relevance to the actual value of the assets of the
company.
 Generally, the higher the P/BV (or the lower its
inverse, Book to Price) the more expensive the
company.
3. Price/Sales (PS=P/SPS)



Price to Sales
 Sales multiples are indicator of growth in sales and
hence a future indicator of growth in profits.
How it is analyzed?
 Can be positive or negative
 Note that growth in sales translates into growth
in profits only if the other drivers of profits are
sustained, i.e. profit margins, turnover, etc.
 New companies
 New companies like PS ratios when they don’t
have any earnings. But if earnings fail to
materialize, then PS ratios are irrelevant.
Generally, the lower the PS ratio, the more attractive
the company, all else being equal
4. Dividend Yield (DY=DPS/P)


Dividend Yield
 Certain companies are known for their high
dividend payouts
 Historically we have seen an overall decline in the
market’s dividend yield as firms decided that they
could use dividend payouts more effectively in
their own firms
How is it analyzed?
 DY assesses the amount of dividend an investor will
receive for his dollar if invested at the current share
price.
 A high dividend yield can be perceived as both
positive and negative. Positively, as you have a
return of capital; negatively, as the company has no
5. Price/Operating Cash Flow (POCF=P/OCFS)

Price to Operating Cash Flow
 P/OCF is an important measure of a firm’s health
 It gives an assessment of the firm’s power to
generate operating cash flow on a price per share
basis
 How is it analyzed?
 Firms that are generating a high amount of cash are
perceived to be more attractive than firms which are
not generating cash
 Generally, the lower the P/OCF the more
attractive the firm
6. Price/EBIT (PEBIT=P/EBITS)


Price to Earnings before Interest and Taxes
 In evaluating firms which are potential takeover
targets or which are not making earnings, analysts
often use Price/EBIT, which they would use instead
of Price Earnings (as there are no earnings).
 This gives the relevant ratio assuming the firm had
no other expenses, i.e. debts, taxes, etc.
 This was used in valuing the high-flying tech
firms
How is it analyzed?
 Generally the lower the ratio, the more attractive the
company
 Be careful as this ratio says nothing about overall
profits, but only operating earnings.
7. Price/EBITDA (PEBITDA=P/EBITDAS)


Price to Earnings Before Interest and Taxes and
Depreciation and Amortization
 Used to put a price on firms which have no
earnings but are generating cash and which may be
attractive as acquisition candidates
 P/EBITDA is similar to the Price/EBIT, except that
it includes depreciation and amortization, which are
non-cash charges
How is it analyzed?
 Takeover firms are concerned with the amount of
cash firms are generating assuming no other
charges and taxes. Generally the lower the ratio, the
more attractive the company
8. PE to IGR (PE/Internal Growth Rate or g)


PE to Internal Growth Rate (which is a proxy for a
firm’s sustainable growth rate)
 Used to relate a company’s PE to its sustainable
growth rate
How is it analyzed?
 A low PE stock with a high internal growth rate will
have a low ratio, while a high PE stock with a low
IGR will have a high ratio.
 Generally the lower the ratio, the more attractive the
company.
9. PE to Earnings Growth (PE/EPS Growth)

Price Earnings to Earnings Growth
 Another takeoff on the PE to growth ratio
 Sometimes used this as a screening device, only
looking at companies whose PE divided by
Earnings growth rates are 1 or less
 How is it analyzed?
 Generally, companies are more attractive when this
ratio is lower, as they have not only higher earnings,
but those earnings are expected to growth in the
near future.
 Can be very volatile due to the volatility of earnings
per share growth
 Due to volatility, some investors prefer the PE to
IGR above
Questions

Do you have any questions on the various types
of metrics used in valuing companies?
Review of Objectives
A. Do
you understand the relationship between
intrinsic value and market value?
B. Are you familiar with the various types of
valuation models, including balance sheet,
dividend discount models, and PE ratios?
C. Do you understand other key metrics used in
valuing securities?