Business Valuation

Major Contributions• Graham & Dodd (1934 – 1962)

o Recognition of the need for a detailed financial statement analysis and focus on Earnings Power

o Growth prospects to be consideredo Basis for Relative Valuation Models

• John Burr Williams (1938)o Intrinsic Value is the present value of cash flows at an opportunity cost

of capitalo Basis for Dividend Discount Models and Free Cash Flow Models

Equity Valuation• Intrinsic Value (IV): true underlying value of the

security given complete understanding• Estimated Value (VE): investor estimate of

intrinsic value• Market Price (P): current price

• Two sources of perceived mispricing: -VE – P = (IV – P) + (VE – IV)

Other Value Concepts• Going Concern Value• Liquidation Value• Orderly Liquidation Value

Uses Of Equity Valuation

• Stock selection• Projecting worth of company actions• Fairness opinions for mergers• Planning and consulting• Communication with investors• Valuing private businesses• Portfolio management

Absolute Vs. Relative Valuation Models

• Absolute Valuation Modelso Intrinsic value based on fundamental characteristics – EPS, Asset

Turnover, Leverage, Return on Equity, and growtho Dividend Discount Model (DDM), Free Cash Flow Model (FCF), Residual

Income Model (RI)

• Relative Valuation Modelso Value derived from relative comparison to similar assetso Based on law of one priceo Price to Equity (P/E), Price to Book Value (P/BV), Price to Cash Flow

(P/CF), Price to sales (P/S) models

Appropriate Valuation Approach

• Consistent with characteristics of the company• Based on quality and availability of data• Consistent with purpose of analysis

Porter’s 5 Forces• Porter – “what is it that enables a firm to earn

superior returns in the long run?”• Porter – “Five forces”

o Threat of entryo Threat of substituteso Bargaining power of buyerso Bargaining power of supplierso Rivalry among existing competitors

Growth Models• Stable Growth

o Firm is large and growing at a rate closer to economyo Constrained by regulation from growing faster than the economyo Has the characteristics of a stable firm (average risk and reinvestment

rates)

• Two Stage Growtho Firm is large and growing at a moderate rate (≤ economic growth +

10%)o Has a single product with barriers to entry with a finite life (e.g.

patents)

• Three Stage Growtho Firm is small and growing at a very high growth rate (> economic

growth + 10%)o Has significant barriers to entry into the businesso Has firm characteristics that are very different from the normal

Practice QsDividends of Rs. 2.5 and Rs. 4.0 are expected at the end of first year and second year from now. Thereafter a constant growth rate 4% is expected forever. What is the value of stock now if required return is 12%?

Practice QsCuck-do-koo Corp.

o Currently pays a dividend of Rs.1.3o Current growth rate is 25%o Growth expected to decay over 5 yearso Constant growth rate of 5% thereaftero Required return is 14%

Calculate intrinsic value of Cuck-do-koo Corp.

Practice QsTechnet Ltd.

o Current growth rate is 25%o Supernormal growth rate expected to last for another 3

yearso After 3 years the growth decays to a sustainable 3%

over the following 7 yearso Last dividend was Rs. 0.3o Required return is 10%

Calculate Technet’s share value as of today.