Company Valuation:
1st Valuation Method
Discounted Cash Flow Valuation
Part III: Examples
Stable Growth model
2-stage Growth model
3-stage Growth model
Kalaitzoglou Iordanis
Summarizing the Inputs
In summary, at this stage in the process, we should have an estimate of the
the current cash flows on the investment, either to equity investors (dividends or free cash flows to equity) or to the firm (cash flow to the firm)
the current cost of equity and/or capital on the investment
the expected growth rate in earnings, based upon historical growth, analysts forecasts and/or fundamentals
The next step in the process is deciding
which cash flow to discount, which should indicate
which discount rate needs to be estimated and
what pattern we will assume growth to follow
Which cash flow should I discount?
Use Equity Valuation
(a) for firms which have stable leverage, whether high or not, and
(b) if equity (stock) is being valued
Use Firm Valuation
(a) for firms which have leverage which is too high or too low, and expect to change the leverage over time, because debt payments and issues do not have to be factored in the cash flows and the discount rate (cost of capital) does not change dramatically over time.
(b) for firms for which you have partial information on leverage (eg: interest expenses are missing..)
(c) in all other cases, where you are more interested in valuing the firm than the equity. (Value Consulting?)
Given cash flows to equity, should I discount dividends or FCFE?
Use the Dividend Discount Model
(a) For firms which pay dividends (and repurchase stock) which are close to the Free Cash Flow to Equity (over a extended period)
(b)For firms where FCFE are difficult to estimate (Example: Banks and Financial Service companies)
Use the FCFE Model
(a) For firms which pay dividends which are significantly higher or lower than the Free Cash Flow to Equity. (What is significant? ... As a rule of thumb, if dividends are less than 80% of FCFE or dividends are greater than 110% of FCFE over a 5-year period, use the FCFE model)
(b) For firms where dividends are not available (Example: Private Companies, IPOs)
What discount rate should I use?
Cost of Equity versus Cost of Capital
If discounting cash flows to equity -> Cost of Equity
If discounting cash flows to the firm -> Cost of Capital
What currency should the discount rate (risk free rate) be in?
Match the currency in which you estimate the risk free rate to the currency of your cash flows
Should I use real or nominal cash flows?
If discounting real cash flows -> real cost of capital
If nominal cash flows -> nominal cost of capital
If inflation is low (<10%), stick with nominal cash flows since taxes are based upon nominal income
If inflation is high (>10%) switch to real cash flows
Which Growth Pattern Should I use?
If your firm is
large and growing at a rate close to or less than growth rate of the economy, or
constrained by regulation from growing at rate faster than the economy
has the characteristics of a stable firm (average risk & reinvestment rates)
Use a Stable Growth Model
If your firm
is large & growing at a moderate rate (≤ Overall growth rate + 10%) or
has a single product & barriers to entry with a finite life (. patents)
Use a 2-Stage Growth Model
If your firm
is small and growing at a very high rate (> Overall growth rate + 10%) or
has significant barriers to entry into the business
has firm characteristics that are very different from the norm
Use a 3-Stage or n-stage Model
The Building Blocks of Valuation
Companies Valued
Company Model Used Remarks
Con Ed Stable DDM Dividends=FCFE, Stable D/E, Low g
DaimlerChrysler Stable FCFF Normalized Earnings; Stable Sector
ABN Amro 2-Stage DDM FCFE=?, Regulated D/E, g>Stable
Nestle 2-Stage FCFE Dividends≠FCFE, Stable D/E, High g
Tsingtao 3-Stage FCFE Dividends≠FCFE, Stable D/E,High g
General Information
The risk premium that I will be using in the latest valuations for mature equity markets is 4%. This is the average implied equity risk premium from 1960 to 2003 as well as the average historical premium across the top 15 equity markets in the twentieth century.
For the valuations from 1998 and earlier, I use a risk premium of %.
Stable Growth Model
Designed to value firms that are growing at a stable rate
Con Ed: Rationale for Model
The firm is in stable growth; based upon size and the area that it serves. Its rates are also regulated; It is unlikely that the regulators will allow profits to grow at extraordinary rates.
Firm Characteristics are consistent with stable, DDM model firm
The beta is and has been stable over time.
The firm is in stable leverage and ROE=10%
The firm pays out dividends that are roughly equal to FCFE.
Average Annual FCFE between 1999 and 2004 = $635 million
Average Annual Dividends between 1999 and 2004 = $ 624 million
Dividends as % of FCFE = 98%
Con Ed: A Stable Growth DDM: December 31, 2004
Earnings per share for 2004 = $ (Fourth quarter estimate used)
Dividend Payout Ratio over 2004 = %
Dividends per share for 2004 = $
Expected Growth Rate in Earnings and Dividends =2%
Con Ed Beta = (Bottom-up beta estimate)
Cost of Equity = % + *4% = %
Value of Equity per Share = $* / (.0742 ) = $
The stock was trading at $ on December 31, 2004
Con Ed: Break Even Growth Rates
Estimating Implied Growth Rate
To estimate the implied growth rate in Con Ed’s current stock price, we set the market price equal to the value, and solve for the growth rate:
Price per share = $ = $*(1+g) / (.0742 -g)
Implied growth rate = %
Given its retention ratio of % and its return on equity in 2003 of 10%, the fundamental growth rate for Con Ed is:
Fundamental growth rate = (.1694*.10) = %
You could also frame the question in terms of a break-even return on equity.
Break even Return on equity = g/ Retention ratio = .0211/.1694 = %
Implied Growth Rates and Valuation Judgments
When you do any valuation, there are three possibilities. The first is that you are right and the market is wrong. The second is that the market is right and that you are wrong. The third is that you are both wrong. In an efficient market, which is the most likely scenario?
Assume that you invest in a misvalued firm, and that you are right and the market is wrong. Will you definitely profit from your investment?
Yes
No
Con Ed: A Look Back
DaimlerChrysler: Rationale for Model
June 2000
DaimlerChrysler is a mature firm in a mature industry. We will therefore assume that the firm is in stable growth.
Since this is a relatively new organization, with two different cultures on the use of debt (Daimler has traditionally been more conservative and bank-oriented in its use of debt than Chrysler), the debt ratio will probably change over time. Hence, we will use the FCFF model.
Daimler Chrysler: Inputs to the Model
In 1999, Daimler Chrysler had earnings before interest and taxes of 9,324 million DM, Cash Holdings of 18,068 mil DM and had an effective tax rate of %.
Based upon this operating income and the book values of debt and equity as of 1998, DaimlerChrysler had an after-tax return on capital of %.
The market value of equity is billion DM, while the estimated market value of debt is billion
The bottom-up unlevered beta for automobile firms is , and Daimler is AAA rated (default spread=).
The long term German bond rate is % (in DM) and the mature market premium of 4% is used.
We will assume a long term growth rate of 3%.
Daimler/Chrysler: Analyzing the Inputs
Expected Reinvestment Rate = g/ ROC = 3%/% = %
Cost of Capital
Bottom-up Levered Beta = (1+()( =
Cost of Equity = % + (4%) = %
After-tax Cost of Debt = (% + %) ()= %
Cost of Capital = %( % ( = %
Daimler Chrysler Valuation
Estimating FCFF
Expected EBIT (1-t) = 9324 () () = 5,096 mil DM
Expected Reinvestment needs = 5,096(.42) = 2,139 mil DM
Expected FCFF next year = 2,957 mil DM
Valuation of Firm
Value of operating assets = 2957 / (.) = 112,847 mil DM
+ Cash = 18,068 mil DM
Value of Firm = 130,915 mil DM
- Debt Outstanding = 64,488 mil DM
Value of Equity = 66,427 mil DM
Value per Share = DM per share (913,714 shares)
Stock was trading at DM per share on June 1, 2000
2-stage Growth Model
Designed to value firms that experience extraordinary growth for a period of time
ABN Amro: Rationale for 2-Stage DDM in December 2003
As a financial service institution, estimating FCFE or FCFF is very difficult.
The expected growth rate based upon the current return on equity of 16% and a retention ratio of 51% is %. This is higher than what would be a stable growth rate (roughly 4% in Euros)
ABN Amro: Summarizing the Inputs
Market Inputs
Long Term Riskfree Rate (in Euros) = %
Risk Premium = 4% (. premium : Netherlands is AAA rated)
Current Earnings Per Share = Eur; Current DPS = Eur;
Variable High Growth Phase Stable Growth Phase
Length 5 years Forever after yr 5
Return on Equity % % (Set = Cost of equity)
Payout Ratio % % (1 - 4/)
Retention Ratio % % (b=g/ROE=4/)
Expected growth .16*.5135=.0822 4% (Assumed)
Beta
Cost of Equity %+(4%) %+(4%)
=% = %
ABN Amro: Valuation
Year EPS DPS PV of DPS (at %)
1
2
3
4
5
Expected EPS in year 6 = () = Eur
Expected DPS in year 6 = *= Eur
Terminal Price (in year 5) = = Eur
PV of Terminal Price = =
Value Per Share = + + + + + = Eur
The stock was trading at Euros on December 31, 2003
The Value of Growth
In any valuation model, it is possible to extract the portion of the value that can be attributed to growth, and to break this down further into that portion attributable to “high growth” and the portion attributable to “stable growth”. In the case of the 2-stage DDM, this can be accomplished as follows:
DPSt = Expected dividends per share in year t
r = Cost of Equity
Pn = Price at the end of year n
gn = Growth rate forever after year n
ABN Amro: Decomposing Value
Value of Assets in Place = Current DPS/Cost of Equity
= Euros/.0835
= Euros
Value of Stable Growth = ()/(.) - Euros
= Euros
(A more precise estimate would have required us to use the stable growth payout ratio to re-estimate dividends)
Value of High Growth = Total Value - (+)
= - (+ ) = Euros
Nestle: Rationale for Using Model - January 2001
Earnings per share at the firm has grown about 5% a year for the last 5 years, but the fundamentals at the firm suggest growth in EPS of about 11%. (Analysts are also forecasting a growth rate of 12% a year for the next 5 years)
Nestle has a debt to capital ratio of about % and is unlikely to change that leverage materially. (How do I know? I do not. I am just making an assumption.)
Like many large European firms, Nestle has paid less in dividends than it has available in FCFE.
Nestle: Summarizing the Inputs
General Inputs
Long Term Government Bond Rate (Sfr) = 4%
Current EPS = Sfr; Current Revenue/share =1,820 Sfr
Capital Expenditures/Share= Sfr; Depreciation/Share= Sfr
High Growth Stable Growth
Length 5 years Forever after yr 5
Beta
Return on Equity % 16%
Retention Ratio % (Current) NA
Expected Growth %*.651= % %
WC/Revenues % (Existing) % (Grow with earnings)
Debt Ratio % %
Cap Ex/Deprecn Current Ratio 50%
Estimating the Risk Premium for Nestle
Revenues Weight Risk Premium
North America % %
South America % %
Switzerland % %
Germany/France/UK % %
Italy/Spain % %
Asia % %
Rest of W. Europe 13 % %
Eastern Europe 4 % %
Total % %
The risk premium that we will use in the valuation is %
Cost of Equity = 4% + (%) = %
Nestle: Valuation
1 2 3 4 5
Earnings $ $ $ $ $
- (Net CpEX)*(1-DR) $ $ $ $ $
-D WC*(1-DR) $ $ $ $ $
Free Cashflow to Equity $ $ $ $ $
Present Value $ $ $ $ $
Earnings per Share in year 6 = () =
Net Capital Ex 6 = Deprecn’n6 * =()5()(.5)= Sfr
Chg in WC6 =( Rev6 - Rev5)(.093) = 1820()5(.04)(.093)= Sfr
FCFE6 = - () - ()= Sfr
Terminal Value per Share = = Sfr
Value=$ +$ +$ +$ +$ +3890/()5=3011Sf
The stock was trading 2906 Sfr on December 31, 1999
Nestle: The Net Cap Ex Assumption
In our valuation of Nestle, we assumed that cap ex would be 50% of depreciation in steady state. If, instead, we had assumed that net cap ex was zero, as many analysts do, the terminal value would have been:
FCFE6 = - () = Sfr
Terminal Value per Share = ) = 4986 Sfr
Value= $ +$ +$ +$ +$ + 4986/()5= Sfr
The Effects of New Information on Value
No valuation is timeless. Each of the inputs to the model are susceptible to change as new information comes out about the firm, its competitors and the overall economy.
Market Wide Information
Interest Rates
Risk Premiums
Economic Growth
Industry Wide Information
Changes in laws and regulations
Changes in technology
Firm Specific Information
New Earnings Reports
Changes in the Fundamentals (Risk and Return characteristics)
Nestle: Effects of an Earnings Announcement
Assume that Nestle makes an earnings announcement which includes two pieces of news:
The earnings per share come in lower than expected. The base year earnings per share will be Sfr instead of Sfr.
Increased competition in its markets is putting downward pressure on the net profit margin. The after-tax margin, which was % in the previous analysis, is expected to shrink to %.
There are two effects on value:
The drop in earnings will make the projected earnings and cash flows lower, even if the growth rate remains the same
The drop in net margin will make the return on equity lower (assuming turnover ratios remain unchanged). This will reduce expected growth.
3-stage Growth Model
Designed to value firms that is expected to go through three stages of growth
Tsingtao Breweries: Rationale for Using Model: June 2001
Why three stage? Tsingtao is a small firm serving a huge and growing market – China, in particular, and the rest of Asia, in general. The firm’s current return on equity is low, and we anticipate that it will improve over the next 5 years. As it increases, earnings growth will be pushed up.
Why FCFE? Corporate governance in China tends to be weak and dividends are unlikely to reflect free cash flow to equity. In addition, the firm consistently funds a portion of its reinvestment needs with new debt issues.
Background Information
In 2000, Tsingtao Breweries earned million CY(Chinese Yuan) in net income on a book value of equity of 2,588 million CY, giving it a return on equity of %.
The firm had capital expenditures of 335 million CY and depreciation of 204 million CY during the year.
The working capital changes over the last 4 years have been volatile, and we normalize the change using non-cash working capital as a percent of revenues in 2000:
Normalized change in non-cash working capital = (Non-cash working capital2000/ Revenues 2000) (Revenuess2000 – Revenues1999) = (180/2253)*( 2253-1598) = million CY
Normalized Reinvestment
= Capital expenditures – Depreciation + Normalized Change in non-cash working capital
= 335 - 204 + = million CY
As with working capital, debt issues have been volatile. We estimate the firm’s book debt to capital ratio of % at the end of 1999 and use it to estimate the normalized equity reinvestment in 2000.
Inputs for the 3 Stages
High Growth Transition Phase Stable Growth
Length 5 years 5 years Forever after yr 10
Beta Moves to
Risk Premium 4%+% --> 4+%
ROE %->12% 12%->20% 20%
Equity Reinv. % Moves to 50% 50%
Exp Growth % Moves to 10% 10%
We wil asssume that
Equity Reinvestment Ratio= Reinvestment (1- Debt Ratio) / Net Income
= = () / = %
Expected growth rate- next 5 years
= Equity reinvestment rate * ROENew+[1+(ROE5-ROEtoday)/ROEtoday]1/5-1
= *.12 + [(1+(.)/.028)1/5-1] = %
Tsingtao: Projected Cash Flows
Tsingtao: Terminal Value
Expected stable growth rate =10%
Equity reinvestment rate in stable growth = 50%
Cost of equity in stable growth = %
Expected FCFE in year 11
= Net Income11*(1- Stable period equity reinvestment rate)
= CY ()() = CY million
Terminal Value of equity in Tsingtao Breweries
= FCFE11/(Stable period cost of equity – Stable growth rate)
= = CY 18,497 million
Tsingtao: Valuation
Value of Equity
= PV of FCFE during the high growth period + PV of terminal value
=+CY18,497/(*****)
= CY 4,596 million
Value of Equity per share = Value of Equity/ Number of Shares
= CY 4,596/ = CY per share
The stock was trading at Yuan per share, which would make it overvalued, based upon this valuation.
Classifying DCF Models
Examples
Appendix
Tube Investments
2-stage FCFF
The value of growth
Embraer
2-stage FCFF
Emerging Market company
Embraer: An Emerging Market Company? A Valuation in October 2003
We will use a 2-stage FCFF model to value Embraer to allow for maximum flexibility.
High Growth Stable Growth
Beta
Lambda
Counry risk premium % %
Debt Ratio % %
Return on Capital % %
Cost of Capital % %
Expected Growth Rate % %
Reinvestment Rate % %/% = %
Embraer’s Cash and Cross Holdings
Embraer has a 60% interest in an equipment company and the financial statements of that company are consolidated with those of Embraer. The minority interests (representing the equity in the subsidiary that does not belong to Embraer) are shown on the balance sheet at 23 million BR.
Estimated market value of minority interests = Book value of minority interest * P/BV of sector that subsidiary belongs to = * = million BR or $ million dollars.
Present Value of FCFF in high growth phase = $1,
Present Value of Terminal Value of Firm = $3,
Value of operating assets of the firm = $5,
+ Value of Cash, Marketable Securities = $
Value of Firm = $6,
Market Value of outstanding debt = $
- Minority Interest in consolidated holdings = = $
Market Value of Equity = $5,
- Value of Equity in Options = $
Value of Equity in Common Stock = $5,
Market Value of Equity/share = $
Market Value of Equity/share in BR = * BR/$ = R$
Tube Investment: Rationale for Using 2-Stage FCFF Model - June 2000
Tube Investments is a diversified manufacturing firm in India. While its growth rate has been anemic, there is potential for high growth over the next 5 years.
The firm’s financing policy is also in a state of flux as the family running the firm reassesses its policy of funding the firm.
Stable Growth Rate and Value
In estimating terminal value for Tube Investments, I used a stable growth rate of 5%. If I used a 7% stable growth rate instead, what would my terminal value be? (Assume that the cost of capital and return on capital remain unchanged.)
The Effects of Return Improvements on Value
The firm is considering changes in the way in which it invests, which management believes will increase the return on capital to % on just new investments (and not on existing investments) over the next 5 years.
The value of the firm will be higher, because of higher expected growth.
Return Improvements on Existing Assets
If Tube Investments is also able to increase the return on capital on existing assets to % from %, its value will increase even more.
The expected growth rate over the next 5 years will then have a second component arising from improving returns on existing assets:
Expected Growth Rate
= .122*.60 +{ (1+(.)/.092)1/5-1} =.1313 or %
You can estimates cashflows, growth rates and discount rates for equity valuation or firm valuation, but you ultimately have to make a choice about how you will approach valuation.
When leverage is stable, you can use the short cut for estimating free cashflows to equity. When leverage is changing, estimating cashflows to equity becomes problematic because you have to estimate how much cash will be raised from new debt issues and how much old debt will be paid off each year. While you have to adjust the cost of capital in the firm valuation approach for changing leverage, this is much simpler to do than estimating cashflows.
As a rule, firm valuation is a more flexible approach than equity valuation.
Restrict the use of the dividend discount model to those firms where you cannot estimate free cashflows to equity easily - because you cannot identify the net capital expenditures and working capital investments of the firm.
In all other cases where you have decided to do equity valuation, you will be on safer ground using the free cashflows to equity model.
In theory, you can make the two models converge by adding the cash accumulated by not paying out dividends to the terminal value in the dividend discount model. In practice, it is difficult to do.
Consistency is key.
The biggest limitation of the two-stage model is the abrupt change in fundamentals (growth, risk and returns) that occurs as the firm goes from high growth to stable growth. The present value effect is small, though, when you are going from a 10% growth rate to a 5% growth rate and you can use a 2-stage model. If the growth rate is much higher, you should allow for a transition phase to allow time for the inputs to adjust over time.
DCF valuation models are like Lego blocks. Combining a cash flow, a discount rate and a growth pattern yields a valuation model.
When the objective is to decide whether to invest in a stock or not, you cannot make this judgment without passing judgment on the market.
If you want to be market neutral (assume that the market is, on average, right, you should use the current implied equity risk premium.
If you assume that the market is correct on average over long time periods but not necessarily at this point in time, you would use the average implied equity risk premium over time (about 4%)
If you are a strong believer in mean reversion, you would go with the historical risk premium
This may be one of the few cases where you can justify using a dividend discount model. The firm is stable and pays out its free cashflows to equity as dividends. It debt ratio has remained relatively unchanged over the last few years. As a regulated company, the growth in earnings will also be kept under check by the regulatory authorities - if earnings grow faster than inflation, the firm will probably not be allowed rate increases.
Stable growth dividend discount model in action. Note that we are using the trailing twelve month data in this valuation.
Stock looks slightly over valued.
There is some growth rate at which you can justify the current market price. The growth rate is called an implied growth rate.
Solving for the implied growth rate, we get %. Assuming that the market and you are in agreement on the other inputs, the question about whether you should invest in Con Ed boils down to a question of whether their earnings can grow faster than % a year in the long term. The fundamental growth rate is slightly higher (%) and suggests that Con Ed may have a tough time maintaining a % growth rate.
The third possibility is probably the most likely one, but you still want to be closer to the true value.
Even if you are right, there is no guarantee that you will make excess returns because the market has to see its mistakes and correct them.
No valuation is timeless and no recommendation is forever. Stocks can go from being under to over valued back to being under valued.
A cyclical, volatile firm can be a stable growth firm. The growth rate is stable on average, but is likely to swing wildly around this table growth rate.
I eliminated one-time charges and income in estimating earnings before interest and taxes.
The reinvestment rate is estimated from the growth and the return on capital. The cost of capital is low, reflecting both Daimler’s low default risk and the substantial debt that it has on its balance sheet.
This valuation is based upon the assumption that Daimler Chrysler will earn % as its return on capital in perpetuity, which is higher than its cost of capital of %. If I assume that the excess returns go to zero, the value per share will drop significantly.
In discounting FCFF, we use the cost of capital, which is calculated using the market values of equity and debt. We then use the present value of the FCFF as our value for the firm and derive an estimated value for equity. Is there circular reasoning here?
There is circular reasoning involved because the market values of equity and debt are both inputs (in computing the cost of capital) and outputs. If you want to get around this problem, you would need to re-estimate the cost of capital using your estimated values, which would change your estimated values, which would change your cost of capital…. Fortunately, there will be convergence at some point in this process.
A cop out… No doubt… You could try to estimate the free cashflow to equity for a bank but you will find yourself quickly stymied by how little information is revealed by firms. There is also the added rationale that equity retained in a bank increases equity capital which is required for the bank to expand (because of regulatory constraints on capital).
I used the German Eurobond rate as the riskfree rate.
There is an argument to be made that Amro’s exposure to country risk should be reflected in a higher risk premium.
The firm’s risk, return on equity and payout ratio changes as the firm goes from being a high-growth to a stable-growth firm.
In year 6, the growth decreases and the payout ratio increases. You cannot take dividends in year 5 and grow them one year at 5% because of the change in the dividend payout ratio.
Note that the new cost of equity is used to estimate the terminal value, but the terminal value is discounted back at the current cost of equity.
Presents the same valuation as a picture.
Decomposes a discounted cash flow value into its component parts. You can change the cost of equity you use for each part to preserve consistency. For instance, you could use the stable period cost of equity to estimate the value of assets in place and stable growth.
The higher the percentage of the value that comes from high growth, the more sensitive the value will be to changes in perceptions and expectations about the future.
Looks like high growth is feasible in the near term, but the firm’s size will probably operate as an impediment to maintaining this growth over the long term.
As growth changes, the return on equity and net cap ex as a percent of revenues drops to industry averages.
Nestle’s exposure to emerging markets results in the use of a higher cost of equity. We should probably routinely do this for all multi-national firms. The revenue weights may not be the best mechanism for weighting the risk premiums, but they represent one of the few pieces of public information that Nestle offers about its exposure.
Note that the net cap ex adjusts in year 6 to become 50% of depreciation (cap ex is 150% of depreciation) and that the non-cash working capital change is computed based upon the revenue change in year 6 (and not by growing the non-cash working capital change in year 5).
The value is higher but the increase in value is illusory. Firms cannot grow without reinvesting….
Nestle’s valuation as a picture.
When new information arrives, you have to consider which inputs to the valuation should change and how to change them. Some of the changes are simple - an increase in interest rates, for instance, changes the cost of capital- and others can be more complex.
There are two pieces of news in this announcement. The first is about the base year earnings (which have decreased). The more important news is about margins. The drop in margins will reduce the return on equity and thus, the expected growth rate in earnings per share.
Small earnings surprises can translate into big changes in value.
If the changes that a firm has to go through to reach stable growth are larger, it is a good idea to go to a 3-stage model and allow for gradual changes in the inputs.
When corporate governance is weak, managers will accumulate cash and pay out less than the FCFE.
Note that the actual change in non-cash working capital bore no resemblance to the normalized change. We have used normalized values to smooth out the year-to-year changes in these numbers.
The high growth rate in the first 5 years comes in large part from the improvement in return on equity on existing assets from % to 12%. I am assuming that this improvement occurs in linear increments over the next 5 years. The new investments are assumed to start making 12% immediately.
Inflation rate is high at around 10%. Stable growth converges to the risk free rate of the economy, which is assumed to be 10%
Note the large negative free cashflows to equity during the first few years. In these years, Tsingtao will have to raise fresh equity to cover its cash requirements. If it cannot, it will have to scale back its investment plans and reinvest less.
The stable growth rate seems high but the valuation is in Chinese Yuan, with higher expected inflation. The discount rate is also high to reflect the high inflation.
Tsingtao seems overvalued, but there is a range around this valuation. Each of the inputs is estimated with noise or error, and the output (value) reflects this errors. Firm does look overvalued.
Uses the lambda estimate from earlier in the notes. Note that we are assuming that there are no excess returns after year 5 and that the country risk premium will drop after year 5 (as Brazil becomes a safer country).
Questions to consider:
What would the value of Embraer be if we use the conventional approach of adding the country risk premium to the cost of equity? (It would raise the cost of equity to about 16% and reduce the value per share by about 50%).
What would happen if we used a stable growth rate of 3% instead of %? (Nothing… since we are assuming zero excess returns)
Note that we estimate the market value of minority interests rather than use the book value….
Tube Investments is in a multitude of businesses, none of which are high growth. The high growth potential comes from the fact that earnings are depressed now….
The value is low… the culprit is the return on capital (%) which is much lower than the cost of capital (%). This firm has assets that are destroying value and is continuing to invest in new assets that destroy even more value… In other words, you have a value destroying machine in place.
Increasing the growth rate will reduce the terminal value. To see why, note that the reinvestment rate will have to rise:
New reinvestment rate = g/ ROC= 7%/% = %
Terminal value = 5790 () ()/(.) = Rs 26,206 million
Why? Because the return on capital is lower than the cost of capital.
If the return on capital had been equal to the cost of capital, the terminal value would not change as the growth rate changed. In such a case, you can estimate the terminal value, ignoring growth:
Terminal value when ROC = Cost of capital = EBIT (1-t)/ Cost of capital
If the return on capital is greater than the cost of capital, increasing growth will increase terminal value.
Note that even the % is lower than the cost of capital but it makes the firm a smaller value destroyer….
Note that the growth rate increases and the value per share also increases.
The improvement in assets in place will increase the growth rate in the near term.
Value per share increases by Rs. 30 per share. This firm gets a much bigger payoff from managing existing assets better than from finding new investments that earn a higher return.
