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Finance 3321 (Moore) Lecture 1 on Valuation and Cost of Capital
Prospective Analysis: Valuation Theory Basics
Key Learning Outcomes
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Developing a broad set of valuation measures
The ability to estimate the appropriate cost of capital
Working with growth rates and terminal values (equilibrium)
Valuation with Multiples (screening methods)
Theory based valuation models
Understanding the residual income and abnormal earnings valuation models
Matching costs of capital with financial statement data and forecasts
The ability to understand and measure Abnormal Earnings and Growth for
terminal values
Assessing the implied cost of capital given the current market price (value)
Earnings Multiples Valuation
(Method of Comparables)
1992
Company
EPS
BPS
DPS
Chrysler
Daimler-Benz
Federal Signal
Ford Motor, Canada
Ford Motor, US
General Motors, US
Honda Motor, Ltd.
Navistar, Intl.
Paccar, Inc.
2.21 25.5 0.60
Not Traded in US
1.00 5.23 0.42
-35
64.2 0.00
-15.6 30.1 1.60
-38.3 8.47 1.40
0.67 18.31 0.24
-0.95 0.37 0.00
1.93 30.7 1.30
1993
PPS
EPS
BPS
DPS
PPS
32.25
-7.62
0.74
1.15
-22.5
4.55
2.13
0.47
-15.5
4.21
19.3
21.7
5.81
39.9
31.2
7.77
19.3
7.10
32.8
0.65
8.01
0.48
0.00
1.60
0.80
0.27
0.00
0.00
53.25
48.63
28.00
95.50
64.50
54.88
32.38
27.25
61.25
21.25
85.5
42.88
32.25
25.50
1.88
57.25
Required:
a. Calculate estimated prices in 1992 and 1993 for Chrysler using averages
multiples of earnings, book values and dividends of the other firms in the
industry. Which valuation comes closest to the actual price?
b. List and explain the reservations (problems) you identify in using the multiples.
c. All else being equal, would you expect the price of a firm with a high dividend
payout ratio to be higher or lower than that of comparison firms? Explain.
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Finance 3321 (Moore) Lecture 1 on Valuation and Cost of Capital
Method of Comparables (Mechanics and Logic) – Screening Tool
A. Determine Relevant Valuation Multiples
1. Take relevant industry averages (excluding firm to be analyzed)
a. Omit negative values and (possibly) large outliers
2. Possible measure to use:
a. P/E
(trailing)
b. P/E
(forecast)
c. P/B
d. D/P
e. P.E.G. (Price/Earnings) / (1-Year ahead Earnings Growth Rate)
f.
P/EBITDA (un-levered measure)
g. P/(FCF per share)

FCF = CFFO + CFFI (physical assets) +/- CFFF (Change in Debt)
h. (Enterprise Value)/(EBITDA) or (Enterprise Value)/(FCF)
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Enterprise Value = EV
EV = Market Value of Equity + Value Liabilities – (Cash and Financial
Investments)
Compute Industry Average EV/FCF or EV/EBITDA and then value your
firm
B. Compute Value based on Average Multiple (comparable) and forecast metric
1. Example for P/E (forecast)
average
 P
PPSassessed, t  E ( EPSt 1 ) *  
 E  comparable firms
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Finance 3321 (Moore) Lecture 1 on Valuation and Cost of Capital
C. Examine Price (PPS) assessment across all multiples.
1. Commonly, there exist a wide range of values
2. No “theory” to state which valuation multiple is “best”
3. Keep in mind you are not doing an “intrinsic” valuation
a. Industry average benchmarks are determined by market consensus
D. Workshop on PEG, P/EBITDA; P/FCF; EV/FCF.
1. Sample Companies (Broad-Line Semi-Conductors)
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Mkt Cap
STMICROELECTRONICS [STM]
ANALOG DEVICES [ADI]
MAXIM INTEGRATED [MXIM]
NATL SEMICONDUCTOR [NSM]
ADV MICRO DEVICES [AMD]
$17.3 B
$12.3 B
$10.5 B
$8.8 B
$7.5 B
2. Value Maxim Integrated (MXIM) Using Valuation Multiples
PEG
STM
ADI
NSM
AMD
MXIM
1.69
1.63
1.36
EBITDA
2.46
0.814
0.645
0.705
1.81
0.925
NA
Levered
FCF
EV
0.168
0.235
0.292
-1.05
0.224
Data from Yahoo Finance
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16.63
11.52
8.04
10.18
MVE
17.4
12.32
8.82
7.45
Shares
P
0.89742
0.327
0.3103
0.55044
9.14
10.46
0.32007
19.41 Billions
37.68
28.43
13.53
32.7
Finance 3321 (Moore) Lecture 1 on Valuation and Cost of Capital
Which cost of Capital? (Matching with financial statements)
1. Weighted Average Cost of Capital (WACC)
WACC AT 
Vd
Ve
rd (1  T ) 
r

Vd  Ve
Vd  Ve e
2. Capital Asset Pricing Model (CAPM)
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Formula
What about Leverage??
3. Discounted Earnings or Cash Flow?
 Free Cash Flow?
Intrinsic Valuation Methods
A. Intrinsic Valuation
1. Involves Detailed Forecasts and Analysis
2. Requires substantial professional judgment and estimates
3. Is the analyst’s “opinion” (assessment) of firm value (not consensus)
4. Can help identify under-valued; over-valued; and “reasonably” valued firms
5. Severe differences between Intrinsic and Market values should be examined
6. Utilizes present values
B. Popular Valuation Methods Available
1. Discounted Dividends
2. Discounted Free-Cash Flows
3. The Residual Income Method (accounting based)
4. Abnormal Earnings Approach (accounting based)
5. Residual Income Perpetuity
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Finance 3321 (Moore) Lecture 1 on Valuation and Cost of Capital
C. Discounted Dividends Valuation
1. The Model

PPS t 

t 1
~


E  d t 1 
1  k 
t
e
or (in perpetuity)
~

E  d t 1 
PPSt 
r g
2. Examine data requirements and estimates
3. Empirical considerations
D. Residual Income Valuation
1. Foundations: Consistent with Modigliani and Miller Model (and intuition)
a. Finance Model (Market Value Based)
VF = VD + VE
(Market Values)
b. Balance Sheet (Accounting Value Based)
A=L+E
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(Accounting Values)
Finance 3321 (Moore) Lecture 1 on Valuation and Cost of Capital
2. Residual Income (RI) Valuation Model

VE, t  BVEt 

~
 E ( NI

t  1 )  k e ( BVEt )
 t

t0
1  k 
t 1
e
a. Examine data requirements and estimates
b. Empirical considerations
E. Discounted Free Cash Flows
VE , 0
 ~ 
Et  FCFt 


  Liabilitie s

MV , 0
t


1

WACC
t 1
BT , t
1. Examine data requirements and estimates
2. Empirical considerations
3. Difference between accounting earnings and free cash flow (conceptual)
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