Corporate Finance 101: Equity Valuation

In finance, as in life, price and value are all too easy to mix up.

Intrinsic value is intangible, so it can only be estimated (by models), not measured.

For a publicly traded firm, market capitalisation is synonymous with valuation. The difference between value and valuation is what keeps the investing industry alive and awake, however.

Going concern, liquidation, or sum-of-the-parts? Take your pick of valuation models.

Absolute valuation models focus on a point estimate of intrinsic value. They are invariably based on the concept of Net Present Value.

The idea of Net Present Value (NPV) is one of the most fundamental in all of finance - and it all starts with compound interest.

NPV and price are related: if NPV > price, the asset is undervalued, and should be bought ASAP! If NPV < price, the asset is overvalued - don't buy it.

Calculate the NPV of a cash flow in the future. The cash flow is deterministic, btw.

The higher the compounding frequency on the risk-free instrument, the higher the discount rate.

Taken to its limit, compounding could be continuous. This yields the highest possible discount factor, given a certain discount rate.

Calculating the NPV of a stream of cash flows in the future is one of the most common use-cases in all of finance. Its used across bond math as well as corporate finance.

Discounting risky cash flows presents a challenge: you can either increase the discount rate (by risk-adjusting it) or decrease the cash flow (replace it with its certainty equivalent). Almost everyone does the former. 

Assets with the same risk should offer the same return. This is the principle underlying risk-return models. We see a simple example of a risk-return model, calculating the cost of debt for a firm from its credit rating and the duration of the borrowing.

The CAPM is the most widely known and widely used risk-return model for equities. Understand how the CAPM works, what market beta is, and how the ERP can (or rather can not) be cleanly measured.

The overall cost of capital for a firm with both debt and equity is given by the wacc. This is a weighted average of the costs of debt and equity. The weights used in the average? The market prices of debt and equity respectively.

Interest expenses are pre-tax, while dividend payments are not. So, from the point-of-view of a firm, we need to reduce the cost of debt using an adjustment for the tax shield.

Be careful to use the WACC for all cash flows related to a firm. This leads to a few strange situations (eg negative cash flows) but at least it is consistent and transparent.

Top-down betas are obtained from regression, but are very noisy (standard errors in regressions are quite large!) Instead, we should use bottoms-up betas, especially for conglomerates. Understand the intuition, as well as the outline of the procedure.

If you are valuing a private company, the beta you really ought to use in your WACC calculation is not the market beta, its the total beta.

The beta that we get via regression, or (on Yahoo FInance:-)) is a levered beta, which reflects the market co-movement of a company at its current level of leverage. There is a simple way to unlever and relever betas. 

Debt is an important part of WACC. Don't forget to take operating leases as well.

Don't forget leases, including operating leases!

Dividend Discount Models are a specific family of absolute value models that discount dividends. These can seem simplistic, but have a lot of simple wisdom embedded within.

DDM have a neat relationship between the price of a stock today, its price in the future, and the dividends in the period in between.

Depending on the company's growth and stage in its life-cycle, different DDM profiles can be applied to model its growth.

A cash cow is a company with zero growth. Cash cows are not as uncommon as you might think - look no further than many state-owned resource firms.

The Gordon Growth Model works best for stable-growth, dividend paying companies.

Micro Econ 101 dictates that firms experience a period of extra-ordinary growth early in their lives, before perfect competition sets in. At that point, growth subsides. We explore a few Dividend Discount Models that allow us to model this.

Free Cash Flow valuation is conceptually similar to Dividend Discount Valuation, but the FCF method can be used for a far wider range of firms, and in a far wider range of situations. This is the real deal in equity valuation.

FCFF is free cash flow available to all providers of capital to the firm (both debt and equity). FCFE is the free cash flow available only to equity holders.

The easiest way to calculate FCFF is from the Cash Flow Statement. FCFF is basically Cash Flow from Operations (CFO), minus Investments in Fixed Assets, plus tax-adjusted interest expense.

FCFE is simply FCFF minus payments from the equity holders to the debt holders, plus payments from debt holders to equity holders:-)

FCFF and FCFE each have their strengths and weaknesses. We also discuss an alternative discounting method of valuation, called the Adjusted Present Value (APV) method, which discounts FCFF using the cost of equity. This allows valuation with having to calculate the WACC, but it is tricky for another reason: determining the costs of financial distress.

There are 2 reasons why Net Income can't be used: for one, it does not take into account investments that are required to maintain the operations of the firm in the future, and for another, it includes various non-cash items, notably depreciation. EBITDA has both of these flaws, and in addition, it also has a third: it is a pre-tax measure. And of course taxes have to be deducted from any measure of cash flows to the capital providers of a firm (the government is not, usually, a capital provider!)

We discuss non-cash charges, preferred stock (include in FCFF, remove from FCFE), non-operating assets, and forecasting FCFF and FCFE

The proportion of debt and equity that a firm chooses is known as its capital structure. We also look at 3 important decisions that firms have to make: the investment decision, the financing decision, and the dividend decision.

The second of the famous Modigliani-Miller propositions is easier to arrive at intuitively than the first, so let's start there - we see how leverage makes good times better, and bad times worse. 

We now circle back to the first, and more famous, Modigliani-Miller proposition:  leverage, by itself can not change the value of a company.

The M-M propositions, as we studied them so far, made some important assumptions about the world a firm operated in - the most important and unrealistic of these was the absence of taxes. Let's now factor in the effect of taxes.