Lecture 1 (CH1 +2)
Value vs Price
● Price is what you pay, value is what you get
Drivers of value are cash flows (return) and risk associated with cash flows (discount rate).
- Impacted by investor risk aversion
- Not impacted by short-run fads or memes (low volatility)
- Low short-run volatility
Drivers of price are demand and supply
- Impacted by liquidity and control considerations
- Impacted by short-run fads or memes (high volatility)
- High short-run volatility
* liquidity is the cost you have to bear when you have to do an investment. The more illiquid
the asset the steeper the discount (e.g. Rembrand painting / buying 49% vs. 51% of the
shares of a company → control premium)
In efficient markets, value and price converge
P/E ratio: the price of the company/index reflects the ‘x’ amount of the earnings per share of
the company/index.
3 valuation approaches: fundamental valuation, relative valuation and other methods
1. Fundamental valuation:
a. firms which are close to the end of their life and close to liquidation
Asset-based method (APV)
i. Book value method (use accounting book value as the measure of the
value of the assets)
ii. Liquidation value method (aggregating the estimated sale proceeds of
the assets owned by a firm)
iii. Replacement value method (estimate what it would cost to replace all
of the assets that a firm has today)
b. Firms that are still very much alive (estimates
Income-based method (estimates intrinsic value)
i. Abnormal profit (AP) model
ii. Abnormal profit growth (APG) model
iii. Discounted cashflow valuation (superior)
, 2. Relative valuation
Market-based method (compare price of assets to the price of other assets
in the market)
i. Trading multiples
ii. Transaction multiples
Discounted Cashflow Valuations (book)
DCF: relates the value of an asset to the present value of the expected future cash flows on
that asset.
Equity valuation: ‘cash flows considered are cash flows from assets, after debt payments
and after making reinvestments needed for future growth. Discount rate reflects only the cost
of raising equity financing. Present value is value of just the equity claims on the firm’ (p. 13)
Firm valuation: ‘cash flows considered are cash flows from assets, prior to any debt
payments but after the firm has reinvested to create growth assets. Discount rate reflects the
cost of raising both debt and equity financing, in proportion to their use. Present value is
value of the entire firm, and reflects the value of all claims on the firm’ (p. 13)
Dividend discount model: the value of equity is the present value of expected future
dividends.
Effects of debt:
- Positive → tax deductibility of interest expenses provides a tax subsidy or benefit to
the firm
- Negative → increases the likelihood that the firm will default on its commitments
Cost of Capital: cost of equity + pretax cost of debt (1- tax rate)
Adjusted present value method (APV): separate the effects on value of debt financing from
the value of the assets of a business → value the business as if it were all equity funded and
assess the effect of debt separately.
APV = value of business with 100% equity financing + PV of expected tax benefits of debt -
expected bankruptcy costs.
,Total cash flow model vs excess cash flow models
Assumption: $100M invested, $12M in cash flows after tax in perpetuity, CoC 10%
Total CF model: $12M / 0.1 = $120M
Excess return CF model: = CF earned - CoC * Capital invested = $12M - 0.1*$100M = $2M
= PV of excess return + investment on the asset
= $2M / 0.1 + $100M = $120M
The DCF method does not work well when:
1. Firms are in trouble (negative cash flows)
2. Cyclical firms (negatieve earnings)
3. firm s with unutilized assets
4. Firms with patents or product options
5. Firms in the process of restructuring
6. Firms involved in acquisitions
7. Private firms
Relative valuations (book)
Often used measurements and multiples are the price to earnings ratio (PE) and price to
book ratio (PB) and EV/EBITDA.
Relative valuations rely mostly on the market being ‘right’ rather than intrinsic value of a
company. Assumption: the market is right in pricing stocks on average but the market makes
errors in pricing individual stocks.
Cross-sectional vs time series comparisons
Cross-sectional: when we compare the PE ratio of a software firm to the average PE ratio of
other software firms, we are doing relative valuation and we are making cross-sectional
comparisons → you cannot make comparisons between firms without assessing their
fundamentals.
Comparisons across time: if you have a mature firm with a long history, you can compare the
multiple it trades at today to the multiple it used to trade at in the past → assume that the
firm's fundamentals have not changed over time. Complications are changes in macro
environments and interest rates. (low interest rates, higher multiples)
, Contingent claim valuation
The value of an asset may be greater than the present value of expected cash flows if the
cash flows are contingent on the occurrence or nonoccurrence of an event. Assets e.g.
patents, or undeveloped reserves → option pricing model
A contingent claim or option is a claim that pays off only under certain contingencies - if the
value of the underlying asset exceeds a prespecified value for a call option or is less than a
prespecified value for a put option.
Fundamental premise: discounted CF models tend to understate the value of assets that
provide payoffs that are contingent on the occurrence of an event. E.g. an undeveloped oil
reserve belonging to Exxon Mobil. The market recognizes these values in options and prices
them accordingly.
CH3
Net income to shareholders = revenues - operating expenses - financial expenses - taxes -
(+) extraordinary losses/profits - income changes associated with accounting changes -
preferred dividends
Net change in cash balance = cash flows from operations + cash flows from investing + cash
flows from financing (see p.29)
Valuation of assets in accounting principles:
1. An abiding belief in book value as the best estimate of value
2. A distrust of market or estimated value
3. A preference for underestimating value rather than overestimating it
1. Free cashflow to equity (FCFE)
a. CF available to equity holders after interest payments and debt repayments
i. Equity value
2. Free cashflow to firm (FCFF)
a. Aggregate CF available to all providers of capital
b. Does not distinguish between debt & equity holders
(see slide: discounted cashflow valuation)
What drives value:
Value vs Price
● Price is what you pay, value is what you get
Drivers of value are cash flows (return) and risk associated with cash flows (discount rate).
- Impacted by investor risk aversion
- Not impacted by short-run fads or memes (low volatility)
- Low short-run volatility
Drivers of price are demand and supply
- Impacted by liquidity and control considerations
- Impacted by short-run fads or memes (high volatility)
- High short-run volatility
* liquidity is the cost you have to bear when you have to do an investment. The more illiquid
the asset the steeper the discount (e.g. Rembrand painting / buying 49% vs. 51% of the
shares of a company → control premium)
In efficient markets, value and price converge
P/E ratio: the price of the company/index reflects the ‘x’ amount of the earnings per share of
the company/index.
3 valuation approaches: fundamental valuation, relative valuation and other methods
1. Fundamental valuation:
a. firms which are close to the end of their life and close to liquidation
Asset-based method (APV)
i. Book value method (use accounting book value as the measure of the
value of the assets)
ii. Liquidation value method (aggregating the estimated sale proceeds of
the assets owned by a firm)
iii. Replacement value method (estimate what it would cost to replace all
of the assets that a firm has today)
b. Firms that are still very much alive (estimates
Income-based method (estimates intrinsic value)
i. Abnormal profit (AP) model
ii. Abnormal profit growth (APG) model
iii. Discounted cashflow valuation (superior)
, 2. Relative valuation
Market-based method (compare price of assets to the price of other assets
in the market)
i. Trading multiples
ii. Transaction multiples
Discounted Cashflow Valuations (book)
DCF: relates the value of an asset to the present value of the expected future cash flows on
that asset.
Equity valuation: ‘cash flows considered are cash flows from assets, after debt payments
and after making reinvestments needed for future growth. Discount rate reflects only the cost
of raising equity financing. Present value is value of just the equity claims on the firm’ (p. 13)
Firm valuation: ‘cash flows considered are cash flows from assets, prior to any debt
payments but after the firm has reinvested to create growth assets. Discount rate reflects the
cost of raising both debt and equity financing, in proportion to their use. Present value is
value of the entire firm, and reflects the value of all claims on the firm’ (p. 13)
Dividend discount model: the value of equity is the present value of expected future
dividends.
Effects of debt:
- Positive → tax deductibility of interest expenses provides a tax subsidy or benefit to
the firm
- Negative → increases the likelihood that the firm will default on its commitments
Cost of Capital: cost of equity + pretax cost of debt (1- tax rate)
Adjusted present value method (APV): separate the effects on value of debt financing from
the value of the assets of a business → value the business as if it were all equity funded and
assess the effect of debt separately.
APV = value of business with 100% equity financing + PV of expected tax benefits of debt -
expected bankruptcy costs.
,Total cash flow model vs excess cash flow models
Assumption: $100M invested, $12M in cash flows after tax in perpetuity, CoC 10%
Total CF model: $12M / 0.1 = $120M
Excess return CF model: = CF earned - CoC * Capital invested = $12M - 0.1*$100M = $2M
= PV of excess return + investment on the asset
= $2M / 0.1 + $100M = $120M
The DCF method does not work well when:
1. Firms are in trouble (negative cash flows)
2. Cyclical firms (negatieve earnings)
3. firm s with unutilized assets
4. Firms with patents or product options
5. Firms in the process of restructuring
6. Firms involved in acquisitions
7. Private firms
Relative valuations (book)
Often used measurements and multiples are the price to earnings ratio (PE) and price to
book ratio (PB) and EV/EBITDA.
Relative valuations rely mostly on the market being ‘right’ rather than intrinsic value of a
company. Assumption: the market is right in pricing stocks on average but the market makes
errors in pricing individual stocks.
Cross-sectional vs time series comparisons
Cross-sectional: when we compare the PE ratio of a software firm to the average PE ratio of
other software firms, we are doing relative valuation and we are making cross-sectional
comparisons → you cannot make comparisons between firms without assessing their
fundamentals.
Comparisons across time: if you have a mature firm with a long history, you can compare the
multiple it trades at today to the multiple it used to trade at in the past → assume that the
firm's fundamentals have not changed over time. Complications are changes in macro
environments and interest rates. (low interest rates, higher multiples)
, Contingent claim valuation
The value of an asset may be greater than the present value of expected cash flows if the
cash flows are contingent on the occurrence or nonoccurrence of an event. Assets e.g.
patents, or undeveloped reserves → option pricing model
A contingent claim or option is a claim that pays off only under certain contingencies - if the
value of the underlying asset exceeds a prespecified value for a call option or is less than a
prespecified value for a put option.
Fundamental premise: discounted CF models tend to understate the value of assets that
provide payoffs that are contingent on the occurrence of an event. E.g. an undeveloped oil
reserve belonging to Exxon Mobil. The market recognizes these values in options and prices
them accordingly.
CH3
Net income to shareholders = revenues - operating expenses - financial expenses - taxes -
(+) extraordinary losses/profits - income changes associated with accounting changes -
preferred dividends
Net change in cash balance = cash flows from operations + cash flows from investing + cash
flows from financing (see p.29)
Valuation of assets in accounting principles:
1. An abiding belief in book value as the best estimate of value
2. A distrust of market or estimated value
3. A preference for underestimating value rather than overestimating it
1. Free cashflow to equity (FCFE)
a. CF available to equity holders after interest payments and debt repayments
i. Equity value
2. Free cashflow to firm (FCFF)
a. Aggregate CF available to all providers of capital
b. Does not distinguish between debt & equity holders
(see slide: discounted cashflow valuation)
What drives value:
