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BOND VALUATIONS

BOND: A security sold by governments and corporations to raise money from investors today in exchange

for promised future payments

ZERO COUPON BONDS: A bond that does not make coupon payments

• Although the bond pays no ‘interest’ directly, as an investor you are compensated for the time

value of your money by purchasing the bond at a discount to its face value

• EG: TREASURY BONDS: US government bonds with a maturity of up to one year – Zero-coupon bonds

𝑭𝑽 𝟏

𝑷𝟎 = 𝑭𝑽 𝒏

(𝟏 + 𝒓𝒏 )𝒏 𝒀𝑻𝑴𝒏 = ' + − 𝟏

𝑷

ZERO COUPON BONDS PROVIDE A RISK-FREE RETURN: Because a default-free zero-coupon bond that

matures on date n provides a risk-free return over the same period, the LAW OF ONE PRICE guarantees that

the risk-free interest rate equals the YTM on such a bond

• AKA: Spot Interest rates

𝒓𝒏 = 𝒀𝑻𝑴𝒏

We often refer to the YTM of the appropriate maturity, zero-coupon risk-free bond

as the risk-free interest rate

2. COUPON BONDS

COUPON BONDS: Pay investors their face value at maturity, and in addition, these bonds make regular

coupon interest payments

• TREASURY NOTES: Original maturities from 1-10 years

• TREASURY BONDS: Original maturities of more than 10 years

𝑪𝑶𝑼𝑷𝑶𝑵 𝑷𝑨𝒀𝑴𝑬𝑵𝑻

𝟏 𝟏 𝑭𝑽 𝑪𝑶𝑼𝑷𝑶𝑵 𝑹𝑨𝑻𝑬 𝒙 𝑭𝑨𝑪𝑬 𝑽𝑨𝑳𝑼𝑬

=

𝑷 = 𝑪𝑷𝑵 𝒙 '𝟏 − ++ 𝑵𝑶. 𝑶𝑭 𝑪𝑶𝑼𝑷𝑶𝑵 𝑷𝑨𝒀𝑴𝑬𝑵𝑻𝑺 𝑷𝑬𝑹 𝒀𝑬𝑨𝑹

𝒚 (𝟏 + 𝒚)𝒏 (𝟏 + 𝒚)𝒏

YIELDS

IRR: The discount rate at which the NPV of the cash flows of the investment opportunity is equal to ZERO

• The IRR of a zero-coupon bond is the rate of return that investors will earn on their money if they buy

the bond at its current price and hold it to maturity

• The IRR of an investment in a bond is the YTM

Yield To Maturity

YTM: The yield to maturity of a bond is the discount rate that sets the present value of the promised bond

payments equal the current market price of the bond

• The YTM is the per-period rate of return for holding the bond from today until maturity on date n

1. TIME AND BOND PRICES

AS TIME PASSES, THE BOND PRICE GETS CLOSER TO ITS FACE VALUE

ZERO-COUPON BONDS

If a bond’s YTM has not changed, then the IRR of an investment in the bond equals the YTM even if you sell

the bond early

COUPON BONDS

Between coupon payments, the prices of all bonds rise at a rate equal to the YTM as the remaining cash

flows of the bond become closer

• As each coupon is paid, the price of the bond drops by the amount of the coupon

TRADING AT …

DISCOUNT The price INCREASE between coupons will EXCEED the drop when a coupon is paid

• The bond’s price will RISE

• Discount will DECLINE as time passes

PREMIUM The price DROP when a coupon is paid ill be LARGER than the price INCREASE

between coupons

• The bond’s price will DROP

• Premium will DECLINE as time passes

AT ANY POINT IN TIME, CHANGES IN MARKET INTEREST RATES AFFECT THE BOND’S YTM AND ITS PRICE

• A higher YTM implies a higher discount rate for a bond’s remaining cash flows, reducing their present

value and hence the bond’s price

• INVERSE RELATIONSHIP: As interest rates and bond yields rise, bond prices will fall

THE SENSITIVITY OF A BOND’S PRICE TO CHANGES IN INTEREST RATES DEPENDS ON THE TIMING OF ITS CASH

FLOWS

• Shorter-maturity zero-coupon bonds are less sensitive to changes in interest rates than are longer-

term zero-coupon bonds

• The sensitivity of a bond’s price to changes in interest rates is measured by the bond’s duration –

Bonds with high durations are highly sensitive to interest rate changes

• Because it is discounted over a shorter period, the present value of a cash flow that will be received

in the near future is less dramatically affected by interest rates than a cash flow in the distant future

• Because higher coupon rate bonds pay higher cash flows upfront, they are less sensitive to interest

rate changes that otherwise identical bonds with lower coupon rates

THE YIELD CURVE AND BOND ARBITRAGE

LAW OF ONE PRICE IMPLIES: Given the spot interest rates, which are the yields of the default-free zero-

coupon bonds, we can determine the price and yield of any other default-free bond

Match each coupon payment to a zero-coupon bond with a face value equal to the coupon payment

and a term equal to the term remaining until the coupon date

• Because the coupon bond cash flows are identical to the cash flows of the portfolio of zero-coupon

bonds the Law of One Price states that the price of the portfolio of zero-coupon bonds must be the

same as the price of the coupon bonds

IF PRICE OF COUPON BOND WERE HIGHER… IF PRICE OF COUPON BOND WERE LOWER…

SELL COUPON BOND BUY COUPON BOND

BUY ZERO-COUPON BOND SHORT SELL ZERO-COUPON BOND

Because the coupon bond provides cash flows at different points in time, THE YTM OF A COUPON BOND IS A

WEIGHTED AVERAGE OF THE YIELDS OF THE ZERO-COUPON BONDS OF EQUAL AND SHORTER MATURITIES

• The weights depend on the magnitude of the cash flows each period

• Most of the value in the present value calculation comes from the present value of the last cash

flow, because it includes the principal, so the yield would be closest to the final year zero-coupon

yield.

COUPONS WITH THE SAME MATURITY CAN HAVE DIFFERENT YIELDS DEPENDING ON THEIR COUPON RATES

• As the coupon increases, earlier cash flows become relatively more important than later cash flows

in the calculation of the present value

UPWARD SLOPING The YTM will DECREASE with the coupon rate

DOWNWARD SLOPING The YTM will INCREASE with the coupon rate

FLAT All zero-coupon and coupon-paying bonds will have the same yield,

independent of their maturities and coupon rates

CORPORATE BONDS

CORPORATE BONDS: Bonds issued by corporations

• Issuer may default

• CREDIT RISK: The risk of default means that the bond’s cash flows are not known with certainty

INVESTORS PAY LESS FOR BONDS WITH CREDIT RISK THAN THEY WOULD FOR AN OTHERWISE IDENTICAL

DEFAULT-FREE BOND

• Because the YTM for a bond is calculated using the promised cash flows, the yield of bonds with

credit risk will be higher than that of otherwise identical default-free bonds

• The prospect of default lowers the cash flow investors expect to receive and hence the price they

are willing to pay

THE BOND’S EXPECTED RETURN, WHICH IS EQUAL TO THE FIRM’S DEBT COST OF CAPITAL, IS LESS THAN THE YTM

IF THERE IS A RISK OF DEFAULT

• Moreover, a higher YTM does not necessarily imply that a bond’s expected return is higher

• Note that the bond’s price decreases, and its YTM increases, with the greater likelihood of default

Bond Ratings

The rating depends on the risk of bankruptcy as well as the bondholders’ ability to lay claim to the firm’s

assets in the event of such a bankruptcy

• Thus, debt issues with low-priority claim in bankruptcy will have a lower rating than issues from the

same company that have a high-priority claim in bankruptcy or that are backed by a specific asset

such as a building or a plant

• EG: Investment-grade bonds, speculative bonds, junk bonds, high-yield bonds

STOCK VALUATION

THE LAW OF ONE PRICE IMPLIES: The price of a security should equal the present value of the expected cash

flows an investor will receive and the appropriate cost of capital with which to discount those cash flows

A One-Year Investor

Because the cash flows of a share are not risk-free, we cannot compute their PV using the risk-free interest

rate

• Discount them based on the EQUITY COST OF CAPITAL rE: The expected return of other investments

available in the market with equivalent risk to the firm’s shares)

STOCK PRICE

𝑫𝑰𝑽𝟏 + 𝑷𝟏

𝑷𝟎 =

𝟏 + 𝒓𝑬

investment opportunity

𝑫𝑰𝑽𝟏 + 𝑷𝟏 𝑫𝑰𝑽𝟏 + 𝑷𝟏

𝑷𝟎 ≤ 𝑷𝟎 ≥

𝟏 + 𝒓𝑬 𝟏 + 𝒓𝑬

A Multiyear Investor

As a two-year investor, we care about the dividend and the stock-price in year 2

• Does this imply that a two-year investor will value the stock differently than a one-year investor?

• No – They care about the stock price in year 2 indirectly

o These prices will affect the price for which she can sell the stock at the end of year 1

o Suppose the investor sells the stock to another one-year investor with the same beliefs

o The investor will expect to receive the dividend and the stock price at the end of year 2, so

he will be willing to pay the present value of those cash flows

STOCK PRICE

𝑫𝑰𝑽𝟏 𝑫𝑰𝑽𝟐 + 𝑷𝟐

𝑷𝟎 = +

𝟏 + 𝒓𝑬 (𝟏 + 𝒓𝑬 )𝟐

Dividend-Discount Model

𝑫𝑰𝑽𝟏 𝑫𝑰𝑽𝟐 𝑫𝑰𝑽𝟑 𝑫𝑰𝑽𝒏

𝑷𝟎 = + 𝟐

+ 𝟑

+ ⋯+

𝟏 + 𝒓𝑬 (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )𝒏

The price of the stock is equal to the present value of the expected future dividends it will pay

Dividend Yields, Capital Gains & Total Returns

Capital Gains

Yield

TOTAL Return

𝑫𝑰𝑽𝟏 + 𝑷𝟏 𝑫𝑰𝑽𝟏 𝑷𝟏 − 𝑷𝟎

𝒓𝑬 = − 𝟏 = +

𝑷𝟎 𝑷𝟎 𝑷𝟎

Dividend Yield

DIVIDEND YIELD: The percentage return the investors expects to earn from the dividend paid by the stock

CAPITAL GAINS YIELD: The capital gain the investor will earn on the stock

TOTAL RETURN

TOTAL RETURN: The total return is the expected return that the investor will earn for one-year investment in

the stock

THE EXPECTED TOTAL RETURN OF THE STOCK SHOULD EQUAL THE EXPECTED RETURN OF OTHER INVESTMENTS

AVAILABLE IN THE MARKET WITH EQUIVALENT RISK

• Firms must pay its shareholders a return commensurate with the return they can earn elsewhere

while taking the same risk

• If the stock offered a higher return than other securities with the same risk, investors would sell those

other investments and buy the stock instead

o This activity would drive up the stock’s current price, lowering its dividend yield and capital

gain rate

𝑫𝑰𝑽𝟏

𝑷𝟎 =

𝒓𝑬 − 𝒈

According to the constant dividend growth model, the value of the firm depends on the dividend

level for the coming year, divided by the equity cost of capital adjusted by the expected growth

rate of dividends

𝑫𝑰𝑽𝟏

𝒓𝑬 = +𝒈

𝑷𝟎

In other words, with constant expected dividend growth, the expected growth rate of the share

price matches the growth rate of dividends

DIVIDEND VS. INVESTMENT AND GROWTH

TO MAXIMISE ITS SHARE PRICE, A FIRM WOULD LIKE TO INCREASE BOTH DIVIDEND AND GROWTH RATE

• Often, however, the firm faces a trade-off: Increasing growth may require investment, and money

spent on investment cannot be used to pay dividends

DIVIDEND PAYOUT RATE: The fraction of its earnings that the firm pays as dividends each year

𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔𝒕

𝑫𝑰𝑽𝒕 = 𝒙 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑷𝒂𝒚𝒐𝒖𝒕 𝑹𝒂𝒕𝒆

𝑺𝒉𝒂𝒓𝒆𝒔 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈𝒕

IE: EPS x Dividend Payout Rate

1. Increase its earnings (Net Income)

2. Increase its dividend payout rate

3. Decrease its shares outstanding

1. Pay out to investors

2. Retain and reinvest them

By investing cash today, a firm can increase its future dividends. If all increases in future earnings result

exclusively from new investment made with retained earnings, then:

𝑪𝑯𝑨𝑵𝑮𝑬 𝑰𝑵 𝑬𝑨𝑹𝑵𝑰𝑵𝑮𝑺

𝑬𝑨𝑹𝑵𝑰𝑵𝑮𝑺 𝑮𝑹𝑶𝑾𝑻𝑯 𝑹𝑨𝑻𝑬 =

𝑬𝑨𝑹𝑵𝑰𝑵𝑮𝑺

If the firm chooses to keep its dividend payout rate constant, then the growth in dividends will equal growth

of earnings

PROFITABLE GROWTH

A firm can INCREASE ITS GROWTH RATE BY RETAINING MORE OF ITS EARNINGS

• However, if the firm retains more earnings, it will be able to pay out less of those earnings, and will

have to reduce dividends

• If a firm wants to increase its share price, should it cut its dividend and invest more, or should it cut

investment and increase its dividend?

o The answer will depend on the profitability of the firm’s investments

o The effect of cutting the firm’s dividend to grow crucially depends on the RETURN ON NEW

INVESTMENT

CUTTING THE FIRM’S DIVIDEND TO INCREASE INVESTMENT WILL RAISE THE STOCK PRICE IF, AND ONLY IF, THE

NEW INVESTMENTS HAVE A POSITIVE NPV

CHANGING GROWTH RATES

𝑫𝑰𝑽𝟏 𝑫𝑰𝑽𝟐 𝑫𝑰𝑽𝑵 𝟏 𝑫𝑰𝑽𝑵U𝟏

𝑷𝟎 = + +⋯+ + ' +

𝟏 + 𝒓𝑬 (𝟏 + 𝒓𝑬 )𝟐 (𝟏 + 𝒓𝑬 )𝑵 (𝟏 + 𝒓𝑬 )𝒏 𝒓𝑬 − 𝒈

The price of the stock is equal to the present value of the expected future dividends it will pay

Share Repurchases & The Total Payout Model

SHARE REPURCHASE: The firm uses excess cash to buy back its own stock

• The more cash the firm uses to repurchase shares, the less it has available to pay dividends

• By repurchasing shares, the firm decreases its share count, which increases its earnings and

dividends on a per-share basis

TOTAL PAYOUT MODEL: Values ALL of the firm’s equity, rather than a single share

• Discount the total payouts that the firm makes to shareholders, which is the total amount spent on

both DIVIDENDS and SHARE REPURCHASES

• Then, we divided by the current number of shares outstanding to determine the share price

𝑷𝑽 (𝑭𝒖𝒕𝒖𝒓𝒆 𝑻𝒐𝒕𝒂𝒍 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 & 𝑹𝒆𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔)

𝑷𝟎 =

𝑺𝒉𝒂𝒓𝒆𝒔 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈𝟎

We can apply the same simplifications that we obtained by assuming constant growth in the dividend

discount model

• The only change is that we discount total dividends and share repurchases and use the growth rate

of total earnings (Rather than earnings per share) when forecasting the growth of the firm’s total

payouts

3. DISCOUNTED FREE CASH FLOW MODEL

DISCOUNTED CASH FLOW MODEL: Begins by determining the total value of the firm to all investors – both

equity AND debt holders

• The advantage of the discounted free cash flow model is that it allows us to value a firm without

explicitly forecasting its dividends share repurchases, or its use of debt

FREE CASH FLOW: Measures the cash generated by the firm before any payments to debt or equity holders

are considered

NET INVESTMENT: Investment intended to support the firm’s growth, above and beyond the level needed to

maintain the firm’s existing capital

𝑭𝑪𝑭 = 𝑬𝑩𝑰𝑻 𝒙 (𝟏 − 𝑻𝒄 ) + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 − 𝑪𝒂𝒑𝑬𝒙 − 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆𝒔 𝑰𝒏 𝑵𝑾𝑪

𝑭𝑪𝑭 = 𝑬𝑩𝑰𝑻 𝒙 (𝟏 − 𝑻𝒄 ) − 𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 − 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆𝒔 𝑰𝒏 𝑵𝑾𝑪

Net Investment

𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 = 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔 − 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏

ENTERPRISE VALUE: The value of the firm’s underlying business, unencumbered by debt and separate

from any cash or market

• The net cost of acquiring the firm’s equity, taking its cash, paying off all debt and thus owning the

unlevered business

Enterprise Value

𝑬𝑵𝑻𝑬𝑹𝑷𝑹𝑰𝑺𝑬 𝑽𝑨𝑳𝑼𝑬 = 𝑴𝑨𝑹𝑲𝑬𝑻 𝑽𝑨𝑳𝑼𝑬 𝑶𝑭 𝑬𝑸𝑼𝑰𝑻𝒀 + 𝑫𝑬𝑩𝑻 − 𝑪𝑨𝑺𝑯

WACC: The average cost of capital the firm must pay to all of its investors, both debt and equity holders

𝑽𝟎 = + 𝟐

+⋯+

𝟏 + 𝒓𝑾𝑨𝑪𝑪 (𝟏 + 𝒓𝑾𝑨𝑪𝑪 ) (𝟏 + 𝒓𝑾𝑨𝑪𝑪 )𝑵

Often, the terminal value is estimated by assuming a constant long-run growth rate gFCF for Free

Cash flows beyond year N, so that:

𝑭𝑪𝑭𝑵 𝟏 + 𝒈𝑭𝑪𝑭

𝑽𝑵 = =' + 𝒙 𝑭𝑪𝑭𝑵

𝒓𝑾𝑨𝑪𝑪 − 𝒈𝑭𝑪𝑭 𝒓𝑾𝑨𝑪𝑪 − 𝒈𝑭𝑪𝑭

𝑽𝟎 + 𝑪𝒂𝒔𝒉𝟎 − 𝑫𝒆𝒃𝒕𝟎

𝑷𝟎 =

𝑺𝒉𝒂𝒓𝒆𝒔 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈𝟎

A Comparison Of Discounted Cash Flow Models Of Stock Valuation

Dividend Payments Stock Price No adjustment necessary

Total Payouts (All Dividends & Equity Value Divide by shares outstanding

Repurchases)

Free Cash Flow (Cash Available To Enterprise Value • Subtract what does not belong to

Pay All Security Holders) equity holders (debt and preferred

stock)

• Add back cash and marketable

securities

• Divide by shares outstanding

Valuations

𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑭𝒊𝒓𝒎 = 𝑽𝒂𝒍𝒖𝒆 𝑶𝒇 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔 + 𝑪𝒂𝒔𝒉

4. VALUATION BASED ON COMPARABLE FIRMS

METHOD OF COMPARABLES: Rather than value of the firm’s cash flows directly, we estimate the value of the

firm based on the value of other, comparable firms or investments that we expect to generate very similar

cash flows in the future

VALUATION MULTIPLES

VALUATION MULTIPLE: The ratio of the value to some measure of the firm’s scale

• We can adjust for differences in scale between firms by expressing their value in terms of a valuation

multiple

PRICE-TO-EARNINGS MULTIPLE

P/E RATIO: A firm’s P/E ratio is equal to the share price divided by its earnings per share

• When you are buying a stock, you are buying the rights to a firm’s future earnings

• Because differences in the scale of the firms’ earnings are likely to persist, you should be willing to

pay proportionally more for a stock with higher current earnings

𝑺𝒉𝒂𝒓𝒆 𝑷𝒓𝒊𝒄𝒆

𝑷⁄𝑬 𝑹𝑨𝑻𝑰𝑶 =

𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆

FORWARD P/E: The P/E multiple computed based on its forward earnings (Expected earnings over the next

12 months)

• For valuation purposes, the forward P/E is generally preferred, as we are most concerned about

future earnings

TRAILING P/E: A firm’s trailing P/E is computed using its trailing earnings (earnings over the period 12 months)

To interpret the P/E multiple, consider the stock price formula for the case of constant dividend growth:

𝑷𝟎 = 𝑫𝒊𝒗𝟏/(𝒓𝑬 – 𝒈)

𝑫𝒊𝒗𝟏

𝑷𝟎 𝑬𝑷𝑺𝟏 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑷𝒂𝒚𝒐𝒖𝒕 𝑹𝒂𝒕𝒆

𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑷 𝑬 = = =

𝑬𝑷𝑺𝟏 𝒓𝑬 − 𝒈 𝒓𝑬 − 𝒈

• This implies that if two stocks have the same payout and EPS growth rates, as well as equivalent risk

(and therefore the same equity cost of capital), then they should have the same P/E

• It shows that firms and industries with high growth rates, and that generate cash well in excess of

their investment needs so that they can maintain high payout rates, should have high P/E multiples

Because ENTERPRISE VALUE represents the total value of the firm’s underlying business rather than just the

value of equity, using the enterprise value is advantageous if we want to compare firms with different

amounts of leverage

• Because the enterprise value represents the entire value of the firm before the firm pays its debt, to

form an appropriate multiple, we divide it by a measure of earnings or cash flows BEFORE INTEREST

PAYMENTS ARE MADE

𝑬𝒏𝒕𝒆𝒓𝒑𝒓𝒊𝒔𝒆 𝑽𝒂𝒍𝒖𝒆

𝑬𝑽⁄𝑬𝑩𝑰𝑻 =

𝑬𝑩𝑰𝑻

𝑬𝒏𝒕𝒆𝒓𝒑𝒓𝒊𝒔𝒆 𝑽𝒂𝒍𝒖𝒆

𝑬𝑽⁄𝑬𝑩𝑰𝑻𝑫𝑨 =

𝑬𝑩𝑰𝑻𝑫𝑨

𝑬𝒏𝒕𝒆𝒓𝒑𝒓𝒊𝒔𝒆 𝑽𝒂𝒍𝒖𝒆

𝑬𝑽⁄𝑭𝑪𝑭 =

𝑭𝑪𝑭

ENTERPRISE VALUE TO EBITDA MULTIPLES: Because capital expenditures can vary substantially from period to

period (EG: A firm may need to add capacity and build a new plant one year, but then not need to

expand further for many years), most practitioners rely on EV/EBITDA multiples

• As with P/E multiples, this multiple is higher for firms with high growth rates and low capital

requirements (so that FCF is high in proportion to EBITDA)

𝑽𝟎 𝑭𝑪𝑭𝟏 /𝑬𝑩𝑰𝑻𝑫𝑨𝟏

=

𝑬𝑩𝑰𝑻𝑫𝑨𝟏 𝒓𝑾𝑨𝑪𝑪 − 𝒈𝑭𝑪𝑭

LIMITATIONS OF MULTIPLES

1. FIRMS ARE NOT IDENTICAL

• The usefulness of a valuation multiple will depend on the nature of the differences between the

firms and the sensitivity of the multiples to these differences

• The differences in these multiples are most likely due to differences in their expected future

growth rates, profitability and risk (And therefore cost of capital)

2. COMPARABLES ONLY PROVIDE INFORMATION REGARDING THE VALUE OF THE FIRM RELATIVE TO THE

OTHER FIRMS IN THE COMPARISON SET

• Using multiples will not help us determine if an entire industry is overvalued

ADVANTAGE OF MULTIPLES

Rather than separately estimate the firm’s cost of capital and future earnings or FCF, WE RELY ON THE

MARKET’S ASSESSMENT OF THE VALUE OF OTHER FIRMS WITH SIMILAR FUTURE PROSPECTS

• The multiples approach has the advantage of being based on actual prices of real firms, rather

than what may be unrealistic forecasts of FCF

Discounted FCF allows us to INCORPORATE SPECIFIC INFORMATION ABOUT THE FIRM’S PROFITABILITY, COST

OF CAPITAL, OR FUTURE GROWTH POTENTIAL, as well as perform sensitivity analysis.

• Because the true driver of value for any firm is its ability to generate cash flows for its investors,

the discounted cash flow methods have the potential to be more accurate and insightful than

the use of a valuation multiple

FINANCIAL STATEMENT ANALYSIS

Market Value Vs. Book Value

Market Value Of Equity

The market value of a share does not depend on the historical cost of the firm’s assets

• Instead, it depends on what investors expect those assets to produce in the future

• The ratio of a firm’s market capitalization to the book value of shareholders’ equity

𝑴𝒂𝒓𝒌𝒆𝒕 𝑻𝒐 𝑩𝒐𝒐𝒌 𝑹𝒂𝒕𝒊𝒐 =

𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 𝑶𝒇 𝑬𝒒𝒖𝒊𝒕𝒚

• The market to book value for most successful firms substantially exceeds 1 – This indicates the value

of the firm’s assets when put to use exceeds their historical cost

o This is one way a company’s share price provides feedback to its managers on the market’s

assessment of their decisions

• VALUE STOCKS: Low market-to book ratios

• GROWTH STOCKS: High market-to-book ratios

Enterprise Value

ENTERPRISE VALUE: The enterprise value of a firm assesses the value of the underlying business assets,

unencumbered by debt and separate from any cash and marketable securities

Retained Earnings

RETAINED EARNINGS: The difference between a firm’s net income and the amount it spends on dividends

• Also: The retention ratio x net income

Profitability Ratios

Gross Margin

GROSS MARGIN: The ratio of gross profits to revenues (Sales)

• A firm’s gross margin reflects its ability to sell a product for more than the cost of producing it (Only

taking into account the COGS of the product)

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