77. Asset Based Valuation Model, Residual Income Valuation Model. Модель оценки на основе активов. Модель оценки на основе остаточного дохода.

Asset - based approach to Valuation

This approach aims at determining the value of net assets. It focuses on a company's net asset value, or the fair-market value of its total assets minus its total liabilities. The asset-based approach basically asks what it would cost to recreate the business.

The challenge of the asset based valuation is fixed asset calculation. The analyst should be able to predict the value of fixed assets. The company may have fixed asset or deprecation calculation. The second difficult is goodwill or royalty. No one knows exactly the royalty of mining company, book company, etc. Fair value estimation of goodwill is also problematic.

Residual Income Valuation Model

Residual income (economic profit or Economic Value Added) is net income less common equity opportunity cost in generating net income. Mathematically, EVA= NOPAT – (C% х TC), where NOPAT = net operating profit after taxes; C% = cost of capital; TC = total capital.

I ntrinsic value of the firm has two components: current BV of equity + PV of future residual income or:

B₀ =current book value of equity,

B_t =book value of equity at time t,

RI_t =residual income in future periods,

r =required rate of return on equity,

E_t = net income during period t,

RI_t = E_t – rB_t-1.

Advantages: 1) Timing of recognition of value; 2) Terminal value (the determination of book value today is much easier than the determination of a terminal value ten or twenty years hence); 3) can be used for companies not paying dividends, firms with negative FCF or with great uncertainty in forecasting terminal values.

Problems: 1) Violations of the Clean Surplus Relationship (B_t=B_t-1+E_t-D_t).Violations of clean surplus accounting occur when accounting standards permit charges directly to stockholders’ equity, bypassing the income statement. 2) Balance Sheet Adjustments for Fair Value. Reported assets and liabilities should be adjusted to fair value where possible. 3) Intangible Assets. Fair value representation of goodwill and R&D on the platform of ISAs is essential. 4) Aggressive Accounting Practices. Firms may engage in accounting practices that result in the overstatement of assets (book value) and/or overstatement of earnings. 5) International considerations. There are differences in standards worldwide particularly for goodwill and R&D.

78. Dividend Discount Model. Discounted Cash Flow Valuation Model. Модель дисконтированных денежных потоков.

The dividend discount model (DDM) is a method of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. It involves a procedure for valuing the price of a stock by using predicted dividends and discounting them back to PV. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued. Mathematically, P₀= Div₁/(r-g), where r=discount rate; g=dividend growth rate or in other terms EPS/r+NPVGO=P₀, where NPVGO=NPV of growth opportunities (potential future profit from existing projects).

This procedure has many variations, and it doesn't work for companies that don't pay out dividends. The principal behind the model is NPV of the CFs. To get a growth number, one option is to take the return on equity (ROE) and multiply it by the retention ratio (which is 1-the payout ratio) or divide change in earnings by total earnings.

The equation can also be understood to generate the value of a stock such that the sum of its dividend yield (income) plus its growth (capital gains) equals the investor's required total return. 

Income + Capital Gain = Total Return

Dividend Yield + Growth = Cost of Equity

D/P+g=r

r-g cannot be negative. When growth is expected to exceed the cost of equity in the short run, then usually a multi-stage DDM is used.

Disadvantages: 1) Constant dividends, cost of capital and growth rate – impossible; 2) what if no dividends at all, but company is profitable and choose to invest earnings into new projects, rather than pay shareholders?; 3) what if growth rate>discount rate for a long period of time?

The discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth. The concept of DCF valuation is based on the principle that the value of a business or asset is inherently based on its ability to generate cash flows for the providers of capital. A DCF analysis yields the overall value of a business (i.e. enterprise value), including both debt and equity.

Key components: 1) Free cash flow (FCF) – Cash generated by the assets of the business (tangible and intangible) available for distribution to all providers of capital. FCF is often referred to as unlevered free cash flow, as it represents cash flow available to all providers of capital and is not affected by the capital structure of the business. 2) Terminal value (TV) – Value at the end of the FCF projection period (horizon period). 3) Discount rate – The rate used to discount projected FCFs and terminal value to their present values. Mathematically,

The DCF method of valuation involves projecting FCF over the horizon period, calculating the TV at the end of that period, and discounting the projected FCFs and terminal value using the discount rate to arrive at the NPV of the total expected cash flows of the business or asset.

Steps in the DCF Valuation: 1) Project unlevered FCFs (UFCFs); 2) Choose a discount rate; 3) Calculate the TV; 4) Calculate the enterprise value (EV) by discounting the projected UFCFs and TV to net present value; 5) Calculate the equity value by subtracting net debt from EV; 6) Review the results

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