WEEK 7 DISCOUNTED CASH FLOW VALUATION SHORT .pptx

WEEK 7 DISCOUNTED CASH FLOW VALUATION SHORT .pptx -...

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Financial Statement Analysis and Security Valuation Discounted Cash Flow Valuation April 12, 2018
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What You Will Learn From This Chapter How the dividend discount model works (or does not work) How a constant growth model works How does a two-stage discounted cash flow model work? What is meant by free cash flow How discounted cash flow valuation works 4-2
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Valuation Models for Going Concerns CF 1 CF 2 CF 3 CF 4 CF 5 A Firm 1 2 3 4 5 0 d 1 d 2 d 3 d 4 d 5 Dividend Flow 1 2 3 4 5 0 TV T T d T Equity The terminal value, TV T is the price payoff, P T when the share is sold Valuation issues : The forecast target: dividends, cash flow, earnings? The time horizon: T = 5, 10, ? The terminal value? The discount rate? 4-3
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Required Rate of Return Required Rate of Return is the return necessary to compensate an investor for the risk involved in an investment. Used as a target return to compare forecasted returns on potential investment option. For example, if the average return on stock investment is 15%. The required rate of return is 15%.
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Present Value vs. Future Value The first step in a time value analysis is to set up a time line to see what happens in the future. PV represents $100 that is in a bank account today and FV is the value that will be in the account at some future time (3 years from now.)
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Future Value
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Required rate of return: 10% $1,000[1/1.10] + 1,000 [1/1.10] 2 + 1,000 [1/1.10] 3 = $2,486.80
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Present Value Example
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The Dividend Discount Model Forecast of Dividends Constant Dividend: Vo = stock value, D1 = dividend year 1, D2 = dividend year 2, K = required rate of return R R R R R
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The Dividend Discount Model: Forecasting Dividends with terminal value 4-12 P E = 1 + the required rate VE = VALUE OF EQUITY D = dividend PE = required rate of return
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Example You want to invest in Company B for one year, what is its value today? You expect to receive $20 dividend in one year. You expect the price of the stock to be $150 in one year. Required rate of return: 10% $154 ($20/1.1 + $150 / 1.1)
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Terminal Values for the DDM A. Capitalize expected terminal dividends B. Capitalize expected terminal dividends with growth 4-14 g = the forecasted rate of growth R R PV T 1 T T E d TV P 1 T 1 T T E d TV P g
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Terminal Values for the DDM A . A firm is paying $10 dividend perpetually, the required rate of return is 10%, what is the value of equity? B. The same firm has a constant growth rate of 5% each year, what is the value of equity? 4-15 $10 / (0.1) = $100 $10 / (0.1 – 0.05) = $200 R R T 1 T T E d TV P 1 T 1 T T E d TV P g
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Some Financial Math: The Value of a Perpetuity and a Perpetuity with Growth The Value of a Perpetuity A perpetuity is a constant stream that continues without end. The periodic payoff in the stream is sometimes referred to as an annuity, so a perpetuity is an annuity that continues forever. To value that stream, one capitalizes the constant amount expected. If the dividend expected next year is expected to be a perpetuity, the value of the dividend stream is
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