1349
Other Comparative Valuation Ratios
Pricetobook
Pricetocash flow
Pricetosales
Be creative
1350
Figure 13.7 Valuation Ratios for the S&P
500
1351
13.5 Free Cash Flow
Valuation Approaches
1352
Free Cash Flow
Free cash flow for the firm (FCFF) is used to calculate
the amount available to BOTH debt and equity holders.

Useful for firms that don’t pay dividends,

Helpful to understand sources and uses of cash
•
EBIT = earnings before interest and taxes
•
Tc = the corporate tax rate
•
NWC = net working capital = Current assets – current liabilities
NWC
in
Increase
es
Expenditur
Capital
on
Depreciati
)
T
EBIT(1
FCFF
C


+

=
1353
FCFF, Firm Value & Equity Value
The free cash flow methods discount year to year cash
flows plus some estimate of the terminal value PT
where
WACC = Weighted average cost of capital
= wd x rd x (1t) + we x re
g = estimate of long run growth in free cash flow
T = time period when the firm approaches constant
growth
g
WACC
FCFF
P
1
T
T

=
+
T
T
T
1
t
t
t
)
WACC
1
(
P
)
WACC
1
(
FCFF
Value
Firm
+
+
+
=
=
1354
Free Cash Flow (cont.)
Another approach calculates the free cash
flow to the equity holders (FCFE) and
discounts the cash flows directly at the cost
of equity, kE.
Equity value can then be estimated as:
Debt
Net
in
Increase
)
T
Expense(1
Interest
FCFF
FCFE
C
+


=
g
k
FCFE
P
E
1
T
T

=
+
T
E
T
T
1
t
t
E
t
)
k
1
(
P
)
k
1
(
FCFE
Value
quity
E
+
+
+
=
=
1355
Input
Year
2006
2007
Working capital
5505
5660
Profits (after tax)
5460
Interest (after tax)
452.9
Depreciation
2675
Capital Spending
5278
Longterm debt
15000
13500
Cash flow Calculations
EBIT(1Tc)
Increase in NWC
FCFF
FCFE
Input
Year
2006
2007
Working capital
5505
5660
Profits (after
tax)
5460
Interest (after
tax)
452.9
Depreciation
2675
Capital
Spending
5278
Longterm debt
15000
13500
Cash flow
Calculations
EBIT(1Tc)
5912.9
Profits (after tax) + Interest
(after tax)
Increase in
NWC
155
WC(2007)  WC(2006)
FCFF
3154.9
EBIT(1tc) + Depreciation  Capital Spending 
Increase in NWC
FCFE
1202
FCFF  Interest expense(1tc) + Increase
in Net debt
1357
Comparing the Valuation Models
In theory free cash flow approaches should provide the
same estimate of intrinsic value as the dividend growth
model
In practice the various approaches often differ
substantially
•
Simplifying assumptions are used in all models
•
The models establish ranges of likely intrinsic value
•
Using multiple models forces rigorous thinking about the
inputs
1358
13.6
THE AGGREGATE STOCK MARKET
1359
Earnings Multiplier Approach
STEP 1: Forecast corporate profits for the coming period.
Corporate Profits = Earning per share
= EPS
STEP 2: Derive an estimate for the aggregate P/E
(Price/Earning) ratio using longterm interest rates.
1360
Figure 13.8 Earnings Yield of the S&P
500 Versus 10year Treasury Bond
Yield
1361
Earnings Multiplier Approach
1362
Earnings Multiplier Approach
Example:
The early 2007 forecast for 12month forward earnings per share for
the S&P 500 portfolio was about $86. The 10year Treasury bond yield at
this time was about 4.8%. What would be the forecast for the level of the
S&P 500 index?
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 Summer '15
 Valuation, P/E ratio