FUNDAMENTALS of Corporate Stephen A.

Ross
Randolph W. Westerfield
Corporate FINANCE Bradford D. Jordan
ASIA GLOBAL EDITION
FINANCE Joseph Lim
Ruth Tan
ASIA GLOBAL EDITION
Copyright © 2016 by McGraw-Hill Education. All rights reserved.
 TOPIC 2:
S T O C K S & C O R P O R AT E VA L U AT I O N

Copyright © 2016 by McGraw-Hill Education. All rights reserved.

WHAT WILL BE COVERED IN THIS TOPIC?

1. Importance of valuation to corporate managers

2. General Dividend Discount Model (DDM)

3. Gordon (Constant) Growth DDM
4. Two-stage DDM
5. PVGO, Corporate Valuation & Competitive
Strategy

6. FCF Approach

7. Case Study: Acquisition of Warner Communications

by Time Inc.

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Copyright © 2016 by McGraw-Hill Education. All rights reserved
 INTRODUCTION TO STOCKS &
CORPORATE VALUATION
• Corporate valuation is about determining the intrinsic value
of a corporation and its stocks.
• In corporate valuation, it is important to analyze & discuss
how corporate/financial strategy can add value for the
shareholders.
• Stocks & corporate valuation is important because corporate
managers need to know the process of valuing a company and
its stock in order to make good corporate or financial
decisions that add value for the shareholders.
• Examples of corporate or financial decisions that could affect
firm value:
1. To what extent is a project on product development (new products) able to
increase the company and its stock value?
2. In what way is borrowing/leverage able to affect the value of a corporation?
3. To what extent is a change in the dividend and retained earnings policy adds
value to a company?
4. Before deciding on stock buyback, the management should consider whether
the current market price of their stock is over- or undervalued compared to the
fair price of the stock.
5. In M&A, before deciding to buy over a target firm, the acquiring firm should
estimate the fair value of the target firm so that it wouldn’t overpay for the target
firm.
 DIVIDEND DISCOUNT MODEL

• The most basic valuation approach is the Dividend Discount

Model (DDM):
• First, we need to know the difference between your expected return and the
required return of a stock.
• Expected return is the return you expect to get based on the current stock
price you purchase. Bear in mind that the current stock price could be over,
fairly or undervalued.
• Required return is the minimum return needed to compensate for the risk of
the stock. It can be estimated by CAPM.
• In an efficient market (according to efficient market hypothesis), stock price
should be efficiently priced (fairly priced), therefore in this situation, your
expected return will be the required return of the stock (Expected return =
Required return).
• In other words, if the stock price that you pay is the fair price
of the stock, the return that you can expect from the stock is
the required return of the stock, no more no less.
Since Expected return, R = [D1+(P1- P0)]/P0
-- Therefore, P0 = (D1+ P1) / (1+ R)

• By the same reasoning, If we use Required

return as the discount
• ddas rate, then P0 will be the
estimated fair price
General DDM formula
• Message from General DDM: Fair value of any stocks
depends on the present value of cash flows expected in the
future from the stock.
• Not only stocks, fair value of any kind of financial asset
depends on the expected cash flows that the asset can
generate, if an asset cannot generate any cash flow, nobody
will pay to invest in the asset.
• Constant Growth DDM (a.k.a. Gordon Growth): many
mature companies will have more or less constant growth
(steady or stable growth rate) every year in their sales,
earnings and thus dividends.
• Constant Growth DDM formula can be derived from the
general DDM formula.
• It is stated as:
P0 = D1 /(k-g)
where k=required return (some books use R),
g=constant growth rate
• Two-stage DDM:
Unstable growth stage + Stable growth stage
Used to estimate:
a) High growth firms
b) Firms which are recently recovering from loss
c) Firms with expected volatile earnings/dividends for the first
few years before their earnings and dividends are expected
to stabilize.
• Example: Formula to calculate 2-stage DDM for a firm with 3-
year high growth stage:

P0 = D1/(1+ k) + D2/(1+k)2 + D3/(1+k)3 + P3/(1+k)3

where P3 can be estimated by constant growth formula:

P3 = D4/(k-g)

High growth Constant growth

stage stage
• Example: Given that the high growth stage will last for three
years with D0 =1.00 and expected growth rate for year 1 is
40% followed by 30% in year 2 and 20% in year 3., From year
4 and onward the growth will stabilize at 6% every year. If the
required return of equity is 9%, what is the fair price per
share?

• D1 = D0(1+g) = 1.00 (1.40) = 1.40

• D2 = D1(1+g) = 1.40 (1.30) = 1.82
• D3 = D2(1+g) = 1.82 (1.20) = 2.18
• Answer:
P0 = (D1/1.09) + (D2/1.092 )+ (D3/1.093 )+ (P3/1.093 )
where P3=D4/(k-g)
= [D3(1+g)] / (k-g)
= 2.18(1.06) / (0.09-0.06)
= 2.31/0.03 = 77

P0 = 1.40/1.09 + 1.82/1.092 + 2.18/1.093 + 77/1.093

= 1.28 + 1.53 + 1.68 + 59.46
= 63.95
• High growth is referring to at least a double digit growth (at
least 10% and above) in earnings and dividends.
• The first stage of high growth is normally NOT sustainable.
It will drop and stabilize at a lower and sustainable rate one
day in the future, due to:
a) First reason: Competition from new competitors in the
industry because of high growth opportunity in that industry.
• Biotechnology, pharmaceutical, technology companies like Apple,
Facebook, Alibaba, Google, LinkedIn, Amazon, Huawei are some
of the examples of high growth industry or company.
• High growth companies are in the rapid growth stage of the
industry life cycle S curve that attracts new firms into the industry
and existing firms will also expand their capacity. As a result, the
industry will eventually enter the mature stage of its industry life
cycle and the profit margin will eventually be driven down by the
intense competition.
• Drop in profit margin means the ROE decreases (remember PM is
the first component of the three components of ROE). When ROE↓,
g will also ↓ because g= b x ROE.
• Second reason why the high growth stage cannot be sustained forever
is due to the fact that resources in our economy/market are scarce.
• Resources here include not only raw material, but also human capital
and the technology level. When more and more resources are being
used to support the high growth, firms will find it more and more
difficult to get suitable resources, (for example, the biotech firm will
find that it is more and more difficult to recruit suitable biotech
experts after it has recruited the excellent ones) and as a result, there
will be diminishing return to the resources.
• Diminishing return simply means more and more resources are needed to
generate every dollar of sales and thus the costs will ↑, asset efficiency ↓ 
ROE ↓ and g↓.
• The main limitation in using 2-stage DDM is when will the
high growth stage end? Competitiveness in the industry plays
the most important role in bringing a high growth firm to
stable growth eventually. But the problem is when will this
happen?
 PVGO, CORPORATE VALUATION AND
COMPETITIVE STRATEGY

• Fair value of stocks can always be split into their no-growth

component and the PVGO component.
(P0 = No-growth component + PVGO component)
• Case I Example: If a company’s expected EPS next year is
$8.33 and it pays out all its dividends, its growth rate will be
zero. Given the required return of its stock is 15%, what is the
estimated fair value?
• P0 = D1/k = E1/k = 8.33/0.15 = 55.5
• But if the company suddenly decides to plowback 40% of its
earning every year in the future, given that it has a ROE of
25%, what will be its stock worth now?
• With 40% retention ratio, D1 will be 0.6 x 8.33 = $5
• Steady growth rate, g= b x ROE = 0.4 x 25 = 10%
• P0 = D1/(k-g) = 5/(0.15-0.10) = 5/0.05 = $100

Interpretation: The fair price that investors in the market are

willing to pay for the stock has increased from $55.5 to $100,
when the firm decided to retain back 40% of its expected
earnings. This additional value of 44.5 (100-55.5) is known as
the present value of growth opportunity (PVGO) of the stock.
• P0 = No-growth component + PVGO component
P0 = E1/k + PVGO -------first formula of PVGO
100 = 55.5 + 45.5

You may ask why is market willing to pay the additional $45.5?
Answer is because by retaining 40% of its earnings to reinvest back
to the company, the firm is able to generate 25% return from its
reinvestment (because its ROE is 25%). This is better than
returning the money back to shareholders as dividends because
shareholders can only reinvest their dividends in somewhere else
(with similar risk level as the stock of this company) for only 15%
return. You may ask why only 15%?
• This is because the required return needed by the shareholders
is 15% for this stock. The required return indicates that the
opportunity cost of this equity is 15%.
• In other words, by investing their fund into this company’s
shares and not somewhere else, the forgone return for the
shareholders is 15%.
• In short, investors welcome this company’s decision to
increase the retention ratio from zero to 40% as this 40%
retained earnings can generate a return more than the required
return needed for the stock.
• With 40% retained earnings, the expected retained earnings
per share next year will be 0.4x8.33 = 3.33. What will happen
when this 3.33 is retained and reinvested into the company?
• Let’s assume this 3.33 is used to purchase a machinery item.
The extra earnings that can be generated every year in the
future from this machine is $0.83 (3.33 x ROE). The net
present value (NPV) of this machine purchased in year 1 is
therefore:
• NPV1 = -3.33 + (0.83/0.15) = +2.22
• Since EPS in year 1 is 8.33, EPS for year 2 will then be EPS1
plus the 0.83 extra earnings generated in year 2. Therefore
EPS2 = 8.33 + 0.83 = 9.16
• Retained earning in Year 2 will then be 0.4 x 9.16 = 3.66.
Assume this amount is reinvested to purchase the second
machinery item.
• The extra earnings that can be generated every year in the
future from this second machine is $0.915 (3.66 x ROE). The
net present value (NPV) of this machine purchased in year 2 is
therefore:
• NPV2 = -3.66 + (0.915/0.15) = +2.44
• You can repeat the process to calculate the NPV of the retained
earnings in year 3, year 4 and so on.
• The current PVGO of a stock is therefore derived from the NPVs of
all its future reinvestment from retained earnings.
• With 10% constant growth rate for the company, the NPVs of
retained earnings also grow at 10% from year to year.
• In this case, based on constant growth formula, PVGO can be
written as:
PVGO0 = NPV1 / (k – g) ----------second formula of PVGO
• This formula is called the ‘constant growth PVGO’ formula because
the growth in NPV of the retained earnings is constant.
PVGO0 = NPV1 / (k – g)
= 2.22/(0.15-0.10)
= 44.5

Case II: Suppose the ROE of this company is not 25% but
12%, what will be the fair value of its stock if it retains 40% of
its earnings?
Answer: With ROE of 12%, the constant growth rate will be:
g = b x ROE = 0.4 x 12% = 4.8%
P0 = D1/(k-g) = 5/(0.15 – 0.048) = $49
• PVGO = P0 – (E1/k) = 49 – (8.33/0.15) = -6.5
• Negative PVGO means that the fair value of the stock is
‘destroyed’ by 6.5 because the retained earnings are reinvested to
generate a return of only 12%, which is lower than the required
return of 15% needed by the investors. The firm is ‘penalized’ in
this case by retaining 40% of its earnings. The firm’s stock price
will enjoy a higher value (55.5) had it distributed all its earnings
as dividends.
• By now, you should therefore know that not all the growths are
good or desirable. In this case, growth rate of 4.8%, ( even
though is positive) is considered as an ‘undesirable growth’ as
shareholders’ wealth is destroyed or negatively affected.
• Desirable growth is achieved when ROE of reinvestment > k
----- positive NPV, positive PVGO
• Undesirable growth happens when ROE of reinvestment < k
----- negative NPV, negative PVGO
• ROE of a firm will be greater than its ‘k’ only if the firm has
competitive advantage in its business compared to its
competitors (such as gigantic economies of scale like
Amazon.com, Alibaba among the largest internet retailer, or
strong brand name like ‘Nike’ shoes and CocaCola).
• Warren Buffet calls this the ‘Economic Moat’ that protects the
firm from other invaders. A firm without any competitive
advantage will not have ROE greater than its k.
• A firm, under a very competitive business environment where it
does not have any advantage over the others, will not be able to
generate positive NPV in its business. Its NPVs will be zero
(NPVs=0).
• In other words, the cash flows or return generated from its
projects/business are only able to meet the required return of the
shareowners, not more than that. In this case, since PVGO is
derived from future NPVs, PVGO will also be zero (PVGO=0).
• No competitive advantage ROE  k  zero NPV in business 
zero PVGO in stock  lower stock price (compared to firms who
have competitive advantage)
• As mentioned in Topic 1, every company needs to grow.
• Growth can come in four ways based on Ansoff matrix below. A company can sell more
of the same product to the same market (Quadrant 1), it can sell new products into the
same markets (Q2), existing products into new markets (Q3), or it can take the high-risk
strategy of diversifying totally (Q4). CEO and BOD of a company can use the Ansoff
matrix in conjunction with their PVGO analysis to analyze how the company can
achieve the growth – for example, which quadrant of growth should be the focus of
the company to create competitive advantage for the company?
 FCF APPROACH: THE BUSINESS VALUE
• Definition: Free Cash Flow to the firm is the cash flow available
to all the investors (shareholders + debt holders) after the firm has
fulfilled its capital expenditure (CAPEX) and working capital
needs.
• Firms need to spend a certain amount of cash flow to finance the
Capex and WC needs in order to maintain or support the sales
& earnings growth. One of the activities that is common under
Capex is the acquisition or purchase of physical
assets/division/subsidiaries of other firms and selling of its own
assets to other firms. [If a firm spent $100 to acquire a division of another
company and received $60 from disposing one of its own assets, its capex will
be $40 (cash outflow)] : we say that its “Acquisition net of asset sales” = $40
FCF for the Firm = (EBIT – taxes) + Depreciation expense +
deferred taxes – Capital expenditure (Capex) - Working capital
expenditures

• Using FCF approach will give us the value of the entire

firm/business. So to find the equity value, we must subtract the
firm’s value from the debt value.
CASE STUDY: WARNER COMMUNICATIONS TAKEN OVER BY TIME
INC. –
this case is taken from Modern Corporate Finance by Alan Shapiro
• In using the multiple approach (earnings, cash flows, sales, or
book value) to estimate the Terminal Value, we are assuming
that the Multiple from the ‘industry average’ is the ‘fair’
multiple for our firm. Some firms in the same industry maybe
overvalued and have higher multiples, and some firms maybe
undervalued and have lower multiples, BUT the overall
average multiple from the industry will more or less reflecting
the ‘fair’ multiple since any overvalued and undervalued
multiples among the firms will cancel out each other.
END OF CHAPTER
END OF CHAPTER

4-53
Copyright © 2016 by McGraw-Hill Education. All rights reserved