Description UNFORMATTED ATTACHMENT PREVIEW Strategic Financial Analysis & Modeling Section: Valuati ...
Description UNFORMATTED ATTACHMENT PREVIEW Strategic Financial Analysis & Modeling Section: Valuation Workbook 11: Equity Valuation Sheet: ENTER SFAM ID 25S. Enter your SFAM ID (For CUNY enter your Employee Code) Warning: If you change your SFAM ID after you have begun working on the Workbook you will alter the randomization. As a result your answers will be wrong. © All rights reserved, 2019, Marianne Wolk & Richard Horwitz u will alter the randomization. Strategic Financial Analysis & Modeling © All rights reserved, 2019, Marianne Wolk & Richard Horwitz Section: Valuation Workbook 11: Equity Valuation Sheet: INTRO Valuation SHEET ROADMAP The material through Row 290 is a tutorial that will not contribute to your grade. The Homework starting in Row 292 is Required. Valuation is Not a Single Process or Technique, but Rather a Broad and Evolving Part of Economic Theory Core Competencies Used in Modeling and Forecasting are Essential to Performing Valuations This Workbook focuses on valuating a company as a whole (commonly refered to as the 'firm') and/or its Equity. This is distinguished from the exercises in Workbook 7 (where we valued a capital project for example), although the logic is quite similar. Valuation requires a strong understanding of Accounting, Corporate Finance and Portfolio Theory. EXHIBIT: VALUATION BUILDS UPON THE WORK PERFORMED IN FINANCIAL STATEMENT ANALYSIS, MODELING AND FORECASTING Risk Valuation Modeling Financial Statement Analysis Strategy Forecasting Data Analysis Data Integrity Source: Marianne Wolk & Richard Horwitz In Accounting classes, students learn that value is based on the lower of historical cost or market (current price) of an asset. In Corporate Finance classes, students learn that firm value rises by changing investment, financing and dividend levels. In Investments or Portfolio Theory, value is determined by how the company deploys and seeks returns from invested capital. Invested Capital is defined in Row 267 below. This requires understanding how value has been created prior to the valuation date (from existing assets) and an understanding of how value will be created in the future (from expected growth in, and future investments of, capital). The Goal of Financial Analysis is to Make a Decision Financial analysis is conducted for a variety of reasons but always performed to support a decision. In Balance Sheet (Workbook 5), we examined a variety of performance ratios used to determine whether to invest in, or expand, a business. Businesses rely on performance measures such as Economic Value Added (EVA) which explores whether the Return on Invested Capital (ROIC) is greater than the business's Weighted Average Cost of Capital (WACC). In Developing a Model (Workbook 7), we included several capital budgeting examples to support an operating decision. The critical measure for decision-making is cash flow and we utilized an Internal Rate of Return (IRR) and a Net Present Value (NPV) to make decisions. In Strategic Forecasting Strategic Forecasting (Workbook 9), we looked at financial decisions companies make to invest and support individual businesses. The critical measures for decision-making were growth, profitability and competitiveness. In Fixed Income Valuation (Workbook 13), we look at financial decisions to effect risk management. The critical measure for decision-making is the assessment of risk. Other financial decisions, not explored in this course, include Corporate Finance, determining the appropriate capital structure of an organization, and managing tax obligations. In this Workbook, we will describe valuations performed to drive a financial investment decision, particularly equities, although there is a wide array of purposes for financial valuations detailed below. The critical measure for financial investment decision-making is 'valuation'. Valuation requires determining 'fair value' for the investment target (a measure of the asset's worth), and whether the market value (it's price) is considered cheap or expensive relative to the determination of fair value. Valuation may be performed to determine whether to purchase equities, debt or physical assets such as a home, a manufacturing plant or a piece of equipment. Valuation may also be performed to determine whether to construct a facility, start a business or acquire a business (discussed in detail in Mergers & Acquisitions (Workbook 12)). Valuation is performed for a variety of purposes and each may necessitate a different approach. EXHIBIT: VALUATION IS ACTUALLY A DIVERSE FIELD Purpose of Valuation Explanation Investment Investment valuations may be of individual companies or portfolios of companies by individual investors, financial analysts and/or professional money managers. Business Sales / Restructuring Evaluations for business sales or restructuring often involve the use of independent valuation firms such as Duff & Phelps. Mergers and Acquisitions This may rely on internal valuations by the buyer and seller, investment banking valuations and/or independent valuations. Derivative or Equity Awards Share-based compensation (e.g., restricted stock) and/or derivatives are often valued by independent experts. Others may use option pricing models to value assets that share those characteristics. Credit Worthiness Lenders may value businesses before setting terms and finalizing loan agreements. Litigation This can vary from expert testimony regarding derivatives or other complex assets in dispute. Goodwill and Intangibles Intangible Assets (e.g., intellectual property) and Goodwill are often valued as part of a transaction (afterward, if impaired). Source: Marianne Wolk & Richard Horwitz Economic Theory of Investment Valuation Theory Posits Stock Markets are Efficient, Rationally Reflecting All Available Information The Random Walk Theory states past performance cannot be used to predict future performance because in the future prices will also follow a random and unpredictable path. Assuming randomness in price changes is not the same as assuming price levels are irrational. Under the Random Walk Theory, the expected return is zero and there is no possibility of outperformance. The Efficient Market Hypothesis is an alternative model of markets described by Nobel Prize winner, Eugene Fama in the 1970s. The Efficient Market Hypothesis asserts that asset prices reflect all available information. Self-interested traders seek out new information and, as they buy and sell on the information, the market becomes more efficient. If there is a signal (new information) that future market prices will be higher (lower), competitive traders would buy on that signal and in doing so bid prices up or down to reflect the information in the signal. Essentially, the competition among financial analysts, investors, money managers, etc. leads to market efficiency. According to theory, in a perfectly Efficient Market the market price is the fair value of the asset. The key requirements of "informational efficiency" are: competition, low costs of information and liquidity (the ability to buy or sell). According to the theory, analyses never produce consistent excess returns on a risk-adjusted basis. In other words, outperforming the market would require taking on incremental risk, i.e., the excess return is expected as compensation for incremental risk. Fama, Eugene F. (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work." Journal of Finance . Under perfect competition (an 'ideal'), the Efficient Market Hypothesis is consistent with the Random Walk Theory. In his seminal work, Fama indicated 'efficiency, like all perfect-competition supply-and-demand economics, is an ideal, which real-world markets can only approach.' With perfect competition markets reflect all available information and can only respond to new signals. New information by definition is unpredictable so of course price changes following the information are random and unpredictable. As new information is disseminated and rapidly becomes known, the Efficient Market Hypothesis dictates it is quickly absorbed by the market and reflected in prices. Thus, under this 'ideal' circumstance, the Efficient Market Hypothesis is consistent with the Random Walk Theory. Even in a perfectly Efficient Market there is a role for valuation and investment management. These relate, in good part, to the fact that all investors do not interpret information the same way; they have biases. - managing firm-specific risks with a diversified portfolio - managing tax considerations that will vary from individual to individual - managing the individual's risk profile - biases in how different investors evaluate efficiency, i.e., what is efficient to most investors may be a sizable investment opportunity to others (1) High frequency trading (2) High magnitude trading, as an individual might not consider a tenth of a basis point investible but a portfolio manager with a $5 billion fund might Investors Employ Valuation Techniques because Market Inefficiencies Exist Based on the Efficient Market Hypothesis, stock prices should trade at fair value and would never be over- or under-valued. Yet, market anomalies or price inefficiencies do exist. Thus, valuation is conducted for the market as a whole, individual stocks and/or bonds and other assets. Yet, investors have been able to beat the market or the average annual returns of other investors for a period of time —but it is by no means easy. Bill Miller, the portfolio of Legg Mason's Value Trust, outperformed the S&P 500 every year for 15 years until his streak ended in 2005. He was touted as one of the greatest living investment managers of the era. The next three years underperformance erased those gains relative to the market and the $70 billion fund lost two-thirds of its value, but rebounded dramatically in the following two years. Bill Miller launched his Miller Opportunity Trust (LGOAX) in 2009 and once again ranked in the top 1% of money managers for the last 1, 3 and 10 years. Warren Buffet and Berkshire Hathaway (BRK) had a 20+ year return of 20.5% but has not overperformed the S&P 500 for the last 10 years. Renaissance Technologies, a hedge fund using quantitative trading models run by James Simons (an award-winning mathematician), has reported the best record in investing history. It's Medallion fund averaged a 71.8% return (before fees) from 1994-mid-2014; further performance data has been unavailable since it eliminated outside investors. Zuckerman, Gregory. (2019). "The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution ." Portfolio Bernard Madoff claimed consistent 10%+ returns for more than 10 years, but was proven to be a fraud in 2008. Investors and Economists Dispute the Efficient Market Hypothesis for Several Reasons There are many explanations for the anomalies in market pricing relative to the Efficient Market Hypothesis. (1)The Efficient Market Hypothesis is a model of ideal informational efficiency. The market is not perfect; it is not 100% efficient 100% of the time. As new information emerges there may be windows of time before trading opportunities compete information away. The Efficient Market Hypothesis does not define the timeframe required for prices to conform to fair value. (2) Other economists attribute anomalies to behavioral factors such as: overconfidence, overreaction and bias, i.e., human inefficiencies in processing available information. These theories are explored in advanced Economic classes at your university. (3) Using the same available information, investors may arrive at a different view of fair value; it is a subjective figure. Investment style could mean one investor chooses to buy, for example, paying a premium for growth, while another chooses to sell. (4) Anomalies in market behavior may stem from the failure of the market models to represent a perfectly efficient market. There have been many empirical analyses that have found anomalies that reject the Efficient Market Hypothesis. Examples of anomalies that appear to contradict the Efficient Market Hypothesis include: - P/E effect, where lower P/E stocks have shown higher risk-adjusted returns than higher P/E stocks - Small firm effect, where smaller capitalization stocks outperformed the market even when risk-adjusted (Economists have explained some of the out-performance of smaller and neglected stocks due to liquidity.) - Book to Market effect, where companies with high book to market ratios (low Price/Book) outperform - Momentum effect, where stocks sustain a period of over- or under-performance Many of these anomalies have emerged for a period of time and then dissipated or vanished. While these anomalies present challenges to the Efficient Market Hypothesis, they may also be attributed to failures of the models utilized to assess asset valuation. In particular, these models may be questioned as to their accuracy in assessing risk. The elements used by market models may not appropriately match the ideals set by the Efficient Market Hypothesis. The 'market' used to define the risk premium is a theoretical value and not a purchasable asset. (Most analyses substitute the S&P 500.) Similarly, the risk-free rate (detailed below) may not function in the way the model suggests as it could vary during the actual holding period. Beta (?) estimates may also be imprecise. Valuation is an Evolving Science Capital Asset Pricing Model (CAPM) Since the 1960s asset pricing has relied on the Capital Asset Pricing Model (CAPM), described by William Sharpe (1990 winner of the Noble Prize in Economics) and John Lintner. It is still widely used to estimate the cost of capital for firms and evaluate portfolio performance and taught in investment courses. CAPM describes the relationship between the return of a stock and the return of the market relative to the 'risk-free rate'. The 'risk-free rate' is a concept used to describe the return you can expect with certainty. In most analyses, the 'risk-free rate' or R f is measured by the return on Treasury bills. The expected return of the market is symbolized by RM. The average return of the S&P 500 from 1956 (when the 500 company index was formed) to 2019 was about 8% (adjusted for inflation). The Market Risk Premium (also known as Equity Risk Premium) describes the excess return the stock market earns relative to the risk-free rate. In plain language, the Market Risk Premium is the additional return to equity investors to compensate for the greater risk relative to the guaranteed return of the risk-free rate (a government-backed Treasury bill). Market Risk Premium = RM - R f. The Market Risk Premium has averaged between 5.3% - 5.7% for the past 10 years (Statista). However, as the EXHIBIT below demonstrates, the Market Risk Premium has been very volatile, swinging wildly from period to period. 'In 2018, the equity premium between 2008 and 2018 was 10.15%. This is up dramatically from the low of -8.22% in 1999/2009 and ended a dramatic decline from 8.87% in 1990/2000. The equity premium has passed through 10-year cycles during the twenty-first century because the stock market has passed through 10-year cycles. EXHIBIT: TEN YEAR AVERAGE EQUITY RISK PREMIUM Source: Global Financial Data, Taylor Bryan. (February 5, 2020) 300 Years of the Equity-Risk Premium. Global Financial Data, February 5, 2020 https://www.globalfinancialdata.com/300-years-of-the-equity-risk-premium/ CAPM uses Beta (?), to describe the returns of an individual stock (Ri ) or a portfolio. Individual equities are expected to generate returns commensurate with their risk relative to the market. According to CAPM, a riskier equity will generate a greater return than the Market Risk Premium, and a less risky equity is expected to generate a lower return than the Market Risk Premium. Beta (?) describes the systemic risk of a stock, it's volatility relative to the market's returns. Beta (?) represents the equity's correlation to the market. A Beta of one (? = 1.0) indicates the equity is equally as volatile as the market overall. When Beta is more than one (? > 1.0) the equity is more sensitive to market moves. If the market's value moves by a certain amount, a stock with a beta greater than one has historically moved more than the market overall. Conversely, a stock with a beta less than one (? < 1.0) has historically moved less than the market. CAPM describes the expected return of an equity or asset given it's relative risk: Ri = Rf + ? (RM - Rf) This model rests on the assumptions of the Efficient Market Hypothesis (EMH) discussed previously, specifically: - markets are competitive and efficient - markets are comprised of risk-averse investors - security risk premiums (expected excess returns) will be proportional to Beta - investors are rational (absent the behavioral factors detailed earlier) For a mispriced stock, alpha (?) represents the excess return over fair value. Alpha (?) is the excess return due to the firm-specific or idiosyncratic risk not described by the market. If alpha is equal to zero (?=0), there is no reward for bearing the firm's specific, idiosyncratic risk. A negative alpha (? < 0) indicates that, even if you made money, you would have done better investing an index fund to match the market's return. The expected return of a mispriced stock (R i): Ri = ? + Rf + ? (RM - Rf) Newer, Multi-Factor Models Provide Better Explanations for Valuation Anomalies Models incorporating several systemic factors may provide a better explanation of returns. Newer valuation models look to capture the variance in asset valuations due to capitalization and liquidity (anomalies noted previously relative to the Efficient Market Hypothesis). The assumption is that these variables capture the systemic risk not explained by Beta. In the 1990s, seminal research by Nobel Prize winner Eugene Fama concluded book values (Equity) were the primary drivers of valuation. Using monthly data from 1963 through 1990 the research determined that the higher the book to price ratio the higher the return. The analysis also found the impact of book value to be more powerful than the size effect (market capitalization). The average return of low P/E stocks has been higher than expected based on betas. As you recall, we discussed that book value (equity) was also frequently used to predict returns as detailed in our discussion of the the DuPont Analysis in Balance Sheet (Workbook 5). The three-factor model incorporating factors for firm size and book/price is: Ri = ? + Rf + ? (RM - Rf) + bs * SMB + bv * HML Here, SMB represents Small - Big Market Capitalization and HML represents High - Low book-to-market ratios. In the Fama-French Three-Factor Model, Beta no longer explains risk related to firm size or book/market value which are now explicitly measured. EXHIBIT: 1963-1990 RELATIONSHIP BETWEEN STOCK RETURNS AND BOOK TO PRICE RATIOS Average Monthly Return 2.0% 1.5% 1.0% 0.5% 0.0% Low High Book to Price Ratio Fama, Eugene F., French, Kenneth R. (June 1992). "The Cross-Section of Expected Stock Returns". The Journal of Finance https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.1992.tb04398.x Carhart added a fourth factor for momentum in in 1997. Carhart, M. M. (1997). "On Persistence in Mutual Fund Performance". The Journal of Finance Fama and French added profitability and investment into the model in 2015 introducing a Five-Factor model for asset valuation. This improved the explanation of returns over the three-factor model. Fama, Eugene F., French, Kenneth R. (2015). "A Five-Factor Asset Pricing Model". Journal of Financial Economics Disruptive Digitization Provides New Challenges to Valuation Models Disruptive Digitization has significantly altered company financials since the 1990s. Over the last 30 years, the economy has become less dependent upon physical assets and more dependent upon services and digital products. As detailed in the Disruptive Digitization segments of our Workbooks, the advent of communications in the mid '90s (Internet, Cellphones) was transformative. Now, coupled with ubiquitous, always responsive interconnected real-time networks, digitization is affecting the entire economy. Digital and service-oriented firms are far less capital intensive and more cash generative than their counterparts. When combined with cheap and easy money, this has led to hoards of Excess Cash on corporate Balance Sheets. This cash Tsunami has led to a spike in acquisition activity and a significant build up in Intangible Assets. Therefore, Tangible Invested Capital (T-IC) has declined sharply since the 1980s. As a reminder from Balance Sheet (Workbook 5)'s SFAM Balance Sheet, there are many ways to calculate 'Invested Capital' as used in valuation exercises. We treat Noncurrent Liabilities as an obligation related to the business's operations, rather than a financial obligation, and do not include it as a source of capital. We also introduce the term Tangible Invested Capital to evaluate the retun on invested capital before Intangibles (which dilute operating returns). EXHIBIT: DEFINITIONS OF INVESTED CAPITAL Invested Capital (IC) = = Tangible Invested Capital = Non-cash Net Trade Working Capital + Net Noncurrent Assets (Noncurrent Assets - Noncurrent Liabilities) Debt + Equity - Excess Cash Invested Capital - Intangible Assets Source: Marianne Wolk & Richard Horwitz Thus the relationship between Equity and Assets has changed with the dramatic shift in the composition of Assets. Essentially there has been a decoupling of Equity as a barometer as so much of digital firm's assets are comprised of Excess Cash and Intangible Assets (assets with lower returns than those invested in operations). Therefore, valuations based on values to Equity such as Price to Book may prove less valuable. Later in this Workbook, we will explore alternative valuations techniques to the Return on Equity and compare the results of these techniques. Required Homework Questions Equity as very good barometer of value despite the rise in Intangible Assets. CAPM describes the relationship between the excess return of a stock and the excess return of the market relative to the 'risk-free rate'. Because it is impossible to forecast market inefficiencies, there is little reason for investors to employ quantitative valuation techniques. The Efficient Market Hypothesis asserts that assets are valued at fair value reflecting all available information. An expensive investment is priced near it's fair value. Financial analysis is conducted for a variety of reasons but always performed to support a decision. TRUE FALSE Strategic Financial Analysis & Modeling © All rights reserved, 2019, Marianne Wolk & Richard Horwitz Section: Valuation Workbook 11: Equity Valuation Sheet: VALUATION Techniques SHEET ROADMAP The material through Row 306 is a tutorial that will not contribute to your grade. The Homework starting in Row 308 is Required. The Purpose of Investment Valuation is Seeking Outperformance Active Investors Rely on Valuation Techniques to Identify Mispriced Securities Passive investors assume they cannot gain differential returns from the market as a whole. Believers in the Efficient Market Hypothesis believe that any opportunity discovered by valuation techniques will be competed away Passive investors assume any opportunities from mispriced securities may be offset by transaction costs and taxes associated with m Rather than trying to outperform the market, passive investors invest in a well-diversified portfolio aimed at matching the market's r The 'market' return is generally represented by the S&P 500. Passive investors generally buy and hold index funds or exchange traded funds (ETF) that mirror the performance of the market as a Active investors believe they can pursue strategies that will enable them to outperform the market as a whole or a particular benchmark. Active investors are seeking positive alpha (?). We defined alpha (?) earlier as the excess return related to idiosyncratic or firm-specific risk not described by the market in 'INTRO Val It is the excess return of a price that is not trading at fair value. Active investors use valuation techniques to identify mispriced securities that are under- or over-valued relative to fair value. Active Financial Investors Often Seek to Outperform a Benchmark Individual investors may choose to invest for a total or 'absolute return'. For corporations or professional investment managers, it is more important to outperform. Whether investing in a home or a piece of capital equipment, the buyer doesn't wish to overpay. The concept of outperformance when discussing financial investments is similar. Outperformance goes beyond buying and selling a financial instrument to lock in a profit. Financial outperformance is defined as beating the average return for the market as a whole or a particular 'benchmark'. Investors may benchmark their performance relative to the market as a whole (usually a comparison to the S&P 500) or to an index rel The S&P 500 is the most common benchmark, but it is not the only one utilized. EXHIBIT: TYPICAL INVESTMENT BENCHMARKS Investment Vehicle Benchmark Shares of Apple (AAPL) S&P 500 Index (.SPX or ^GSPC) NASDAQ Composite (.IXIC or ^IXIC) NYSE Technology Index (.MSH or ^MSH) S&P Technology Sector Select Index (.IXT or ^IXT) Technology Hardware, Storage and Peripherals Index (.GSPCOPE) Fidelity Contrafund (FCNTX) S&P 500 Index (.SPX or ^GSPC) US Large Cap Growth Equity Fund Vanguard Growth Index Fund (VIGRX) Comparable funds (e.g., AGTHX) Morgan Stanley Growth Fixed Income Bloomberg Barclays U.S. Aggregate Bond Index Opportunities Fund (DINAX) Multisector Bond Index Source: Marianne Wolk & Richard Horwitz Valuation Measures Expected Future Returns and Cash Flows A 'going concern' is an accounting term for a firm that has the resources to continue to operate. When a company is a 'going concern', it can carry out its commitments to customers, suppliers, shareholders and creditors. A 'going concern' is not viewed to be in danger of going out of business or liquidation. Valuation techniques examine a 'going concern' based on the combination of: (a) existing investments, and (b) expected future investments, their profitability (e.g., returns) and resulting cash flows. The value of an asset is based on the expected future cash flows it will generate. A significant percentage of the value of a going concern is derived from expected future growth. In contrast when a business is not judged to be a 'going concern', it is likely to be valued as a collection of it's existing assets, (placing no value on growth and expected future investments that would generate significant future cash flows). Asset-based valuations are always lower than valuations performed for businesses that have growth potential (going concerns). Intrinsic Valuation is Derived from the Cash Flows of a Company, Not its Price If a company is perceived to be a 'going concern', there are two major forms of valuation, 'intrinsic' and 'relative'. Also called 'Absolute Valuation', intrinsic valuation is based on the economics of the company itself and not it's current price or market valu 'Intrinsic Valuation' defines the value of an asset from its cash flows, expected growth and risk. Below we see the value expressed as the present value of expected cash flows (CF) for periods 1-7 and onward to infinity, discounted to its present value by a rate that reflects the riskiness of the cash flows (r ). EXHIBIT: VALUATION DRIVEN BY THE AGGREGATE SUM OF ALL FUTURE EXPECTED CASH FLOWS Value = CF1 + (1+r) CF2 + CF3 + CF4 + CF5 + CF6 + CF7 + 2 3 4 5 6 (1+r)7 (1+r) (1+r) (1+r) (1+r) (1+r) ? Value = CFn S (1+r) n n=1 Source: Marianne Wolk & Richard Horwitz The cash flows used to perform an intrinsic valuation depend on the asset in question. Note, bond valuations are not infinite and their cash flows (interest payments or coupons) will only be paid through the maturity date. For zero coupon bonds, the discount rate used is the measure of risk for the expected cash flows upon maturity rather than the annua EXHIBIT: CASH FLOWS UTILIZED IN INTRINSIC VALUATIONS Asset Cash Flow Equity (stocks) Dividends Free Cash Flow (after tax) Debt (bonds) Coupons (interest) Valuation Method Dividend Discount Model (DDM) Discounted Cash Flow (DCF) Model Bond Valuation Source: Marianne Wolk & Richard Horwitz Free Cash Flows have emerged as the best measure to use as cash flows for intrinsic valuation. Historically, most intrinsic valuations of equity were Dividend Discount Models (DDM). Most companies distributed excess cash through dividends. Therefore, the measure of cash flow used was dividends and analysts frequently used a 'Dividend Discount Model' (DDM) to value The historic tie between cash flow generation and dividends has decoupled. As we demonstrated in the Disruptive Digitization discussion of Cash Flow Statement (Workbook 6), dividends have become less po as a method of returning capital to shareholders over time. Though dividend payments have remained high, dividend payout ratios as a percentage of earnings have declined steadily since th In place of dividends, cash flow generation has been deployed elsewhere. There has been a sharp rise in share repurchases for the past 10+ years, which have eclipsed dividend payments through 2019. There has been a steady multi-decade increase in acquisition activity, building balances of Intangible Assets. In addition, our analysis has found a significant build up of Excess Cash, hoards of uninvested cash on corporate Balance Sheets. Although analysts might differ, we believe the best measure of cash flow is Free Cash Flow. As a reminder, Free Cash Flow is defined as Cash Flow from Operations less Capital Expenditures (but before Dividends, Share Repu Free Cash flow represents the cash flow net of what is reinvested in the operating business. Discounted Cash Flow (DCF) models look at an expanded definition of cash flow after taxes and investments, Free Cash Flows to the Fir Relative Valuations are Based on Current Prices or Market Values In 'Relative Valuation', the value of equity, debt or an asset is compared with historical values, comparable companies or a benchmark or in Relative Valuations' often apply the valuations of comparable companies or transactions to a financial figure. A target price is generated by applying the multiple of the peer group to the financial statistic of the company. Both the multiple and the company element rely on the same financial figure, making the analysis similar to the common size adjustments the vertical analysis we explored in Financial Statement Analysis (Workbook 3). While the analyses may be based on historical figures, most valuations are applied to forecasts of future financial metric for a future period In our experience, most Wall Street financial analysts apply multiples to forecasts 18-24 months into the future, i.e., in June 2020 they Relative Valuations are only performed across a peer group and are not utilized to make allocations across sectors. Target Price = Comparables Multiple to Financial Metric x Target Company's Financial Metric The asset is deemed over- or under-valued based on its current market value (price) versus the target price. Multiples To perform relative valuation, assets are valued based on a standardized measure of price, a 'multiple', applied to a common finan The 'multiple' may be the market multiple, which is the value of the entire stock market (typically the S&P500). The 'multiple' may be an average of the valuations of a selected group of comparables (as detailed below). The multiples reflect expectations for future growth applied to a 'normalized' estimate of current financial performance. Because multiples are based on comparables, a peer universe of companies in the same sector or industry or others with similar gr the valuation represented by the multiple should be applicable. Typically the multiple are created from the current market value or price of the asset or the 'enterprise value' or EV of the compan Comparables Relative valuation relies on an identical or similar asset. Multiples are extremely sensitive to the selection of the peer universe. We discussed comparables analysis of a peer universe in Forecasting (Workbook 8). Establishing a representative peer universe was much easier in a world where there were many similar companies in an industry. For traditional companies, our OldCos, comparables were easy to identify; there are ~3 domestic steel companies, ~3 domestic In the age of Disruptive Digitization, it is more difficul
