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AFIN353
DCF and Multiples
Valuation
AFIN353
LEARNING OUTCOMES..TOPIC 1, WEEK 1

1.To refresh our understanding of the time value of money.
2.To understand the alternative approaches to valuation.
3.Use the dividend-discount model to compute the value of a dividend-paying company’s stock and to calculate the total return of a stock, given the dividend payment.
4.Discuss the determinants of future dividends and growth rate in dividends, and the sensitivity of the stock price to estimates of those two factors.
5.Assuming a firm has a long-term constant growth rate after time         N + 1, use the constant growth model to calculate the terminal value of the stock at time N.
6.To apply the Multiples approach to valuation
7.Understand the limitations of each valuation model.
Overview
DCF and MULTIPLES VALUATION

A.Introduction: Valuation
B.Toolbag – Present Values
C.Toolbag – Rates and Returns
D.Income, Capital and Total Returns
E.Valuing Shares and Firms
§Dividend Discount Model
§Relative Valuation/Valuation Multiples
§Free Cash Flow to Firm [Next Week]
WEEK 1
A. Intro: Valuation
§Valuation is important to investment decision-making.
§
§There are 3 ways to think about valuation. They are:
1.Discounted Cash Flow (DCF) valuation,
2.Multiples/Relative or Comparables valuation,
3.Contingent claims: Option valuation.
§Arguably DCF is the most important.

§DCF has 3 main parts: the formulas, the cash flows and
the required returns.
Intro: DCF Valuation Overview
•DCF is also called 'net present value' or 'discounted
expected value'.

•Preferred when future cash flows are predictable and the
required return (discount rate) can be easily calculated.

•Widely used for valuing securities (eg. Bonds, shares),
assets (eg. real estate with stable rental income), companies,
and for evaluating investment projects.

•More of an absolute or intrinsic valuation technique,
as opposed to a relative valuation technique.
Intro: Multiples Valuation
•Multiples Valuation is a relative valuation technique.
Prices assets using the prices of other, similar assets.

•Many different types of multiples can be used.
e.g Price/Earnings, Price/Sales, Price/m2

•Simple, intuitive, based on real-world prices.
•Preferred when future cash flows are unpredictable,
and when there are many similar assets that are frequently
traded at observable prices, such as stocks.

•Real estate and stocks are suitable for multiples valuation.
.
MULTIPLES VALUATION/RELATIVE VALUATION
B. Toolbag: Present Value
Formulas (Ch 4)
Toolbag: Present Value
Formulas (Ch 4)
Annuity: a series of identical cash flows occurring at
regular intervals through time for a specified number of
periods.

Toolbag: Present Value
Formulas (Ch 4)
To determine FV (future value), remember the future value
of a single cash flow is:

HINT: If you need the future value of an annuity or perpetuity,
Find the PV and multiply the PV formula by (1+r)t.

Question 1: Ordinary Perpetuity: You want to create a fund
that will pay a scholarship of \$30,000 each year in perpetuity
(forever) starting in one year’s time. The fund will earn 8%pa.
How much will you need to donate today (t=0)?

Calculation Examples: Perpetuity

Question 2: Perpetuity Due: What is the answer to Q1
if the first payment was to be made at t=0?

Question 3: What is the answer to Q1 if the first payment
was made exactly 3 years  from today (t=3)?

Answer: Tricky! The PV perpetuity formula assumes the
first cash flow is one period into future. So, calculate the
value at one period prior the first cash flow, then discount
that back to t=0.
Value of perpetuity       Discount Value t=2
at t=2  to t=0

Try this yourself!
C. Toolbag: Rates & Returns
(Ch 5)
Lessons:
(1)When we use a particular discount rate in DCF,
we must match the discount rate period with the periodicity
of cash flows e.g. If cash flows are at 6  month intervals,
we must use the effective 6 month discount rate.

(2) Effective rates can be used to discount cash flows.

APR's cannot be used to discount cash flows,
they must be converted to effective rates first.
Toolbag: Rates & Returns
(Ch 5)

Toolbag: Rates & Returns
(Ch 5)

Toolbag: Rates & Returns
(Ch 5)
Example:
A credit card might advertise an interest rate of 12% pa.
This is an APR. Because credit cards are always paid off
monthly, the compounding frequency is per month. Therefore
the interest rate is 12% pa compounding monthly and the
effective rate that you pay is greater than the
quoted APR.

EAR= (1+0.12/12)12-1=12.6825%
Toolbag: Rates & Returns
(Ch 5)
Toolbag: Rates & Returns
(Ch 5)

Toolbag: Rates & Returns
(Ch 5)

Toolbag: Rates & Returns
(Ch 5)
•Note that the rates used in the above equation should be effective rates,
not APR's.

•Be aware that Annualised Percentage Rates (APR's) are also sometimes
called 'nominal rates' even though they have nothing to do with the concept
of inflation.
This is very confusing. In these notes, when a 'nominal rate' is mentioned,
it means a rate that is not adjusted for inflation.

Question 5:
Westpac advertises a 6 month term deposit with an interest rate of
5%pa (APR).
a) What is the effective interest rate per compounding period?