Lecture 1 Value Drivers
Firm value = economic value of the firm is the discounted sum of expected future cash flows
→ Is economic value equal to market value? That is what we are trying to do with valuation
Accounting = a language to measure and communicate firm performance
Financial statement analysis = analyzing a firm’s accounting information to learn about its
true performance
Understanding the Past
- Goal: understanding a firm’s financials in the context of its business strategy and the
industry and economy it operates in
- Understand the business
- What does the firm make? How is it made? Who buys it?
- Who are competitors? What industry is the company in? Where is the industry
heading?
- Accounting analysis
- Check how the business is mapped into numbers
- Do the numbers reflect the economics of the business well?
- Ratio analysis
- Understand key strengths and weaknesses of the firm’s strategy
- Identify key drivers of value
- Spot any irregularities
Forecasting the Future
- Goal: forecasting the firm’s value creation in the future
- Information collection
- Based on your understanding of the past, collect information to broaden your
view and inform your predictions
- Forecasting
- Framing the forecasting problem using the same ratios as we used for
understanding the past
- Starting with sales, build a structured forecast
- Use pro-forma statements to anchor your valuation inputs and double-check
how reasonable your forecasts are
Valuation methods
1. Net Present Value (NPV)
Question: what is the maximum you are willing to pay for an investment that you expect to
yield EUR 100 for three years while a comparable risky investment is expected to return 8%
per year?
100/1,08 + 100/1,08^2 + 100/1,08^3 = 257,71 EUR
1
, 2. Dividend Discount Formula
The value of an equity interest is based on the present value of the expected future cash
dividends to be received
The dividend discount formula is rarely used directly, because:
- Dividends don’t directly reflect performance
- Dividends are to a large extent discretionary
- Many firms do not pay dividends right now, but promise to pay later
- Dividend irrelevance theorem
- Theory that posits that dividends don’t affect a company’s stock price or
profitability. It suggests that investors are not better off owning shares of
companies that issue dividends than shares that do not.
- As receiving $1 dividend, it means getting $1 value less firm-wise; yet
reinvesting this 1$ in the firm, gives the same rate of return
3. Earnings-Based Valuation
CE = book value of common equity = = amount that all common shareholders have invested
in the company
NI = net income
ROE = return on equity = NI/CE
Valuation drivers
- Investment growth (g)
- Risk (r)
- Profitability (ROE)
2
,Structured approach to valuation:
1. Understanding the past
2. Forecasting the future
3. Valuation
→ future profitability, future investments ⇒ ROE, CE for different t’s and infinite
Tesla example
- Profitability
- 2020 EPS forecasts: from $-0,58 to $5,45
- Growth:
- Expected 5-year earnings growth 114,3%
- Risk
- Market beta of 0,58
Core drivers: Profitability
- ROE is the ROI for equity investors
- Return on investment:
- ROE is the rate of return that equity owners get
- ROE must be higher than the opportunity cost (r) in order to generate value
- ROE > r ⇒ good
- ROE < r ⇒ bad
- r = the opportunity cost = expected return = cost of equity capital
Only if ROE > r, does a firm create value
Core drivers: Investment Growth
- 10% on 100 EUR versus 10% on 1,000,000
→ Profitability is only part of the picture
- Amount of capital invested is crucial as well
- Investment depreciates and becomes obsolete
- Investment needs to grow to expand the business
- Investment in new assets to not become obsolete and stay competitive
Core drivers: Risk
In our NPV calculation, we used expected values. However, they are uncertain.
→ To adjust for uncertainty (riskiness) of these expectations, we discount them.
r is our measure of this uncertainty.
Coming up with the right (“true” discount rate, r, is challenging → asset pricing models:
determining discount rate in valuation models (alpha technology), price of undiversifiable risk
(beta technology).
Simplification: constant growth
- Under the assumption that:
- Profitability is constant: ROE_t+1 = ROE_t
3
, - Capital grows by g each year: CE_t = (1+g) * CE_t-1
→ This helps to simplify our earnings-based valuation formula (important!!):
4
Firm value = economic value of the firm is the discounted sum of expected future cash flows
→ Is economic value equal to market value? That is what we are trying to do with valuation
Accounting = a language to measure and communicate firm performance
Financial statement analysis = analyzing a firm’s accounting information to learn about its
true performance
Understanding the Past
- Goal: understanding a firm’s financials in the context of its business strategy and the
industry and economy it operates in
- Understand the business
- What does the firm make? How is it made? Who buys it?
- Who are competitors? What industry is the company in? Where is the industry
heading?
- Accounting analysis
- Check how the business is mapped into numbers
- Do the numbers reflect the economics of the business well?
- Ratio analysis
- Understand key strengths and weaknesses of the firm’s strategy
- Identify key drivers of value
- Spot any irregularities
Forecasting the Future
- Goal: forecasting the firm’s value creation in the future
- Information collection
- Based on your understanding of the past, collect information to broaden your
view and inform your predictions
- Forecasting
- Framing the forecasting problem using the same ratios as we used for
understanding the past
- Starting with sales, build a structured forecast
- Use pro-forma statements to anchor your valuation inputs and double-check
how reasonable your forecasts are
Valuation methods
1. Net Present Value (NPV)
Question: what is the maximum you are willing to pay for an investment that you expect to
yield EUR 100 for three years while a comparable risky investment is expected to return 8%
per year?
100/1,08 + 100/1,08^2 + 100/1,08^3 = 257,71 EUR
1
, 2. Dividend Discount Formula
The value of an equity interest is based on the present value of the expected future cash
dividends to be received
The dividend discount formula is rarely used directly, because:
- Dividends don’t directly reflect performance
- Dividends are to a large extent discretionary
- Many firms do not pay dividends right now, but promise to pay later
- Dividend irrelevance theorem
- Theory that posits that dividends don’t affect a company’s stock price or
profitability. It suggests that investors are not better off owning shares of
companies that issue dividends than shares that do not.
- As receiving $1 dividend, it means getting $1 value less firm-wise; yet
reinvesting this 1$ in the firm, gives the same rate of return
3. Earnings-Based Valuation
CE = book value of common equity = = amount that all common shareholders have invested
in the company
NI = net income
ROE = return on equity = NI/CE
Valuation drivers
- Investment growth (g)
- Risk (r)
- Profitability (ROE)
2
,Structured approach to valuation:
1. Understanding the past
2. Forecasting the future
3. Valuation
→ future profitability, future investments ⇒ ROE, CE for different t’s and infinite
Tesla example
- Profitability
- 2020 EPS forecasts: from $-0,58 to $5,45
- Growth:
- Expected 5-year earnings growth 114,3%
- Risk
- Market beta of 0,58
Core drivers: Profitability
- ROE is the ROI for equity investors
- Return on investment:
- ROE is the rate of return that equity owners get
- ROE must be higher than the opportunity cost (r) in order to generate value
- ROE > r ⇒ good
- ROE < r ⇒ bad
- r = the opportunity cost = expected return = cost of equity capital
Only if ROE > r, does a firm create value
Core drivers: Investment Growth
- 10% on 100 EUR versus 10% on 1,000,000
→ Profitability is only part of the picture
- Amount of capital invested is crucial as well
- Investment depreciates and becomes obsolete
- Investment needs to grow to expand the business
- Investment in new assets to not become obsolete and stay competitive
Core drivers: Risk
In our NPV calculation, we used expected values. However, they are uncertain.
→ To adjust for uncertainty (riskiness) of these expectations, we discount them.
r is our measure of this uncertainty.
Coming up with the right (“true” discount rate, r, is challenging → asset pricing models:
determining discount rate in valuation models (alpha technology), price of undiversifiable risk
(beta technology).
Simplification: constant growth
- Under the assumption that:
- Profitability is constant: ROE_t+1 = ROE_t
3
, - Capital grows by g each year: CE_t = (1+g) * CE_t-1
→ This helps to simplify our earnings-based valuation formula (important!!):
4
