ADB1023

Corporate Finance

Chapter 3
Valuation of Assets, Shares
and Companies

1
2
Learning Outcomes
To provide an understanding of the main ways of valuing companies
and shares, and of the limitations of these methods.
To stress that valuation is an imprecise art, requiring a blend of
theoretical analysis and practical skills.
To introduce the dividend valuation model.

3
4
 Introduction

 With a well-established market and if the asset is fairly homogeneous, valuation

So long as the market is reasonably efficient, the market price can be trusted as
a fair assessment of value.

Problems arise in valuing unique assets, or assets that have no recognizable

Even with a ready market, valuation may be complicated by a change of use or

5
Three basic Valuation Models

1) Net asset value,

2) Price–earnings Ratio.

3) Discounted cash flow/ General Valuation Model.

6
7
 Net Asset Value Approach
Calculation of the equity value in a firm by
netting the liabilities against the assets.

8
Net Asset Value Approach
 Calculation of the equity value in a firm by netting the liabilities
against the assets.

9
Problems with NAV Approach

Fixed asset values are based on historical cost

Stock values are often unreliable

The debtors figure may be suspect

A further problem: valuation of intangible assets

10
11
 Price-earnings Ratio
 In essence, the price-earnings ratio indicates the dollar amount an investor
can expect to invest in a company in order to receive one dollar of that
company’s earnings.
This is why the P/E is sometimes referred to as the multiple because it shows
how much investors are willing to pay per dollar of earnings.
If a company were currently trading at a multiple (P/E) of 20, the interpretation
is that an investor is willing to pay $20 for $1 of current earnings.
In general, a high P/E suggests that investors are expecting higher earnings
growth in the future compared to companies with a lower P/E.
A low P/E can indicate either that a company may currently be undervalued or
that the company is doing exceptionally well relative to its past trends. 

12
 Price-earnings Ratio
In essence, the price-earnings ratio indicates the dollar
amount an investor can expect to invest in a company in
order to receive one dollar of that company’s earnings.
This is why the P/E is sometimes referred to as the
multiple because it shows how much investors are willing
to pay per dollar of earnings.
If a company were currently trading at a multiple (P/E)
of 20, the interpretation is that an investor is willing to
pay $20 for $1 of current earnings.

13
 Price-earnings Ratio
In general, a high P/E suggests that investors are
expecting higher earnings growth in the future
compared to companies with a lower P/E.

14
 Price-earnings Ratio
A low P/E can indicate either that a company may
currently be undervalued or that the company is
doing exceptionally well relative to its past trends.

15
16
 General Valuation Model (GVM)

States that the value of any asset is the sum of all future discounted
net benefits expected to flow from the asset

P0 = Price of asset at time 0 (today)

CFt = Cash flow expected at time t

17
 Free Cash Flow (FCF) Approach
 Free Cash Flows adjust for depreciation as it is a non-cash expense.
The inflow remaining net of investment outlays is referred to as free
cash flow (i.e. ‘free’ of investment expenditure).
Free cash flow =[revenues - operating costs] - [interest payments] -
[taxes] + [depreciation] - [investment expenditure].
 The depreciation charge is added back because it is merely an
accounting adjustment to reflect the fall in value of assets.
Using this measure, the value of the owners’ stake in a company is the
sum of future discounted free cash flows:

18
 Free Cash Flow (FCF)
Free cash flow
=
[revenues - operating costs]
-
[interest payments]
-
[taxes]
+
[depreciation]
-
[investment expenditure]

19
20
 Free Cash Flow (FCF) Approach

The value of the owners’ stake in a company is the

21
22
 Valuing Shares: The Dividend Valuation Model

 Shareholders attach value to shares because they expect to receive a stream

This is appropriate for valuing part shares of companies rather than whole
enterprises.

The DVM states that the value of a share now, P , is the sum of the stream of
future discounted dividends plus the value of the share as and when sold, in
some future year, n:

23
24
However, since the new purchaser will, in turn, value the stream of
dividends after year n, we can infer that the value of the share at any time
may be found by valuing all future expected dividend payments over the
lifetime of the firm.
If the lifespan is assumed infinite and the annual dividend is constant, we
have:

This is an application of valuing a perpetuity.

25
26
 Allowing for dividend growth: the DGM
 The constant dividend valuation model can be extended to cover constant growth thus
becoming the Dividend Growth Model (DGM) or also known as Dividend Discount
Model.

This states that the value of a share is the sum of all discounted dividends, growing at the
annual rate g:

 If Do is this year’s recently paid dividend,* Do(1+g) is the dividend to be paid in one
year’s time (D1), and so on.

 Such a series growing to infinity has a present value of:

27
Problems with Dividend Discount Model

 What if the company pays no dividend?

Will there always be enough worthwhile projects in the future?

What if the growth rate exceeds the discount rate?

28
29
 DDM with Unequal Growth Rates

We could segment the company’s lifespan into periods of varying growth and
value these separately.

For example, if we expect fast growth in the first five years and slower growth
thereafter, the expression for value is:

P0 = [Present value of dividends during year 1-5] + [Present value of all

30
Note that the second term is a perpetuity beginning in year 6, but we have to find
its present value. Hence it is discounted down to year zero as in the following
expression:

where gf is the rate of fast growth during years 1–5 and gs is the rate of slow
growth beginning in year 6 (i.e. from the end of year 5).

31