A B C D E F G

1 Tool Kit Chapter 7

2
3 Corporate Valuation and Stock Valuation
4
5 7-4 Valuing Common Stocks—Introducing the Free Cash Flow (FCF) Valuation Model
6
7 Data for B&B Corporation (Millions)
8
9 Constant free cash flow (FCF) = $10
10 Weighted average cost of capital (WACC) = 10%
11 Short-term investments = $2
12 Debt = $28
13 Preferred stock = $4
14 Number of shares of common stock = 5
15
16 The first step is to estimate the value of operations, which is the present value of all expected free cash flows. Because the
17 FCF's are expected to be constant, this is a perpetuity. The present value of a perpetuity is the cash flow divided by the cost
18 of capital:
19
20 Value of operations (Vop) = FCF/WACC
21 Value of operations (Vop) = $100.00 million
22
23 B&B's total value is the sum of value of operations and the short-term investments:
24
25 Value of operations $100
26 + ST investments $2
27 Estimated total intrinsic value $102
28
29 The next step is to estimate the intrinsic value of equity, which is the remaining total value after accounting for the claims
30 of debtholders and preferred stockholders:
31
32 Value of operations $100
33 + ST investments $2
34 Estimated total intrinsic value $102
35 − All debt $28
36 − Preferred stock $4
37 Estimated intrinsic value of equity $70
38
39 The final step is to estimate the intrinsic common stock price per share, which is the estimated intrinsic value of equity
40 divided by the number of shares of common stock:
41
42 Value of operations $100
43 + ST investments $2
44 Estimated total intrinsic value $102
45 − All debt $28
46 − Preferred stock $4
47 Estimated intrinsic value of equity $70
48 ÷ Number of shares 5
49 Estimated intrinsic stock price = $14.00
50
51 The figure below shows a summary of the previous calculations.
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52
53
54 Figure 7-2
55 B&B Corporation's Sources of Value and Claims on Value (Millions of Dollars except Per Share Data)
56
57 Inputs: Valuation Analysis
58 Constant free cash flow (FCF) = $10 Value of operations
59 Weighted average cost of capital (WACC) = 10% + ST investments
60 Short-term investments = $2 Estimated total intrinsic value
61 Debt = $28 − All debt
62 Preferred stock = $4 − Preferred stock
63 Number of shares of common stock = 5 Estimated intrinsic value of equity
64 ÷ Number of shares
65 Estimated intrinsic stock price
66
67
68 Sources of Value Claims on Value
69
70
71 Short-term
investments
72 = $2
73
74
75 Debt = $28
76
77 Estimated
78 equity value
79 = $70 Preferred
stock = $4
80 Value of operations
81 = $100
82
83
84
85
86
87
88
89 7-5 The Constant Growth Model: Valuation when Expected Free Cash Flow Grows at a Constant Rate
90
91 Case 1: The expected free cash flow at t=1 and the expected constant growth rate after t=1 are known.
92
93 First expected free cash flow (FCF1) = $105
94 Weighted average cost of capital (WACC) = 9%
95 Constant growth rate (gL) = 5%
96
97 When free cash flows are expected to grow at a constant rate, the value of operations is:
98
99 𝐕_𝐨𝐩=
100 〖𝐅𝐂𝐅〗 _𝟏/(𝐖𝐀𝐂𝐂−𝐠_
101 𝐋)
102
103
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104 Value of operations (Vop) = FCF1 / [WACC-gL]
105 Value of operations (Vop) = $2,625
106
107
108 Case 2: Constant growth is expected to begin immediately.
109
110 Most recent free cash flow (FCF0) = $200
111 Weighted average cost of capital (WACC) = 12%
112 Constant growth rate (g L
) = 7%
113
114 When free cash flows are expected to grow at a constant rate, the value of operations is:
115
116 𝐕_𝐨𝐩= ( 〖𝐅𝐂𝐅〗 _𝟎
117 (𝟏+𝐠_𝐋))/(𝐖𝐀𝐂𝐂−𝐠_𝐋
118 )
119
120
121 Value of operations (Vop) = [FCF0(1+gL)]/[WACC-gL]
122 Value of operations (Vop) = $4,280
123
124
125 7-6 The Multi-Stage Model: Valuation when Expected Short-Term Free Cash Flow Grows at a Nonconstant Rate
126
127 Thurman Corporation's expected free cash flows are shown below.
128
129 Year 0 1 2 3 4
130 FCF −$20 $80 $100 $110
131 Growth in FCF 25% 10%
132
133
134
135 Free cash flows are expected to grow at a 5% rate starting at Year 4 and to continue growing
at a 5% rate for the foreseeable future. We know the free cash flow at Year 4 and we know
136 that FCF grows at a constant rate after Year 4. Therefore, we set the horizon date at Year 4.
137
138
139 Free cash flow at beginning of the constant growth phase (FCF 4) = $110
140 Weighted average cost of capital (WACC) = 15%
141 Constant growth rate (gL) = 5%
142
143 〖𝐇𝐕〗 _𝟒= 〖 𝐕〗 _(𝐨𝐩, 𝐚𝐭 𝟒)= ( 〖𝐅
144
145 𝐂𝐅〗 _𝟒 (𝟏+𝐠_𝐋))/(𝐖𝐀𝐂𝐂−𝐠_𝐋 )
146
147
148 HV4 = Vop, at 4 = [FCF4 (1+gL)]/ [WACC-gL]
149 HV4 = Vop, at 4 = $1,155
150
151
152 Thurman's time line of expected free cash flows and horizon value is shown below.
153
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154 Year 0 1 2 3 4
155 FCF −$20 $80 $100 $110
156 Horizon value $1,155
157
158
159 Present value of HV4 = $660.375
160 Present value of free cash flows = $171.745
161 Total value of operations at Year 0, V op, at t=0 = $832.120
162
163
164 There is more than one correct way to find the present value of the FCFs and the horizon
165 value. For example, you could find the total cash flows, as shown below, which are equal to
the free cash flows except for the last period, when they are equal to the sum of the free cash
166 flow and the horizon value. (It is as though you received the FCF at Year 4 and then "sold" the
167 operations and received cash equal to the horizon value.) You could then find present value
168 of the combined free cash flows and horizon value.
169
170 Year 0 1 2 3 4
171 FCF −$20 $80 $100 $110
172 Horizon value $1,155
173 Combined FCF and HV −$20.00 $80.00 $100 $1,265
174
175
176 PV of combined FCF and HV =
177 Total value of operations at Year 0, V op, at t=0 = $832.12
178
179
180
181 Here is a third way to find the present value of the FCFs and the horizon value. The basic idea
182 is to find the value of operations at each date. For the last date, the value of operations is the
183 horizon value. For the previous date, the value of operations is equal to the present value of
the sum of the next date's value of operations and FCF. For example, if you sell the operations
184 immediately after receiving the FCF at Year 3, then the purchaser would receive the FCF at
185 Year 4 plus the value of operations at Year 4 (which is the present value of all cash flows
186 beyond Year 4).
187
188 Year 2021 2022 2023 2024 2025
189 FCF −$20.00 $80.00 $100.00 $110.00
190 Horizon value $1,155
191 Vop,t =
192 (FCFt+1 + Vop,t+1)/ $832.12 $976.94 $1,043.48 $1,100.00 $1,155.00
(1+WACC)
193
194
195
196
197 Optional Material. You may have noticed that we could have defined the horizon date at
Year 3 because we have an estimate of the Year 4 free cash flow, which is expected to grow at
198 a constant rate thereafter. However, we recommend defining the horizon date as the last
199 date in the forecast period even if growth becomes constant at or prior to this date because
200 we have found that this leads to fewer errors. But we illustrate this approach below for the
interested reader.
201
202
203 Free cash flow at beginning of the constant growth phase (FCF 4) = $110
204 Weighted average cost of capital (WACC) = 15%
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205 Constant growth rate (gL) = 5%
206 HV3 = Vop, at 3 = FCF4 / [WACC-gL]
207 HV3 = Vop, at 3 = $1,100
208
209
210 Thurman's time line of expected free cash flows and horizon value is shown below.
211
212 Year 0 1 2 3
213 FCF −$20 $80 $100
214 Horizon value $1,100
215
216
217 Present value of HV4 = $723.268
218 Present value of free cash flows = $108.852
219 Total value of operations at Year 0, V op, at t=0 = $832.120
220
221
222
223 Following is a summary of the steps used in estimating Thurman Corporation's value of operations.
224
225
226 Figure 7-3
227 Thurman Corporation's Value of Operations (Millions of Dollars)
228 INPUTS:
229 gL = 5%
230 WACC = 15% Projections
231 Year 0 1 2 3 4
232 FCF −$20.00 $80.00 $100.00 $110.00 ⟶⟶ ⟶↴
233 ↓ ↓ ↓ ↓ ↓
234 FCF1 FCF2 FCF3 FCF4 HV = Vop(t=4)
235 ────── ────── ────── ────── ↓
236 (1+WACC)1 (1+WACC)2 (1+WACC)3 (1+WACC)4 FCF4(1+gL)
237 ↓ ↓ ↓ ↓ ─────────
238 ↓ ↓ ↓ ↓ (WACC− gL)
239 ↓ ↓ ↓ ↓ ↓
240 ↓ ↓ ↓ ↓ $115.500
241 −$17.391 ⟵ ⟵⤶ ↓ ↓ ↓ 10.00%
242 $60.491 ⟵⟵⟵⟵ ⟵⟵⤶ ↓ ↓ ↓
PVs of FCFs
243 $65.752 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⤶ ↓ $1,155.000
244 $62.893 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⤶ ↓
245 PV of HV $660.375 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⟵⟵⟵ $1,155.000 ⟵⟵⟵⤶
246 ↓ = ──────
247 Vop = $832.12 (1+WACC)4
248
249
250
251
252
253
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254 7-7 Application of the FCF Valuation Model to MicroDrive
255
256 We begin with MicroDrive's most recent financial statements and selected additional data.
257
258 Figure 7-4
259 MicroDrive’s Most Recent Financial Statements (Millions, Except for Per Share Data)
260 INCOME STATEMENTS BALANCE SHEETS
261 2018 2019 Assets 2018 2019
262 Net sales $4,800 $5,000 Cash $102 $100
263 COGS (excl. depr.) 3,710 3,900 ST Investments 40 10
264 Depreciation 180 200 Accounts receivable 384 500
265 Other operating expenses 470 500 Inventories 774 1,000
266 EBIT $440 $400 Total CA $1,300 $1,610
267 Interest expense 40 60 Net PP&E 1,780 2,000
268 Pre-tax earnings $400 $340 Total assets $3,080 $3,610
269 Taxes (25%) 100 85
270 NI before pref. div. $300 $255 Liabilities and Equity
271 Preferred div. $7 $7 Accounts payable $180 $200
272 Net income $293 $248 Notes payable 28 150
273 Accruals 370 400
274 Other Data Total CL $578 $750
275 Common dividends $59.4 $60.0 Long-term bonds 350 520
276 Addition to RE $233.6 $188.0 Total liabilities $928 $1,270
277 Tax rate 25% 25% Preferred stock 100 100
278 Number of common shares 60 60 Common stock 500 500
279 Price per share (P) $45.00 $31.00 Retained earnings 1,552 1,740
280 Earnings per share (EPS) $4.88 $4.13 Total common equit $2,052 $2,240
281 Dividends per share (DPS) $0.99 $1.00 Total liabs. & equity $3,080 $3,610
282 Dividend yield (DPS/P) 2.2% 3.2%
283
284 Weighted average
285 cost of capital (WACC) 11.50% 11.50%
286
287 7-7a Forecasting MicroDrive’s Free Cash Flows
288 The first step is to calculate the key performance measures that determine free cash flows.
289
290 Figure 7-5
291 Key Performance Measures for MicroDrive (Millions of Dollars)
292 MicroDrive Industry
293 2018 2019 2019
294 Calculating Net Operating Profit after Taxes (NOPAT)
295 NOPAT = EBIT(1 − T) $330 $300
296 Calculating Net Operating Working Capital (NOWC)
297 Operating current assets $1,260 $1,600
298 − Operating current liabilities $550 $600
299 NOWC $710 $1,000
300 Calculating Total Net Operating Capital (OpCap)
301 NOWC $710 $1,000
302 + Net PP&E $1,780 $2,000
303 OpCap $2,490 $3,000
304 Investment in operating capital $510
305 Calculating Free Cash Flow (FCF)
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306 FCF = NOPAT – Investment in operating capital −$210
307 Calculating Return on Invested Capital (ROIC)
308 ROIC = NOPAT/Total net operating capital 13.25% 10.00% 13.19%
309 Calculating the Operating Profitability Ratio (OP)
310 OP = NOPAT/Sales 6.88% 6.00% 6.75%
311 Calculating the Capital Requirement Ratio (CR)
312 CR = (Total net operating capital)/Sales 51.88% 60.00% 51.19%
313
314
315
316
317 The next step is to forecast sales, NOPAT, and total net operating capital. We do this by estimating future sales' growth
318 rates, operating profitability ratios, and capital requirement ratios, as shown in Panel A in the Figure below.
319
320
321 Yearly sales are forecast by letting the previous year's sales increase by the forecasted sales growth rate. Operating
322 profitability and total net operating capital in a forecasted year are assumed to be proportional to sales in that year.
323
324
325 Figure 7-6
326 MicroDrive's Forecast of Operations for the Selected Scenario (Millions of Dollars, Except for Per Share Data)

327 Status Quo

Industry MicroDrive MicroDrive
328 Panel A: Actual Actual Forecast
329 Operating Ratios 2019 2018 2019 2020 2021 2022
330 g = Sales growth rate 10% 4% 10% 8% 7%
331 OP = NOPAT/Sales 6.75% 6.9% 6% 6.00% 6.00% 6.00%
332 CR = OpCap/Sales 51.2% 51.9% 60% 60.00% 60.00% 60.00%
333 Tax rate 25% 25% 25% 25.00% 25.00% 25.00%
334 Panel B: Actual Forecast
335 Operating Items 2019 2020 2021 2022
336 Net sales $5,000 $5,500 $5,940 $6,356
337 Net operating profit after taxes $300 $330 $356 $381
338 Total net operating capital (OpCap) $3,000 $3,300 $3,564 $3,813
339 FCF = NOPAT – Investment in OpCap −$210 $30 $92 $132
340 Growth in FCF 208% 43%
341 ROIC = NOPAT/OpCap 10.00% 10% 10% 10%
342
343 Note: Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate
344 calculations using the figure’s rounded values will be inexact.
345
346 Figure 7-7, shown next, applies to MicroDrive the same procedures used previously for Thurman Corporation in Figure 7-
347 3.
348 Figure 7-7
349 MicroDrive Inc.'s Value of Operations (Millions of Dollars)
350 INPUTS: Scenario: Status Quo
351 gL = 5.0%
352 WACC = 11.50% Projections
353 Year 2019 2020 2021 2022 2023 2024
354 FCF $30.00 $92.40 $131.87 $209.74 $220.23
355 ↓ ↓ ↓ ↓ ↓
356 FCF2020 FCF2021 FCF2022 FCF2023 FCF2024
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357 ────── ────── ────── ────── ──────
358 (1+WACC)1 (1+WACC)2 (1+WACC)3 (1+WACC)4 (1+WACC)5
359 ↓ ↓ ↓ ↓ ↓
360 ↓ ↓ ↓ ↓ ↓
361 ↓ ↓ ↓ ↓ ↓
362 ↓ ↓ ↓ ↓ ↓
363 $27 ⟵⤶ ↓ ↓ ↓ ↓
364 $74 ⟵⟵⟵⟵ ⟵⤶ ↓ ↓ ↓
365 PVs of FCFs $95 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⤶ ↓ ↓
366 $136 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⤶ ↓
367 $128 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⤶
368 PV of HV $2,064 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵⟵⟵⟵ ###
369 ↓ = ───────
370 Vop = $2,524 (1+WACC)5

371
372 Note: Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate
373 calculations using the figure’s rounded values will be inexact.
374
375
376 7-7b MicroDrive’s Horizon Value
377
378
379 The next step is to estimate the horizon value and the value of operations, beginning with the horizon value.
380
381
382 Free cash flow at beginning of the constant growth phase (FCF 2022) = $220.2285
383 Weighted average cost of capital (WACC) = 11.50%
384 Constant growth rate (gL) = 5.000%
385
386
387 〖𝐇𝐕〗 _𝟐𝟎𝟐𝟒= 〖 𝐕〗 _(𝐨𝐩, 𝟐𝟎𝟐𝟒)=
388 ( 〖𝐅𝐂𝐅〗 _𝟐𝟎𝟐𝟒
389 (𝟏+𝐠_𝐋))/(𝐖𝐀𝐂𝐂−𝐠_𝐋 )
390
391 HV2024 = Vop, 2024 = [FCF2024 (1+gL)]/ [WACC-gL]
392 HV2024 = Vop, 2024 = $3,558
393
394
395 MicroDrive's time line of expected free cash flows and horizon value is shown below.
396
397 Year 2019 2020 2021 2022 2023 2024
398 FCF $30.00 $92.40 $131.87 $209.74 $220.23
399 Horizon value $3,557.5
400
401
402 Present value of HV = $2,064
403 Present value of free cash flows = $460
404 Total value of operations at Year 0, V op, at t=0
= $2,524
405
406
407
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408 Alternatively, with estimates of the value of operations and FCF at Year-T, we can discount each of these back one period to determine
409 the value of operations at the end of the prior year. As shown below, we can use this recursive approach to determine the current
410 value of operation.
411
412
413 Figure 7-8
414 MicroDrive Inc.'s Projected Annual Value of Operations (Millions of Dollars)
415 INPUTS: Scenario: Status Quo
416 gL = 5%
417 WACC = 11.50% Projections
418 Year 2019 2020 2021 2022 2023 2024
419 FCF $30.00 $92.40 $131.87 $209.74 $220.23
420 HV = Vop(2024)a $3,558
421 Vop(t)b $2,524 $2,784 $3,012 $3,227 $3,388 $3,558
422
423 Notes:
424 Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate calculations
425 using the figure’s rounded values will be inexact.
426 a
HV = [ FCF2023(1+gL)]/(WACC− gL)
427 b
Vop(t) = [FCFt+1 + Vop(t+1)]/(1 + WACC)
428
429
430
431 Estimating MicroDrive's Intrinsic Stock Price per Share
432
433 Value of operations = $2,524
434 Weighted average cost of capital (WACC) = 11.50%
435 Short-term investments = $10
436 Short-term debt (notes payable) = $150
437 Long-term debt (bonds) = $520
438 Preferred stock = $100
439 Number of shares of common stock = 60
440
441 MicroDrive's total value is the sum of value of operations and the short-term investments:
442
443 Value of operations $2,524
444 + ST investments $10
445 Estimated total intrinsic value $2,534
446
447 The next step is to estimate the intrinsic value of equity, which is the remaining total value after accounting for the claims
448 of debtholders and preferred stockholders:
449
450 Value of operations $2,524
451 + ST investments $10
452 Estimated total intrinsic value $2,534
453 − All debt $670
454 − Preferred stock $100
455 Estimated intrinsic value of equity $1,764
456
457 The final step is to estimate the intrinsic common stock price per share, which is the estimated intrinsic value of equity
458 divided by the number of shares of common stock:
459
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460 Value of operations $2,524 $2,524.00
461 + ST investments $10 $10
462 Estimated total intrinsic value $2,534 $2,534.00
463 − All debt $670 $670
464 − Preferred stock $100 $100
465 Estimated intrinsic value of equity $1,764 $1,764.00
466 ÷ Number of shares 60.00 60.00
467 Estimated intrinsic stock price = $29.40 $29.40
468
469 The figure below shows a summary of the previous calculations.
470
471
472 Figure 7-9
473 MicroDrive Inc.'s Intrinsic Stock Price (Millions, Except for Per Share Data)
474 INPUTS:
475 gL = 5%
476 WACC = 11.50%
477 Year = 2020 2021 2022 2023 2024
478 Projected FCF = $30.00 $92.40 $131.87 $209.74 $220.23
479
480 Horizon Value: Value of operations $2,524
481 + ST investments $10
482 〖𝐇𝐕〗 _𝟐𝟎𝟐𝟒= ( 〖𝐅𝐂 $3,558 Estimated total intrinsic value $2,534
483 𝐅〗 _𝟐𝟎𝟐𝟒 − All debt $670
484 Value
(𝟏+𝐠_𝐋))/((𝐖𝐀𝐂𝐂
of Operations: − − Preferred stock $100
485 𝐠_𝐋)) = Present value of HV $2,064.31 Estimated intrinsic value of equity $1,764
486 + Present value of FCF $459.85 ÷ Number of shares 60
487 Value of operations = $2,524.16 Estimated intrinsic stock price = $29.40
488
489 Note: Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus, intermediate
490 calculations using the figure’s rounded values will be inexact.
491
492
493 7-8 Do Stock Prices Reflect Long-Term or Short-Term Cash Flows?
494
495
496 Managers often claim that stock prices are "short-term" in nature in the sense that they reflect what is happening in the
near-term and ignore the long-term. We can use MicroDrive's results to shed light on this claim.
497
498
499
We previously estimated MicroDrive's current value of operations. We also estimated MicroDrive's horizon value at Year 5
500 and calculated its present value. If we divide the present value of the horizon value, we can estimate how much of
MicrDrive's value is due to cash flows occurring beyond Year 5. In other words, we can determine how much of
501 MicroDrive's value is due to long-term cash flows and how much is due to short-term cash flows.
502
503
504 Inputs:
505 Weighted average cost of capital = 11.50%
506 Horizon year = 5
507 Horizon value at Year 5 (HV5) = $3,558
508 Value of operations at Year 0 (Vop,0) = $2,524
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509
510 Analysis:
511 Value of operations at Year 0 = $2,524
512 PV of cash flows from Year 1 to Year 5 = $460
513 Present value of the horizon value = $2,064
514
515
516
517 Results:
518 Percent of current value due to long-term cash flows (i.e., PV of HV 5) = 82%
519 Percent of current value due to short-term cash flows = 18%
520
521 For most stocks, the percentage of the current price that is due to long-term cash flows is over 80%.
522
523
524 7-9 Using the Free Cash Flow Valuation Model to Identify Value Drivers
525
526
527 We can use the free cash flow valuation model we developed previously for MicroDrive to determine how the inputs (sales
growth, operating profitability, and capital requirements) affect the value of operations and intrinsic stock price. It is very
528 easy to do this in Excel by using the Scenario Manager feature. Following is an explantion of how to use this feature.
529
530
531
532 The Scenario Manager allows you to specify values for particular cells and then save those values as a "scenario." If you
533 later change the values in the cells, perhaps to see the impact that the change has on an output, the Scenario Manager
allows you to restore the saved scenario without having to re-input the original values. You can create numerous different
534 scenarios, and you can even have the Scenario Manager create a summary that shows the values of the input cells and the
535 values of the output cells for each scenario that you created.
536
537
538
539 To create a scenario, go to the Data tab in the menu, look in the Data Tools section for What-If Analysis, and then select
540 Scenario Manager. This will open a dialog box that shows seven existing scenarios. If you select the button for "Add…", you
541 will get another dialog box asking you to give the scenario a name and to specify the "Changing cells." The "Changing cells"
542 are the cells with values that you want the Scenario Manager to save. For example, we want to save the values for
MicroDrive's estimated sales growth rates, operating profitabiltiy ratio, and capital requirement ratio.
543
544
545
546
547 After specifying the "Changing cells", click "Ok" and you will get a new dialog box asking you to input the values into the
changing cells that you want for this scenario. There will already be values shown, which are the values currently in those
548 cells. So if you have already put the values into the cells in the Excel workbook, you won't have to re-enter them in the
549 dialog box, you can simply click "Ok" and you will have created a new scenario.
550
551
552
553 The original dialog box gives you several options, including adding a scenario, deleting a scenario, and editing a scenario.
It also give you the option to run a "Summary." If you select the "Summary" button, you get a dialog box asking you to
554 specify some "Results" cells. For example, we specified the cells in this worksheet that have the value of operations, the
555 intrinsic stock price, and the return on invested capital for the last year in the forecast horizon.
556
557
558
559 After selecting the "Results" cells, you can click "Ok" and the Scenario Manager will create a new worksheet named
"Scenario Summary". This new sheet contains the name of each scenario, the values in the "Changing cells", and the values
560 in the "Results" cells. We copied the information from the "Scenario Summary" into the table below and then formatted the
table to make it a bit more reader-friendy.
 After selecting the "Results" cells, you can click "Ok" and the Scenario Manager will create a new worksheet named
"Scenario Summary". This new sheet contains the name of each scenario, the values in the "Changing cells", and the values
A cells. We copied theBinformationCfrom the "Scenario
in the "Results" D E into theFtable below and
Summary" G then formatted the
561 table to make it a bit more reader-friendy.
562
563
564
565 Figure 7-10
566 Value Drivers for MicroDrive Inc. (Millions, Except for Per Share Data)
567
568 Scenario
569
570 (2) (3) (4)
571 Higher Higher Better (5)
572 Sales Operating Capital Improve
(1) Growth Profitabilit Utilization Growth and
573 Status Quo (Only) y (Only) (Only) OP
574 Inputs
575 Sales growth in 1st year 10% 11% 10% 10% 11%
576 Sales growth in 2nd year 8% 9% 8% 8% 9%
577 Sales growth in 3rd year 7% 8% 7% 7% 8%
578 Long-term sales growth (g L) 5% 6% 5% 5% 6%
579 Operating profitability (OP) 6% 6% 7% 6% 7%
580 Capital requirement (CR) 60% 60% 60% 51% 60%

581 Weighted average cost

of capital (WACC) 11.50% 11.50% 11.50% 11.50% 11.50%
582 Results
583 Value of operations $2,524 $2,492 $3,408 $3,344 $3,546
584 Intrinsic stock price $29.40 $28.87 $44.13 $43.07 $46.43
Return on invested
585 capital (ROIC) 10.00% 10.00% 11.67% 11.76% 11.67%
586
587
588 To better understand why growth doesn't always add value, we can express the horizon value as:
589
590
591  1 g L  ROICT  WACC
592 Vop(at HorizonYear T )  OpCapT 1 
593  WACC  g L 
594
595
596
597
598 If the numerator in the fraction in brackes, (1+gL) ROIC − WACC, is negative, then the value of operations will be less than
the total net operation capital, OpCapT. If ROIC < WACC/(1+WACC), then growth hurts value. The 2-way data table below
599 show the difference between the value operations and the amount of operating capital for different combinations of
600 growth and ROIC. For input values, we use values similar to those of MicroDrive's at the horizon.
601
602
603 Input Values (Base Case)
604 OpCap = $4,204
605 gL = 5.0%
606 ROIC = 10.00%
607 WACC = 11.60%
608
609 Output from equation above in yellow.
 A B C D E F G
610 Vop = $3,504
611 Vop − OpCap = -$701
612
613
614 A Two-Way Data Table Showing How Combinations of Growth and ROIC Affect the Value of
615 Operations Minus the Value of Operating Capital
616
617
618 Combinations of growth and ROIC that have Vop < OpCap are shown in pink. Notice that for very low values of ROIC, such as
the first row with ROIC = 9%, growth reduces value (you can see this by looking across the row. For very high values of
619 ROIC, such as the last row with ROIC = 14.6%, growth adds value. For other combinations, it depends on the relative values
of growth, ROIC, and WACC.
620
621
622
623 gL
624 −$701 0.0% 2.5% 5.0% 7.5% 9.5%
625 9.00% -$942 -$1,097 -$1,370 -$1,974 -$3,494
626 9.40% -$797 -$908 -$1,102 -$1,533 -$2,617
627 9.80% -$652 -$718 -$835 -$1,092 -$1,740
628 10.20% -$507 -$529 -$567 -$651 -$863
629 10.60% -$362 -$340 -$299 -$210 $14
630 11.00% -$217 -$150 -$32 $231 $891
631 11.40% -$72 $39 $236 $672 $1,768
ROIC

632 11.80% $72 $229 $503 $1,113 $2,645

633 12.20% $217 $418 $771 $1,554 $3,522
634 12.60% $362 $608 $1,038 $1,995 $4,399
635 13.00% $507 $797 $1,306 $2,435 $5,275
636 13.40% $652 $986 $1,573 $2,876 $6,152
637 13.80% $797 $1,176 $1,841 $3,317 $7,029
638 14.20% $942 $1,365 $2,109 $3,758 $7,906
639 14.60% $1,087 $1,555 $2,376 $4,199 $8,783
640
641
642
643 7-11 Valuing Common Stocks with the Dividend Growth Model
644
645 The Discounted Dividend Approach
646
647
648 The value of any financial asset is the present value of the future cash flows provided by the asset. When an investor buys a share of
649 stock, he or she typically expects to receive cash in the form of dividends and then, eventually, to sell the stock and to receive cash
from the sale. However, the price the first investor receives is dependent upon the dividends the next investor expects to earn, and so
650 on for different generations of investors. Thus, the stock's value ultimately depends on the cash dividends the company is expected
651 to provide and the discount rate used to find the present value of those dividends.
652
653
654 Here is the basic dividend valuation equation:
655
656 P0 =
D1 D2 DN
+ + . . . .
657 ( 1 + r s
) ( 1 + rs
) 2
( 1 + rs ) N

658
 A B C D E F G
659 The dividend stream theoretically extends on out forever, i.e., to N = infinity. Obviously, it would not be feasible to deal with an
660 infinite stream of dividends, but fortunately, a relatively simple equation has been developed that can be used to find the PV of the
661 dividend stream, provided it is growing at a constant rate.
662
663 Valuing a Constant Growth Stock
664
665
666
In the constant growth model, we assume that the dividend and stock will grow forever at a constant growth rate. Naturally, assuming
667 a constant growth rate for the rest of eternity is a rather bold assumption. However, considering the implications of imperfect
668 information, information asymmetry, and general uncertainty, the assumption of constant growth is often reasonable. It is
669 reasonable to guess that a given stock will experience ups and downs throughout its life. By assuming constant growth, we are trying
670 to find the average of the good times and the bad times, and we assume that we will see both scenarios over the firm's life. In addition
to a constant growth rate, we also need the estimated long-term required return for the stock, and it too must be constant. If these
671 variables are constant, our price equation for common stock simplifies to the following expression:
672
673
674
675 D1
P0 =
676 ( rs – g L )
677
678 Generally speaking, the long-run growth rate of a firm is likely to fall between 5% and 8% a year.
679
680 Example: Value of a Constant Growth Stock
681
682 A firm just paid a $1.15 dividend and its dividend is expected to grow at a constant rate of 8%. What is its stock price, assuming it has
683 a required return of 13.4%?
684
685
686 D0 = $1.15
687 gL = 8%
688 rs = 13.4%
689
690 P0 = D1 = D0 (1 + gL) = $1.2420
691 ( rs – g L ) ( rs – g L ) 0.0540
692
693 P0 = $23.00
694
695
696
697 Expected Rate of Return on a Constant Growth Stock
698
699 Using the constant growth equation introduced earlier, we can re-work the equation to solve for r s. In doing so, we are now solving
700 for an expected return. The expression we are left is:
701
r ̂ = D_1/P_0 +
702 g_L
703
704
705
706 This expression tells us that the expected return on a stock comprises two components. First, it consists of the expected dividend
yield, which is simply the next expected dividend divided by the current price. The second component of the expected return is the
707 expected capital gains yield. The expected capital gains yield is the expected annual price appreciation of the stock, and is given by g L.
This shows us the dual role of g L in the constant growth rate model. Not only does g indicate expected dividend growth, but it is also
the expected stock price growth rate.
 This expression tells us that the expected return on a stock comprises two components. First, it consists of the expected dividend
yield, which is simply the next expected dividend divided by the current price. The second component of the expected return is the
A gains yield. The expected
expected capital B C gains yieldD
capital E annual price
is the expected F appreciation
G of the stock, and is given by g .
L
708 This shows us the dual role of g L in the constant growth rate model. Not only does g indicate expected dividend growth, but it is also
709 the expected stock price growth rate.
710
711
712 Example: Expected Rate of Return on a Constant Growth Stock
713
714
You buy a stock for $23, and you expect the next annual dividend to be $1.242. Furthermore, you expect the dividend to grow at a
715 constant rate of 8%. What is the expected rate of return on the stock, and what is the dividend yield of the stock?
716
717
718 Inputs:
719 P0 $23.00
720 D1 $1.242
721 gL 8%
722
𝐫 ̂ =
723 13.40%

724
725 Dividend yield = 5.40%
726
727
728 What is the expected price of this stock in 1 year?
729
730 Application of Constant Growth Model at t=1
731
732 P1 =
D2
733 ( rs – g L )
734 D2 = 1.34136
735
736 P1 = $24.84
737
738
739 Valuing Nonconstant Growth Stocks
740
741
742 For many companies, it is unreasonable to assume that they grow at a constant growth rate. Hence, valuation for these companies
743 proves a little more complicated. The valuation process, in this case, requires us to estimate the short-run nonconstant growth rate
744 and predict future dividends. Then, we must estimate a constant long-term growth rate at which the firm is expected to grow.
745 Generally, we assume that after a certain point of time, all firms begin to grow at a rather constant rate. Of course, the difficulty in
this framework is estimating the short-term growth rate, how long the short-term growth will hold, and the long-term growth rate.
746
747
748
749
750 Specifically, we will predict as many future dividends as we can and discount them back to the present. Then we will treat all
dividends to be received after the convention of constant growth rate with the Gordon constant growth model described above. The
751 point in time when the dividend begins to grow constantly is called the horizon date. When we calculate the constant growth
752 dividends, we solve for the horizon value (also called a terminal value or a continuing value) as of the horizon date. The horizon
753 value can be summarized as:
754
755
 A B C D E F G
756
757 HVT = PT =
DT+1 DT (1 + g)
=
758 ( rs – g L ) ( rs – g L )
759
760 This condition holds true, where T is the horizon date. The horizon value can be described as the expected value of the stock at the
761 time period corresponding to the horizon date.
762
763 A company's stock just paid a $1.15 dividend, which is expected to grow at 30% the first year, 20% the second year, and 10% the
764 third year. After three years the dividend is expected to grow constantly at 8% forever. The stock's required return is 13.4%; what is
765 the price of the stock today?
766
767
768 Figure 7-11
769 Process for Finding the Value of a Nonconstant Growth Stock
770 INPUTS:
771 D0 = $1.15 Last dividend the company paid.
772 rs = 13.4% Stockholders' required return.
773 g0,1 = 30% Growth rate for Year 1 only.
774 g1,2 = 20% Growth rate for Year 2 only.
775 g2,3 = 10% Growth rate for Year 3 only.
776 gL = 8% Constant long-run growth rate for all years after Year 3.
777 Projections
778 Year 0 1 2 3 ⟶∞
779 Growth rate 30% 20% 10% 8%
780 Dividend D0 D0(1+g0,1) D1(1+g1,2) D2(1+g1,2)
781 Dt $1.15 $1.495 $1.794 $1.973
782 ↓ ↓ ↓
783 D1 D2 D3

784 ────── ────── ────── HV𝐏 ̂

=
3 _𝟑

785 (1+rs)1 (1+rs)2 (1+rs)3 ↓

786 ↓ ↓ ↓ D3(1+gL)
𝐏 ̂_𝟑
787 ↓ ↓ ↓
=
───────
788 ↓ ↓ ↓ (rs− gL)
789 ↓ ↓ ↓ ↓
790 ↓ ↓ ↓
𝐏 ̂_𝟑
$2.131
791 $1.318 ⟵ ⟵⤶ ↓ ↓ = 5.400%
792 PVs of Dividends $1.395 ⟵⟵⟵⟵ ⟵ ⟵⤶ ↓ ↓
793 $1.353 ⟵⟵⟵⟵ ⟵⟵⟵⟵ ⟵ ⟵⤶ 𝐏 ̂_𝟑 $39.468
=
794 ↓
795 𝐏 ̂
Pv _𝟑of $27.065 ⟵⟵⟵⟵ ⟵⟵⟵⟵ $39.468 𝐏 ̂_𝟑
796 ↓ ──────── ⟵⟵⟵⟵ ─────
797 Vop = $31.13 (1+0.134)3 (1+rs)3

798
799 Note: Numbers in the figure are shown as rounded for clarity in reporting. However unrounded values are
800 used for all calculations.
801
802
 A B C D E F G
803 7-12 Market Multiple Analysis
804
805 Use the following data in the market multiple approach to estimate the stock price per share.
806
807 Forecasted earnings per share (EPS) = $7.70
808 Average peer price/earnings (P/E) ratio = 12
809
810 Estimated stock price: $92.40
811
812
 H I
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all expected free cash flows.
petuity is the cash flow17
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ts: 23
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29 for the claims
otal value after accounting
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the estimated intrinsic39value of equity
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 H I
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58 $100
59 $2
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61 $28
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63 $70
64 5
65 $14.00
66
67
Claims on Value 68
69
70
71
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75
Debt = $28
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ated 77
y value 78
0 79 Preferred
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Cash Flow Grows at89a Constant Rate
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ions is: 114
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alue of operations. 223
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⟶ ⟶ 232⟶↴
233 ↓
234
HV = Vop(t=4)
235 ↓
236
FCF4(1+gL)
237
─────────
238
(WACC− gL)
239 ↓
240
$115.500
24110.00%
242 ↓
243
$1,155.000
244 ↓
⟵⟵⟵⤶
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 H I
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onal data. 256
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 H I
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his by estimating future sales' growth
318
Panel A in the Figure below.
319
320
321
asted sales growth rate. Operating
e proportional to sales322
in that year.
323
324
325
s, Except for Per Share326
Data)

327
MicroDrive
328
Forecast
329 2023 2024
330 5% 5%
331 6.00% 6.00%
332 60.00% 60.00%
333 25.00% 25.00%
334
Forecast
335 2023 2024
336 $6,674 $7,007
337 $400 $420
338 $4,004 $4,204
339 $210 $220
340 59% 5%
341 10% 10%
342
343
ng Excel’s full precision. Thus, intermediate
344
345
346 in Figure 7-
sly for Thurman Corporation
347
348
349
350
351
352
353
354 ⟶ ⟶ ⟶ ↴
355 ↓
356 ↓
 H I
357 HV = Vop(2024)
358 ↓
359 FCF 2024
(1+gL)
360 ─────────
361 (WACC− gL)
362 ↓
363 $231
364 0.065
365 ↓
366 $3,558
367 ↓
368 ⟵⤶
369
370
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372
ng Excel’s full precision. Thus, intermediate
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low. 395
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 H I
408
discount each of these back one period to determine
his recursive approach409
to determine the current
410
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423
424
el’s full precision. Thus, intermediate calculations
425
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estments: 441
442
443
444
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446
447 for the claims
otal value after accounting
448
449
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451
452
453
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455
456
the estimated intrinsic457
value of equity
458
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 H I
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ng Excel’s full precision. Thus, intermediate
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at they reflect what is happening in the
ht on this claim. 496
497
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499
mated MicroDrive's horizon value at Year 5
500
ue, we can estimate how much of
we can determine how much of
erm cash flows. 501
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oDrive to determine how 527the inputs (sales
rations and intrinsic stock price. It is very
plantion of how to use528 this feature.
529
530
531
532
ave those values as a "scenario." If you
s on an output, the Scenario
533 Manager
values. You can create numerous different
hows the values of the534 input cells and the
535
536
537
538
n for What-If Analysis,539and then select
540for "Add…", you
s. If you select the button
the "Changing cells." The541"Changing cells"
e, we want to save the542values for
tal requirement ratio.
543
544
545
546
asking you to input the 547values into the
n, which are the values currently in those
ou won't have to re-enter 548them in the
549
550
551
552
eleting a scenario, and553editing a scenario.
n, you get a dialog box asking you to
554
t that have the value of operations, the
recast horizon. 555
556
557
558
559 named
ill create a new worksheet
ues in the "Changing cells", and the values
nto the table below and 560
then formatted the
 H I
561
562
563
564
565
566
567
Scenario 568
569
570 (7)
571 (6) Improve
572 Improve Growth,
Growth and OP, and
573 CR CR
574
575 11% 11%
576 9% 9%
577 8% 8%
578 6% 6%
579 6% 7%
580 51% 51%

581
11.50% 11.50%
582
583 $3,470 $4,524
584 $45.17 $62.74

585
11.76% 13.73%
586
587
588
589
590
591
592
593
594
595
596
597
598
n the value of operations will be less than
hurts value. The 2-way data table below
599
apital for different combinations of
s at the horizon. 600
601
602
603
604
605
606
607
608
609
 H I
610
611
612
613
614
615
616
617
e that for very low values
618of ROIC, such as
across the row. For very high values of
binations, it depends on619
the relative values
620
621
622
623
624
625
626
627
628
629
630
631
632
633
634
635
636
637
638
639
640
641
642
643
644
645
646
647
ided by the asset. When 648an investor buys a share of
n, eventually, to sell the
649stock and to receive cash
he dividends the next investor expects to earn, and so
650the company is expected
nds on the cash dividends
s. 651
652
653
654
655
656
657
658
 H I
659
viously, it would not be feasible to deal with an
en developed that can 660
be used to find the PV of the
661
662
663
664
665
666
orever at a constant growth rate. Naturally, assuming
667
ver, considering the implications of imperfect
f constant growth is often668reasonable. It is
t its life. By assuming 669
constant growth, we are trying
will see both scenarios670 over the firm's life. In addition
for the stock, and it too must be constant. If these
owing expression: 671
672
673
674
675
676
677
% and 8% a year. 678
679
680
681
nt rate of 8%. What is682 its stock price, assuming it has
683
684
685
686
687
688
689
690
691
692
693
694
695
696
697
698
tion to solve for r s. In 699
doing so, we are now solving
700
701
702
703
704
705
onents. First, it consists
706of the expected dividend
he second component of the expected return is the
707
ual price appreciation of the stock, and is given by g L.
es g indicate expected dividend growth, but it is also
 H I
708
709
710
711
712
713
714
urthermore, you expect the dividend to grow at a
s the dividend yield of715
the stock?
716
717
718
719
720
721
722
723
724
725
726
727
728
729
730
731
732
733
734
735
736
737
738
739
740
741
742 for these companies
rowth rate. Hence, valuation
743nonconstant growth rate
to estimate the short-run
744is expected to grow.
wth rate at which the firm
a rather constant rate.745
Of course, the difficulty in
m growth will hold, and the long-term growth rate.
746
747
748
749
m back to the present.750
Then we will treat all
ordon constant growth model described above. The
751
ate. When we calculate the constant growth
752 date. The horizon
nuing value) as of the horizon
753
754
755
 H I
756
757
758
759
760 value of the stock at the
described as the expected
761
762
he first year, 20% the763
second year, and 10% the
764 return is 13.4%; what is
rever. The stock's required
765
766
767
768
769
770
771
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 H I
803
804
ce per share. 805
806
807
808
809
810
811
812
 A B C D E F G
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285 11.50%
286
287
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304
305
 A B C D E F G
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317
318
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322
323
324
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326
327 Status Quo

328
329
330 10% 8% 7%
331 6.00%
332 60.00%
333
334
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336
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338
339
340
341
342
343
344
345
346
347
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324
325
326
327
328
329
330 5%
331
332
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 A B C D E F G
254
255
256
257
258
259
260
261
262
263
264
265
266
267
268
269
270
271
272
273
274
275
276
277
278
279
280
281
282
283
284
285 11.50%
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303
304
305
 A B C D E F G
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327 Higher Growth (Only)

328
329
330 11% 9% 8%
331 6.00%
332 60.00%
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 H I
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330 6%
331
332
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 A B C D E F G
254
255
256
257
258
259
260
261
262
263
264
265
266
267
268
269
270
271
272
273
274
275
276
277
278
279
280
281
282
283
284
285 11.50%
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303
304
305
 A B C D E F G
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327 Higher OP (Only)

328
329
330 10% 8% 7%
331 7.00%
332 60.00%
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 H I
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330 5%
331
332
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 A B C D E F G
254
255
256
257
258
259
260
261
262
263
264
265
266
267
268
269
270
271
272
273
274
275
276
277
278
279
280
281
282
283
284
285 11.50%
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303
304
305
 A B C D E F G
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327 Better CR (Only)

328
329
330 10% 8% 7%
331 6.00%
332 51.00%
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 H I
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330 5%
331
332
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 A B C D E F G
254
255
256
257
258
259
260
261
262
263
264
265
266
267
268
269
270
271
272
273
274
275
276
277
278
279
280
281
282
283
284
285 11.50%
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303
304
305
 A B C D E F G
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327 Improve Growth and OP

328
329
330 11% 9% 8%
331 7.00%
332 60.00%
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 H I
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330 6%
331
332
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 A B C D E F G
254
255
256
257
258
259
260
261
262
263
264
265
266
267
268
269
270
271
272
273
274
275
276
277
278
279
280
281
282
283
284
285 11.50%
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303
304
305
 A B C D E F G
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327 Improve Growth and CR

328
329
330 11% 9% 8%
331 6.00%
332 51.00%
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 H I
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330 6%
331
332
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 A B C D E F G
254
255
256
257
258
259
260
261
262
263
264
265
266
267
268
269
270
271
272
273
274
275
276
277
278
279
280
281
282
283
284
285 11.50%
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303
304
305
 A B C D E F G
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327 Improve Growth, OP, and CR

328
329
330 11% 9% 8%
331 7.00%
332 51.00%
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 H I
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330 6%
331
332
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 A B C D E F G
254
255
256
257
258
259
260
261
262
263
264
265
266
267
268
269
270
271
272
273
274
275
276
277
278
279
280
281
282
283
284
285 10.50%
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303
304
305
 A B C D E F G
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327 Lower WACC (Only)

328
329
330 10% 8% 7%
331 6.00%
332 60.00%
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 H I
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330 5%
331
332
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 A B C D E F G
254
255
256
257
258
259
260
261
262
263
264
265
266
267
268
269
270
271
272
273
274
275
276
277
278
279
280
281
282
283
284
285 11.50%
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303
304
305
 A B C D E F G
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327 Better OP and CR

328
329
330 10% 8% 7%
331 7.00%
332 51.00%
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
 H I
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330 5%
331
332
333
334
335
336
337
338
339
340
341
342
343
344
345
346
347
348
349
350
351
352
353
354
355
356
Scenario Summary
Current Values: Status Quo Higher Growth (Only)
Changing Cells:
$A$326 Status Quo Status Quo Higher Growth (Only)
$F$329 8% 8% 9%
$G$329 7% 7% 8%
$H$329 5% 5% 6%
$E$329 10% 10% 11%
$E$330 6.00% 6.00% 6.00%
$E$331 60.00% 60.00% 60.00%
$C$283 11.50% 11.50% 11.50%
Result Cells:
$D$460 $2,524 $2,524 $2,492
$D$467 $29.40 $29.40 $28.87
$I$340 10% 10% 10%
Notes: Current Values column represents values of changing cells at
time Scenario Summary Report was created. Changing cells for each
scenario are highlighted in gray.
 Higher OP (Only) Better CR (Only) Improve Growth and OP Improve Growth and CR

Higher OP (Only) Better CR (Only) Improve Growth and OP Improve Growth and CR
8% 8% 9% 9%
7% 7% 8% 8%
5% 5% 6% 6%
10% 10% 11% 11%
7.00% 6.00% 7.00% 6.00%
60.00% 51.00% 60.00% 51.00%
11.50% 11.50% 11.50% 11.50%

$3,408 $3,344 $3,546 $3,470

$44.13 $43.07 $46.43 $45.17
12% 12% 12% 12%
 Improve Growth, OP, and CR Lower WACC (Only) Better OP and CR

Improve Growth, OP, and CR Lower WACC (Only) Better OP and CR

9% 8% 8%
8% 7% 7%
6% 5% 5%
11% 10% 10%
7.00% 6.00% 7.00%
51.00% 60.00% 51.00%
11.50% 10.50% 11.50%

$4,524 $3,027 $4,228

$62.74 $37.78 $57.80
14% 10% 14%
SECTION 7-4
SOLUTIONS TO SELF-TEST

A company expects a constant FCF of $240 million per year forever. If the WACC is 12%, what is the value of
operations?

Expected FCF $240

WACC 12%

Vop = $2,000.00

A company has a current value of operations of $800 million. The company has $100 million in short-term
investments. If the company has $400 million in debt and has 10 million shares outstanding, what is the price per
share?

Vop $800
ST investments $100
Total value $900
Debt $400
Value of equity $500
Number of shares 10

Price per share $50.00

SECTION 7-5
SOLUTIONS TO SELF-TEST

A company expects to have a FCF in 1 year of $300, which is expected to grow at a constant rate of 3% forever. If the
WACC is 11%, what is the value of operations?

Expected FCF1 = $300

Expected gL = 3%
WACC = 11%

Vop = $3,750

A company's most recent free cash flow was $270. The company expects to have a FCF in 1 year of $300, which is
expected to grow at a constant rate of 3% forever. If the WACC is 11%, what is the value of operations?

Expected FCF1 = $300

Expected gL = 3%
WACC = 11%

Notice that the FCF of $270 at t = 0 is irrelevant to the value of operations, because it occurred in the past. The value
of operations depends only on the future free cash flows.

Vop = $3,750

A company's most recent free cash flow was $600 and is expected to grow at a constant rate of 4% forever. If the
WACC is 10%, what is the value of operations?

FCF0 = $600
Expected gL = 4%
WACC = 10%

Vop = $10,400
SECTION 7-6
SOLUTIONS TO SELF-TEST

A company expects to have a FCF at Year 10 of $600, which is expected to grow at a constant rate of 8% thereafter. If
the WACC is 8%, what is the value of operations at Year 10, HV 10?

Expected FCF12 = $600

Expected gL = 4%
WACC = 8%

Vop = $15,600

A company expects a FCF of -$10 million at Year 1 and a FCF of $20 million at Year 2. FCF is expected to grow at a 5%
rate after Year 2. If the WACC is 10%, what is the horizon value of operations; i.e., V op(Year 2)? What is the current value
of operations; i.e., Vop(Year 0)?

Long-term growth rate 5%

WACC 10%

Year
1 2
FCF1 FCF2
Expected FCF -$10.00 $20.00

Vop(Year 2) $420.00

PV of expected FCF $7.44

PV of expected Vop(Year 2) $347.11

Vop(Year 0) $354.55
SECTION 7-7
SOLUTIONS TO SELF-TEST

Cathey Corporation currently has sales of $1,000, which are expected to grow by 10% from Year 0 to Year 1 and by 4% from Year 1
to Year 2. The company currently has and operating profitability (OP) ratio of 7% and a capital requirement (CR) ratio of 50% and
expects to maintain these ratios at their current levels. The current level of operating capital is $510. Use these inputs to forecast
free cash flow (FCF) for Years 1 and 2. Hint: You must first forecast sales, net operating profit after taxes (NOPAT), and total net
operating capital (OpCap) for each year.

Sales0 = $1,000
g0,1 = 10%
g1,2 = 4%
OP = NOPAT/Sales = 7%
CR = OpCap/Sales = 50%
OpCap0 = $510

Year 0 1 2 3
Growth rate in sales 10% 4% 4%
Sales $1,000 $1,100.00 $1,144.00 $1,189.76
NOPAT $77.00 $80.08 $83.28
OpCap $510 $550.00 $572.00 $594.88
Investment in OpCap $40.00 $22.00 $22.88
FCF $37.00 $58.08 $60.40
Growth in FCF 57.0% 4.0%

Cathey Corporation has a 12% weighted average cost of capital. Cathey's free cash flows, estimated in the previous question, are
expected to grow at 4% beginning at Year 2 and continuing for the foreseeable future. What is the horizon value (use Year 2 for the
horizon)? What is the current value of operations?

Long-term growth rate 4%

WACC 12%

Year
1 2
FCF1 FCF2
Expected FCF $37.00 $58.08

HV2 = Vop(Year 2) $755.04

PV of expected FCF $79.34

PV of expected HV (Year 2) $601.91

Vop(Year 0) $681.25

Cathey Corporation has $80 in short-term investments, $20 in short-term debt, $140 in long-term debt, $30 in preferred stock, and
10 shares of common stock outstanding. Use the value of operations from the previous question to estimate the intrinsic common
stock price per share.

Vop = $681.25
ST investments = $80.00
ST debt = $20.00
Long-term debt = $140.00
Preferred stock = $30.00
Number of shares = 10

Vop $681.25
ST investments $80.00
Total value $761.25
All debt $160.00
Preferred stock $30.00
Value of equity $571.25
Number of shares 10.00

Price per share $57.13

SECTION 7-11
SOLUTIONS TO SELF-TEST

If D1 = $3.00, P0 = $50, and the expected P at t=1 is equal to $52, what are the stock’s expected dividend yield, capital gains yield, and
total return for the coming year?

D1 $3.00
P0 $50.00
Expected P1 $52.00

Exp. dividend yield 6.0% =B6/B7

Exp. capital gains yield 4.0% =(B8-B7)/B7
Exp. total return 10.0% =C10+C11

A stock is expected to pay a dividend of $2 at the end of the year. The required rate of return is r s = 12%. What would the stock’s price
be if the growth rate were 4%?

D1 $2.00
gL 4%
rs 12%

Stock price $25.00

A stock is expected to pay a dividend of $2 at the end of the year. The required rate of return is r s = 12%. What would the stock’s price
be if the growth rate were 0%?

D1 $2.00
gL 0%
rs 12%

Stock price $16.67

If D0 = $4.00, rs = 9%, and g = 5% for a constant growth stock, what are the stock’s expected dividend yield and
capital gains yield for the coming year?

D0 $4.00
gL 5%
rs 9%

Expected D1 $4.20

Stock price $105.00

Expected dividend yield 4.00%

 Expected capital gains yield 5.00%

Alternatively, you know that the capital gains yield is equal to the growth rate.

Expected capital gains yield = growth rate = 5.00%

Because the total return is rs, the dividend yield is rs minus the capital gains yield:

Expected dividend yield = 4.00%

Suppose D0 = $5.00 and rs = 10%. The expected growth rate from Year 0 to Year 1 (g 0 to 1) = 20%, the expected
growth rate from Year 1 to Year 2 (g 1 to 2) = 10%, and the constant rate beyond Year 2 is g L = 5%. What are the
expected dividends for Year 1 and Year 2? What is the expected horizon value price at Year 2? What is the
expected price at Time 0?

D0 $5.00
g0 to 1 20%
g1 to 2 10%
gL 5%
rs 10%
Year
1 2
D1 D2
Expected dividends $6.00 $6.60

Expected HVP,2 $138.60

PV of expected dividends $10.91

PV of expected HVP,2 $114.55

Expected price at Time 0 $125.45

SECTION 7-12
SOLUTIONS TO SELF-TEST

Dodd Corporation is a private company that earned $4.00 per share for the most recent year. If the average P/E ratio of a group of
comparable public companies is 11, what is an estimate of Dodd's stock value on a per share basis?

Earnings per share = $4.00

Average comparable P/E ratio = 11.0

Estimated price per share = $44.00

The company in the previous question, Dodd Corporation, has 100,000 shares of common stock owned by its founder. Dodd owes
$1,300,000 to its bank. Dodd has 11,400 customers. If the average ratio of total entity value to customers is $500 for a group of
comparable public companies, what is Dodd's estimated total entity value? What is its estimated stock value on a per share basis?

Number of shares = 100,000

Debt = $1,300,000
Number of customers = 11,400

Average comparable ratio of

total entity value to number of customers = $500

Estimated entity value = $5,700,000

− Debt $1,300,000
Intrinsic equity value 4,400,000
÷ Number of shares 100,000

Estimated price per share = $44.00

SECTION 7-14
SOLUTIONS TO SELF-TEST

A preferred stock has an annual dividend of $5. The required return is 8%. What is the V ps?

Dps $5.00
rps 8%

Vps $62.50