PALAWAN STATE UNIVERSITY

College of Business and Accountancy

Department of Accountancy
Puerto Princesa City

MODULE 2:
Intrinsic Valuation
PrE13: VALUATION CONCEPTS AND METHODS
Midyear | SY: 2020-2021

BSA 3

LARA CAMILLE C. CELESTIAL, CMA, CTT, CAP, CB

College of Business and Accountancy
Palawan State University
TABLE OF CONTENTS

Title Page of Module 1

Table of Contents 2

Overview 3
Learning Outcomes 3
Summary of Topics 3

Content
Topic 1: Enterprise Value VS Equity Value 4
1.1 Enterprise Value 4
1.2 Equity Value 4
Topic 2: Intrinsic Value 5
Topic 3: Intrinsic Valuation 7
3.1 Discounted Cash Flow Method (DCF) 7
3.2 Discounted Dividend Model 10

References 11

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 MODULE 2 |
INTRINSIC VALUATION
Overview
An intrinsic value has different meanings in different contexts.
In business, an intrinsic value refers to a valuation method used in
measuring the financial status or strength of a company. This method
of business valuation uses Discounted Cash Flow (DCF) in assessing
the wealth of a company. It is important to note that the absolute value
of a business differs from its relative value. While an absolute value
examines a company's wealth using the time value of money and
accumulation of interest, relative value models gauge a company's
wealth by comparing it to its competitors' wealth.

Intended Learning Outcomes:

 Differentiate enterprise value from equity value
 Define intrinsic value
 Discuss the intrinsic valuation methods
 Distinguish DCF Model versus DDM
 Identify the various components of DCF and its application
 Describe the Gordon Model
 Demonstrate understanding of intrinsic valuation in problem-solving

Topics:
1: Enterprise Value VS Equity Value
1.1 Enterprise Value
1.2 Equity Value
2. Intrinsic Value
3. Intrinsic Valuation Methods
3.1 Intrinsic Value
3.2 Discounted Cash Flow Method (DCF)
3.3 Discounted Dividend Model

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Topic #1: Enterprise Value VS Equity Value

Enterprise Value VS Equity Value: An Overview

Enterprise value and equity value are two common ways that a business may be valued
in a merger or acquisition. Both may be used in the valuation or sale of a business, but each
offers a slightly different view. While enterprise value gives an accurate calculation of the
overall current value of a business, similar to a balance sheet, equity value offers a snapshot
of both current and potential future value.

In most cases, a stock market investor, or someone who is interested in buying

a controlling interest in a company, will rely on an enterprise value for a fast and easy way
to estimate the value. On the other hand, equity value is commonly used by owners and
current shareholders to help shape future decisions.

Enterprise Value
Enterprise value constitutes more than just outstanding equity. It theoretically reveals
how much a business is worth, which is useful in comparing firms with different capital
structures since the capital structure doesn't affect the value of a firm.

In the purchase of a company, an acquirer would have to assume the acquired company’s
debt, along with the company’s cash. Acquiring the debt increases the cost to buy the
company, but acquiring the cash reduces the cost of acquiring the company.

Businesses calculate enterprise value by adding up the market capitalization, or market

cap, plus all of the debts in the company. Debts may include interest due to shareholders,
preferred shares, and other such things that the company owes. Subtract any cash or cash
equivalents that the business currently holds, and you get the enterprise value. Think of
enterprise value as a business' balance sheet, accounting for all of its current stocks, debt,
and cash.

Equity Value
Equity value constitutes the value of the company's shares and loans that the
shareholders have made available to the business. The calculation for equity value adds
enterprise value to redundant assets (non-operating assets) and then subtracts the debt net
of cash available. Total equity value can then be further broken down into the value of
shareholders' loans and (both common and preferred) shares outstanding.

Preferred shares and shareholders' loans are considered debt. By contrast, equity value
includes these instruments in its calculation. Equity value uses the same calculation as
enterprise value but adds in the value of stock options, convertible securities, and other
potential assets or liabilities for the company. Because it considers factors that may not
currently impact the company, but can at any time, equity value offers an indication of
potential future value and growth potential. The equity value may fluctuate on any given day
due to the normal rise and fall of the stock market.

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Topic #2: Intrinsic Value

Intrinsic Value

The intrinsic value of a business (or any investment security) is the present value of all
expected future cash flows, discounted at the appropriate discount rate. Unlike relative forms
of valuation that look at comparable companies, intrinsic valuation looks only at the inherent
value of a business on its own.

There are different variations of the intrinsic value formula but the most “standard”
approach is similar to the net present value formula.

Where:
NPV = Net Present Value
FVj = Net cash flow for the j th period (for the initial “Present” cash flow, j = 0
i = annual interest rate
n = number of periods included

Risk Adjusting the Intrinsic Value

The task of risk adjusting the cash flows is very subjective and a combination of both art and
science.

There are two main methods:

a) Discount rate – Using a discount rate that includes a risk premium in it to adequately
discount the cash flows

In the discount rate approach, a financial analyst will typically use a company’s weighted
average cost of capital (WACC). The formula for WACC includes the risk-free rate (usually
a government bond yield) plus a premium based on the volatility of the stock multiplied by
an equity risk premium.

The rationale behind this approach is that if a stock is more volatile, it’s a riskier
investment. Therefore, a higher discount rate is used, which has the effect of reducing the
value of cash flow that would be received further in the future (because of the greater
uncertainty).
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 b) Certainty factor – Using a factor on a scale of 0-100% certainty of the cash flows in the
forecast materializing

A certainty factor, or probability, can be assigned to each individual cash flow or multiplied
against the entire net present value (NPV) of the business as a means of discounting the
investment. In this approach, only the risk-free rate is used as the discount rate, since the
cash flows are already risk-adjusted.

For example, the cash flow from a US Treasury note comes with a 100% certainty
attached to it, so the discount rate is equal to yield, say 2.5% in this example. Compare
that to the cash flow from a very high-growth and high-risk technology company. A 50%
probability factor is assigned to the cash flow from the tech company and the same 2.5%
discount rate is used.

At the end of the day, both methods are attempting to do the same thing – to discount an
investment based on the level of risk inherent in it.

Why Intrinsic Value Matters

Why does intrinsic value matter to an investor? Analysts employ these methods
to see whether or not the intrinsic value of a security is higher or lower than its current
market price, allowing them to categorize it as "overvalued" or "undervalued." Typically,
when calculating a stock's intrinsic value, investors can determine an appropriate margin
of safety, wherein the market price is below the estimated intrinsic value.

By leaving a "cushion" between the lower market price and the price you believe
its worth, you limit the amount of downside you would incur if the stock ends up being
worth less than your estimate.

For instance, suppose in one year you find a company that you believe has strong
fundamentals coupled with excellent cash flow opportunities. That year it trades at $10
per share, and after figuring out its DCF, you realize that its intrinsic value is closer to
$15 per share: a bargain of $5. Assuming you have a margin of safety of about 35%, you
would purchase this stock at the $10 value. If its intrinsic value drops by $3 a year later,
you are still saving at least $2 from your initial DCF value and have ample room to sell if
the share price drops with it.

For a beginner getting to know the markets, intrinsic value is a vital concept to remember
when researching firms and finding bargains that fit within his or her investment objectives.
Though not a perfect indicator of the success of a company, applying models that focus
on fundamentals provides a sobering perspective on the price of its shares.

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Topic #3: Intrinsic Valuation Models

Intrinsic valuation, also known as absolute valuation, calculate the present worth of
businesses by forecasting their future income streams. The models use the information
available in the financial statements and books of accounts of a company to arrive at its intrinsic
or real worth.

The absolute valuation method is reductive as the analysis is focused on the

characteristics of the company in isolation. There is no comparison to its competitors in the
same industry or complementary sectors.

However, the process is problematic because the competitive analysis is important to

assess the overall market movement in a particular sector. Disruptive innovation due to new
technology, major mergers, and acquisitions, regulatory change, new market entrants,
or bankruptcy may impact the trajectory of an entire sector.

There are two main types of intrinsic valuation models:

a) Discounted Cash Flow Model (DCF)
b) Dividend Discounted Model (DDM)

3.1 DISCOUNTED CASH FLOW MODEL

Appropriate discount rates need to be calculated to arrive at the present value of the company,
and the discount rate equals the rate of return for the investor. The Discounted Cash Flow model
can be used for the valuation of anything that can affect cash flow, i.e., bonds, shares, an entire
business, or a project within a business.

The DCF model uses a formula to calculate the rate of return of a business by evaluating
anticipated payments and amounts receivable in the near future. The conclusion is a projected
cash flow that can be used to predict how long the company can sustain a growth trajectory.

Where:
PV0 = Present value at time 0
CFn = Cash flow in period n
rn = Interest rate in period n
N = Number of periods

COMPONENTS OF DCF MODEL

a) Free cash flow (FCF) measures a company’s financial performance. It shows the cash
that a company can produce after deducting the purchase of assets such as

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 property, equipment, and other major investments from its operating cash flow. In other
words, FCF measures a company’s ability to produce what investors care most about:
cash that’s available to be distributed in a discretionary way.

The most common types of FCF include:

 Unlevered Cash Flow
This measure requires a multi-step calculation and is used in Discounted Cash
Flow analysis to arrive at the Enterprise Value (or total firm value). It is a hypothetical
figure, an estimate of what it would be if the firm was to have no debt.

 Levered Cash Flow

This measure is derived from the statement of cash flows by taking operating cash flow,
deducting capital expenditures, and adding net debt issued (or subtracting net debt
repayment). This includes interest expense paid on debt and net debt issued or repaid,
so it only represents the cash flow available to equity investors (interest to debt holders
has already been paid).

IMPORTANCE OF FREE CASH FLOW

Knowing the company’s free cash flow enables management to decide on future ventures
that would improve the shareholder value. Additionally, having an abundant FCF indicates that
a company is capable of paying its monthly dues. Companies can also use their FCF to expand
business operations or pursue other short-term investments.

Compared to earnings per se, free cash flow is more transparent in showing the
company’s potential to produce cash and profits. Meanwhile, other entities looking to invest may
likely consider companies that have a healthy free cash flow because of a promising future.
Couple this with a low-valued share price, investors can generally make good investments with
companies that have high FCF. Other investors greatly consider FCF compared to other
measures because it also serves as an important basis for stock pricing.

b) Discount Rates are the rate of return used to discount future cash flows back to their
present value. This rate is often a company’s Weighted Average Cost of Capital (WACC),
required rate of return, or the hurdle rate that investors expect to earn relative to the risk
of the investment.

A discount rate is used to calculate the Net Present Value (NPV) of a business, as part
of a Discounted Cash Flow (DCF) analysis. It is also utilized to:
 Account for the time value of money
 Account for the riskiness of an investment
 Represent opportunity cost for a firm
 Act as a hurdle rate for investment decisions
 Make different investments more comparable

In corporate finance, there are only a few types of discount rates that are used to discount
future cash flows back to the present. They include:
 Weighted Average Cost of Capital (WACC) – for calculating the enterprise value of
a firm

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  Cost of Equity – for calculating the equity value of a firm

Where:
E(Ri) = Expected return on asset i
Rf = Risk-free rate of return
βi = Beta of asset i
E(Rm) = Expected market return

 Cost of Debt – for calculating the value of a bond or fixed-income security

 A pre-defined hurdle rate – for investing in internal corporate projects

 Risk-Free Rate – to account for the time value of money

In this course, the WACC and Cost of Equity will be the most often utilized discount rates.

c) Period Number
Each cash flow is associated with a time period. Common time periods are years,
quarters, or months. The time periods may be equal, or they may be different. If they’re
different, they’re expressed as a percentage of a year.

d) Terminal Value
Terminal value is the estimated value of a business beyond the explicit forecast period.
It is a critical part of the financial model, as it typically makes up a large percentage of
the total value of a business.

There most used approach in terminal valuation is the perpetual growth terminal method.
This method assumes the business will continue to generate Free Cash Flow (FCF) at a
normalized state forever (perpetuity).

The formula for calculating the perpetual growth terminal value is:
TV = (FCFn x (1 + g)) / (WACC – g)

Where:
TV = terminal value
FCF = free cash flow
n = year 1 of terminal period or final year
g = perpetual growth rate of FCF
WACC = weighted average cost of capital

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3.2 DISCOUNTED DIVIDEND MODEL
According to the Dividend Discount Model, the future dividends generated by the securities of
any company provide a fair representation of the intrinsic value of that business, once
discounted to their present value. The DDM assumes that the future cash flows of a company
are equal to dividends that are generated on its shares and consequently distributed to
stakeholders.

The DDM method uses a fairly straight forward mathematical perspective to predict future
dividend payments and the cost of equity share capital. However, the resulting valuation is far
from accurate as the underlying assumption that dividend equals cash flow may not always be
true.

The Gordon Growth Model (GGM) is one of the most commonly used variations of the
dividend discount model. The model is called after American economist Myron J. Gordon, who
proposed the variation. The GGM assists an investor in evaluating a stock’s intrinsic value based
on the potential dividend’s constant rate of growth.
The GGM is based on the assumption that the stream of future dividends will grow at some
constant rate in the future for an infinite time. The model is helpful in assessing the value of
stable businesses with strong cash flow and steady levels of dividend growth. It generally
assumes that the company being evaluated possesses a constant and stable business model
and that the growth of the company occurs at a constant rate over time.

Where:
V0 – The current fair value of a stock
D1 – The dividend payment in one period from now
r – The estimated cost of equity capital (usually calculated using CAPM)
g – The constant growth rate of the company’s dividends for an infinite time

As a hypothetical example, consider a company whose stock is trading at $110 per share. This
company requires an 8% minimum rate of return (r) and will pay a $3 dividend per share next
year (D1), which is expected to increase by 5% annually (g).

The intrinsic value (P) of the stock is calculated as follows:

According to the Gordon Growth Model, the shares are currently $10 overvalued in the market.

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REFERENCES|
https://www.investopedia.com/ask/answers/111414/what-difference-between-enterprise-
value-and-equity-value.asp

https://corporatefinanceinstitute.com/resources/knowledge/valuation/absolute-valuation/

https://www.investopedia.com/terms/t/terminalvalue.asp

https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-debt/

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