Corporate Finance Fundamentals
Module 9: Valuation Fundamentals
Module Overview
Welcome to Module 9! This is where everything comes together. Valuation is the art and science of determining what a company (or investment) is worth. It combines all the concepts you've learned—time value of money, risk and return, cost of capital, and cash flows.
Whether you're evaluating a stock investment, considering an acquisition, or assessing your own company's value, the principles in this module are essential.
Learning Objectives:
By the end of this module, you will be able to:
- Understand the fundamental principles of valuation
- Calculate intrinsic value using discounted cash flow (DCF) methods
- Value companies using the dividend discount model
- Apply free cash flow valuation models
- Use relative valuation methods (multiples)
- Understand what drives company value
- Recognize the limitations of different valuation approaches
- Apply valuation techniques to real companies
- Make informed investment and business decisions based on valuation
Estimated Time: 6-7 hours
9.1 Introduction to Valuation
What is Valuation?
Valuation is the process of determining the present value of an asset or company.
Key Question: What is something worth today?
Value vs. Price
Value: What something is fundamentally worth (intrinsic value) Price: What someone will pay for it (market price)
Relationship:
- Price = Value → Fairly priced
- Price < Value → Undervalued (buy opportunity)
- Price > Value → Overvalued (sell opportunity)
Famous Quote (Warren Buffett): "Price is what you pay. Value is what you get."
The Fundamental Principle
All value comes from future cash flows.
Formula (general):
Value = PV of Future Cash Flows
Value = CF₁/(1+r) + CF₂/(1+r)² + CF₃/(1+r)³ + ...
Key insight: We're back to time value of money and NPV!
Example:
Investment generates:
- Year 1: $100
- Year 2: $110
- Year 3: $120
Discount rate: 10%
Value = $100/1.10 + $110/1.10² + $120/1.10³
Value = $90.91 + $90.91 + $90.16
Value = $271.98
If you can buy this for $250, it's undervalued!
Valuation Approaches
1. Absolute Valuation (Intrinsic Value)
- Discounted Cash Flow (DCF)
- Calculate present value of cash flows
- Independent of market prices
2. Relative Valuation (Multiples)
- Compare to similar companies
- P/E ratio, EV/EBITDA, etc.
- Based on market prices
3. Asset-Based Valuation
- Sum of individual asset values
- Less common for operating companies
- Used for holding companies, real estate
We'll focus on DCF and relative valuation.
Why Valuation Matters
For Investors:
- Stock selection
- Portfolio management
- Buy/sell decisions
For Companies:
- M&A decisions
- Strategic planning
- Performance measurement
For Entrepreneurs:
- Raising capital
- Exit planning
- Negotiating with investors
For Everyone:
- Understanding value creation
- Making informed decisions
- Avoiding overpaying
9.2 Dividend Discount Model (DDM)
The Basic Idea
If a company pays dividends, value those dividends.
General DDM:
P₀ = D₁/(1+r) + D₂/(1+r)² + D₃/(1+r)³ + ...
Where:
- P₀ = Stock price today (value)
- D = Dividends
- r = Required return (cost of equity)
Gordon Growth Model (Constant Growth DDM)
Assumes dividends grow at constant rate forever.
Formula:
P₀ = D₁ / (r - g)
Where:
- D₁ = Next year's dividend
- r = Required return
- g = Constant growth rate
- Requirement: r > g
Example 1: Basic Valuation
Stock pays:
- Current dividend: $2.00
- Growth rate: 5%
- Required return: 12%
D₁ = $2.00 × 1.05 = $2.10
P₀ = $2.10 / (0.12 - 0.05)
P₀ = $2.10 / 0.07
P₀ = $30
Stock is worth $30.
If trading at $25 → Undervalued (buy) If trading at $35 → Overvalued (sell)
Example 2: Finding Expected Return
Stock characteristics:
- Current price: $50
- Next dividend: $3
- Growth rate: 6%
Solve for r:
$50 = $3 / (r - 0.06)
$50(r - 0.06) = $3
50r - 3 = 3
50r = 6
r = 12%
Expected return is 12%.
Example 3: Finding Growth Rate
Stock characteristics:
- Price: $40
- Next dividend: $2.40
- Required return: 10%
Solve for g:
$40 = $2.40 / (0.10 - g)
$40(0.10 - g) = $2.40
4 - 40g = 2.40
40g = 1.60
g = 4%
Implied growth rate is 4%.
Two-Stage Growth Model
More realistic: High growth, then stable growth.
Formula:
P₀ = PV(High Growth Dividends) + PV(Terminal Value)
Example:
Company dividends:
- Current: $1.00
- High growth: 20% for 5 years
- Then: 5% growth forever
- Required return: 14%
Stage 1: High Growth (Years 1-5)
| Year | Dividend | PV Factor | PV |
|---|---|---|---|
| 1 | $1.20 | 0.8772 | $1.05 |
| 2 | $1.44 | 0.7695 | $1.11 |
| 3 | $1.73 | 0.6750 | $1.17 |
| 4 | $2.07 | 0.5921 | $1.23 |
| 5 | $2.49 | 0.5194 | $1.29 |
PV of Stage 1: $5.85
Stage 2: Stable Growth (Year 6 onward)
Terminal value at end of Year 5:
D₆ = $2.49 × 1.05 = $2.61
Terminal Value = $2.61 / (0.14 - 0.05) = $2.61 / 0.09 = $29.00
PV of Terminal Value:
PV = $29.00 / 1.14⁵ = $29.00 × 0.5194 = $15.06
Total Value:
P₀ = $5.85 + $15.06 = $20.91
Stock is worth approximately $21.
Limitations of DDM
1. Only works for dividend-paying stocks
- Many growth companies don't pay dividends
- Can't value Amazon, Tesla (historically), etc.
2. Very sensitive to growth assumption
- Small changes in g = Big changes in value
- Example: With r = 12%, g = 5%, P = D/(0.07)
- If g = 6%, P = D/(0.06) → 17% higher value!
3. Assumes constant growth
- Reality: Growth rates change
- Two-stage helps, but still simplified
4. Difficult to estimate g
- What's the long-term growth rate?
- No perfect method
Best for:
- Mature, dividend-paying companies
- Stable growth expectations
- Utilities, consumer staples
Not good for:
- Growth companies
- Companies with no dividends
- Cyclical companies
9.3 Free Cash Flow Valuation
Why Free Cash Flow?
Free Cash Flow (FCF) is cash available to all investors (debt and equity).
Better than dividends because:
- Works for non-dividend companies
- Dividends are discretionary (management choice)
- FCF reflects true cash generation
- Can value entire firm, not just equity
Two Types of FCF
1. Free Cash Flow to Firm (FCFF)
- Cash available to all investors
- Before debt payments
- Discount at WACC
- Values entire firm
2. Free Cash Flow to Equity (FCFE)
- Cash available to equity holders
- After debt payments
- Discount at cost of equity
- Values equity directly
FCFF Formula
FCFF = EBIT(1 - Tax Rate)
+ Depreciation & Amortization
- Capital Expenditures
- Change in Net Working Capital
Or:
FCFF = Operating Cash Flow
- Capital Expenditures
Or (alternative):
FCFF = Net Income
+ Interest(1 - Tax Rate)
+ Depreciation & Amortization
- Capital Expenditures
- Change in Net Working Capital
FCFE Formula
FCFE = FCFF
- Interest(1 - Tax Rate)
+ Net Borrowing
Or directly:
FCFE = Net Income
+ Depreciation & Amortization
- Capital Expenditures
- Change in Net Working Capital
+ Net Borrowing
Example: Calculating FCFF
Company Data:
- EBIT: $500M
- Tax rate: 25%
- Depreciation: $100M
- Capital expenditures: $150M
- Increase in NWC: $30M
FCFF = $500M(1 - 0.25) + $100M - $150M - $30M
FCFF = $375M + $100M - $150M - $30M
FCFF = $295M
Company generated $295M free cash flow.
Example: Calculating FCFE
Using FCFF from above:
- FCFF: $295M
- Interest expense: $50M
- Tax rate: 25%
- New debt issued: $20M
- Debt repaid: $40M
- Net borrowing: -$20M
FCFE = $295M - $50M(1 - 0.25) + (-$20M)
FCFE = $295M - $37.5M - $20M
FCFE = $237.5M
Cash available to equity holders: $237.5M
Valuing with FCFF
Two-stage approach (common):
Stage 1: Explicit forecast (5-10 years)
- Forecast FCFF for each year
- Discount at WACC
Stage 2: Terminal value
- Perpetuity from end of forecast
- Discount to present
Terminal Value Formula:
Terminal Value = FCFF(n+1) / (WACC - g)
Where FCFF(n+1) is first year of stable growth.
Complete Example:
ABC Company Valuation:
Given:
- Current FCFF: $100M
- Growth: 15% for 5 years, then 4% forever
- WACC: 10%
- Shares outstanding: 50M
- Debt: $500M
- Cash: $50M
Step 1: Forecast FCFF
| Year | FCFF | Growth | PV Factor | PV |
|---|---|---|---|---|
| 1 | $115M | 15% | 0.9091 | $104.5M |
| 2 | $132.3M | 15% | 0.8264 | $109.3M |
| 3 | $152.1M | 15% | 0.7513 | $114.3M |
| 4 | $174.9M | 15% | 0.6830 | $119.5M |
| 5 | $201.1M | 15% | 0.6209 | $124.9M |
PV of explicit period: $572.5M
Step 2: Terminal Value
FCFF(Year 6) = $201.1M × 1.04 = $209.1M
Terminal Value = $209.1M / (0.10 - 0.04)
Terminal Value = $209.1M / 0.06
Terminal Value = $3,485M
PV of Terminal Value:
PV = $3,485M / 1.10⁵
PV = $3,485M × 0.6209
PV = $2,164M
Step 3: Enterprise Value
Enterprise Value = $572.5M + $2,164M = $2,736.5M
Step 4: Equity Value
Equity Value = Enterprise Value - Debt + Cash
Equity Value = $2,736.5M - $500M + $50M
Equity Value = $2,286.5M
Step 5: Value Per Share
Value per share = $2,286.5M / 50M shares
Value per share = $45.73
Stock is worth approximately $46 per share.
Decision:
- If trading at $40 → Undervalued by 15%
- If trading at $50 → Overvalued by 9%
Sensitivity Analysis
Valuation is sensitive to assumptions.
Test different scenarios:
Base Case (from above):
- WACC: 10%, g: 4% → Value: $46
Optimistic:
- WACC: 9%, g: 5% → Value: $68
Pessimistic:
- WACC: 11%, g: 3% → Value: $33
Key insight: Small changes in WACC and g dramatically affect value!
Sensitivity Table:
g = 3% g = 4% g = 5%
WACC=9% $52 $68 $95
WACC=10% $37 $46 $60
WACC=11% $28 $33 $40
Always test multiple scenarios!
9.4 Relative Valuation (Multiples)
The Concept
Compare company to peers using ratios (multiples).
Logic: Similar companies should trade at similar multiples.
Advantages:
- Quick and easy
- Market-based
- Useful for comparison
Disadvantages:
- Assumes market prices are "right"
- Differences between companies
- Can miss fundamental value
Common Valuation Multiples
Price Multiples:
1. Price-to-Earnings (P/E)
P/E = Stock Price / Earnings Per Share
Or for entire company:
P/E = Market Cap / Net Income
Example:
- Stock price: $50
- EPS: $4
- P/E = 12.5x
Interpretation: Market pays $12.50 for each $1 of earnings.
Using P/E for valuation:
Company: EPS = $3, Industry average P/E = 15x
Estimated Value = $3 × 15 = $45 per share
2. Price-to-Book (P/B)
P/B = Stock Price / Book Value Per Share
Example:
- Price: $30
- Book value per share: $20
- P/B = 1.5x
Market values company at 1.5× its book value.
Good for: Banks, financial institutions, asset-heavy companies
3. Price-to-Sales (P/S)
P/S = Market Cap / Revenue
Example:
- Market cap: $5B
- Revenue: $10B
- P/S = 0.5x
Good for: Early-stage companies without profits, comparing revenue growth
Enterprise Value Multiples:
4. EV/EBITDA
EV/EBITDA = Enterprise Value / EBITDA
Where:
Enterprise Value = Market Cap + Debt - Cash
Example:
Company:
- Market cap: $1B
- Debt: $300M
- Cash: $100M
- EBITDA: $200M
EV = $1,000M + $300M - $100M = $1,200M
EV/EBITDA = $1,200M / $200M = 6.0x
Best multiple for comparing companies with different capital structures.
5. EV/Sales
EV/Sales = Enterprise Value / Revenue
Good for: Companies without earnings, technology companies
6. EV/EBIT
EV/EBIT = Enterprise Value / EBIT
Similar to EV/EBITDA but accounts for depreciation.
Using Multiples for Valuation
Step 1: Calculate target company's metric
- EPS, EBITDA, Sales, etc.
Step 2: Find comparable companies
- Same industry
- Similar size
- Similar growth
- Similar margins
Step 3: Calculate average multiple
- P/E, EV/EBITDA, etc. for comparables
Step 4: Apply to target
- Value = Multiple × Target's Metric
Example: Valuing a Tech Company
Target Company:
- EBITDA: $150M
- Debt: $100M
- Cash: $50M
- Shares: 20M
Comparable Companies:
| Company | EV/EBITDA |
|---|---|
| Comp A | 12x |
| Comp B | 14x |
| Comp C | 13x |
| Comp D | 11x |
Average: 12.5x
Valuation:
Enterprise Value = 12.5 × $150M = $1,875M
Equity Value = $1,875M - $100M + $50M = $1,825M
Value per share = $1,825M / 20M = $91.25
Stock worth approximately $91 per share.
Forward vs. Trailing Multiples
Trailing Multiples:
- Based on past 12 months
- Actual reported data
- Historical
Forward Multiples:
- Based on next 12 months forecast
- Analyst estimates
- Forward-looking
Example:
Stock trading at $50:
- Last year EPS: $4 → Trailing P/E = 12.5x
- Next year EPS (est): $5 → Forward P/E = 10.0x
Forward multiples typically lower (growth expected).
PEG Ratio (Price/Earnings to Growth)
Adjusts P/E for growth:
PEG = P/E Ratio / Growth Rate
Example:
Stock A:
- P/E: 20x
- Growth: 20%
- PEG = 20/20 = 1.0
Stock B:
- P/E: 15x
- Growth: 10%
- PEG = 15/10 = 1.5
Stock A is "cheaper" relative to growth (lower PEG).
Rule of thumb:
- PEG < 1.0: Undervalued
- PEG = 1.0: Fairly valued
- PEG > 1.0: Overvalued
Limitation: Oversimplifies relationship between valuation and growth.
Choosing the Right Multiple
Different multiples for different situations:
P/E:
- Mature, profitable companies
- Stable earnings
- Banks, utilities
P/B:
- Financial institutions
- Asset-heavy industries
- Distressed companies
P/S:
- Unprofitable companies
- Early-stage tech
- Consistent revenue but not profit
EV/EBITDA:
- Most versatile
- Companies with different leverage
- M&A valuation
EV/Sales:
- Growth companies
- SaaS, technology
- Negative earnings
Industry norms:
- Tech: P/S, EV/Sales, P/E (if profitable)
- Banks: P/B, P/E
- Manufacturing: EV/EBITDA, P/E
- Real Estate: P/B, Price to NAV
9.5 What Drives Value?
Value Drivers Framework
Value comes from:
1. Cash Flow Magnitude
- Higher cash flows = Higher value
- Revenue growth
- Margin improvement
- Operating efficiency
2. Growth
- Faster growth = Higher value
- Revenue growth
- Market expansion
- New products
3. Risk (Cost of Capital)
- Lower risk = Higher value
- Lower WACC
- More stable cash flows
- Better credit quality
4. Duration
- Longer cash flows = Higher value
- Sustainable competitive advantage
- Economic moat
- Long product lifecycles
The Value Equation Simplified
Value = (Cash Flow × Growth Factor) / (Risk - Growth)
Maximize value by:
- ↑ Cash flows (efficiency, margins)
- ↑ Growth (market expansion, innovation)
- ↓ Risk (stability, diversification)
- ↑ Duration (competitive advantage)
Return on Invested Capital (ROIC)
Key metric for value creation:
ROIC = NOPAT / Invested Capital
Where:
- NOPAT = Net Operating Profit After Tax
- Invested Capital = Debt + Equity
Value Creation:
- ROIC > WACC: Creating value
- ROIC = WACC: Breaking even
- ROIC < WACC: Destroying value
Example:
Company A:
- ROIC: 18%
- WACC: 10%
- Spread: +8% → Creating value
Company B:
- ROIC: 7%
- WACC: 10%
- Spread: -3% → Destroying value
Even profitable Company B destroys value if ROIC < WACC!
Economic Profit (EVA)
Economic Value Added:
EVA = (ROIC - WACC) × Invested Capital
Or:
EVA = NOPAT - (WACC × Invested Capital)
Example:
Company:
- NOPAT: $500M
- Invested Capital: $3,000M
- WACC: 12%
Capital Charge = $3,000M × 12% = $360M
EVA = $500M - $360M = $140M
Company created $140M of economic profit.
Interpretation:
- EVA > 0: Creating value
- EVA < 0: Destroying value
- Maximizing EVA → Maximizing value
Growth vs. Value Trade-off
Not all growth creates value!
Good Growth:
- ROIC > WACC
- Profitable expansion
- Creates value
Bad Growth:
- ROIC < WACC
- Unprofitable expansion
- Destroys value
Example:
Company considering expansion:
- Investment: $100M
- ROIC: 8%
- WACC: 12%
Economic Profit = ($8M - $12M) = -$4M annually
This growth destroys $4M per year! Better to return capital to shareholders.
Competitive Advantage and Value
Sustainable competitive advantage → Higher value
Porter's Five Forces:
- Threat of new entrants
- Bargaining power of suppliers
- Bargaining power of buyers
- Threat of substitutes
- Industry rivalry
Economic Moat (Buffett concept):
- Cost advantage
- Network effects
- Brand power
- Switching costs
- Regulatory advantages
Companies with moats:
- Higher margins
- Better pricing power
- More sustainable growth
- Lower risk
- Higher valuations
Example:
Coca-Cola:
- Strong brand moat
- High margins: 25%+
- Stable cash flows
- Commands premium valuation
Generic beverage company:
- No moat
- Low margins: 5-10%
- Volatile cash flows
- Lower valuation
9.6 Practical Valuation Considerations
Dealing with Negative Earnings
Problem: Can't use P/E for unprofitable companies.
Solutions:
1. Use Revenue Multiples
- P/S or EV/Sales
- Assumes eventual profitability
2. Use Forward P/E
- When profitability expected
3. Focus on Path to Profitability
- Unit economics
- Contribution margin
- Operating leverage
Example: SaaS Startup
- Revenue: $50M
- Losses: -$20M
- Industry EV/Sales: 8x
Enterprise Value = 8 × $50M = $400M
Key questions:
- When will it be profitable?
- What margins at maturity?
- Is growth sustainable?
Cyclical Companies
Challenge: Earnings vary dramatically with cycle.
Wrong approach:
- Value at peak earnings → Overvalued
- Value at trough earnings → Undervalued
Right approach:
1. Normalize Earnings
- Average through cycle
- 5-10 year average
2. Use Mid-Cycle Multiples
- What P/E at middle of cycle?
3. Focus on Through-Cycle Metrics
- Average ROIC
- Cycle-adjusted cash flows
Example: Auto Manufacturer
Earnings history:
- 2020: $2/share (trough)
- 2021: $5/share
- 2022: $8/share (peak)
- 2023: $6/share
- 2024: $4/share
Normalized: ~$5/share
Use P/E based on $5, not current year.
Terminal Value Assumptions
Terminal value often 60-80% of total value!
Critical assumptions:
1. Terminal Growth Rate
- Should be ≤ GDP growth
- Typically 2-4%
- Be conservative!
2. Terminal Margins
- Revert to industry average?
- Sustainable competitive advantage?
Bad assumption: 10% growth forever Reality: No company grows at 10% forever
Example Impact:
Base case (g = 3%): Value = $50 If g = 4%: Value = $60 (+20%) If g = 2%: Value = $43 (-14%)
Terminal value sensitivity is huge!
Control Premium
Control premium: Extra paid to control a company.
Typical premiums: 20-40% over market price
Why?
- Strategic value
- Synergies
- Ability to change management
- Eliminate inefficiencies
Example:
Stock trading at $40:
- Minority value: $40
- Control value: $50-56 (25-40% premium)
M&A valuations typically higher than public market.
Illiquidity Discount
Private companies worth less than public (all else equal).
Typical discount: 20-30%
Reasons:
- Can't easily sell shares
- Limited market
- No price discovery
- Information asymmetry
Example:
Comparable public company: EV = $500M
Private company valuation:
Value = $500M × (1 - 0.25) = $375M
25% discount for illiquidity.
9.7 Putting It Together: Complete Valuation
Step-by-Step Valuation Process
Step 1: Understand the Business
- What does it do?
- How does it make money?
- Competitive position?
- Growth prospects?
Step 2: Analyze Historical Performance
- Revenue growth
- Margin trends
- ROIC
- Cash flow generation
Step 3: Build Financial Forecast
- Revenue projection (5-10 years)
- Margin assumptions
- Capex and working capital needs
- Calculate free cash flows
Step 4: Determine Cost of Capital
- Cost of equity (CAPM)
- Cost of debt
- WACC
Step 5: Calculate Terminal Value
- Perpetuity growth or exit multiple
- Be conservative
Step 6: Discount to Present Value
- DCF calculation
- Sum of PVs
Step 7: Calculate Per-Share Value
- Adjust for debt, cash
- Divide by shares outstanding
Step 8: Sensitivity Analysis
- Test key assumptions
- Range of values
Step 9: Sanity Check with Multiples
- Does DCF value make sense?
- Compare to peer multiples
- Reconcile differences
Step 10: Make Recommendation
- Undervalued/Overvalued/Fair
- Margin of safety
- Investment thesis
Example: Complete Company Valuation
XYZ Corporation
Business: Software company, enterprise SaaS Shares Outstanding: 100M Current Stock Price: $45 Debt: $200M Cash: $100M
Historical Performance:
| Year | Revenue | Growth | EBIT Margin |
|---|---|---|---|
| 2020 | $300M | -- | 15% |
| 2021 | $360M | 20% | 17% |
| 2022 | $450M | 25% | 18% |
| 2023 | $560M | 24% | 20% |
| 2024 | $700M | 25% | 22% |
Forecast Assumptions:
- Revenue growth: 20% for 5 years, then 5% perpetuity
- EBIT margin: Stabilize at 25%
- Tax rate: 25%
- Capex: 5% of revenue
- NWC change: 10% of revenue increase
- Depreciation: 4% of revenue
Cost of Capital:
- Beta: 1.3
- Risk-free rate: 4%
- Market premium: 8%
- Cost of debt: 6%
- WACC: 11%
Forecast (Millions):
| Year | Revenue | EBIT | Tax | NOPAT | D&A | Capex | ΔNW C | FCFF |
|---|---|---|---|---|---|---|---|---|
| 2025 | $840 | $210 | $53 | $157 | $34 | $42 | $14 | $135 |
| 2026 | $1,008 | $252 | $63 | $189 | $40 | $50 | $17 | $162 |
| 2027 | $1,210 | $302 | $76 | $227 | $48 | $60 | $20 | $195 |
| 2028 | $1,452 | $363 | $91 | $272 | $58 | $73 | $24 | $233 |
| 2029 | $1,742 | $436 | $109 | $327 | $70 | $87 | $29 | $281 |
PV of Explicit Period:
| Year | FCFF | PV Factor | PV |
|---|---|---|---|
| 2025 | $135 | 0.9009 | $122 |
| 2026 | $162 | 0.8116 | $131 |
| 2027 | $195 | 0.7312 | $143 |
| 2028 | $233 | 0.6587 | $153 |
| 2029 | $281 | 0.5935 | $167 |
Total PV: $716M
Terminal Value (2029):
FCFF(2030) = $281M × 1.05 = $295M
Terminal Value = $295M / (0.11 - 0.05) = $4,917M
PV of TV = $4,917M × 0.5935 = $2,918M
Enterprise Value:
EV = $716M + $2,918M = $3,634M
Equity Value:
Equity = $3,634M - $200M + $100M = $3,534M
Value Per Share:
Value = $3,534M / 100M = $35.34
Analysis:
- Intrinsic Value: $35.34
- Current Price: $45.00
- Overvalued by 27%
Sanity Check (Multiples):
Implied EV/Sales (2024) = $3,634M / $700M = 5.2x
Implied EV/EBIT (2024) = $3,634M / $154M = 23.6x
Implied P/E (2024) = Similar companies: 30-35x
Peer multiples: 6-8x sales, 25-30x EBIT
Conclusion: DCF suggests overvalued. Multiples suggest fairly valued to slightly rich. Recommendation: Hold or Sell if seeking better opportunities.
9.8 Common Valuation Mistakes
Mistake 1: Being Too Optimistic
Problem: Overestimating growth, margins, or duration.
Reality check:
- Few companies sustain >20% growth for >5 years
- Margins revert to industry average
- Competition erodes advantages
Fix: Use conservative assumptions, test scenarios.
Mistake 2: Circular Reasoning with Multiples
Problem: "Stock is cheap because P/E is 10x, and industry average is 15x."
Issue: What if entire industry is overvalued?
Fix: Always validate with DCF or fundamentals.
Mistake 3: Ignoring Quality
Problem: Two companies with same P/E aren't equally attractive.
Consider:
- Growth prospects
- Competitive position
- Management quality
- Balance sheet strength
Fix: Adjust for quality differences.
Mistake 4: Forecast Hockey Sticks
Problem: Projecting inflection point: "Company will turn around starting next year!"
Reality: Turnarounds are rare and slow.
Fix: Base on history, not hope.
Mistake 5: Precision Illusion
Problem: "$47.23 per share" implies false accuracy.
Reality: Valuation is inherently uncertain.
Fix: Think in ranges: "$40-50 per share."
Mistake 6: Ignoring Capital Requirements
Problem: Focus on revenue growth, ignore cash needs.
Reality: Growth requires investment.
Fix: Account for capex and working capital.
Mistake 7: Terminal Value Assumptions
Problem: Perpetual 10% growth, or 40x exit multiple.
Reality: Unsustainable.
Fix: Conservative terminal assumptions (2-4% growth).
Mistake 8: Not Testing Assumptions
Problem: Single-point estimate.
Fix: Sensitivity analysis, scenario analysis.
Module 9 Practice Problems
Problem Set 1: Dividend Discount Model
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Gordon Growth Model: Stock pays $3 dividend, expects 6% growth. Required return: 13%
Calculate stock value.
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Finding Required Return: Stock price: $60 Next dividend: $4 Growth rate: 5%
What's the required return?
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Two-Stage Model: Current dividend: $2 High growth: 15% for 4 years Then: 4% forever Required return: 12%
Calculate stock value.
Problem Set 2: Free Cash Flow Valuation
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Calculate FCFF:
- EBIT: $800M
- Tax rate: 28%
- Depreciation: $120M
- Capex: $150M
- Increase in NWC: $40M
Calculate FCFF.
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Company Valuation: Current FCFF: $200M Growth: 12% for 5 years, then 3% WACC: 9% Debt: $800M Cash: $200M Shares: 100M
Calculate: a. PV of 5-year cash flows b. Terminal value c. Enterprise value d. Equity value e. Value per share
Problem Set 3: Multiples Valuation
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P/E Valuation: Company EPS: $5 Comparable companies P/E ratios: 18x, 20x, 22x, 19x
Estimate stock value.
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EV/EBITDA Valuation: Target company:
- EBITDA: $300M
- Debt: $500M
- Cash: $100M
- Shares: 50M
Comparable EV/EBITDA multiples: 10x, 12x, 11x
Calculate value per share.
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PEG Ratio: Stock A: P/E = 25x, Growth = 25% Stock B: P/E = 20x, Growth = 15%
Calculate PEG for each. Which is cheaper relative to growth?
Problem Set 4: Value Drivers
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ROIC Calculation:
- NOPAT: $400M
- Invested Capital: $2,500M
- WACC: 10%
a. Calculate ROIC b. Is company creating value? c. Calculate economic profit (EVA)
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Growth Value: Company considering expansion:
- Investment: $500M
- Expected ROIC: 14%
- WACC: 12%
Calculate annual economic profit from expansion.
Problem Set 5: Comprehensive Valuation
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Complete Valuation:
Tech Company:
- Current revenue: $500M
- Revenue growth: 25% for 3 years, 15% for 2 years, then 5%
- EBIT margin: Currently 20%, improve to 30% by year 5
- Tax rate: 25%
- Capex: 8% of revenue
- D&A: 6% of revenue
- NWC: 15% of revenue (calculate change each year)
- Beta: 1.4
- Risk-free: 4%
- Market premium: 8%
- Debt: $300M at 7%
- Cash: $150M
- Shares: 75M
- Capital structure: 20% debt, 80% equity (use for WACC)
Calculate complete DCF valuation: a. WACC b. FCFF for years 1-5 c. Terminal value d. Enterprise value e. Equity value f. Value per share
Additional Resources
Excel Models
Download templates for:
- Dividend discount model
- DCF valuation model
- Comparable companies analysis
- Sensitivity analysis
Further Reading
Books:
- "Valuation" by McKinsey & Company
- "Investment Valuation" by Aswath Damodaran
- "The Little Book of Valuation" by Aswath Damodaran
Online:
- Damodaran Online (free valuation resources)
- Company investor presentations
- Equity research reports
Looking Ahead to Module 10
You now understand how to determine what companies are worth—the culmination of everything you've learned. Valuation integrates time value of money, risk and return, cost of capital, cash flows, and business strategy.
In Module 10, our final module, we'll Put It All Together:
- Integrate all course concepts
- Real-world applications and case studies
- Career paths in corporate finance
- Continuing your finance education
- Capstone project
This final module will solidify your understanding and prepare you for real-world application.
Summary
Congratulations on completing Module 9! You now understand:
✓ The fundamental principle: value comes from cash flows ✓ Dividend discount models for equity valuation ✓ Free cash flow valuation (FCFF and FCFE) ✓ Relative valuation using multiples ✓ What drives company value (cash flow, growth, risk, duration) ✓ ROIC and economic profit concepts ✓ Practical considerations and common mistakes ✓ How to conduct complete valuations
Valuation is both art and science. The models provide structure, but judgment, experience, and business understanding determine success. Every valuation involves assumptions and uncertainty—the key is being thoughtful, conservative, and testing your assumptions.
You now have the tools to value companies, stocks, and business decisions. Use them wisely.
Ready for the final module? Proceed to Module 10: Putting It All Together to consolidate your learning and see how everything connects.
"Price is what you pay. Value is what you get." — Warren Buffett
"In the short run, the market is a voting machine, but in the long run it is a weighing machine." — Benjamin Graham
You now know how to weigh value. Use this knowledge to make better investment and business decisions.
See you in Module 10 for the grand finale!