Firm Valuation: Which model gives me the most accurate share price, the Dividend Discount Model ...

78 Pages·2011·6.53 MB·English

by  Gustav Claesson

Firm valuation
Which model gives me the most accurate share price, the Dividend
Discount Model or the Free Cash Flow to Equity model?
“What is a cynic? A man who know the price of everything and the value of nothing” – [Oscar Wilde, 1892]
Master Thesis in Finance
Author: Gustav Claesson
Tutors: Johan Eklund
Andreas Högberg
Jönköping June 2011
Acknowledgements

I would hereby like to acknowledge the following persons for their help and guidance along
the way:

My tutors Johan Eklund and Andreas Högberg who have encouraged me for a deeper
understanding for the subject, while at the same time providing valuable feedback during
this whole process.

My opponents that have been giving me support and valuable critique during the seminars
we have had.

Finally, I would like to acknowledge a special thank to my family and friends for their
support and patience.

Jönköping, 2011-06-01

___________________________
Gustav Claesson

i
Master Thesis in Finance
Title Firm Valuation
Authors Gustav Claesson
Tutors Johan Eklund and Andreas Högberg
Date 2011-06-01
Subject terms Stock valuation, future growth prospects, and valuation models
Abstract
Purpose:
The purpose of this thesis is to investigate the applicability of the Free Cash Flow to
Equity Model and the Dividend Discount Model on ten large cap firms on the
Stockholm Stock Exchange. Moreover the author intends to examine whether these
valuation methods differs in regards of the companies’ operational segment,
business cycle and turnover. The target prices will hereafter be benchmarked with
actual closing prices and professional analysts to observe similarities and deviations.
Method:
The focus lies on Swedish companies listed on Nasdaq OMX Stockholm’s Large
Cap list. The companies are valued by collecting financial information from 2006-
2010 in order to find out what the share price in the beginning of 2011 should be.
The models that are used to value the share are the Dividend Discount Model,
which basically discounts actual dividends in order to find the present value of the
share, and the Free Cash Flow to Equity model, which is discounting the firms’ cash
flow available to its stockholders, i.e. the potential dividends. Since both of the
valuation models require assumptions on future growth to be made, a combination
of calculations and goals presented by the companies has been made in order to
assume growth rates.
Findings:
The findings reveal that out of the twenty valuations that were made half of the
most accurate ones came from the Dividend Discount Model, and half came from
the Free Cash Flow to Equity model. It was however the Dividend Discount Model
that provided the most accurate share prices, in comparison to the actual share prices
from January 2011. It is also concluded that the turnover of the firm being evaluated
does not have an impact on the valuation process, whilst the industry in which the
firm operates as well as its payout ratio are factors that need to be taken into
consideration when choosing between the Dividend Discount Model and the Free
Cash Flow to Equity model.

ii
Abbreviations and explanations
Market Capitalization – The market value of a company’s equity, share price times
the number of shares outstanding

ROE – The Return on Equity

FCFE – The Free Cash Flow to Equity

DDM – The Dividend Discount Model

DCF – Discounted Cash Flow

SCB – Swedish Statistical Service

P/E ratio – Price-to-earnings ratio

Large Cap – Stockholm Stock Exchange’s list of companies with a market
capitalization of over one billion euros

Due Diligence – A process whereby an individual, or an organization, seeks
sufficient information about a business entity to reach an informed judgement as to
its value for a specific purpose

Intrinsic Value – The fundamental value, or the present value of all future cash
flows

DPS – Dividends per Share

EPS – Earnings per Share

GDP – Gross domestic product

GWP – Gross world product

PV – Present Value

CAPM – Capital Asset Pricing Model
iii
iv
Table of Contents
1
  INTRODUCTION
 .........................................................................................................
 1

1.1
  BACKGROUND INFORMATION
 .........................................................................................
 1

1.2
  PROBLEM DISCUSSION
 ......................................................................................................
 3

1.3
  PURPOSE
 ..........................................................................................................................
 5

1.4
  DELIMITATIONS
 ...............................................................................................................
 5

1.5
  OUTLINE OF THE THESIS
 ..................................................................................................
 5

2
  METHODOLOGY
 .........................................................................................................
 6

2.1
  METHOD APPROACHES
 ....................................................................................................
 6

2.1.1
  Inductive vs. Deductive
 ....................................................................................................
 6

2.1.2
  Quantitative vs. Qualitative
 .............................................................................................
 7

2.2
  THE CASE STUDY
 .............................................................................................................
 8

2.3
  COLLECTION OF THE DATA
 .............................................................................................
 8

2.4
  LIMITATIONS
 ....................................................................................................................
 8

3
  THEORETICAL FRAMEWORK
 ..................................................................................
 9

3.1
  OUTLINE OF THE THEORETICAL FRAMEWORK
 ................................................................
 9

3.2
  MOTIVES FOR VALUATION
 ...............................................................................................
 9

3.2.1
  Who Values Stocks?
 ...................................................................................................
 10

3.3
  RELATED CONCEPTS
 ......................................................................................................
 11

3.3.1
  The Concept of Value
 ..................................................................................................
 11

3.3.2
  Due Diligence
 .............................................................................................................
 11

3.3.3
  Capital Market Efficiency
 .............................................................................................
 12

3.3.4
  Capital structure and firm value
 ......................................................................................
 13

3.4
  FINANCIAL MODELS & VALUATION
 ..............................................................................
 13

3.4.1
  Dividend Discount Model
 ..............................................................................................
 13

3.4.2
  Free Cash Flow to Equity
 .............................................................................................
 17

3.4.3
  Related concepts and formulas connected with DDM & FCFE
 ............................................
 19

3.5
  THE COMPANIES
 ............................................................................................................
 22

3.6
  PREVIOUS RESEARCH
 .....................................................................................................
 23

3.7
  ASSUMPTIONS PRIOR TO EMPIRICAL FINDINGS & ANALYSIS
 .........................................
 23

4
  EMPIRICAL FINDINGS & ANALYSIS
 .....................................................................
 25

4.1
  FUTURE GROWTH ASSUMPTIONS
 ...................................................................................
 25

4.2
  ABB (INDUSTRIAL GOODS & SERVICES – LARGE CAP)
 ...................................................
 25

4.2.1
  Financials & Assumptions
 ...........................................................................................
 26

4.2.2
  The Gordon Growth Model
 ...........................................................................................
 26

4.2.3
  Constant Growth FCFE Model
 .....................................................................................
 26

4.2.4
  Summary Analysis
 ......................................................................................................
 26

4.3
  ASSA ABLOY (INDUSTRIAL GOODS & SERVICES – LARGE CAP)
 .....................................
 27

4.3.1
  Financials & Assumptions
 ...........................................................................................
 27

4.3.2
  The Gordon Growth Model
 ...........................................................................................
 28

4.3.3
  Constant Growth FCFE Model
 .....................................................................................
 28

4.3.4
  Summary Analysis
 ......................................................................................................
 28

4.4
  ASTRAZENECA (HEALTH SERVICE – LARGE CAP)
 ..........................................................
 29

4.4.1
  Financials & Assumptions
 ...........................................................................................
 29

4.4.2
  Two-stage Dividend Discount Model
 ...............................................................................
 30

4.4.3
  Two-stage FCFE Model
 ...............................................................................................
 30

4.4.4
  Summary Analysis
 ......................................................................................................
 30

4.5
  ATLAS COPCO (INDUSTRIAL GOODS & SERVICES – LARGE CAP)
 ....................................
 31

4.5.1
  Financials & Assumptions
 ...........................................................................................
 31

v
4.5.2
  Two-stage Dividend Discount Model
 ...............................................................................
 32

4.5.3
  Two-stage FCFE Model
 ...............................................................................................
 32

4.5.4
  Summary Analysis
 ......................................................................................................
 32

4.6
  AXFOOD (FAST MOVING CONSUMER GOODS – LARGE CAP)
 ..........................................
 33

4.6.1
  Financial & Assumptions
 ............................................................................................
 33

4.6.2
  Two-stage Dividend Discount Model
 ...............................................................................
 34

4.6.3
  Two-stage FCFE Model
 ...............................................................................................
 34

4.6.4
  Summary Analysis
 ......................................................................................................
 35

4.7
  GETINGE (HEALTH SERVICE – LARGE CAP)
 ..................................................................
 35

4.7.1
  Financials & Assumptions
 ...........................................................................................
 35

4.7.2
  Two-stage Dividend Discount Model
 ...............................................................................
 36

4.7.3
  Two-stage FCFE Model
 ...............................................................................................
 36

4.7.4
  Summary Analysis
 ......................................................................................................
 36

4.8
  MEDA (HEALTH SERVICE – LARGE CAP)
 ........................................................................
 37

4.8.1
  Financials & Assumptions
 ...........................................................................................
 37

4.8.2
  The Gordon Growth Model
 ...........................................................................................
 38

4.8.3
  Constant Growth FCFE Model
 .....................................................................................
 38

4.8.4
  Summary Analysis
 ......................................................................................................
 38

4.9
  NCC (INDUSTRIAL GOODS & SERVICES – LARGE CAP)
 ..................................................
 39

4.9.1
  Financials & Assumptions
 ...........................................................................................
 39

4.9.2
  Two-stage Dividend Discount Model
 ...............................................................................
 40

4.9.3
  Two-stage FCFE Model
 ...............................................................................................
 40

4.9.4
  Summary Analysis
 ......................................................................................................
 40

4.10
  ORIFLAME (FAST MOVING CONSUMER GOODS – LARGE CAP)
 .....................................
 41

4.10.1
  Financials & Assumptions
 .........................................................................................
 41

4.10.2
  Two-stage Dividend Discount Model
 ..............................................................................
 41

4.10.3
  Two-stage FCFE Model
 .............................................................................................
 42

4.10.4
  Summary Analysis
 ....................................................................................................
 42

4.11
  SWEDISH MATCH (FAST MOVING CONSUMER GOODS – LARGE CAP)
 ...........................
 42

4.11.1
  Financials & Assumptions
 .........................................................................................
 43

4.11.2
  Two-stage Dividend Discount Model
 ..............................................................................
 43

4.11.3
  Two-stage FCFE Model
 .............................................................................................
 44

4.11.4
  Summary Analysis
 ....................................................................................................
 44

4.12
  SUMMARIZING THE ANALYSES
 .....................................................................................
 44

5
  CONCLUSION
 ............................................................................................................
 49

5.1
  CONCLUSIONS IN RELATION TO THE PURPOSE
 ..............................................................
 49

5.2
  IMPLICATIONS AND SUGGESTIONS FOR FUTURE STUDIES
 ..............................................
 50

6
  REFERENCES
 ............................................................................................................
 51

APPENDICES
 ...................................................................................................................
 57

APPENDIX 1
 ............................................................................................................................
 57

APPENDIX 2
 ............................................................................................................................
 57

APPENDIX 3
 ............................................................................................................................
 57

APPENDIX 4
 ............................................................................................................................
 58

APPENDIX 5
 ............................................................................................................................
 58

APPENDIX 6
 ............................................................................................................................
 59

APPENDIX 7
 ............................................................................................................................
 59

APPENDIX 8
 ............................................................................................................................
 60

APPENDIX 9
 ............................................................................................................................
 61

APPENDIX 10
 ..........................................................................................................................
 61

vi
APPENDIX 11
 ..........................................................................................................................
 61

APPENDIX 12
 ..........................................................................................................................
 62

APPENDIX 13
 ..........................................................................................................................
 62

APPENDIX 14
 ..........................................................................................................................
 63

APPENDIX 15
 ..........................................................................................................................
 63

APPENDIX 16
 ..........................................................................................................................
 63

APPENDIX 17
 ..........................................................................................................................
 64

APPENDIX 18
 ..........................................................................................................................
 65

APPENDIX 19
 ..........................................................................................................................
 65

APPENDIX 20
 ..........................................................................................................................
 65

APPENDIX 21
 ..........................................................................................................................
 66

APPENDIX 22
 ..........................................................................................................................
 66

APPENDIX 23
 ..........................................................................................................................
 66

APPENDIX 24
 ..........................................................................................................................
 67

APPENDIX 25
 ..........................................................................................................................
 67

APPENDIX 26
 ..........................................................................................................................
 68

APPENDIX 27
 ..........................................................................................................................
 69

APPENDIX 28
 ..........................................................................................................................
 69

APPENDIX 29
 ..........................................................................................................................
 69

APPENDIX 30
 ..........................................................................................................................
 70

vii
1 Introduction
In the introductory chapter is a background given to the thesis. It provides information about the stock
market and why it has become such a popular topic in recent years, the importance of correct valuation is
highlighted. A problem discussion and the purpose of the thesis are also included. An outline of the thesis
and its limitations finishes the Introduction part.
1.1 Background Information
The activity on the stock markets around the world has increased during the last decades,
correspondingly, so has the stock markets influence on and importance to our society.
Nowadays, many corporations and institutions are heavily dependent on the stock market
movements. According to statistics provided by the World Bank (2011), the number of
listed domestic companies in Sweden has more than doubled during the two last decades,
as illustrated in Figure 1.1.
Figure 1.1 Listed domestic companies in Sweden

Listed
 domes2c
 companies
 in
 Sweden

400

350

300

250

200

Listed
 domes5c

150
  companies
 in
 Sweden

100

50

0

(World Bank, 2011)
However, it is not only corporations and institutions that invest in the stock markets, as of
June 2010, 16,9 per cent of the Swedish population owned shares, with an average
portfolio value of SEK 292 000 (SCB, 2010); the corresponding Swedish households’
wealth in shares was worth SEK 506 billion1 (SCB, 2010). Figure 1.2 illustrates shareholder
statistics, with ownership by sector.

1 Share of wealth of households does not include investments in funds or insurance savings.
1
Figure 1.2 Shareholder statistics, June 2010 [Ownership by sector (SCB, 2010)]

In order for the stock market to function properly, there has to exist a confidence amongst
the investors in techniques for valuing a publicly traded stock. It is crucial to know the true
value of a stock before deciding whether to sell it or buy it. Often there are uncertainties
related to the valuation process, not only from the specific asset being valued, but also
related to the valuation model in particular. With too much uncertainty, actors in the stock
market would not be able to arrive at conclusions on what price to buy or sell an asset and
bad decisions, leading to bad investments, would be made.
A postulate of healthy investing is that an investor does not pay more for an asset than it is
worth, which has to be backed up by reality, i.e. the price paid for any asset should be
reflected by the future cash flow it is expected to create. (Damodaran, 2002)
In order to manage a portfolio, consisting of investments that are held long term, the
valuation process is fundamental were firm-specific analyses are made. Scott Hoover, the
author of Stock Valuation – An Essential Guide to Wall Street’s Most Popular Valuation Models
(2006), claims that individuals most often are better off investing in an index fund rather
than trying to pick stocks themselves. One way for a passive investor, such as regular
people investing in stocks for the long run, pension funds or bonds, is to rely on
professional stock (fundamental) analysts. A fundamental stock analysis most often
concerns its financial characteristics, such as growth forecasts, risk profiles, and cash flows.
Financial analysts play a crucial role in today’s society, either as investment bankers whose
goal is to match companies with investors or as equity researchers making assessments of
the true value of companies allowing them to make recommendations both to public and
private investors. (Hoover, 2006)
Some analysts’ use discounted cash flow models in the valuation process, while others use
different financial multiples (e.g. P/E ratio) in order to find out if a stock is under- or
overvalued. (Damodaran, 2002)
When looking at different analysts’ results of specific firm valuations, the value often
differs. If looking at the target price recommendations for Swedbank AB made by four
2