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 .....................................................................................................