What are your assumptions about your cost of debt and target capital structure?

The Main Contents of the Report

– Executive summary: A very brief introduction to the company, which models you have used for valuation, what your overall view of the company’s price is and what the main risk factors are.

– Company overview: Including info on the services or products, market share, main competitors, major events (M&As, strategic reviews, management turnaround, etc.), business strategy, management of the company, life cycle and a brief look into Porter’s Five Forces and industry conditions.

– Historical information of the company: 3 – 5 years financial statements (balance sheet, income statement and cash flow statement), preferably common-sized as well to give a better perspective. These will probably end up in the appendix.

– Ratio analysis: You will be able to calculate them or extract them directly from a source, but if I find errors and irregularities I’ll hold you responsible for not checking. So even if you’re extracting these from a source, make sure you cross-check the main numbers. These can include liquidity, leverage, efficiency and capital ratios along with anything else required. Look into these and discuss any irregularities or major patters. Also you’d ideally compare these ratios with some benchmark, like the peer companies’ ratios or the industry average.

– Quality of financial reporting: Balance sheet-based accrual ratio and cash flow-based accrual ratio. If the net value of these ratios is increasing, then they have more room for manipulation; otherwise, you are good. If there is manipulation, you might as well look at cash flows too, like the case of Nestle right after checking the accrual ratios.

– Choice of valuation model: Dividend Discount Model, FCF models and Relative Valuation. Explain why you’re using/not using a specific model. You probably don’t need to do both FCFE and FCFF, one would suffice.

– Discuss the main assumptions you make and how you get there: Growth rate- why did you assume this? How do you calculate the required return on equity? What are your assumptions about your cost of debt and target capital structure? etc. Present your case and the valuation results clearly under each method.

– Sensitivity analysis: What happens if your main assumptions change? Range of potential values.

– Conclusion and recommendations: Checking the price in the market, is the share under or over-priced? What are the main concerns about your valuation outcome and the main risks the company faces, which might affect this valuation? The Main Contents of the Report

The Most Common Mistakes I Come Across

Here is a general list of the most common comments I’ve made when assessing your valuation reports. Please read them and make sure I won’t have to make these comments on your final assessment report 😉

You’re not following the structure (or any structure!) as you should and the information do not follow a pattern and are hard to follow.
You have spent too much time and effort on describing the industry and its forces. Although pointing out the main industry/economic forces are justified, this is a stock valuation report and more attention should be paid to the latter.
You jump into valuation without giving adequate info (although summarized) on the company and the environment it works in. These are required to assess the company’s overall performance and have a better overview of the future.
Financial and accounting ratios have been presented, but there is not much of an analysis on this. What are the main patterns, sources of concern and points of interest? How do these compare to the norm?
If the quality of financial reports does not turn out to be great, its advised to look at the cash generation power of the company as well (as done with Nestle) subsequent to this analysis as well.
If your company does not pay any dividend or is very volatile, it doesn’t make sense to use the DDM. Stock repurchase is also a form of dividend payment and should be taken into account when calculating the aggregate dividends paid. The dividends cannot grow for ever at a rate higher than your cost of equity. The discounting in the model hasn’t been done properly. You don’t justify the assumed growth rates in your dividends and the stages (constant growth, two-stage, H-model, etc.).
In your FCFF or FCFE model, you just look at the previous FCFFs and FCFEs and try to extrapolate them into the future. This strategy is very vague and not justifiable. You’ll need to estimate the components which make the FCFs in the future and estimate the FCFs from there. A few examples where provided in class where, subsequent to estimating future sales and EBITDAs and then alterations for FC Investment and WC Investments, future FCFs could be estimated.
Your cost of debt, equity and WACC are not reasonable. Cost of debt should be higher than the risk free, and cost of equity is typically a few percentage points higher than the cost of equity, otherwise you’re violating the fundamental assumptions of valuation.
Your Beta in the CAPM does not appear to be sustainable in the long run. You need to use a different Beta estimate (based on a different historical period or frequency) or amend your Beta by adjusting it based on industry Beta, etc. Also the market return (expected return on the market) is not sensible. This always has to be a few percentage points higher than the risk free rate of course.
Your growth rate is not very well-justified. Very high or very low growths are not sustainable in the future, and the growth rate typically does not drop all of a sudden from a high rate to a long-term sustainable rate, there is usually a gradual decline. The long term growth rate is typically in line with the industry long-term growth rate or the GDP growth rate in that economy.
When it comes to sensitivity analysis, its best to use the discount rate in one axis and the long term growth rate in the other. These are the two most important assumptions.
In your relative valuation models, you do not justify the choice of peers. Using forward ratios is more justifiable than trailing ratios. I understand this is difficult to do in many cases, but this is at least a shortcoming that you need to raise and mention in your report. (especially for the final report) it is important to look at the historical trend of the ratio you are using and to compare it with the historical averages for your peer group, and then adjust the ratio you’ll use in your valuation accordingly. It is also important to use a few different ratios, if applicable, to get a better overall view.
In your conclusions, it is good to provide a range of potential values based on the methods used above and make your recommendations accordingly. You also need to highlight again the main risks the company is exposed to which would distort the valuationThe Most Common Mistakes I Come Across

Here is a general list of the most common comments I’ve made when assessing your valuation reports. Please read them and make sure I won’t have to make these comments on your final assessment report 😉

You’re not following the structure (or any structure!) as you should and the information do not follow a pattern and are hard to follow.
You have spent too much time and effort on describing the industry and its forces. Although pointing out the main industry/economic forces are justified, this is a stock valuation report and more attention should be paid to the latter.
You jump into valuation without giving adequate info (although summarized) on the company and the environment it works in. These are required to assess the company’s overall performance and have a better overview of the future.
Financial and accounting ratios have been presented, but there is not much of an analysis on this. What are the main patterns, sources of concern and points of interest? How do these compare to the norm?
If the quality of financial reports does not turn out to be great, its advised to look at the cash generation power of the company as well (as done with Nestle) subsequent to this analysis as well.
If your company does not pay any dividend or is very volatile, it doesn’t make sense to use the DDM. Stock repurchase is also a form of dividend payment and should be taken into account when calculating the aggregate dividends paid. The dividends cannot grow for ever at a rate higher than your cost of equity. The discounting in the model hasn’t been done properly. You don’t justify the assumed growth rates in your dividends and the stages (constant growth, two-stage, H-model, etc.).
In your FCFF or FCFE model, you just look at the previous FCFFs and FCFEs and try to extrapolate them into the future. This strategy is very vague and not justifiable. You’ll need to estimate the components which make the FCFs in the future and estimate the FCFs from there. A few examples where provided in class where, subsequent to estimating future sales and EBITDAs and then alterations for FC Investment and WC Investments, future FCFs could be estimated.
Your cost of debt, equity and WACC are not reasonable. Cost of debt should be higher than the risk free, and cost of equity is typically a few percentage points higher than the cost of equity, otherwise you’re violating the fundamental assumptions of valuation.
Your Beta in the CAPM does not appear to be sustainable in the long run. You need to use a different Beta estimate (based on a different historical period or frequency) or amend your Beta by adjusting it based on industry Beta, etc. Also the market return (expected return on the market) is not sensible. This always has to be a few percentage points higher than the risk free rate of course.
Your growth rate is not very well-justified. Very high or very low growths are not sustainable in the future, and the growth rate typically does not drop all of a sudden from a high rate to a long-term sustainable rate, there is usually a gradual decline. The long term growth rate is typically in line with the industry long-term growth rate or the GDP growth rate in that economy.
When it comes to sensitivity analysis, its best to use the discount rate in one axis and the long term growth rate in the other. These are the two most important assumptions.
In your relative valuation models, you do not justify the choice of peers. Using forward ratios is more justifiable than trailing ratios. I understand this is difficult to do in many cases, but this is at least a shortcoming that you need to raise and mention in your report. (especially for the final report) it is important to look at the historical trend of the ratio you are using and to compare it with the historical averages for your peer group, and then adjust the ratio you’ll use in your valuation accordingly. It is also important to use a few different ratios, if applicable, to get a better overall view.
In your conclusions, it is good to provide a range of potential values based on the methods used above and make your recommendations accordingly. You also need to highlight again the main risks the company is exposed to which would distort the valuation

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