Hi everyone. The valuation of a corporate entity involves several building blocks. We first need an understanding of the financial information we can gather from financial statements and SEC filings this information can be used to compute a series of financial ratios and to identify trends, risks, and opportunities. But financial information is not the only type of information that is useful for valuation. We must analyze a company's strategies It's competitive dynamics plus other external factors. We then bring this all together to develop a forecast or future outlook of the company. Today, we will start our discussion on how to input your forecasts into advanced valuation models. We will use these models to estimate a company's fundamental or intrinsic equity value. But before we get into those details, let's discuss the basic role of a valuation model. Now the model you select to value a company will determine what you need to forecast. For example, if you're using the residual income valuation model you will need to forecast both earnings per share and dividends. If you're using a discounted cashflow or DCF model then you will need to forecast the company's cashflows. The valuation model you select will also direct how you take the output of your calculations and convert it into an estimate of the company's equity value so for example the discounted cashflow or DCF model will give us an output of the company's enterprise value that is the intrinsic value of equity and debt. We would then need to take that enterprise value and subtract the intrinsic value of debt to arrive at the intrinsic equity value. If we use our residual income model then the output will already be in terms of intrinsic equity value. Lastly, the valuation model you choose will also determine the types of sensitivity and post audit analyses that should be done. Bear in mind that valuation models are based on forecasts and valuation estimates will not be a 100 percent correct. So you will need to test how your valuation estimates vary within a range of your forecasted inputs, for example, if you're using a residual income model then you can test how your estimate of equity value would vary if earnings per share varies by say five cents or ten cents. Before we get even deeper into our valuation models, let's review concepts related to the time value of money or TMV. These concepts are crucial in value in a company as valuation models are essentially about forecasting or projecting future earnings or cash flows and then discounting these earnings or cashflows to present time. Let's watch this brief video on the time value of money. In this lesson, we'll discuss how the key concepts of time value of money can be applied to various accounting or finance topics. Our initial topic in this lesson is simple versus compound interests. Simple interest is basically the initial investment times the interest rate times the time period. Example of this would be if we have $100 that we invest for one year and an annual interest rate of 10 percent that would be worth a $110 at the end of the first year, pretty basic, right? Next let's discuss about compound which is quite the best of all. This is what we want in our valued investments. Compound interests is our initial investment plus the prior interest times the interest rate times the period. So example of this would be if we have $100 hours invested for three years and an annual interest rate of 10 percent compounded annually, what would it be worth? Well let's review this slide calculation together. Year 1, this looks very similar, right? It's what we just saw in the simple interest example. At the end of the first year it's worth a $110. Now the compounding takes effect in Years 2 and 3, so at the end of Year 2, we take the a 110, the original principal plus the interest rate earned in Year 1, times the 10 percent interest rate and now we grow that to a $121 at the end of the second year. And in the third year you'll see you take that $121, again, at the 10 percent interest rate and now you've built that up to a $133.10 at the end of the third year. Much better when you're earning money on top of your interest. Our next topic is present versus future value. First of all let's talk about future value. The future value is the amount of money that $1 will grow to in some future period. To calculate future values you see here in the formula, it's investment represented by I times 1 plus little i to the nth power where the little i is the interest rate and the n is the number of periods. Let's go through an example to make this make a little bit more sense. So in this example, how much would I have to save after three years if I invest $100 for three years at an annual compounded rate of 10 percent? For the previous example as well as for using your future value tables which can be found online or in our textbook, basically take a $100 times 1.331 which is the future value factor, get you that $133.10 that we saw in that prior example. Next let's look at present value that's the current value of money to be received in the future. So for example, how much do I need to invest today in a savings account to achieve my retirement goal of a $133.10? I know, not a very lofty goal but we got to start somewhere. When I turn 60 years old in three years, if the compound interest rate is 10 percent. Well, per the prior example as well as using your present value tables which you can find online, you take the $133.10 times the present value factors you see here 0.75131 that gets you to $100 it's what you started with. Our next topic is going to be annuities little bit more complicated we talked about ordinary annuities versus annuity due. So what are annuities? Annuities are a series of cash receipts or payments that are equal in amount every period. There's two types we have to look at. An ordinary annuity has a bland name but it basically means cashflows occur at the end of each period, key point being end of the period. Then we have the second type which is annuity due where the cash flows occur at the beginning of the period. So next let's look at an ordinary annuity example. Let's say how much would I need to accumulate for a new car if I invest $10,000 at the end of each of those next three years in a savings account at an annual compound interest rate of 10 percent? I know your first question is where do I get 10 percent in today's world, hard to do but let's say we invested very [inaudible] got that return. By using our future value of an annuity table found online, you can take your initial amount that you're putting in for each of the three years, $10,000, times the future value of annuity factor of 3.31, you'll come up with $33,100. Sound like a pretty nice vehicle for the old professor. Next let's talk about annuity due. How much would I accumulate for this new car if I invest $10,000 at the beginning, not the end, but beginning of each of the next three years in a savings account and that annual compounded rate of 10 percent? Well by using the future value of an annuity due table found online, you take your $10,000 times that FVAD factor of 3.641 and you get $36,410. Now this sound like an even nicer vehicle, I kind a like on this idea. Let's stop here and recap what's just happened. Keep in mind the future value of an ordinary annuity when I put it in at the end of the year was $33,100. The future value of annuity due when I invested at 10,000 at the beginning of the year grew to $36,410, quite a difference, right? Well, as you'll see here what you just saw quite honestly is the power of the time value of money. The key takeaway from this is the earlier that you put money away for your retirement whether it's being a 401 k or 3B or other retirement vehicle, the more money you're going to have to enjoy in your retirement.
