Learning about Intrinsic Valuation with the Help of an Integrated Valuation Model

James A. Gentry, Frank K. Reilly and Michael J. Sandretto
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James A. Gentry: U of Illinois at Urbana-Champaign
Frank K. Reilly: U of Notre Dame
Michael J. Sandretto: U of Illinois at Urbana-Champaign

Working Papers from University of Illinois at Urbana-Champaign, College of Business

Abstract: An integrated strategic financial management system provides students of finance an invaluable learning experience in assessing the financial health of a company or estimating the value of this company. We found students' questions and misunderstanding about how to assess a company's financial health or apply current valuation theories led to the development an integrated valuation system (IVS). One objective of a dynamic valuation system is to help students simulate changes in a firm's financial strategies and discover how these changes affect a firm's credit health or its value. Additionally, an IVS provides a solid conceptual foundation for a student to justify the credibility of a growth rate used to estimate the terminal value of a project or stock. The IVS helps students learn why the intrinsic value of a stock estimated by a dividend discount model (Vs[DIV]) may not equal the intrinsic value of a stock estimated by discounting the free cash flow to equity (Vs[FCFE]), i.e., Vs[DIV]‚ Vs[FCFE]. An IVS can also help a student to understand why the value of a firm that is based on discounted free cash flow to the firm (Vf[FCFF]) may not equal discounted free cash flow to equity (Vs[FCFE]) plus discounted free cash flow to debt (Vd[FCFD]), or Vf[FCFF]‚ [Vs[DIV] + Vd[FCFD]]. One reason for these valuation inconsistencies is that the underlying theories were developed independently in different time periods. Also inputs for each of the models were unique because the models were not developed as a total integrated system. Therefore, a valuation system was created that integrates the key components needed to estimate the intrinsic value of a company's equity (Vs[FCFE]), debt (Vd[FCFD]) and its firm value (Vf[FCFF]). The integrated valuation system helped reconcile the valuation dilemmas by solving for an implied terminal growth rate of dividends [gDIV] that causes the Vs[DIV] = Vs[FCFE]. The IVS also determines an implied terminal growth rate of the FCFF[(gFCFF), that causes the Vf[FCFF] = [Vs[FCFE] + Vd[FCFD]]. The challenge to the learners is to interpret accurately the information conveyed via the implied terminal growth rate of dividends (gDIV) and the implied terminal growth rate of the FCFF (gFCFF).

Date: 2003-06
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