Ch 18 EqtyValuation

8/10/2019 Ch 18 EqtyValuation

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Book Value Measure: It is the net worth of acompany as shown in the balance sheet.

Book value per share = 8074/273 = 29.57

Balance Sheet Valuation Methods

Dow Chemical Balance Sheet Dec 31, 19921 ($ Million)

Assets Liabilities and Owners Equity

23,360 Liabilities 17,286

Common Equity 8,074

273 million shares outstanding


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Book value per share of Dow Chemical stock on Dec 31,1992 was $29.58. On that day Dow stock had a marketprice of $57.25

The above two prices differ because book value is basedon balance sheet figure as determined by accountingrules. On the other hand, market value of stock is basedon firmsvalue as a going concern i.e. market consensusestimate of the present value of the firms expectedfuture cash flows.

It is unlikely that market price will be same asbook value. Also, book value cannot always be

floor for stocksprice .



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Liquidation Value: This represents the amount ofmoney that could be realized by liquidating the firm i.e.selling its assets, repaying debts, and distributing theremainder to the shareholders.

Liquidation value per share is considered to be the floorfor the stocks price because if market price of stock

(value as a going concern) goes below the liquidationvalue the firm becomes attractive for takeover.



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Replacement Cost: This is the cost to replacefirmsassets less its liabilities.The market value of firmcan not go too far above its replacement cost because ifit did competitors would try to replicate the firm, this inturn will drive down the value equal to the replacementcost.

The ratio of market price to replacement cost is known

as Tobinsq. According to this, in the long run this ratiowill tend toward 1.

However, evidence indicates for very long periods of

time, the ratio can significantly differ from 1.



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Current price per share Po = 48Expected dividend per share E(D1) = 4

Expected price per share E(P1) = 52

Therefore, Expected HPR = 16.7%

which consists of dividend yield i.e. E(D1) Po

and capital gains yield i.e. [ E(P1)Po ] Po

The required rate of return on stock is the ratethat investors expect to earn on a security andwhen prices are in equilibrium it can be

determined by CAPM i.e. k = rf- [E(rMrf)]

Intrinsic Value Vs. Market Price


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The required return on a security indicates thereturn that investors will need from any otherinvestment of equivalent risk.

If a stock is priced correctly, its expectedreturn willequal to the required return.

If risk free rate is 6%, beta = 1.2, and market riskpremium = 5%, then required rate of return or

market capitalization rate k = 12%Therefore, based on the available information theexpectedrate of return exceeds the required returnby 4.7%. As such, investors will try to include more

this stock in their portfolio.



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Another way to make the above decision is tocompare intrinsic value (V) of a stock to its marketvalue or price (Po).The current market value or price is 48.and the intrinsic value is Vo = 50 (discounted by r.r.)This indicates the stock is underpriced in the marketand should be included in the portfolio if investor isnot following a passive strategy.In market equilibrium, the current price will reflect

the intrinsic value estimates of all marketparticipants i.e. there is no differences of the marketconsensus estimates of E(D1), E(P1), or k. A commonterm for the market consensus value of the requiredrate of return i.e. k is the market capitalizationrate.



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Stock Prices & Investment Opportunity

Cash Cow Inc. (firm with considerable cash flow butlimited investment prospects)

Growth Prospect (GP)

Both the companies expected earnings per share (EPS) is 5 andthis can be paid out as perpetual dividend per share.

If the market capitalization rate k = 12.5%, then value per share

of both the companies will be d1/k = 5/.125 = 40

If earnings are not reinvested both the companies value willremain same without any growth i.e. earnings and dividend willnot grow.


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Stock Prices & Investment Opportunity

Growth Prospect (GP)

Now Growth Prospect involves in project which generatesROE of 15% i.e. greater than k = 12.5%

If earnings are retained, can be invested at 15%, if distributedamong shareholders, will earn 12.5%.

b = Earnings retention ratio, also known as Plowback ratio and

1

b = Dividend payout ratio

If b = 60% then 1-b = 40%, therefore, dividend per share will be2 instead of 5.


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Stock Prices & Investment OpportunityGrowth Prospect (GP)

The reduced DPS will depress the price of share initially, but thesubsequent growth in assets will produce positive impact on shareprice, as such price of share will rise.

Figure 18.1 shows dividend growth under two earningsreinvestment plans.The low reinvestment plan results in higher initial DPS but lowerdividend growth rate. On the other hand,The high reinvestment plan results in lower initial DPS but higher

dividend growth rate. And if the growth rate is high enough thestock will worth more under high reinvestment strategy.

For example if GP starts with 100 million investment with allequity financed, then return on investment or equity will be 15%

of 100 million = 15 million.


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Stock Prices & Investment OpportunityGrowth Prospect (GP)

If 60% of 15 million earnings are reinvested, then the firmscapital stock will increase by .6 x 15m = 9 million.The percentage increase in capital stock = 15% x 60% = 9%

With 9% more capital, the company earns 9% more income, pays9% higher dividends. The growth rate of dividend will be same asgrowth rate of capital i.e. g = ROE x b =.15 x .60 = .09 or 9%

If stock price equals its intrinsic value, it will sell atPo = d1/(kg) = 2/(.125 - .09) = 57.14

When GP pursued no-growth strategy its stock price was 40 Thiscan be interpreted as value per share of assets already in place orat initial stage.


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Stock Prices & Investment OpportunityGrowth ProspectThe reason for increase of stock price is that the expected rate ofreturn from investment is greater than the required rate of return.

In other words, it can be said that the investmentopportunities have positive NPV and the value of firmrises by the amount of NPV. This NPV is also known aspresent value of growth opportunities or PVGO

Therefore, the value of firm equals no-growth value + PVGO

No-growth value = 40, therefore, PVGO = 57.1440 = 17.14

Stock price Po = D1 or E1 /k + PVGO = 40 + 17.14 = 57.14

Growth increases value only if ROE > K


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Stock Prices & Investment OpportunityCash Cow Inc.Cash Cows ROE is equal to k i.e. 12.5%.As such the NPV of itsinvestment opportunity will be equal to zero. With zero growthstrategy, b = 0, g = 0, and value of cash cow will be 40 per share

If cash cow plows back 60% of its earnings, then its growth rateg will be ROE x b = .125 x .6 = .075 and stock price will still be40 per share.

DPS (d1) = .4 x 5 = 2, k = 12.5%, and g = 7.5%,

Po = d1/(kg) = 2/(.125 - .075) = 40

This indicates if firm can not reinvest earnings at a ratehigher than what shareholders can earn by investing ontheir own, the firm can not add value. If ROE is equal or

less than k, there is no advantage of plowing funds backinto the firm. Example 18.4 demonstrates this fact.


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Life Cycles & Multistage Growth Models

Firms typically pass through life cycles with very different dividendprofiles in different phases.

In early years, there are ample opportunities for profitablereinvestment. Payout ratios are low and growth is rapid.

In later years the firm matures, competitors enter the market,

reinvestment opportunities become limited. In this phase, the firmmay choose to increase the dividend payout ratio rather thanretain earnings. The dividend level increases but it grows at aslower rate.


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Industry Return on

Assets(Average)

Retention

Ratio b(Average)

Payout

Ratio 1-b(Average)

Growth rate

of EPS19992004

(Average)

Drugs andPharm.

25.35% 89.83% 10.17% 60.83%

FoodProducts

24.97% 68% 32% 2.8%


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EPS for the year ended March 31, 2004 of Infosys TechnologiesLimited was 46.27.

Forecasted EPS for the next two years i.e. 2005 and 2006 are 68and 93 respectively.

Projected growth rate is 44% till year 2008

Long term steady growth rate of 6% is assumed afteryear 2008.

Market capitalization rate k is determined as per CAPM, which is

13.1%


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Infosyssintrinsic value in 2004 is 1262

The market price on March 31 2004 was 1234.55

This indicates the stock was slightly under priced.

The reliability of this fact depends on the accuracy of theestimated values of the variables (as per assumptions) used todetermine the intrinsic value. The assumptions were made

regarding the amount of dividends, the growth rate of dividends,and market capitalization rate. Moreover, it is assumed thecompany follows a simple two-stage growth process. In reality,the growth of dividends may follow more complicated pattern and

even a small errors in estimations can entirely change a decision.


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For example, if the estimated growth rate is 5% instead of 6% in2008, this will change the intrinsic value to 1122.

Therefore, estimation of intrinsic value is very sensitive to

the different assumptions that are made to determine it.

As such,it isvery important that sensitivity analysisbe donein valuation of stocks.

The sensitivity analysis will highlight the variable that needs to becarefully examined. For instance, besides growth rate, a smallchange in capitalization rate will change the intrinsic valuesubstantially, whereas reasonable changes in dividend forecast

between 2005 and 2008 would have a small impact on intrinsicvalue.


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Price Earnings Ratio

P E ratio or multiple is the ratio of PPS and EPS.

Company ROE K RetentionRatio b

PPS EPS PERatio

Cash CowInc.

12.5% 12.5% 0% 40 5 8

GrowthProspect

15% 12.5% 60% 57.14 5 11.4


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Price Earnings Ratio

The P E ratio indicates future expectations about growthopportunities. Growth opportunities are reflected by P/Eratio as follows:

When PVGO = 0 the above equation shows that Po = E1/k Thestock is valued like a non growing perpetuity of E1 and the P/Eratio is just 1/k. However, as PVGO becomes increasinglydominant contributor to price, the P/E ratio can rise

dramatically.

k

E

PVGO

kE

Po1

1

1


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Price Earnings RatioThe ratio of PVGO to E/kindicates the component of firm value

due to growth opportunities to the component of value due toassets in place or initial stage i.e. the no growth value of thefirm.

When future growth opportunities dominate the estimate oftotal value, the firm will command high price relative to currentearnings. Therefore, a high P/E multiple indicates that a firmhas ample growth opportunities.

The differences in expected growth opportunities impliesdifferentials in P/E ratios across firms. The P/E ratio actually isan indication of the markets optimism regarding a firmsgrowth prospects.


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Price Earnings RatioAccording to constant DDM formula

Po = D1 / (kg)

The payout ratio is 1b, E1 is expected EPS, g = ROE x b

Therefore the above formula can be written as follows:

Po = E1(1b) / (kROE x b)

Po/E1 = (1b) / (kROE x b)

The P/E ratio increases for higher plow back as long as ROEexceeds k.


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Table 18.3

Market Capitalization Rate k = 12%Plow back

Ratio

0 .25 .50 .75

ROE A. Growth Rate g

10% 0 2.5% 5% 7.5%

12% 0 3% 6% 9%

14% 0 3.5% 7% 10.5%

ROE B. P/E Ratio10% 8.33% 7.89% 7.14% 5.56%

12% 8.33% 8.33% 8.33% 8.33%

14% 8.33% 8.82% 10.00% 16.67%


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Price Earnings RatioIt is evident from Table 18.3 that higher plow back increases

growth rate but higher plow back does not necessarilyincrease P/E ratio.

A higher plow back increases P/E ratio only if investment

undertaken by the firm offer an expected rate of return(ROE) greater than the market capitalization rate.

However, P/E ratios are in general considered to be proxies

for expected growth in dividends or earnings. As per WallStreet rule of thumb, the growth rate should be roughlyequal to P/E ratio i.e. the ratio of P/E to g or PEG ratioshould be about 1.

Example 18.5


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Price Earnings Ratio & Stock RiskOne important implication of any stock valuation model is that

riskier stock will have lower P/E multiples holding all else equal.This can be examined by analyzing the following formula

Riskier firms will have higher required rates of return i.e. k,therefore, P/E multiple will be lower. Moreover, if futuredividends are discounted at a higher rate, the price will belower and also the P/E ratio.

It is also observed that many small, risky, new companies havevery high P/E ratios, this indicates marketsexpectation of highgrowth rates for those companies. Therefore, with a givengrowth projection, the P/E multiple will be lower when risk is

perceived to be higher.

gk

b

E

P

1


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Pitfalls in P/E AnalysisFirst, the denominator in the P/E ratio is accounting earnings

which are influenced by accounting rules such as depreciationand inventory valuation methods. At high inflation historic costdepreciation and inventory costs will be under priced. As such,P/E ratio will be lower. It is shown in figure 18.3

Firms get considerable flexibility in case of earningsmanagement (i.e. the practice of using flexibility in accountingrules to improve apparent profitability of firm), as such justifiedP/E ratio becomes difficult to determine.

Justified or Normal P/E ratio implicitly assumes that earningsrise at a constant rate or on a smooth trend line, however,reported earnings can fluctuate dramatically with business

cycle.


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Pitfalls in P/E Analysis

In other words, the calculated P/E ratio indicates the ratio ofcurrent price to trend value of future earnings. But in the

financial pages of Newspaper report P/E multiple as a ratio of

current price to the most recent past earnings.

In DDM earnings are defined as net of economic

depreciation (i.e. maximum flow of income that the firm could

pay out without depleting its productive capacity. However, the

reported earnings are calculated as per GAAP and do notcorrespond to economic earnings.


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Pitfalls in P/E Analysis

In other words, the calculated P/E ratio indicates the ratio ofcurrent price to trend value of future earnings. But in the

financial pages of Newspaper report P/E multiple as a ratio of

current price to the most recent past earnings.

In DDM earnings are defined as net of economic

depreciation (i.e. maximum flow of income that the firm could

pay out without depleting its productive capacity. However, the

reported earnings are calculated as per GAAP and do notcorrespond to economic earnings.


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Combination of P/E & DDM

P/E ratios can also be used in conjunction with earnings

forecasts to estimate price of stock. For example, if

projected P/E for 2008 is 15 of Infosys stock and EPS

forecast for the same year is 192.8, this implies price in

2008 = 15 x 192.8 = 2892. With this estimate of 2008

price, intrinsic value in 2004 is 1,973 which is quite

closer to the average price of Infosys in 2004.


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Other comparative valuation ratios

Price to Book Ratio:This is ratio of price per share and

book value per share. Some analysts consider this ratio

to be an indicator of how aggressively the market values

the firm.

Price to Cash Flow Ratio:

Some analysts prefer to use

this ratio (i.e. PPS to CFPS) rather than P/E ratio as

cash flow is relatively less affected by accountingpractices or rules. Operating cash flow per share and

free cash flow per share (i.e. operating cash flow net of

new investment) are also used in computing this ratio.


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Other comparative valuation ratios

Price to Sales Ratio:Many start up firms have no

earnings. As such, P/E ratio does not provide any

useful information. The ratio of price per share

and annual sales per share i.e. price to salesratio is now being commonly used for valuing

these firms. However, this ratio may differ

significantly across industries as profit marginvary widely.


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Free Cash Flow Valuation Approach

The valuation approaches so far discussed are

based on the assumption thatretained earnings

were the only source of financing new equity

investment.

Now it will be examined if extern l equity nd

debtwere used instead of retained earningshow

it will affect the value of a irms share, i.e. how

dividend policy nd c pit l structure

affect the

same?



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Free Cash Flow Valuation ApproachThe answer to this question has been provided by MMtheory, which states that if a firms future investment is

considered to be given, then the value of its existingcommon stock will not be affected by how thoseinvestments are financed. As such, neither the firmsdividend policy nor its capital structure should affect the

value of share.The reason is that the intrinsic value of equity dependson the present value of net cash flows to shareholdersthat can be produced by firmsexisting assets plus net

present value of any investment to be made in future.Given those existing and expected future investments,firms dividend and financing decisions will affect onlythe form in which existing shareholders will receive their

future returns (i.e. either dividends or capital gains).


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One of the out comes of their proof of the above

propositions is the free cash flow approach to valuation.

This approach estimates the value of the firm as a whole

and determined the value of equity by subtracting themarket value of all nonequity claims. The estimate of the

value of the firm is found as the present value of cash

flows, assuming all equity financed plus the net present

value of the interest tax shields for using debt.



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Example of MiMo Corporation

EBIT = 1 million in the year just ended and it will grow @

6% per year forever.

For keeping this growth the firm will invest an amount

equal to 15% of pretax cash flow each year.

The tax rate is 30%.

Annual depreciation in the year just ended = 100,000 and

it will grow @ 6% per year forever also.

The appropriate market capitalization rate for unlevered

cash flow = 10% per year

The current amount of debt = 2 million



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Free Cash Flow Valuation ApproachExample of MiMo Corporation

Calculation of Free Cash Flow of

MiMo Corporation

Before tax cash flow from operation 1060,000

Annual depreciation 106,000

Taxable income 954,000

Tax @ 30% 286,200

After tax unlevered income 667,800

After tax cash flow from operations 773,800

New Investment (15% of cash flow from oper.) 159,000

Free C F A. Tx. C.F. from oper. less New Inv.) 614,800Note that the projected free cash flow is the irmscash flow under

all equity financing, it ignores interest expense and any tax

savings from interest expense.



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Calculation of Free Cash Flow of

MiMo CorporationThe PV of all future free cash flowVo = C1/(kg)

= 614800/(.10 - .06)

= 15,370,000This is the value of the whole firm i.e. debt plus equity.

As debt = 2 million, therefore, equity = 13,370,000

If it is assumed that interest tax shield from using debt hasincreased the firmsvalue by .5 million, the total value of thefirm will be 15,370,000 + 500,000 = 15,870,000 and thevalue of equity will be 13,870,000.



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Calculation of Free Cash Flow of MiMo Corporation

It should be noted that the market capitalization rate

used for discounting future cash flows under Free CashFlow approach and other approaches are different.

Under Free Cash Flow approach the market

capitalization rateis appropriate for unleveragedequity,in case of other approaches, the market capitalization

ratethat was used, is appropriate forleveragedequity.


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Inflation and Equity ValuationAs long as real values are unaffected, the sto kscurrent

price will not be affected by inflation. The followingrelationship exists between real and nominal variables

Variable Real NominalGrowth rate

Capitalization rate

ROEExpected DPS

Plow back ratio

g*

k*

ROE*D1*

b*

g = (1+g*)(1+i)1

k = (1+k*)(1+i)1

ROE=(1+ROE*)(1+i)1D1= D1* (1 + i)

(1 + b* x ROE*)(1+i) - 1b=--------------------------

(1 + ROE*)(1+i) - 1


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Inflation and Equity Valuation

Note that, expected reported earnings (nominal) do not,in general, equal to expected real earnings multiplied by

one plus inflation rate i.e. E1 is not equal to E1*(1 + i).This is because historical cost accounting distorts themeasured cost of goods sold, which in turn distorts thereported earnings. This also influences the P/E ratio. Wheninflation rate increases P/E ratio decreases as isindicated in figure 18.3

Many companies show gains in reported earnings duringinflationary periods, even when real earnings may beunaffected.


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Inflation and Equity ValuationFor many years it has been thought that stocks are

inflation-neutral investments and changes in inflation ratehas no effect on the expected real rate of return on

common stocks. However, recent research indicates that

the real rates of return are negatively correlated with

inflation.In reference to the constant DDM, this means thatincrease in inflation is associated with a decrease in D1 ,an increase in k, a decrease in g, or some combination of

all three.

As per another view, economic shocks such as oil price

hikes can simultaneously increase in inflation & decline in

expected real earnings & dividends. This will result in

negative correlation between inflation & real stock returns.


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Inflation and Equity ValuationStill another view implies that the higher the rate of

inflation, the riskier the stock return. The reason is thathigher inflation is an indication of greater uncertainty in theeconomy, which in turn induces to increase requiredreturn.

Also higher inflation results in lower real dividendsbecause after tax real earnings reduces as the inflationrate rises.

Finally, during the period of high inflation, nominal interestrate rises but real rate may not increase. Investorsmistakenly considering the rise in nominal rate, undervalue

Ch 18 EqtyValuation

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