Equity Valuation June 2009

8/22/2019 Equity Valuation June 2009

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Equity Valuation.


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INTRODUCTION TO

SECURITY VALUATION


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2 Approaches of Valuation

Absolute MethodDiscounted Cash flowMethodDDM, Free Cash flow and RI

MethodRelative Valuation-Market Based

Approach PE, P/BV, P/Sales and P/Cash

flow


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Cash Flow Definitions

Dividend

Free Cash Flows

Residual Income


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Compare and contrast dividends , freecash flow and RI as measures of

cashbook in DCF valuation and identifythe investment scenario for which eachmeasure is suitable


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Dividends

In stock valuation there are 3 predominant definitionsof future cash flowDividends : DDM model Defines cash flow as thedividends to be received by the shareholdersPrimary Advantage of using dividends as thedefinition of cash flow is thats its theoretically

justifiedShareholders Investment today is worth the PV ofexpected dividends

Another advantage of using dividend as a measure ofcash flow is that dividends are not volatile andreflects long term earning potential of the company


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Dividends

Disadvantage: This method of valuation isdifficult to use for companies which do notpay dividends

DDM takes the perspective of an investorwhich takes a minority stake in the firm andcannot control the dividend policy

If the dividend policy is not related to thefirms ability to create value then dividendsare not appropriate measure of expectedfuture cash flow to shareholders


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Appropriateness of DDM

The company has a history of dividends

Dividend policy is clear and related to

earnings of the firmPerspective of valuation is that ofminority shareholders

2007 2006 2005 2004 2003

EPS $7.50 $6.25 $5.85 $5.40 $50

DPS $1.25 $1.25 $1.25 $1.25 $1.25


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Free Cash method of DCF

Free cash flow to equity FCFE is defined asthe cash flow generated by the firms

operation into that is in excess of capitalrequirement to sustain the firms productivecapacity

FCFE is the cash available to stockholders

after funding capital requirement andexpenses associated with debt financing


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Advantage of Free cash flwomethod

Can be applied to many firmsregardless of dividend policy or capital

structureThe ability to influence the distributionand application of a firms free cash flowmakes these models more pertinent to

a firms controlling shareholders


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Free cash flow -Disadvantages

Firms that have significant capitalrequirement may have negative free

cash flow for many year


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Appropriateness of Free Cashflow method

For Firms that do not have a dividendpayment history

Valuation perspective is that of aninvestor


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Residual Income

Residual; Income is the amount of earningsduring the period that exceeds investorsexpectations

The theoretical basis for this approach is thatthe required return is the opportunity to thesuppliers of credit and the residual income is

the amount that the firm is able to generatein excess of return


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Advantage and Disadvantage

Can be applied to firms with negative cashflow

Can also be used for dividend and nondividend paying company

Disadvantage : requires in dept analysis offirms accounting accruals

Management discretion in establishingaccruals for both income and expenses mayobscure true accounting results


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Appropriateness

Firms that do not have Dividend history

Firms that have negative cash flow

Firms with transparent financialreporting and high quality earning


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14.

Top Down Approach to EquityValuation.

Various Forms of ReturnsCommon Stock Valuation

Multiple Period Discounting

Single period discountingValuation of a company experiencingtemporary supernormal growth.


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Security Valuation.

Security Evaluation is important todecide on the portfolio of an investor.

Investors buy under-priced securitiesand sell the over-priced ones.

The value of a share is a function of the

companys dividend paying capacity orits earnings capacity.


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Factors influencing Valuation

Regular dividends or interest

Capital gains or loss.


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DDM-Dividend Discounting Model


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h) Explain the concept of Investors requiredrate of return, Expected return and RP

Required rate of return on an equity isdependent upon 3 factors

RFR real IP and RPRequired rate of Return =(1+RFR real) (1+ IP) (1+ RP)1RFRreal + IP = RFRnominal

Therefore, K = RFRnominal + Risk Premium

According to CAPM

E = RFR + Beta ( R mkt RFR)

RFR is nominal


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i) Risk factors associated in determining a countryrisk Premium

Business Risk

Financial Risk

Liquidity

Exchange Rate Risk

Political Risk


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Estimate the Dividend growth, givenROE and RR

G=ROE*(1-payout)

Roe=10% on equity of 100

Payout=40% of earning

RR=60%


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Profit Margin ROE

ROE Growth

Growth Diff Between Ke & G

Lower Ke-g Price


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The value of a security is equal to the present value of thebenefits associated with it.

V=C1/(1+K)+C2/(1+K)^2+Cn/(1+n)^n

V: Value of Security

C: Cash Flows.K : Discounting Factors.

d) Single period discounting model


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Gordon Growth Model

GGM assumes that dividends increaseat a constant rate indefinitely

Model Assumes the firm to pay DividendD1 in year one

Dividend grow indefinitely at a constantrate

Growth rate is less than required rate ofreturn


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Constant growth Model

Price = D1/Ke-G

Ke = RFR +Beta (RmktRFR).

G = (1-payout) * ROE

P = D0(1+G)

KE -G


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Strengths and weakness of GGM

Strength: Applicable to mature and dividendpaying firms

Appropriate for valuing market index

Straight forward and easy to explainCan supplement other valuation modelsWeakness: Valuation sensitive to G and RCannot be applied to non dividend paying

companiesUnpredictable growth patter of some firmswould make using the model difficult


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GGM ModelConstant Growth InDividend Assumption

Part I PV of dividend in normal growth

Part II : PV of the price in the normal

growth after normal growth.Part I: D1Dn/ Discounting factor

Part II :Price of the stock (D1/Ke - G ) / discounting factor

Value of Stock is Part I + Part II


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High-growth phase (assuming a growth rateof 9% for first five years and 6% for theremaining period for illustration purposes):

DPS = $1.30 growth phase (assuming fiveyears for illustration purposes):

Ks = = 12.39%

g = 9%


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DPS(1) = $1.30 * 1.09 = $1.42DPS(2) = $1.42 * 1.09 = $1.54DPS(3) = $1.54 * 1.09 = $1.68DPS(4) = $1.68 * 1.09 = $1.84DPS(5) = $1.84 * 1.09 = $2.00now, we must discount the dividends by theappropriate rate todetermine their present value.$1.42 / (1.1239) = $1.26

$1.54 / (1.1239)2 = $1.22$1.68 / (1.1239)3 = $1.19$1.84 / (1.1239)4 = $1.15$2.00 / (1.1239)5 = $1.12

We add up the present value for the dividends during the high-growth stage and get $5.94.


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Next, we value the stable growth period:DPS = $2.00 (1.06) = $2.12Ks = 12.80%g = 6%

$2.12 / (.1239-0.06) = $31.18Next, we must calculate the present value of the dividends.$31.18 / (1.1239)5 = $17.39When calculating the present value of the dividends of thestable growth period, we use the same required rate of returnas the high-growth phase and raise it to the fifth power for afive-year example like the one above.Adding the two values, we get: $17.39 + $5.94 = $23.33


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Multi stage Model

2 Stage

H-Model

3-Stage

Spreadsheet Model


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Multistage Model

For Most companies GGM Assumesdividend growth that continues foe

perpetuity is unrealisticTherefore we need more realisticmultistage growth models to estimate

values of companies with several stagesin future growth


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Imp Points for Multistage ModelMS

Forecast Dividend and discount themback to PV

Over the long run growth rate tends torevert to the long run average growth

rate which is typically equal to GDPgrowth rate


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Two Stage Model


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2 Stage Model

Yrs

G


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H Model

The Problem with 2 stage model is that is itusually unrealistic to assume that a stock willexperience high growth for a short period andthen immediately fall to a long run average

H model uses a more realistic approach, thegrowth starts out high, then declines linearly

over the high growth period until it reachesthe long run average


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H-Model

Yrs

G


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3-Stage Model

More Appropriate for Firms that areexpected to have 3 Distinct Stages of

Growth


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3-Stage Model


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Growth

Initial Growth Transition Maturity

Earnings Growth High

Above Avg, but

falling Stable

Capital

Investment High Decreasing Stable

Profit Margin High

Above Avg, but

falling Stable

FCFE Negative Maybe be + Stable

ROEV/s R ROE>R ROE approaching r ROE=r

Dividend Payout Low Increasing Stable

Model Three Stage Two Stage GGM Constant growth


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Justified leading andtrailing P/E based on GGM


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Justified Leading P/PE

P/E0 = (D1/E0)/Ke-G

Trailing P/E P/E1= (D1/E1)/Ke-G

P t V l f G th


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Present Value of GrowthOpportunity

A firm that has an additional opportunity toearn extra return which is in excess of therequired rate of return would benefit fromretained earnings and invest those in growthopportunities rather than paying out asdividend

V0= (E/R) +PVGO. E= No growth earning.R= Required rate of return


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Estimation of Terminal Value

No matter which Model we are using forvaluation , we have to calculate a

terminal Value at some point in futureThere are two approaches of doing this

USE GGM model

USE Market Based approach


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Valuation Using a 2-Stage Model

H Model

V0=

D0*(1-GL) + D0*H*(Gs-GL)

R-Gl R-Gl

GL= Growth In long term

Gs= Growth in short term

H=T/2, Half line of High Growth Period

V0= Value of Stock

R = Required Rate of Return


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Estimated Terminal Value

As per GGM

Terminal Value in year 10=D11/Ke-G

As per Market Based approach

Terminal Value in year 10=

Justified P/e *EPS estimated


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Forecasting EPS

Market Share to Profit marginratio

EPS= S*M*C/ Number of shares.S: Estimated Industry sales.

M: Estimated Market Share

C: Net profit Margin

Financial Statement ApproachEPS= PAT -Preference Dividend/Number of Shares


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Current Market Price=18.00

Last Year Earnings = 2.00

ROE=10% expect it to stay that way for foreseeable

future

Dividend payout=40%

RFR=7%

Expected market Return=12%

Beta =1.2

Is the stock over Priced or under priced


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First Determine k= RFR+B(Excess Return )=13%

Determine G=RR*ROE=0.6*0.10=6%

RR =1-.04=0.6

Determine Dividend

Last Year Div=2*0.40=0.80

Next Year Div =D0(1+g)=0.80+(1+0.06)=0.85

Value =D1/Ke-g=0.85/13-0.06=12.14

Compare stock Value to its current Market PriceEstimated Value >market price Buy

Estimated Value


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I. Growth companies are one whose management has the ability toconsistently select investments which earn higher returns than required bytheir risk. A growth stock is one that earns higher return than other stocksof equivalent risk

II.A defensive company is a company that has an earning that are

relatively insensitive to downturns in the economy eg utility companiesand retail grocery are good examples of defensive companies. A defensivestock is a stock that will not decline as much as the market when theoverall market return declines. The returns of defensive have lowcorrelation with the market returns

III. Speculative company is a company that has an asset that are veryrisky, but the assets have the potential to generate very large earnings,example diamond mining, oil exploration, etc. A speculative stock is astock that is highly likely to have very low or negative returns because it isalmost overpriced. These stocks have a low probability of a return nearthat of market but a slight possibility of enormous returns.


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Introduction to price multiple

PE

Price to Book value

Price to salesPrice to cash flow


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Rationales for using PE

Earning power as measured by EPS is theprimary determinants of investment value

PE ratio is popular in the Investmentcommunity

Disadvantages of PE: earnings can benegative, volatile, transitionary period of

earnings makes interpretation of PE ratiodifficult


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2 versions of PE

Trailing PE

Leading PE


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Price to Book value

Advantages:

- BV is a cumulative amount that is usually

positive even when EPS is negative- It can be used of valuing which are going

out of the business

- BV is more stable than EPS, so it may bemore useful than PE when EPS is too high,low or volatile


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Price to Book value

Disadvantages

-it does not recognize the value of non physical assets such as

human capital-IT can be misleading when there are significant differences in the

amount of the assets used by the firms being compared

-Different accounting conventions can obscure the true investmentin the firm made by the shareholders

-Inflation and technological changes can cause the book andmarket value of assets to differ significantly


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Price to sales ratio

Advantages:

-the ratio is meaningful for even for

distressed firms-sales figures are not easy to manipulate

or distort as EPS or book value

-It is not volatile as price earning ratio


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Price to sales ratio

Disadvantages

-High sales do not necessarily indicateoperating profits as measured by earningsand cashflow

-It is not able to capture differences in the coststructure of different firms

-while less subject to distortion, revenuerecognition practices can distort sales figures


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Price to Cash flow

Advantages

-cash flow is hard to manipulate

-more stable that PE-Less management discretion in cash flow

than in reported earnings

-


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Price to Cash flow

Disadvantages

-FCF should be used instead of cash flow.

However again FCF is subject tomanipulation.


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Free Cash Valuation


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Free Cash Flow


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FCFF

NI +Interest (1-T)+NCC-Fcap invWCAP invEBIT * (1-T)+ DepFcap Inv- Wcap

InvEBIDTA *(1-t) +Dep*TFcap InvWcap Inv

CFO+ Int (1-t)-Fcap Inv*Fcap = Changes in Fixed Capital Investments in a year*Wcap Inv= Changes in working capital Investment in a year


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FCFE

FCFE=FCFFInt(1-T)+Net Borrowing

FCFE=NI+NCC-Fcap InvWcap Inv

+Net BorrowingFCFE=CFO-Fcap Inv +Net Borrowing


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Discount Rate

Use WACC for Discounting FCFF

Use Required Rate of Return for FCFE

Valuation Using Free Cash flow


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Valuation Using Free Cash flowMethod

Single stage Model

Valuation Using Free Cash flow


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Valuation Using Free Cash flowMethod

Two Stage Model

Three Stage Model

Equity Valuation June 2009

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