10 Pdfsam EDITED UOL FM Topic 9 Posted

8/13/2019 10 Pdfsam EDITED UOL FM Topic 9 Posted

1/85

Earnings-Based Approach This method requires us to estimate the

earning power of a company.

Typically, we use the price-to-earning ratio(PER) as an indication of the growth potential

Historic PER =

Current market price of share

Last year's earnings per share

=pt

Et 1

PER = = = 1XgooglePrice per share $100

EPS $1000

PER = = = 100XPrice per share $50

EPS $0.50facebook

Example:


2/85

Earnings-Based Approach

How many times of earnings are investorswilling to pay for the shares?

PER = $10 / $1 = 10 times

For PER of 10x, it could also be argued that

you are buying 20 years of constant profits.

1


3/85

For a company with a high PER, the marketisexpecting it to show a faster growth in earnings in thefuture.

P = D1 [Gordons Model: to be explained later]

rg

Dividing both sides by EPS,

P / E = [ D/E] / ( rg )

= Payout ratio / ( rg )



4/85

PER has 3 determinants

1. Growth potential

2. Risk level

3. Payout ratio

Investors can analyse the historic PER of acompany and determine the future price.



5/85


SG p. 101, Example 9.1

The following data relates to Company A plc:


6/85


Use of PER in business valuation:

How many times of earnings are you willingto pay for the stock?

Est. share price = PER x Est. EPS

As Average PER (2007-2010)=10.425 times

Estimated (prospective) EPS = 0.75

Estimated share price (historic PER)

= 10.425 x 0.75 = 7.82 (TP, target price).

one way is EPS x (1+g) = 0.750


7/85


Shortcomings of PER approach

i. SG:We assume that the PER of acompany stays constant over time. Buthistory tells us that PER fluctuates

Practice: Analysts use the historic high / lowPER and average PER to derive three

estimates of fair values

OR use industry PER as benchmark


8/85

Refer to Handout 9.2on valuation

approaches (UOB Limited)

Here, we are using historical ranges (band) of

UOBs price-multiples to estimate the high and low

values of UOB.

Approaches used are:

1. PER approach

Example: UOBs highest (lowest) value

= Forecasted EPS x Highest (lowest) PER

2. Price-Book Multiple

3. Price-Net tangible asset (NTA) Multiple

(not given)


9/85


ii. We assume that the stock market knowshow to value companies correctly in the pastand that the PER has been correctlycomputed

This assumption that stock market analystshave a view of an appropriate PER for eachcompany seems to be unfounded.

A good example of this is the internet bubblebetween 1998 and 2000. Prices for someinternet companies were too high relative to

their earnings.

Shortcomings of PER approach


10/85

Priceearnings ratio approach

to Value a Target FirmValue Target

= P/E ratio Prospective EPS of target firm

Problem here is which P/E ratio to use.

If prospective EPS is not available, use the

current EPS


11/85

Priceearnings ratio approach

to Value a Target Firm

If acquirer believes performance of targetcompany will be similar to its own, it can apply

its own PER

Value of Target plc using Acq.s PER:

= Acq.s PER x Targets Current Earnings


12/85

Find the estimated price of Stock A (unquoted)

Step 1: Compute the Price-earnings ratio (PER) of a

similar firm (Stock B)

If Bs PER = 10 x, investors are willing to pay a stock

price that is 10 times of Bs earnings

If A and B are similar firms, then investors should alsobe willing to pay a price that is 10 times of Asearnings

Priceearnings ratio approach(Unquoted shares)


13/85

Step 2: Estimate Stock As value using its

own EPS and Stock Bs PER

Stock s A value = As EPS x Bs PER

Priceearnings ratio approach(Unquoted shares)


14/85

Discounted Cash Flow Approach

A company is typically engaged in a number

of investments or activities that are financedby, roughly speaking, debt and equity

PV

$$

$$$$

$$


15/85


16/85

Treat valuation of firm as a complex capital budgetingproject

DCF value of target

= PV of incremental cash flows gained by acquirer

Problems

Difficult to quantify expected benefits from operating and

financial synergies

Difficult to choose appropriate time horizon and terminalvalue for target

Which discount rate should be used?



17/85

Example: Targets data

Current cash flows = 38m Cash flow growth rate = 4% per year

Surplus assets sold in two years = 60m

WACC of Acquirer = 7% per year

(38 1.04) = 1317.3

(0.070.04)60/1.072 = 52.4

DCF value = 1369.7



18/85

DEBT

Why do firms borrow?

4 forms of debt

Irredeemable Debt (Bonds / Loan Stock)

Redeemable Debt (Bonds / Loan Stock)

- Bond Characteristics

- Interest Rates and Bond Prices- Yield to Maturity

Zero coupon bonds

Bank loans


19/85

Why do firms borrow?

A. Cost of debt lower than cost of equity becausedebtholders face lower risk than shareholders

Cost of debt is fixed; any excess return belongs toshareholders

B. Interest payments are tax deductible

The after-tax cost of debt is lower than the pre-taxcost of debt (either bank interest rate or a bondsYTM)


20/85

Income Statement: Tax shield

effect Sales

Less Cost of Goods Sold

Gross Profit Less: Operating Expenses

Less Depreciation Expense

Earnings Before Int. and Tax (EBIT)

Less Interest Expense

Net Profit Before Tax

Less Taxes

Net Profit After Tax


21/85

Bonds / Loan Stock / Debentures

These represent loans extended by investors tocorporations and/or the government.

These are issued by the borrower, andpurchased by the lender.

$


22/85

Bond Issue: $100m

Bonds issued: 100,000 units

12 units:

Loan =

$12,000

1 units

par

value =$1,000


23/85

Irredeemable Debt:

These bonds involve a constant annual payment inperpetuity.

No principal repayment

Use perpetuity equation

Note: Interest is before tax

Rd is also before taxcost of debt

hence,

recall: Topic 2 Slide 64


24/85

Irredeemable bonds/loan stock

KdAT Kd

Kd= cost of debt (before tax)

KdAT= cost of debt (after tax)

PMT = annual interest payment in $$

P0= value of bond

note that interest is tax-deductible.

PMT (1-T)Po =PMT

=

recall: Topic 2 Slide 64


25/85


What is the after-tax cost of debt?

(same answer)

Kd= cost of debt (before tax) = PMT / Po

KdAT= cost of debt (after tax)

PMT = annual interest payment in $$

P0= current ex-interest market price

0P

PMT (1-T)KdAT= Kd(1-T)or KdAT=

K =dPMT

P


26/85


Calculating the (current) cost

10% irredeemable bonds (par value = 100)

Ex-interest market price: 72Corporation tax: 30%

Kid(before tax) = PMT/Po =10/ 72 = 13.9%Kid(after tax) = 13.9% (10.3) = 9.7%

OR: Kid(after tax)= 10x(10.3)/72 = 9.7%

(same)

T

method 1

method 2


27/85

Key Features The par (or face or matur i ty) valueis the amount

repaid (excluding interest) by the borrower to the lender(bondholder) at the end of the bonds life. The par valuefor U.S. corporate bonds is $1000.

The coupon rate (pa) determines the interestpayments. Total annual amount = coupon rate x parvalue. Bonds can pay coupons, annual, semi-annuallyor quarterly

A bonds matur i tyis its remaining life, which decreasesover time. Original maturity is its maturity when itsissued. The firm promises to repay the par value at theend of the bonds life (also called maturity).

Redeemable bonds/loan stock


28/85

Treasury Bond: Example

Temasek Financials Bond

Listed: 27 Oct 2009

Tenure: 10 years

Size : SGD1.5 bn (application: USD4 bn) Rating: AAA (S&P); Aaa (Moodys)

Coupon: 4.3% (


29/85

The bonds fair value is the present value of thepromised future coupon and principal payments.

At issue, the coupon rate is set such that the fairvalue of the bonds is very close to its par value.

Later, as market conditions change, the fairvalue may deviate from the par value.

Redeemable bonds: Valuation


30/85

The price of a bond= Present Value of all cash flows

generated by the bond

i.e. coupons and redemption value (RV)discounted at the cost of debt, rd

tr

RVcpnInt

r

cpnInt

r

cpnIntPV

)1(

)(....

)1()1( 21

=



31/85

SG:

Value of a bond is accurately

determined because all figures arepre-determined


, except Rd.

Bond traders act on interest rate

forecasts on the bond

R can be known as the required return on bondd


32/85

nn

n

r)(1

RV

r)(1(r)

1r)(1PMTPV

=

Bond Value:

PV = PV(coupon payments) + PV(RV)

= PV (Annuity) + PV (Single sum)



33/85

Note: $10 is ____________ interest expense

15 percent is the __________ cost of debt

SG example:Rd =cost of debt = 15%

before

before


34/85

Semi-annual coupon payment

= [coupon rate / 2] x par value

= [0.09 / 2] x $1,000 = $45 Number of payments = 12 x 2 = 24

Semiannual required rate of return = 3%

Find the fair value of a bond with a $1,000 par value,a remaining life of 12 years, and a coupon rate of 9%

per year paid semi-annually. The required return on

bonds like this one is currently 6%.

Redeemable bonds: Example

left

^


35/85

$1,254.03

(1.03)

$1,000

(1.03)(0.03)

1(1.03)45$B 2424

24

0

=

=

Bond Value: B0= PV(coupon payments) + PV(par value)

= PV (Annuity) + PV (Single sum)

Redeemable bonds: Example

> 1000 (par value)


36/85


37/85

Bond Values and Discount Rate

(Required Return)

Required Return Bond Value

6.0 %9.0 %

12.0 %

$ 1, 254.03$ 1,000.00

$ 811.74

premium bond

par bond

discount bond

Coupon rate = 9% per year.

Coupon = $90 per year ($45 per 6 months)

So, the higher the required return, the lower

the present value of the bond (bond price)

Yi ld T M i


38/85

Yield To Maturity(YTM always on per annum basis)

The Yield to Maturity is the investors return ifthe bond is held till maturity

It is equivalent to the IRR in capital budgeting

-1000 +1000

$45 $45 $45

t = 24

return ytm = 9% p.a

$45 $45 $45

t = 24-1254 +1000

return ytm = 6% p.a

before tax

R d bl b d


39/85

Redeemable bonds The before-tax cost of redeemable bonds is the

YTM of the bond.

Is after-tax cost of debt =YTM (1-T)? No.

Applying the tax effect of (1-T) to the coupon

payment [Coupon$(1-T)] is more accurate thanmultiplying the before-tax cost of debt by (1T),since the redemption value is not tax-

deductible.

The cost of debt can be found using linearinterpolation.

YTM; return ytm include capital item which do not have tax shield effect


40/85

Redeemable Debt:

After-tax cost of debt

Find the Yield to Maturity (YTM) of a bond with:

Par value = $1,000

Remaining life = 12 years. Tax rate = 30%

Coupon rate = 9% per year paid semi-annually.

The bond is currently selling for $1,076.23.

After-tax PMT = $45(1-0.3) = $31.50


41/85

Using a financial calculator,

after-tax cost of debt

= 2.71% per 6-months

= 5.42% per year

2424

24

YTM/2)(1

1,000

YTM/2)+(1(YTM/2)

1YTM/2)+(131.51,076.23

=

Redeemable Debt:

After-tax cost of debt

Redeemable Debt:


42/85

Using interpolation (similar to IRR interpolation)

Try YTM/2 (after tax) = 2% => LHS = + 141

Try YTM/2 (after tax) = 5% => LHS = - 332

Interpolate: Estimated YTM/2 (after tax)

= 2% + [141 / (332+141)] x [ 5 - 2 ] = 2.89%

Est. YTM (after tax) = 2.89 x 2= 5.78%

2424

24

YTM/2)(1

1,000

YTM/2)+(1(YTM/2)

1YTM/2)+(131.51,076.230

=

Redeemable Debt:After-tax cost of debt

Zero Co pon Bonds (ZCB)


43/85

Zero Coupon Bonds (ZCB) No interest payments to bondholder

Issued at deep discount and traded at a discount

TVM: Single sum problem

What is the price of a ZCB with a par value

$1,000 yielding 3 percent p.a. for 6 years?

PV = FV / (1+r)^t= 1,000 / (1.03)^6

= $837.48

PV < FV

Zero Coupon Bonds (ZCB)


44/85

Zero Coupon Bonds (ZCB)

What is the YTM of the same ZCB is theinvestor bought the bond at $700?

r = (FV/PV)^ 1/n - 1= (1000/700)^ 1/6 - 1

= 0.061 (6.1%)cannot be done for UOL examSlide: 54

Bank loan $1.0m $0.8mInterest paid $80000 $60000

Year 1 Year 2

[60K + 80K]/2

[1.0m + 0.8m]/2

=

= =7.7%

formula for

cost of debtAverage interest

Average LoanCost of Bank loan

for year 2 [before tax]

After-tax debt cost = 7.7% x (1 - T)

Bank borrowings


45/85

Bank borrowings Bank borrowings are not traded and have no

market value that interest can be related to.

Cost of bank borrowings can be found by dividingaverage interest paid by average borrowings for

a given period.

Alternatively, the cost of traded debt may be used

as the best approximation.

Appropriate adjustment for taxation is needed.


46/85

Preferred Stock (Preferred Shares)

Claims of preferred stockholders are juniorto claims of debtholders, but senior tothose of common stockholders.

Limited voting rights compared to commonstock.

Preferred stock has a par value and a

dividend rate.

Failure to pay the dividend does not forcethe issuing firm into bankruptcy.


47/85

Irredeemable Preferred Stock:

Valuation

Consider a $100 par value share ofpreferred stock with an 8% dividend rate

(paid quarterly). The required return is12% pa.

Find the preferred shares fair valuetoday.


48/85

Preferred Stock: Irredeemable

This preferred stock is a perpetuity

Then the value would be:

PV = C / i

= $2 per quarter / 0.03 per quarter= $66.67

P f d h I d bl


49/85

Preferred shares: Irredeemable

The cost of preference shares (constant

annual payment in perpetuity) can be foundby dividing the preference dividend by the edividend market price:

Kps = cost of preference shares

P0 = current ex div preference share price

Dp = preference dividend.

0PDK

pps=


50/85

Preferred shares: Irredeemable

Calculating the cost of preference shares:

9% preference shares, nominal value: 100p

Current ex dividend market price: 67p

Kp= (0.09 100)/67 = 0.134Kp= 13.4%.


51/85

Preferred Stock: Redeemable

If the preferred stock is redeemable afterx years, the valuation follows that of abond:

PV = PV (Annuity of Pref Dividends)

+ PV (Par value)


52/85

Preferred shares: Redeemable

The cost of this is found in the samemanner as redeemable bonds EXCEPTthat there is no tax adjustment.

nr)(1

ParPVIFA*DivPrefPV

=

C t f R d bl


53/85

Cost of Redeemable

Preference Shares

Use interpolation as per redeemblebonds except do not apply (1-T) tothe preference dividends

Sh V l ti


54/85

Share Valuation

PER Approach (covered)

Dividend Discount ModelEarnings Yield ApproachDividend Yield Approach

Market Value Approach


55/85

Dividend Discount Model (DDM)

The value of a share of stock is thepresent value of the expected dividendsover the holding period plus the

expected sale priceat the end of theholding period.

n

n

n

n

r

P

r

D

r

DP )1()1()1(

1

10

=

Po on LHS = Fair Value

P on RHS = Market price


56/85

Example

Current forecasts are for XYZ Company to pay div idendsof $3, $3.24, and $3.50 over the next three years,respectively.

At the end of three years you antic ipate sel l ing you rs tock at a market price of $94.48.

The required return on this stock = 12%

How much would you be prepared to pay for th is stock?

That is, what is the intr ins ic (fair) pr ice of the stock?



57/85

PV

PV

=

=

300

1 12

324

1 12

350 94 48

1 1200

1 2 3

.

( . )

.

( . )

. .

( . )$75.


DDM SG p 103


58/85

DDM - SG, p. 103


59/85

DDM - SG, p. 103

The value of a share is the present

value of all future dividends

Th Di id d Di t M d l


60/85

The Dividend Discount Model

....

)1()1()1(2

2

1

10

=n

n

r

D

r

D

r

DP


61/85

The company may pay dividends tocommon stockholders.

However, it is not required to do so.Moreover, there is no pre-set dividend rate.

Future dividends are uncertain.

We need a way to forecast future dividends.



62/85

Gordons Model(Constant Growth)

11

3

14

2

1123

12

1

1

11111

=

=

====

t

t gDD

gDD

gDggDgDD

gDD

Assume dividends are growing at a constant

percentage rate of gper year.


63/85

Constant Growth (Gordons Model)

For a stock with with constant growth forever

after time t:

grD

P t

t

=1

Dt = first constant growth dividend

Given any combination of variables in the

equation, you can solve for the unknown variable.

P Div

r g0

1=

r = cost of equity

Important Features of the Constant


64/85

po ta t eatu es o t e Co sta t

Growth Model

stocks total return

0

1

P

D dividend yield ( = ) plus

capital gains yield ( =g)

0

1

P

D+ gr =

Under Gordons Model, g is also the

growth rate in the stock price

g =[P1- P0]

P0


65/85

Constant dividends where g=0


66/85

Cost of equity

Cost of equity (rate of return required bystockholders) can be derived in two ways:

*Gordons Model: r = (D1/Po) + g

*CAPM (SML equation): Rf + (RmRf) x Beta

Earnings yield approach (to be discussed laterunder business valuation)

Refer to Handout 9.1 on UOLs preference

equity

*

in the past

*

Stock Valuation: Example


67/85

Stock Valuation: Example

The per share annual dividend on a common

stock is expected to be $3.00 one year fromtoday. Stockholders require a 12% rate ofreturn. Find the fair value of the stock for each ofthe following cases:

1. Zero Growth: dividends are constant every year.

2. Five-Percent Growth: dividends are growing at aconstant rate of 5% per year forever

3. Supernormal growth

Div1


68/85

1. Zero Growth (g = 0)

$25.000.12

3.00$

r

DP 10 ===

With g = 0, the dividends of $3.00 per share form a

perpetuity.


69/85

2. Five-Percent Constant Growth

86.42$

05.012.0

00.3$0 =

=P

Recall that D1= $3.00; r = 12%; and g = 5%

3 Supernormal Growth


70/85

3. Supernormal GrowthAn analyst forecasts Stock Xs dividends to grow at 15%

per year for the next 2 years. Thereafter, dividends areexpected to grow constantly at 10%. The last paid DPSwas $1. The cost of equity is 12%. What is the stocksfair value?

D1 = 1 (1.15) = 1.15

D2 = 1 (1.15)^2 = 1.32

D3 = 1.32 (1.1) = 1.45

Fair value = PV (D1) + PV(D2) + PV(P2)

= 1.15/1.12^1 + 1.32/1.12^2

+ [1.45 / (0.120.10)]/1.12^2

= $59.88

t = 0 1 2 3

D1= D0x (1 + gs)P2

P0 = PVC (future dividends) = PV (D1,D2...Dinfinity)D3

r - g

gs = 15% gc = 10%

P2

= PV(D1) + PVC(D2) + PV [P2+ ]

Gordon's growth

D0= $1 D2= D0(1 + gs) D3

S f Di id d G h


71/85

Source of Dividend Growth If the Payout Ratio (POR) is constant, growth

in dividends depends on the growth inearnings.

The growth in earnings depends on: the plowback ratio or retention ratio(1 - POR),

and

the return on investment, i ( = ROA)

i also can be Return on Equity (ROE)

Sustainable growth rate

g = (1 - POR) i

g = (1 - POR) x ROE

ROA = ROE

note:

BMA textbook

uses ROE


72/85

ExampleOur company forecasts to pay a $3.00dividend next year, which represents 100%of its earnings. This will provide investors

with a 12% expected return.

Instead, we decide to plow back 40% ofthe earnings at the firms current return on

equity of 20%. What is the value of thestock before and after the plowbackdecision?

Source of Dividend Growth

S f Di id d G thTested in UOL finals May 2013


73/85

00.25$12.

30 ==P

No Growth With Growth

00.75$08.12.

3

08.40.20.

0 ==

==

P

g

A firm with more growth prospects is worth more!

g = (1 - POR) x ROE

Source of Dividend Growth


74/85

Stock Valuation: Other methods

Earnings Yield Approach

Dividend Yield App roach

Market Value Appro ach



75/85


IGNORING GROWTH,

Value of Target = Annual maintainable earnings

Earnings Yield

OR

Targets share price = EPS

Earnings yield

EPS =[NPAT - Pref Divi]

number of shares outstanding



76/85


ExampleTarget plc Acquirers earnings yield

= EPS/share price

=(25p/250p) 100 = 10%

Assume Target plc enjoys same yield.

Targets earnings yield value

= Targets Earnings/Acq.s earnings yield

= 10m/0.10

= 100m.



77/85

WITH GROWTH = 2%

Growth can be included by adapting the dividendgrowth (Gordons) model.

P = D1 / (kg)

Earnings yield value

= (10m 1.02) = 127.5m.(0.100.02)


Earnings Yield


78/85

Earnings Yield

Earnings yield is also used as a proxy for cost of equity:

Eg. Cost of equity = 10%

Cost of equity (to firm) = Return to shareholders

Return (%) = Return in $ / Price paid to earn the return

So, 10% = EPS /market price

This is the earnings yield equation



79/85

g pp

The PER approach is the mirror image

of the Earnings yield approach

Since PER = Market price / EPS,

Then, PER = 1/ 0.1 = 10X

[Investors are willing to pay a multiple of 10

times for the firms earnings]

So, Cost of Equity

= Earnings Yield

= 1 / PER

Price EPS

EPS PricePER inversely proportional to Earnings Yield

how many times of

dividends willing to pay

Price DPS

DPS Priceinversely proportional to Earnings Yield

Dividend Yield Approach: (comparative approach):


80/85

pp

- Price paid as a multiple of gross dividends

(how many times of dividends are investors willing to pay?)Price / dividends = 10 times

Find the estimated price of Stock A

Step 1: Compute the dividend yield of a similar firm (Stock B)

Gross dividendsMarket price

If A and B are similar firms, then the two firms shouldhave similar dividend yields (Dividends/price)

(unquoted)

Dividend Yield Approach:


81/85


Step 2: Estimate Stock As value

Stock s A value

= As Gross dividend per share

Bs Dividend yield

= As Gross DPS * Number of times of DPS



82/85

Dividend Yield

Find Allenby Ltds (unquoted firm) valueusing a quoted firms Dividend Yield.

Tax rate= 20%

Allenbys value per share

= Allenbys Gross Div per share / Quoted Stocks Div Yield

= [Allenbys Net DPS / (1-Tax rate)] / Dividend Yield

= ($0.80/ 0.8) / 0.10

= $10 [ or $1 * 10times = $10]

Market Price Approach


83/85

Market Price Approach

Value = Number of shares x market price

Fair price if market is efficient, but not fixed

Quoted price reflects marginal trading

Cannot be used for unquoted shares

Useful starting point in negotiations

Market Value does not reflect acquirerintentions

Homework


84/85

Homework

Cost of capital components Attempt FM 2009 Prelim Exam, Question 1

(Alpha plc)

Valuation Methods

Attempt FM 2008 Prelim Exam, Question 3(Sources of financing and valuation)

Attempt FM 2009 Prelim Exam, Question 8(Essay on valuation methods in a takeover)


85/85

Session 16 Topics 8 and 9: Past Exam Questions

Session 17- Class test 2

Scope: Topics 6 to 9

Documents

10 Pdfsam EDITED UOL FM Topic 9 Posted