Chapter 13

EQUITY VALUATION

How to Find Your Bearings

Outline

• Balance Sheet Valuation

• Dividend Discount Model

• Earnings Multiplier Approach

• Earnings – Price Ratio, Expected Return, and Growth

• Other Comparative Valuation Ratios

• Equity Portfolio Management

• Forecasting the Aggregate Stock Market Return

Techniques of Fundamental Equity Valuation

Balance Sheet Techniques

• Book Value • Liquidation value• Replacement Cost

Discounted Cash Flow Techniques

• Dividend discount model• Free cash flow model

Relative Valuation Techniques

• Price earnings ratio • Price-book value ratio• Price-sales ratio

Balance Sheet Valuation

• Book Value

• Liquidation Value

• Replacement Cost

Dividend Discount Model• Single Period Valuation Model

D1 P1

P0 = + (1+r) (1+r)

• Mufti - Period Valuation Model Dt

P0 = t=1 (1+r)t

• Zero Growth Model D P0 =

r

• Constant Growth Model D1

P0 =r - g

Two-Stage Growth Model

1 - 1+g1 n

1+r Pn

P0 = D1 + r - g1 (1+r)n

Where

Pn D1 (1+g1)n-1 (1+g2) 1 =

(1+r)n r - g2 (1+r)n

Two-Stage Growth Model: ExampleEXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OF VERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY AN ABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6 YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISE AT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15 PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OF VERTIGO ? THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE : g1 = 20 PERCENT g2 = 10 PERCENT n = 6 YEARS r = 15 YEARS D1 = D0 (1+g1) = RS.2(1.20) = 2.40 PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THE INTRINSIC VALUE ESTIMATE AS FOLLOWS : 1.20 6 1 -

1.15 2.40 (1.20)5 (1.10) 1 P0 = 2.40 + .15 - .20 .15 - .10 (1.15)6 1 - 1.291 2.40 (2.488)(1.10) = 2.40 + [0.4322] -0.05 .05 = 13.968 + 56.79 = RS.70.76

H Model

ga

gn

H 2H

D0 PO = [(1+gn) + H (ga - gn)]

r - gn

D0 (1+gn) D0 H (ga - gn) = +

r - gn r - gn

Value based Premium due to

on normal abnormal growth rate growth rate

Illustration: H Ltd

D0 = 1 ga = 25% H = 5 gn = 15% r = 18%

1 (1.15) 1 x 5(.25 - .15)

P0 = + 0.18 - 0.15 0.18 - 0.15

= 38.33 + 16.67 = 55.00

IF E = 2 P/E = 27.5

Impact Of Growth On Price, Returns, and P/E Ratio

Price Dividend Capital Price D1 Yield Gains Earnings

PO = Yield Ratio r - g (D1 / PO) (P1 - PO) / PO (P / E)

RS. 2.00Low Growth Firm PO = = RS.13.33 15.0% 5.0% 4.44

0.20 - 0.05

RS. 2.00Normal Growth PO = = RS.20.00 10.0% 10.0% 6.67 Firm 0.20 - 0.10

RS. 2.00Supernormal PO = = RS.40.00 5.0% 15.0% 13.33Growth Firm 0.20 - 0.15

Free Cash Flow Model

The enterprise value (EV) according to the free cash flow model is:

EV=EV= FCFFCF11 ++ FCFFCF22 +…++…+ FCFFCFHH ++ VVHH

(1+WACC(1+WACC))

(1+WACC)(1+WACC)22 (1+WACC)(1+WACC)HH (1+WACC)(1+WACC)HH

Present value of the FCF during thePresent value of the FCF during the

explicit forecast periodexplicit forecast period

Present value of horizon Present value of horizon valuevalue

Illustration

The balance sheet of Azura Limited at the end of year 0 (the present point of time) is as follows.

Rs. in crore

Liabilities Assets

Shareholders’ funds 250 Net fixed assets 400 Equity capital 100(10 crore shares of Rs. 10 each)

Net working capital 100

Reserves and surplus 150 Loan funds rate(9 percent) 250

500 500

Based on the above information we can calculate the intrinsic value of the equity share as follows: 1.The explicit forecast period is 6 years because the firm reaches a steady state at the end of 6 years.2.The free cash flow forecast for the explicit forecast period is given in Exhibit 13.4. Exhibit 13.4 Free Cash Flow Forecast

 

3. The weighted average cost of capital is:

  WACC = 0.5 x 16 + 0.5 x 9 (1-0.333) = 11 percent4.The horizon value of the firm is

 

Rs. In croreYear 1 2 3 4 5 6

Asset value (Beginning)

500.0 600.0 720.0 864.0 967.7 1083.2

NOPAT 60.0 72.0 86.4 103.7 116.1 130.1Net investment 100.0 120.0 144.0 103.7 116.1 86.7FCF (40.0) (48.0) (57.6) - - 43.4Growth rate (%) 20 20 20 12 12 8

VH =FCFH+1

+FCFH (1+g)

=43.4 (1.08)

r – g 0.11 – 0.08 0.11 – 0.08

= Rs.1562.4 crore

5. The enterprise value of Azura is:

= Rs. 741.4 crores

 6. The equity value of Azura is:

7. The value per share of Azura is: 

Rs. 491.4 crore / 10 crore = Rs. 49.

+

0

+

43.4

+

1562.4

(1.11)5 (1.11)6

(1.11)6

Enterprise value -Preference value

=741.4 – 250.0 = Rs. 491.4 Crores

EV =-40.00

-48

-57.6

+

0

(1.11)(1.11

)2

(1.11)3

(1.11)4

Earnings Multiplier Approach P0 = m E1

Determinants of m (P / E)

D1

P0 =

r - g

E1 (1 - b)

= r - ROE x b

(1 - b) P0 / E1 =

r - ROE x b

Cross -Section Regression AnalysisP / E = 8.2 + 1.5g + 6.7b - .2 g = Growth rate for ‘normalized’ eps b = Payout ratio = Std. Dev .. of % eps change

• Every conceivable variable & combination of variables .. tried..

• Almost .. all … these models .. highly successful .. explaining stock prices .. at a point .. time, but less successful … in selecting appropriate .. stocks .. buy .. sell.

• Why1. Market Tastes Change

• Weights Change

2. Input values change over time• Div … & growth in earnings

3. There are firm effects not captured by the model

P / E Benchmark Rules Of Thumb

• Growth rate in earnings

10% 15% 20% 25% 35%

1 1 • = 8.33 Nominal interest rate .12

1= 5.00

.20

1 1 • = 25

Real return .04

1 = 16.67

.06

0.5 Payout ratio • = 16.67

.18 - .15 Req. Ret - gr. Rate

Growth And P / E Multiple

Case A : No Growth Case B : 10 Percent GrowthYear 0 Year 1 Year 0 Year 1

Total Assets 100 100 100 110Net Worth 100 100 100 110Sales 100 100 100 110Profit AfterTax 20 20 20 22Dividends 20 20 10 11RetainedEarnings - - 10 11

Case A Case BNo Growth Growth

Discount Discount Discount Discount Discount Discount Rate: 15% Rate: 20% Rate: 25% Rate: 15% Rate: 20% Rate: 25%

Value 20 / 0.15 20 / 0.20 20 / 0.25 10 / (0.15 10 / (0.20 10 / (0.25 - 0.10) - 0.10) - 0.10)

= 133.3 = 100 = 80 = 200 = 100 = 66.7

Price- 133.3 / 20 100 / 20 80 / 20 200 /20 100 / 20 66.7 / 20earnings = 6.67 = 5.0 = 4.0 = 10.0 = 5.0 = 3.33multiple

E / P, Expected Return, And Growth1 2

……... E1 = D1 E2 = D2

= 15 = 15

15r = 15% P0 = = 100

0.15

Investment .. RS. 15 Per Share in Year 1 … Earns 15% 2.25

Npv Per Share = - 15 + = 0 0.15

RATE OF INCREMENTAL PROJECT'S IMPACT ON SHARE PRICE E1/P0 r RETURN CASH FLOW NPV IN SHARE PRICE IN YEAR 0, YEAR 1 IN YEAR 0 P0 0.05 0.75 -10 -8.70 91.30 0.164 0.15 0.10 1.50 -5 -4.35 95.65 0.157 0.15 0.15 2.25 0 0 0 0.15 0.15 0.20 3.00 5 4.35 104.35 0.144 0.15 0.25 3.75 10 8.70 108.70 0.138 0.15

IN GENERAL, WE CAN THINK OF THE STOCK PRICE AS THE CAPITALISED VALUE OF THE EARNINGS UNDER THE ASSUMPTION OF NO GROWTH PLUS THE PRESENT VALUE OF GROWTH OPPORTUNITIES (PVGO).

E1 P0 = + PVGO

r

MANIPULATING THIS A BIT, WE GET E1 PVGO = r 1 - P0 P0 FROM THIS EQUATION, IT IS CLEAR THAT :

EARNINGS-PRICE RATIO IS EQUAL TO r WHEN PVGO IS ZERO. EARNINGS-PRICE RATIO IS LESS THAN r WHEN PVGO IS

POSITIVE. EARNINGS-PRICE RATIO IS MORE THAN r WHEN PVGO IS

NEGATIVE.

Price To Book Value Ratio (PBV Ratio)

Market price per share at time tPBV ratio =

Book value per share at time t

The PBV ratio has always drawn the attention of investors. During

the 1990s Fama and others suggested that the PBV ratio explained to

a significant extent the returns from stocks.

Determinants Of The PBV Ratio D1

P0 = r – g

D1 = E1 (1 – b) = E0 (1 + g) (1 – b)

E0 (1 + g) (1 – b)

r – g

E0 = BV0 x ROE

BV0 (ROE) (1 + g) (1 – b)

r – g

P0 ROE (1 + g) (1 – b)

BV0 r - g

P0 =

P0 =

PBV ratio = =

Price To Sales Ratio (PSR Ratios)

• In recent years PSR has received a lot of attention as a

valuation tool. The PSR is calculated by dividing the current

market value of equity capital by annual sales of the firm.

• Portfolios of low PSR stocks tend to outperform portfolios of

high PSR stocks.

• It makes more sense to look at PSR/Net profit margin as net

profit margin is a key driver of PSR.

Determinants of the PS Ratio

PS ratioPS ratio == PPoo == NPM (1+NPM (1+gg) (1-) (1-bb))

SS00 r r - - gg

Companion Variables and Modified Multiples

Let us look at the equations for P/E ratio, PBV ratio, and PS ratio.P/EP/E == (1 - (1 - bb))

rr – – gg

PBVPBV == ROE (1 + ROE (1 + gg) (1 – ) (1 – bb))

((rr – – gg))

PSPS == NPM (1 + NPM (1 + gg) (1 – ) (1 – bb))

rr - - gg

Looking at these equations, we find that there is one variable that dominates when it comes to explaining each multiple – it is g for P/E, ROE for PBV, and NPM for PS. This variable – the dominant explanatory variable – is called the companion variable.

Taking into account the importance of the companion variable, investment practitioners often use modified multiples which are defined below.

• P/E to growth multiple, referred to as P/E to growth multiple, referred to as PEG PEG

:: P/EP/E

g g

• PBV to ROE, referred to as value ratioPBV to ROE, referred to as value ratio :: PBVPBV

ROEROE

• PS to NPM, referred to as PSMPS to NPM, referred to as PSM :: PSPS

Net profit marginNet profit margin

Sum of the Parts MethodMany companies have subsidiaries or associate companies in which they have significant equity stakes that usually range between 25 percent and 100 percent. To ascertain the intrinsic value per share of such companies the sum of the parts (SOTP) method of valuation is commonly employed. The SOTP method involves the following steps:

1. Determine the value per share attributable to the core business. One way to do is to calculate the earnings per share from the core business and apply a suitable multiple to it.

2. Find the value per share for each of the listed subsidiaries. In computing this value a discount factor of 15 to 20 percent is generally applied to the observed market value of the equity stake in the listed subsidiary.3. Assess the value per share for each of the unlisted subsidiaries. To do this, the analyst has to first estimate the market value using an earnings multiple or some other basis as there is no observed market value and then apply a discount factor of 15 to 25 percent to the same.4. Add the per share values for the core business, for listed subsidiaries, and for unlisted subsidiaries, to get the total value per share.

An illustrative sum of the parts (SOTP) valuation of Mahindra and Mahindra, done in 2007, is given in exhibit 13.8

Exhibit 13.8 SOTP Valuation – Based on FYO8E Business M&M

stake

Multiple Parameter Discount

(%)

Per share

value

Core auto business 10.5 Eps 451.7

Mahindra and Mahindra financial

services

68% Market cap 20% 48.6

Mahindra GESCO developer 39% Market cap 20% 27.6

Tech Mahindra 44% Market cap 20% 250.2

Mahindra Ugine steel co ltd 55% Market cap 20% 5.2

Mahindra forgings 47% Market cap 20% 11.6

Mahindra holidays and resorts 100% Pat 25% 37.0

Mahindra holdings and finance 100% Pat 25% 8.0

Total subsidiaries value 388.3

Total value per share (Rs.) 840.0

Source: company, CSEC research

Equity Portfolio Management

Passive Strategy

• Buy and hold strategy

• Indexing strategy

Active Strategy

• Market Timing

• Sector Rotation

• Security Selection

• Use of a Specialised Concept

Forecasting The Aggregate Stock Market Return

Stock market returns are determined by an interaction of two factors : investment returns and speculative returns.

• In formal terms :

SMRn = [DYn + EGn] + [(PEn / PE0)1/n – 1]

Investment return Speculative return

where : SMRn = annual stock market return over a period of n years

DYn = annual dividend yield over a period of n years

EGn = annual earnings growth over a period of n years

PEn = price-earnings ratio at the end of n years

PE0 = price-earnings ratio at the beginning of n years.

IllustrationSuppose you want to forecast the annual return from the stock market over the next five years (n is equal to 5). You come up with the following estimates. DY5 = 0.025 (2.5 percent), EG5 = 0.125 (12.5

percent), and PE5 = 18. The current PE ratio, PEo, is 15. The forecast

of the annual return from the stock market is determined as follows: SMR5 = [0.025 + 0.125] + [(18/15)1/5 – 1]

  = [0.15] + [0.037] 

= 15 percent + 3.7 percent = 18.7 percent 15 percent represents the investment return and 3.7 percent represents the speculative return.

Summing Up

• While the basic principles of valuation are the same for fixed income securities as well as equity shares, the factors of growth and risk create greater complexity in the case of equity shares.

• Three valuation measures derived from the balance sheet are: book value, liquidation value, and replacement cost.

• According to the dividend discount model, the value of an equity share is equal to the present value of dividends expected from its ownership.

• If the dividend per share grows at a constant rate, the value of the share is : P0 = D1/ (r – g)

• A widely practised approach to valuation is the P/E ratio or earnings multiplier approach. The value of a stock, under this approach, is estimated as follows:

P0 = E1 x P0/E1

• In general, we can think of the stock price as the capitalised value of the earnings under the assumption of no growth plus the present value of growth opportunities (PVGo)

E1

P0 = + PVGOr

• Apart from the price-earnings ratio, price to book value (PBV) ratio and price to sales (PSR) ratio are two other

widely used comparative valuation ratios.

• Two broad approaches are followed in managing an equity portfolio : passive strategy and active strategy.

• Stock market returns are determined by an interaction of two factors : investment returns and speculative returns.