Equity Valuation (2)

8/11/2019 Equity Valuation (2)

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Equity shares can be described more easily thanfixed income securities, however they are moredifficult to analyse.

Fixed income having a limited life and a welldefined cash flow stream, equity share haveneither.

Fundamental analysis assess the fair market value

of equity shares by examining the assets, earningprospects, cash flow projections and dividendpotential.

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Balance sheet valuation Book value

Liquidation value

Replacement value

Discounted cash flow models Dividend discount model

Single period valuation, Multiple period valuation.

Free cash flow model

Relative valuation techniques Price-earning ratio

Price book value ratio

Price sales ratio

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Book value:- Book value per share is simply thenet worth of the company(which is equal to paid upequity capital plus reserves and surplus) divided byno. of shares outstanding.

Liquidation value:- Value realised from liquidatingall the assets of the firm amount to be paid to allthe creditors and preference shareholders dividedby no. of outstanding equity shares.

Replacement cost:- this measure considered byanalysts in valuing firm is the replacement cost ofits assets less liabilities.

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The value of an equity share is equal to the presentvalue of dividends expected from its ownershipplus the present value of the sale price expectedwhen the equity share is sold.

Assumptions

1. Dividends are paid annually.

2. The first dividend is received one year after theequity share is bought.

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DIVIDEND DISCOUNT MODEL

SINGLE PERIOD VALUATION MODEL

D1 P1

P0 = +

(1+r) (1+r)

A equity share is expected t provide a dividend of Rs 2 and fetch a price

of Rs 18 a year hence. What price would it sell for now if investors

required rate of return is 12%.

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What happens if the price of the equity shareis expected to grow at a rate of g percentannually.

1

P

0

=

r g

The expected dividend per share on the equityshare of a company is Rs 2. the dividend per sharehas grown over the past five years @ 5%. Thisgrowth will continue in future. Further the marketprice of the equity share is expected to grow at thesame rate. What is the fair value of the equity shareif the required rate is 15%.

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More realistic

MULTI - PERIOD VALUATION MODEL

Dt

P0 =t=1 (1+r)t

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ZERO GROWTH MODEL

If the dividend per year remain constant.

D

P0 =

r

CONSTANT GROWTH MODEL

assumes that dividend per year grows at a constant rate g.

D1

P0 =

r -g

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The extension of the constant growth modelassumes that the extraordinary growth willcontinue for a finite period of years and thereafterthe normal growth rate will prevail forever.

Po = Current market price

D1= expected dividend a year hence

G1= extraordinary growth rate applicable for nyears.

G2= constant growth rate r= required rate of return

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TWO - STAGE GROWTH MODEL

1 - 1+g1n

1+r

P0 = D1 +

r- g1

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

r- g2 (1+r)n

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TWO - STAGE GROWTH MODEL : EXAMPLE

EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OFVERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY ANABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6

YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISEAT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OFVERTIGO ?THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE :

g1 = 20 PERCENTg2 = 10 PERCENTn = 6 YEARS

r = 15 YEARSD1 = D0(1+g1) = RS.2(1.20) = 2.40

PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THEINTRINSIC 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 + [0.497]

-0.05 .05

= 13.968 + 65.289= RS.79.597

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Assumptions While the current dividend growth rate, gais greater

than gn, the normal long-run growth rate declineslinearly for 2H years.

After 2H years the growth rate becomes gn.

At H years the growth rate is exactly halfway between gaand gn.

Where Po is the instrinsic value of the share, Do is thecurrent dividend per share, r is the rate of return expected

by investor, gnis the normal long-run growth rate, gaisthe current above-normal growth rate, H is the one half ofthe period during which gawill level off to gn.

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H MODEL

ga

gn

H 2H

D0

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

r- gn

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

= r-gn

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Current dividend on an equity share ofinternational computers limited is Rs 3. Thepresent growth rate is 50%. However this willdecline linearly over a period of 10 Years and then

stabilise at 12 %. What is the intrinsic value pershare, if investor requires a return of 16%.

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The share of a certain stock paid a dividend ofRs.3.00 last year. The dividend is expected togrow at a constant rate of 8 percent in thefuture. The required rate of return on this stock

is considered to be 15 percent. How muchshould this stock sell for now? Assuming thatthe expected growth rate and required rate ofreturn remain the same, at what price should

the stock sell 3 years hence?

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Do = Rs.3.00, g = 0.08, r = 0.15

Po = D1 / (r g)

= Do (1 + g) / (r g)= Rs.3.00 (1.08) / (0.15 - 0.08)

= Rs.46.29

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The equity stock of Max Limited is currentlyselling for Rs.280 per share. The dividendexpected next is Rs.10.00. The investors'required rate of return on this stock is 14

percent. Assume that the constant growthmodel applies to Max Limited. What is theexpected growth rate of Max Limited?

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The current dividend on an equity share ofOmega Limited is Rs.8.00 on an earnings pershare of Rs. 30.00.

(i) Assume that the dividend per share will

grow at the rate of 20 percent per year for thenext 5 years. Thereafter, the growth rate isexpected to fall and stabilise at 12 percent.

Investors require a return of 15 percent from

Omegas equity shares. What is the intrinsicvalue of Omegas equity share?

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Assume that the growth rate of 20 percentwill decline linearly over a five year periodand then stabilise at 12 percent. What is theintrinsic value of Omegas share if the

investors required rate of return is 15percent?

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1. divide the future into two parts, the explicitforecast period and the balance period.

Explicit period- represents the period duringwhich the firm is expected to evolve.

balance period- a state in which the return oninvested capital, growth rate and cost of capitalstabilise.

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Forecast the free cash flow, year by year, duringthe explicit forecast period.

FCF is the cash flow available for distribution tocapital providers(Shareholders and debt holders) afterproviding for the investment in fixed assets and networking capital required to support the growth of thefirm.

FCF= NOPAT- Net Investment

NOPAT is net operating profit adjusted for taxes. It is

profit before interest and taxes(1- Tax rate).Net Investment: Change in net fixed assets + Changein net working capital.

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Calculate the weighted average cost of capitalWACC= WeRe + WpRp + WdRd (1-t)

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Establish the horizon value of the firmHorizon value is the value placed on the firm at

the end of the explicit forecast period(H years) Sincethe FCF is expected to grow at a constant rate of g

beyond h, horizon value is equal to

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Estimate the enterprise valueThe EV or value of the firm is the present value

of the FCF during the explicit forecast period plus thepresent value of the horizon value.

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Step 6: Derive the equity value=Enterprise value Preference value- Debt value

Step 7: Compute the value per share

The value per share is simply the equity value

divided by the no of outstanding equity shares.

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

Rs. in crore

Liabilities Assets

Shareholders funds 500 Net fixed assets 550

Equity capital(20 crore shares of

Rs. 10 each)

200 Net working capital 200

Reserves and surplus 300

Loan funds( rate

10 percent) 250

750

750

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The weighted average cost of capital is:

WACC = (2/3) x 24 + (1/3) x 10 (1-0.34) =18.2 percent

The horizon value of the firm = (183.55 x1.10) /(0.182-0.10) = 2462.26 crores

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A valuation ratio of a company's current shareprice compared to its per-share earnings.

Calculated as:

Market Value per Share/ Earnings per Share (EPS)

For example, if a company is currently trading at 43 ashare and earnings over the last 12 months were 1.95per share, the P/E ratio for the stock would be 22.05

(43/1.95).

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The P/E is sometimes referred to as the "multiple",because it shows how much investors are willing topay per dollar of earnings. If a company werecurrently trading at a multiple (P/E) of 20, the

interpretation is that an investor is willing to pay20 for 1 of current earnings.

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A high P/E suggests that investors are expectinghigher earnings growth in the future compared tocompanies with a lower P/E.

Compare the P/E ratios of one company to other

companies in the same industry, to the market in

general or against the company s own historical

P/E.

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A ratio for valuing a stock relative to its own pastperformance, other companies or the market itself.Price to sales is calculated by dividing a stock'scurrent price by its revenue per share for the

trailing 12 months.

PSR= Market Price/ Revenue per share

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Equity Valuation (2)