Equity Valuation Models

Dr. Himanshu JoshiFORE School of Management

The Agenda

• Is market efficient?• If it is efficient, then what is the use of

fundamental valuation and technical analysis?• What makes market efficient?

• It is the ongoing search for mispriced securities that maintains a nearly efficient market.

The Agenda..• Here we discuss the valuation models that stock market analysts use to uncover

mispriced securities. These models are used by fundamental analysts.• Alternatives measures of the value of a company (valuation by comparables)Dividend Discount Models1. No Growth Model2. Constant Growth Model3. Two Stage Growth Model4. Multi-Stage Growth Model

Operating Cash Flow ModelFree Cash Flow ModelPrice –Earning MultiplesP/E ratios and its relationship with firm’s dividends and growth prospects.Free Cash Flow AnalysisReal Firm Analysis – Reasons for discrepancies.

Approaches to Equity Valuation..Equity Valuation

Relative Valuation TechniquesDiscounted Cash Flow Techniques

*Present Value of Dividends (DDM)

*Present Value of Operating Free Cash Flows

*Present Value of Free Cash Flow to Equity

*Price/Earning Ratio (P/E)*Price/Cash Flow Ratio*Price/Book Value Ratio

*Price /Sales Ratio

Table 18.1 Financial Highlights for Microsoft Corporation, October 25, 2007

An Overview of the Valuation Process

• Assume that you own shares of the strongest and most successful firm producing home furnishings. If you own the shares during the strong economic expansion, the sales and earnings of the firm will increase and your rate of return should be quite high. In contrast if you own the same stock during the strong recession, the sales and earnings of this firm and probably most of the firm in the industry would likely to experience a decline and price of the stock would be stable or decline.

• However, if your investment is in a Pharmaceutical or food retail business or utility services firms then return in recession and expansion will not be much different.

An Overview of Valuation Process

• Therefore, when assessing the future value of security , it is necessary to analyze the outlook for the aggregate economy and the firm’s specific industry.

Three Step Process..

• General Economic Influences.• Industry Influences.• Company Analysis

• Top – Down Approach Vs. Bottom –Top Approach

Intrinsic Value vs. Market Price

• Intrinsic Value– Self assigned Value– Variety of models are used for estimation

• Market Price– Consensus value of all potential traders

• Trading Signal– IV > MP Buy– IV < MP Sell or Short Sell– IV = MP Hold or Fairly Priced

Intrinsic Value and Market Price

What is Intrinsic Value?

• Market Price?• Book Value?• Liquidation Value?

Limitations of Book Value.

• Shareholders in firm are “residual Claimants” which means that the value of their stake is what is left over when the liabilities of a firm are subtracted from its assets.

• Shareholder’s equity is that net worth.• Value of both these assets and liabilities are based on

historical not- current values.• Book value of an asset = original cost of acquisition –

depreciation ≠ Market Value• The market value of shareholder’s equity = current value of

all assets – liabilities.• Share Price = Market value of Shareholder's Equity• Number of outstanding shares

Floor for the stock price

Can book value represent a floor for the stock’s price?( below which level the market price can never fall)

No! in case of recession market value can be lower than book value.

Can we have such measure?

Liquidation Value per Share

• A better measure of a floor for the stock price is the firm’s liquidation value per share.

• This represent the amount of money that could be realized by breaking up the firm, selling its assets, repaying its debt, and distributing its remainder to the shareholders.

• why a better measure for floor value?• Corporate Raider.

Replacement Cost (Tobin’s q)

• Another approach to valuing a firm is the replacement cost of its assets less its liabilities.

• Assumption: firm can not remain for long too far above its replacement cost because if it did, competitors would try to replicate the firm. And competition would drive down the market value of all firms un-till they came to equality with replacement cost.

• Popular theory among economist. • Tobin’s q = Market Price/replacement cost• Which tends toward 1.

Limitations

• Although, Focusing on balance sheet can give some useful information about firm’s liquidation value or its replacement cost, analysts must usually turn to expected future cash flows for a better estimate of the firm’s value as a going concern.

Expected Holding Period Return

• The return on a stock investment comprises cash dividends and capital gains or losses– Assuming a one-year holding period

1 1 0

0

( ) ( )Expected HPR= ( )

E D E P PE r

P

Required Return

• CAPM gave us required return:

• If the stock is priced correctly– Required return should equal expected return

( )f M fk r E r r

Example..

• ABC stock has an expected dividend per share, E(D1), of $4, the current price of a share, P0, is $48, and expected price at the end of the year is, E(P1) is $52.

• Whether the stock seems attractively priced toady given your forecast of next year’s price?

• Suppose rf =6%, E(rM - rf ) = 5%, β =1.2

Comparison of I.V with Market Price.

• V0 = P1 +D1

1+KIn market equilibrium, the current market price will reflect the

intrinsic value estimates of all market participants. This means that the individual investor whose V0 estimate differs

from the market price, P0 in effect must disagree with some or all of the market consensus estimates of:

Expected price, orExpected Dividend, orRequired rate of return (market capitalization rate)

VD

ko

t

tt

( )11

V0 = Value of Stock

Dt = Dividend

k = required return

Dividend Discount Models: General Model

Does DDM ignore Capital Gain?

• It is tempting, but incorrect, to conclude from previous equation that the DDM focuses on dividends and ignore capital gains, as a motive for investing in stock.

• Price at which you can sell your stock in future depends upon dividend forecasts at that time.

• The DDM asserts that stock prices are determined ultimately by the cash flows accruing to stockholders, and those are dividends.

What about non-dividend paying stocks?

• If investors never expected a dividend to be paid, then this model implies that the stock would have no value.

• Is it true in real world?

Table 18.2 Financial Ratios in Two Industries

One must assume that investors expect that some day it may pay out some cash, even if only a liquidating dividend.

VD

ko

• Stocks that have earnings and dividends that are expected to remain constant– Preferred Stock

No Growth Model

E1 = D1 = $5.00

k = .15V0 = $5.00 /.15 = $33.33

VD

ko

No Growth Model: Example

(1 )o

o

D gV

k g

g = constant perpetual growth rate

Constant Growth Model

VoD g

k g

o

( )1

E1 = $5.00 b = 40% k = 15%

(1-b) = 60% D1 = $3.00 g = 8%

V0 = 3.00 / (.15 - .08) = $42.86

Constant Growth Model: Example

g ROE b

g = growth rate in dividendsROE = Return on Equity for the firmb = plowback or retention percentage rate

(1- dividend payout percentage rate)

Estimating Dividend Growth Rates

Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies

Example..

• High flyer industries has just paid its annual dividend of $3 per share. The dividend is expected to grow at a constant rate of 8% indefinitely. The beta of High Flyer stock is 1.0, risk free rate prevailing in the market is 6%, and market return is 14%.

• What is the intrinsic value of this stock?• What would be your estimate of intrinsic value if

you believed that stock was 1.25 times riskier than the market?

Present Value of Growth Opportunities

• If the stock price equals its IV, growth rate is sustained, the stock should sell at:

• If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist)

10

DP

k g

Present Value of Growth Opportunities Continued

• Price = No-growth value per share + PVGO (present value of growth opportunities)

10

EP PVGO

k

ROE = 20% d = 60% b = 40%

E1 = $5.00 D1 = $3.00 k = 15%

g = .20 x .40 = .08 or 8%

Partitioning Value: Example

V

NGV

PVGO

o

o

3

15 0886

5

1533

86 33 52

(. . )$42.

.$33.

$42. $33. $9.

Vo = value with growth

NGVo = no growth component value

PVGO = Present Value of Growth Opportunities

Partitioning Value: Example Continued

Infinite Period DDM and Growth Companies

• Infinite period DDM has the following assumptions:

• Dividend grow at a constant rate.• The constant growth rate will continue till

infinite period.• The required rate of return (k) is greater than

the infinite growth rate (g). If it is not model will give a meaningless results because denominator become negative.

Infinite Period DDM and Growth Companies

Can we apply this model to value stocks of growth Companies like Microsoft, Infosys, Bio-Con?

Why or Why Not?

Growth Companies

• Growth Companies are firms that have opportunities and abilities to earn rates of return on investments that are consistently higher than their required returns.

• Some firms experience periods of abnormally high rates of growth for some finite period of time. The infinite period DDM can not be used to value these true growth firms because these high growth conditions are temporary and therefore inconsistent with the assumptions of DDM.

Life Cycles and Multistage Growth Models

• g1 = first growth rate

• g2 = second growth rate

• T = number of periods of growth at g1

1 20 0

1 2

(1 ) (1 )

(1 ) ( )(1 )

tTT

t Tt

g D gP D

k k g k

Multistage Growth Rate Model: Example

D0 = $2.00 g1 = 20% g2 = 5%

k = 15% T = 3 D1 = 2.40

D2 = 2.88 D3 = 3.46 D4 = 3.63

V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 +

D4 / (.15 - .05) ( (1.15)3

V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

Valuation with Temporary Supernormal Growth

• Goldsmith has a current Dividend of $2 per share. The following are the expected annual growth rates for dividends. Required rate of return on Co. equity is 14%.

Year Dividend Growth Rate

1-3 25%

4-6 20

7-9 15

10 on 9

Valuation of Temporary Supernormal Growth

• Vj = 2.0 (1.25)/1.14 + 2.0 (1.25)2 /(1.14)2 + 2.0 (1.25)3 /(1.14)3 + 2.0 (1.25)3 (1.20)/(1.14)4 +2.0(1.25)3 (1.20)2 /(1.14)5

+2.0(1.25)3 (1.20)3 /(1.14)6

+2.0(1.25)3 (1.20)3 (1.15)/(1.14)7

+2.0(1.25)3 (1.20)3 (1.15)2 /(1.14)8

+2.0(1.25)3 (1.20)3 (1.15)3 /(1.14)9

+2.0(1.25)3 (1.20)3 (1.15)3 (1.09)/(0.14-0.09)*(1.14)9

FREE CASH FLOW VALUATION APPROACHES

• Alternative approach to DDM.• Free cash available to the firm means Free

cash flow net of capital expenditures.• Useful for the firm which does not pay

dividends and DDM is difficult to implement.• FCFF can be applied to any firm and can

provide useful insight about firm value beyond the DDM.

Free Cash Flow Approach

• Discount the free cash flow for the firm• Discount rate is the firm’s cost of capital• Components of free cash flow– After tax EBIT– Depreciation– Capital expenditures– Increase in net working capital

Free Cash Flow to the Firm Approach

• In this approach we discount the free cash flow for the firm (FCFF) at WACC. And then we subtract the then existing value of debt to find the value of equity.

• FCFF = EBIT(1-Tc) + Depreciation –Capital Expenditure – Increase in Net Working Capital

Free Cash Flow to Equity Approach

• In this approach we focus from start on the free cash flow to equity holders(FCFE), discounting these directly at the cost of equity to obtain the market value of equity.

• FCFE =FCFF – Interest Expense*(1-Tc) + Increase in net debt

Firm Value

T• Firm Value = ∑ FCFFt + VT

t=1 (1+WACC)T (1+WACC)T

where VT = FCFFT+1

WACC-g

Firm Value

• There is one final mopping-up steps in valuation. The first is to add the value of cash, marketable securities and other non-operating assets to the value estimated above.

• We would include any assets, the operating income from which is not included in the operating income of the firm, in non-operating assets. Thus, we would consider minority holdings in other firms as non-operating assets, since the income from these holdings are not consolidated with those of the firm.

• In summary, then, to value any firm, we begin by estimating how long high growth will last, how high the growth rate will be during that period and the cash flows during the period. We end by estimating a terminal value and discounting all of the cash flows, including the terminal value, back to the present to estimate the value of the firm.

• Once we have valued the firm, we can estimate the value of equity by subtracting the outstanding debt from firm value. To get to value of equity per share, we subtract the value of equity.

• To get to value of equity per share, we subtract the value of equity Options issued by the firm (to managers, warrant holders and convertible bond holders) and then divide by the actual number of shares outstanding. Figure 1 summarizes the process and the inputs in a discounted cash flow model.

Value of Equity

• Value of Operating assets+ Cash and Non operating Assets

= Value of the Firm - Value of Debt = Value of Equity - Equity options = Value of Equity in Stock/No. of outstanding

shares = Intrinsic Value per share.

Estimating the Inputs: The Required Rate of Return (k) and the Expected Growth

Rate (g) of Valuation Variables• Required Rate of Return: • Dividend Discount Models and Free Cash Flow

to equity Models use required rate of return on equity (k).

• While present value of Operating Cash Flow Models use weighted Average Cost of Capital (WACC).

• Note that (k) is an important input for WACC.

Required Rate of Return (k)

• Recall the three factors influence an equity investor’s required rate of return are:

• The economy’s risk free rate.• The expected rate of inflation.• The company’s Risk Premium.

The Economy’s Real Risk Free Rate..

• This is the absolute minimum rate that an investor should require. It depends on the real growth rate of the investor’s home economy because capital invested should grow at least as fast as the economy.

• This rate can be affected for short periods of time by temporary tightness or ease in the capital markets.

• Real Growth Rate of economy = GDP growth Rate – Inflation.

The Expected Rate of Inflation

• Investors are interested in real rates of returns that will allow them to increase their rate of consumption. Therefore, if investors expect a given rate of inflation, they should increase their required nominal risk free rate of return (NRFR) to reflect any expected inflation as follows:

• NRFR = [1+RRFR] [1+ E(I)] -1

Risk Premium

• β * (Rm – Rf)

• K = Rf + β * (Rm – Rf)

Risk Premium..

• Business Risk: Operating Leverage• Financial Risk: Financial Leverage• Liquidity Risk:• Exchange Rate Risk:• Country Risk:

Expected Growth Rates

• g = Retention Rate * Return on Equity• g = RR * ROE• Breakdown of ROE• ROE = Net Income/Sales * Sales/Total Assets *

Total Assets/Equity• ROE = Profit Margin * Total Asset Turnover *

Financial Leverage• Operating Performance of the Firm• Effect of Financial leverage on ROE