Equity Valuation Models

Dr. Himanshu Joshi

FORE 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 Models
1. No Growth Model
2. Constant Growth Model
3. Two Stage Growth Model
4. Multi-Stage Growth Model

Operating Cash Flow Model

Free Cash Flow Model
Price Earning Multiples
P/E ratios and its relationship with firms dividends and growth
prospects.
Free Cash Flow Analysis
Real Firm Analysis Reasons for discrepancies.

Approaches to Equity
Valuation..
Equity Valuation

Relative Valuation Techniques

Discounted 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 firms
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 and 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

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.
Shareholders 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 shareholders 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 stocks 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 firms 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 (Tobins

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.
Tobins q = Market Price/replacement cost
Which tends toward 1.

Limitations
Although, Focusing on balance sheet
can give some useful information
about firms liquidation value or its
replacement cost, analysts must
usually turn to expected future cash
flows for a better estimate of the
firms 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
E ( D1 ) E ( P1 ) P0
Expected HPR= E ( r )
P0

Required Return
CAPM gave us required return:

k rf E (rM ) rf
If the stock is priced correctly
Required return should equal
expected return

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 years price?
Suppose rf =6%, E(rM - rf ) = 5%,
=1.2

Comparison of I.V with Market Price.

V0 = P1 +D1
1+K
In market equilibrium, the current market price will reflect
the intrinsic value estimates of all market participants.
This means that the individual investor whose V 0 estimate
differs from the market price, P0 in effect must disagree
with some or all of the market consensus estimates of:
Expected price, or
Expected Dividend, or
Required rate of return (market capitalization rate)

Dividend Discount Models: General

Model

Dt
Vo
t
t 1 (1 k )
V0 = Value of Stock
Dt = Dividend
k = required return

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.

No Growth Model

D
Vo
k
Stocks that have earnings and
dividends that are expected to
remain constant
Preferred Stock

No Growth Model: Example

D
Vo
k
E1 = D1 = $5.00
k = .15
V0 = $5.00 /.15 = $33.33

Constant Growth Model

Do(1 g )
Vo
kg
g = constant perpetual growth rate

Constant Growth Model: Example

Do (1 g )
Vo
kg
E1 = $5.00 b = 40%
k=
15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86

Estimating Dividend Growth Rates

g ROE b
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage
rate
(1- dividend payout percentage rate)

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:
D

P0

kg

If all earnings paid out as dividends,

price should be lower (assuming growth
opportunities exist)

Present Value of Growth Opportunities Continued

Price = No-growth value per share + PVGO

(present value of growth opportunities)
E1
P0
PVGO
k

Partitioning Value: Example

ROE = 20% d = 60% b = 40%
E1 = $5.00 D1 = $3.00 k = 15%
g = .20 x .40 = .08 or 8%

Partitioning Value: Example

Continued
3
Vo
$42.86
(.15.08)
5
NGVo
$33.33
.15
PVGO $42.86 $33.33 $9.52
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities

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
(1 g1 )t
DT (1 g 2 )
P0 D0

t
T
( k g 2 )(1 k )
t 1 (1 k )
T

g1 = first growth rate

g2 = second growth rate
T = number of periods of growth at
g1

Multistage Growth Rate Model:

Example
D0 = $2.00 g1 = 20% g2 = 5%
k = 15%
D2 = 2.88

T=3

D1 = 2.40

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.Year
equity is 14%.Dividend Growth Rate
1-3

25%

4-6

20

7-9

15

10 on

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)/(0.140.09)*(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 firms 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

where VT = FCFFT+1
WACC-g

(1+WACC)T

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 investors required rate of
return are:
The economys risk free rate.
The expected rate of inflation.
The companys Risk Premium.

The Economys Real Risk Free Rate..

This is the absolute minimum rate that an
investor should require. It depends on the
real growth rate of the investors 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
* (Rm Rf)
K = Rf + * (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