EQUITY VALUATION:

CONCEPTS AND BASIC

TOOLS

Estimated Value and Market

Price
Undervalu
ed:
Fairly
valued:
Overvalue
d:

Intrinsic
value >
market
price
Intrinsic
value =
market
price
Intrinsic
value <
market
price

Dealing with Uncertainty

Confidence in
intrinsic value
estimate

Uncertainties
related to
model
appropriatenes
s and the
correct value
of inputs

Asset-based Multiplier
valuation
models

models
Share price
Adjustments to multiples
Enterprise
book value
value
multiples

Present
value
models
Dividend
discount
models
Free cash fow
models

Major Categories of Equity Valuation

Models

Present Value Models

Value of an investment =
present value of expected
future benefits
Future
benefits =
dividends

Dt
V0
t
(
1

r
)
t 1

Future
benefits =
free cash
fow

FCFEt
V0
t
(
1

r
)
t 1

Preferred Stock Valuation (Non-callable,

Non-convertible Shares)
Perpet
ual

D0 $5.50
V0

$91.67
r
0.06

Maturit
y at
time
period
n

Dt
F
V0

t
n
t 1( 1 r ) ( 1 r )
12
GBP2.00 GBP20.00
V0

GBP31.01
t
12
t 1( 1 0.041) ( 1 0.041)
n

The Effect of Options on the Price of a

Preferred Share

Call option

May be
exercised
by the
issuer

Lower
share price

Retraction
(put)
option

May be
exercised
by the
investor

Higher
share price

The Gordon Growth Model

Assumptions:
Dividends are the correct metric to use for
valuation purposes.
The dividend growth rate is forever: It is
perpetual and never changes.
The required rate of return is also constant over
time.
The dividend growth rate is strictly less than the
required rate
t
of return.

D0 (1 g )
D0 (1 g )
D1
V0

t
(1 r )
rg
rg
t 1
EUR5.00(1 0.04)
V0
EUR130
0.08 0.04

When Is the Gordon Growth

Model Most Appropriate for
Valuing Equity?
Insensitive
Dividendpaying
company
Mature
growth
phase

to the
business
cycle
Use the
Gordon
growth
model

Estimating a Long-Term Growth Rate

Earnin
gs
retenti
on rate
(b)

Return
on
equity
(ROE)

Divide
nd
growth
rate
(g)

0.40

15.00
%

6.00%

Multistage Dividend Discount Model

Rapidly
growing
companies

Company
will pass
through
different
stages of
growth

Use
multistag
e
dividend
discount
model

Growth is
expected to
improve or
moderate

The Two-Stage Dividend Discount

Model
Dividends grow at rate gS for n years and rate gL
thereafter:

D0 1 g S
Vn
V0

t
n
(
1

r
)
(
1

r
)
t 1
Dn 1
Vn
r gL
t

Dn 1 D0 1 g S 1 g L
n

The Two-Stage Dividend Discount Model

(continued from previous slide)
D1 $5.00(1 0.10) $5.50
D2 $5.00(1 0.10) 2 $6.05
D3 $5.00(1 0.10) 3 $6.655
D4 $5.00(1 0.10) 3 (1 0.05) $6.98775
$6.98775
V3
$69.8775
0.15 0.05
$5.50
$6.05
$6.655
$69.8775
V0

2
3
1 0.15 (1 0.15)
(1 0.15)
(1 0.15) 3
V0 $59.68

Price Multiples

Group or sector of stocks

Use price multiples as a
screen
Identify overvalued and
undervalued stocks

 Stock price cash fow per

share
Stock price sales per share
Stock price book value per
share
Stock price earnings per
share

Price-to-sales
ratio (P/S)
Price-to-cash
fow ratio
(P/CF)
Price-toearnings
ratio (P/E)
Price-to-book
ratio (P/B)

Popular Price Multiples

Price Multiples for

Telefnica and Deutsche
Telekom

Sources: Company websites: www.telefonica.es and

www.deutschetelekom.com.

Justified Value of a Multiple

Fundamentals or cash
fow predictions
Discounted cash fow
model
Justified value of a
multiple

Justified Forward P/E for Nestl

Required Rate of Return = 12 percent

D1 algebra P0 D1 / E1
p
0.45
P0

12.9
rg
E1 r g
r g 0.12 0.085

The Method of Comparables

Method of
comparable
s

Time series
analysis

Crosssectional
analysis

Comparison
to past or
average
values

Comparison
to
benchmark
or peer
group

Price-to-Sales Ratio Data for Major

Automobile Manufacturers (2009)

P/E Data for Canon

Sources: EPS and P/E data are from Canons website:

www.canon.com. P/E is based on share price data from the Tokyo
Stock Exchange.

Enterprise Value Multiples

Market
capitalizatio
n

Market
value of
preferred
stock

Enterpri
se value
(EV)

Market
value of
debt

EBITDA

Cash and
equivalent
s

EV/EBIT
DA

Enterprise
value

EV/Operating Income Data

for Nine Major Mining
Companies

Source: www.miningnerds.com

Asset-Based Valuation
Book value of assets and liabilities
Estimation process or processes
Market value of assets and
liabilities
Market value of equity = market
value of assets market value of
liabilities

Asset-Based Valuations:
Potential Problems
Difficulties determining
market (fair) values
Book values differ
significantly from market
values
Intangible assets
Hyper- or rapidly rising
infation

Asset-Based Valuation
versus Discounted Present
Valuatio
Value
Approaches
Compan
y to be
valued

Airline in
financial
distress

n
approac
hes

Present value
models

Asset-based
valuation

Valuation
inputs

Airline stopped
the dividend
and is losing
money and
burning cash
Routes, fight
agreements,
equipment, and
aircraft have
value

Advantages and Disadvantages

Present
value
models
Multiplier
models
Assetbased
valuation

Theoretically appealing and

provide a direct computation
of intrinsic value
Input uncertainty can lead to
poor estimates of value
Ratios are easy to compute
and analysis is easily
understood
Problems with selecting a
peer group or comps
Consistent with the notion
that a business is worth the
sum of its parts
Difficulties determining
market value and the value of
intangible assets

Summary

Overvalued, fairly valued, or undervalued

securities
Major categories of equity valuation models
Present value models: dividend discount models
and free cash fow models
Multiplier models: price ratios and enterprise
value ratios
Asset-based valuation
Advantages and disadvantages of equity
valuation models