Equity Valuation-1

Equity Valuation
Learning Objectives
• Calculate and interpret the intrinsic value of an equity security based
on
• Dividend Discount Model
• Free Cash to Firm & Free Cash Flow to Equity
• Equity valuation (using single-stage, two-stage and three-stage models)
• Relative valuation using price and enterprise value multiples
• Residual Income Model
Basic Questions
• What is intrinsic value?
• What are the inputs required?
Streams of Expected Cash Flows
• Dividends
• Free Cash Flows
• Residual Income
Dividends as Expected Cashflows
• The company is dividend paying
• The Board of Directors have established a dividend policy that bears
an understandable and consistent relationship to the company’s
profitability
• Investors take a non-control perspective
• If dividends do not bear an understandable relation to value creation
in the company, applying the DDM to value stock is prone to error
Example
As the director of equity research firm, you have final responsibility in the choice of valuation
models. An analyst covering consumer/non-cyclicals has approached you about the use of DDM for
valuing two companies coke and HRL. You have the following data of EPS, DPS and pay out ratio.
Explain if DDM is appropriate choice of model for valuing both firms.
Free Cash Flows
• Meaning of Free
• FCFF and FCFE
• More suitable when
• The company is not dividend paying
• The company is dividend paying but dividend significantly exceed or fall short
of free cashflow to equity
• Investors takes a control perspective
Residual Income
• It is the earnings for a period in excess of the investors’ required return (opportunity
cost) on beginning of the period
• E.g. Shareholders initial investment is $200 million and required rate of return is 8%. The
company earns $18 million in the course of the year. How much value has the company
created for its shareholders?
• $ 2 million is the value added or economic gain
• Residual income approach match the profits to the time period in which they are earned
(whether realised as cash or not)
• Residual income = BVPS + Prevent Value of expected future residual earnings
• In comparison to DDM and FCF models, residual model introduces stock concept, book
value per share and present value expression
• This model is suitable when
• The company is not paying dividends
• Companies FCFs are negative in analyst’s comfortable forecast horizon
Dividend Discount Model
• Suppose you expect Carrefour SA to pay a € 0.58 dividend next year.
You expect the price of Carrefour SA stock to be € 27 in one year. The
required rate of return for Carrefour SA stock is 9%. What is your
estimate of the value of Carrefour SA stock ?
• For the next five years, the annual dividends of a stock are expected
to be $2.00, $2.10, $2.20, $ 3.50, and $3.75. In addition the stock
price is expected to be $40.00 in five years. If the required rate of
return is 10%, what is the value of the stock?
Gordon Growth Model
Do (1  g )
Vo 
kg
g = constant perpetual growth rate
and k > g
The model implies that in a case of constant growth of
dividends, the rate of price appreciation in any year will
equal that constant growth rate, g
Gordon Growth Model
• What if r=g?
• What if r<g?
• DDM is appropriate for kind of companies?
• Use of DDM in calculating the terminal value
• Nominal GDP?
Gordon Growth Model
Joel Williams follow Sonoco Products Company, a manufacturer of paper and plastic
packaging for both consumer and industrial use. Sonoco appears to have a dividend policy
of recognizing sustainable increases in the level of earnings with increases in dividends,
keeping the dividend pay-out ratio with in the range of 40% to 60%. Williams also notes:
• Sonoco’s most recent quarterly dividend was $0.31, consistent with a current annual
dividend of 4x$0.31= $1.24 per year
• A forecasted dividend growth rate of 4% per year
• Beta is 0.95, equity risk premium is 4.5% and risk free rate is 3%.
Williams believes the Gordon growth model may be an appropriate model for valuing
Sonoco.
• Calculate the value of stock
• Current market price of Sonoco stock is $38.10. Using the above calculate value, judge
whether Sonoco is fairly valued, under valued or overvalued.
Derivation of Gordon Growth Model
Example
• In previous example, the Gordon Growth model value for MSEX was
estimated as $21.88 based on a current dividend of $0.74, an
expected dividend growth rate of 3.5% and a required rate of return
on equity of 7%. What if the estimates of r and g can each vary by 25
basis points? How sensitive is the model value to changes in the
estimates of r and g?
Valuing Noncallable Fixed Rate Perpetual
Preferred Stock
• Kansas City Southern Preferred 4% (KSU-P), issued 2 January 1963,
has a par value of $25 per share. If the required rate of return is 5.5%.
What is the value of the issue.
Derivation of Gordon Growth Model
Share Repurchases
• A consistent increase
• Harder to forecast
• If applied correctly, the DDM is valid approach to common stock
valuation even when the company being analysed engages in share
repurchase
• Estimate the value of the company’s stock
• Determine the constant dividend growth rate that would be required to justify the market
price of $40.
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)
Growth
• When do shareholder wealth increases?
• What is a no growth company?
• What should a no growth company do?
No Growth Model
D
Vo 
k
• Stocks that have earnings and dividends that
are expected to remain constant
• Preferred Stock
Present Value of Growth Opportunities
Suppose growth opportunities exist:
Price = No-growth value per share + PVGO (present
value of growth opportunities)
E1
P0   PVGO
k
• What leads to high PVGO?
Example
• Suppose JCL is expected to have average EPS of $0.79 if it distributed
all earnings as dividends. Its required rate of return is 9.25% and
current market price is $18.39. Calculate its PVGO.
P/E Ratio: No Expected Growth
E1
P0 
k
P0 1

E1 k
• E1 - expected earnings for next year
• E1 is equal to D1 under no growth
• k - required rate of return
P/E Ratio: No Expected Growth
E1
P0 
k
P0 1

E1 k
• E1 - expected earnings for next year
• E1 is equal to D1 under no growth
• k - required rate of return
P/E Ratio: Constant Growth
D1 E1 (1  b)
P0  
k  g k  (b  ROE )
P0 1 b

E1 k  (b  ROE )
b = retention ratio
ROE = Return on Equity
Also break the expected return into dividend yield and capital yield
Two-Stage DDM

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