CHAPTER-5

EQUITY VALUATION
Introduction
• Equity valuation is determining the fundamental
value of stocks that reflects the intrinsic value of
an equity investment held over long term, as
opposed to the value that can be realized by
short term which refers speculative value.
• There are three techniques of equity valuation
namely: balance sheet technique, dividend
discount method (absolute technique), and
relative valuation technique (price multiple model).

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Balance Sheet Technique
• Balance sheet methods are the methods which utilize the
balance sheet information to value a company. It includes
3 approaches: book value method, liquidation value
method, replacement cost method.
1. Book value – in this method, book value as per balance
sheet is considered as the value of equity. Book value
means the net worth of the company and it is simply
determined by deducting total liabilities of the business
from the total assets of the business.
• Companies whose stocks sell for less than book value are
generally considered to be undervalued, or having less risk
than companies selling for greater than book value.
• The basic limitation of this value is that the book value
doesn’t reflect the true current economic value of the
share. It also doesn’t consider the future earnings
potential of the company.

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Balance Sheet Technique
2. Liquidation Value: This approach is similar to the
book valuation method, except that the liquidation value
of equity is used instead of the book value.
• In the liquidation cost method, liquidation value is
considered the value of equity. Liquidation value is
the value realized if the firm is liquidated today. It is
determined by deducting the liabilities of the business
from the liquidation value of assets of the business.
• Although it seems to be more realistic. The major
problems in applying this method are:
• It is too difficult to estimate the liquidation value of
the assets unless the company is really sold. Thus, it
is applied only to dead companies
• It doesn’t consider the future earnings potential of
the company.

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Balance Sheet Technique
3. Replacement Cost: If individuals or companies
want to enter a business, they have to decide
whether to buy a business for less than what it
would take to establish from scratch.
• In replacement cost method, the value of equity is
the replacement cost which is the cost that would
be incurred to create a duplicate firm.
• Equity Value = Replacement cost of Assets – Liabilities =
Replacement cost

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Balance Sheet Technique
• According to the replacement cost approach, the
total market value of all companies will coincide in
the long run to the replacement cost. Thus, the
famous ratio by James Tobin (Tobin’s Q) tends
to become 1.
• Tobin’s Q is given by the formula
Market price of the firm
Replacement cost of the firm
• If the Q ratio is significantly less than 1, then it
would be cheaper for potential competitors to buy
the firm rather than start a new business.

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Discounted Cash Flow Technique
• Discounted cash flow technique also known as
absolute technique determines the value of an
equity as the present value of future cash flows in
the form of dividend plus present value of
expected sale proceeds of equity share.
A) Single Period Valuation model – Let us begin
with the case where the investor expects to hold
the equity share𝐷1
for one
𝑃
year. The price of equity
share will be + where, D1 is dividend one
(1+𝑟) (1+𝑟)
year after, P stands for selling price of the stock,
and r is required rate of return.
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Discounted Cash Flow Technique
• To illustrate, Assume Zemen Bank is expected to give 3
br. dividend and fetch a price of 57 br. at the end of a
year? What should be the present price of the bank’s
equity if investor expects to have 20% rate of return?
3 57
+ = 50 Br.
(1+0.2) (1+0.2)
• Assume the current forecasts for dividend payments of
Zemen Bank are Br. 5.6 for 1st year, Br 2.5 for 2nd year,
and Br. 7 for 3rd. At the end of the 3rd year you anticipate
selling the stock at a market price of Br. 98.36. What
should be the price of the stock if you require a 12%
return from the stock?
5.6 2.5 7 98.36
+ 2 + 3 + 3 = 82 Br.
(1+0.12) 1+0.12 1+0.12 1+0.12

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Discounted Cash Flow Technique
B) Zero Growth Model: If dividend per share
remains constant year after year, the value of
𝐷
equity share will be where, D represents dividend
𝑟
and r stands for required rate of return.
• Consider a company that pays 2$ annual dividend
indefinitely. Assume, the required rate of return is
5%. According to the dividend discount model, the
company should be worth $40 i.e.,($2 / 0.05).

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Discounted Cash Flow Technique
C) Constant Growth Model (Gordon Model): A
model for determining the intrinsic value of a stock
that has a current value of D and grows at a
constant rate of g for indefinite period.
• The formula for valuating a company with a
𝐷1
constantly growing dividend is , where D1 is
𝑟−𝑔
dividend one year after, r is required rate of
return, and g stands for dividend growth rate.
• D1 = D0 (1+g), where D0 stands for current
dividend.

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Discounted Cash Flow Technique
• What is the value of a stock that currently pays
dividend of $4 and the dividend is expected to
increase at a constant rate of 8% per year
indefinitely? Assume a 12% expected return. The
4.32
value of the stock = = 108
0.12 −0.08
• If the same stock is selling for $200 in the stock
market, what might the market be assuming about
4.32
the growth in dividends? 9.84% i.e., = 200
0.12 −𝑔

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Discounted Cash Flow Technique
D) Multi stage - The Gordon growth model
implicitly assumes that growth will be stable
forever. However, many companies grow at
different rate on different time. In such cases,
investors can use a multi-stage dividend discount
model. There are different versions of the
multistage model including the two-stage-model,
H-model, and three-stage model.

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Discounted Cash Flow Technique
1. Two Stage Dividend Discount Model: This model
assumes that dividends grow at a constant
extraordinary rate during the first stage and then
grow at a normal growth rate indefinitely.
• The value of stock under the two stage dividend
discount model is the sum of:
• Present value of dividends in first stage (which is
calculated based on single Period valuation model)
• Present value of dividends in second stage (which is
calculated based on Gordon Model)

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Discounted Cash Flow Technique
• To illustrate, consider X-pro Industries is expected to pay
$1.16 dividend next year that is expected to grow at 14%
annually for the next four years. Then the growth rate is
expected to fall to 7% and continues at the same rate
thereafter. If an investor wants 10% rate of return what
should be the value of its equity share?
Year Dividend Growth rate Present Value @ 10%
1 1.16 0.14 1.05
2 1.32 0.14 1.09
3 1.51 0.14 1.13
4 1.72 0.14 1.17
5 1.96 0.07 1.22
2.10 43.46
= 70
0.1 −0.07
Value of the stock = 1.05+1.09+1.13+1.17+1.22+43.46 = 49.12
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Discounted Cash Flow Technique
• The current dividend on an equity share of vertigo limited
Co. is $ 2. Vertigo is expected to enjoy an above normal
growth rate of 20% for a period of 6 years. There after the
growth rate will fall and establish at 10%. An investor
require a return of 15%. What is the intrinsic value of
equity share of vertigo?
Year Dividend Growth Present Value @15%
1 2.4 0.2 2.09
2 2.88 0.2 2.18
3 3.46 0.2 2.27
4 4.15 0.2 2.37
5 4.98 0.2 2.46
6 5.97 0.1 2.58
6.57 56.81
= 131.4
0.15 −0.1
Value of the stock = 2.09+2.18+2.27+2.37+2.46+2.58+56.81 = 70.76
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Discounted Cash Flow Technique
• Exercise - given a stock currently pays 1.75$.
The stock grows at 15% for 3 years and 5% from
year 3 to infinity. You as investor requires 12%
return from the stock. Find the value of the
stock? g1 = 15% for 3 years; g2 = 5%; r = 12%.

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Discounted Cash Flow Technique
2. The H-Model - assumes that growth begins at
some super-normal rate, then the growth rate
declines in a linear fashion over time until it
reaches the normal rate.
• The value of stock under the H-Model =
D0(1 + gt) D0 ∗ H(gs − gt)
+ where, gt is the growth
(r − gt) (r − gt)
rate at time t, gs is the current super growth rate
and H is the half-life of the expected high growth
period.

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Discounted Cash Flow Technique
• To illustrate, consider a potential investment in
X-pro Industries that pays a current dividend of
$1.16 per share. The dividend growth rate over
the last six years has been 36%. Analysts expect
that the growth will slow from 36% to the 7%
linearly over the course of the next 10 years and
will stabilize indefinitely. If an investor with a 10%
required return wants to invest in X- pro, how
much he would have to pay?
1.16(1 + 0.07) [1.16 ∗ (10/2)](0.36 − 0.07)
+ = $97.43.
(0.1 − 0.07) (0.1 − 0.07)

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Discounted Cash Flow Technique
3. Three Stage Dividend Discount Model: This model
has three stages. The first stage is with a stable high
growth rate that lasts for a certain period. In the
second phase, the growth rate declines linearly over
time until it reaches the final stable growth rate. In the
third stage, the growth continues for indefinite period.
• To illustrate, an analyst expects that X-pro co. will
declare dividend of $1.16 next year and the dividend
is expected to grow at 14% for the next four years.
After the 5th year, the growth rate will slow from 14%
to the 7% linearly over the course of 10 years and will
stabilize at 7% thereafter. If an investor with a 10%
required return wants to invest in X- pro, how much
would he have to pay?
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Discounted Cash Flow Technique
• First phase - we need to calculate the present
value of the dividends for the next five years.
Year Dividend Growth rate Present Value @
10%
1 1.16 0.14 1.05
2 1.32 0.14 1.09
3 1.51 0.14 1.13
4 1.72 0.14 1.17
5 1.96 1.22
5.67

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Discounted Cash Flow Technique
• Second and third phase - the terminal value for
second and third phase can be estimated using
the two-stage H model =
1.96(1 + 0.07) [1.96 ∗ (10/2)](0.14 − 0.07)
+ = $92.77
(0.1 − 0.07) (0.1 − 0.07)
• However, $92.77 is the value at the end of five
years. So, it must be discounted back to the
present value @ 10%. The present value is thus
$92.76/(1.10^5) = $57.60
• Value of the stock = $57.60 + $5.67 = $63.27
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Discounted Cash Flow Technique
• Decision rules for the results of dividend
discounting models are;
• If market value < DDM Valuation - decision to buy the
stock, because the stock is undervalued;
• If market value > DDM Valuation - decision to sell the
stock, because the stock is over valuated;
• If market value = DDM Valuation - stock is valuated at
the same range as in the market and its current
market price shows the intrinsic value.

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Exercise
• Assume that a company paid a dividend of $250
this year. The current return to shareholders of
companies in the same industry as is 14%.
Compute the expected value of the company’s
common stock assuming:
a) The current level of dividend is expected to
continue into the foreseeable future.
b) The dividend is expected to grow at a rate of 4% pa
into the foreseeable future.
c) The dividend is expected to grow at a 3% rate for 3
years and 2% afterwards.

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Relative Valuation Techniques
• In relative valuation, we value an asset based upon
how similar assets are priced. Thus, these techniques
determine the share prices based upon shares of the
similar companies in the same industry.
• Relative valuation technique generally yield stock
values that are closer to market prices than
discounted cash flow valuations. However, it has the
following weaknesses:
• It results in inconsistent estimates of value where key
variables such as risk, growth or cash flow potential
are ignored.
• Result in values that are too high when the market is
over valuing the comparable firms, or too low, when it
is under valuing these firms.
• There is lack of transparency regarding the underlying
assumptions and this make the valuation vulnerable to
manipulation.
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Relative Valuation Techniques
• The relative valuation technique is also called
multiples approach because it applies several ratios.
1. Earnings Multiplier Approach (P/E Ratio): A valuation
ratio of a company's current share price compared to
its per-share earnings.
• P/E Ratio is calculated as Market value per share/
Earnings Per Share.
• For example, if a company is currently trading at $50
per share and earnings over the last 12 months were
10 per share, the P/E ratio for the stock would be 5
i.e., 50/10.

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Relative Valuation Techniques
2. Price to Book Value Ratio (P/BV Ratio): A ratio
used to compare a stock's market value to its book
value.
• P/BV Ratio is calculated by dividing the current
closing price of the stock by the latest book value per
share. A lower P/BV ratio could mean that the stock
is undervalued.
3. Price-to-Sales Ratio: A ratio for valuing a stock
relative to its own past performance, other companies
or the market itself.
• Price to sales is calculated as share price/revenue
per share.
• All things being equal, a low price-to-sales ratio is
good news for investors, and a very high price-to-
sales ratio can be a warning sign.
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Relative Valuation Techniques
4. Enterprise value to EBITDA (EBITDA Multiple):
EBITDA stands for earning before interest tax
depreciation, and amortization.
• Enterprise multiple is calculated as enterprise
value/EBITDA
• The ratio is used to determine the value of a
company for potential acquirer. It is better than other
multiples like P/E because it takes debt into account.
• A low ratio indicates that a company might be
undervalued. Therefore, a company with a low
enterprise multiple can be viewed as a good takeover
candidate.

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Relative Valuation Techniques
• Value Added Concept - when the firms are in expansion
phase and want to raise the capital for their business, it is
necessary for the investor to know how their investment
would fetch the returns. Following are some of the
important methods which assist the investor for the same.
1. Economic Value Added – EVA: A measure of a company's
financial performance based on the residual wealth
calculated by deducting cost of capital from its operating
profit (adjusted for taxes).
• The formula for calculating EVA = Net Operating Profit
After Taxes (NOPAT) - (Capital * Cost of Capital)
• The higher the EVA, the better for the investor.

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Relative Valuation Techniques
2. Market Value Added - MVA: A calculation that shows the
difference between the market value of a company and the
capital contributed by investors (both bondholders and
shareholders).
• The formula for calculating MVA = Market value - (Capital
* Cost of Capital)
• The higher the MVA, the better for the investor because a
high MVA indicates that the company has created
substantial wealth for the shareholders.
• A negative MVA means that the value of management's
actions and investments are less than the value of the
capital contributed to the company by the capital market
(or that wealth and value have been destroyed).
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-END-

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