Equity Valuation Models
Equity Valuation Models
Equity Valuation Models
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
Approaches to Equity
Valuation..
Equity Valuation
*Price/Earning Ratio
(P/E)
*Price/Cash Flow
Ratio
*Price/Book Value
Ratio
*Price /Sales Ratio
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.
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.
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
Dt
Vo
t
t 1 (1 k )
V0 = Value of Stock
Dt = Dividend
k = required return
No Growth Model
D
Vo
k
Stocks that have earnings and
dividends that are expected to
remain constant
Preferred Stock
D
Vo
k
E1 = D1 = $5.00
k = .15
V0 = $5.00 /.15 = $33.33
Do(1 g )
Vo
kg
g = constant perpetual growth rate
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
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)
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?
P0
kg
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.
t
T
( k g 2 )(1 k )
t 1 (1 k )
T
T=3
D1 = 2.40
D3 = 3.46
D4 = 3.63
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
Firm Value
T
(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.
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.
Risk Premium
* (Rm Rf)
K = Rf + * (Rm Rf)
Risk Premium..