Corp Fin Session 11-12 Valuing Equity

Corporate Finance
Equity Valuation
Dr Avinash Ghalke, CFA
Stock Valuation
 Like other assets in finance, the value of a stock is the PV
of its CF’s
 Stocks are typically valued as perpetual securities
 Corporations potentially have an infinite life
 Can pay dividends forever
2
Returns from Equity
 The returns from equity consist of
 Dividend paid
 Capital gain – increase in the stock value
 The total return can be expressed as
Expected return = (Div1 +P1 –P0)/P0
You expect that INC Corp stock will sell for INR250 one year from
today. You expect to receive INR12 in dividends over the year you
hold this stock. For a 15% required rate of return for this stock,
how much should you pay for it? What is your projected capital
gain?
227.82 and 22.18
Common Stock Valuation : 1 year holding
D1  P1 D1 P1
P0   
(1  i ) (1  i ) (1  i )
• P0 = Present value or price of stock today

• P1 = Price of stock next period
• D1 = Dividends received in first period
• i = discount rate
Stock Value next year: Use same approach
D2 P2
P1  
(1  i ) (1  i )
D2  P2
D1 (1  i ) D1 D2 P2
P0     
(1  i ) (1  i ) (1  i ) (1  i ) (1  i ) 2
2
Valuation Fundamentals: Common Stock
 How was P1 determined?
 PV of expected stock price P2, plus dividends
 P2 is the PV of P3 plus dividends, etc...
 Repeating this logic over and over, you find that
today’s price equals PV of the entire dividend stream
the stock will pay in the future:
D1 D2 D3 D4 D5
P0  1
 2
 3
 4
 5
 .... ( Eq.4.5)
(1  i ) (1  i ) (1  i ) (1  i ) (1  i )
Must be able to predict future dividends to use this model

Zero Growth Valuation Model
 To value common stock, you must make assumptions
about future dividend growth.
Zero growth model assumes a constant,
non-growing dividend stream.
D1 = D2 = ... = D
• Plugging constant value D into the common stock
valuation formula reduces to simple equation for the
present value of a perpetuity:
D1
P0 
i
Constant Growth Valuation Model
 Assumes dividends will grow at a constant rate (g) that
is less than the required return (r)
 If dividends grow at a constant rate forever, you can
value stock as a growing perpetuity, denoting next
year’s dividend as D1:
D1 Note: D1 = D0(1+g)
P0  Eq.4.6
rg
Commonly called the Gordon growth model
Also called a DDM : Dividend Discount Model
Review Notation
 D0 = Current Dividend (time period 0)

 D1 = Dividend one period from now
 r = appropriate discount rate or rate of return for the
particular stock (adjusts for time value of money and risk)
 g = constant growth rate in dividends
 P0 = the present value of the infinite series of dividends,
which is the estimate stock price
9
Numericals
 ABC Ltd. paid a dividend of $3.97 last year. If the

company's growth in dividends is expected to be 10
percent thereafter forever, then what is the cost of equity
capital for ABC Ltd. if the price of its ordinary shares is
currently $26.71?
 [26.35]
10
Numericals
 Ace Corp paid dividends per share of $3.56 in 2020 and

dividends are expected to grow 5.5% a year forever. The
stock has a beta of 0.90 and the treasury bond rate is
3.25%. Assume Equity risk premium as 4%
 a. What is the value per share, using the Gordon Growth
Model?
 b. The stock was trading for $40 per share. What would
the growth rate in dividends have to be to justify this
price?
11
Use the Gordon model when . . .
 A dividend is paid on a regular basis
 Growth rate in the dividends is constant
 r>g
 Remember, It can also be valuing Preference Shares
12
Estimating the capitalization rate
D1
P0  Eq.4.6
rg
This can we rewritten as
D1
r g Eq.4.6
P0
Dividend Yield
Estimating the dividend growth rate
 Estimate from security analyst-experts
 Alternate method – using payout ratio
Plowback ratio = 1 – dividend Payout Ratio

= 1 – DPS/EPS
RoE = EPS / Book Value per share
g = Plowback ratio * RoE

PVGO
 A stock’s valuation can be heavily influenced by future
growth expectations
 Present Value of Growth Opportunities (PVGO)
 When a company sees no attractive growth
opportunities, it should payout all earnings as dividends
 For the positive retained earnings to create wealth for
investors, the company’s return on equity must exceed its
cost of equity.
 PVGO = P(Growth) - P(No growth) = [D1/(r-g)] – E1/r
Stock Price and Earnings Per Share
Our company forecasts to pay a $8.33 dividend next
year, which represents 100% of its earnings. This will
provide investors with a 15% expected return. Instead,
we decide to plowback 40% of the earnings at the
firm’s current return on equity of 25%. What is the
value of the stock before and after the plowback
decision?
Before - $ 55.56
After - $ 100
Discounted Cash flow method
 Free cash flow(FCF) is the amount that a company can
pay to its investors after paying all its liabilities and all
investments for future growth
 FCF is then discounted at the opportunity cost of capital
Terminal Value
 Firm is a going concern
 How to value the infinite cashflows
 Divide cashflows into near term and long term cashflows
 Near Term CFs
 Discount under discount rate
 Long Term CFs
 Valued life infinite perpetuity
Terminal Value
The free cash flows (FCF) for a firm are given in the
following table. The required rate of return is 10%
and g is 4%. Calculate the present value of the FCF
assuming firm as a going concern.
1 2 3 4
22.34 34.12 45.1 51.6
Relative Valuation
 Valuation based on peer group
 Market knows the value
 Some metrics used
 Price to Earnings multiple
 Price to Book multiple
ABC Infosystem is expected to clock an EPS of Rs. 20.1 for

next year. IT companies of similar size are trading at P/E
multiple of 15.6x. Find the stock price of ABC Infosystem
Numerical
 From the following information ascertain the current
intrinsic value of share
 Recent EPS = INR 2.00
 Growth rate (constant) = 5%
 Dividend Payout Ratio = 50%
 Required Rate of Return = 10%
 Intrinsic Value = 22
Numerical
 ABC Company is expected to have dividends grow at a
rate of 12% for the next three years. In three years, the
dividends will settle down to a more sustainable growth
rate of 6% which is expected to last “forever.” If
Whitewater just paid a dividend of $2.00 and its level of
risk requires a discount rate of 10%, what is the intrinsic
value of ABC stock?
 62.16

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Corporate Finance

Expected return = (Div1 +P1 –P0)/P0

• P0 = Present value or price of stock today

Must be able to predict future dividends to use this model

 D0 = Current Dividend (time period 0)

 ABC Ltd. paid a dividend of $3.97 last year. If the

 Ace Corp paid dividends per share of $3.56 in 2020 and

Plowback ratio = 1 – dividend Payout Ratio

RoE = EPS / Book Value per share

g = Plowback ratio * RoE

ABC Infosystem is expected to clock an EPS of Rs. 20.1 for

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