WORKSHOP ON
Equity Valuation Dated:16th Sep 2012.
Important Terms The Nature of Equity Securities Preferred Share Valuation Valuation of Equities Constant Growth Model Multistage Growth Model H - Model Using Multiples to Value Shares Retained Earnings Valuation.
Common share Constant growth DDM Dividend discount model Equity securities Enterprise Value to EBIT ratio Enterprise Value to EBITDA ratio Price-to-Book Value ratio H- Ratio Retained Earnings. Du-Pont Model.
Preferred share Price-earnings ratio Price-to-cash-flow ratio Price-to-sales ratio Relative valuation Sustainable growth rate
Equity Valuation
Equities represent ownership claims on businesses. Despite having residual claims to earnings after tax and to assets upon dissolution equities offer the prospect for participation in the growth and profitability of the business. Equity securities can be valued based on approaches using the present value of expected future dividend stream.
Equity Securities Include preferred (Disputed) and common shares. Represent ownership claims on the underlying entity. Usually have no specified maturity date, and since the
underlying entity has a life separate and apart from it’s owners, equities are treated as investments with infinite life. Equities may pay dividends from after-tax earnings at the discretion of the board of directors.
Have some preference over the common share class Usually have the following characteristics: A fixed annual dividend (not legally enforceable by shareholders if not
declared) Have prior claim to dividends and assets upon dissolution/liquidation over and above the common shares Non-voting – except if dividends are in arrears (Cumulative). No maturity date Often have a cumulative feature (dividends in arrears must be paid before common shareholders can receive dividends) Often called a ‘fixed income’ investment because the regular annual dividend is fixed (set) at the time the shares are originally issued.
Equity Valuation
Valuation of equities can follow a discounted cash flow approach. The discount rate used reflects current level of interest rates (based on the risk-free rate) plus a risk premium. This relationship is expressed as:
Ke Rf * Risk Premium.
[ 7-1]
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The risk-free rate is equal to the real rate of return plus expected inflation (Fisher Equation)
The risk premium is based on an estimate of the risk associated with the security.
Required Return (%) Required return on Equity Security (M)
Risk Premium
RF
Real Return Expected Inflation Rate Risk of Equity Security M
Risk
Equity Valuation
Preferred shares can be viewed as perpetuities because of the nature of the dividend stream they offer. A perpetuity is an infinite series of equal and periodic cash flows.
Pp s
Dp kp
Pps is the market price (or present value) Dp is the annual dividend amount kp is the required rate of return investors demand (or discount rate)
Determine the market price of a $100 par value preferred share that pays dividend based on a 7 percent dividend rate when investors require a return of 10 percent on the investment. [ 7-2]
.07 $100 $7.00 Pps $70.00 kp 0.10 0.10 Dp
What happens to the market price if interest rates rise and investors now require a 12 percent rate of return on the investment?
[ 7-2]
.07 $100 $7.00 Pps $58.33 kp 0.12 0.12 Dp
What happens to the market price if interest rates fall and investors now require a 7 percent rate of return on the investment?
[ 7-2]
.07 $100 $7.00 Pps $100.00 kp 0.07 0.07 Dp
Like bonds, when the required return is equal to the preferred dividend rate, the preferred will be priced to equal its par value.
The preferred share valuation equation can be modified to solve for the investor’s required rate of return. Remember, for market traded preferred shares, the stock price will be observable (known) and so too will the annual dividend, so this type of calculation is very common.
[ 7-3]
kp 
Dp Pps
Assuming the previous 7%, $100 par value preferred share is currently trading for $57.25, what is the implied market-demanded required return? [ 7-3]
.07 $100 $7.00 kp 12.22% Pps $57.25 $57.25 Dp
You knew that the share was trading for less than its par value, so even before trying to solve for the answer, you should have known that investors were requiring a higher rate of return than 7%.
So How do we value a Preference Share which is set to retire after a given period of time??
Kp = Dividend + [Redemption Value – Net Proceeds] Number of Preference share issue } [Redemption Value + Net Proceeds] 2
{
Where, Net Proceeds = Market Price of Preference Share * (1-Floatation Cost)
Equity Valuation
All discount valuation models estimate the current economic value of any security as the sum of the discounted (present) value of all promised future cash flows. The current value is therefore a function of the timing, magnitude and riskiness of all future cash flows:
Cash Flown Cash Flow1 Cash Flow2 V0 ... 1 2 (1 k ) (1 k ) (1 k ) n n
i 1
Cash Flowi (1 k )i
In the case of common stock the cash flows of a going-concern business are expected to go on in perpetuity (forever).
Cash Flow Cash Flow1 Cash Flow2 V0 ... 1 2 (1 k ) (1 k ) (1 k )
Cash Flowi (1 k )i i 1 The purchaser exchanges the price she/he paid for the investment at time O with a possible series of future cash flows. Risk is factored into the equation through k (investor’s required return)
Cash Flow Cash Flow1 Cash Flow2 V0 ... 1 2 (1 k ) (1 k ) (1 k )
i 1
Cash Flowi (1 k )i
Remember, the amount and timing of future dividends (if that is the cash flow you are using) is highly uncertain for most businesses because dividends are not fixed obligation of the firm, but rather are declared at the discretion of the board of directors, when, and if the firm is profitable, and doesn’t have other uses for the cash.
The DDM says the intrinsic value or inherent economic worth of the stock is equal to the sum of the present value of all future dividends to be received. [ 7-4]
Dn D1 D2 P0 ... 1 2 (1 k e ) (1 ke) (1 k e ) n
Security analysts that use the DDM model are called FUNDAMENTAL ANALYSTS because they base the estimate of inherent worth on the economic fundamentals of the stock. D Dt D1 D2 P0 ... 1 2 t (1 k e ) (1 k e ) (1 k e ) ( 1 k ) t 1 e
Once they have estimated the inherent worth, they compare their estimate with the actual stock price in the market to determine whether the stock is UNDER, OVER, or FAIRLY valued.
When the firm’s dividends are growing at a slow, constant rate, and reasonably can be expected to do so for the foreseeable future, we use the constant growth dividend discount model. [ 7-6]
D0 (1 g )1 D0 (1 g ) 2 D0 (1 g ) P0 ... 1 2 (1 k e ) (1 k e ) (1 k e )
Which can be simplified by multiplying D0 by a factor of (1+g)/(1+kc) every period to get:
D0 (1 g ) D1 P0 ke g ke g
The Constant Growth DDM can be reorganized to solve for the investor’s required return
[ 7-8]
D1 ke g P0
This formula can be decomposed into two components, demonstrating that equity investors receive two forms of prospective income from their investment, dividends and capital gains.
D kc 1 g Current Dividend Yield Capital Gain Yield P0
Assuming the firm has no profitable growth opportunities g should be equal to 0, and D1=EPS1 Or RoE = Ke resulting in 100% Payout.
The Constant Growth DDM reduces to:
P0
EPS 1 ke
Therefore, the share price of any constant growth common stock is made up of two components: ▪ The no-growth components or ROE = Ke and ▪ The present value of growth opportunities This can be expressed as:
[ 7-10]
P0
EPS1 PVGO kc
no growth component present value of growth opportunit ies
Decomposing the constant-growth DDM into its two components gives us an analytical tool to examine the two sources of current value of the firm.
[ 7-7]
D1 P0 kc g
The formula assumes that the growth rate will remain the same in period 1 through infinity. ▪ This is a very long period of time ▪ Because of compounding over time, small changes in g will have dramatic effects on the estimated stock value today. ▪ If g is assumed to be greater than kc a non-sense answer would result. In practice this could never happen because no company can continue to grow at compound rates of return to infinity at a rate that exceeds the long-term rate of growth in the economy.
D1 P0 ke g The formula predicts stock price increases if: ▪ D1 is increased ▪ g is increased ▪ Ke is decreased
Conversely, the formula predicts stock price increases if: ▪ D1 is decreased ▪ g is decreased ▪ Ke is increased
Sustainable growth can be estimated using the following equation:
g b ROE
[ 7-11]
Where: b
= the firm’s earnings retention ratio = (1 – firm’s dividend payout ratio)
and
ROE = firm’s return on common equity = net profit/common equity Clearly, the value of the firm will rise if the firm retains and reinvests its profits at a rate of return (ROE) greater than kc Under such conditions, g increases more than kc
[ 7-11]
[ 7-12]
g b ROE
Net income Sales Total Assets ROE Sales Total Assets Equity Net Profit Margin Turnover Ratio Leverage Ratio Decomposing ROE using the DuPont system allows managers to see how they can increase the value of the firm: ▪ increase the profit margin on sales ▪ Increase the turnover rate on sales ▪ Leverage the firm using less equity and more debt (although use of more debt implies higher risk and the benefits may be offset by a higher kc)
Firms with earnings that are growing rapidly (more rapid than the general rate of economic expansion) require another approach. Remember, no firm’s growth in earnings can exceed the general rate of economic expansion forever…at some point, earnings growth will fall.
Earnings g3= g4= gα=4% g2= 30%
g1= 50%
Time
g1 g 2 g 3 g 4 g 5 ... g
Predict each dividend during the high growth years. Predict the first dividend during the constant growth years. Discount the individual dividends to the present and sum together with the price at time t when the constant growth model is used. The following is the formula you would use for two years of high earnings growth followed by a constant growth in years three through infinity.
D0 (1 g1 )(1 g 2 )(1 g 3 ) D (1 g1 ) D0 (1 g1 )(1 g 2 ) ke g P0 0 (1 k e )1 (1 k e ) 2 (1 k e ) 2
D1 D2 P2 (1 k e )1 (1 k e ) 2 (1 k e ) 2
D1 D2 P2 Forecast Assumptions: P0 2 (1 kc ) (1 kc ) (1 kc ) Investor’s required return = k = 10.9% $0.25(1.148)(1.1)(1.05) Most recent dividend per share = D0 = $0.25 $0.25(1.148) $0.25(1.148)(1.1) Growth rate in first year = g1 =14.8% .109 .05 1 2 (1 .109) (1 .109) (1 .109) 2 Growth rate in second year= g2 = 10% Growth rate in years three through infinity = g3-α = 5% $0.29 $0.32 $5.62
Time 1 2 2
(1.109)
(1.109) 2
(1.109) 2
$5.08
Present Dividend / Price Dividend Value Present Calculation /Price Factor Value $0.25 X (1+.148) = $0.29 0.901713 $0.26 $0.287 X (1+.1) = $0.32 0.813087 $0.26 P(2) = D(3)/ (.109 - .05) = $5.62 0.813087 $4.57 Intrinsic Value Estimate = $5.08
[ 7-7]
D1 P0  kc ď€ g
The Model predictions are highly sensitive to changes in g and kc Not helpful in valuing non-dividend paying firms.
Use of the Model is best suited to:  Firms that pay dividends based on a stable dividend
payout history that are likely to maintain that practice into the future.  Are growing at a steady and sustainable rate.
This model works for large corporations in mature industries such as banks and utility companies.
H-Model developed by Fuller & Hsia (1984). It is also an extension of Two-Stage Model. In this model, growth begins at a High rate and declines linearly throughout Supernormal growth period until it reaches a normal rate at the end. V0
D 0(1 GL ) D 0( H )(Gs GL ) (r G L ) ( r GL )
Where, r = required rate of return on equity. H=Half-Life in years of high-growth period. Gs = Initial Short Term dividend growth rate. GL = Normal Long-Term dividend growth rate afterYear 2H.
Siemens A.G(Frankfurt :SIE) has current dividend of Є1.00. Dividend Growth rate is 29.28%, declining linearly over a 16 year period to a final and Perpetual growth rate of 7.26%. Rf is 5.34% and Beta of Company against DAX is 1.37.
Using CAPM to find out Required rate of return i.e 12.63%.
Use H – Model to value Per share estimate:
V0
1.00(1.0726) 1.00(8)(0.29.28 0.0726) (0.1263 0.0726) (0.1263 0.0726) 52.77
Equity Valuation
Relative valuation approaches estimate the value of common shares by comparing market prices of similar companies, relative to some variable such as:
Earnings EBITDA Cash flow Book value Sales
The challenge is finding the right comparable!!
Also known as the price-earnings multiple. The ratio tells you how many times projected annual earnings (per share) the share is currently trading
P0 Estimated EPS1 Justified P/E ratio [ 7-13]
EPS1
P0 E1
If you buy a company that is trading 10 times projected earnings, it will take 10 years of those earnings to recover your investment.
If you buy a company trading 100 times projected earnings, it will take 100 years of those earnings to simply recover your investment (not including any time value of money or return on your investment).
Given the constant growth DDM P0
D1 ke g
Divide both sides by expected earnings per share.
Notice that D1/EPS1 is the expected dividend payout ratio at time 1.
The following equation indicates: The higher the expected payout ratio, the higher the P/E The higher the expected growth rate, g, the higher the P/E The higher the required rate of return, Ke the lower the P/E
P0 EPS 1
D1 EPS 1 P E ke g
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P/Es are uninformative when companies have negative (or very small) earnings The volatility in earnings creates great volatility in P/Es throughout the business cycle. Given the foregoing problems, analysts normally use smoothed or Normalized estimates of earnings for the forecast year, as well as using a variety of different approaches to develop a range of potential values for the stock.
P/E Ratios in the Paper and Forest Products Sector
Large number of firms with negative earnings
Company
Price
2006 EPS
Forecast EPS
P/E
Abitibi 2.72 Canfor 11.13 Cascades 11.54 Canfor Pulp 11.56 Catalyst 3.22 Fraser Papers 7.01 International 6.6 Mercer 9.69 Norbord 8.41 PRT 11.2 SFK Pulp 4.14 Tembec 1.43 TimberWest Forest 14.07 West Fraser Timber37.45
-0.30 -0.27 0.71 1.38 -0.07 -1.35 0.26 -0.07 0.74 0.69 0.64 -2.00 0.01 0.94
0.12 0.47 0.60 1.20 0.03 -0.41 0.53 0.14 0.40 0.70 0.82 -1.11 -0.27 2.35
nm nm 16.25 8.38 nm nm 25.38 nm 10.24 16.23 6.47 nm nm 39.84
Note: nm = not meaningful Source: RBC Dominion Securities Inc., September 2006.
P/E TSX Forecast Symbol 22.67 23.68 19.23 9.63 nm nm 12.45 54.35 18.95 16.00 5.05 nm nm 15.94
A CFP CAS CFX.UN CTL FPS IFPA MERC NBD PRT.UN SFK.UN TBC TWF.UN WFT
Price-to-Book Value (P/BV) ratio Price-to-sales (P/S) ratio Price-to-cash-flow (P/CF) ratio Enterprise Value to EBIT ratio Enterprise Value to EBITDA ratio
P / BV ratio
Market Price per Share Book Value per Share
Multiply justifiable P/BV ratio times the firm’s book value per share to get an estimate of intrinsic value.
Advantages Book values provide a relatively stable, intuitive measure of value relative to
market values. Eliminates problems associated with P/E multiples because book values are rarely negative and are not volatile.
Disadvantages Book values may be sensitive to accounting standards. Book values may be uninformative for companies with few fixed assets.
Multiply justifiable P/S ratio times the firm’s sales per share to get an estimate of intrinsic value Advantages
Sales are relatively insensitive to accounting decisions and are never
negative Sales are not as volatile as earnings Sales provide useful information about corporate decisions such as product pricing
Disadvantages Sales do not provide information about expenses and profit margins
which are key determinants of corporate performance.
Cash Flow is estimated as Net Income + Depreciation and Amortization + Deferred Taxes.
Multiply justifiable P/CF ratio times the firm’s cash flow per share to get an estimate of intrinsic value.
Advantages Reduces accounting concerns regarding earnings measurement
Multiply justifiable ratio times the firm’s forecast EBIT or EBITDA per share to get an estimate of intrinsic value.
Use Market Value of both Debt and Equity reflecting the fact that EBIT or EBITDA represents income available to satisfy the claims of both debt and equity holders.
Advantages Using EBIT and EBITDA instead of net income eliminates volatility
caused by EPS
Sales Volume Unit price $10 Variable costs Fixed cash costs EBITDA Depreciation EBIT Interest EBT Income Tax @ 50 percent Net Income Dividends Book value of equity Book value of debt
1 million units $10 million 5.0 1.7 3.3 0.8 2.5 0.5 2.0 1.0 1.0 0.5 5.0 5.0
EBITDA ratio
Debt MVEquity Cash EBITDA
EV 3.3
EBIT
MV
EV 2.5
ratio
MV
Debt MVEquity Cash EBIT
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Use of comparative multiples is a popular approach to valuing stock Despite apparent simplicity of generating the ratios, consideration of the accounting, volatility and other issues affecting the usefulness of these approaches.
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Can we use Relative Valuation Techniques in DCF to find out the Cost of Equity & Subsequently Price per share???
Retained Earnings / Reserves & Surplus / Internal Equity. Is it the same as Cost of Equity?? Kre = Ke Can also be determined through Bond –Yield plus Risk Premium Approach. Cost of Retained Earning < Cost of External Equity.
Ke1 = Kre (1-f)