EQUITY VALUATION

Claims on Cash Flows of Firm

Investors forego consumption and invest expecting future returns

Risk is associated with the investmentInvestors are differ in their Risk/return

tolerancePriority on claims to cash flows in the

case of bankruptcy

Claims in Bankruptcy

1. Administrative expenses related to bankruptcy

2. Expenses after filing and before assignment of Trusted

3. Wages, Salaries, Commissions4. Contribution to employee benefit plan5. Consumer claim6. Government Tax claims7. Payment to unsecured creditors8. Payment to preferred stock holders9. Payment to common stock holders

Scope of Equity Valuation Valuation is the estimation of an asset’s

value. Equity valuation can be used in a number of

ways Stock Selection Inferring market expectation Evaluation of corporate events Evaluating business strategies and models Appraising private business

Valuation Process Understanding the business Forecasting Performance Selecting Valuation model

Understanding Business

Industry size and growth potential Recent development in industry Overall supply demand balance Qualitative factors including legal and

regulatory

Valuation Methods

Valuation by ComparisonDividend Discount ModelConstant Growth Dividend Discount

ModelLife Cycles and Multistage Growth

ModelsPrice-Earnings RatioFree Cash Flow Valuation

Valuation by ComparisonValue of the firm is estimated by

comparing some elements of the financial statements of the company with other firms in the same industryPrice to Earnings (P/E ratio)Price to Book ValuePrice to SalesPrice/Cash Flow

Book Value uses historical numbers and includes depreciation

Liquidation ValueReplacement costTobin q = Market Value/Replacement cost (mainly

of interest to economists)

Dividend Discount Model

Assume one year holding periodLet P1 be value at end of

investment horizonLet D1 be Dividend P0 = (D1 + P1)/(1+k)k = Market Capitalization RateP1 = (D2 + P2)/(1+k)P0 = D1/(1+k) + (D1 + P1)/(1+k)2 If we assume constant dividendP0 = D/(1+k)+D/(1+k)2 + …. = D/k

Constant-Growth DDM

Assume dividend grows at constant rate of g

P0 = D/(1+k) + D(1+g)/(1+k)2 +

D(1+g)2/(1+k)3 + …. P0 = D/(1+k) [ 1+(1+g)/(1+k) +

(1+g)2/(1+k)2 + …. P0 = D/(k-g) Life Cycle and Multi-Stage Growth

Model

Investment Opportunities Investment opportunities with returns

higher than market capitalization rates create value

Such opportunities can be funded using retained earnings

Company ABC, fully equity funded $100 MM3,000,000 Shares15% ROE12.5% Market Capitalization Rate

Dividend/Share = $100 MM * 15%/3,000,000 = $5

Share value based on DDM = $5/12.5% = $40

Project with 15% Return Fund project internally

Earnings Retention Ratio 60% (Plowback Ratio)Dividend Payout Ratio 40%

New Dividend = Capital * 15% * 40%/3MMEarning growth rate 15% * 60% = 9%Earning/Share after n period$100MM *(1+9%)n * 15% * 40% /3MM=

$2*(1+9%)n Share Price = $6/(12.5% - 9%) = $57.17Price = No Growth Value /Share + PVOG (PV of growth opportunities) $57.17 = $40 +

$17.17

P/E Ratio

P/E = Price-earnings multiple a common way to value a stock as the multiple of its earnings

Earnings is challenging to forecast as it depends on macro-economics, business cycle, industry,…

P/E varies over time and across industriesPrice = No Growth Value /Share + PVOG P= E/k + PVOG → P/E=1/k[1+(PVOG/E/k)]P/E increases as growth opportunities of

the company increase

P/E Ratio InterpretationConsider a company with

Earning = EMarket Capitalization Rate = kEarning Retention Ratio = bDividend Payout Ratio = 1- b

P/E = (1-b)/( k – ROE * b)Riskier stocks should have higher k hence

lower P/ECompanies with higher growth opportunities

(ROE) will have higher P/EHigher plowback increases P/E only if ROE > kP/E proxy for Earnings Growth

Ratio Analysis

P/E is based on accounting earnings that is impacted byDepreciation methodInflationEarning managementPro Forma reportingBusiness Cycle

Other Ratios Price-to-BookPrice-to-Cash-FlowPrice-to-Sales…….

Free Cash Flow Variation

Consider a company withEBIT= Earnings before interest and taxesT = Corporate Tax RateNWC = Net Working CapitalFCFF= Free Cash Flow to Firm

FCFF = EBIT (1-T) + Depreciation – Capital Expenditure – Increase in NWC

Firm Value = FCFF/(WACC –g)P = Firm Value – Market Value of DebtAlternatively P = FCFF/(kE –g)kE = cost of equity