Equity Valuation June 2009
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Transcript of Equity Valuation June 2009
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Equity Valuation.
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INTRODUCTION TO
SECURITY VALUATION
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2 Approaches of Valuation
Absolute MethodDiscounted Cash flowMethodDDM, Free Cash flow and RI
MethodRelative Valuation-Market Based
Approach PE, P/BV, P/Sales and P/Cash
flow
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Cash Flow Definitions
Dividend
Free Cash Flows
Residual Income
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Compare and contrast dividends , freecash flow and RI as measures of
cashbook in DCF valuation and identifythe investment scenario for which eachmeasure is suitable
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Dividends
In stock valuation there are 3 predominant definitionsof future cash flowDividends : DDM model Defines cash flow as thedividends to be received by the shareholdersPrimary Advantage of using dividends as thedefinition of cash flow is thats its theoretically
justifiedShareholders Investment today is worth the PV ofexpected dividends
Another advantage of using dividend as a measure ofcash flow is that dividends are not volatile andreflects long term earning potential of the company
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Dividends
Disadvantage: This method of valuation isdifficult to use for companies which do notpay dividends
DDM takes the perspective of an investorwhich takes a minority stake in the firm andcannot control the dividend policy
If the dividend policy is not related to thefirms ability to create value then dividendsare not appropriate measure of expectedfuture cash flow to shareholders
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Appropriateness of DDM
The company has a history of dividends
Dividend policy is clear and related to
earnings of the firmPerspective of valuation is that ofminority shareholders
2007 2006 2005 2004 2003
EPS $7.50 $6.25 $5.85 $5.40 $50
DPS $1.25 $1.25 $1.25 $1.25 $1.25
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Free Cash method of DCF
Free cash flow to equity FCFE is defined asthe cash flow generated by the firms
operation into that is in excess of capitalrequirement to sustain the firms productivecapacity
FCFE is the cash available to stockholders
after funding capital requirement andexpenses associated with debt financing
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Advantage of Free cash flwomethod
Can be applied to many firmsregardless of dividend policy or capital
structureThe ability to influence the distributionand application of a firms free cash flowmakes these models more pertinent to
a firms controlling shareholders
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Free cash flow -Disadvantages
Firms that have significant capitalrequirement may have negative free
cash flow for many year
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Appropriateness of Free Cashflow method
For Firms that do not have a dividendpayment history
Valuation perspective is that of aninvestor
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Residual Income
Residual; Income is the amount of earningsduring the period that exceeds investorsexpectations
The theoretical basis for this approach is thatthe required return is the opportunity to thesuppliers of credit and the residual income is
the amount that the firm is able to generatein excess of return
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Advantage and Disadvantage
Can be applied to firms with negative cashflow
Can also be used for dividend and nondividend paying company
Disadvantage : requires in dept analysis offirms accounting accruals
Management discretion in establishingaccruals for both income and expenses mayobscure true accounting results
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Appropriateness
Firms that do not have Dividend history
Firms that have negative cash flow
Firms with transparent financialreporting and high quality earning
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14.
Top Down Approach to EquityValuation.
Various Forms of ReturnsCommon Stock Valuation
Multiple Period Discounting
Single period discountingValuation of a company experiencingtemporary supernormal growth.
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Security Valuation.
Security Evaluation is important todecide on the portfolio of an investor.
Investors buy under-priced securitiesand sell the over-priced ones.
The value of a share is a function of the
companys dividend paying capacity orits earnings capacity.
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Factors influencing Valuation
Regular dividends or interest
Capital gains or loss.
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DDM-Dividend Discounting Model
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h) Explain the concept of Investors requiredrate of return, Expected return and RP
Required rate of return on an equity isdependent upon 3 factors
RFR real IP and RPRequired rate of Return =(1+RFR real) (1+ IP) (1+ RP)1RFRreal + IP = RFRnominal
Therefore, K = RFRnominal + Risk Premium
According to CAPM
E = RFR + Beta ( R mkt RFR)
RFR is nominal
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i) Risk factors associated in determining a countryrisk Premium
Business Risk
Financial Risk
Liquidity
Exchange Rate Risk
Political Risk
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Estimate the Dividend growth, givenROE and RR
G=ROE*(1-payout)
Roe=10% on equity of 100
Payout=40% of earning
RR=60%
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Profit Margin ROE
ROE Growth
Growth Diff Between Ke & G
Lower Ke-g Price
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The value of a security is equal to the present value of thebenefits associated with it.
V=C1/(1+K)+C2/(1+K)^2+Cn/(1+n)^n
V: Value of Security
C: Cash Flows.K : Discounting Factors.
d) Single period discounting model
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Gordon Growth Model
GGM assumes that dividends increaseat a constant rate indefinitely
Model Assumes the firm to pay DividendD1 in year one
Dividend grow indefinitely at a constantrate
Growth rate is less than required rate ofreturn
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Constant growth Model
Price = D1/Ke-G
Ke = RFR +Beta (RmktRFR).
G = (1-payout) * ROE
P = D0(1+G)
KE -G
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Strengths and weakness of GGM
Strength: Applicable to mature and dividendpaying firms
Appropriate for valuing market index
Straight forward and easy to explainCan supplement other valuation modelsWeakness: Valuation sensitive to G and RCannot be applied to non dividend paying
companiesUnpredictable growth patter of some firmswould make using the model difficult
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GGM ModelConstant Growth InDividend Assumption
Part I PV of dividend in normal growth
Part II : PV of the price in the normal
growth after normal growth.Part I: D1Dn/ Discounting factor
Part II :Price of the stock (D1/Ke - G ) / discounting factor
Value of Stock is Part I + Part II
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High-growth phase (assuming a growth rateof 9% for first five years and 6% for theremaining period for illustration purposes):
DPS = $1.30 growth phase (assuming fiveyears for illustration purposes):
Ks = = 12.39%
g = 9%
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DPS(1) = $1.30 * 1.09 = $1.42DPS(2) = $1.42 * 1.09 = $1.54DPS(3) = $1.54 * 1.09 = $1.68DPS(4) = $1.68 * 1.09 = $1.84DPS(5) = $1.84 * 1.09 = $2.00now, we must discount the dividends by theappropriate rate todetermine their present value.$1.42 / (1.1239) = $1.26
$1.54 / (1.1239)2 = $1.22$1.68 / (1.1239)3 = $1.19$1.84 / (1.1239)4 = $1.15$2.00 / (1.1239)5 = $1.12
We add up the present value for the dividends during the high-growth stage and get $5.94.
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Next, we value the stable growth period:DPS = $2.00 (1.06) = $2.12Ks = 12.80%g = 6%
$2.12 / (.1239-0.06) = $31.18Next, we must calculate the present value of the dividends.$31.18 / (1.1239)5 = $17.39When calculating the present value of the dividends of thestable growth period, we use the same required rate of returnas the high-growth phase and raise it to the fifth power for afive-year example like the one above.Adding the two values, we get: $17.39 + $5.94 = $23.33
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Multi stage Model
2 Stage
H-Model
3-Stage
Spreadsheet Model
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Multistage Model
For Most companies GGM Assumesdividend growth that continues foe
perpetuity is unrealisticTherefore we need more realisticmultistage growth models to estimate
values of companies with several stagesin future growth
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Imp Points for Multistage ModelMS
Forecast Dividend and discount themback to PV
Over the long run growth rate tends torevert to the long run average growth
rate which is typically equal to GDPgrowth rate
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Two Stage Model
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2 Stage Model
Yrs
G
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H Model
The Problem with 2 stage model is that is itusually unrealistic to assume that a stock willexperience high growth for a short period andthen immediately fall to a long run average
H model uses a more realistic approach, thegrowth starts out high, then declines linearly
over the high growth period until it reachesthe long run average
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H-Model
Yrs
G
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3-Stage Model
More Appropriate for Firms that areexpected to have 3 Distinct Stages of
Growth
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3-Stage Model
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Growth
Initial Growth Transition Maturity
Earnings Growth High
Above Avg, but
falling Stable
Capital
Investment High Decreasing Stable
Profit Margin High
Above Avg, but
falling Stable
FCFE Negative Maybe be + Stable
ROEV/s R ROE>R ROE approaching r ROE=r
Dividend Payout Low Increasing Stable
Model Three Stage Two Stage GGM Constant growth
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Justified leading andtrailing P/E based on GGM
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Justified Leading P/PE
P/E0 = (D1/E0)/Ke-G
Trailing P/E P/E1= (D1/E1)/Ke-G
P t V l f G th
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Present Value of GrowthOpportunity
A firm that has an additional opportunity toearn extra return which is in excess of therequired rate of return would benefit fromretained earnings and invest those in growthopportunities rather than paying out asdividend
V0= (E/R) +PVGO. E= No growth earning.R= Required rate of return
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Estimation of Terminal Value
No matter which Model we are using forvaluation , we have to calculate a
terminal Value at some point in futureThere are two approaches of doing this
USE GGM model
USE Market Based approach
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Valuation Using a 2-Stage Model
H Model
V0=
D0*(1-GL) + D0*H*(Gs-GL)
R-Gl R-Gl
GL= Growth In long term
Gs= Growth in short term
H=T/2, Half line of High Growth Period
V0= Value of Stock
R = Required Rate of Return
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Estimated Terminal Value
As per GGM
Terminal Value in year 10=D11/Ke-G
As per Market Based approach
Terminal Value in year 10=
Justified P/e *EPS estimated
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Forecasting EPS
Market Share to Profit marginratio
EPS= S*M*C/ Number of shares.S: Estimated Industry sales.
M: Estimated Market Share
C: Net profit Margin
Financial Statement ApproachEPS= PAT -Preference Dividend/Number of Shares
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Current Market Price=18.00
Last Year Earnings = 2.00
ROE=10% expect it to stay that way for foreseeable
future
Dividend payout=40%
RFR=7%
Expected market Return=12%
Beta =1.2
Is the stock over Priced or under priced
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First Determine k= RFR+B(Excess Return )=13%
Determine G=RR*ROE=0.6*0.10=6%
RR =1-.04=0.6
Determine Dividend
Last Year Div=2*0.40=0.80
Next Year Div =D0(1+g)=0.80+(1+0.06)=0.85
Value =D1/Ke-g=0.85/13-0.06=12.14
Compare stock Value to its current Market PriceEstimated Value >market price Buy
Estimated Value
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I. Growth companies are one whose management has the ability toconsistently select investments which earn higher returns than required bytheir risk. A growth stock is one that earns higher return than other stocksof equivalent risk
II.A defensive company is a company that has an earning that are
relatively insensitive to downturns in the economy eg utility companiesand retail grocery are good examples of defensive companies. A defensivestock is a stock that will not decline as much as the market when theoverall market return declines. The returns of defensive have lowcorrelation with the market returns
III. Speculative company is a company that has an asset that are veryrisky, but the assets have the potential to generate very large earnings,example diamond mining, oil exploration, etc. A speculative stock is astock that is highly likely to have very low or negative returns because it isalmost overpriced. These stocks have a low probability of a return nearthat of market but a slight possibility of enormous returns.
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Introduction to price multiple
PE
Price to Book value
Price to salesPrice to cash flow
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Rationales for using PE
Earning power as measured by EPS is theprimary determinants of investment value
PE ratio is popular in the Investmentcommunity
Disadvantages of PE: earnings can benegative, volatile, transitionary period of
earnings makes interpretation of PE ratiodifficult
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2 versions of PE
Trailing PE
Leading PE
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Price to Book value
Advantages:
- BV is a cumulative amount that is usually
positive even when EPS is negative- It can be used of valuing which are going
out of the business
- BV is more stable than EPS, so it may bemore useful than PE when EPS is too high,low or volatile
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Price to Book value
Disadvantages
-it does not recognize the value of non physical assets such as
human capital-IT can be misleading when there are significant differences in the
amount of the assets used by the firms being compared
-Different accounting conventions can obscure the true investmentin the firm made by the shareholders
-Inflation and technological changes can cause the book andmarket value of assets to differ significantly
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Price to sales ratio
Advantages:
-the ratio is meaningful for even for
distressed firms-sales figures are not easy to manipulate
or distort as EPS or book value
-It is not volatile as price earning ratio
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Price to sales ratio
Disadvantages
-High sales do not necessarily indicateoperating profits as measured by earningsand cashflow
-It is not able to capture differences in the coststructure of different firms
-while less subject to distortion, revenuerecognition practices can distort sales figures
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Price to Cash flow
Advantages
-cash flow is hard to manipulate
-more stable that PE-Less management discretion in cash flow
than in reported earnings
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Price to Cash flow
Disadvantages
-FCF should be used instead of cash flow.
However again FCF is subject tomanipulation.
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Free Cash Valuation
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Free Cash Flow
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FCFF
NI +Interest (1-T)+NCC-Fcap invWCAP invEBIT * (1-T)+ DepFcap Inv- Wcap
InvEBIDTA *(1-t) +Dep*TFcap InvWcap Inv
CFO+ Int (1-t)-Fcap Inv*Fcap = Changes in Fixed Capital Investments in a year*Wcap Inv= Changes in working capital Investment in a year
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FCFE
FCFE=FCFFInt(1-T)+Net Borrowing
FCFE=NI+NCC-Fcap InvWcap Inv
+Net BorrowingFCFE=CFO-Fcap Inv +Net Borrowing
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Discount Rate
Use WACC for Discounting FCFF
Use Required Rate of Return for FCFE
Valuation Using Free Cash flow
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Valuation Using Free Cash flowMethod
Single stage Model
Valuation Using Free Cash flow
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Valuation Using Free Cash flowMethod
Two Stage Model
Three Stage Model