Lecture 7 Equity Valuation
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Transcript of Lecture 7 Equity Valuation
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Business Valuation:
Equity Valuation
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Fundamental Stock Analysis:
Models of Equity Valuation Basic Types of Models
Balance Sheet Models
Dividend Discount Models
Price/Earning Ratios
Estimating Growth Rates and Opportunities
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Type of Equity Capital
Type of sharecapital
Security or votingright
Income Amount of capital
Ordinary shares
Have voting rightsin AGM.Rank after all
payables and
preference shares
in rights to assets
on liquidation
Dividends payablesat the discretion ofthe directors out of
undistributedprofits remaining
after senior claims
have been met.
Amounts availablefor dividends but
not paid out areretained in thecompany on behalf
of the ordinary
shareholders.
The right to allsurplus funds after
prior claims have
been met.
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Type of Equity Capital
Type of sharecapital
Security or votingright
Income Amount of capital
Non-cumulative
preference shares
Likely to have
some voting rights
at all times ratherthan in specified
circumstances as in
the case ofcumulative.
Rank as cumulative
in liquidation
A fixed amount per
year, as above.
Arrears do not
accumulate
A fixed amount per
share
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Balance Sheet Models
A common valuation measure is book value, whichis the net worth of a company as shown on thebalance sheet.
Book value cannot be a floor for the stock pricebecause there are always some firms selling theirstock below the book value.
A better measure is the firms liquidation value per
share. It is the amount that can be realized by selling the
assets of a firm and paying off the debt.
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Intrinsic Value and Market Price
Intrinsic Value
Self assigned Value
Variety of models are used for estimation
Market Price
Consensus value of all potential traders
Trading Signal
IV > MP Buy
IV < MP Sell or Short Sell
IV = MP Hold or Fairly Priced
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Intrinsic Value and Market Price
The return on a stock comprises cash dividends and capitalgain/losses
Example:
ABC stocks expected dividend per share (D1) is $4. Current price
(P0) is $48. Expected price at the end of year (P1) is $52
%7.16)r(E
48$
)48$52($4$)r(E
P
)PP(D)r(E
0
011
!
!
!
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Intrinsic Value and Market Price
According to CAPM, in equilibrium, if a stock ispriced correctly, its E(r) will equal the requiredreturn (k)
Assume Krf= 6%, (Km Krf) = 5% and = 1.20
%12K
%)`5(20.1%6K
!
!
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VD
k
o
t
tt
!!
g
( )11
V0 = Value of Stock
Dt = Dividend
k = required return
Dividend Discount Models:
General Model
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No Growth Model
VD
k
o !
Stocks that have earnings and dividends that areexpected to remain constant
Example: Preferred Stock
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Features of Preferred Stock
A hybrid security with both debt and equitycharacteristics.
Has priority over common stock in receipt ofdividends and in liquidation.
Dividends are fixed as a percentage of parvalue.
Only participating preferred stock (which israre) shares in the residual income with thecommon stockholders.
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Valuing Preferred Stock
V0 = Value of Preferred Stock
= PV ofALL dividends discounted at
investors Required Rate of Return
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
s 42 29 QuakerOats OAT 1.14 3.3 24 5067 35 34 34 -s 36 25 RJR Nabisco RN .08p ... 12 6263 29 285/8 287/8 -
237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23 ...
7 5 RJR Nab pfC .60 9.4 ... 2248 6 6 63/8 -1/8
0 1 2 3 g
V0=23.75 D1=2.31 D2=2.31 D3=2.31 Dg=2.31
237
/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235
/8 23 ...
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Valuing Preferred Stock
V0 = + + +2.31
(1+ kp)2.31
(1+ kp)2
2.31(1+ kp)
3 g
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
s 42 29 QuakerOats OAT 1.14 3.3 24 5067 35 34 34 -s 36 25 RJR Nabisco RN .08p ... 12 6263 29 285/8 287/8 -
237
/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235
/8 23 ...7 5 RJR Nab pfC .60 9.4 ... 2248 6 6 63/8 -1/8
0 1 2 3 g
V0=23.75 D1=2.31 D2=2.31 D3=2.31 Dg=2.31
237
/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235
/8 23 ...
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Valuing Preferred Stock
V0 =Dk
=2.31.10
= $23.10
V0 = + + +2.31
(1+ kp)2.31
(1+ kp )2
2.31(1+ kp )
3 g
52 Weeks Yld Vol Net Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
s 42 29 QuakerOats OAT 1.14 3.3 24 5067 35 34 34 -s 36 25 RJR Nabisco RN .08p ... 12 6263 29 285/8 287/8 -
237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23 ...
7 5 RJR Nab pfC .60 9.4 ... 2248 6 6 63/8 -1/8
0 1 2 3 g
V0=23. =2.31 D2=2.31 D3=2.31 Dg=2.31
237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23 ...
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VoD g
k g
o!
( )1
g = constant perpetual growth rate
Example: common stock
Constant Growth Model
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Characteristics of Common Stock
Dividends
Vary over time
Not guaranteed
Residual Claim
Voting Rights
Sometimes Preemptive Right to buy New
Stock
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Valuing Individual Shares of
Common StockV0 = PV ofALL expected dividends discounted at
investors Required Rate of Return
Not like Preferred Stock since D0 = D1 = D2 = D3 = DN ,therefore the cash flows are no longer an annuity.Not like Preferred Stock since D0 = D1 = D2 = D3 = DN ,therefore the cash flows are no longer an annuity.
V0 = + + +gD1
(1+ ks )D2
(1+ ks )2
D3(1+ ks )
3
D1 D2 D3V0 Dg
0 1 2 3 g
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Valuing Individual Shares of
Common StockV0 = PV ofALL expected dividends discounted at
investors Required Rate of Return
Investors donot know thevaluesofD1,D2,....,DN. Thefuture dividends mustbeestimated.
Investors donot know thevaluesofD1,D2,....,DN. Thefuture dividends mustbeestimated.
D1 D2 D3V0 Dg
0 1 2 3 g
V0 = + + +gD1
(1+ ks )D2
(1+ ks )2
D3(1+ ks )
3
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Constant Growth Model
Requires
ks> g
Requires
ks> g
Reducesto:
V0 = + + ++D0 (1+ g)(1+ ks )
D0 (1+ g)2
(1+ ks )2
D0 (1+ g)3
(1+ ks )3 g
V0 = =D0(1+g)ks g
D1ks g
Assumethat dividends growataconstantrate (g).
D1=
D0 (
1+g)D0
D2=
D0 (
1+g)
2 D3=
D0 (
1+g)
3 Dg=
D0 (
1+g)
g
0 1 2 3 g
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Simplification of the Algebra
)1()k1()g1(
)k1()g1(
k1g1V
)k1(
)g1(V
)k1(
)g1(V
3
3
2
2
00
1tt
t
00
1tt
t
0
0
!
!
!
g
!
g
!
.
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Simplification of the Algebra
00
2
2
00
D1g1
k1
)2(from)1(Subtract
)2(
)k1(
)g1(
k1
g11D
g1
k1
!
!
.
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Simplification of the Algebra
gk
)g1(D
)g1(D)gk(
rearrange
)3(Dg1
gk
D)g1(
)g1()k1(
)2(equationrearrange,gkAssume
0
0
00
00
00
!
!
!
!
"
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Constant Growth Model
P0 = = $30.501.14(1+.07)
.11 .07
What is the value of a share of common stock if themost recently paid dividend (D0) was $1.14 per share anddividends are expected to grow at a rate of 7%?Assume that you require a rate of return of 11%
on this investment.
P0 = =D0(1+g)ks g
D1ks g
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Constant Growth Model
The Jackson Corporation has a required rate ofreturn of 16% and its current dividend is $3 pershare. if the current price of Jacksons stock is $55
per share, what is the growth rate of its dividend?
%10g
g3$3$g55$8.8$
)g1(3$)g%16(55$)g%16
)g1(3$55$
gk
)g1(DPV 0
00
!
!
!
!
!!
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Constant Growth Model
The constant growth model is valid only wheng is less than k
The constant growth rate implies that a stock
value will be greater when: The expected dividend per share is larger
The market capitalization rate is lower
The expected growth rate of dividend is higher
The constant growth model assume that thestock price is expected to grow at the samerate as dividend.
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Constant Growth Model
Example: ABC stocks expected dividend per share (D1) is $4.
Suppose that the stock is selling at its intrinsic value of$57.14. so that V0 = P0. The k is 12%
If the dividend is expected to grow at 5%, price should alsoincrease by 5%
14.57$ofpricecurrentthethan
higher%5iswhich
60$%5%12
20.4$
gk
D
P
20.4$)05.1(4$D
2
1
2
!
!
!
!!
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Constant Growth Model
)g1(PP
g1
gk
DP
gk
)g1(D
gk
DP
01
1
1
12
1
!
!
!
!
If V0 = P0, then the expected rate of return equalsthe dividend yield plus the capital gain yield
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Stock Price and Investment
Opportunities No firm would grow in value if all earnings is
paid out as dividend (no earnings reinvestedin the firm)
A firm that retains or plowback some of itsearnings into highly profitable project canearn more rate of return to its shareholders.
A firm should reduce the dividend payoutratio to maintain a suitable plowback ratio (b).
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Life Cycle and Multistage Growth
Models In early year, payout ratios are low and
growth is correspondingly rapid.
In later years, the firm matures, so theydecide to increase the payout ratios. To valuecompanies with temporarily high growth,analysts use a multistage discount model
(Specified Holding Period Model)
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)1()1()1(
...2
2
1
1
0
k
PD
k
D
k
DV N
NN
!
PN = the expected sales price for the stock at time N
N = the specified number of years the stock isexpected to be held
Specified Holding Period Model
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Specified Holding Period Model: Example
1
ABC Company
Beta = 0.85, P0 = $32.50, Krf = 5%, g = 7%
Dividend 2005 = $1.25, Km Krf = 8%,
Year Dividend ($)2002 0.802003 0. 5200 1.10
2005 1.25
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Partitioning Value: Example 1
k = Krf+ (Km Krf)
= 5%+
0.85 (8%) = 11.8%
2001
V0 = ?
2002
$0.8
0
2003
$0.95
2004
$1.1
0
2005
$1.25
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Partitioning Value: Example 1
865.27$%8.4
3375.1$P
%7%8.11
%)71(25.1P
gk)g1(DP
gk
DP
2005
2005
20052005
2006
2005
!!
!
!
!
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Partitioning Value: Example 1
90.20V)8.111(
87.2725.1
)8.111(
10.1
)8.111(
95.0
)8.111(
80.0V
)k1()k1()k1()k1(V
2001
43212001
4
20052005
3
2004
2
2003
1
2002
2001
!
!
!
Since V0 = $20.90 is less than P0 = $32.50, thisstock is overvalued/overpriced. Overvalued stock isnot worth to buy.
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Partitioning Value: Example 2
Investors require a 20 percent per year returnon the stock of Happy Corporation. YesterdayHappy Corporation paid a dividend of $2
(dividend are paid annually). The dividend isexpected to grow 30 percent per year for thenext two years and at 8 percent per yearthereafter. Assume that the stock is currentlyselling at $24 per share, should the investorsbuy the stock?
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Partitioning Value: Example 2
In Example 1, the dividend for the respectiveyears have been given. In Example 2, weneed to determine the dividends for each
year first.D0 = $2 D1 D2 D3
D1 = 2 (1 + 30%) = 2.60
D2 = 2 (1 + 30%)2 = 3.38
D3 = 3.38 (1 + 8%) = 3.65
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Partitioning Value: Example 2
Then, we can calculate the V0 for the stock at the
required rate of return of 20%.
D0 = $2 D1 D2 D3+ P2
64.25V
)201(
42.3038.3)201(
60.2V
)k1()k1(V
0
20
2221
0
!
!
!
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Partitioning Value: Example 2
Since V0 = $25.64 is more than MP = $24,this stock is undervalued/underpriced.undervalued stock is worth to buy.
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Inflation and Equity Valuation
Inflation has an impact on equity valuations
Historical costs underestimate economiccosts
Empirical research shows that inflation hasan adverse effect on equity values
Research shows that real rates of return are lower
with high rates of inflation
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Potential Causes of Lower Equity
Values withInflation
Shocks cause expectation of lower earningsby market participants
Returns are viewed as being riskier withhigher rates of inflation
Real dividends are lower because of taxes