equity 8: Equity Valuation: Concepts and Basic Tools

What are the three possible conclusions when comparing estimated intrinsic value to market price?

• Undervalued - intrinsic value > market price.

• Fairly valued - intrinsic value = market price.

• Overvalued - intrinsic value < market price.

How do present value models estimate intrinsic value?

• Value is based on present value of future benefits.

• Future benefits are usually cash flows to equity holders.

• Models range from simple to highly complex.

• Examples include Gordon Growth Model and two-stage DDM.

• AKA (Discounted Cash Flow Models)

in dividend discount models (DDMs) and Free Cash Flow to Equity (FCFE), what are the “benefits” being valued?

Dividend Discount Models (DDM) use expected dividends.
Free Cash Flow to Equity (FCFE) uses cash after reinvestment needs.

What are multiplier models based on?

• Value is based on valuation multiples.

• Compares price to a fundamental variable.

• Multiples can use trailing or forward data.

• Consistency is required when comparing companies.

• Used heavily for relative valuation across firms.

what are common multiples used for multiple method?

• Common multiples include P/E and P/S ratios.

• P/E = price per share divided by earnings per share.

• P/S = price per share divided by sales per share.

What is the Enterprise Value (EV) Multiples model based on?

• EV measures total firm value available to all capital providers.

• Cash and short-term investments are subtracted from EV.

• Equity value is derived indirectly from EV.

• Subtract debt and preferred shares from EV to get equity value.

common EV multiples

EV/EBITDA and EV/Revenue.

How do asset-based valuation models estimate intrinsic value?

• Value is based on net asset value of the company.

• Equity value = assets - (liabilities + preferred shares)

• Asset values are often adjusted from book value.

• Book value reflects accounting values, not market values.

• theory assumes firm value equals sum of asset values.

What are the two sources of return from investing in equities?

1. Cash dividends

2. Capital gains (change in share price)

What is a cash dividend?

A dividend paid in cash to shareholders.

What are regular cash dividends?

Dividends paid at consistent, scheduled intervals

• quarterly in North America.

• Europe and Japan often pay semiannually.

• Some countries pay annually

What is an extra (special) dividend?

A non-regular or one-time dividend payment in addition to regular dividends.

In what situations are extra dividends commonly used?

• Cyclical industries

• Corporate restructuring situations

What is a stock dividend?

Distribution of additional shares instead of cash.

features of stock dividends?

• No change in total shareholder value.

• Ownership percentage remains unchanged.

• Only the number of shares increases.

• Stock dividends are irrelevant for valuation.

What is a stock split?

increase in number of shares with proportional decrease in price.

• value-neutral.

What is a reverse stock split?

Decrease in number of shares with proportional increase in price.

• value-neutral.

What is a share repurchase?

A company buys back its own shares using cash.

• They no longer receive dividends, vote, or count in EPS.

• same effect on shareholders wealth as cash dividends

Why do firms repurchase shares?

• Signal undervaluation

• Flexibility in payout timing

• Tax efficiency

• Offset dilution from stock options

Dividend Payment Chronology.

1. Declaration date.

• date the board of directors approves payment of a dividend,

• specify:

  • per-share dividend amount,

  • date shareholders must own the stock to receive the dividend (record date)

  • payment date

2. Ex-dividend date.

• First day a stock trades without the dividend.

• Buyers on or after this date do NOT receive it.

• one or two business days before the holder-of-record date,

3. Holder-of-record date (record date).

• Date when shareholders officially recorded as owners receive dividend rights.

4. Payment date

What typically happens to stock price on the ex-dividend date?

• buyers no longer receive dividend.

• Share price typically drops by dividend amount.

• Price adjustment reflects loss of upcoming cash flow.

What is the basic DDM formula conceptually?

$$V_0=\sum_{t}^{\infty}\frac{D_{t}}{\left(1+r_{}\right)^{t}}$$

• V₀ = value of a share of stock today, at t = 0

• D_t = expected dividend in year t, assumed to be paid at the end of the year

• r = required rate of return on the stock

terminal value of share formula

$$V_0=\sum_{t}^{n}\frac{D_{t}}{\left(1+r_{}\right)^{t}}+\frac{P_{n}}{\left(1+r\right)^{n}}$$

What is FCFE?

Cash flow available to common shareholders after capital needs and debt financing.

• reflects dividend-paying capacity, not just actual dividends.

FCFE formula?

FCFE = CFO - FCInv + Net borrowing  

CFO = Net income + non-cash expenses − investment in working capital

FCInv = Fixed capital investment

Valuation obtained by using FCFE

$$V_0=\sum_{t}^{\infty}\frac{FCFE_{t}}{\left(1+r_{}\right)^{t}}$$

• V₀ = value of a share of stock today, at t = 0

CAPM equation?

$$r=r_{f}+\beta\left(r_{m}-r_{f}\right)$$

= risk free rate + beta (market risk premium)

preferred stock value

$$V_0=\frac{D_0}{r}$$

estimated intrinsic value using the preferred stock’s par value, F

$$V_0=\sum_{t}^{n}\frac{D_{t}}{\left(1+r_{}\right)^{t}}+\frac{F}{\left(1+r\right)^{n}}$$

What problem does the Gordon Growth Model solve in DDM?

It avoids forecasting an infinite series of dividends by assuming constant growth.

Gordon Growth Model formula?

$$V_0=\frac{D_1}{r-g}$$

sustainable growth rate fomula

g = b × ROE  

• g = dividend growth rate

• b = earnings retention rate = (1 – Dividend payout ratio)

• ROE = return on equity

four key assumptions of Gordon model

1. Dividends are the correct metric to use for valuation purposes.

2. The dividend growth rate is forever: It is perpetual and never changes.

3. The required rate of return is also constant over time.

4. The dividend growth rate is strictly less than the required rate of return.

3 alternatives to gordon model

1. Use a more robust DDM that allows for varying patterns of growth.

2. Use a cash flow measure other than dividends for valuation purposes.

3. Use some other approach (such as a multiplier method) to valuation.

Multistage Dividend Growth Model

$$V_0=\sum_{}^{n}\frac{D_0\left(1+g_{s}\right)^{t}}{\left(1+r\right)^{t}}+\frac{V_{n}}{\left(1+r\right)^{n}}$$

$$V_{n}=\frac{D_{n+1}}{r-g_{L}}$$

$$D_{n+1}=D_0\left(1+g_{s}\right)^{n}\left(1+g_{l}\right)$$

g_L is the long-term or sustainable growth rate

s the short-term growth rate

What is a price multiple?

A ratio comparing a stock’s price to a financial measure (earnings, sales, cash flow, or book value).

Formula and meaning for Price-to-Earnings (P/E)?

P/E = price per share/ earnings per share

• How much investors pay per unit of earnings.

Formula and meaning for Price-to-Book (P/B)?

P/B = Price per share/ Book value per share

• Market value relative to accounting value of equity.

Formula and use for Price-to-Sales (P/S)?

P/S = price per share/ sales per share

• useful multiple for predicting future returns.

what is Price-to-Cash Flow (P/CF)?

P/CF = Price per share/ cash flow per share

• Operating cash flow (OCF)

• Free cash flow (FCF)

What is a trailing vs forward multiple?

trailing: uses historical data

forward: Uses forecasted future fundamentals.

What is the method of comparables?

Valuing a stock by comparing its multiples to peers.

Gordon growth valuation model

$$P_0=\frac{D_1}{r-g}$$

model for the justified forward P/E

$$\frac{P_0}{E_1}=\frac{\frac{D_1}{E_1}}{r-g}=\frac{p}{r-g}$$

What is the economic rationale behind comparables?

The law of one price: identical or similar assets should trade at similar values.

Main advantages of price multiples?

• Easy to calculate

• Widely available

• Good for relative valuation

• Useful for sector comparison

Main disadvantages of price multiples?

• May ignore future cash flows

• Not directly linked to intrinsic value

• Sensitive to accounting differences

• Can be distorted in cyclical industries

What type of companies is asset-based valuation best suited for?

• Tangible assets

• High current assets/liabilities

• Low intangible asset intensity

Advantages of discounted cash flow models:

• They are based on the fundamental concept of discounted present value and are well grounded in finance theory.

• They are widely accepted in the analyst community.

Disadvantages of discounted cash flow models

• Their inputs must be estimated.

• Value estimates are very sensitive to input values.

Advantages of comparable valuation using price multiples:

• Evidence that some price multiples are useful for predicting stock returns.

• Price multiples are widely used by analysts.

• Price multiples are readily available.

• They can be used in time series and cross-sectional comparisons.

• EV/EBITDA multiples are useful when comparing firm values independent of capital structure or when earnings are negative and the P/E ratio cannot be used.

Disadvantages of comparable valuation using price multiples:

• Lagging price multiples reflect the past.

• Price multiples may not be comparable across firms (size, products, and growth)

• cyclical firms may be greatly affected by economic conditions at a given point in time.

• A stock may appear overvalued by the comparable method but undervalued by a fundamental method or vice versa.

• Different accounting methods can result in price multiples that are not comparable

• A negative denominator in a price multiple results in a meaningless ratio. esp P/E

Advantages of price multiple valuations based on fundamentals:

• They are based on theoretically sound valuation models.

• They correspond to widely accepted value metrics.

Disadvantage of price multiple valuations based on fundamentals:

• Price multiples based on fundamentals will be very sensitive to the inputs (especially the r − g denominator).

Advantages of asset-based models:

• They can provide floor values.

• They are most reliable when the firm has primarily tangible short-term assets, assets with ready market values, or when the firm is being liquidated.

• They are increasingly useful for valuing public firms that report fair values.

Disadvantages of asset-based models:

• Market values are often difficult to obtain.

• Market values are usually different than book values.

• They are inaccurate when a firm has a high proportion of intangible assets or future cash flows not reflected in asset values.

• Assets can be difficult to value during periods of hyperinflation