EQUITY

VALUATION
Prof. Sudhakar Reddy
Approaches to the Valuation of
Common Stock
Two approaches have developed
1. Discounted cash-flow valuation
■ Present value of some measure of cash flow, including dividends, operating
cash flow, and free cash flow
2. Relative valuation technique
■ Value estimated based on its price relative to significant variables, such as
earnings, cash flow, book value, or sales
Approaches to the
Valuation of Common Stock
The discounted cash flow approaches are dependent on some
factors, namely:
• The rate of growth and the duration of growth of the cash
flows
• The estimate of the discount rate
 Why and When to Use the
Discounted Cash Flow Valuation
Approach
■ The measure of cash flow used
– Dividends
■ Cost of equity as the discount rate
– Operating cash flow
■ Weighted Average Cost of Capital (WACC)
– Free cash flow to equity
■ Cost of equity
■ Dependent on growth rates and discount rate
 Why and When to Use the
Relative Valuation Techniques

■ Provides information about how the market is currently valuing stocks

– aggregate market
– alternative industries
– individual stocks within industries
■ No guidance as to whether valuations are appropriate
– best used when have comparable entities
– aggregate market is not at a valuation extreme
Discounted Cash-Flow
Valuation Techniques

Where:
Vj = value of stock j
n = life of the asset
CFt = cash flow in period t
k = the discount rate that is equal to the investor’s
required rate of return for asset j, which is
determined by the uncertainty (risk) of the stock’s
cash flows
 Valuation Approaches
and Specific Techniques
Approaches to Equity Valuation

Discounted Cash Flow Relative Valuation

Techniques Techniques
• Present Value of Dividends (DDM) • Price/Earnings Ratio (PE)
•Present Value of Operating Cash Flow •Price/Cash flow ratio (P/CF)
•Present Value of Free Cash Flow •Price/Book Value Ratio (P/BV)
•Price/Sales Ratio (P/S)
Dividend Discount Models: General Model

V0 = Value of Stock
Dt = Dividend
k = required return
The Dividend Discount Model (DDM)
■ The DDM describes cash flows as dividends.
■ The basic argument for using this definition of cash flow is that an investor
who buys and holds a share of stock generally receives cash returns only in
the form of dividends.
■ In practice, analysts usually view investment value as driven by earnings.
■ This doesn’t mean that dividends ignore the earnings not distributed to the
shareholders. Reinvested earnings should provide the basis for increased
future dividends.
■ Therefore accounts for reinvested earnings when it takes future dividends
into consideration.
■ Dividends are less volatile than earnings and other return measures
■ DDM values reflect the long-run intrinsic value.
DDM is most suitable when:
■ The company is dividend paying (that is when we have a
dividend record of a company to analyze)
■ The board of directors has established a dividend policy that
bears an understandable and consistent relationship to the
company’s profitability

■ Example of Company A and B in the next slide – Company A not

suitable for DDM. Company B’s data is ideal to apply DDM.
 Company A Company B

Year EPS (INR) DPS (INR) Payout Ratio (%) EPS (INR) DPS (INR) Payout Ratio (%)

2020 3.02 1 32 1.86 0.6 32

2019 3.03 1 32 1.74 0.51 29

2018 3.94 1 25 1.51 0.42 28

2017 3.55 1 28 1.27 0.38 30

2016 1.77 1 56 1.04 0.37 36

2015 2.19 1 46 1.07 0.3 28

2014 2.55 1 39 1.03 0.28 27

2013 2.53 1 40 0.91 0.26 29

2012 2.41 1 41 0.78 0.23 29

2011 3.4 1 29 0.67 0.2 31

2010 2.56 1 39 0.68 0.21 29

2009 1.07 1 93 0.65 0.19 29

2008 0.71 1 141 0.61 0.18 30

2007 0.37 1 270 0.54 0.17 31

2006 1.75 1 57 0.41 0.16 39

The Dividend Discount Model (DDM)

If the stock is not held for an infinite period, a sale at the end of year 2 would
imply:
The Dividend Discount Model (DDM)

If the stock is not held for an infinite period, a sale at the end of year 2 would
imply:

Selling price at the end of year two is the value of all remaining dividend
payments, which is simply an extension of the original equation
The Dividend Discount Model (DDM)

Stocks with no dividends are expected to start paying dividends at some

point, say year three...

Where:
D1 = 0
D2 = 0
The Dividend Discount Model (DDM)
Infinite period model assumes a constant growth rate for
estimating future dividends

Where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k = required rate of return on stock j
n = the number of periods, which we assume to be infinite
The Dividend Discount Model (DDM)
Infinite period model assumes a constant growth rate for estimating
future dividends

This can be reduced to:

The Dividend Discount Model (DDM)
Infinite period model assumes a constant growth rate for
estimating future dividends

This can be reduced to:

1. Estimate the required rate of return (k)
The Dividend Discount Model (DDM)
Infinite period model assumes a constant growth rate for
estimating future dividends

This can be reduced to:

1. Estimate the required rate of return (k)
2. Estimate the dividend growth rate (g)
Implications Of Gordon’s Dividend
Discount Model
■ Investors’ expectations cannot be lesser than growth.
■ Price rises with reduced expected return.
■ The price grows as much as dividend growth.

■ The volatility in prices results from differences in growth

estimates .
■ Stock that pays no dividend too has value.
Estimating Dividend Growth Rates

g = growth rate in dividends

ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
Growth & No Growth Components of Value

PVGO = Present Value of Growth Opportunities

E1 = Earnings Per Share for period 1
 Price-Earnings Ratio and
Growth

■ The ratio of PVGO to E / k is the ratio of firm value due to growth

opportunities to value due to assets already in place (i.e., the no-growth value
of the firm, E / k ).

18-22
 Price-Earnings Ratio and
Growth

■ When PVGO=0, P0=E1 / k. The stock is valued like a nongrowing perpetuity.

■ P/E rises dramatically with PVGO.

■ High P/E indicates that the firm has ample growth opportunities.

18-23
Partitioning Value: Example

ROE = 20% d = 60% b = 40%

E1 = $5.00 D1 = $3.00 k = 15%

g = .20 x .40 = .08 or 8%

 Partitioning Value: Example

Vo = value with growth

NGVo = no growth component value
PVGO = Present Value of Growth Opportunities
Price Earnings Ratios
■ P/E Ratios are a function of two factors
– Required Rates of Return (k)
– Expected growth in Dividends

■ Uses
– Relative valuation
– Extensive Use in industry
P/E Ratio with Constant Growth

b = retention ratio
ROE = Return on Equity
Numerical Example: No Growth

E0 = $2.50 g = 0 k = 12.5%

P0 = D/k = $2.50/.125 = $20.00

PE = 1/k = 1/.125 = 8
Numerical Example with Growth
b = 60% ROE = 15% (1-b) = 40%

E1 = $2.50 (1 + (.6)(.15)) = $2.73

D1 = $2.73 (1-.6) = $1.09

k = 12.5% g = 9%

P0 = 1.09/(.125-.09) = $31.14

PE = 31.14/2.73 = 11.4

PE = (1 - .60) / (.125 - .09) = 11.4

Infinite Period DDM and Growth
Companies
Assumptions of DDM:
1. Dividends grow at a constant rate
2. The constant growth rate will continue for an infinite period
3. The required rate of return (k) is greater than the infinite growth rate (g)
 Infinite Period DDM and Growth
Companies
Growth companies have opportunities to earn return on investments greater
than their required rates of return
To exploit these opportunities, these firms generally retain a high percentage of
earnings for reinvestment, and their earnings grow faster than those of a
typical firm
This is inconsistent with the infinite period DDM assumptions
Infinite Period DDM and Growth
Companies
The infinite period DDM assumes constant growth for an infinite period, but
abnormally high growth usually cannot be maintained indefinitely
Risk and growth are not necessarily related
Temporary conditions of high growth cannot be valued using DDM
Multi Stage Model

■ g1 = first growth rate

■ g2 = second growth rate
■ T = number of periods of growth
at g1
Valuation with Temporary
Supernormal Growth
Combine the models to evaluate the years of supernormal growth and then use
DDM to compute the remaining years at a sustainable rate
For example:
With a 14 percent required rate of return and dividend growth of:
Valuation with Temporary
Supernormal Growth
Dividend
Year Growth Rate
1-3: 25%
4-6: 20%
7-9: 15%
10 on: 9%
Valuation with Temporary
Supernormal Growth
The value equation becomes
Computation of Value for Stock of
Company with Temporary Supernormal
Growth
Present Value of Free Cash Flows to
Equity
■ “Free” cash flows to equity are derived after operating cash flows have been
adjusted for debt payments (interest and principle)
■ The discount rate used is the firm’s cost of equity (k) rather than WACC
 Free Cash Flow Approach

■ Value the firm by discounting free

cash flow at WACC.
■ Free cash flow to the firm, FCFF,
equals:
After tax EBIT
Plus depreciation
Minus capital expenditures
Minus increase in net working capital
Computing FCFF from Net Income
■ Free cash flow to the firm (FCFF) is the cash flow available to the firm’s
suppliers of capital after all operating expenses (including taxes) have been
paid and operating investments have been made.
■ The firm’s suppliers of capital include creditors and bondholders and
common stockholders (and occasionally preferred stockholders that we will
ignore until later). Free cash flow to the firm is:
FCFF = Net income available to common shareholders
Plus: Net Non-Cash Charges
Plus: Interest Expense times (1 – Tax rate)
Less: Investment in Fixed Capital
Less: Investment in Working Capital
Finding FCFE from FCFF

■ Free cash flow to equity is cash flow available to equity holders only.
■ It is therefore necessary to reduce FCFF by interest paid to debtholders and
to add any net increase in borrowing (subtract any net decrease in
borrowing).
■ FCFE = Free cash flow to the firm
Less: Interest Expense times (1 – Tax rate)
Plus: Net Borrowing
Or
FCFE = FCFF – Int (1 – Tax rate) + Net borrowing
Present Value of Free Cash Flows to
Equity

Where:
Vj = Value of the stock of firm j
n = number of periods assumed to be infinite
FCFt = the firm’s free cash flow in period t
K j = the cost of equity
Relative Valuation Techniques

■ Value can be determined by comparing to similar stocks based on relative

ratios
■ Relevant variables include earnings, cash flow, book value, and sales
■ The most popular relative valuation technique is based on price to earnings
Earnings Multiplier Model
As an example, assume:
– Dividend payout = 50%
– Required return = 12%
– Expected growth = 8%
– D/E = .50; k = .12; g=.08
Estimating the Inputs: The Required
Rate of Return and The Expected
Growth Rate of Valuation Variables

Valuation procedure is the same for securities around the world, but the
required rate of return (k) and expected growth rate of earnings and
other valuation variables (g) such as book value, cash flow, and
dividends differ among countries
 Required Rate of Return (k)
The investor’s required rate of return must be estimated regardless of the
approach selected or technique applied
■ This will be used as the discount rate and also affects relative-valuation
■ This is not used for present value of free cash flow which uses the required
rate of return on equity (K)
■ It is also not used in present value of operating cash flow which uses WACC
Required Rate of Return (k)

Three factors influence an investor’s required rate of return:

■ The economy’s real risk-free rate (RRFR)
■ The expected rate of inflation (I)
■ A risk premium (RP)
 The Economy’s Real Risk-Free
Rate
■ Minimum rate an investor should require
■ Depends on the real growth rate of the economy
– (Capital invested should grow as fast as the economy)
■ Rate is affected for short periods by tightness or ease of credit markets
The Expected Rate of Inflation

■ Investors are interested in real rates of return that will allow them to increase
their rate of consumption
The Expected Rate of Inflation

■ Investors are interested in real rates of return that will allow them to increase
their rate of consumption
■ The investor’s required nominal risk-free rate of return (NRFR) should be
increased to reflect any expected inflation:
The Risk Premium

■ Causes differences in required rates of return on alternative investments

■ Explains the difference in expected returns among securities
■ Changes over time, both in yield spread and ratios of yields
Risk Premium

■ Must be derived for each investment in each country

■ The five risk components vary between countries
Estimating Growth Based on
History
■ Historical growth rates of sales, earnings, cash flow, and dividends
■ Three techniques
1. arithmetic or geometric average of annual percentage changes
2. linear regression models
3. long-linear regression models
■ All three use time-series plot of data