Equity Valuation

Equity Valuation
Determinants of Valuation
⮚ Present value of future cash flows(D/ CF)
⮚Growth rate in cash flows(g)
⮚Life of the asset(t)
⮚Riskiness of the asset ( r)

Purpose of valuation
⮚Striving towards a singular objective of firm value maximization
leading to stock price maximization
⮚Investment decision – Investing in a project leads to value addition or

not
⮚Financing Decision – Combination of financing mix ; debt and equity

has on the value
⮚Dividend Decision – Whether to payout or reinvest

Valuation Methods
Dividend Discount Model
Absolute Valuation NPVGO
Discounted Cashflow Method

Dividend Discount Model
⮚Value of a stock is present value of expected future cash flows
⮚Dividends are the source of cash flows for an investor who intends to
hold the stock forever
( Price P0 = D1 / (1+r) + D2/(1+r)2 + …….. +D∞ /(1+r)∞
⮚Even if this assumption is violated and investor sells the stock, its
price by next buyer is based upon the aggregate cash flows in the
form of dividends thereon
No growth Valuation
⮚ Price Po = D1 + D2 + D3 + ….. = Dividend(D1=D2=D3)

(1+r) (1+r)^2 (1+r)^3 r
r – required rate of return
D1 – Dividend one year hence
It’s an infinite geometric series with first term a = D1/1+r ;
common ratio = 1/1+r
Sum of such an infinite series = a = Div / 1+r = Div/1+r = Div
1 - CR 1 – 1/1+r r/1+r r
Constant Growth valuation
⮚Instead the dividends grow at a constant rate g

⮚How is growth rate determined
⮚Discounting inflation , earnings will not grow next year over current year
earnings UNLESS net investment happens ( which are obviously expected
to earn returns)
⮚So, Earnings (T1) = Earnings(T0) + Retained earnings(RE) * Return on RE

Earnings (T1) = Earnings(T0) + Retained earnings(RE) * Return on RE
Dividing the equation by current earnings

Earnings (T1) = Earnings(T0) + Retained earnings(RE) * Return on RE
Earnings(T0) Earnings(T0) Earnings(T0)
Leads to
1 + g (say E(t1)= 105 n E(t0) =100, therefore 105/100 = 1.05 = 1 + 5% )
1+g = 1 + Retention ratio(RE/Earnings) * Return on RE
If retention ratio = b
1 + g = 1 + b * ROE
Therefore , g = b* ROE
The growth rate in earnings is considered also the growth rate in

dividends assuming the Dividend payout ratio(D /E) as constant
Constant growth valuation
Hence , If dividends grow at a constant rate g ,

Price Po = D1 + D1 (1+g) + D1 (1+g)^2 +…..
(1+r) (1+r)^2 (1+r)^3
Represents a geometric series with a = D1/1+r ; common ratio =(1+g)/(1+r)
Therefore sum = a /1- common ratio = D1/1+r

1 – (1+g)/(1+r)
Po = D1/1+r = D1
(r-g)/1+r r –g
So , Po = D1/ r-g
Rearranging the equation,
r - g = D1 / Po
r = D1 / Po + g
Expected rate of return = Dividend yield + Capital gains
Differential growth model
2 stage growth
If the firm grows at a growth rate for certain number of years and then
at growth rate g2 perpetually
Po = PV of dividends with growth g1 till year n + Price at year n

(1+r) ^n
Price at year n = D n+1 / r –g2
In other words, for a 2 stage growth model,
Po = Pv of growing annuity(= D1) for n years + PV of share Price Pn

after n years having growth g2
Po = D1 { 1- (1+g1)/(1+r)^n} + Pn
r – g1 (1+r)^n
Where Pn = D1(1+g1)^n(1+g2)
r –g2
Disadvantages of Dividend Discount Valuation
⮚Though Dividend discount valuation helps us to understand the

volatility in stock prices on change of dividends ,
- It does not help explain valuation of new companies in the growth
phase
- Even established firms with growth opportunities do not pay
dividends(Apple till 9-10 years ago)
- Difficult to value a firm with multiple business units with multiple
assets as dividend is single and consolidated
Discounted Cash Flow Valuation
⮚Estimates of cash flows considered instead of dividends
⮚Valuation can be done for firms with no payout
⮚Valuation feasible for separate units of a single firm as each has its own
stream of cashflows
⮚Feasible at two levels - 1)Firm Value (Free cash flows to the firm)
2)Equity value (Free cash flows to Equity)
DCF valuation
⮚ Discounts cash flows instead of dividends
⮚However, the cash flows considered are Free Cash Flows to equity(FCFE)
FCFE = Net Income - Reinvestment - Net Debt Paid
Price of share = ∑ FCFEt + FCFE t+1

( 1 + ke)t ( ke – g)
Why FCF instead of operating cash flows
Free cash flows account for the reinvestment needs ( capex and
working capital) as well as debt issued to estimate the actual cash
flows to equity holders more correctly
Valuation of Firm
Value of Firm = ∑ FCFFt + FCFF t+1

( 1+ WACC)t (WACC – g)
Where FCFF = Free cash flow to the firm = NOPAT – Reinvestment needs
WACC – Weighted average cost of capital
g – growth rate

Equity Valuation

Uploaded by

Copyright:

Available Formats

Equity Valuation

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Equity Valuation

Uploaded by

Copyright:

Available Formats

Equity Valuation

⮚ Present value of future cash flows(D/ CF)

⮚Growth rate in cash flows(g)

⮚Life of the asset(t)

⮚Riskiness of the asset ( r)

⮚Investment decision – Investing in a project leads to value addition or

⮚Financing Decision – Combination of financing mix ; debt and equity

⮚Dividend Decision – Whether to payout or reinvest

Dividend Discount Model

Absolute Valuation NPVGO

Discounted Cashflow Method

⮚Value of a stock is present value of expected future cash flows

⮚ Price Po = D1 + D2 + D3 + ….. = Dividend(D1=D2=D3)

⮚Instead the dividends grow at a constant rate g

⮚So, Earnings (T1) = Earnings(T0) + Retained earnings(RE) * Return on RE

Dividing the equation by current earnings

The growth rate in earnings is considered also the growth rate in

Hence , If dividends grow at a constant rate g ,

Therefore sum = a /1- common ratio = D1/1+r

Rearranging the equation,

Po = PV of dividends with growth g1 till year n + Price at year n

Po = Pv of growing annuity(= D1) for n years + PV of share Price Pn

⮚Though Dividend discount valuation helps us to understand the

⮚Estimates of cash flows considered instead of dividends

⮚Valuation can be done for firms with no payout

⮚ Discounts cash flows instead of dividends

FCFE = Net Income - Reinvestment - Net Debt Paid

Price of share = ∑ FCFEt + FCFE t+1

Value of Firm = ∑ FCFFt + FCFF t+1

You might also like