Equity Valuation - Professor: M. Emrul Hasan PDF

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Professor: M. Emrul Hasan...

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50. Equity Valuation: Concepts and Basic Tools Security Valuation! ( !>%$F+%1K).C+0#1 ].K1,C+0#1K: *+,61%.;,$51 < T.,$.>$5. `C1,C+0#1K: *+,61%.;,$51 > T.,$.>$5. (!>%$F+%1K).C+0#1 § §

Market price “must” converge towards intrinsic value in the future Market price is more likely to be “correct” when a security is followed by many analysts

Types of Equity Valuation Models 1. Discounted Cash Flow Models 2. Multiplier Models! [Comparable or “Comps”] 3. Asset-Based Valuation 1. Discounted Cash Flow Models Dividend Discount Model

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c$C$K1.K% ;,$51. + ;,$51%bG = ;/.23.c$C$K1.K>.+.K.N#%#,1.;,$51 d= . (E + 6 )% (E + 6 ). %bE

Check your skill! A stock paid a $1.50 dividend last year that will grow at 8% every year. You require a 12% return and you expect the stock price to be $51.00 at the end of Year 3. What is the stock’s value today? A. $40.5 B. $41.5 C. $39.5! Assuming the company pays dividend forever,

e

;,$51%bG = ;/.23.c$C$K1.K> =d .

%bE

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c$C$K1.K% (E + 6 )%

“k” is the required return or cost of equity Corporation has an indefinite life Investor must receive future cash dividends to be willing to invest today

Preferred Stock Valuation § Preferred stock (usually) has no maturity date and pays a fixed dividend /+0#1.23.;,131,,1K.4?+,1%bG =

;,131,,1K.c$C$K1.K> 6X 275

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Check your skill! What’s the price of a $50 par value 7% preferred share if the required rate of return is 8%? A. $40.75 B. $43.75 C. $87.50 .Gordon (Constant) Growth Model § Dividends grow at a constant rate forever § fg must be greater than the growth rate (g) § Need to distinguish between D1 (next dividend) and D0 (dividend paid) ;,$51%bG =

cG (E + -) cE = 61 − 61 − -

Check your skill! A stock paid a $1.50 dividend last year that will grow at 8% forever. You require a 12% return. What is the stock’s value today? A. $40.5 B. $41.5 C. $39.5 Estimating the Value of g! § g represents the earnings and dividend growth rate - = D1%1.%$2..D+%$2 ∗ D1%#,..2..!"#$%&.(D`!) - = (E − c$C$K1.K.;+&2#%.D+%$2) ∗ D1%#,..2..!"#$%&.(D`!) Check your skill! FT has an ROE of 18%, EPS of $2.00 for last year, and paid a dividend of $1.20. If the ROE and payout ratio remain the same and the required rate of return is 13%, the value of the stock according to the constant growth model is closest to: A. $22.18. B. $40.24. C. $60.44 Multistage Dividend Discount Model (DDM) § For companies experiencing temporary rapid growth that slows down later § Assumes that dividend growth will be constant at some future date § Estimate dividends during the rapid growth period ! § Use Gordon growth model to find the terminal !value of the firm when growth is constant

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! Example: Calculate the value of a stock given:! § Last year’s dividend = $1.00! § Dividend will grow at 15% for two years § Dividend will grow at 5% after two years § Required return is 11% Tips: Always forecast “rapid growth period + 1” year dividend! Step 1: Forecast the dividend for each year of rapid growth (2 years) and for the first year of constant growth cE = cG (E. EI) . = $E. EI cJ = cG (E. EI)J = $E. hJ ch = cG (E. EI)J (E. GI) = $E. hR Step 2: Use the last dividend (first one for slow growth) in the constant growth model to find the value of the stock one period before that ;J =

$E. hR ch = = $Jh. Ei 61 − - G. EE − G. GI

Step 3: Find the PV of expected dividends and of the expected future stock price ;G =

E. EI (E. hJ + Jh. Ei) + = $JG. R (E. EE)E (E. EE)J

Tips: You can add the last rapid growth dividend with the PV from constant growth in Step 3 (D2 + P2) and call it CF2 in your calculator. Along with CF1(D1) with I = 11, you can compute NPV. Use of Dividend Discount Model § Constant Growth Model is most appropriate for firms that pay a dividend that will grow at a constant rate, such as: v Stable and mature firms v Noncyclical firms § 2-stage DDM is appropriate for: v Firms with high current growth that will fall to a stable rate in the future v Older firms that were in the constant growth phase, but are now in a high growth phase or are losing market share § 3-stage DDM is appropriate for:! v Young firms still in the high growth phase

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! Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE) Model /+0#1.23.N$,F%bG = .!/ = */M...4%256 + */c1O% − M+>?.&.M+>?.!"#$C+01.%> e NMNN% /+0#1.23.N$,F%bG = ;/.23.NMNNd =. ( E + UkMM )% %bE

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NMN!% */M...4%256 = /+0#1.23.!"#$%&%bG = ;/.23.NMN! d=. (E + 61 )% %bE

NMNN = MN` + T.%1,1>%(E − %) − NMT.C

MN` = lT + c&k − T.5,1+>1.$..lUM (Mk%mE − M8%mE ) − (Mk% − M8%) T.5,1+>1.$..lUM = NMN! = MN` − NMT.C + Q2,,2P$.- − c1O%.D1X+&F1.% To Value the “Firm” – Use FCFF: v Free cash flow available to both equity and debt holders v Notice FCFF do not take into account the cash inflow and outflow related to debtholders [borrowing, repayment or interest expenses] v It adds back the after-tax interest expense that was deducted to arrive at CFO v Notice the denominator uses WACC that is the cost of capital derived from both equity and debtholders § To Value the “Equity” Only – Use FCFE: v Free Cash available to equity holders only v Notice FCFE adds any kind of cash inflow from debtholders (borrowings) and deducts any kind of debt repayment v Notice it also takes into account the payment of after-tax interest that is deducted before getting CFO v Notice the denominator uses “ke” that is the cost of equity only § Alternative Way to Value the “Equity” Using FCFF: v Find value of the firm using FCFF which is also the EV v Deduct MV of debt and add cash and CE to get MV of Equity Make sure the CA and CL are operating only [do not take into account ST Investments and interest bearing notes payable or CPLTD] §

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Check your skill! Free cash flow to equity would be best measured as: A. CFO minus fixed capital investment minus net borrowing. B. total cash flow plus financing cash flow minus investing cash flow. C. CFO minus debt payments plus debt issued minus fixed capital investment.

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! 2. Multiplier Models! Price Multiples § P/E = stock price / earnings per share § P/S = stock price / sales per share! § P/B = stock price / book value per share, (sometimes called market-tobook ratio or M/B) § P/CF = stock price / cash flow per share, where cash flow = operating cash flow or free cash flow Using Price Multiple Comparables § Based on the law of one price: Two comparable assets should sell for the same multiple § P/E, P/S, P/B, or P/CF ratio lower than industry average or comparable stock suggests stock is undervalued This is an example of relative valuation (Comparables = “Comps”) Most commonly used one is “Enterprise Value Multiple” !/.*#0%$X01 =

!.%1,X,$>1./+0#1.(!/) !QT[ck

!/ = */M2FF2..4%256 + */c1O% − M+>?.&.M+>?.!"#$C+01.%> Useful when:! § Firms have different capital structures! § Earnings are negative, can’t use P/E ratio EV / EBITDA Multiple Example § Stock price! = $40.00 § Shares outstanding = 200,000 § Market value of long-term debt = $600,000 § BV of long-term debt! = $900,000 § BV of total debt and liabilities = $2,100,000 § Cash and marketable securities = $250,000 § EBITDA = $1,000,000 Solution: */.23.4[.K1O% = Q/.23.4[.c1O% = Q/.23.[2%+0.c1O% − Q/.23.8[.c1O% = $J, EGG, GGG.– .$RGG, GGG = .$E, JGG, GGG */c1O% = */.23.8[.c1O%.+.K.*/.23.4[.c1O% = $SGG, GGG + $E, JGG, GGG = $E, pGG, GGG */M2FF2..4%256 = ;,$51 ∗ #23.>? = $qG ∗ JGG, GGG = $p, GGG, GGG 279 !

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!/ = */M2FF2..4%256 + */c1O% − M+>?.&.M+>?.!"#$C+01.%> = $R, IIG, GGG $R, IIG, GGG = R. SW !/.*#0%$X01 = $E, GGG, GGG Compare this multiple to competitor or industry average, lower than average value indicates that the share price is undervalued P/E Multiple and Gordon Growth Model Start with: ;,$51%bG =

cE 61 − -

Divide both sides by EPS of next year = E1 to get P/E: cE ;G c$C$K1.K.;+&2#%.D+%$2 ! = 81+K$.-.;,$51.%2.!+,.$.->.D+%$2 =E. = 61 − 61 − !E. Other § § § §

things equal, fundamental P/E ratio (price) is higher if firm has: Higher dividend payout ratio Higher growth rate Lower required return Note that increasing the payout ratio will decrease the growth because: - = (E − c$C$K1.K.;+&2#%.D+%$2) ∗ D1%#,..2..!"#$%&.(D`!)

Check your skill! You expect a firm to pay out 30% of its earnings as dividends. Earnings and dividends are expected to grow at a constant rate of 6%. If you require a 13% return on the stock, what is the stock’s expected P/E ratio? A. 4.5x B. 4.3x C. 5.3x

3. Asset-Based Models § Equity equals market or fair value of assets minus liabilities § Analysts usually adjust asset book values to market values § Asset-based valuation models provide a floor value, estimate of value in liquidation 280 !

! Advantages and Disadvantages of Different Valuation Models Model Present Value Models

Multiplier Models

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Asset-Based Models

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Advantages Theoretically sound Widely accepted Widely used, associated with stock returns Easily calculated and readily available Good for identifying attractive companies in an industry Useful for time-series or cross-sectional analysis Can provide floor values !Useful for firm with mostly tangible shortterm assets or if firm is to be liquidated

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Disadvantages Inputs are estimated! Very sensitive to input values Differences in accounting methods reduce comparability Multiples for cyclical companies highly variable

Ongoing firm value may be greater than asset value, does not reflect future CF Fair values of assets can be difficult to estimate; especially with primarily intangible assets, high inflation environments

Choice of Valuation Model § Model should be chosen based on available inputs § Model should be chosen based on the intended use of the valuation § More complexity is not necessarily better § Consider values using more than one method § Consider uncertainty about input values § Consider uncertainty about the appropriateness of the model

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