14120 equity valuation

8/13/2019 14120 Equity Valuation

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Equity Valuation

Prepared by Sumit Goyal- LPU



Introduction

• Equity shares can be described more easily than fixed income

securities, however they are more difficult to analyse.

•

Fixed income having a limited life and a well defined cash flowstream, equity share have neither.

• Fundamental analysis assess the fair market value of equity

shares by examining the assets, earning prospects, cash flowprojections and dividend potential.




Fundamental valuation

• Balance sheet valuation

– Book value

– Liquidation value

– Replacement value

• Discounted cash flow models

– Dividend discount model• Single period valuation, Multiple period valuation.

– Free cash flow model

•

Relative valuation techniques – Price-earning ratio

– Price book value ratio

– Price sales ratio




Balance sheet valuation

• Book value:- Book value per share is simply the net worth of

the company(which is equal to paid up equity capital plus

reserves and surplus) divided by no. of shares outstanding.

• Liquidation value:- Value realised from liquidating all the

assets of the firm – amount to be paid to all the creditors and

preference shareholders divided by no. of outstanding equity

shares.

• Replacement cost:- this measure considered by analysts in

valuing firm is the replacement cost of its assets less liabilities.




Dividend discount model

• The value of an equity share is equal to the present value of

dividends expected from its ownership plus the present value

of the sale price expected when the equity share is sold.

• Assumptions

1. Dividends are paid annually.

2. The first dividend is received one year after the equity shareis bought.




DIVIDEND DISCOUNT MODEL

•SINGLE PERIOD VALUATION MODEL

D1 P 1

P 0 = +

(1+r ) (1+r )

•A equity share is expected t provide a dividend of Rs 2 and fetch a price

of Rs 18 a year hence. What price would it sell for now if investor’s

required rate of return is 12%.




SINGLE+ GROWTH

• What happens if the price of the equity shareis expected to grow at a rate of g percentannually.

D1 P 0 = r – g

• The expected dividend per share on the equity share of acompany is Rs 2. the dividend per share has grown over the

past five years @ 5%. This growth will continue in future.Further the market price of the equity share is expected togrow at the same rate. What is the fair value of the equityshare if the required rate is 15%.





• More realistic

•MULTI - PERIOD VALUATION MODEL

D t

P 0 =t =1 (1+r )t




•ZERO GROWTH MODEL

If the dividend per year remain constant.

D

P 0 =

r

•CONSTANT GROWTH MODEL

assumes that dividend per year grows at a constant rate g.

D 1

P 0 =

r - g



Two stage growth model

• The extension of the constant growth model assumes that the

extraordinary growth will continue for a finite period of years

and thereafter the normal growth rate will prevail forever.

• Po = Current market price

• D1= expected dividend a year hence

• G1= extraordinary growth rate applicable for n years.

•

G2= constant growth rate• r= required rate of return




TWO - STAGE GROWTH MODEL

1 - 1+g 1n

1+r

P 0 = D 1 +

r - g 1

D 1 (1+g 1)n -1 (1+g 2) 1

r - g 2 (1+r )n



TWO - STAGE GROWTH MODEL : EXAMPLE

EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OFVERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY ANABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6

YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISEAT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OFVERTIGO ?THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE :

g 1 = 20 PERCENTg 2 = 10 PERCENTn = 6 YEARS

r = 15 YEARSD 1 = D 0 (1+g 1) = RS.2(1.20) = 2.40

PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THEINTRINSIC VALUE ESTIMATE AS FOLLOWS :

1.20 6

1 -1.15 2.40 (1.20)5 (1.10) 1

P 0 = 2.40 +.15 - .20 .15 - .10 (1.15)6

1 - 1.291 2.40 (2.488)(1.10)= 2.40 + [0.497]

-0.05 .05

= 13.968 + 65.289= RS.79.597



H Model

Assumptions

• While the current dividend growth rate, ga is greater than gn,the normal long-run growth rate declines linearly for 2H years.

• After 2H years the growth rate becomes gn.

• At H years the growth rate is exactly halfway between ga andgn.

Where Po is the IV of the share, Do is the current dividend per

share, r is the rate of return expected by investor, gn is thenormal long-run growth rate, ga is the current above-normalgrowth rate, H is the one half of the period during which ga willlevel off to gn.




H MODEL

g a

g n

H 2H

D 0

P O = [(1+g n ) + H (g a - g n )]

r - g n

D 0 (1+g n ) D 0 H (g a - g n )

= +

r - g n r - g n

VALUE BASED PREMIUM DUE TO

ON NORMAL ABNORMAL GROWH

GROWTH RATE RATE



Example

• Current dividend on an equity share of international

computers limited is Rs 3. The present growth rate is 50%.

However this will decline linearly over a period of 10 Years

and then stabilise at 12 %. What is the intrinsic value per

share, if investor requires a return of 16%.




Free Cash Flow Model

• It involves determining the value of the firm as a whole(the

value is called enterprise value) by discounting the free cash

flow to investors and then subtracting the value of preference

and debt to obtain the value of equity.

• It involves following steps.




Steps 1

1. divide the future into two parts, the explicit forecast period

and the balance period.

Explicit period- represents the period during which the

firm is expected to evolve.

balance period- a state in which the return on invested

capital, growth rate and cost of capital stabilise.




Step 2

• Forecast the free cash flow, year by year, during the explicit

forecast period.

FCF is the cash flow available for distribution to capital

providers(Shareholders and debt holders) after providing for the

investment in fixed assets and net working capital required to

support the growth of the firm.

FCF= NOPAT- Net Investment

NOPAT is net operating profit adjusted for taxes. It is profit

before interest and taxes(1- Tax rate).

Net Investment: Change in net fixed assets + Change in net

working capital.




Step 3

• Calculate the weighted average cost of capital

WACC= WeRe + WpRp + WdRd (1-t)




Step 4

• Establish the horizon value of the firm

Horizon value is the value placed on the firm at the end

of the explicit forecast period(H years) Since the FCF is expected

to grow at a constant rate of g beyond h, horizon value is equal

to




Step 5

• Estimate the enterprise value

The EV or value of the firm is the present value of the FCF

during the explicit forecast period plus the present value of the

horizon value.




• Step 6: Derive the equity value=

Enterprise value – Preference value- Debt value

• Step 7: Compute the value per share

The value per share is simply the equity value divided by

the no of outstanding equity shares.




Example

• The balance sheet of Cosmos Limited at the end of year 0 (the

present point of time) is as follows.


Rs. in crore Liabilities Assets

Shareholders’ funds 500 Net fixed assets 550 Equity capital

(20 crore shares of

Rs. 10 each) 200 Net working capital 200

Reserves and surplus 300 Loan funds( rate

10 percent) 250 750 750



Additional information

• The return on assets( NOPAT) is expected to be 18 percent of

the asset value at the beginning of each year. The growth rate

in assets and revenues will be 30 percent for the first three

years, 18 percent for the next two years, and 10 percent

thereafter. The effective tax rate of the firm is 34 percent, thepre-tax cost of debt is 10 percent and the cost of equity is 24

percent. The debt-equity ratio of the firm will be maintained

at 1:2. Calculate the intrinsic value of the equity share.




Solution

Rs. In crore Year 1 2 3 4 5 6

Asset value (Beginning)

750.0

975.0

1267.50

1647.75

1944.35

2294.33

NOPAT 135.0 175.50 228.15 296.60 349.98 412.98 Net investment 225.00 292.50 380.25 296.60 349.98 229.43 FCF (90.0) (117.0) (152.1) - - 183.55 Growth rate (%) 30 30 30 20 20 10




• The weighted average cost of capital is:

WACC = (2/3) x 24 + (1/3) x 10 (1-0.34) = 18.2percent

•

The horizon value of the firm = (183.55 x 1.10)/(0.182-0.10) = 2462.26 crores




Price-Earnings Ratio - P/E Ratio

• A valuation ratio of a company's current share price

compared to its per-share earnings.

Calculated as:

Market Value per Share/ Earnings per Share (EPS)

For example, if a company is currently trading at 43 a share and

earnings over the last 12 months were 1.95 per share, the P/E

ratio for the stock would be 22.05 (43/1.95).




Earning Multiplier Approach

• The P/E is sometimes referred to as the "multiple", because it

shows how much investors are willing to pay per dollar of

earnings. If a company were currently trading at a multiple

(P/E) of 20, the interpretation is that an investor is willing to

pay 20 for 1 of current earnings.




• A high P/E suggests that investors are expecting higher

earnings growth in the future compared to companies with a

lower P/E.

• Compare the P/E ratios of one company to other companies

in the same industry, to the market in general or against the

company's own historical P/E.




Price to book value ratio

• A ratio used to compare a stock's market value to its book

value. It is calculated by dividing the current closing price of

the stock by the latest quarter's book value per share.

• A lower P/B ratio could mean that the stock is undervalued.

• However, it could also mean that something is fundamentally

wrong with the company.

• As with most ratios, be aware that this varies by industry.




Price to sales ratio

• A ratio for valuing a stock relative to its own past

performance, other companies or the market itself. Price to

sales is calculated by dividing a stock's current price by its

revenue per share for the trailing 12 months.

• PSR= Market Price/ Revenue per share


14120 equity valuation

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