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Reading 41: Equity Valuation: Concepts and Basic Tools - Coggle Diagram
Reading 41: Equity Valuation: Concepts and Basic Tools
Terminology
Undervalued asset: Market price < Estimated value
Overvalued asset: Market price > Estimated value
For security valuation to be profitable, the security must be MISVALUED NOW and must CONVERGE TOWARD INTRINSIC VALUE IN THE FUTURE
Market price is more likely to be correct when several analysts follow a security
Equity Valuation Models
Discount Cash Flow Model
Estimated value is the PV of cash flow:
Dividend discount model
One-year holding period
\(Value=\frac{D_1}{1+k_e}+\frac{P_1}{1+k_e}\)
\(P_1\): sale price immediately after dividend \(D_1\) is paid
\( k_e \): required rate of return
Multiple-year holding period
\(Value=\sum_{i=1}^{n} \frac{D_n}{(1+k_e)^{i}}+\frac{P_n}{(1+k_e)^{n}} \)
\(P_n\): sale price immediately after dividend \(D_n\) is paid
Pay attention to the wording regarding dividend
Ex: "Dividend last year is $1, with growth rate = 8% → Dividend this year = $1.08"
Dividend Discount Model
\(V_0=\sum_{i=1}^{\infty} \frac{D_i}{(1+k_e)^{i}}\)
Corporation has an indefinite life
Investor must receive future cash dividends to be willing to invest today
Preferred Stock Valuation
Preferred stock pays a fixed dividend and has no maturity date
\(V_0=\frac{Preferred.Dividend}{k_p}\)
Gordon (constant) Growth Model
Assumptions
Dividends grow at a constant rate \( (g_c)\) forever
\(k_e > g_c \)
\( P_0 = \frac{D_1}{k_e - g_c} \)
\(D_1\) : expected dividend next period
To estimate growth rate g
g represents the earnings and dividend growth rate in the constant growth model
g = RR x ROE
RR: earnings retention rate = 1 - Dividend Payout Ratio
ROE: Return on Equity
Gordon Growth Model is most appropriate for firms that pay a dividend that will grow at a constant rate, such as:
Stable and mature firms
Noncyclical firms
Multistage DDM
Usage:
For companies experiencing temporary rapid growth. Then, dividend growth will be constant at some future date
To do:
Estimate dividends during the rapid growth period
Use Gordon growth model to find the terminal value of the firm when growth is constant
Find PV of expected dividends and expected future stock price
2-stage DDM
appropriate for firms with high current growth that will fall to a stable rate in the future
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
appropriate for young firms still in the high growth phase
Free Cash Flow To Equity Model
\(V_0=\sum_{i=1}^{\infty} \frac{FCFE_i}{(1+k_e)^{i}}\)
FCFE: Cash available after a firm meets its debt obligations and necessary capital expenditures.
FCFE = CFO - Fixed Capital Investment + Net Borrowing
FCFE reflects the firm's capacity to pay dividends
This model is useful for firms that currently do not pay a dividend
Analyst does not have to project the amount and timing of future dividend payments
Pros and Cons
Pros
Theoretically sound
Widely accepted
Cons
Inputs must be estimated
Valuation can be sensitive to input values
Asset-based
Pros and Cons
Pros
Useful for firm with mostly tangible short-term assets or if firm is to be liquidated
Can provide a floor value
Cons
Ongoing firm value may be greater than asset value
Fair values of assets can be difficult to estimate, especially with primarily intangible assets, inflation
Equity = market value of assets - liabilities
Analysts usually adjust asset book values to market values
Multiplier Model
The price multiple approach - relative valuation
Types
Common price multiples based on comparables
Price-to-cash flow per share (P/CF) . Cash flow = operating cash flow or free cash flow (per share)
Price-to-sales per share(P/S)
Price-to-book value per share(P/B)
Price-to-earnings per share (P/E)
P/E Based on Fundamentals
Begin with the constant growth value \( P_0 = \frac{D_1}{k - g} \)
Divide both side of the equation by next year's projected earnings \(E_1\) to get P/E
\(\frac{P_0}{E_1}=\frac{\frac{D_1}{E_1}}{k-g}\)
\(\frac{D_1}{E_1}\): Dividend Payout Ratio
The primary determinants of a P/E ratio are the required rate of return (k) and the growth rate (g)
The same factors that affect a stock price will affect the stock's P/E ratio
other things equal,
Fundamental P/E ratio is higher if
Higher dividend payout ratio
Higher growth rate
Lower required return
NOTE: increasing payout ratio will decrease growth rate:
g= ROE x (1 - Payout ratio)
Using Price Multiple Comparables
Based on 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 in undervalued
Enterprise Value Multiples
\( \frac{EV}{EBITDA}\)
Enterprise value (EV) = Market value of common stock + Market value of debt - cash and short-term investments
EV represents total market value of firm
EBITDA represents total earning to both debt and equity
Useful when:
Firms have different capital structures
Earnings are negative and P/E ratio cannot be used
Operating Income can be used instead of EBITDA
Pros and Cons
Pros
Readily available
Easy to calculate
Can be used for cross sectional or time series analysis
Associated with equity returns
Multiples can be historical or forward-looking (e.g., \(\frac{P_0}{E_0}\) vs. \(\frac{P_0}{E_1}\)
Widely used
Cons
Differences in accounting methods, comparisons
Multiples for cyclical companies highly variable
Choice of valuation model
Model should be chosen based on available inputs
Model should be chosen based on the intended used of the valuation
More complexity is not necessarily better
Consider value using more than one method
Consider uncertainty about input values
Consider uncertainty about model appropriateness
Dividends
Types
Cash dividends:
Regular dividends
Extra (special) dividends
is Cash payment toward shareholders
Stock dividends:
Payment to shareholder in share of stock (e.g., 10% of existing shares)
Stock split:
Proportionate increase in shares outstanding (e.g., 2 for 1)
Reverse stock split: Proportionate decrease in shares outstanding (e.g., 1 for 2)
Stock split, reverse stock split and stock dividend do not change the total value of stock outstanding
Share repurchase:
Alternative to cash dividend as a way to distribute cash to shareholders
Tax advantage to shareholders if tax rate on capital gains is less than tax rate on dividends
Signal to shareholders that management believes shares are undervalued
Can offset increase in shares outstanding due to employee exercise of stock options which may cause dilution of stock price
Share repurchase methods
Buy shares in open market
Buy at a fixed price through a tender offer
Directly negotiate and buy a large block from a large shareholder.
Effects of share repurchase
On EPS
If repurchased is financed with borrowed funds
If firm's E/P = after-tax cost of borrowing, then no effect on EPS
If E/P > after-tax cost of borrowing, EPS rises
If E/P < after-tax cost of borrowing, EPS falls
If repurchase is financed with firm's excess cash
On Book value
If share price < original book value per share -> increase book value per share
If share price > original book value per share -> decrease book value per share
Cash dividend & Share-repurchase of same amount
Share repurchase is economically equivalent to cash dividend (of equal amount) considering the effect on shareholder's wealth (if the tax treatment of 2 are similar)
Chronology of dividend payment
Declaration date
Date that board approves dividend
Ex-dividend date
stock purchased on & after this will not earn dividend
usually, price down by dividend value
Holder-of-record date
2 biz days after Ex-dividend date
Date shareholders must own to receive dividend
Payment date
Date that payment is made