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

  1. Discount Cash Flow Model

Estimated value is the PV of cash flow:

  1. Asset-based

Dividends

Types

  1. Cash dividends:
  1. Stock dividends:

Regular dividends

Extra (special) dividends

  1. Stock split:

Payment to shareholder in share of stock (e.g., 10% of existing shares)

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

  1. 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

Chronology of dividend payment

  1. Declaration date
  1. Ex-dividend date
  1. Holder-of-record date
  1. Payment date

Date that board approves dividend

stock purchased on & after this will not earn dividend

usually, price down by dividend value

2 biz days after Ex-dividend date

Date shareholders must own to receive dividend

Date that payment is made

Dividend discount model

One-year holding period

Value=D11+ke+P11+ke

\(P_1\): sale price immediately after dividend \(D_1\) is paid

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"

\( k_e \): required rate of return

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

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

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

Multistage DDM

Usage:

To do:

  1. Estimate dividends during the rapid growth period
  1. Use Gordon growth model to find the terminal value of the firm when growth is constant
  1. Find PV of expected dividends and expected future stock price

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

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

For companies experiencing temporary rapid growth. Then, dividend growth will be constant at some future date

  1. 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)

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. \(\frac{P_0}{E_1}\)

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

Pros and Cons

Equity = market value of assets - liabilities

Analysts usually adjust asset book values to market values

Pros and Cons

Pros

Theoretically sound

Widely accepted

Cons

Inputs must be estimated

Valuation can be sensitive to input values

Price-to-earnings per share (P/E)

Widely used

Cons

Differences in accounting methods, comparisons

Multiples for cyclical companies highly variable

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

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

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)

is Cash payment toward shareholders

Operating Income can be used instead of EBITDA