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 flow stream, equity share have neither. Fundamental analysis assess the fair market value of equity shares by examining the assets, earning prospects, cash flow projections and dividend potential.

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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
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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.

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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 share is bought.

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DIVIDEND DISCOUNT MODEL

SINGLE PERIOD VALUATION MODEL D1 P1 P0 = + (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 investors required rate of return is 12%.

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SINGLE+ GROWTH
What happens if the price of the equity share is expected to grow at a rate of g percent annually. D1 P0 = r g
The expected dividend per share on the equity share of a company 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 to grow at the same rate. What is the fair value of the equity share if the required rate is 15%.
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DIVIDEND DISCOUNT MODEL

More realistic

MULTI - PERIOD VALUATION MODEL t=1 Dt

P0

(1+r)t

DIVIDEND DISCOUNT MODEL

ZERO GROWTH MODEL
If the dividend per year remain constant.

D
P0 = r CONSTANT GROWTH MODEL assumes that dividend per year grows at a constant rate g. D1 P0 = 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

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TWO - STAGE GROWTH MODEL 1 - 1+g1 1+r

n

P0 =

D1
r - g1

D1 (1+g1)n-1 (1+g2)
r - g2

1
(1+r)n

TWO - STAGE GROWTH MODEL : EXAMPLE

EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OF VERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY AN ABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6 YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISE AT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15 PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OF VERTIGO ? THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE : g1 = 20 PERCENT g2 = 10 PERCENT n = 6 YEARS r = 15 YEARS D1 = D0 (1+g1) = RS.2(1.20) = 2.40 PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THE INTRINSIC VALUE ESTIMATE AS FOLLOWS : 1.20 1 1.15 P0 = 2.40 .15 - .20 1 - 1.291 = 2.40 -0.05 = 13.968 + 65.289 = RS.79.597 + .05 + .15 - .10 2.40 (2.488)(1.10) [0.497]
6

2.40 (1.20)5 (1.10)

1 (1.15)6

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 and gn. 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 the normal long-run growth rate, ga is the current above-normal growth rate, H is the one half of the period during which ga will level off to gn.
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H MODEL
ga gn

H D0 PO = r - gn D0 (1+gn)

2H

[(1+gn) + H (ga - gn)] D0 H (ga - gn)

=
r - gn

+
r - gn PREMIUM DUE TO ABNORMAL GROWH RATE VALUE BASED ON NORMAL GROWTH 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%.

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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.

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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.

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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.
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Step 3
Calculate the weighted average cost of capital WACC= WeRe + WpRp + WdRd (1-t)

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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

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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.

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 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.

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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
Shareholders funds Equity capital (20 crore shares of Rs. 10 each) Reserves and surplus Loan funds( rate 10 percent)

Assets
500 Net fixed assets 200 Net working capital 550 200

300
250 750
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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, the pre-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.

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Solution
Rs. In crore Year Asset value (Beginning) NOPAT Net investment FCF Growth rate (%) 1 750.0 2 3 4 5 6

975.0 1267.50 1647.75 1944.35 2294.33 228.15 380.25 (152.1) 30 296.60 296.60 20 349.98 349.98 20 412.98 229.43 183.55 10

135.0 175.50 225.00 292.50 (90.0) (117.0) 30 30

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 The weighted average cost of capital is: WACC = (2/3) x 24 + (1/3) x 10 (1-0.34) = 18.2 percent The horizon value of the firm = (183.55 x 1.10) /(0.182-0.10) = 2462.26 crores

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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).

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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.

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 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.

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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.

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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

Prepared by Sumit Goyal- LPU

Prepared by Sumit Goyal- LPU