Topic 5: Equity Valuation

Overview of the Valuation Process

Bottom-up,
Top-down, Stock Valuation,
Two
Three-step Stock Picking
Approach
Approaches
Approach

11-2
Three-Step Valuation Process

Analysis of Alternative Economies and Security Markets

• How to allocate investment funds to bonds, stocks, and
1 cash

Analysis of Alternative Industries

• Determine which industries will prosper / suffer globally and
2 within countries

Analysis of Individual Companies and Stocks

• Objective: Determine prospering companies and
3 undervalued stocks

https://www.youtube.com/watch?v=Sk8eKylRtOo

11-3
General Economic Influences

• Tax • Money
Credits/Cuts Supply
• Government • Interest
spending Rate
Fiscal Monetary
Policy Policy

Inflation International
Events
• Real vs • War
nominal
• Monetary
• Spending, Devaluation
saving
11-4
The Stock Market and the Business Cycle

o Different industries react to economic changes at

different points in the business cycle

Consumer
Basic
Staples
Industries
Excel
Excel
Capital
Goods Consumer
Excel Durables
Financial Excel
Stock Excel

11-5
Company Analysis

Evaluate Firms’ Past And Future Performance

Compare Intrinsic Value and Market Price

Choose Best Companies In A Promising Industry

11-6
Does the Three-Step Process Work?
Studies have shown that…
aggregate fundamentals determine stock performance

Change in
Change in Firm’s
Firm’s
Industry
Earnings
example: the airlines industry in 2020, the retail store in the era of e-
commerce

Change In Change In
Employment, Aggregate
Income, Production Stock Prices
i.e. the macroeconomic-based model in explaining stock returns in Week 3

11-7
Theory of Valuation

Stream Of Required
Expected Returns Rate Of
Present Value Of Return
Asset’s Expected
Return

Value Of The Asset

11-8
Stream of Expected Returns

Form: Dividends, Free Cash Flow To Equity

Time Pattern: commonly every year

Growth Rate: 5%, 10%, 15%, etc.

11-9
Required Rate of Return

Risk-free
Rate

Required
Rate of
Return
Expected Risk
Inflation Premium

(Refer to Topic 3: CAPM and multifactor model)

11-10
Investment Decision Process
• A Comparison of Estimated Values and Market Prices

o If Estimated Value > Market Price, Buy

o If Estimated Value < Market Price, Don’t Buy

This is similar to target price and recommendation from the analyst’s report

11-11
Valuation of Common Stock
• Two General Approaches
o Discounted Cash-Flow Techniques
• Present value of future cash flows, including dividends,
operating cash flow, and free cash flow

11-12
Valuation of Common Stock (cont)
• Two General Approaches:
o Relative Valuation Techniques
• Value estimated by comparing stocks to similar stocks
using relative ratios.

• These ratios compare stock price to variables such as

earnings, cash flows, book values and sales.

Example: peer analysis in airlines industry

11-13
 Example: Common Stock Valuation
Approaches and Specific Techniques

Approaches to Equity Valuation

• Discounted Cash Flow • Relative Valuation Techniques

Techniques
o PV of Dividends (DDM) o Price/ Earning Ratio (P/E)
o PV of Operating Free Cash Flow
o PV of Free Cash Flow to Equity o Price/ Cash Flow Ratio

o Price/ Book Value Ratio

o Price/ Sales Ratio

11-14
Valuation of Common Stock

Required Both Estimated

Rate Of Approaches Are Growth Rate
Return Affected By

11-15
Why Discounted Cash Flow Approach
• The epitome of how we describe value - the present
value of expected cash flows.

• Affected by growth rates and discount rate

This focuses on the individual firm basis

11-16
Types of Cash Flows

Cash Flows Definition

Dividends Cash Flows That Go Straight To Investors

Free Cash Flow To Cash Flows Available To Equity Holders

Equity After Payments To Debt Holders

Operating Free Cash Flows Available To All Suppliers Of

Cash Flow Capital (not covered)

Depending on whether the firm pays dividend, or what type of investors

11-17
Limitation of DCF Valuation
• Estimates highly dependent on:

o The growth rates of cash flows

o The estimated discount rate

• GIGO (garbage in garbage out)

, i.e. incorrectly input will always produce unreasonable pricing

11-18
Why Relative Valuation Techniques

• Provides information about how the market is

currently valuing stocks, i.e. market wisdom

o Aggregate market

o Alternative industries

o Individual stocks within industries

11-19
Why Relative Valuation Techniques (cont)

Country P/E Ratio Industry (US) P/E Ratio Company P/E Ratio
(2016) (2016) (2016)

Russia 9.1 Advertising 23.48 Microsoft 22.44

Italy 31.5 Bank 14.91 Apple 14.39

France 23.4 Computer 80.05 Yahoo! 161.96

Germany 18.7 Medicine 182.25 Sony 29.68

China 7.2 Entertainment 34.22 Google 35.30

Hong Kong 15.3 Environment 468.68 Amazon 168.51

Singapore 13.3 Furniture 21.04 Facebook 37.35

Japan 19.4 Insurance 39.68 Alibaba 58.83

Star Capital (2016) Damodaran Online (2016) NASDAQ(2016)

11-21
Why Relative Valuation Techniques (cont)

• No guidance as to whether valuations are

appropriate

o Best used for comparable entities

o Aggregate market and company’s industry are not at

a valuation extreme
It does not guarantee that a firm with lower valuation ratio will outperform
the others because the market may have:
+ priced it correctly due to poor profit & operation
+ forgotten to reflect future performance into price

11-20
Which approach to use?
• No need to choose!

• The best approach is to use both approaches to

come up with the best valuation estimate possible.

11-22
Discounted Cash Flow (DCF)
Valuation Techniques
• The General Formula
t =n
CFt
Vj = ∑
t =1 (1 + k) t

Where:

Vj = value of stock j, n = life of the asset

CFt = cash flow in period t

k = the discount rate that is equal to the investor’s

required rate of return for asset j

11-23
Discounted Cash Flow Techniques
• Where:
n Dt
Vj = ∑ t =n
t =1 (1 + k )
Vj = value of stock j FCFE t
t
Vj = ∑
t =1 (1 + k) t

n = life of the asset

CFt = cash flow in period t (could be DIV or FCFE)

k = the discount rate that is equal to the investor’s

required rate of return for asset j,

11-24
The Dividend Discount Model (DDM)

• The value of a share of common stock is the present

value of all future dividends

D1 D2 D3 D∞
Vj = + + + ... +
(1 + k) (1 + k) 2 (1 + k)3 (1 + k) ∞
n
Dt
= ∑
t =1 (1 + k) t

where:
Vj = value of common stock j
Dt = dividend during time period t
k = required rate of return on stock j

11-25
The Dividend Discount Model (DDM) (cont)

• The N-Period Model

o If the stock is held for only N period, e.g. 2 years,

and a sale at the end of year 2 would imply:

D1 D2 SPj2
Vj = + +
(1+ k) (1+ k) (1+ k)2
2

D3 D4 D∞
SPj2 = + + ... +
(1+ k ) (1+ k )2
(1+ k )∞

11-26
The Dividend Discount Model (DDM) (cont)

• The N-Period Model (cont):

o The expected selling price, SPj2, of stock j at the end

of Year 2 is crucial, which is in fact the present
value of future expected dividends.

11-27
Example
• You expect Blum Foods Ltd. to pay a dividend of $0.30
next year. The shares will be sold after the dividend for
$5.20. Assume ke=15%. The PV of one share is:

D1 P1
PV = +
(1 + k e ) (1 + k e )
$0.30 $5.20
= +
(1 + 0.15) (1 + 0.15)
= $4.78

11-28
The Dividend Discount Model (DDM) (cont)

• Infinite Period Model (Constant Growth Model)

o Assumes a constant growth rate for estimating all of

future dividends
D0 (1 + g) D0 (1 + g)2 D0 (1 + g)n
Vj = + + ... +
(1 + k) (1 + k) 2
(1 + k)n
where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k = required rate of return on stock j
n = the number of periods, which we assume to be infinite

11-29
The Dividend Discount Model (DDM) (cont)

• Given the constant growth rate, the earlier formula

can be reduced to:

D1
Vj =
k −g
where D1 = D0*(1+g) or given

What if no growth?

11-30
The Dividend Discount Model (DDM) (cont)

• Assumptions of DDM:

o Constant growth rate for an infinite period..

o The required rate of return (k) is greater than the

infinite growth rate (g).

In other words, the dividend discount model with constant growth rate is

only applicable when k > g

11-31
Valuation with Temporary Supernormal
Growth

• Suppose a 14% required rate of return, a dividend of $2

with the following dividend growth pattern

Dividend
Year
Growth Rate
1-3 25%
4-6 20%
7-9 15%
10 on 9%

11-32
Valuation with Temporary Supernormal
Growth (cont)

• The Value of the Stock

2.00(1.25) 2.00(1.25) 2 2.00(1.25) 3
Vi = + +
1.14 1.14 2 1.14 3
2.00(1.25) 3 (1.20) 2.00(1.25) 3 (1.20) 2
+ 4
+
1.14 1.14 5
2.00(1.25) 3 (1.20)3 2.00(1.25) 3 (1.20)3 (1.15)
+ 6
+
1.14 1.14 7
2.00(1.25) 3 (1.20)3 (1.15) 2 2.00(1.25) 3 (1.20)3 (1.15)3
+ 8
+
1.14 1.14 9
2.00(1.25) 3 (1.20)3 (1.15)3 (1.09)
(.14 − .09)
+
(1.14)9

11-33
Valuation with Temporary Supernormal
Growth (cont)
Year Dividend Discount Factor Present Value
(14 per cent)
1 $2.50 0.8772 $2.193
2 3.12 0.7695 2.401
3 3.91 0.6750 2.639
4 4.69 0.5921 2.777
5 5.63 0.5194 2.924
6 6.76 0.4556 3.080
7 7.77 0.3996 3.105
8 8.94 0.3506 3.134
9 10.28 0.3075b 3.161

10 11.21
a
price at year 9: $224.20 0.3075b
Total value=$94.355

11-34
PV of dividends
• What would you do if:

o The stock price is less than $94.35?

o The stock price is more than $94.35?

11-35
Dividend Discount Models
• What if the stock does not pay any dividends?

o A firm with a non-dividend paying stock is

reinvesting its capital in profitable projects so
that its earnings and dividend stream will be larger
in the future

11-36
Dividend Discount Models (cont)
• What if the stock does not pay any dividends?

o Same concept but early dividends equals zero

o Difficult to estimate when a firm will initiate a

dividend

ð Most analysts would not apply this model, but

FCFE as follows

11-37
Example
• Great Plains Corporation plans to reinvest its profits
for the next 6 yrs. In yr 7, the company will pay its first
dividend of $0.20, after which constant growth is
expected at a rate of 5% p.a. If ke = 15% p.a. what is the
‘value’ of Great Plains?

11-38
Dividend Discount Models (cont)

• PV of dividend stream at year 6:

D7/(k - g) = 0.2/(0.15 - 0.05) = 2

• Discount $2.00 back to present:

2/(1.15^6) = 0.86

Do we ignore the firm’s growth in the first 6 years from its reinvestment policy?
In other words, the dividend to be paid from year 7 can change significantly
if the firm succeeds to grow in 6 years

11-39
Estimating the Inputs: k and g
• 2 most important variables for asset valuation

• Differ among countries

• Quality of estimates are key

11-58
Expected Growth Rate (g)
• Estimating Growth From Fundamentals

o In the short run, dividends can grow at a different

rate than earnings if the firm changes its dividend
payout ratio.

o For mature firms

g = (Retention Rate)x(Return on Equity) = RRxROE

In other words, for mature firms, the growth rates of dividend and earnings
are the same

11-60
Expected Growth Rate (g) (cont)
• Breakdown of ROE

Net Income Sales Total Assets

• ROE = × ×
Sales Total Assets Common Equity

= Profit Margin x Total Asset Turnover x Financial Leverage

Sale Operating Financing

Profitability Efficiency Decision

11-61
Expected Growth Rate (g) (cont)
• Estimating Growth Based on History

o Historical growth rates of sales, earnings, cash

flow, and dividends

More useful when the retention rate is unstable and the firm is expected
to maintain its growth from history

11-62
Expected Growth Rate (g) (cont)
o Three techniques

• Arithmetic or geometric average of annual

percentage changes (most popular)

• Linear regression models

• Log-linear regression models

o All three use time-series plot of data

11-63
Free Cash Flows to Equity

Operating cash flows adjusted for debt payments

Precede dividend payments

Cost of equity (k) as discount rate

11-40
Present Value of FCFE

• The Formula
n
FCFE t
Vj = ∑
t =1 (1 + k j ) t

where:

Vj = Value of the stock of firm j

n = number of periods assumed to be infinite

FCFEt = the firm’s free cash flow in period t

K j = the cost of equity

11-41
Present Value of FCFE (cont)

FCFE (can be on per share basis) If the FCFE is assumed

to grow at the constant rate
in the future:
= Net Income

+ Depreciation Expense
FCFE1
Value =
- Capital Expenditures k − gFCFE
- ∆ in Working Capital

- Principal Debt Repayments

+ New Debt Issues

Illustration of depreciation, capital expenditure, and working capital in cash flow
statements and in Appendice 4 exercise
Do the exercise FCFE forecast and valuation in Excel 11-42
Present Value of FCFE (cont)
Assume firm maintains target capital structure or debt
ratio, i.e. all principal payments will have to be
covered by new debt issues:
FCFE = Net Income or Earnings per share

- (Capital Expenditures-Depreciation)(1-δ)

- (∆ in Working Capital) (1-δ)

Where (1-δ) =(1-debt ratio), debt ratio = debt/(debt+equity)

This is useful when forecating FCFE into future periods because there are

fewer inputs to estimate

11-43
Relative Valuation Techniques

Determine Value By Comparing To Similar

Stocks Using Ratios

Price/Earning (P/E) ; Price/Cash Flow (P/CF);

Price/Book Value (P/BV) & Price/Sales (P/S)

P/E Is The Most Popular

11-44
Earnings Multiplier Model
• P/E Ratio: This values the stock based on expected
annual earnings (*)

• P/E Ratio = Earnings Multiplier

Current Market Price

=
Expected 12 - Month Earnings
Note: in practice it is confusing between trailing P/E (current price/most recent
earnings) and the P/E based on expected annual earnings (*).

We assume historical P/E is an approximation of (*)

11-45
Earnings Multiplier Model (cont)
• Combining the Constant DDM with the P/E ratio
approach by dividing earnings on both sides of DDM
formula to obtain

Pi D1/E1
=
E1 k −g

11-46
Earnings Multiplier Model (cont)
• Thus, the P/E ratio is determined by

o Expected dividend payout ratio

o Required rate of return on the stock (k)

o Expected growth rate of dividends (g)

11-47
Earnings Multiplier Model (cont)
• Assume the following information for AGE stock:
(1) Dividend payout = 50% (2) Required return = 12%
(3) Expected growth = 8% (4) D/E = .50 and the growth
rate, g=.08. What is the stock’s P/E ratio?

0.50
P/E = = 0.50/0.04 = 12.5
0.12 - 0.08
Note that D/E here means dividend/earnings, NOT debt/equity

11-48
Earnings Multiplier Model (cont)
• What if the required rate of return is 13%

0.50
P/E = = 0.50/0.05 = 10.0
0.13 - 0.08

• What if the growth rate is 9%

0.50
P/E = = 0.50/0.03 = 16.7
0.12 - 0.09

11-49
Earnings Multiplier Model (cont)
• Given D/E =0.50; k=0.12; g=0.09; P/E = 16.7

• Suppose the current earnings of $2.00. What would be

the estimated stock price?

E1 = $2 x (1 + 0.09) = $2.18

V = 16.7 x $2.18 = $36.41

• Compare this estimated value to market price to decide

if you should invest in it

11-50
The Price-Book Value Ratio
• Widely used to measure bank values

• Fama and French (1992) study indicated inverse

relationship between P/BV ratios and excess return for
a cross section of stocks

11-51
The Price-Book Value Ratio (cont)
• The Formula
P
t
P/BV =
j BV
where: t +1
o P/BVj = the price/book value for firm j

o Pt = the end of year stock price for firm j

o BVt+1 = the estimated end of year book value per

share for firm j

11-52
The Price-Cash Flow Ratio
• Why Price/CF Ratio

o Cash-flow is less prone to manipulation than earning

o Cash-flow is important for fundamental valuation and

credit analysis

11-53
The Price-Cash Flow Ratio (cont)
• The Formula
Pt
P/CFi =
where: CFt +1

o P/CFj = the price/cash flow ratio for firm j

o Pt = the price of the stock in period t

o CFt+1 = expected cash low per share for firm j

11-54
The Price-Sales Ratio
• Sales is subject to less manipulation than other
financial data

• This ratio varies dramatically by industry

 Relative comparisons using P/S ratio should be

between firms in similar industries
Easier to forecast sales than other cash flows

11-55
The Price-Sales Ratio (cont)
• The Formula
Pt
P/S j =
S t +1

where:

o P/Sj = the price to sales ratio for Firm j

o Pt = the price of the stock in Period t

o St+1 = the expected sales per share for Firm j

11-56
Implementing the Relative Valuation
Technique

Compare Stock’s Ratio To The Market,

Industry, Other Stocks

Identify Main Factors Affecting earnings,

book value, etc.

Apply the valuation ratio with the

estimate of earnings, book value, etc.
to find the
price
11-57
Reference(s)

o Reilly, FK & Brown, KC 2011, Investment Analysis & Portfolio

Management, 10th edn, South-Western Cengage Learning,
Mason, Ohio.

o Bodie, Z, Kane, A & Marcus, AJ 2013, Essentials of

investments, 9th edn, McGraw-Hill/Irwin, New York.

o Jones, CP 2010, Investments Principles and Concepts, 11th

edn, International student version, Wiley, Hoboken, N.J.

RMIT University Vietnam 64