2015, Study Session # 14, Reading # 50

EQUITY VALUATION: CONCEPTS AND BASIC TOOLS

FCFE = Free Cash Flows to Equity
WC = Working Capital
EV = Enterprise Value
TA = Total Asset
TL = Total Liabilities
PS = Preferred Stock
GGM = Gordon Growth Model
RR = Retention Rate
SGR = Sustainable Growth Rate
MP = Market Price

50.a

Intrinsic / fundamental value rational value based on assets

characteristics (derived through valuation models).

If IV MV, abnormal return is possible.

Perceived mispricing, appropriateness of valuation model &
inputs are important considerations in investment decision.

50.b

IV = Intrinsic Value
MV = Market Value
DCF = Discounted Cash Flow
PV = Present Value
TV = Terminal Value
FCinv = Fixed Capital Investment
DDM = Dividend Discount Model
MDDM = Multistage Dividend
Discount Model
PMs = Price Multiples
FV = Fair Value

Equity Valuation Models

DCF or PV Models

Multiplier Models

Asset-Based Models

DDM

1st Type

IV of common stock = TA-TL &

preferred stock.

Stock value is PV of cash

distributed to shareholders.

Ratio of stock to some

fundamental (earnings, sales
BV, CF etc).
2nd Type

FCFE Model

PV of cash available to
shareholders after capital
expenditures & WC expense.

Ratio of EV to EBITDA or
sales.

EV = MV of all outstanding
securities cash & short
term investment.

50.c

DDM

One-year holding period DDM

 =

Multiple year holding periods DDM

 
  
  
+
(1 + 
)
(1 + 
)

1. Sum of the PV of estimated dividends over

holding period & estimated TV.
2. For two year holding period
1
2


 =
+
+
(1 + 
) (1 + 
) (1 + 
)
FCFE

3. It reflects firms capacity to pay dividends & also useful for firms not currently
paying dividends.
4.  =  +  
  
 
  
.
5. FCFE = CFO FCinv + net borrowings (represent cash to equity holders after
meeting all obligations).

1.
 =


( )

Where 
is obtained from CAPM or adding risk premium to publically traded

dRatio of EV to EBITDA or sales.
2. EV = MV of all outstanding securities cash & short term investment.
3. ebt or govt bond yield.

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2015, Study Session # 14, Reading # 50

50.d

PS usually has indefinite maturity & fixed dividend.

  =

50.e

GGM assumes annual dividend growth rate is constant  .


 =


 

Where 
= cost of equity.

Assumptions of GGM

Dividends are appropriate measure of shareholder
wealth.

 & 
never expected to change.


> 

When difference b/w 
&  widens, value
& vice versa.

Small changes in difference cause large changes in value.

Stock value due to dividend growth = stock value at 0%
growth rate stock value at a positive growth rate.

Estimating Dividend Growth Rate

Use historical dividend growth rate.

Median industry dividend growth rate.

Sustainable growth rate

Rate at which equity earnings & dividends continue to

grow indefinitely.

Assumptions are constant ROE, dividend payout ratio &
no new equity is issued.

 ! = !! !".

Firm may not be able to pay dividend currently due to
financial distress or higher reinvestment income.

Multistage Dividend Growth Models

If g > r this relationship cant hold indefinitely (higher growth will attract competition).

Sustainable growth rate is more realistic assumption.

To determine MDDM;

Duration & size of high growth period should be projected.

Estimates of high growth period dividends & constant growth rate.


 =


( )


( )

+ +


( )


( )

where
 =

 


50.f

GGM is appropriate for stable, mature & dividendpaying firms with single growth rate.

MDDM can be two or three stages (growth, transition &
mature).

For non-dividend paying firms estimating future
dividend payments are speculative so FCFE is
appropriate.

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2015, Study Session # 14, Reading # 50

50.g

DDM is very sensitive to inputs so price multiple approach (comparison
of stock price multiple to a benchmark value) is used by many analysts.

PMs are used in time series & cross sectional comparisons.

Critique reflect only the past (often historical data is used).

Multiples based on comparables compare multiple of the firm with
other firms based on MP.

Multiples based on fundamentals what a multiple should be based on
some valuation models.

50.h

Price Multiples

P/E Ratio

P/S Ratio
#
   




Widely used by analysts.

P/B Ratio

P/CF Ratio

#
$
% &   


 
 

CF is CFO or free cash flow.

Multiples can be industry specific (e.g. cable industry

market cap is compared to number of subscribers).

Multiples

Fundamental Based
!
P

'E =
(it is justified because we assume that inputs
"#

are correct & leading because it is based on next period expected earnings).
P
This 'E serves as a benchmark at which stock should trade.

Very sensitive to inputs, (several sets of inputs for a range of justified P/E).
D
 Dividend payout 'E , g,
k cause  P/E.

Dividend displacement of earnings  dividend,
growth so firms value
impact is ambiguous.

Justified leading

Comparable Based

Compare multiple with benchmarks (historical avg, stocks & industry avg.) &
determine its valuation.

Law of one price two identical assets should sell at same price.

Not applicable if firms are of different size, in different industries etc.

P/S ratio is favored over P/E for cyclical firms (sales are less volatile).

50.i

EV total company value cost to acquire the firm
EV = MV of common stock + MV of debt cash & short term investments.

Acquirers cost for a firm is decreased by amount of targets liquid assets (cash &
investments).

EV is appropriate for firms with different capital structure.

EBITDA is normally used as denominator of EV multiple (usually a positive number as
compared to NI & show both equity & debt owners earnings).

Disadvantage of EBITDA non-cash revenue & expense.

If MV of debt is not available than comparables MV of debt or BV is used

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2015, Study Session # 14, Reading # 50

50.j

Asset-Based Valuation Models

Equity value = MV or FV of assets MV or FV of liabilities.

Problematic if large amount of intangible assets.

More reliable when short term tangible assets, assets with ready MV or
when firm is liquidating.

Often used to value private companies but increasingly useful for public
companies (FV reporting on BS).

50.k

DCF Models

Advantages

Disadvantages

Strong base in finance theory (concept of

discounted PV).

Widely accepted in analyst community.

Inputs must be estimated.

Value estimates are very sensitive to
inputs.

Comparable Based Valuation

Advantages

Disadvantages

Useful for predicting stock returns.

Readily available & widely used by analysts.
Can be used in time series & cross sectional.
EV/EBITDA is useful when comparing a firms value
independent of capital structure, or when earnings are
negative.

Not comparable across firms with different size, products &

growth.

Lagging price multiples reflect the past.

Cyclical firms greatly affected by eco conditions.

Stock may appear overvalued by comparables but undervalued
by fundamental method & vice versa.

Different accounting methods distort comparability.

Negative denominator results in meaningless ratio.

Fundamental Based Valuation

Advantages

Disadvantage

Based on theoretically sound valuation models.

Correspond to widely accepted value metrics.

Very sensitive to inputs

Asset-Based Models

Advantages

Disadvantages

Provide floor values.

Reliable when short-term tangible assets, readily
measurable MV assets & in liquidation.

Increasingly useful to value public firms that are reported
at FV.

MVs are difficult to obtain & usually different than BV.

Inaccurate when higher proportion of intangible assets.

Assets can be difficult to value during hyperinflation.

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