FIN4030: INVESTMENTS

UNIT 2: VALUATION OF SHARES Objective : To provide an understanding of the various ways of valuing shares and companies and of the limitations of the various valuation approaches The Valuation Question The concept of value is at the heart of financial management. If there is an efficient market in a companys shares, it should provide a reliable indication of the companys share value. Value can be said to be whatever the highest bidder is prepared to pay. As long as the market is reasonably efficient, the market price of a share can be trusted as a fair assessment of value. Problems do arise however, in valuing assets that have no recognized market, e.g. shares of most unquoted companies. Valuation Methods 1. Discounted cash flow 2. Price-earnings multiple 3. Net Asset value VALUING CASH FLOWS The value of any asset depends upon the stream of benefits that the owner of the asset expects to get from his/her ownership. Ownership of ordinary shares entitles the holder to receive a stream of future cash flows in the form of dividends and the appreciation in value of the shares (capital gain). Basic Valuation Model: The value of any asset (bonds, shares etc) is simply the present value of the cash flows that the asset is expected to produce over the period it is owned. V0 = CF1 + CF2 + -------+ CFn 1 (1 + K) (1 + K)2 (1 +K)n Where: V0 = Value of the asset at time zero CF = Expected cash flow K = the appropriate required rate of return (discount rate) 1

= relevant time period.

THE DIVIDEND VALUATION MODEL According to the dividend valuation model, the value of a share now (V0) is the sum of the discounted present value of all future dividends plus the value of the share as and when it is sold in some future time period. Estimated value of a share today = V0 = D1 + D2 + -------+ D 1 (1 + Ke) (1 + Ke)2 (1 +Ke) Where: D1, D2 = the expected dividends to be received in each future time period. Ke = the required rate of return for the ordinary share. This is the intrinsic value of a share i.e. the estimated value of the share today, derived from estimating and discounting the future cash flows of the share. Note: 1. If intrinsic value of the share > Market Price = the asset is undervalued - therefore Buy/Hold 2. If intrinsic value < Market Price, the share is overvalued therefore do not buy/sell if held 3. If intrinsic value = Market Price, here the share is correctly valued. It is because investors believe shares are not always priced at their intrinsic values that lead to buy and sell opportunities. Estimating future dividends The dividend stream is usually uncertain. The reason for this is that it is difficult to forecast earnings on which dividends are based. Other things being equal, shareholders prefer higher to lower dividends. Given that dividends are uncertain, using the dividend valuation model requires some assumptions to be made about the expected growth rate of dividends. The 3 growth rate models for dividends are: 1. Zero growth rate i.e. where the annual dividend is constant 2. Normal/Constant growth rate i.e. where the dividend stream grows at a constant rate 3. Multiple growth rate model where at least 2 different growth rates are involved. Zero Growth Rate Model

Here the current dividend, D0 is assumed to be paid every year from now to infinity. Hence the model assumes a dividend that does not change over time. In effect this model reduces to a perpetuity. V0 = D0 Ke Where: D0 = Current dividend Ke = the required rate of return on the stock The Normal/Constant Growth Rate In this model, dividends are expected to grow at a constant rate, g Thus, V0 = D0(1 +g) + D0(1 + g)2 + D0(1 + g)3 +.+ D0(1 + g) (1 + Ke) (1 + Ke)2 (1 + Ke)3 (1 + Ke) Where: V0 = Value of the share D0 = Current dividend being paid g = Constant growth rate Ke = Discount rate The formula reduces to: V0 = D1 (Ke - g)

The constant growth model therefore specifies the numerator as dividend expected to be received one year from now (D1). NB: D0 = represents the dividend currently being paid D1 = represents the dividend expected to be paid in the next period, i.e. current dividend must therefore be compounded for 1 year. Implications of the Constant growth model: 1. Dividend next period (D1) = the higher this dividend the higher the current share price will be. 2. Growth rate in dividends (g) - an increase in g will result in an increase in the share price. Similarly an increase in earnings will result in an increase in g and therefore an increase in share price. 3. Required rate of return (Ke) = the higher the required return by investors, the lower the current share price and vice versa. Estimation of g there are 2 approaches to estimating g: 3

1. Use historical growth rates of past dividends. For example use your observations of dividends paid say in the previous 5 years and use the figures to calculate the average growth rate the problem with this is that the data is historical in nature and may therefore not reflect what will happen in the future. Example:
Year 2000 2001 2002 2003 2004 Dividend 1.10 1.20 1.35 1.40 1.55

Estimate the growth rate for the share above. 2. Use projected growth rates i.e. analysts forecasts of future growth rates. Limitations of the Constant Growth Model the model requires that the stock pay dividends and that the dividends grow at a constant rate. the required rate of return must be greater than the growth rate (g) otherwise the share price will be infinite.

Expected rate of return Ke = D1/P0 + g, In effect the expected rate of return on a constant growth stock is the sum of the dividend yield and the expected growth rate in dividends. The Multiple Growth Rate Model The distinguishing feature of this model is that at least 2 different growth rates are involved. The share valuation here is a 2-stage process 1. Work out each of the dividends during the abnormally high growth period and then discount them back to time zero (present) using the discount rate. 2. Apply the constant growth valuation model for the second period after which discount the result back to period zero. V0 = PV of dividends during period of rapid growth + PV of dividends during constant growth rate

V0 = D0(1 +gs)t + Dn(1 + gc) ( 1 ) (1 + Ke)t (Ke - gc) (1 + Ke)n Where: V0 = Value of the share D0 = Current dividend being paid gs = Supernormal growth rate of dividends gc = Constant growth rate Ke = Discount rate n = number of years of the supernormal growth rate Dn = the dividend at the end of the supernormal growth period Valuation Using P/E Ratio or the Earnings Multiplier Approach This is a method popular with practicing security analysts. It is the most widely used valuation technique. By using this approach you avoid making estimates like, g, and Ke used in Dividend Valuation method. You then compare the value with the market or any other benchmark. The P/E ratio is also one of the most widely used variables when it comes to shares. The method is based on a firms accounting profits and uses the P:E ratio. The P/E ratio is simply the number of times investors value earnings expressed in the share price. P:E Ratio = Market price of a share Last reported Earnings per Share P/E Ratio = MPS EPS NB: A high P/E ratio does not signify that a company has done well but tat it is expected to do better in the future. Limitation of the P/E Ratio approach 1. It relies on accounting profits rather than the expected cash flows. Value depend upon the cash generating ability of the asset rather than profitability. 2. Where the company is not quoted use the market price of a surrogate/similar company quoted. Net Assets Value Approach This approach uses published accounts. Use the asset values stated in the accounts i.e. use the value of net assets or the book value of the owners equity.

The net assets value is a very unreliable indicator of value in most cases. Reasons: 1. It is derived from a valuation of the separate assets of the company (break-up values) thus understates the earning power of the companys assets i.e. the ability of the assets to generate earnings. 2. Fixed assets values are based on historical costs calculated after depreciation. Therefore the values are mostly out of date especially during periods of rising prices. 3. Stock values are not reliable valued at the lower of cost or NRV. 4. Debtors figure may not all be converted into cash re bad debts