Computation of Intrinsic Value of Equity Shares:

EQUITY VALUATION METHODS

• The Dividend Discount Model: The stock price should be equal to
the present value of all expected future dividends.

• Constant Growth DDM / Gordon Model

• Two-Stage DDM
• Three Stage DDM
• Free Cash Flow to Equity (FCFE) Model
• Measures of Relative Value
• Price/Earnings Ratio
• Price/Book Value Ratio
• Price/Sales Ratio
• THE DIVIDEND DISCOUNT MODEL
• One-period Model: assumes you receive all cash flow after one year. We
assume one annual dividend and estimate a price target, P1 for year-end.
• Then, V = P0 = (D1+P1) …… (1)
(1+r)
Current Price, P0, may or may not equal intrinsic value, PV.

• Multi-period Model:

P0 = D1 + D2 +…… + Dn= α ……. (2)

(1+k)1 (1+k)2 (1+k)n=α
• CONSTANT GROWTH DDM / GORDON MODEL

P0 = D0 (1+g) + D0 (1+g)2 +…….+ D0 (1+g) n=α ….. (3)

(1+k)1 (1+k) 2 (1+k)n=α
• A stock price is expected to grow at the same rate as dividends.
• THE DIVIDEND DISCOUNT MODEL: Cont…
The Equation (3) can be reduced to

P0 = D0 (1+g) => D1 ……(4)

(ke- g) (ke- g)

• Consider no (Zero) growth, then g= 0 and all dividends are equal.

P0 = D0 (1+0)/(ke-0) = D/ke ……. (5)

• The above special case is sometimes called a perpetual growth model and is
also useful in evaluating preferred stock.
LIMITATIONS OF CONSTANT GROWTH DDM:
1. Restricted to firms that are growing at a stable growth rate;
2. Should not be used to those companies which have high current growth rates;
3. Ke > g and initial dividend (D0)must be greater than zero.
• THE DIVIDEND DISCOUNT MODEL: Cont…
• Multistage growth models: Two-Stage DDM
-- Whenever the growth rate is not constant we cannot use the div.discount model.
-- In reality, through the different stages of the firms’ life cycles they have different
dividend profiles.
• In early stages, payout ratios are low; more inv. Opportunities and rapid growth.
• In later stages, payout ratios are high; production capacity is enough to meet the
demand; less investment opportunities; stable growth.

LIMITATIONS OF THE MODEL:

1. Difficult to define the length of the supernormal
growth period;
2. Sudden change in the growth rate is unrealistic;
3. It also suffers from the limitations of the Gordon Model as the terminal
price is calculated using Gordon Model.
• Multistage growth models: Two-Stage DDM
n
P0 = Σ D0 (1+gs)t + Dn (1+gn) ……(6)
t=1 (1+ke)t (ke- gn) (1+ke)n

PV of Dividends PV of dividends during

during supernormal infinite normal growth period
growth period i.e. PV of terminal price

Where gs = Extraordinary growth rate in the first n years

gn = Stable/normal growth rate forever after n years
The formula can be restated as:

P0 = D0 (1+gs) 1 – (1+gs) n + Dn (1+gn) ….(7)

(1+ke) n (ke- gn) (1+ke)n
(ke- gs)
• Multistage growth models: Three-Stage DDM
n1 n2
P0 = Σ D0 (1+gs)t + Σ Dt + Dn2 (1+gn) ……(8)
t =1 (1+ke)t t = n1+1 (1+ke)t (ke- gn) (1+ke)n2

High growth phase Transition Stable Growth Phase

Growth Rate

High growth phase Transition Stable

Payout Ratio
Problem on Three-stage DDM:
V Ltd. has EPS of Rs.2 last year,
Div. Pay-out = Re.1
Current growth rate = 18% will be maintained for next 4 yrs,
Length of transition period = 4 yrs,
Stable growth rate 6%,
Current Rf = 8%; β = 1.2; Rm = 13%, i.e. current required rate of return = 14%,
After the growth rate stabilizes : Rf = 7%; β = 1.0; Rm = 10%, i.e. required rate of return
after 4 yrs will be = 10%.
Div. Pay-out ratio after 4 years = 0.70
Calculate the intrinsic value of the company and comment thereon if the current market
price of the share is Rs.9.50
WHICH GROWTH PATTERN SHOULD BE USED?
If your firm is: • large and growing at a rate close to or less than growth rate
of the economy, or • constrained by regulation from growing at rate faster than
the economy;
• has the characteristics of a stable firm (average risk & reinvestment rates)

---- Use a Stable Growth Model

If your firm • is large & growing at a moderate rate (≤ Overall growth rate +
10%) or • has a single product & barriers to entry with a finite life (e.g.
patents)

---- Use a 2-Stage Growth Model

If your firm • is small and growing at a very high rate (> Overall growth rate
+ 10%) or • has significant barriers to entry into the business
• has firm characteristics that are very different from the normal

---- Use a 3-Stage or n-stage Model

• FREE CASH FLOW TO EQUITY (FCFE) MODEL
Alternative method that can be used to value firms.
• The analysts examine the free cash flow, cash flow available to the firms or
its equity holders net of capital expenditures.
Free Cash Flows to Firm (FCFF):

FCFF=EBIT(1-tc) + Depreciation - Capital expenditures ±

Changes in Net Working Capital
Free Cash Flows to Equity (FCFE):

Earnings available to Equity Shareholders – (1-δ) (Capital

expenditure – Depreciation) ± (1- δ) (Changes in net working
capital)
Where, δ = Debt Ratio
FCFE MODEL: Constant Growth FCFE Model
P0 = FCFE0 (1+g) => FCFE1
(ke- g) (ke- g)

Multistage growth models: Two-Stage FCFE Model

n
P0 = Σ FCFE0 (1+gs)t + FCFEn (1+gn)
t=1 (1+ke)t (ke- gn) (1+ke)n
Problem based on FCFE: Data relating to a Communication company is as follows:
Current EPS = Rs.4.00; Capex per share = Rs.3.70; Dep = Rs.1.70 per sh.
Increase in WC = Rs. 1.00; Debt ratio = 20%; Rf = 7%; β = 1.3; Rm = 10%
Supernormal growth rate is 22% for the next 5 ys. and thereafter at 10%.
Calculate intrinsic value per share.
Sol: Required rate of return is = 7% + 1.3(10-7) = 10.9%
Year 1 2 3 4 5
EPS 4.88 5.95 7.26 8.86 10.8
Less: (1-δ) (Capital expenditure
– Depreciation) 1.95 2.38 2.91 3.55 4.33
Less: (1- δ) (Increase in
working capital) 0.80 0.98 1.19 1.45 1.77
FCFE 2.13 2.59 3.16 3.86 4.71

DF @ 10.9% 0.902 0.813 0.733 0.661 0.596

PV of FCFE 1.92 2.10 2.32 2.55 2.81
Total = Rs.11.70
FCFE for 6th year is Rs.4.71 * 1.10 = Rs.5.18
The PV of terminal value = (4.71 * 1.10) × 1 = Rs.343.17
(0.109 – 0.10) (1.109)5
The value of the stock = Rs.(11.70 + 343.17) = Rs.354.87
GIVEN CASH FLOWS TO EQUITY, SHOULD WE DISCOUNT
DIVIDENDS OR FCFE?
Use the Dividend Discount Model
• (a) For firms which pay dividends (and repurchase stock) which are close to
the Free Cash Flow to Equity (over a extended period)
• (b)For firms where FCFE are difficult to estimate (Example: Banks and
Financial Service companies)
Use the FCFE Model
• (a) For firms which pay dividends which are significantly higher or lower
than the Free Cash Flow to Equity. (What is significant? ... As a rule of thumb,
if dividends are less than 80% of FCFE or dividends are greater than 110% of
FCFE over a 5-year period, use the FCFE model)
• (b) For firms where dividends are not available (Example: Private
Companies, IPOs)