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EQUITY VALUATION
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^ To determine the expected rates of return on

alternative assets, it is necessary to   

  of the asset since a major component of the rate
of return is the change in value for the asset over time.
^ Therefore, the crux of investments is valuation! The
value of any earning asset is the present value of the
expected cash flows generated by the asset.
^ Therefore, to estimate the value of an asset, you must
derive an estimate of
± (1) the discount rate for the asset (your required rate of return)
± (2) its expected cash flows.
^ The point is, the main source of information that will
help you make these two estimates is the financial
statements,
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^ inancial statements are also the main

source of information when deciding
whether to lend money to a firm (invest in
its bonds) or to buy warrants or options on a
firm¶s stock.
^
e first look into corporation¶s major
financial statements and discuss why and
how financial ratios are useful.
^
e will see how can internal liquidity,
operating performance, risk analysis, and
growth analysis can be assessed.
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^ inancial statements are intended to provide

information on the resources available to
management, how these resources were financed, and
what the firm accomplished with them.
^ orporate shareholder annual and quarterly reports
include three required financial statements:
o the balance sheet,
o the income statement, and
o the statement of cash flows.
^ Information from the basic financial statements can be
used to calculate financial ratios and to analyze the
operations of the firm to determine what factors
influence a firm¶s earnings, cash flows, and risk
characteristics.
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^ The Balance Sheet Ratios

^ The debt figure includes all long-term fixed obligations,

including lease obligations and subordinated convertible
bonds.
^ The equity typically is the book value of equity and includes
preferred stock, common stock, and retained earnings.
^ Some analysts prefer to exclude preferred stock and
consider only common equity.
^ Total equity is preferable if you are examining an industry in
which some of the firms being analyzed have preferred
stock.
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^ The Balance Sheet Ratios

^ Book Value:
It is simply the net worth of the company (paid-up
equity + reserves + surplus) divided by the number of
outstanding equity shares.
^ Liquidation Value
It is value realized from liquidating all the assets of the
firm and subtracting from it amounts to be paid to all
the creditors and preference shareholders. Thus the
figure obtained divided by Number of outstanding
equity shares provides the liquidation value.
^ Replacement ost
It is obtained by estimating a replacement cost of asset
minus the liabilities.
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#+!
^ All of these valuation techniques are based on the
basic valuation model, which asserts that the value of
an asset is the present value of its expected future
cash flows as follows:
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)%"
"

To start it we assume that the investor is holding the

stock for one year. Using the standard formula of stock
valuation we work it out as follows:

V, = D- P-
-------- + --------
(1+k) (1+k)

here:
D- .Dividend expected in the forthcoming year
P- .Price of the share at the end of year (investment)
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)%"
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D- P-
V, = -------- + --------
(1+k) (1+k)

onsider a stock which is expected to give a dividend

of Rs.2 and the stock price is expected to increase to
Rs.25. If the required rate of return of the investor is
12% -- what s the current price of the stock.

V,.
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#+!
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#+!
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#+!
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„ult-period Valuation „odel

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„ult-period Valuation „odel

The next estimate is the expected sale price (V ) for

the stock three years in the future. Assume an
estimated sale price using the DD„ of $34.
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#+!

^ If you anticipate holding the stock for several years

and then selling it, the valuation estimate is harder.
^ You must forecast several future dividend payments
and estimate the sale price of the stock several years
in the future.
^ The difficulty with estimating future dividend payments
is that the future stream can have numerous forms.
^ The exact estimate of the future dividends depends on
two projections.
^ The first is your outlook for earnings growth because
earnings are the source of dividends.
^ The second projection is the firm¶s dividend policy,
which can take several forms.
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#+!
^ The easiest dividend policy to analyze is
one where the firm enjoys a constant
growth rate in earnings and maintains a
constant dividend payout. This set
^ of assumptions implies that the dividend
stream will experience a constant growth
rate that is equal to the earnings growth
rate.
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#+!/%"% $"
The easiest dividend policy to analyze is one where
the firm enjoys a constant growth rate in earnings and
maintains a constant dividend payout. This set of
assumptions implies that the dividend stream will
experience a constant growth rate that is equal to the
earnings growth rate.
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#+!
^ The infinite period constant growth rate
model can be simplified to the following
expression:
^ To use this model for valuation, you
must estimate:
^ the required rate of return (G) and
^ the expected constant growth rate of dividends
().
^ After estimating it is a simple matter to
estimate 1, because it is the current
dividend (0) times (1 + ).
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#+!
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#+!
^ These examples show that as small a change
as 1 percent in either or Gproduces a large
difference in the estimated value of the stock.
^ The crucial relationship that determines the
value of the stock is
³the 
 

 

 


(k) 



 (g).
^ Anything that causes a decline in the spread
will cause an increase in the computed value,
whereas any increase in the spread will
decrease the computed value of the stock.
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^ As noted, the assumptions of the model make
it impossible to use the infinite period constant
growth model to value true growth companies.
^ A company cannot permanently maintain a
growth rate higher than its required rate of
return because competition will eventually
enter this apparently lucrative business, which
will reduce the firm¶s profit margins and
therefore its ROE and growth rate.
^ Therefore, after a few years of exceptional
growth²that is, a period of temporary
supernormal growth²a firm¶s growth rate is
expected to decline.
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^ To determine the value of a temporary supernormal
growth company, you must combine the previous
models.
^ In analyzing the initial years of exceptional growth, you
examine each year individually.
^ If the company is expected to have two or three stages
of supernormal growth, you must examine each year
during these stages of growth.
^
hen the firm¶s growth rate stabilizes at a rate below
the required rate of return, you can compute the
remaining value of the firm assuming constant growth
using the DD„ and discount this lump-sum constant
growth value back to the present.
^ The technique should become clear as you work
through the following example.
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^ The XYZ ompany has a current dividend (0)
of $ 2 a share. The following are the expected
annual growth rates for dividends.
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#+!u
 
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 V
^ The relative valuation techniques implicitly contend
that it is possible to determine the value of an
economic entity (i.e., the market, an industry, or a
company) by comparing it to similar entities on the
basis of several relative ratios that compare its stock
price to relevant variables that affect a stock¶s value,
such as
a. earnings,
b. cash flow,
c. book value; and
d. sales.
^ Therefore, following relative valuation ratios:
a. price/earnings ( / ),
b. price/cash flow ( / ),
c. price/book value ( /
); and
d. price/sales ( V).
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#+!u
 
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 V

^
e will discuss the / ratio, also referred

to as the earnings multiplier model,
because it is the most popular relative
valuation ratio.
^ In addition, we will show that the / ratio
can be directly related to the DD„ in a
manner that indicates the variables that
affect the / ratio
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 V
^ „any investors prefer to estimate the value of common stock using
an %)%".
^ The reasoning for this approach recalls the basic concept that the
value of any investment is the present value of future returns.
^ In the case of common stocks, the returns that investors are entitled
to receive are the net earnings of the firm.
^ Therefore, one way investors can estimate value is by determining
how many dollars they are willing to pay for a Rupee of expected
earnings.

^ This computation of the current earnings multiplier ( / ratio)

indicates the prevailing attitude of investors toward a stock¶s value.
^ Investors must decide if they agree with the prevailing / ratio (that
is, is the earnings multiplier too high or too low?) based upon how it
compares to the / ratio for the aggregate market, for the firm¶s
industry, and for similar firms and stocks.
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^
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 V

^ The infinite period dividend discount model can

be used to indicate the variables that should
determine the value of the / ratio as follows:

^ If we divide both sides of the equation by 1

(expected earnings during the next 12 months),
the result is
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 V
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 V
^ After estimating the earnings multiple, you would apply it to your
estimate of earnings for the next year ( 1) to arrive at an estimated
value.
^ In turn, 1 is based on the earnings for the current year ( 0) and your
expected growth rate of earnings.
^ Using these two estimates, you would compute an estimated value of
the stock and compare this estimated value to its market price.
^ onsider the following estimates for an example firm:
/ = 0.50 G= 0.12 = 0.09 0 = $2.00
^ Using these estimates, you would compute an earnings multiple of:

^ iven current earnings ( 0) of $2.00 and a of 9 percent, you would

expect 1 to be $2.18. Therefore, you would estimate the value (price)
of the stock as = 16.7 × $2.18 = $36.41
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#+!u
 
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 V 
 

^ The advocates consider this ratio meaningful and useful for two
reasons.
^ irst, they believe that strong and consistent sales growth is a
requirement for a growth company. Although they note the
importance of an above-average profit margin, they contend that 



 
 
^ Second, given all the data in the balance sheet and income
statement, sales information is subject to less manipulation than any
other data item. The specific /Vratio is:
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^
e analyze economies because of the strong link
between the overall economic environment in a
country and the performance of its security markets.
^ V

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  because the value of an investment is
determined by its expected cash flows and its future
required rate of return, and both of these factors are
influenced by its expected aggregate economic
environment.
^ Therefore, if you want to estimate cash flows, interest
rates, and risk premiums for securities, you need to
consider aggregate economic analysis.
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^ Three major techniques are available for analyzing
securities markets.
^ irst, the  
   
attempts to project
the outlook for securities markets based on the
underlying relationship between the aggregate economy
and the securities markets.
^ Second, the 
  
involves using the
present value of cash flows and the relative valuation
ratios to estimate a value for a country¶s aggregate stock
market.
^ inally, the     
assumes that
the best way to determine future changes in security
market values is to examine past movements in interest
rates, security prices, and other market variables.
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^ There are two possible reasons why stock prices lead the
economy.
^ One is that stock prices reflect   of earnings,
dividends, and interest rates. As investors attempt to
estimate these future variables, their stock price decisions
reflect expectations for  
economic activity, not current
activity.
^ A second possible reason is that the stock market reacts to
various leading indicator series, the most important being
corporate earnings, corporate profit margins, interest rates,
and changes in the growth rate of the money supply.
^ Because these series tend to lead the economy, when
investors adjust stock prices to reflect expectations for
these leading economic series, it makes stock prices a
leading series as well.
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overnment Policy:
++ iscal policy is concerned with the spending and tax
initiatives of the government. It is perhaps the most direct tool to
stimulate and dampen the economy. An increase to government
spending stimulates the demand for goods and services.
%+ „any academic and professional observers
hypothesize a close relationship between stock prices and various
monetary variables that are influenced by monetary policy.
The best-known monetary variable in this regard is the money
supply. The money supply can be measured in several ways,
including currency plus demand deposits (referred to as the „1
money supply) and the „- money supply plus time deposits
(referred to as the „; money supply). There are other measures of
the money supply, but „- and „; are the best known. The Sate
bank of Pakistan controls the money supply through various tools,
the most useful of which is open market operations.
"+
hile the demand-siders focus on the impact
of taxes on consumption demand, supply-siders look at the effect of
taxes on incentives to work and invest.
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„acroeconomic Analysis:
The key variables commonly used to describe the state of the macro
economy %

^ rowth in DP
^ Industrial growth rate
^ Agriculture and rainfall
^ Savings and investments
^ overnment budget and deficit
^ Price level and inflation
^ Interest rates
^ Balance of Payment, forex reserves, and exchange rate
^ Infrastructure facilities and arrangements
^ Sentiments
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Industry Analysis:
^ Investment practitioners perform industry analysis because they believe it
helps them isolate investment opportunities that have favorable return-risk
characteristics.
^ it is part of our three-step, top-down plan for valuing individual companies
and selecting stocks for inclusion in our portfolio.

hat exactly do we learn from an industry analysis?
^ an we spot trends in industries that make them good investments?
^ Are there unique patterns in the rates of return and risk measures over time in
different industries?.
The industry analysis can be divided into three parts:
o The business cycle and industry sectors
o Industry life cycle analysis
o Study of the structure and characteristics of an industry
o Profit potential of industries
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Industry Analysis:
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^ Toward the end of a recession, financial stocks rise in
value because investors anticipate that banks¶ earnings
will rise as both the economy and loan demand recover.
^ Brokerage houses become attractive investments
because their sales and earnings are expected to rise as
investors trade securities, businesses sell debt and
equity, and there is an increase in mergers during the
economic recovery.
^ These industry selections assume that when the
recession ends there will be an increase in loan demand,
housing construction, and security offerings.
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V VV

^ Once the economy begins its recovery, consumer
durable firms that produce expensive consumer items,
such as cars, personal computers, refrigerators, lawn
tractors, and snow blowers, become attractive
investments because a reviving economy will increase
consumer confidence and personal income.
^ Once businesses recognize the economy is recovering,
they begin to think about modernizing, renovating, or
purchasing new equipment to satisfy rising demand and
reduce costs. Thus, capital goods industries such as
heavy equipment manufacturers, machine tool makers,
and airplane manufacturers become attractive.
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V VV

^ yclical industries whose sales rise and fall along with
general economic activity are attractive investments during
the early stages of an economic recovery because of their
high degree of operating leverage, which means that they
benefit greatly from the sales increases during an economic
expansion. Industries with high financial leverage likewise
benefit from rising sales volume.
^ Traditionally, toward the business cycle peak, the rate of
inflation increases as demand starts to outstrip supply. Basic
materials industries such as oil, metals, and timber, which
transform raw materials into finished products, become
investor favorites. Because inflation has little influence on the
cost of extracting these products and they can increase
prices, these industries experience higher profit margins.
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V VV

^ During a recession, some industries do better than
others. onsumer staples, such as pharmaceuticals,
food, and beverages, outperform other sectors during a
recession because, although overall spending may
decline, people still spend money on necessities so
these ³defensive´ industries generally maintain their
values.
^ Similarly, if a weak domestic economy causes a weak
currency, industries with large export components to
growing economies may benefit because their goods
become more cost competitive in overseas markets.
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Industry Analysis:
Industry Life ycle Analysis:

The number of stages in this "%#++

can vary based on how much detail
you want. A five-stage model would include:
^ 1. Pioneering development
^ 2. Rapid accelerating growth
^ 3. „ature growth
^ 4. Stabilization and market maturity
^ 5. Deceleration of growth and decline
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Industry Analysis:
Industry Life ycle Analysis:
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Industry Analysis:
Industry Life ycle Analysis:
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Industry Analysis:
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Industry Analysis:
Study of the structure and characteristics of an industry :
^ Structure of the Industry and Nature of ompetition
^ Nature and Prospects of Demand
^ ost Efficiency and Profitability
^ Technology and Research

^ During any time period, the returns for different industries vary within a wide range,
which means that industry analysis is an important part of the investment process.
^ The rates of return for individual industries vary over time, so we cannot simply
extrapolate past industry performance into the future.
^ The rates of return of firms within industries also vary, so analysis of individual
companies in an industry is a necessary follow-up to industry analysis.
^ During any time period, different industries¶ risk levels vary within wide ranges, so we
must examine and estimate the risk factors for alternative industries.
^ Risk measures for different industries remain fairly constant over time, so the
historical risk analysis is useful when estimating future risk.
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Industry Analysis:

^ Threat of new entrants

^ Rivalry among the existing firms
^ Pressure from substitute products
^ Bargaining power of buyers
^ Bargaining power of sellers
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Industry Analysis:
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Industry Analysis:
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Industry Analysis:
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Industry Analysis:
Profit Potential of Industries:

^ Threat of new entrants

^ Rivalry among the existing firms
^ Pressure from substitute products
^ Bargaining power of buyers
^ Bargaining power of sellers
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Industry Analysis:
Profit Potential of Industries:

^ Threat of new entrants

^ Rivalry among the existing firms
^ Pressure from substitute products
^ Bargaining power of buyers
^ Bargaining power of sellers
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Industry Analysis:
Profit Potential of Industries:
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Industry Analysis:
Profit Potential of Industries:

^ The basic S
OT analysis, is intended to

articulate a firm¶s strengths, weaknesses,
opportunities, and threats.
^ These two analyses should provide a
complete understanding of a firm¶s overall

approach.
^ iven this background, we review the
financials
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^ Analysts use two general approaches to valuation. The techniques
that serve each of these approaches follow:
^
    
  
1. Present value of dividends (DD„)
2. Present value of free cash flow to equity (  E)
3. Present value of free operating cash flow to the firm
(  )
^ u     
1. Price/earnings ratio ( / )
2. Price/cash flow ratio ( / )
3. Price/book value ratio ( /
)
4. Price/sales ratio ( /V)
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^ or simplicity, we will initially discuss the
constant growth DD„.
e saw that when
dividends grow at a constant rate, a stock¶s price
should equal next year¶s dividend, 1, divided by
the difference between investors¶ required rate
of return on the stock Gand the dividend
growth rate 
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