Equity Valuation (1)

Study Session 26. Equity Valuation: Application and Processes

1. Market prices may or may not reflect the intrinsic value of the company. The prices
sometimes move on account of irrational reactions to news. Valuation Models allow us to
make an independent estimate of value based on various assumptions. This value is then
compared to the current market prices to check for mis-pricing. Sometimes the lack of
liquidity in the market may affect prices as well.
2. Hypothetically – To estimate intrinsic value, we need to be able to estimate various
parameters, not all of which may be measurable. Further, the estimates are for the future,
which may have high degree of error.
3.
a. Liquidation value assumes that the company is being wound up and all assets are
being auctioned off. The basic assumption in a profitable company is that of Going
Concern. Value of a going concern will generally be far higher than liquidated value.
b. The company’s inventory would be affected by going concern assumption as the
market places a significant discount incase of liquidation of inventory
4. A valuation model which is inferring market expectation starts with the value and works
backward to arrive at the assumptions necessary to achieve this value. The valuation model
focussing on intrinsic value will start with assumptions and work forward to reach at an
independent estimate of value
5. Implications of using higher discount rate – Estimated price will be lower
6. Understanding a company’s business allows us to determine the key drivers affecting various
financial numbers including revenue, cost, growth estimates. Sensitivity is then done on
these drivers to arrive at a range of company’s valuation.
7. We would need the dividend growth rate and the discount rate assumed to obtain the target
price. This will help in forming our own opinion of target price. If Target > Current, stock is
undervalued
8.
a. By making the target prepay its accounts payable, the current liabilities are reduced
as is the cash balance. This will shrink the balance sheet size. This helps in fixing a
more favourable exchange ratio, resulting in boost in EPS. ??????
b. Relative valuation

Study Session 27. Return Concepts:

Example 1

1 Microsoft

Absolute return in 1 years = 37.5/33.31 -1 = 12.58%

Required return = 7%

Analyst expected return over 1 year = 12.58% + 7% = 19.58%

Analysis: INCORRECT

Correct Soln: Dividend yield = 0.23 + 0.23 + 0.25 + 0.25 over 1 year = 0.96, which is dividend
yield of 2.9% (0.96/33.31).
 Price yield over 1 year = 12.58%. Analyst expected return = 2.9% + 12.58% = 15.48%

2 Target price consistent with MS being fairly valued = 33.31

Analysis: INCORRECT
Correct Soln: Required return = Dividend yield + Price appreciation => Price appreciation =
7% - 2.9% = 4.1%. => Target price = Current price * (1+Price appreciation) = 33.31 * (1+4.1%)
= 34.67

Example 2

1. Factors that can bias unadjusted historic risk premium upward?

Risk free rates if artificially kept low due to regulations.
Analysis: PARTLY Correct
Correct soln. Survivorship bias will lead to selection of companies that were successful.
Expected return on return is higher since dataset has only successful companies => ERP is
also upward (Expected return approx. = Risk Free Rate + ERP). If Risk Free Rate is v low,
again ERP is biased upward, since Expected Return is unchanged.

2. Factors that can bias unadjusted historic risk premium downward?

Survivorship bias. Unusual volatility resulting in high risk free rate.
Analysis: Incorrect
Correct SOln: Failure to incorporate return from dividend.

3. 2 indications that historic time series is nonstationary

 No Idea

Correct Soln: Lifting of regulation in 1991, Change in Volatility post deregulation

4. Preference for historical or adjusted historical equity risk premium estimate

Adjusted is better because it takes into account dividends, corrects for suppression of rates,
smoothens volatility

Example 3

1. Calculation of adjusted beta using Blume method

Adjusted beta = 2/3 (raw beta) + 1/3 (1.0) = 2/3 (1.537) + 1/3 (1.0) = 1.358
2. Required return on L&T using CAPM with adjusted beta
Return on Equity = Risk Free Rate + Adjusted beta * ERP = 8.7% + 1.358 * 4% = 14.13%
3. Evidence that beta has been estimated with accuracy
R Squared is 73.6%, data is over 5 years
Correct Soln: Standard Error is 0.121, which is relatively small compared to raw estimate of
1.537

Example 4

CAPM

1. Exxon return = 3.2% + 0.77 * 4.5% = 6.67%

 2. BP return = 3.56% + 1.99*4.1% = 11.72%
3. Total return = 2.46% + 1.53*4% = 8.58%

Example 5

1. Incorrectly used unadjusted beta

2. Analyst says cost of equity is 10%. To estimate above or below average systemic risk, need to
calculate CAPM using Beta of 1 => system return on equity = 7%. Analyst estimate implies
above average systemic risk (10 > 7)

Example 6

Beta of comparable = 0.7, Debt = 0

Unlevered beta = 0.7

Debt in pvt firm = 20%

Levered beta of pvt firm = (1+20/80)*0.7 = 0.875

Example 7

1. Cost of Equity
a. CAPM Method = 0.03% + 0.93*5.9% = 8.49%
b. FFM Method = 0.03% + 0.96*5.9% - 0.44% -0.62% =7.43%
Analysis: INCORRECT
CALCULATION ERROR!!!!!

2. ‘MS’s cost of equity benefits from company’s above average marketing capitalization’
SMB factor takes a view that small cap will outperform large. Since SMB factor premium is
negative here, the view emerging is that large cap is benefiting, so statement seems correct.

3. ‘Growth portfolio will outperform value portfolio’

HML factor takes a view that high P/B stock will decline and low P/B will go up. Growth
stocks generally have high P/B compared to value stocks. Since the HML factor premium is
negative here, the view emerging is that growth stocks will benefit, so statement seems
correct.
Analysis: INCORRECT
Correct SOln. Statement was that CAPM should be favoured over FFM because growth will
outperform value. Since FFM compensates for risk of holding portfolio over long term &
takes into account growth vs value stocks, it is still suited for this purpose

Example 8

Small cap (positive Size beta), Growth stock (negative Value beta), low liquidity (positive liquidity
beta). High liquidity => Easier to trade => Investor demands lower returns to hold the stock.
Conversely, Low Liquidity => Difficult to trade => Investor demand higher returns to justify holding
the stock

Example 9

1. CAPM CoE = Rf + Beta * ERP = 3.7% + 0.73 * 4.20% = 6.77%

2. Bond yield method CoE = Bond Yield + Risk Premium = 4.43% + 2.75% = 7.18%
3. Valuation based on CAPM estimates undervaluation of stock. i.e. Estimated value < USD 195
per share. Alternative estimate of CoE from Bond Yield method discounts at higher rate so
valuation will be lower than using CAPM CoE. So it supports the view of undervaluation of
the stock.
ANALYSIS: INCORRECT.
Correct Soln. Estimated value > 195 since undervaluation. Bond Yield discount rate is higher
so Revised Estimated value < CAPM based value. So the view may or may not be supported.

Example 10

WACC = MVD / (MVD + MVE) * YTM Debt * (1- Tax Rate) + MVE / (MVD+MVD)* CoE

= 0.36 / 1 * 4.4% * (1-25%) + 0.64 / 1 * 7.1%

= 0.01188 + 0.04544 = 0.05732 = 5.732%

PRACTICE PROBLEMS

1. A
a. Length of Expected holding period = 1 year. Length of actual holding period = 25
days
b. Required rate of return 1 year = 8.7%, Dividend = CD 2.11 annual. Price = CD 72.08
Price Appreciation return = Required return – Dividend yield
Dividend yield = 2.11/ 72.08 = 2.927% => Price appreciation return = 8.7% - 2.927% =
5.77%
c. Realized return = (69.52 – 72.08) / 72.08 = -3.55% on absolute basis
d. Realized alpha = Realized return – Expected return = -3.55% - 8.7% = -12.25%

Analysis: a,b,c are CORRECT, d is WRONG

For d., 3 weeks elapsed so expected return = (1+0.161%)^3 – 1 = 0.484% => Realized alpha =
-3.55%-0.484% = -4.034%

2. AOL CoE = 4.35% + 2.5 * 8.04% = 24.25%

JPM CoE = 4.35% + 1.5* 8.04% = 16.41%
Boeing CoE = 4.35% + 0.8 * 8.04% = 10.782%

Analysis: CORRECT

3. FFM
a. FFM CoE = Rf + Beta Market * Market Premium + Beta Size * Size Premium + Beta
Value * Value Premium
 FFM CoE = 4.7% + 1.2 * 4.5% + (-0.5)*2.7% + (-0.15)* 4.3% = 4.7 + 5.4 – 1.35 – 6.45 =
2.3%
Analysis: INCORRECT (Inputs were correct, CALCULATION ERROR in 6.45 -> 0.645)
b. Size factor sensitivity negative => Large size company
Value factor sensitivity negative => P/B is low
Analysis: Partly correct. Negative size beta, Negative value beta, Market Beta>1
=>Large Cap, Growth Oriented, High market risk
4. CAPM CoE = 4.5% + (-0.2)*7.5% = 3%
Analysis: CORRECT
5. FFM is most appropriate.
Analysis: CORRECT
6. L&T WACC = D/(D+E)*Cost of Debt * (1-Tax rate) + E/(D+E)*Cost of Equity
= 0.2 * 8.28% * (1-30%) + 0.8 * 15.6%
= 1.1592% + 12.48% = 13.6392%

Analysis: CORRECT

7. Inclusion of pre-2001 index returns will bias the ERP downward because it has companies
which were part of 2001 index only, introducing survivorship bias.
Analysis: INCORRECT. Survivorship bias => Only companies which were growing were
included=>Higher returns realized=>ERP is biased upward (A)
8. 2004-2006 returns would reflect the uncertainty in the country so the ERP would be very
high during that period. Inclusion will bias the ERP upward. (A)
Analysis: INCORRECT. 2004-2006 would have depressed share returns, not offset by other
positive events, not a persistent feature, led to low valuation levels expected to rebound.
=>ERP biased downward (B)
9. Use of Required Return based on Short Term Bond rate and Historical ERP defined in term of
short term bond rate. Short term bond rates are high, so bias ERP downward. Historial ERP is
biased downward due to past events. Required Return is biased downward.(B)
Analysis: INCORRECT.
STEP 1: Historical ERP based on Short Term Bond. Usually Short Term Bond rate <Long Term
Bond rate. We know the returns based on past data. Historical ERP is DERIVED as = Returns –
Historical Short Term Bond Rate (which was lower) => Historical ERP is high
STEP 2: Current Short Term Bond rates > Long Term Bond rates. Return on Equity is now
DERIVED as = Current Short Term Bond rates (which are high) + Historical ERP (also high) =>
Long Term Return on Equity is biased UPWARD (A)

10. IMPORTANT!
Ibbotson and Chen method of ERP
ERP = { [ (1+Expected Inflation) * (1 + Expected Real Earnings Growth Rate) * (1 + Expected
Growth in P/E ratio) – 1] + Expected income component} – Expected Risk Free Return
ERP = { [ (1+4%) * (1+5%) * (1+1%)-1]+ 1%} – 7% = 4.292%
Answer: C
Analysis: CORRECT
11. Since current yields are 9%, common stock with average systemic risk should return atleast
9% or greater.
ANALYSIS: CORRECT BUT…., reasoning partly correct. Return can be based on short term
bond or long term term bond. Short term => Returns >9%
Long term bond => Return = 7% + 1.0 * 2% (Historical ERP) = 9%
 OR
Return = 7% + 1.0 * 4.3% (Supply side ERP) = 11.3%. Min return = 9%

12. B. Higher leverage

Analysis: CORRECT

13. Based on Exhibit 1, expected 3 year holding period return with no dividend paid =
(1+12.6%)^3 -1 = 42.76%
Analysis: INCORRECT. 12.6% is CAPM but it is only an input to the price expectation. We
have actual price expected => 3 year holding = (29-20.75) / 20.75 = 39.76%

14. Realized holding period return with no dividend paid = (30.05/20.75) -1 = 44.82%
Analysis: CORRECT

15. Unexpected inflation and productivity surprises would have led to higher Return
expectations from equity so ERP needs to be adjusted downward.
ANALYSIS: CORRECT BUT…., reasoning partly correct. Unexpected inflation and productivity
surprises would have led to higher actual Returns (not just expectation)

16. ERP = {[(1+Expected Nominal Earnings Growth Rate)* (1+Expected Growth in P/E)-]
+Expected income component} – Expected Risk Free Return
= {[ (1+4%)*(1+0%) -1]+1.2%} – 3% = 2.2%
Analysis: CORRECT

17. CoE = 3% + 2 * 5.5% = 14%

WACC = 0.25 * 4.9% * (1-30%) + 0.75 * 14% = 0.8575+10.5 = 11.3575%
Analysis: CORRECT

18. Beta for Twin industries

Unlevered Beta = (1/(1+D/E)) * Levered Beta
UL Beta = (1/(1+60/40))*1.09 = 0.436
Levered Beta for Twin Industries = (1+0.49/0.51) * 0.436 = 0.855
Analysis: CORRECT

19. Analysis doesnot account for difference in size between Twin and the listed peer
Analysis: CORRECT