EQUITY INVESTMENTS: EQUITY: MARKET ORGANIZATION,

MARKET INDICES, AND MARKET EFFICIENCY

EQUITY VALUATION: CONCEPTS AND BASIC TOOLS

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READING 49 EQUITY VALUATION: CONCEPTS AND BASIC TOOLS 2

 WHAT IS AN OVERVALUED OR UNDERVALUED STOCK?

Difference between intrinsic (fundamental) value and market value is the source of
profits.

Securities that are followed by many investors are more likely to be fairly valued.

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 EQUITY VALUATION: 3 GROUPS OF METHODS

1) Present value models (DCF models)

- Dividend models
- Free-cash-flow-to-equity models

2) Multiplier models
- Price multiples
- Enterprise value multiples

3) Asset-based models
Assets – Liabilities – Preferred Stock = Equity

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 THE DIVIDEND DISCOUNT MODEL

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 THE FREE-CASH-FLOW-TO-EQUITY MODEL

Multiple-year holding period DDM = PV of all estimated dividends

plus terminal value

 Time t – end of period t.

For firms that do not pay dividends FCFE method is useful.

FCFE – cash available to equity holders after a firm meets all other
obligations.

FCFE = net income + depreciation – increase in working capital – fixed

capital investment – debt principal repayments + new debt issues

FCFE = cash flow from operations – FCInv. + net borrowing

(borrowed – repaid)

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 HOW TO ESTIMATE VALUE OF A PREFERRED STOCK?

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 GORDON (CONSTANT) GROWTH DIVIDEND DISCOUNT MODEL

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 HOW MUCH OF THE ESTIMATED STOCK VALUE IS DUE TO DIVIDEND GROWTH?

1) Calculate value with g = 0

2) Subtract this value from value estimated with growth rate g

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 HOW TO ESTIMATE THE GROWTH RATE IN DIVIDENDS?

- use historical growth

- use median industry growth rate
- estimate sustainable growth rate

Sustainable growth – rate at which equity, earnings and dividends can

continue to grow indefinitely assuming that ROE and div. payout ratio are
constant and no new equity is sold.

Retention rate = 1 – dividend payout ratio

- proportion of net income that goes to retained earnings

READING 49 EQUITY VALUATION: CONCEPTS AND BASIC TOOLS 10

 MULTISTAGE DDM

STEPS:
1) Determine discount rate k
2) Project size and duration of high-growth rate g*
3) Estimate dividends during high-growth period D
4) Estimate the constant growth rate gc
5) Estimate the first dividend in the second stage Dn
6) Calculate stock value at the end of high-growth period
7) Add the PVs of all dividends to the PV of terminal value

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 WHAT MODEL IS THE BEST FOR SPECIFIC COMPANY?

Gordon-growth – valuing stable, mature companies

Multistage growth – firms with a high current growth rate that will
slow down later

FCFE – if company does not pay dividends or future dividends cannot

be estimated, but you can decide on growth rate of earnings

Multiples – when even growth rates of earnings can not be estimated

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 WHAT ARE MULTIPLES MODELS?

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 S&P 500: P/E VS DIVIDEND PAYOUT

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 S&P 500: P/E VS RISK

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 COMPANY FUNDAMENTALS AND P/E MULTIPLE

 Example 1
Company A Industry
Trailing P/E 12.0 8.5
Payout ratio 25% 20%
EPS 5Y growth 27% 15%

Why Company A has higher P/E vs industry?

 Example 2.
Calculate justified forward P/E for Company if ROE=16%, payout ratio 45%, required
rate of return 12%

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 HOW TO USE COMPARABLES?

 Methods of comparables
 Time series analysis comparison to past or average values
 Cross-sectional analysis comparison to benchmark or peer group
 Example 3
$ Price EPS P/E
2011 5546 400 13.9x
2012 6883 412 16.7x
2013 6603 350 18.9x
2014 5010 370 13.5x
2015 2600 248 10.5x

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 HISORICAL P/E FOR CATERPILLAR INC. STOCK

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 HOW TO USE COMPARABLES?

 Comparable multiples are used to

 Identify industry stocks – peer group
 Use price multiple as a screening factor
 Find overvalued and undervalued securities
 Key metrics to screen peer group:
 Industry and product mix
 Size (by revenue and Mcap)
 Geography of operations
 Growth prospects (revenue and earnings)
 Profitability (margins)
 Product positioning within market (high end or low end)
 Key customers (one large or diversified customer base)
 Cost structure (efficiency), etc.

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 EXAMPLE ON RELATIVE VALUATION (SOURCE: VTB CAPITAL)

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 COMPANY FUNDAMENTALS AND P/E MULTIPLE

 Example 4
$ Company A Company B
Revenue 45000 60000
Growth, % 10% -5%
D/E 70% 95%
Order backlog 135000 60000
Share price 15 40
EPS 2 3
DPS 0.2 1.5
Payout ratio 10% 50%
P/E ratio 7.5 13.3

What supports higher P/E for Company B?

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 VARIOUS MULTIPLES CALCULATION

 Example 5
Company A Company B
$ 2013 2014 2015 2013 2014 2015
Weighted avg shares outstanding, bn 4.6 4.75 4.78 4.34 4.3 4.35
Price per share 15.8 23.2 17 10.75 15 13.9
Revenue, bn 58 55.6 53.1 62 62.5 61
Net income, bn 7.5 9.2 6.5 1.7 0.8 2.8
OCF, bn 16 15.5 15.2 15 13.4 14
Book value, bn 19.5 23 20.2 43 45.2 48.6
P/R 1.3x 2.0x 1.5x 0.8x 1.0x 1.0x
P/CF 4.5x 7.1x 5.3x 3.1x 4.8x 4.3x
P/B 3.7x 4.8x 4.0x 1.1x 1.4x 1.2x
P/E 9.7x 12.0x 12.5x 27.4x 80.6x 21.6x

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 ENTERPRISE VALUE MULTIPLES AND EQUITY VALUATION

 Enterprise value (EV) multiples have the form (Enterprise value)/(Value of a

fundamental variable)
 Enterprise value is the market value of the business
 EV=Mcap + Debt - Cash and cash equivalents
 An estimate of common share value can be calculated indirectly from the EV
multiple; the value of liabilities and preferred shares can be subtracted from the
EV to arrive at the value of common equity
 Examples of enterprise value multiples are EV/Revenue, EV/EBITDA, EV/EBIT,
EV/FCF
Example 6:
EBITDA=2000, EV/EBITDA =5, Cash=500, Debt=5000, Number of shares=200
What is share price?

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 EXAMPLE ON EV MULTIPLE

EV/EBITDA P/E

2013 2014E 2015E 2013 2014E 2015E

Air France-KLM 5,1 4,6 3,6 N/A N/A 20,8

British Airways 7,1 5,2 4,1 13,6 9,1 6,5

Lufthansa 4,2 4,5 3,4 22,5 10 4,6

EasyJet 8 6,8 6,1 12,8 11,2 10

Ryanair 8,7 7,9 7 16,8 14,7 12,5

Average 6 5,3 4,5 16,1 9,2 11

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 ASSET-BASED VALUATION MODELS

 Asset-based valuation is estimating the market or fair value of the company’s

assets and liabilities
 Asset-based valuations work well for companies that do not have a high
proportion of intangible and that do have a high proportion of current assets
and current liabilities
 Asset-based valuation approach:
 Start with Book value of assets and liabilities
 Estimation process
 MV of assets and liabilities
 MV of equity=MV of assets – MV of liabilities

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 ASSET-BASED VALUATION MODELS: ASSOCIATED PROBLEMS

 Asset-based valuation: potential problems

 Difficulties determining market value
 BV differ significantly from MV
 Intangible assets
 Rapidly rising inflation
 Asset-based valuation vs DCF
 Company to be valued – airline in financial distress
 Valuation approaches
1) DCF airline stopped the dividend and is losing money and
“burning” cash
2) Asset-based valuation Routes, flight agreements, equipment
and aircraft have value

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 WRAP-UP: WHAT IS THE BEST METHOD?

 Present value models

 Theoretically appealing and provide a direct computation of intrinsic value
 Input uncertainty can lead to poor estimates of value
 Multiplier model
 Ratios are easy to compute and analysis is easily understood
 Problems with selecting a peer group or “comps”
 Asset-based model
 Consistent with the notion that a business is worth the sum of its parts
 Difficulties determining market value and the value of intangible assets

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 HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2019) Volume V  Reading 49

PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume V  Reading 49  Practice Problems
MOODLE  CFA® Level I 2019  TESTS  Equity #6

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