FINANCE 4000 equity investments formula sheet

Chapter 10
Dividend discount model (DDM)

FV N
Present value of a single cash flow PV =
( 1+ r )N
Where
N = number of years
r = annual interest rate

net income
Earning per share ( E ) E=
number of common shares

P price of the share

Price to earning ratio (P/E): =
E earnings per share

Profit = profit margin * sales

If a constant rate of return is assumed, then the intrinsic value of a share is:

∞
Dt
V 0=∑
t =1 (1+ r)t
Where
V 0=¿ value of a share of stock today, at t = 0
Dt =¿ expected dividend in year t, assumed to be paid at the end of the year
r =¿required rate of return on the stock

If an investor intends to buy and hold a share for one year, the value of the share today is the present
value of 2 cash flows – namely, the expected dividend + the expected selling price in one year:

D 1 + P1 D1 P1
V 0= = +
(1+r )1 (1+r )1 (1+r )1

The general expression for an n-period holding period or investment horizon is:

n
Dt Pn
V 0=∑ t
+
t =1 (1+ r) (1+ r)n
Where:
Pn=¿¿ the expected selling price of a share in year n

Free – cash flow – to equity (FCFE) valuation model:

FCFE = CFO – FCInv + Net borrowing

Where:
CFO = cash flow from operations = net income + non cash expenses – investment in working capital
FCInv = fixed capital investment
Net borrowing = net amounts borrowed (borrowings – repayments)

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 ∞
FCFE t
Valuation is V 0=∑
t =1 (1+r )t

Required rate of return on share i = current expected risk free rate of return +
+ beta i ¿ ]

Required rate of return=risk free rate+ [ stoc k ' s beta∗(market return−risk free rate) ]

Free cash flow to equity model (Discounted Cash Flow Model – DCF)
- There are similarities to the dividend growth model. In present value calculations, we discount
future cash flows rather than future dividends. So apply same formulas, just with cash flows
instead of dividends
Value of a share of a stock= present value of future free cash flows going ¿ equity ¿
shares outstanding

Free cash flow=after tax earnings+depreciation−investments ∈working capital−investments ∈¿ assets

FCF 1 FCF 2
1
+ +… .
( 1+ r ) ( 1+ r )2
V=
N
Where
FCF t =free cash flow ∈ year t
N=number of common shares outstanding
As in the dividend growth model, we may assume that free cash flows remain constant over time, grow
at a constant rate, or grow at a rate that varies over time. Investment in working capital, and fixed assets
can be found on the company’s balance sheet.

Calculating growth rates:

If FCF grows at a rate g per year, every year, then
FCF t +1=FCF t∗( 1+ g )
FCF t =FCF 0 (1+ g)t
The same is applied to dividends:

D 1=D 0 ( 1+ g )
D2=D1 ( 1+ g )=D0 (1+ g)2
Etc.,,,
Dt =D0 (1+ g)t
Preferred stock valuation:

For a noncallable, nonconvertible perpetual preferred share paying a dividend D and assuming a
constant rate of return over time, its value reduces to the formula for the present value of a perpetuity.
D0
Its value is: V 0=
r

For a noncallable, nonconvertible preferred stock with maturity at time n , the estimated intrinsic value
can be estimated as below, using the preferred stock’s par value, F , instead on Pn:
n
Dt F
V 0=∑ t
+
t =1 (1+ r) (1+ r)n
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The Gordon Growth Model
This model assumes dividends grow indefinitely at a constant rate.
The estimated intrinsic value is:
∞
D 0 (1+ g)t (1+ g) (1+ g)2 (1+ g)∞
V 0=∑
t =1 (1+ r)t
=D 0
[ +
(1+r ) (1+ r)2
+ …+
(1+r )∞ ]
D0 (1+ g) D1
Which simplifies as: V 0= =
r−g r−g
where r is the rate of return and g is dividend growth rate

next yea r ' s dividends

Value of a share of stock=
rate of return−divident growthrate

the estimated growth rate is g=b∗ROE

where
g=¿dividend growth rate
b=¿earnings retention rate = (1-Dividend payout ratio)
ROE=¿return on quity

Multistage dividend discount model: (Multistage DDM)

The two – stage DDM assumes the company is assumed to experience an initial, finite period of high
growth , perhaps prior to the entry of competitors, follow by an infinite period of sustainable growth.
The two- stage DDM thus make use of two growth rates : a high growth rate for the initial, finite period,
followed by a lower, sustainable growth rate into perpetuity. The Gordon Growth model is used to
estimate a terminal value at time n that reflects the present value at time n of the dividends received
during the sustainable growth period.

The below equations estimate the intrinsic value:

n
D 0 ( 1+ gs ) t Vn
V 0=∑ t
+
t =1 ( 1+r ) ( 1+r )n

D n +1
V n=
r −g L

D n +1=D 0 ( 1+ g S )n ( 1+ g L )
Where:
gS =¿ the short term growth rate that lasts for n years
V n=¿the intrinsic value per share in year n represents the year n value of dividends received during the
sustainable growth period or the terminal value at time n. V n can be estimated using the Gordon
Growth model as shown in equation above.

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g L=¿long term or sustainable growth rate
Dn +1=¿dividend in year n+1

Relationship among price multiples, present value models and fundamentals

Using the Gordon growth model and assuming the price equals intrinsic value ( P0 =V 0 ), we have:
D1
P 0=
r −g
To arrive at the model for price to earning ratio (P/E), we divide both sides of the above equation by a
forecast of next year’s earnings, E1:
D1
P0 E p
= 1 =
E1 r −g r−g
D1
Where p= , p=¿ the dividend payout ratio
E1

P price
Price to earning ratio: ratio= where EPSis earnings per share
E EPS

Retention rate = 1 – payout ratio

After tax earnings = sales * net profit margin

after tax earnings
EPS=
shares outstanding

Chapter 8
( Pt −Pt −1 + Dt )
The total return of an equity security: total return , R t=
Pt−1
Where
Pt −1 =¿ the purchase price of a share at the end of time t−1
Pt =¿ the sale price of a share at the end of time t
Dt =¿dividends

¿t ¿t
ROEt = =
Return on equity (ROE) average BVE t ( BVE t + BVE t−1 )
2
Where
¿t =¿net income available to ordinary shareholders in year t (after preferred dividends have been
deducted)
Average BVEt =¿ is the average book value of equity computed as the book values at the beginning and
end of year t divided by 2.
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Market value of equity = market price per share X shares outstanding

Book value of equity per share = total shareholders’ equity/shares outstanding

Price – to – book – ratio = market price per share / book value of equity per share