2015, Study Session # 14, Reading # 50

“EQUITY VALUATION: CONCEPTS AND BASIC TOOLS”

FCFE = Free Cash Flows to Equity IV = Intrinsic Value
WC = Working Capital MV = Market Value
50.a
EV = Enterprise Value DCF = Discounted Cash Flow
TA = Total Asset PV = Present Value
TL = Total Liabilities Intrinsic / fundamental value ⇒ rational value based on asset’s TV = Terminal Value
PS = Preferred Stock characteristics (derived through valuation models). FCinv = Fixed Capital Investment
GGM = Gordon Growth Model If IV ≠ MV, abnormal return is possible. DDM = Dividend Discount Model
RR = Retention Rate Perceived mispricing, appropriateness of valuation model & MDDM = Multistage Dividend
SGR = Sustainable Growth Rate inputs are important considerations in investment decision. Discount Model
MP = Market Price PMs = Price Multiples
FV = Fair Value

50.b Equity Valuation Models

DCF or PV Models Multiplier Models Asset-Based Models

DDM 1st Type IV of common stock = TA-TL &

preferred stock.

Stock value is PV of cash Ratio of stock to some

distributed to shareholders. fundamental (earnings, sales
BV, CF etc.).

FCFE Model 2nd Type

PV of cash available to Ratio of EV to EBITDA or

shareholders after capital sales.
expenditures & WC expense. EV = MV of all outstanding
securities – cash & short
term investment.

50.c DDM

One-year holding period DDM Multiple year holding periods DDM

1. Sum of the PV of estimated dividends over

= +
(1 + ) (1 + ) holding period & estimated TV.

2. For two year holding period

1 2
= + +
(1 + ) (1 + ) (1 + )

FCFE

3. It reflects firm’s capacity to pay dividends & also useful for firms not currently
paying dividends.
4. = + − ! − + " #$ $% & .
5. FCFE = CFO – FCinv + net borrowings (represent cash to equity holders after
meeting all obligations).
*+*,-
1. ( = ∑234. -
(./01 )
Where is obtained from CAPM or adding risk premium to publically traded
dRatio of EV to EBITDA or sales.
2. EV = MV of all outstanding securities – cash & short term investment.
3. ebt or govt bond yield.

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 2015, Study Session # 14, Reading # 50

50.d

PS usually has indefinite maturity & fixed dividend.

67
5 =
07

50.e

GGM ⇒ assumes annual dividend growth rate is constant &8 .

69
( = Where = cost of equity.
01 : ;<
Assumptions of GGM
Dividends are appropriate measure of shareholder
wealth.
&8 & never expected to change.
> &8
When difference b/w & &8 widens, value & vice versa.
Small changes in difference cause large changes in value.
Stock value due to dividend growth = stock value at 0%
growth rate – stock value at a positive growth rate.

Estimating Dividend Growth Rate

Use historical dividend growth rate. Median industry dividend growth rate. Sustainable growth rate

Rate at which equity earnings & dividends continue to

grow indefinitely.
Assumptions are constant ROE, dividend payout ratio &
no new equity is issued.
5=> = >> × >@ .
Firm may not be able to pay dividend currently due to
financial distress or higher reinvestment income.

Multistage Dividend Growth Models

If g > r this relationship can’t hold indefinitely (higher growth will attract competition).
Sustainable growth rate is more realistic assumption.
To determine MDDM;
Duration & size of high growth period should be projected.
Estimates of high growth period dividends & constant growth rate.
69 6A 6C DC
= + + ⋯ + +
(./01 ) (./01 )A (./01 )C (./01 )C
where
6C /.
2 =
01 :;<

50.f

GGM is appropriate for stable, mature & dividend-

paying firms with single growth rate.
MDDM can be two or three stages (growth, transition &
mature).
For non-dividend paying firms estimating future
dividend payments are speculative so FCFE is
appropriate.

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 2015, Study Session # 14, Reading # 50

50.g

DDM is very sensitive to inputs so price multiple approach (comparison

of stock price multiple to a benchmark value) is used by many analysts.
PMs are used in time series & cross sectional comparisons.
Critique ⇒ reflect only the past (often historical data is used).
Multiples based on comparables ⇒ compare multiple of the firm with
other firms based on MP.
Multiples based on fundamentals ⇒ what a multiple should be based on
some valuation models.

50.h Price Multiples

P/E Ratio P/S Ratio

EF I
GFH
ℎ
Widely used by analysts.

P/B Ratio P/CF Ratio

I ND
+* O P QRSTU
K $L M " ℎ
CF is CFO or free cash flow.

Multiples can be industry specific (e.g. cable industry

market cap is compared to number of subscribers).

Multiples

Fundamental Based Comparable Based

Z 9Y Compare multiple with benchmarks (historical avg, stocks & industry avg.) &
PW G9
Justified leading YE = (it is justified because we assume that inputs
. [:\ determine its valuation.
are correct & leading because it is based on next period expected earnings). Law of one price⇒ two identical assets should sell at same price.
P
This WYE serves as a benchmark at which stock should trade. Not applicable if firms are of different size, in different industries etc.
.
Very sensitive to inputs, (several sets of inputs for a range of justified P/E). P/S ratio is favored over P/E for cyclical firms (sales are less volatile).
D
Dividend payout .YE , g, k cause P/E.
.
Dividend displacement of earnings ⇒ dividend, growth so firm’s value
impact is ambiguous.

50.i

EV ⇒ total company value ⇒ cost to acquire the firm

EV = MV of common stock + MV of debt – cash & short term investments.
Acquirer’s cost for a firm is decreased by amount of target’s liquid assets (cash &
investments).
EV is appropriate for firms with different capital structure.
EBITDA is normally used as denominator of EV multiple (usually a positive number as
compared to NI & show both equity & debt owner’s earnings).
Disadvantage of EBITDA ⇒ non-cash revenue & expense.
If MV of debt is not available than comparable’s MV of debt or BV is used

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 2015, Study Session # 14, Reading # 50

50.j Asset-Based Valuation Models

Equity value = MV or FV of assets – MV or FV of liabilities.

Problematic if large amount of intangible assets.
More reliable when short term tangible assets, assets with ready MV or
when firm is liquidating.
Often used to value private companies but increasingly useful for public
companies (FV reporting on BS).

50.k DCF Models

Advantages Disadvantages

Strong base in finance theory (concept of Inputs must be estimated.

discounted PV). Value estimates are very sensitive to
Widely accepted in analyst community. inputs.

Comparable Based Valuation

Advantages Disadvantages

Useful for predicting stock returns.
Readily available & widely used by analysts.
Can be used in time series & cross sectional.
EV/EBITDA is useful when comparing a firm’s value
independent of capital structure, or when earnings are
negative.
Not comparable across firms with different size, products &
growth.
Lagging price multiples reflect the past.
Cyclical firms greatly affected by eco conditions.
Stock may appear overvalued by comparables but undervalued
by fundamental method & vice versa.
Different accounting methods distort comparability.
Negative denominator results in meaningless ratio.

Fundamental Based Valuation

Advantages Disadvantage

Based on theoretically sound valuation models. Very sensitive to inputs

Correspond to widely accepted value metrics.

Asset-Based Models

Advantages Disadvantages

Provide floor values. MVs are difficult to obtain & usually different than BV.
Reliable when short-term tangible assets, readily Inaccurate when higher proportion of intangible assets.
measurable MV assets & in liquidation. Assets can be difficult to value during hyperinflation.
Increasingly useful to value public firms that are reported
at FV.

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