Fabricio Chala, CFA, FRM

Equities S6&7
Equity Securities
❖  Represent ownership claims on a Company’s net assets (residual
claim)!

Liabilities
Assets

Equity
Equity securities
❖  Main sources of total return: (i) Dividends, (ii) Capital gain/loss.
❖  Return is uncertain (Company has no obligation to pay dividends).
❖  When the Company is in operation, share issuance is a source of
funding that allows the company to acquire assets that may
increase shareholder’s wealth.
❖  Share issuance can also be used to incetivize employees.
❖  Shares have a book value and a market value.!
Type of equity securities
❖  Common shares: Predominant type.
Ø  Dividends

Ø  Voting rights

Ø  Claim on Company’s net assets in case of liquidation

❖  Preferred stock: Rank above common shares (dividends and

liquidation). Can be convertible. Generally:

Ø  No voting rights

Ø  Fixed dividends (Cumulative, participating, etc)

Payout policy
❖  Different forms of cash distributions
Ø  Dividends

Ø  Share repurchases
Dividends
❖  Dividend irrelevance theory “Neither the price of firm's stock nor
its cost of capital are affected by its dividend policy. Irrespective of
whether a company pays a dividend or not, the investors are
capable enough to make their own cash flows from the stocks
(Modigliani-Miller). Does this theory hold?

❖  ¿What is the impact of…

➡  … an unexpected increase in dividends declared?

➡  … an unexpected decrease in dividends declared?

➡  … paying a dividend?
Dividends vs. Share repurchases
❖  Investors regard dividends as a signaling device: healthier firms
can afford to pay higher dividends.
❖  The firm’s dividend payout ratio will determine its investors …
its tax clientele.
❖  Share repurchases are a tax efficient form of distributing surplus
cash-flow to shareholders.
Stock splits
❖  Increasing the number of the outstanding shares by reducing its
nominal value
❖  Example: 2:1 split
❖  A rationale for a stock split: makes stocks cheaper for small
investors! The opposite is also possible.
Stock splits
Equity Valuation

How do we determine the price of stocks?

Equity Valuation
We can use the Dividend Discount Model (DDM): A.k.a Gordon
Model

❖  The value of a share depends on future dividends.

Div Div Div Div

1 2 3 4

❖  Could it be a perpetuity?
DDM- Gordon Model
❖  Question 1: Ladex Inc. common shares currently pay an annual
dividend of $2.00. This dividend is expected to be mantained
constant for ever. If the required rate of return on the shares is
10%, what is the estimated value of a share today?

❖  Question 2: Assume that there is no change in variables, what

would be the share price in one year?

❖  Question 3: You bought one share a year ago, have you obtained
any profit?
The Gordon Growth Model
❖  What if we expect dividends to grow indefinitely?

Div Div (1+g) … …

1 2 3 4

Important: (i) g (long-term growth rate) is constant (ii) r > g

The Gordon Growth Model
❖  But… How can I obtain “g"?

❖  Intuitively, if a Company reinvests more, will grow more…

The Gordon Growth Model
❖  And if we ask ourselves…

What is the Present Value of growth opportunities (PVGO)?

The Gordon Growth Model
❖  When is it appropiate?
➡  Stable or mature industries

➡  Non cyclical industries

❖  Question 1: If D1 = $1.00, r = 10%, and dividends are expected to
grow at a anualized rate of 5% per year. What is the estimated value
of the share today?

❖  Question 2: What if g=3%?

❖  Question 3: Suppose a company paid a $5 dividend per share. You
expect the dividend to grow at 5% per year for ever. If the share price
today is $65.625. What is the required rate of return?
Multistage Dividend Discount
Model
❖  Often used to model rapidly growing companies that at some
point will begin to pay dividends that grow at a constant rate, but
prior to that time the Company will pay dividends that are
growing at a higher rate that can be sustained in the long run.

… …

1 2 … n n+1 …
Two-Stage DDM
❖  A growing annuity and a perpetuity!

D0 (1+ gs ) ⎡ n
⎛ 1+ gs ⎞ ⎤ n
1 D0 (1+ gs ) (1+ gl )
V0 = ⎢1− ⎜⎝ ⎟⎠ ⎥ +
r − gs ⎣ 1+ r ⎦ (1+ r) n
r − gl

Growing Annuity Perpetuity

“n”- Stage DDM
❖  Suppose a stock just paid a $5 dividend per share. You expect the
dividend to grow at an annual rate of 10% for the next two years,
after that the growth rate will fall to 8% for one year and finally
will achieve a constant growth rate of 6% indefinitely. The
required rate of return of the stock is 12%. What is the estimated
value of the share?
The H- Model
❖  Assumes that the Company starts with a high growth rate and
then converges linearly to the long term growth rate over time…
The H- Model
❖  What is the difference with the Two-stage model?
The H- Model
❖  Suppose a stock just paid a $5 dividend per share. You expect the
dividend will grow at an annual rate of 20% next year. After that,
the growth rate will start falling linearly over the next 5 years until
it reaches a long term growth rate of 6%. The required rate of
return of the stock is 12%. What is the estimated value of the
share?
DDM
❖  Advantages:
❖  Based on fundamental concept of discounted PV

❖  Widely accepted.

❖  Disadvantages:

❖  Inputs must be estimated

❖  Value estimates are very sensitive to input values

Valuation using Cash Flows
❖  What about firms that don’t pay any dividends?

❖  Total cash flow from the business can also be used to value the
company. Generally speaking, we use cash flows after paying for
all investments necessary for growt:
Valuation using Cash Flows
❖  How much is this company worth, assuming its long-term growth
rate is 6%?

❖  How important is the assumption of the long-term growth rate?

Valuation using Cash Flows
❖  Advantages:
❖  Applicable to any firm. (no need to have stable dividends)

❖  Useful for a firm with shareholders that have control over the
cash flows.

❖  Disadvantages:

❖  Need to forecast the Financial Statements of the firm

❖  Firm’s capital structure matters

Valuation using Comparables
❖  Compare a stock’s Price multiple to a benchmark value based on
another firm, an index or an industry group of firms.

❖  Intuition: I should pay aproximately the same for a unit of earnings/sales/

value that the market, for the rest of the companies in an industry. (Law
of one Price)

❖  Common Price multiples:

Ø  Price-to-Earnings (P/E)

Ø  Price-to-Book Value (P/B)

Ø  Price-to-Sales (P/S)
Valuation using Comparables
Price-Earnings (P/E)
❖  Firm’s stock Price divided by earnings per share.
❖  Pros: Widely used, earnings are important.
❖  Cons: Earnings can be negative, are exposed to cyclicality and
can be manipulated (accounting principles).
Price-Book value (P/B)
❖  Firm’s stock Price divided by book value of equity per share.
❖  Pros: positive, book value is stable.
❖  Cons: Doesn’t reflect market value of assets (e.g Intangibles).
Valuation using Comparables
Price-Sales (P/S)
❖  Firm’s stock Price divided by sales per share.
❖  Pros: Sales are difficult to manipulate, less volatile than P/E.
❖  Cons: Growth in sales doesn’t necesarily mean growth in
earnings, doesn’t incorporate costs.
Dividend Yield
❖  Dividends paid divided by the firm’s stock price.
❖  Pros: Component of total return, useful for mature and stable
companies.
❖  Cons: Doesn’t take into account potential capital gains.
Valuation using Comparables
Enterprise Value / EBITDA (EV/EBITDA)
❖  EV can be viewed as what it would cost to acquire the firm

❖  Total company value divided by EBITDA.

❖  Pros: Captures the total value of a firm, proxy of cash flows

generated by firm’s operations, EBITDA is usually positive even
when earnings are not.

❖  Cons: Can be negative, market value of a firm’s debt is often not

available.
Valuation using Comparables