Equity Valuation 13/08/2020 8:15-9:30 + Claims of investors + Dividend vs. Interest + Redemption + Conversion + Why is share valuation difficult compared to bond valuation? + Investors know the future value of dividends + Dividends are paid at the end of every year + Dividends are the only way of cash flows + Investor is expected to hold the shares till infinity p= Dy Py Gant an (or) _ Di +P o G4r) You plan to sell the stock in one year. You somehow know that the stock will be worth $70 at that time. You predict that the stock will also pay a dividend of $10 per share at the end of the year. If you require a 25 percent return on your investment, what is the most you would pay for the stock?Answer: (10/(1+0.25))+(70/(1+0.25))=64 Alternatively, (10+70)/(1+0.25)=64 Suppose we somehow knew the price in two periods, P2. Given a predicted dividend in two periods, D2, the stock price in one period would be: p= yh 1 G4n° 4+n (or) _ D+ Pp A= Gor) If we were to substitute this expression for P, into our expression for Pp, we would have: Dy, +Py P, = o G4r) Dz + Py p 2 t) 0 +r) By simplifying, we have: P= Dy Dz P, °= Geni Gen? Ger? If we were to substitute this expression for P, into our expression for Pp, we would have: Dy Dz Ds Ps Py = ot a ta tt (l+r)t G@4+r)? (Q4+r)3 (1+r)3 You should start to notice that we can push the problem of coming up with the stock price off into the future forever. Note that no matter what the stock price is, the present value is essentially zero if we push the sale of the stock far enough away.Dy Da Ds Da = Gant Gan Gan Gant Pa tan If we substitute the price indefinitely, we are eventually left with the result that the current price of a stock is simply the present value of the dividends beginning in one period and extending out forever: Dy D2 Ds Da Ds Gane Gare Gene Gan Oe _ Db Dp Ds De Ds aan aan ase ant Gens te D, = D, = D3 = Dy = Ds = Constant Because the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period. The per-share value is thus given by: Po Py = D+ = D+ 0 = Dis (or) D, Py= $ Suppose the Paradise Prototyping Company has a policy of paying a dividend of $10 per share every year. If this policy is to be continued indefinitely, what is the value of a share if the required return is 20 percent? Answer:P, = 10/0.2=50 Py = $50 per share Suppose we know that the dividend for some company always grows at a steady rate. Call this growth rate as 'g'. If we let Do be the dividend just paid, then the next dividend, D,, is: D, = Do*(1+g) or D, = Do*(1+g)* Dz, = D,*(1+g) or Dz = Do*(1+9)* Dn = Dn-1* (1 +9) or Dn = Do *(1 +9)" An asset with cash flows that grow at a constant rate forever is called a If the dividend grows at a steady rate, then we have replaced the problem of forecasting an infinite number of future dividends with the problem of coming up with a single growth rate, a considerable simplification. p D, D, Ds Da Ds o> Gent Gen? Gen! Gary * Gant PB ” Do*(1+g) Dox(1+g)* , Dox +g)* , Dyox(1+g)* , Dox (1+g)* ~ G+rnt a+r)? a+r? a+r a+r As long as the growth rate, g , is less than the discount rate, r, the present value of this series of cash flows can be written simply as below. We call it as dividend growth model. Do*(1+9) Py = ° TgSuppose the current dividend is $2.30, required rate of return is 13 percent, and growth rate is 5 percent. What would be the price per share in this case? Answer: D, = Do * (1 +g) = 2.30*(1+0.05)=2.415 Po = 2.415/(0.13-0.05)=30.1875 Alternatively, >, = Dow (+9) r—-g Py = (2.30*(1+0.05))/(0.13-0.05)=30.1875 We can actually use the dividend growth model to get the stock price at any point in time, not just today. In general, the price of the stock as of time 'n' is: Dn* (A+g) P= a Tg AS, Dn+1 = Dn* (1+ 9) Suppose we are interested in the price of the stock in five years, P;. We first need the dividend at time-5, D,. Because the dividend just paid is $2.30 andthe growth rate is 5 percent per year, D, is: Dn = Do* (1 +g)" De = 2.30*(1+0.05)45=2.9354 Ds *(1+ P= s* A+) rT-g Pz = (2.9354*(1+0.05))/(0.13-0.05)=38.5271 Alternatively, D, Ps g Dg = 2.30*(1+0.05)46=3.0822 Ps, = 3.0822/(0.13-0.05)=38.5275 The next dividend for the Gordon Growth Company will be $4 per share. Investors require a 16 percent return on companies such as Gordon. Gordon’s dividend increases by 6 percent every year. Based on the dividend growth model, what is the value of Gordon’s stock today? What is the value in four years? Answer: Current Price: Dy Py = o rag Py = 4/(0.16-0.06)=40.0 Price in four years: Dax (1+ P, = 4 *(1+9) g rD, = D,*(1+9) 4*(140.06)=4.24 Ds = 4.7641*(1+0.06)=5.0499 Alternatively, = Dox (1 +9)" D.x(1+g)"™ *(1+0.06)43=4.7641 *(1+0.06)44=5.0499 P, = (4.7641*(1+0.06))/(0.16-0.06)=50.4995 Alternatively, P, = 5.0499/(0.16-0.06)=50.499 Dy D2 Ds Da R= fee P, °- Gent Ger? Gere Gen ar Assuming a high growth rate in dividends for n years and a constant growth rate thereafter, we compute the present value as follows: P ° Dy+(1+ga)* Do *(1+ga)* Do *(1+ga)® | Dy *(1+9a)* ~ Gent Gtr? a+r G+n* Pott ae)® . (1+ g4)" Dy * (1+ gn) ans ~ Gtr" ° @—g Gtr)"Py = Present value of future dividend cashflow stream + Present value of the terminal value (P,) Amico Ltd. has declared dividend of Rs.2 for the current year. The earnings of the company are expected to increase by 10% per annum for next 5 years and at 5% thereafter. The shareholders expect 15% rate of return on their investment. What would be the intrinsic value of Amico's share? Solution: — Di Dz D3 Dg Ds De 1 ant * Gane t Gan? * Gant t Gans t O-9) * aan Po Dn = Dn-i(1 +9) Dna = Dn(1 +9) Dy =2 Dy = Do(1 + g) = 2*(1+0.1)=2.2 Dy = Dy(1 + g) =2.2*(1+40.1)=2.42 D3 = D2 (1 + g) =2.42*(1+0.1)=2.662 Dg = Dg (1 + g) =2.662*(1+0.1)=2.9282 Ds = Da(1 + g) =2.9282*(1+0.1)=3.221 Dg = Ds (1 + g) =3.221*(1+0.05)=3.3821 Py = PV of future dividend cashflow stream + PV of the terminal value (P,) Where.— Dn*(1+g) g P= 2? 242, _ 2.662 2.9282 gaz. | sse1_ yt 0 Groasyt * Gtoasy? | G@+t015)% * G@+o1s)* ' (Gt015)§ © (13-008) * Gr0.18)5 Py = (2.2/1.1541)+(2.42/1.1542)+(2.662/1.1543)+(2.9282/1.1544)+(3.221/1.15 45)+(3.3821/(0.15-0.05))*1/1.15°5= Alternatively, PVIF (15% year) = 1/(1+0.15)*1=0.8696 PVIF (15% 2years) = 1/(1+0.15)*2=0.7561 PVIF (5% ayears) =1/(1+0.15)*3=0.6575 PVIF(150%,4years) = 1/(1+0.15)*4=0.5718 PVIF (1504 syears) = /(1+0.15)"5=0.4972 PV of future dividend cashflow stream = (2.2*0.8696)+ (2.42*0.7561)+(2.662*0.6575)+(2.9282*0.5718) +(3.221*0.4972)=8.769 Ds * (1+ P= sto) Ps = (3.221*(140.05))/(0.15-0.05)=33.8205 PV of the terminal value (P;) = 33.8205*0.4972= 16.8156 Pp = PV of future dividend cashflow stream + PV of the terminal value (P,) Py = (8.769 + 16.8156) = 2515846 Supersonic Ltd recently paid a dividend of Rs.4 per share. It is expected to grow by 15% every year for the next three years, thereafter it will continue anormal growth rate of 6% per annum. If the required rate of return is 16%, what is the intrinsic value of the share? Answer: Do= 4D, = Do(1 + g) = 4*(1+0.15)=4.6 Dz = D,(1 + g) = 4.6*(1+0.15)=5.29 D3 = D2(1 + g) = 5.29*(1+0.15)=6.0835 D, = D3(1 + g) = 6.0835*(1+0.06)=6.4485 R= (4.6/1.1641)+(5.29/1.1642)+(6.0835/1.1643)+(6.4485/(0.16-0.06))*1/1.1643=53.1071 Alternatively, PVIF (16% 1year) = 1/(1+0.16)*1=0.8621 PVIF(16%2years) = 1/(1+0.16)*2=0.7432 PVIF (16% ayears) =1/(1+0.16)*3=0.6407 PV of future dividend cashflow stream = (4.6*0.8621)+ (5.29*0.7432)+(6.0835*0.6407)=11.7949 D3* (1+ p, = 23 a+9) r-g P; = (6.0835*(1+0.06))/(0.16-0.06)=64.4851 PV of the terminal value (P3) = 64.4851*0.6407=41.3156 Py = PV of future dividend cashflow stream + PV of the terminal value (P,) Py = 11.7949 + 41.3156 =JP +9)""* (1 + 92) where, P, = a — 92 1-(4e# _ THT, Di(i+g)"*+g2)) | 1 eo PS lel} Supersonic Ltd recently paid a dividend of Rs.4 per share. It is expected to grow by 15% every year for the next three years, thereafter it will continue anormal growth rate of 6% per annum. If the required rate of return is 16%, what is the intrinsic value of the share? Answer: First Stage: (1-((1.15/1.16)43))/(0.16-0.15)=2.564 Second Stage: (4.6*(1+0.15)42*(1+0.06))/(0.16-0.06)*(1/(1+0.16)43)=41.3129 where, D, = Do(1 + g) = 4*(1+0.15)=4.6 (or) (4*(1+0.15)3*(1+0.06))/(0.16-0.06)*(1/(1+0.16)3)=41.3129 Py = 2.564+41.3129=43.8769 Alternatively, Po = (1-((1.15/1.16)3))/(0.16-0.15)+(4*(140.15)43*(1+0.06))/(0.16-0.06)*(1/(1+0.16)4 3)=43.8769Multi Period Valuation Model: P yt >=) a (1+ryjt Acompany’s earnings and dividends are expected to grow at 15% for first 4 years, at 12% for the next 4 years and thereafter at 8% forever. If the last dividend paid per share was Rs.6 and the investors required rate of return is 12%, calculate the intrinsic value per share of the company. Answer: Rs.232.39 6 Dy, =6*(1+0.15)=6.9 Dz =6.9*(140.15)=7.935 D3 =7.935*(1+0.15)=9.1253 Dg =9.1253*(1+0.15)=10.4941 Ds =10.4941*(1+0.12)=11.7534 De =11.7534*(1+0.12)=13.1638 Dy =13.1638*(1+0.12)=14.7435 Dg =14.7435*(1+0.12)=16.5127 Dog =16.5127*(1+0.08)=17.8337 PV = (6.9/1.1241)+(7.935/1.1242)+(9.1253/1.1243)+(10.4941/1.12% 4)+(11.7534/1.1245)+(13.1638/1.1246)+(14.7435/1.1247)+(16.5127/1.124 8)+(17.8337/(0.12-0.08))*1/1.1248=232.396 A firm presently pays a dividend of Rs.6. The company expects the dividend to increase at 20% per annum for the first 4 years, 13% for the next 4 years and the grow at 7% thereafter. If the required rate of return is 24%, what is the present value of the share? Answer:Py (A—b) E, 1—(ROE*b) where, growth rate = return on equity x retention ratio ROE = return on equity b = retention ratio (1-b) = dividend pay-out ratio | If the required return on a stock is 16%, return on equity is 12% and dividend pay-out is 40%, you are required to compute the P/E ratio of the stock. Answer: Py (1—b) FE, r—(ROE*b) P/E= 0.4/(0.16-(0.12*0.6))=4.5455If the required return on a stock is 15%, return on equity is 12% and dividend pay-out is 60%, you are required to compute the P/E ratio of the stock. Answer: P/E= 0.6/(0.15-(0.12*0.4))=5.8824 1. When the firm pays out 100% of its earnings as dividends. D. g In this case, D, = Ey and b=0= Po(1+ In) | Doll (Ga - In) -In T- Gn Po p, = Pol(4+ In) +H(Ga~In)] ° T-Gn Where: Do = The most recent dividend payment a = The initial high growth rate 8n = The terminal growth rate r= The discount rate H = The half-life of the high growth period A company recently issued a dividend of Rs.3. The expected growth rate is 10%, and you expect the rate to fall to a stable growth rate of 2% over the next 12 years. If the required rate of return is 11%, what would the value of a share according to H-model? Answer: