Topic 3 Valuation

Part 2 Equity

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 Content
Share Valuation Models
 Dividend Valuation Model
 Constant Growth In Dividends Valuation Model
 Non-Constant Growth Model
 Price/Earnings Model

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 Ordinary Share Valuation
The Dividend Valuation Model
 The market value of a share is the present value of all the
expected future dividends to be received from the share
discounted at a rate of return that reflects the riskiness of those
dividends.

 Dividend growth is an important aspect of share valuation.

 Share valuation is more difficult than bond/debenture valuation

for two reasons:
 The uncertainty of future cash-flows (dividends); and
 Shares have no maturity.

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 Valuation of Shares (Equity)
Three Models of Share Valuation:
 Dividend Valuation Model
 Price-Earnings Model
X Capital Asset Pricing Model (CAPM)

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 Dividend Valuation Model
Market price of shares = PV of all expected
future dividends.
 What about the future selling price of the shares? Do we
take future selling price into consideration when working out
the current price of the shares?
Even if you sell your shares at time period T, the selling price at
that point in time is the PV to the buyer of all expected future
dividends. Therefore, in valuing the shares we can ignore the
future selling price and treat the current price of the shares
simply as the PV of all expected dividends.
i.e. we ignore future selling price when valuing shares with the
dividend valuation model.

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 Dividend Valuation Model
Current Share Price = PV of All Future Dividends

P0  D1 (1  re ) 1  D2 (1  re ) 2  D3 (1  re ) 3  ...  D (1  re ) 

Where re = required return of shareholders in the firm (cost of equity)

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 Constant Growth Stock
 What is a constant growth stock?
One whose dividends are expected to grow at a
constant rate, g, forever.

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 Constant Growth Stock
 With a constant growth stock dividends grow by the same per cent
each time period. This creates the:
Constant Growth In Dividends Pricing Model.

 Pricing formula for the Constant Growth In Dividends Pricing Model

is:

D 0 (1  g ) D1
P0  
re  g re  g

 Note: D0 is the most recently paid dividend (dividend paid at T0) and
g is the long-term constant growth rate in dividends.

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 Constant Growth Stock
Example
Sumitomo Bank has just paid a dividend of 15 cents per share and
this is expected to grow at 5% per annum indefinitely. What price
should you pay for the Sumitomo Bank shares if your required rate
of return on the investment is 10% p.a.?
D 0 (1  g )
P0 
re  g
0.151.05
P0 
0.10 - 0.05
0.1575
P0 
0.05
P0  $3.15
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 Constant Growth Stock
 Note: The constant growth in dividends pricing formula assume that dividends
grow at a constant rate from T0. The formula for Price at T0 depends on the dividend
at T1:

D1
P0 
re  g

 What if dividends grow at a constant rate from some time after T 0 (say from
Tn+1).? The constant growth in dividends formula can still be used. It becomes:

Dn1
Pn 
re  g
 This formula gives the present value of all dividend payments beyond T n at Tn
and to calculate it requires the dividend payment at T n+1, which is the period in
which dividends begin to grow at a constant rate.
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 Constant Growth Stock
Example
What’s the share’s price if D0 = 2.00, re = 13% and g = 6%?
 We can use the constant growth in dividends pricing model:

D0 1  g  D1
P0  
re  g re  g
2.00(1.06) 2.12
P0  
0.13  0.06 0.07
P0  $30.29
 The price of $30.29 is the PV of dividends to be received in Yr 1, Yr 2,
Yr 3, Yr 4, Yr 5,………Yr 20……..Yr 100 …… Yr ∞.

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 Constant Growth Stock
 What will be the share’s price one year from now, i.e. what will be
P1?
 D1 will have been paid, so expected future dividends are D2, D3,
D4.......D∞. Therefore,

D1 1  g  D2
P1  
re  g re  g
2.12(1.06)
P1 
0.13  0.06
2.2472
P1 
0.07
P1  $32.10
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 Dividend Yield & Capital Gains Yield
 Continuing with the previous example, find the Dividend
Yield (DY) and Capital Gains Yield (CGY) for Year 1:

 Dividend Yield:
D1 $2.12
DY    0.07  7%
P0 $30.29

 Capital Gains Yield:

P1  P0 $32.10  $30.29
CGY    0.06  6%
P0 $30.29

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 Total Return
 Total Return = dividend yield + capital gains yield.
 In the current example, Total Return = 7% + 6% = 13%.
 And the Total Return of 13% also = the Required Rate of
Return, re, of 13% p.a.

 Note: For a constant growth stock the capital gains yield

equals g (the constant growth rate in dividends), which in
this example is 6%

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 Constant Growth Stock
 In summary, the components of Required Return for a constant
growth stock are:
re  DY  CGY
and
CGY  g
 re  DY  g
D1
 re  g
P0
Therefore, in the current example: $2.12
re   0.06
$30.29
re  0.07  0.06
re  0.13  13%

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 Constant Growth Stock
 What happens if g > re? (i.e. the constant growth rate in dividends is greater than
the required rate of return).
D1
 The constant growth in dividends pricing formula, P0 
re  g
requires that re > g.

 If g > re using the formula we will get a negative stock price, which is impossible.
(A negative stock price implies that the investor that you buy the share off will
pay you for buying their share).

 Therefore, you can’t use the constant growth in dividends pricing model unless:
1. g  re, and
2. g is expected to be constant forever.

 Because g is a long-term growth rate it cannot be  re.

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 Constant Growth Stock
 What would the price of a share be if the long-term constant growth
rate in dividends, g, = 0%?
 Since g= 0% the dividend would not change. Therefore, we would
have a constant dividend that we would treat as a perpetuity (a fixed
cash-flow forever i.e. PMT is fixed).
 To find the price of such a share we would use the PV of a
perpetuity formula:
PMT D
PV0  Pr ice0  
r re
 Example: D = $2.00 and re = 13% p.a.
$2.00
Pr ice0   $15.38
0.13

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 Preference Shares
 Preference shares are similar to bonds in that preference
shareholders receive a fixed dividend which must be
paid before dividends can be paid on ordinary shares.
Dividend Valuation Model – Zero Growth
 Preference shares have a constant dividend into
perpetuity, with no growth in dividends. Therefore, the
value of a preference share is found in the same way as
the value of a perpetuity:

D
P0 
re
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 Preference Shares
 Example
What’s the price of a preference share with a dividend of $5 and a
required rate of return (re) of 10% p.a.?
$5
P0   $50
0.10
 Example
What’s the rate of return (re) on a preference share that has a
dividend of $5 and a current price of $50?
D
Use the dividend yield formula: re 
P0
$5
r   0.10  10%
Therefore, e $50
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 Non-Constant Growth In Dividends
(The Modified Constant Growth In Dividends Pricing Model)

 The Non-Constant Growth In Dividends Model allows for

non-constant growth rates over a fixed length of time.
 The non-constant growth rate in dividends may exceed re
in the short term.
 The growth rate in dividends cannot exceed re forever
but can do so for a number of years.
 The growth rate in dividends will have to grow at a
constant rate below re at some time in the future.

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 Non-Constant Growth In Dividends
(The Modified Constant Growth In Dividends Pricing Model)

 Example
If we have growth in dividends of 30% for the first three
years then a long-run constant growth, g, of 6%, what is
P0?
D0 = $2.00 and re = 13% p.a.

 To find P0 we must use the Modified Constant Growth In

Dividends Pricing Model

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 Modified Constant Growth In Dividends Pricing Model
 Note: When using the Modified Constant Growth In Dividends
Pricing Model you only have to calculate dividends up to the first
period in which the long-term constant growth rate commences. In
this example that is Year 4.
 Step 1: Calculate dividends up to D4:
• D0 = $2.00
• D1 = $2.00(1.30) = $2.60
• D2 = $2.60(1.30) = $3.38
• D3 = $3.38(1.30) = $4.394
• D4 = $4.394(1.06) = $4.6576

(continued next page)

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 Modified Constant Growth In Dividends Pricing Model
 Step 2: Apply the Constant Growth In Dividends Pricing Formula to the first of
the long-term constantly growing dividends. In this example that is D4:

Dn 1 D4
Pn   P3 
re  g re  g
$4.6576
P3 
0.13  0.06
P3  $66.5371

 Note: Applying the formula to D4 gives up P3, which is the present value of all the
long-term constantly growing dividends at the end of the period before the long-
term constant growth rate commences.
This will always be the case – whenever you apply the long-term constant
growth in dividends pricing formula to the long-term constantly growing
dividends it will you give the PV or price of those long-term constantly growing
dividends at the end of the period before the long-term constant growth rate
commences.

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Modified Constant Growth In Dividends Pricing Model
 Step 3: Find the PV0 of all the dividends and then find their sum. In the
current example this will be:
PV0 = D1(1+r)-1 + D2(1+r)-2 + D3(1+r)-3 + P3(1+r)-3

PV0 = $2.60(1.13)-1 + $3.38(1.13)-2 + $4.394(1.13)-3 + $66.5371(1.13)-3

PV0 = $2.60(0.8850) + $3.38(0.7831) + $4.394(0.6931) + $66.5371(0.6931)

PV0 = $2.301 + $2.6469 + $3.0455 + $46.1169

PV0 = $54.11

 Note: Because each of the dividends is of a different value, to find their PV0
we must treat each dividend as a single sum and use the PV of a single
sum formula, which is:
n
PV0  FVn (1  r )

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 Short-Term v. Long-Term Performance

 The question can now be asked, are share prices based on short-
term or long-term growth performance?
 Continuing with the previous numerical example:
Current share price = $54.11.
PV0 of dividends beyond Year 3 is $46.11 (i.e. P3 discounted back to T0)
Therefore, the percentage of the share’s price due to “long-term”
dividend growth is:
$46.12
 0.8523  85.23%
$54.11

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 Short-Term v. Long-Term Performance
 If most of a share’s value is due to long-term cash-flows
why do so many corporate managers and the market
focus on short-term (usually quarterly) earnings?
1. Changes in quarterly earnings are sometimes taken
as a signal of changes in future cash-flows. This would
affect the current share price. And,
2. Corporate managers usually have their pay bonuses
tied to quarterly earnings.

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 Constant Growth Stock
• What happens if the growth rate in dividends, g, is negative? Will anyone
still buy the share? Will the share have any value?
• Example: D0 = $2.00 and g = -6% (i.e. dividends are decreasing by 6% each
period).
• We can assume the firm still has earnings and so will still be paying a
dividend.
• To find the share’s value we use the Constant Growth In Dividends Pricing
Formula (because the share still has a constant percentage change in
dividends , but the change is negative):

D0 1  g  D1
P0  
re  g re  g
Continued next page

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 Constant Growth Stock
$2.00(1  (0.06))
P0 
0.13  (0.06)
$2.00(1  0.06)
P0 
0.13  0.06
$2.00(0.94)
P0 
0.19
$1.88
P0 
0.19
P0  $9.89
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 Constant Growth Stock
 What are the annual dividend yield (DY) and capital
gains yield (CGY)?

 Continuing with the previous numerical example:

CGY = g = -6% p.a.
DY = re – g = 13% - (-6%) = 13% + 6% = 19% p.a.
 Both these yields are constant over time, with the
high dividend yield (19% p.a.) offsetting the negative
capital gains yield (-6% p.a.).

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Share Price Sensitivity To The Dividend Growth Rate (g)

Share price ($)

50

45

40

35

30

25

20

15

10

5 Dividend growth
0 2% 4% 6% 8% 10% rate, g

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 Share Price Sensitivity To The Dividend Growth Rate (g)

 The higher is the growth rate in dividends, g, the higher will be the share
price.

 Why?
1. In terms of the constant growth in dividends pricing formula, the higher is
g the lower will be the denominator (re – g) and, therefore, with a fixed
numerator (D1) the result (P0,) must be higher:
D1
P0 
re  g

2. It also makes intuitive sense. If g is higher then future dividends will be

higher so, therefore, more investors will want the share in order to get hold
of the higher future dividends. Therefore, demand for the share will go up,
and with a fixed supply of the share, the price of the share must rise.

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Share Price Sensitivity To The Required Rate of Return, re

Share price ($)

100

90

80

70

60

50

40

30

20

10 Required return, re
6% 8% 10% 12% 14%

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 Share Price Sensitivity To The Required Rate of Return, re

 The higher is the required rate of return on equity, re, the lower will be the
share price.

 Why?
1. In terms of the constant growth in dividends pricing formula, the higher is
re the higher will be the denominator (re – g) and, therefore, with a fixed
numerator (D1) the result (P0,) must be lower:
D1
P0 
re  g

2. It also makes intuitive sense. If re is higher then investors require a higher

rate of return on their investment. Therefore, holding other factors constant,
to get a higher return they must pay a lower price (remember, there is an
inverse relationship between the price of an asset and the rate of return on
the asset: lower price higher return; higher price lower return).

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Modified Constant Growth In Dividends Pricing Model
A Final Numerical Example
 AMP Ltd. has just paid a dividend of 15 cents per share
and the dividend is expected to grow at a rate of 20%
p.a. for the next 3 years and then at a rate of 5% p.a.
after that.
 re = 10% p.a.

 What is the current market price of AMP Ltd.’s shares?

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Modified Constant Growth In Dividends Pricing Model

 Step 1
D0 = $0.15
D1 = $0.15(1.20) = $0.18
D2 = $0.18(1.20) = $0.216
D3 = $0.216(1.20) = $0.259
D4 = $0.259(1.05) = $0.272

 Step 2
$0.272
P3 
0.10  0.05
P3  $5.44

Continued next page.

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Modified Constant Growth In Dividends Pricing Model
 Step 3

PV0 = $0.18(1.10)-1 + $0.216(1.10)-2 + $0.259(1.10)-3 +

$5.44(1.10)-3
PV0 = $0.164 + $0.179 + $0.195 + $4.087

PV0 = $4.63

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 Price-Earnings Model
 The Price/Earnings Model (P/E Model) is another
method used to estimate the firm’s share price.
 With the P/E Model the share price is calculated by
multiplying the firm’s expected earnings per share (EPS)
by the firm’s P/E ratio (although, often the average P/E
ratio for the particular industry is used).
 The P/E ratio reflects the amount investors are willing to
pay for each dollar of earnings.
 With the P/E Model share price = EPS x P/E.

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 Price-Earnings Model
 What determines a firm’s P/E ratio?

1. Risk - The riskier the investment the lower will the P/E ratio.
Why? Because the riskier the investment the higher will be
the investors’ required rate of return. Therefore, to receive a
higher rate of return investors will only be willing to pay a
lower price. The lower the price the lower the P/E ratio.

2. Growth of earnings – The greater the growth rate in the

company’s earnings the higher will be the P/E ratio. Why?
The higher are future earnings the higher will be the demand
for the share, and with a fixed supply, the price of the share
will rise. The higher the price of the share the higher the P/E
ratio.

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 Price-Earnings Model
 Calculating The P/E ratio
The formula to calculate the price/earnings ratio is:

(1  b)
P/E 
re  g

where:
b = percentage of earnings per share retained by the firm;
re = the required rate of return of the firm’s shareholders; and
g = the long-term constant growth rate of earnings per share.

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 Price-Earnings Model
Example
Argyle Mines Pty. Ltd. will retain 40% of its expected
earnings per share of $0.15. If Argyle’s earnings per
share are to grow at 2% p.a. into perpetuity and the
required rate of return of it’s equity holders is 7% p.a.
what is Argyle’s:
a. P/E ratio?
b. Share price?

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 Price-Earnings Model
 a. P/E Ratio
(1  0.40)
P/E 
(0.07  0.02)
0.60
P/E 
0.05
P / E  12

 b. Share Price
P0  P / Ex( EPS )
P0  12 x($0.15)
P0  $1.80

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 Price-Earnings Model
Example
The directors of Parmalat Pty. Ltd. have provided you, the Corporate
Finance Manager, with the following information:
Expected earnings per share $1.50
Shareholders’ required return 11% p.a.
Earnings per share to be retained by the firm 60%
Growth rate in earnings per share 5% p.a.

Required:
a. Calculate Parmalat’s P/E ratio. In simple terms, what does this ratio tell
you?
b. Calculate Parmalat’s share price using the P/E ratio calculated in Part a.

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 Price-Earnings Model
 a. P/E Ratio
(1  0.60)
P/E 
(0.11  0.05)
0.40
P/E 
0.06
P / E  6.67

 This P/E ratio of 6.67 tells us that the equity investors of Parmalat are
prepared to pay $6.67 per $1 of earnings on each Parmalat share.

 b. Shareprice
P0  P / Ex ( EPS )
P0  6.67 x ($1.50)
P0  $10.00

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