Equity Valuation

Learning Objectives:
1.Describes the basic characteristics of equity
securities, and identify the primary factors that
affect stock values.
2.Estimate the value of these securities using the
most common dividend discount models
3.Apply multiples to value stocks, and relate
valuation models to commonly used ratios.
What is equity?
A corporation issues an equity security, which is a
financial instrument that represents ownership in the
corporation.
We often refer to this financial instrument as the stock
of the company.
A unit of ownership is represented by a share or share of
stock, and an owner of a share is a shareholder or
stockholder.
A purchaser of 100 of stock owns 100/n percent of the
corporation, where n is the total number of shares
outstanding.
Common stock and Preferred
Stock
A corporation may issue two types of stocks- common stock
and preferred stock
Both represents ownership interest or equity, but preferred
shareholders, as the name implies, have a prior claim to
income and assets of the company relative to common
shareholders.
Common shareholders are the residual claimants of the
corporation, which means that they are entitled to income
remaining only after all creditors, including preferred
shareholders have been paid.
From the perspective of company issuing the stock, dividend
are not considered a cost of doing business, and therefore
they are not deductible for tax purpose by the paying
company.
The Basics of Valuing Equity
Equity securities may have cash flows in the
form of cash dividends, which are paid at the
discretion of the board of directors.
The valuation of equity is more challenging
than, say, valuing bonds. This is because with
bonds there is a legal commitment to paying
interest and repaying the principal.
In case of equity, there is no such commitment
associated with dividends. Therefore, valuing
equity requires estimating future dividends.
Valuing Preferred Stock
The traditional preferred stock has no maturity
date and pays dividends of a fixed amount at
regular intervals indefinitely.
Because the payments are essentially fixed
when the preferred shares are issued, they are
often referred to as fixed-income investments.
The payment of a fixed dividend amount at
regular intervals indefinitely means we can view
these investments as perpetuities.
Cont.
 P= D/r
P= present value of preferred stock
D= periodic dividend payments
r = required rate of return on Preferred Stock.
Suppose a preferred stock holder of Hindustan
Zinc knows that the face value of the Hindustan
Zinc is Rs. 2 and it declares a dividend of 1890 %. If
the required rate of return is 14%, what is the
value of this preferred stock?
Solution
P= (2*18.9)/.14=37.8/.14= 270.

Determine the value of a Rs. 10 par value (face value)

preferred stock that pays annual dividends based on a
7 percent dividend rate, when the required rate is:
a)7%
b)8%
c)12%
d)Determine the required rate on the preferred shares
that provide a Rs. 5 annual dividend if they are
presently selling for Rs. 60
 Fair Value vs Market Price
• Fair Value
• Self assigned Value
• Variety of models are used for estimation

• Market Price
• Consensus value assessment by all market participants

• Trading Signal
• FV > MP: Buy
• FV < MP: Sell or Short Sell
• FV = MP: Hold or Fairly Priced
 Dividend Discount Models
,

Dt
Vo   t
t  1 (1  k )

V0 = Value of Stock
Dt = Dividend
k = required return
 No Growth Model
•

D
Vo 
k
Where the stock has earnings and dividends that are
expected to remain constant foreever.

Example: Preferred Stock

 No Growth Model: Example
•

D1 = $5.00
D
k = .15 Vo 
k
Then, V0 = $5.00 / .15 = $33.33
Example
• Wipro has provided every year 50% dividend in the last 4
years on its face value of Rs. 2. In the current year also , it is
expected that it will give 50% dividend, if your required
return is 20% per annum, what is the fair value of Wipro
Share?
 Constant Growth Model
•

Do (1  g )
Vo 
kg

g = constant perpetual growth rate

Constant Growth Model: Example
•

Do (1  g )
Vo 
kg

k = 15% D1 = $3.00 g = 8%

V0 = 3.00 / (.15 - .08) = $42.86

 Estimating Dividend Growth
Rates
•

g  ROE  b

 g = growth rate in dividends

 ROE = Return on Equity for the firm
 b = EPS retention rate (1- dividend payout ratio)
Partitioning Value: Growth and No Growth
Components
•
E1
Vo   PVGO
k
Do (1  g ) E1
PVGO  
(k  g) k

 PVGO = Present Value of Growth Opportunities

 E1 = Earnings Per Share for period 1
Partitioning Value: Example

ROE = 20% b = 40%

E1 = $5.00 D1 = $3.00 k = 15%

g = .20 x .40 = .08 or 8%

 Partitioning Value: Example
•
3
Vo   $42.86
(.15.08)
5
NGVo   $33.33
.15
PVGO  $42.86  $33.33  $9.52

• Vo = value with growth

• NGVo = no growth component value
• PVGO = Present Value of Growth Opportunities
 Multi-Period Dividend-Discount
Model
•

V  D  1D 1
2
2
...  DN
P
N
N

(1 k ) (1 k ) (1 k )

0

PN = expected sales price of stock at time N

N = number of years the stock is to be held
 Practical Difficulties with
DDM
• Some firms do not pay dividends

• Can you forecast future dividends?

• Can you predict the terminal liquidation value Pn ?

• What about the discount rate k?

(perhaps, the CAPM? The APT?)
 Multi-Period Earnings-Discount
Model
•

(1  b ) E1 (1  b ) E 2 (1  b ) E N  P N
V0  ... 
(1  k )1 (1  k ) 2 (1  k ) N

PN = expected sales price of stock at time N

N = number of years the stock is to be held
 Practical Concerns with EDM
• EPS forecasts are available from I/B/E/S, First Call, Zacks, ….

• Dividend payout ratio (1-b) can be estimated, either based

on cash dividend or dividend-in-kind

• But, what about Pn and k?

 P/E Ratios

P0 d

E kg

d: dividend payout ratio

k: cost-of-capital (or, risk-adjusted discount rate)
g: EPS growth rate
 P/E Example
k = 12.5% g = 9% d = 40%

Thus, P/E = (1 - .60) / (.125 - .09) = 11.4

If E = $2.73, we have

P = 11.4 X 2.73 =$31.14

 Problems with P/E Ratios

• What is E?
• E = trailing 12-month EPS?

• E = 12-month-forward EPS?

• What is g?
• g = average historical EPS growth?

• g = expected next-yr EPS growth?

• g = long-run EPS growth?