14120 equity valuation
TRANSCRIPT
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 1/32
Equity Valuation
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 2/32
Introduction
• Equity shares can be described more easily than fixed income
securities, however they are more difficult to analyse.
•
Fixed income having a limited life and a well defined cash flowstream, equity share have neither.
• Fundamental analysis assess the fair market value of equity
shares by examining the assets, earning prospects, cash flowprojections and dividend potential.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 3/32
Fundamental valuation
• Balance sheet valuation
– Book value
– Liquidation value
– Replacement value
• Discounted cash flow models
– Dividend discount model• Single period valuation, Multiple period valuation.
– Free cash flow model
•
Relative valuation techniques – Price-earning ratio
– Price book value ratio
– Price sales ratio
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 4/32
Balance sheet valuation
• Book value:- Book value per share is simply the net worth of
the company(which is equal to paid up equity capital plus
reserves and surplus) divided by no. of shares outstanding.
• Liquidation value:- Value realised from liquidating all the
assets of the firm – amount to be paid to all the creditors and
preference shareholders divided by no. of outstanding equity
shares.
• Replacement cost:- this measure considered by analysts in
valuing firm is the replacement cost of its assets less liabilities.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 5/32
Dividend discount model
• The value of an equity share is equal to the present value of
dividends expected from its ownership plus the present value
of the sale price expected when the equity share is sold.
• Assumptions
1. Dividends are paid annually.
2. The first dividend is received one year after the equity shareis bought.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 6/32
DIVIDEND DISCOUNT MODEL
•SINGLE PERIOD VALUATION MODEL
D1 P 1
P 0 = +
(1+r ) (1+r )
•A equity share is expected t provide a dividend of Rs 2 and fetch a price
of Rs 18 a year hence. What price would it sell for now if investor’s
required rate of return is 12%.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 7/32
SINGLE+ GROWTH
• What happens if the price of the equity shareis expected to grow at a rate of g percentannually.
D1 P 0 = r – g
• The expected dividend per share on the equity share of acompany is Rs 2. the dividend per share has grown over the
past five years @ 5%. This growth will continue in future.Further the market price of the equity share is expected togrow at the same rate. What is the fair value of the equityshare if the required rate is 15%.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 8/32
DIVIDEND DISCOUNT MODEL
• More realistic
•MULTI - PERIOD VALUATION MODEL
D t
P 0 =t =1 (1+r )t
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 9/32
DIVIDEND DISCOUNT MODEL
•ZERO GROWTH MODEL
If the dividend per year remain constant.
D
P 0 =
r
•CONSTANT GROWTH MODEL
assumes that dividend per year grows at a constant rate g.
D 1
P 0 =
r - g
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 10/32
Two stage growth model
• The extension of the constant growth model assumes that the
extraordinary growth will continue for a finite period of years
and thereafter the normal growth rate will prevail forever.
• Po = Current market price
• D1= expected dividend a year hence
• G1= extraordinary growth rate applicable for n years.
•
G2= constant growth rate• r= required rate of return
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 11/32
TWO - STAGE GROWTH MODEL
1 - 1+g 1n
1+r
P 0 = D 1 +
r - g 1
D 1 (1+g 1)n -1 (1+g 2) 1
r - g 2 (1+r )n
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 12/32
TWO - STAGE GROWTH MODEL : EXAMPLE
EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OFVERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY ANABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6
YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISEAT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OFVERTIGO ?THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE :
g 1 = 20 PERCENTg 2 = 10 PERCENTn = 6 YEARS
r = 15 YEARSD 1 = D 0 (1+g 1) = RS.2(1.20) = 2.40
PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THEINTRINSIC VALUE ESTIMATE AS FOLLOWS :
1.20 6
1 -1.15 2.40 (1.20)5 (1.10) 1
P 0 = 2.40 +.15 - .20 .15 - .10 (1.15)6
1 - 1.291 2.40 (2.488)(1.10)= 2.40 + [0.497]
-0.05 .05
= 13.968 + 65.289= RS.79.597
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 13/32
H Model
Assumptions
• While the current dividend growth rate, ga is greater than gn,the normal long-run growth rate declines linearly for 2H years.
• After 2H years the growth rate becomes gn.
• At H years the growth rate is exactly halfway between ga andgn.
Where Po is the IV of the share, Do is the current dividend per
share, r is the rate of return expected by investor, gn is thenormal long-run growth rate, ga is the current above-normalgrowth rate, H is the one half of the period during which ga willlevel off to gn.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 14/32
H MODEL
g a
g n
H 2H
D 0
P O = [(1+g n ) + H (g a - g n )]
r - g n
D 0 (1+g n ) D 0 H (g a - g n )
= +
r - g n r - g n
VALUE BASED PREMIUM DUE TO
ON NORMAL ABNORMAL GROWH
GROWTH RATE RATE
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 15/32
Example
• Current dividend on an equity share of international
computers limited is Rs 3. The present growth rate is 50%.
However this will decline linearly over a period of 10 Years
and then stabilise at 12 %. What is the intrinsic value per
share, if investor requires a return of 16%.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 16/32
Free Cash Flow Model
• It involves determining the value of the firm as a whole(the
value is called enterprise value) by discounting the free cash
flow to investors and then subtracting the value of preference
and debt to obtain the value of equity.
• It involves following steps.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 17/32
Steps 1
1. divide the future into two parts, the explicit forecast period
and the balance period.
Explicit period- represents the period during which the
firm is expected to evolve.
balance period- a state in which the return on invested
capital, growth rate and cost of capital stabilise.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 18/32
Step 2
• Forecast the free cash flow, year by year, during the explicit
forecast period.
FCF is the cash flow available for distribution to capital
providers(Shareholders and debt holders) after providing for the
investment in fixed assets and net working capital required to
support the growth of the firm.
FCF= NOPAT- Net Investment
NOPAT is net operating profit adjusted for taxes. It is profit
before interest and taxes(1- Tax rate).
Net Investment: Change in net fixed assets + Change in net
working capital.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 19/32
Step 3
• Calculate the weighted average cost of capital
WACC= WeRe + WpRp + WdRd (1-t)
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 20/32
Step 4
• Establish the horizon value of the firm
Horizon value is the value placed on the firm at the end
of the explicit forecast period(H years) Since the FCF is expected
to grow at a constant rate of g beyond h, horizon value is equal
to
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 21/32
Step 5
• Estimate the enterprise value
The EV or value of the firm is the present value of the FCF
during the explicit forecast period plus the present value of the
horizon value.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 22/32
• Step 6: Derive the equity value=
Enterprise value – Preference value- Debt value
• Step 7: Compute the value per share
The value per share is simply the equity value divided by
the no of outstanding equity shares.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 23/32
Example
• The balance sheet of Cosmos Limited at the end of year 0 (the
present point of time) is as follows.
Prepared by Sumit Goyal- LPU
Rs. in crore Liabilities Assets
Shareholders’ funds 500 Net fixed assets 550 Equity capital
(20 crore shares of
Rs. 10 each) 200 Net working capital 200
Reserves and surplus 300 Loan funds( rate
10 percent) 250 750 750
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 24/32
Additional information
• The return on assets( NOPAT) is expected to be 18 percent of
the asset value at the beginning of each year. The growth rate
in assets and revenues will be 30 percent for the first three
years, 18 percent for the next two years, and 10 percent
thereafter. The effective tax rate of the firm is 34 percent, thepre-tax cost of debt is 10 percent and the cost of equity is 24
percent. The debt-equity ratio of the firm will be maintained
at 1:2. Calculate the intrinsic value of the equity share.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 25/32
Solution
Rs. In crore Year 1 2 3 4 5 6
Asset value (Beginning)
750.0
975.0
1267.50
1647.75
1944.35
2294.33
NOPAT 135.0 175.50 228.15 296.60 349.98 412.98 Net investment 225.00 292.50 380.25 296.60 349.98 229.43 FCF (90.0) (117.0) (152.1) - - 183.55 Growth rate (%) 30 30 30 20 20 10
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 26/32
• The weighted average cost of capital is:
WACC = (2/3) x 24 + (1/3) x 10 (1-0.34) = 18.2percent
•
The horizon value of the firm = (183.55 x 1.10)/(0.182-0.10) = 2462.26 crores
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 27/32
Price-Earnings Ratio - P/E Ratio
• A valuation ratio of a company's current share price
compared to its per-share earnings.
Calculated as:
Market Value per Share/ Earnings per Share (EPS)
For example, if a company is currently trading at 43 a share and
earnings over the last 12 months were 1.95 per share, the P/E
ratio for the stock would be 22.05 (43/1.95).
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 28/32
Earning Multiplier Approach
• The P/E is sometimes referred to as the "multiple", because it
shows how much investors are willing to pay per dollar of
earnings. If a company were currently trading at a multiple
(P/E) of 20, the interpretation is that an investor is willing to
pay 20 for 1 of current earnings.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 29/32
• A high P/E suggests that investors are expecting higher
earnings growth in the future compared to companies with a
lower P/E.
• Compare the P/E ratios of one company to other companies
in the same industry, to the market in general or against the
company's own historical P/E.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 30/32
Price to book value ratio
• A ratio used to compare a stock's market value to its book
value. It is calculated by dividing the current closing price of
the stock by the latest quarter's book value per share.
• A lower P/B ratio could mean that the stock is undervalued.
• However, it could also mean that something is fundamentally
wrong with the company.
• As with most ratios, be aware that this varies by industry.
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 31/32
Price to sales ratio
• A ratio for valuing a stock relative to its own past
performance, other companies or the market itself. Price to
sales is calculated by dividing a stock's current price by its
revenue per share for the trailing 12 months.
• PSR= Market Price/ Revenue per share
Prepared by Sumit Goyal- LPU
8/13/2019 14120 Equity Valuation
http://slidepdf.com/reader/full/14120-equity-valuation 32/32
Prepared by Sumit Goyal- LPU