equity valuation 6 wiley

8/13/2019 Equity Valuation 6 Wiley

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Equity Valuation


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CHAPTER 7 Equity Valuation 7 - 2

Equity SecuritiesNature of these Securities

Equity Securities

Include preferred and common shares Represent ownership claimson businesses. Usually have no specified maturity date, and since the

business has a life separate and apart from itsowners, equities are treated as investments withinfinite life

Equities offer the prospect for participation in thegrowth and profitability of the business.

Equity securities can be valued based on approachesusing the present value of expected future dividendstream


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Equity SecuritiesNature of these Securities


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Common Share ValuationDiscount Models

The formula can be illustrated graphically as follows:

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+

+

+

=

"

"

"

1

2

2

1

10

)1(

)1(

...)1()1(

i

i

i

k

FlowCash

k

FlowCash

k

FlowCash

k

FlowCashV

V0 = Market Price Paid $

CF1 CF2 CF3 CF!0

1 2 3 !


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Common Share Valuation using DDMFundamental Analysts and the Basic Dividend Discount Model

Security analysts that use the DDM model are calledfundamental analystsbecause they base the estimate ofinherent worth on the economic fundamentals of the stock

Once they have estimated the inherent worth, they compare their

estimate with the actual stock price in the market to determinewhether the stock is UNDER, OVER, or FAIRLY valued

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"

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12

2

1

10

)1()1(...

)1()1( tt

c

t

ccc k

D

k

D

k

D

k

DP


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Common Share Valuation using DDMThe Constant Growth DDM

When the firms dividends are growing at a slow, constant rate,we use the constant growth dividend discount model.

Which can be simplified by :

!

!

)1(

)1(...

)1(

)1(

)1(

)1( 02

2

0

1

1

00

ccc k

gD

k

gD

k

gDP

+

+

++

+

+

+

+

+

=[ 7-6]

gk

D

gk

gDP

cc !=

!

+

= 100

)1([ 7-7]


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Common Share Valuation using DDMEstimating the Required Rate of Return

The Constant Growth DDM can be reorganized to solve for theinvestors required return

gP

Dkc +=

0

1[ 7-8]


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The Constant Growth DDMExamining the Importance of the Growth Assumption

The formula assumes that the growth rate will remain thesame in period 1 through infinity.

This is a very long period of time Because of compounding over time, small changes in gwill

have dramatic effects on the estimated stock value today.

gk

DP

c!

=1

0[ 7-7]


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Constant Growth DDMLimitations of the DDM

The Model predictions are highly sensitive to changes ingand kc

Not helpful in valuing non-dividend paying firms.

gk

DP

c!

=1

0[ 7-7]


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Preferred Share ValuationCash Flow Pattern for a Straight Preferred Share


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Preferred Share ValuationCash Flow Pattern for a Straight Preferred Share

0 1 2 3 " #

Dp Dp Dp Dp Dp

FIGURE 7-1

Preferred shares can be viewed as perpetuitiesbecause ofthe nature of the dividend stream they offer

A perpetuity is an infinite series of equal and periodic cashflows.


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Preferred Share ValuationValue of a Perpetuity

Ppsis the market price (or present value)

Dpis the annual dividend amount

kpis the required rate of return investors demand (or discount rate)

p

p

ps k

D

P =[ 7-2]


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Determine the market price of a $100 par value preferred sharethat pays dividend based on a 7 percent dividend rate wheninvestors require a return of 10 percent on the investment.

What happens to the market price if interest rates rise andinvestors now require a 12 percent rate of return on the

investment?

Preferred Share ValuationValue of a Perpetuity - Example

00.70$10.0

00.7$

10.0

100$07.==

!

==

p

p

psk

DP[ 7-2]

33.58$12.0

00.7$

12.0

100$07.==

!

==

p

p

psk

DP[ 7-2]


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What happens to the market price if interest rates fall andinvestors now require a 7 percent rate of returnon theinvestment?

Like bonds, when the required return is equal to the preferreddividend rate, the preferred will be priced to equal its par value.

Preferred Share ValuationValue of a Perpetuity Example!

00.100$07.0

00.7$

07.0

100$07.==

!

==

p

p

psk

DP[ 7-2]


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The preferred share valuation equation can bemodified to solve for the investors required rate ofreturn

Remember, for market traded preferred shares, thestock price will be observable (known) and so too willthe annual dividend, so this type of calculation is verycommon

Preferred Share ValuationEstimating the Required Rate of Return

ps

pp

PDk =

[ 7-3]


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Assuming the previous 7%, $100 par value preferred share iscurrently trading for $57.25, what is the implied market-demanded required return?

You knew that the share was trading for less than its par value,

so even before trying to solve for the answer, you should haveknown that investors were requiring a higher rate of return than7%.

Preferred Share ValuationEstimating the Required Rate of Return An Example

%22.1225.57$

00.7$

25.57$

100$07.==

!

==

ps

p

pP

Dk[ 7-3]

equity valuation 6 wiley

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