Part 11. Equity Valuation: Concepts and Basic Tools

Question 1

Intrinsic/fundamental value

Answer 1

The rational value investors would place on the asset if they had full knowledge.

Valuation models can be used to estimate these values, to determine if stock market prices are overvalued, undervalued or fairly valued.

Analysts who can estimate stocks intrinsic value better than market can earn abnormal profits if market price moves to its intrinsic value over time.

Question 2

Things to consider in deciding whether to invest based on differences between market prices and estimated intrinsic values:

Answer 2

1. Larger the percentage difference between market prices and estimated values, the more likely investor take position based on estimate of intrinsic value, with small difference between between market price and intrinsic to be expected.
2. More confident investor on appropriateness of valuation model used, more likely investor will take investment position in stock identified as overvalued or undervalued.
3. More confidence investors is about estimated inputs used in valuation model, more likely investor to take investment position in stock identified as over or undervalued.

• Sensitivity of model value should be considered to each of its inputs deciding whether to act on difference between model values and market prices.
• Decrease of 1/2% in long term growth rate used in valuation model produce an estimated value = market price.
• Analyst would have to be quite sure models growth estimate take position in stock based on its estimated value.

4. Assume market prices deviate from intrinsic value, market prices must be treated fairly reliable indications of intrinsic values, and must consider why stock is mispriced in market.
   - Investors may be more confident about estimates of value that differ from market prices when few analysts follow particular security.
5. Take position in stock identified as mispriced in market, investor must believe market price will actually move toward its estimated intrinsic value, and will do so to a significant extent within investment horizon.

Question 3

Models used to estimate value of equities:

Answer 3

1. Discounted cash flow model
2. Multiplier models - used to estimated intrinsic values

3, Multiplier models - based on ratio of enterprise value

4. Asset based models

Question 4

Discounted cash flow model

Answer 4

A stock value is estimated as the PV of cash distributed to shareholders (dividend discount models) or PV of cash available to shareholders after firm meets its necessary capital expenditures and working capital expenses (free cash flow to equity models).

Question 5

Multiplier model - to estimate intrinsic values

Answer 5

This is used to estimate intrinsic values.

The first type, the ratio of stock price to such fundamentals as earnings, sales, book value or cash flow per share is used to determine if stock is fairly valued.

e.g. price to earnings (P/E) ratio frequently used by analysts

Question 6

Multiplier models - based on ratio on enterprise value

Answer 6

This is based on ratio of enterprise value to either earnings before interest, taxes, depreciation and amortization (EBITA) or revenue.

Enterprise value - the MV of all firms outstanding securities minus cash and ST investments.

Common stock value - this is estimated by subtracting value of liabilities and preferred stock from an estimate of enterprise value.

Question 7

Asset-based models

Answer 7

The intrinsic value of common stock is estimated as total asset value minus liabilities and preferred stock.

Analysts typically adjust the book values of firms assets and liabilities to their fair values when estimating the MV of its equity with an asset based model.

Question 8

Cash dividends

Answer 8

These are payments made to shareholders in cash.

Regular dividends = occur when company pays out portion of profits on a consistent schedule (e.g. quarterly), with LT record of stable/increasing dividends viewed by investors as sign of company’s financial stability.

Special dividends = used when favourable circumstances allow firm to make one-time cash payments to shareholders, in addition to regular dividends the firm pays.

• cyclical firms will use special dividends to share profits with shareholders when times are good, but maintain flexibility to conserve cash when profits are poor.

Question 9

Stock dividends

Answer 9

The dividends paid out in new shares of stock rather than cash, where there will be more shares outstanding, but each one will be worth less, with total shareholder equity remains unchanged.

e.g. 20% stock dividend means every shareholder gets 20% of stock

Question 10

Stock splits

Answer 10

The divide each existing share into multiple shares, creating more shares, with more shares but the price of each share will drop correspondingly to number created, so there is no change in owners wealth.

e.g. 3 for 1 stock split, each old share is split into 3 new shares.

Question 11

Reverse stock splits

Answer 11

There are fewer shares outstanding, but there is higher stock price, as these factors offset one another, shareholder wealth is unchanged.

Question 12

Share repurchase

Answer 12

This is a transaction in which a company buys outstanding shares of its own common stock.

This is an alternative to cash dividends as a way of distributing cash to shareholders, having the same effect on shareholders wealth as cash dividends the same size.

This may occur to support their price or signal that management believes the shares are undervalued, or used to offset an increase in outstanding shares from exercise of employee stock options.

Countries that tax capital gains at lower rates than dividends, share repurchases are preferred to dividend repayments to distribute cash to shareholders.

Question 13

Dividend payment chronology

Answer 13

1. Declaration date
2. Ex-dividend date
3. Holder of record date (record date)
4. Payment date

Question 14

Declaration date

Answer 14

The date the board of directors approve payment of dividend specifying per-share dividend amount, the date shareholders must own stock to receive dividend (record date), and date the dividend payment will be made (payment date).

Question 15

Ex-dividend date

Answer 15

First day in which a share purchaser will not receive next dividend, with the ex-dividend date being one or two business days before the holder of record date, depending on settlement period for stock purchases.

If you buy share on or after ex-dividend date, you will not receive dividend.

The share price will fall from previous day closing price by approx. amount of dividend, in absence of other factors affecting stock price.

e. g. shares trading at $25 on day prior to ex-dividend date will pay $1 dividend, while purchasing share on day prior to ex-dividend day will give owner share of stock and $1 dividend on payment date.
- purchasing share on ex-dividend date will entitle owner only to share, dividend payment will go to seller.

Question 16

Holder of record date (record date)

Answer 16

The date on which all owners of shares become entitles to receive the dividend payment on their shares.

Question 17

Payment date

Answer 17

The date dividend checks are mailed to, or payment is made electronically to holders of record.

Question 18

Dividend discount model

Answer 18

This is based on the rationale that the intrinsic value of stock is the PV of its future dividends.

Question 19

One year holding period DDM

Answer 19

For a holding period of one year, the value of stock today is PV of any dividends during the year plus PV of expected price of stock at end of the year (terminal value).

Question 20

Multiple year holding period DDM

Answer 20

With a multiple holding period, we simply sum the PV of the estimated dividends over the holding period and the estimated terminal value.

Question 21

Infinite holding period of DDM

Answer 21

The most general form of DDM, as a corporation had an indefinite life.

The PV of all expected future dividends is calculated and there is no explicit terminal value for the stock.

We will se terminal value can be calculated at a time in future after which growth rate of dividends is expected to be constant.

Question 22

Free cash flow to equity (FCFE)

Answer 22

This is often used in DCFM instead of dividends as it represents the potential amount of cash that could be paid out to common shareholders.

This reflects the firms capacity to pay dividends, and useful for firms who do not currently pay dividends.

Definition: The cash remaining after a firm meets all of its debt obligations, and provides for the capital expenditures necessary to maintain existing assets and purchase new assets needed to support assumed growth of firm.

The cash available to firms equity holders after firm meets all of its other obligations.

Question 23

Net borrowing

Answer 23

The increase in debt during the period (i.e. amount borrowed minus amount repaid), assumed to be available to shareholders.

Fixed capital investment must be subtracted as the firm must invest in assets to sustain itself, with FCFE projected for future periods using firms financial statements.

Question 24

Preferred stock

Answer 24

This pays dividends that is usually fixed and has an indefinite maturity.

When the dividend is fixed, and the stream of dividends is infinite, the infinite period dividend discount model reduces to a simple ratio.

Ratio = Dp/kp

Dp = price of annual dividend of stock
kp = required rate of return

Question 25

Gordon growth model (constant growth model)

Answer 25

This assumes the annual growth rate of dividends, gc, is constant.

Hence, the next periods dividend, D1 is D0(1+gc), the 2nd years dividend, D2 is Do(1+gc)^2, and so forth.

Question 26

Assumptions of the Gordon growth model:

Answer 26

1. Dividends are an appropriate measure of shareholder wealth.
2. Constant dividend growth rate, gc, and required return on stock, ke, are never expected to change.
3. ke must be greater than gc, if not math won’t work.

if any assumptions are not met, the model is not appropriate.

Question 27

Gordon growth model example:

Answer 27

This demonstrates that stocks value is determined by relationship between investors required return on equity, ke, and projected growth rate of dividends, gc:

• as the difference between ke, and gc widens the value of the stock falls.
• as difference narrows, the value of stock rises.
• small changes in difference between ke, and gc can cause large changes un stocks value.

Question 28

To estimate growth rate in dividends, the analyst can use 3 methods:

Answer 28

1. Use the historical growth in dividends for the firm.
2. Use the median industry dividend growth rate.
3. Estimate sustainable growth rate.

Question 29

Sustainable growth rate

Answer 29

The rate at which equity, earnings, and dividends can continue to grow indefinitely assuming ROE is constant, the dividends pay out is constant and no new equity is sold.

Question 30

Retention rate

Answer 30

• The quantity ( 1 - dividend pay out).

- The proportion of net income that is not paid out as dividends and goes to retained earnings, thus increasing equity.

Question 31

Multi stage dividend discount model

Answer 31

To value a dividend-paying firm that is experiencing temporarily high growth is to add the PV of dividends expected during high growth period to PV of constant growth value to the firm at end of high-growth period.

Question 32

Steps in using multi-stage model:

Answer 32

1. Determine discount rate, ke.
2. Project size and duration of high initial dividend growth rate, g*.
3. Estimate dividends during the high growth period.
4. Estimate constant growth at end of high growth period, gc.
5. Estimate first dividend that will grow at constant rate.
6. Use constant growth value to calculate the stock value at end of high growth period.
7. Add PVs of all dividends to PV of the terminal value of the stock.

Question 33

Price multiple approach

Answer 33

An analyst compares tock price multiple to benchmark value based on an index, industry group of firms o pees group of firms within an industry.

Common price multiple used for valuation, e.g. price to earnings, price to cash flow, price to sales, and price to book value ratios.

Question 34

Pros and cons of price multiple valuations

Answer 34

• Widely used by analysts and readily available in various media outlets.
• Easily calculated and can be used in time series and cross-sectional comparisons.
• Ratios have been useful in predicting stock returns, with low multiples associated with higher future returns.

Cons:

• they reflect only the past as historical (trailing) data are often used in the denominator.
• this means practitioners use forward (leading or prospective) values denominator (sales, book value, earnings, etc.) resulting in different ratios.
• comparing price multiple P/E for a firm to other firms based on market prices-price multiples based on comparables are being used.
• In contrast, price multiples based on fundamentals tell us what multiple should be based on some valuation model, hence not dependent on current market prices of other companies to establish value.

Question 35

Price multiples for valuation used:

Answer 35

1. Price-earnings (P/E) ratio = a firm’s stock price divided by earnings per share and widely used by analysts and cited press.
2. Price-sales (P/S) ratio = A firm’s stock price divided by sales per share.
3. Price-book value (P/B) ratio = A firm’s stock price divided by the book value of equity per share.
4. Price-cash flow (P/CF) ratio = A firm’s stock price divided by cash flow per share, here cash low may be defined as operating cash flow or free cash flow.

Question 36

Justified P/E

Answer 36

The P/E is based on fundamentals.

Assuming we have correct inputs for D1, E1 and ke, and g, the previous equation will provide a P/E ratio, that is based on PV of future cash flows.

Question 37

Leading P/E ratio

Answer 37

It is based on expected earnings next period, not on actual earnings for the previous period, which would produce a lagging or trailing P/E ratio.

Question 38

Use of justified P/E ratio

Answer 38

This serves as a benchmark for price at which the stock should trade.

e. g. if firms actual P/E ratio (based on market price and expected earnings) was 8, the stock would be overvalued, but if it was 2, the stock would be considered undervalued.
- Ratios based in fundamentals are sensitive to the inputs (especially denominator, k-g), so analyst should use different sets of inputs to indicate range for justified P/E.
- All other things equal, P/E ratio will increase:

1. a higher dividend pay out rate
2. higher growth rate
3. lower required rate of return

• hence, P/E must be justified.

Question 39

Dividend displacement of earnings

Answer 39

• In practice not all other things are equal.
• A rise in dividend pay out ratio will reduce firms sustainable growth rate, while higher dividends will increase a lower growth rate will decrease firm value.
• With net effect of firm value being ambiguous, intuition suggests firms cannot continually increase P/E’s or MV by increasing dividend pay out ratio, otherwise firm would have 100% payout ratios.

Question 40

Multiples based on comparables

Answer 40

• This involves using a price multiple to evaluate whether an asset is valued properly relative to benchmark, with common benchmarks including stock’s historical average (time series comparisons), or similar stocks and industry averages (cross-sectional comparison).

Question 41

Law of one price

Answer 41

• This asserts two identical assets should sell at same price, or in this case two comparable assets should have approx. the same multiple.

Make sure:

• comparable are valid; as firms are not if firms are different sizes, in different industries or grow at different rates.
• using P/E ratios for cyclical firms is complicated due to sensitivity to economic conditions.
• P/S ratio may be favoured over P/E ratio as sales are less volatile than earnings due to operating and financial leverage.

Question 42

Disadvantages of price multiples:

Answer 42

Based on comparable:

1. stock may appear overvalued by comparable method but undervalued by fundamental method, or vice versa.
2. different accounting methods can result in price multiples that are not comparable across firms, especially internationally.
3. Price multiples for cyclical firms may be greatly affected by economic conditions at a given point in time.

Question 43

Disadvantages of price multiples:

Answer 43

Based on comparable:

1. stock may appear overvalued by comparable method but undervalued by fundamental method, or vice versa.
2. different accounting methods can result in price multiples that are not comparable across firms, especially internationally.
3. Price multiples for cyclical firms may be greatly affected by economic conditions at a given point in time.

Question 44

Enterprise value

Answer 44

This measures the total company value, the cost to acquire the firm.

• Cash and ST investments are subtracted as acquirers cost for firm would be decreased by amount target of liquid assets.
• Acquirer assumes firms debt, and receives firms cash and ST investments
• Enterprise value is appropriate when analyst wants to compare values of firms have significant difference in capital structure.
• EBITDA, is the most frequent used denominator for EV multiples, with operating income also used.
  adv: using EBITA instead of net income is its usually positive even when earnings are not, when net income is negative, value multiples based on earnings are meaningless.
  dis: often includes non-cash revenues and expenses.

Question 45

Problem of using enterprise value:

Answer 45

The MV of firms debt is often not available.

The analyst can use MV of similar bonds or use their BV.

BV may not be good estimate of MV if firm and market conditions have changed significantly since bonds were issued.

Question 46

Asset based models

Answer 46

This is based on idea equity value is MV or FV of asset minus the MV or FV of liabilities.

• Approaches to valuing assets are value them at their depreciated values, inflation adjusted depreciated values or estimated replacement values.
• Applying this model is typically problematic for firms that has large amount of intangible assets, on and off BS, with effect of loss of current owners talents and customer relationship on forward earnings difficult to measure.
• Often used as floor or minimum vales when significant intangibles such as business reputation are involved.
• Analysts should consider supplementing asset-based valuation with more forward looking valuation such as one from DCM.
• Most reliable when firm has primarily tangible ST assets, assets with ready MV (e.g. financial or natural resource firms), or when firm will cease to operate and is being liquidated.
• Often used to value private companies, but increasingly useful for public firms as move towards FV reporting on BS.

Question 47

Advantages of discount cash flow models:

Answer 47

• Based on fundamental concept of discounted PV and well grounded in finance theory.
• Widely accepted in analyst community.

Question 48

Disadvantages of discount cash flow models:

Answer 48

• Inputs must be estimated.

- Value estimated are very sensitive to input values.

Question 49

Advantages of comparable valuation using price multiples:

Answer 49

• evidence that some price multiples are useful in predicting stock returns.
• price multiples are widely used by analysts.
• price multiples are readily available.
• used in time series and cross sectional comparisons.
• EV/EBITDA multiples are useful when comparing firm values independent of capital structure or when earnings are negative, the P/E ratio cannot be used.

Question 50

Disadvantages of comparable valuation using price multiples:

Answer 50

• lagging price multiples reflect the past.
• price multiples may not be comparable across firms if firms have different size, products and growth.
• price multiples for cyclical firms may be greatly affected by economic conditions at given point in time.
• stock may appear overvalued by comparable method, but undervalued by fundamental method and vice versa.
• different accounting methods result in price multiples that are not comparable across firms esp. internationally.
• negative denominator in price multiples results in meaningless ratio, with P/E ratio susceptible to this problem.

Question 51

Advantages of price multiple valuations based on fundamentals:

Answer 51

• Based on theoretical sound valuation models.

- Correspond to widely accepted value metrics.

Question 52

Disadvantages of price multiple valuations based on fundamentals:

Answer 52

• Price multiples based on fundamentals will be very sensitive to inputs (especially the k-g denominator).

Question 53

Advantages of asset based models:

Answer 53

• Can provide floor values.
• Most reliable when firm has primarily tangible ST assets, assets with ready MV or when firm is being liquidated.
• Increasingly useful for valuing public firms that report FV.

Question 54

Disadvantages of asset based models:

Answer 54

• MV often difficult to obtain.
• MV usually different than BV.
• Inaccurate when firm has high prop. of intangible assets or future cash flows not reflected in asset values.
• Assets can be difficult to value during periods of hyperinflation.