Topic 6: Equity Valuation Flashcards
What do we mean by equity?
Accounting: The amount of finance raised by a company from the shareholders.
Finance: Market value of shares or equity issued by a company. Can be used as a general term for stocks and shares that do not pay fixed interest.
Key features of equity?
Ownership interest in a company
has some involvement in corporate decision making (voting rights)
Not usually repayable
Gives rights to dividends paid at the discretion of company directors
Provides an opportunity for capital gain
Bond valuation VS Equity valuation
- Bond:
Cash flows are certain due to coupons being contractual
Life of investment is certain because maturity date is specified
Easy to measure the yield to maturity the market expects
- Equity:
Uncertain cashflows because dividends depend on the performance of the company.
Life on investment is uncertain because an equity can theoretically last forever.
Difficult to measure the expected return the market expects.
These two are essentially opposite of each other.
Present Value of Equity
P0 = (Div1)/ (1 + R) + (Div2)/ (1 + R)^2 + (Div3)/ (1 + R)^3… etc
In other words the price of an equity today is equal to the present value of all future dividends.
Dividend Growth Models
Models based on the idea that a company’s equity value is simply the sum of all of it’s future dividend payments when discounted back to their present value.
Dividend growth models assume that:
Dividends will be paid
Dividends will be paid forever; Meaning that the equity provides dividends in perpetuity.
These models provide a discounting method we can use to calculate the value of a company’s equity based on the above assumptions.
Zero dividend growth formula
Div0 = Div1 = Div2 = Div3 = Constant or level
P0 = D/R = PV of equity
Where:
D = The constant dividend
R = The discount rate
P0 = present value of equity
Note: Check example on notes (6.2)
Constant Dividend Growth
Consistent growth in dividened payments is reasonably common some examples are; coca-cola, procter and gamble, Johnson and Johnson and colgate - palmolive.
Constant dividend growth formula
D1 / (R - g) —> this equation is simply a growing perpetuity.
Where:
D1 = D0 * (1 + g)
R = Discount rate
g = Growth rate
D0 = Initial dividend payment
Note: Check notes for examples (6.3)
Differential Dividend Growth
CHECK NOTES IMPORTANT!
The two stage dividend growth model
(IMPORTANT REVIEW NEEDED)
Insert picture of formula and explanation maybe?
This model is typically used when a company has a high growth rate in the initial period, followed by a typically lower growth rate in the subsequent period till infinity.
Note: The valuation dividend is always one period in advance of the valuation point (Check examples 6.4)
