Valuation
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  • The most direct approach for approximating the fair market value of the assets on the balance sheet of a firm is to find out what they would fetch if the firm were liquidated immediately.
  • It measures how much you need to fork out to buy an entire public company.
  • EV to Sales. This ratio measures the total company value as compared to its annual sales.  A high ratio means that the company's value is much more than its sales.  To compute it, divide the EV by the net sales for the last four quarters.  This ratio is especially useful when valuing companies that do not have earnings, or that are going through unusually rough times.  For example, if a company is facing restructuring and it is currently losing money, then the P/E ratio would be irrelevant.  However, by applying a EV to Sales ratio, you could compute what that company could trade for when it's restructuring is over and its earnings are back to normal.
  • EBITDA. EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is one of the best measures of a company's cash flow and is used for valuing both public and private companies.  To compute EBITDA, use a companies income statement, take the net income and then add back interest, taxes, depreciation, amortization and any other non-cash or one-time charges.  This leaves you with a number that approximates how much cash the company is producing.  EBITDA is a very popular figure because it can easily be compared across companies, even if all of the companies are not profitable. EV to EBITDA. This is perhaps one of the best measurements of whether or not a company is cheap or expensive.  To compute, divide the EV by EBITDA (see above for calculations).  The higher the number, the more expensive the company is.  However, remember that more expensive companies are often valued higher because they are growing faster or because they are a higher quality company.  With that said, the best way to use EV/EBITDA is to compare it to that of other similar companies
  • Most executives would say that adding a point of growth and gaining a point of operating-profit margin contribute about equally to shareholder value. Margin improvements hit the bottom line immediately, whereas growth compounds value over time. But the reality is that the two are rarely equivalent. Growth often is far more valuable than managers think. This article presents a new strategic metric, called the relative value of growth (RVG), which gives managers a clear picture of how growth projects and margin improvement initiatives affect shareholder value. Using basic balance sheet and income sheet data, managers can determine their companies' RVGs, as well as those of their competitors. Calculating RVGs gives managers insights into which corporate strategies are working to deliver value and whether their companies are pulling the most powerful value-creation levers. The author examines a number of well-known companies and explains what their RVG numbers say about their strategies. He reviews the unspoken assumption that growth and profits are incompatible over the long term and shows that a fair number of companies are effective at delivering both. Finally, he explains how managers can use the RVG framework to help them define strategies that balance growth and profitability at both the corporate and business unit levels.

Valuation Valuation Presentation Transcript

  • VALUATION OF SHARES Siddharth Jaiswal Shruti Telang Chirag Mehta Kruti Shah Heer Shah
  • Flow of the presentation
    • Introduction
    • Discounted Cash Flow
    • CAPM
    • Dividend Growth
    • WACC
    • The General Model
    • The Gordon Growth Model
    • Two Stage DDM
    • H Model
    • Three Stage DDM
    • FCFE
    • Two Stage FCFE
    • P/E, P/BV, P/S
    • PEG & YPEG
    • Black & Scholes Model
  • CAPM P/E Ratio Gordon’s Model Dividend Growth Model Net Asset Value Liquidation Value Method DCF I need assistance EV
  • What is Valuation?
    • Valuation is the first step toward intelligent investing.
    • The object of investment is to find assets that are worth more than they cost
    • Valuation is the process of estimating how much an asset is worth
    • Valuation encompasses many considerations
    • how the value of an asset is determined
    • why the asset has a certain value, and not a higher or lower one
    • how to compare asset values, as a basis for investment decision making
    What is Valuation?
  • Reasons for Valuation
    • M&A ’ s
    • Buyouts
    • ESOP
    • Divorces
    • Estate Planning
    • Keyman Life Insurance
    • Financing of Potential Investors
    Reasons for Valuation
  • Who Uses Valuation
    • Investors (Active & Passive)
    • Fundamental Analysts
    • Franchise Buyer
    • Chartists
    • Information Traders
    • Market Timers
    • Efficient Marketers
    Who Uses Valuation
  • Concepts of Value
    • Book Value
    • Replacement Value
    • Liquidation Value
    • Going Concern Value
    • Market Value
    Concepts of Value
  • APPROACHES TO ASSET VALUATION
    • Balance Sheet Value method
    • (Net Book Value Method).
    • Adjusted Book Value method.
      • Liquidation Value method.
      • Replacement Cost method.
  • BALANCE SHEET METHOD …Net Book Value
    • Value of a asset will be represented by the book value reflected in the balance sheet.
    • V o = Total assets at balance sheet values – Total Liabilities(excluding networth)
    • Number of ordinary shares issued
    • Or,
    • V o = Share Capital + Reserves and Surplus
    • Number of ordinary shares issued
    • ILLUSTRATION:
    • The balance sheet of Ahuja Ltd shows share capital of Rs 100 crores. (10 CRORE SHARES OF Rs 10 Each) and reserves and surplus of Rs 100 crores. Estimate the value of the firm’s equity shares.
    •  
    BALANCE SHEET METHOD …Net Book Value
    • SOLUTION:
    •  
    • Share Capital = Rs.100 Crs (10 crs shares of Rs.10 each).
    • Reserves & Surpluses = Rs 100 Crs.
    •  Net Book Value = Rs. 200 Crs (100 Crs + 100 Cr)
    • NBV per share = 200 Crs/10 Crs shares
    • = Rs. 20 per share .
    •  
    • One can compare NBV with the going market price while taking investment decisions.
    BALANCE SHEET METHOD …Net Book Value
    • LIMITATIONS:
    • It does not take into account the future earning capacity of the business.
    • It does not take into account the present value or the change in the historical value of the asset over a period of time as the valuation is based on the historical value of the assets.
    • Technological advances renders some of the existing assets worthless which is not accounted for in this model.
    • These limitations of the NBV method is somewhat rectified by the Adjusted Book Value method of valuation.
    BALANCE SHEET METHOD …Net Book Value
    • It involves determining the FAIR MARKET VALUE of the assets and liabilities of the firm as a going concern.
    • Assets are not taken at historical costs but are valued at market price.
    • This fair market value of an asset can be determined by either Replacement Cost method , or Liquidation Value method .
    ADJUSTED BOOK VALUE METHOD …Improvement Over NBV
  • REPLACEMENT COST METHOD …For Adjusted Book Value
    • The value of business is arrived at by determining the current cost of putting up similar facilities or buying similar assets.
    • Net book values are substituted by current replacement costs.
    • The Table on the next page illustrates how replacement costs for various assets are considered.
  • REPLACEMENT COST METHOD …For Adjusted Book Value Debtors Valued at Face Value. Provide for bad debts if doubtful. Inventories R.M. at most recent cost of acquisition WIP at Cost of R.M + Cost of processing FG at Realizable S.P – (holding, transport & selling costs) Other C.A. Other C.A. like deposits, prepaid expenses and accruals valued at Book Value Fixed Assets (Land, P&M, Buildings valued at Market Price ) + (transportation, installation & selling expenses if any). Non-operating assets Financial securities, excess land & buildings valued at Fair Market Value
  • … Replacement Cost per share Total assets at replacement cost Total liabilities (excluding networth) No. of Outstanding shares
  • LIQUIDATION VALUE METHOD …For Adjusted Book Value
    • For approximating the fair market value of the assets on the balance sheet of a firm is to find out what they would fetch if the firm were liquidated immediately
    • The value of the business is arrived at by totaling up the realizable value of various assets of the unit minus the liabilities.
  • … LIQUIDATION VALUE per share The value realized from liquidating all the assets of the firm. Less amount paid to all the creditors and preference share holders No. of outstanding shares
  • LIQUIDATION VALUE METHOD …For Adjusted Book Value
    • LIMITATIONS:
    • This approach is relevant mainly for sick units that are beyond redemption .
    • It is not suitable for going concerns as instead of valuing the company as a whole, it values it as a collection of assets to be sold individually.
    • One of the major drawback of this model is that it does not take into account the future earning potential of the firm and just concentrates on the liquidation costs of the assets.
  • Enterprise Value (EV)
    • Measure of what the market believes a company's ongoing operations are worth
    • Enterprise value discusses the aggregate value of a company as an enterprise rather than just focus on its current market capitalization .
  • Enterprise Value (EV)
    • Equity value
      • Market value of shareholders’ equity (shares outstanding x current stock price)
    • Enterprise value
      • Measure of what the market believes a company's ongoing operations are worth
      • Market value of all capital invested in the firm
        • Equity, debt (short-term and long-term), preferred stock, minority interest
    Equity Debt Preferred Stock Minority Interest Enterprise Value Liabilities Assets =
  • Calculating EV
    • To calculate enterprise value, we start with a company's market cap, add debt (on a company's balance sheet), and subtract cash and Equivalents (on the balance sheet).
    • To get total debt, add together long-term and short-term debt.
    • Market Cap = Current share price * Total shares Outstanding
    • Debt = Long Term Debt + Short Term Debt
    • E V = Market Capitalization + Debt – Cash & Equivalents 
  • Example
    • Tata Steel Ltd.
    • Total shares Outstanding = 553472856
    • Current share price (Rs.) = 347.70
    • Long-Term Debt (Rs. In crores) = 24,681.80
    • Short-Term Debt (Rs. In crores) = 2,715.20
    • Cash & Equivalents = 2467.20
    • Market Cap = (553472856*347.70)
    • = 19244.25
    •  Enterprise Value = 19244.25 +(24681.20 +2715.20) – 2467.20
    • = 44173.45 crores
  • EV/ Sales
    • Ratio measures the total company value as compared to its annual sales
    • A high ratio means that the company's value is much more than its sales.
    • When valuing companies that do not have earnings, or that are going through unusually rough times
  • EV/ EBITDA
    • Higher the number, the more expensive the company is.
    • Best way to use EV/EBITDA is to compare it to that of other similar companies
  • Approaches To Valuation
    • Discounted cash-flow valuation (Intrinsic Value) , relates the value of an asset to the present value of expected future cash-flows on that asset.
    • Relative valuation , estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cash-flows, book value or sales.
    • Contingent claim valuation , uses option pricing models to measure the value of assets that share option characteristics.
  • Valuation Models DCF Model Relative Valuation Model Equity / Balance Sheet Valuation Models Book Value Liquidation Value Replacement Cost P/E Ratio Economic Profit Model Entity DCF Model Dividend Models Dividend Discount Constant Growth DDM
  • Discounted Cashflow Valuation
  • Discounted cash-flow (DCF)
    • DCF method entails estimating the free cash flow available to debt and equity investors (i.e., the annual cash flows generated by the business, and the terminal value of the business at the end of the time horizon) and discounting these flows back to the present using the weighted average cost of capital as the discount rate to arrive at a present value of the assets
  • DCF (contd..)
    • DCF is often the primary valuation methodology in M&A
      • Comparable public company and comparable acquisition analysis are often used as confirming methodologies
    • DCF is the PV of 2 main types of free cash flows:
      • Free cash flows to all capital providers (debt and equity)
      • Free cash flows to equity capital providers
        • special case: dividend discount model
    • Fundamental in nature, DCF allows for questioning all of the assumptions and for performing sensitivity analysis
    • One can easily estimate equity value from firm value by subtracting the market value of debt today
  • DCF Valuation in 5 Steps…
    • Project the free cash flows of a business over the forecast period
      • Typical forecast period is 10 years. However, the range can vary from five to 20 years
    • Use the weighted average cost of capital (WACC) to determine the appropriate discount rate range
    • Estimate the terminal value of the business at the end of the forecast period
    • Determine the value for the enterprise by discounting the projected free cash flows and terminal value to the present
    • Interpret the results and perform sensitivity analysis
  • DCF (contd..)
    • Calculation of free cash flow begins with financial projections
      • Comprehensive projections (i.e., fully-integrated income statement, balance sheet and statement of cash flows) typically provide all the necessary elements
    • Quality of DCF analysis is a function of the quality of projections
      • Confirm and validate key assumptions underlying projections
      • Sensitize variables that drive projections
    • Sources of projections include
      • Target company’s management
      • Acquiring company’s management
      • Research analysts
      • Bankers
  • DCF – FCF: What is it?
    • Free cash flow is un-levered cash available to creditors and owners after taxes and reinvestment
      • Un-levered means free from financing considerations
      • Contrast with Cash Flow from Operations (which consists of Net Income plus Depreciation and Amortization plus Deferred Taxes and Non-Cash charges)
      • Free cash flows can be forecast from a firm’s financial projections, even if those projections include the effects of debt
  • DCF – FCF: How to calculate it?
    • Net Sales (Revenue)
    • - Cost of goods sold (COGS)
    • - Selling, general, and administrative (SG&A)
    • =Earnings before interest, taxes, depreciation and amortization (EBITDA)
    • - Depreciation & Amortization (D&A)
    • = Earnings before interest and taxes (EBIT)
    • - Taxes (tax rate*EBIT)
    • =Net operating profit/loss after taxes (NOPLAT)
    • + Depreciation & Amortization (D&A)
    • - Capital Expenditure (Capex)
    • - Change in Net working capital (  NWC)
    • =Free cash flow (FCF)
  • DCF – FCF: How to forecast?
    • Income Statement
    • Project growth in Net Sales by basing assumptions on
      • Research reports
      • Client forecasts (if available)
      • Industry trends
      • percent growth is usually an input; aggregate sales is derived from this input
    • Estimate the following by percent of sales
      • Cost of Goods Sold (COGS)
      • Selling, General and Administrative (SG&A) Expenses
    • Determine Interest Expense
      • Refer to the debt schedule and calculate the weighted average interest rate.
      • If no debt schedule is available, then compute Interest Expense as a percent of average Long-Term Debt= (Beginning LTD + Ending LTD)/2
    • Assess tax rate based on the marginal tax rate (federal, state and local) and current tax regulation
  • DCF – FCF: How to forecast? (contd..)
    • Depreciation
      • Sometimes expressed as % of Property, Plant and Equipment (PP&E)
    • Capital Expenditures (Capex)
      • Expenditures necessary to maintain the required capital intensity
  • DCF – FCF: How to forecast? (contd..)
    • Balance Sheet Items
    • Working Capital excluding cash and cash equivalents and STD
      • WC = (Current Assets–Cash and Cash Equivalents)–(Current Liabilities–STD)
      • Estimate WC as a percent of sales
      • Possible to squeeze cash from WC by operating more efficiently
      • Three major components of working capital are: inventories, receivables and payables
    • Property, Plant and Equipment (PP&E):
      • Project by capital intensity/efficiency: sales divided by (PP&E)
      • Beginning PP&E–Depreciation+ CapEx = Ending PP&E
  • DCF – WACC
    • Weighted Average Cost Of Capital (WACC)
      • Ascertain the costs of the various sources of capital for the company, with a given capital structure
        • Debt
        • Equity
      • The after-tax costs of the various sources are then averaged to arrive at an appropriate discount rate to value unlevered cash flows
      • Debt and equity market values used should represent the “target” capital structure (the capital structure that includes planned debt and equity financings, if any)
  • DCF – WACC (contd..)
    • Cost of debt
    • Consult with the debt capital markets group for a 10-year maturity all-in new issue rate at the credit rating corresponding to the targeted capital structure. As part of this process, you should look at the yield on new issues of comparable companies since the cost of debt is a function of the risks associated with a given business/industry
    • If the company has public debt outstanding and you do not intend to change its capital structure, find the debt rating
  • DCF – WACC (contd..)
    • Cost of equity
    • Use the Capital Asset Pricing Model (CAPM)
    • The risk-free rate can be taken as the interest rate on a generic 10-year government note
      • Roughly matches the maturity of projections
    •  = cov(r,r M )/var(r M ), usually estimated using a regression
    • Estimation issues
      • Betas may change over time
      • Don’t use data from too long ago
      • Five years of monthly data is reasonable
  • Reliance has a beta of 1.5. Assuming the treasury rate as 5%. The cost of equity can be calculated as follows: Cost of Equity = 5% + (1.5 * 8%) = 17% The market premium of 8% was based upon historical data and is the premium earned by stocks on an average over treasury bills. The cost of equity of 17% will be used to discount dividends and cashflows to equity and to obtain the value of Reliance. Capital Asset Pricing Model Example: Reliance
  • Limitations of CAPM
    • The model does not appear to adequately explain the variation in stock returns.
    • The model assumes that all investors agree about the risk and expected return of all assets.
    • The model assumes the existence of a risk-free rate, that all investors have access to the risk-free rate, and that there is no limit to the amount that may be borrowed or lent at this amount.
    • The model assumes that there are no taxes or transaction costs
    • Non stability of beta
    Capital Asset Pricing Model
  • DCF – Terminal value
    • Terminal value is the value of all future cash flows after the explicit forecast period of 10 years
  • DCF – Terminal value
    • Key value drivers
    • Growth rate of NOPLAT (g)
    • Return on invested capital ROIC
      • Value is higher if ROIC is higher than WACC
        • Higher growth rate is good because our projects have a ROIC greater than the cost of capital
      • Value is lower if ROIC is higher than WACC
        • Higher growth rate is bad because our projects have a ROIC lower than the cost of capital
  • DCF – Terminal value (contd..)
    • Can also estimate terminal value using an exit multiple
    • Terminal value = Statistic x Multiple
    • Forecast 10 explicit years of FCF, EBITDA, Net Income
    • Use a multiple of any relevant figure: Book Value, Net Income, Cash Flow from Operations, EBIT, EBITDA, Sales, etc.
      • Terminal Value should be an Enterprise Value; NOT ALL multiples produce an Enterprise Value (e.g., P/Es)
    • Multiply and estimate Terminal Value
  • DCF – Terminal value: exit multiple
  • DCF – Terminal value: perpetuity growth
  • DCF (contd..)
    • Validate and test projection assumptions
    • Carefully consider all variables in the calculation of the discount rate
    • Consistency of assumptions concerning interest rates, inflation rates, tax rates and the cost of capital is critical
    • Thoughtfully consider terminal value methodology
    • Do sensitivity analysis (base projection variables, synergies, discount rates, terminal values, etc.)
  • DCF – Walmart example
  • Walmart FCF assumptions
    • The sales at the end of 2007 were $370 billion. They are projected to grow by 10% during the next year. The growth rate of sales will decline by 0.5% each year for the next 10 years
    • COGS is currently 76% of sales and is expected to decline by 0.1% during the next 10 years
    • SG&A is currently 17% of sales and is expected to increase by 0.1% during the next 10 years
    • D&A are currently 1.7% of sales and are expected to remain at the same level
    • Capex is currently 3.5% of sales and is expected to remain at the same level
    • NWC is 0.5% of sales and is expected to remain at the same level
  • Walmart FCF’s
  • Walmart continuation value
  • Walmart sensitivity analysis
  • Discounted Cashflow Valuation where, – n = Life of the asset – CFt = Cashflow in period t – r = Discount rate reflecting the riskiness of the estimated cashflows
  • Equity Valuation versus Firm Valuation
    • Value just the equity stake in the business
    • Value the entire business, which includes, besides equity, the other claimholders in the firm
    Discounted Cashflow Valuation
  • Equity Valuation The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity where, CF to Equity t = Expected Cashflow to Equity in period t ke = Cost of Equity Discounted Cashflow Valuation
  • Firm Valuation The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions where, CF to Firm t = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital Discounted Cashflow Valuation
  • Assume that you are analyzing a company with the following cashflows for the next five years. Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.) The current market value of equity is $1,073 and the value of debt outstanding is $800. Discounted Cashflow Valuation Year CF to Equity CF to Firm 1 $ 50 $ 90 2 60 100 3 68 108 4 76.2 116.2 5 83.49 123.49 Terminal Value 1603.008 2363.008
  • Method 1: Discount CF to Equity at Cost of Equity to get value of equity Cost of Equity = 13.625% PV of Equity = 50/1.13625 + 60/1.13625 2 + 68/1.13625 3 + 76.2/1.13625 4 + (83.49+1603)/1.13625 5 = $1073 Method 2: Discount CF to Firm at Cost of Capital to get value of firm Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5% WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94% PV of Firm = 90/1.0994 + 100/1.0994 2 + 108/1.0994 3 + 116.2/1.0994 4 + (123.49+2363)/1.0994 5 = $1873 PV of Equity = PV of Firm - Market Value of Debt = $ 1873 - $ 800 = $1073
  • But Always Remember
    • Never mix and match cash flows and discount rates.
    • The key error to avoid is mismatching cashflows and discount rates, since discounting cashflows to equity at the weighted average cost of capital will lead to an upwardly biased estimate of the value of equity, while discounting cashflows to the firm at the cost of equity will yield a downward biased estimate of the value of the firm.
    Discounted Cashflow Valuation
  • Effects of Mismatching Error 1: Discount CF to Equity at Cost of Capital to get equity value PV of Equity = 50/1.0994 + 60/1.0994 2 + 68/1.0994 3 + 76.2/1.0994 4 + (83.49+1603)/1.0994 5 = $1248 Value of equity is overstated by $175. Error 2: Discount CF to Firm at Cost of Equity to get firm value PV of Firm = 90/1.13625 + 100/1.13625 2 + 108/1.13625 3 + 116.2/ 1.13625 4 + (123.49+2363)/1.13625 5 = $1613 PV of Equity = $1612.86 - $800 = $813 Value of Equity is understated by $ 260. Error 3: Discount CF to Firm at Cost of Equity, forget to subtract out debt, and get too high a value for equity Value of Equity = $ 1613 Value of Equity is overstated by $ 540 Discounted Cashflow Valuation
  • Limitation
    • Firms in trouble
    • Cyclical firms
    • Firms with unutilised assets
    • Firms with patents or product options
    • Firms in the process of restructuring
    • Firms involved in acquisitions
    • Private firms
    Discounted Cashflow Valuation
  • Dividend Growth Model
  • Formula P o = Present Value of expected dividends = DPS / (k e – g) Where, P o = Price of stock today DPS = Expected dividends per share next year K e = Cost of equity g = growth rate in dividends A simple manipulation of this formula yields K e = ( DPS / p o ) + g Dividend Growth Model
  • In 1992, Southwestern Bell paid dividends per share of $ 2.82 and the stock traded at $66 in December 1992. The estimated growth rate in dividends was 5.5% and the firm is assumed to be in steady state. Expected dividends in 1993 = $ 2.82 * 1.055 = $ 2.98 Cost of Equity = $2.98 /$66 + 5.5% = 10% Dividend Growth Model Example: Southwestern Bell
  • Weighted Average Cost Of Capital
  • Cost of Debt After tax cost of debt = Pre tax cost of debt (1 – tax rate) Siemens AG had 4.244 bn DM of debt outstanding in July 1993. Due to its low leverage and substantial cash balances, its default risk was minimal at it could borrow at 6.72%. The tax rate it faced was 38%. After tax cost of debt = 6.72%(1-0.38) = 4.17% WACC
  • Cost of Preferred Stock K ps = Preferred Dividend per share / Mkt price of preferred share At the end of 1992, GM had preferred stock which paid a dividend of $ 2.28 annually and traded at $ 27. Kps = $2.28/$27 = 8.44% WACC
  • WACC: Pepsi Example WACC = k e (E/[E+D+PS]) + K d (D/[E+D+PS]) + K ps (PS/[E+D+PS]) In Dec 1992, Pepsi Cola Corp had a cost of equity of 12.83% and after tax cost of debt of 5.28%. Equity = 76.94% Debt = 23.06% WACC = (12.83% * 0.7694) + (5.28% * 0.2306) = 11.09% WACC
  • WACC Market Value v/s Book Value
    • Rationale
    • Standard arguments against using market value
      • Book value is more reliable & less volatile
    • 2. Perception- lenders will not lend on basis of market value.
    • 3. Be more conservative, it assumes market value debt is lower.
    BUT …… ?
  • Illustration
    • IN 1992 PepsiCo had
    • Market value Book value
    • Equity $30.02 $6.438
    • Debt $9.00 $8.894
    • Book value debt ratio = 58.01%
    • Market value debt ratio = 23.07%
    WACC
  • Dividend Discount Models
    • Value of a stock = future expected cash flows
    • Expected dividends & price on sale
    • Required rate of dividend:k rf + b(k m – k rf )
    • Growth in dividend can be calculated by:
          • Using historical growth rate
          • Generating your own forecast
          • Using formula g=br
    Dividend Discount Models
  • The General Model
    • Rationale
    • Rate appropriate to riskiness of the CF
    • 2 basic inputs: expected dividends & required rate of return on equity
    • Assumptions on expected future growth in earnings & payout ratios
    • RRoE is determined from by its riskiness
    The General Model
    • As per General Model
      • Value per share of stock = DPS t (1+r) t
      • where DPSt = expected dividends per share
      • r = required rate of return
    The General Model
  • The Gordon Growth Model
    • Only for forms in “STEADY STATE”
    • A stable growth rate in long run
    • other measures to grow at the same rate
    • growth rate in the economy
    • Cannot be greater than nominal rate
    • Likely for “above – stable” growth
    • Adding premium to average growth rate
    • It cannot be greater than 1 or 2 %
    The Gordon Growth Model
  • Illustration
    • Value of stock = DPS1
            • r – g
    • Where DPS1 = expected div one year from now
    • r = RRoR for equity investors
    • g = growth rate in dividends forever
    The Gordon Growth Model
  • Example
    • Dividend per share next period of Rs.2.50, a discount rate of 15% and an expected growth rate of 8% forever
    • Value = 2.50/(.15-.08) =Rs 35.71
    • Expected growth rate of 14%
    • Value = 2.50/(.15-.14) = Rs. 250
    The Gordon Growth Model
  • Two Stage Dividend Discount Model
    • Initial stage of extraordinary growth ( n yrs)
    • A subsequent steady state
    • Suitability (patents, super – normal growth)
    The Two Stage Dividend Discount Models
  • Extraordinary growth rate g % each year 1 2 3 4 5 6….. Stable growth for ever PV of dividends during extraordinary growth period + PV of terminal price The Two Stage Dividend Discount Models
    • Po = DPS t + P n
        • ( 1 + r ) t ( 1 + r ) t
        • Where DPSt = expected div. Per share in year t
        • r = required rate of return in high growth period
        • Pn = price at the end of year n
        • Pn = DPS n+1 / (r n – g n )
        • g = growth rate forever after year n
    The Two Stage Dividend Discount Models
  • Limitations
    • Defining the length of high growth rate (duration of PLCs)
    • Overnight transformation of growth rate.
    • Over or under estimating growth rate
    The Two Stage Dividend Discount Models
  • H Model
    • 2 stage, growth rate declines linearly
    • Assumption – earnings growth starts at high initial rate g a
    • Extraordinary rate to last for 2H periods
    • Constant dividend payout
    H Model
  • g a g n Extraordinary growth 2H yrs Infinite growth H Model
    • Value of expected dividends in H model –
    • Po = DPSo (1+ g n ) + DPSo * H(g a – g n )
    • r – g n r – g n
    • stable growth extraordinary growth
    • r = required return on equity
    • g a = growth rate initially
    • g n = growth rate at end of 2H yrs.
    H Model
  • Example
    • Syntex corp. was expected to have EPS of $2.15 in 1993 and payout div. Of $ 1.08.Earnings grew @18% p.a. for 5 yrs but declined linearly @ 2 % a year over the next 6 yrs to a stable growth rate of 6 %
    • Beta = 1.25
    • Treasury bond rate = 7 %
    H Model
    • Expected return on equity
    • = 7% + 1.25 ( 5.5)=13.88%
    • Value of extraordinary
    • = 1.08*6/2 (.18-.06)/.1388-.06= 4.91
    • Value of stable growth
    • = 1.08*1.06/.1388-.06= 14.47
    • Therefore value = 4.91 + 14.47 = $ 19.38
    • Stock was trading @ $19.00 in May 1993
    H Model
  • Limitations
    • Decline has to follow the strict structure
    • Constant payout, when it should be increasing .
    H Model
  • Three stage DDM
    • Combines 2 stage and H model.
    • No restrictions on dividend payout ratio
    • Removes many constraints by other DDMs
    • However requires number of inputs
    Three Stage Dividend Discount Model
  • High growth Transition Infinite growth g a g n Low payout ratio Increasing P/o High P/o Three Stage Dividend Discount Model
  • Formula Three Stage Dividend Discount Model
    • H-model will generate result similar to the three phase model if one assumes that H is half way between the transition period of the three phase model.
    • That is, H is half way between A & B of the three phase model. Under this assumption, H can be interpreted in either of two ways:
      • H is half the amount of time required for the growth rate to change from g a to g n. OR
      • In context of the three phase model, H is assumed to be half way through the transition period A to B.
    THE H-MODEL & THREE STAGE MODEL … Relation Between The Two
  • THE H-MODEL AND THREE STAGE MODEL … Relation Between The Two
    • ILLUSTRATION:
    • It is estimated that for company XYZ, the stock’s dividend will increase at a rate of 6% for the next 2 years, the rate will then decline over the next 3 years to a rate of 3%, which will remain constant thereafter. Also the discount rate is estimated to be 8%. Estimate the value of stock. Given that the company’s stock dividend for the previous year was Re 1.
    THE H-MODEL AND THREE STAGE MODEL … Example1
    • SOLUTION:
    •   In this example we can see that, A = 2 years, g a = 6%
    • B = 3 years, g n = 3%
    • K = 8%, D 0 = 1
    •   As we know H is halfway between A & B, hence H = 3 ½ years.
    •   Hence substituting in the equation (14), we have:
    • V 0 = 1[(1.03) + (0.06-0.03)] / (0.08 – 0.03)
    • Therefore, V 0 = Rs 22.70
    • If we compare this answer with the values given by the three phase model, we find that in most of the cases, both the models will give a similar result.
    THE H-MODEL AND THREE STAGE MODEL … Example1
    • ILLUSTRATION:
    • In FEB 1985, Satyam ltd was selling for Rs 59 per share. Dividend paid out was Rs 4.25 per share. At that time, at dividend growth rate of 11% was forecasted for the next four years. It was estimated that the firm’s long run normal growth rate would be 5%. It was also assumed that the firm would attain this growth rate after 12 years. Also it is known that the expected rate of return is 14.25%. Kindly estimate the value of the Satyam ltd equity and compare with the prevalent market price.
    THE H-MODEL AND THREE STAGE MODEL … Example2
    • SOLUTION:
    • We will illustrate the given case with the example of the chart as shown below:
    THE H-MODEL AND THREE STAGE MODEL … Example2
    • As we can see, H is halfway between A and B, hence H = 4 + (12 – 8)/2. Therefore H=8.
    • V 0 = D 0 [(1 +g n ) + H( g a – g n )] / (k – g n )
    • V 0 = 4.26[(1 +0.05) + 8( 0.11 – 0.05)] / (0.1425 – 0.05)
    • = Rs 70.46
    THE H-MODEL AND THREE STAGE MODEL … Example2
  • FCFE Valuation Models
  • Free CashFlows to Equity - FCFE FCFE Model
    • What is FCFE?
    • Levered firm
    • FCFE = Net Income + Dep. – Capex – Change in WC –
    • Principal repayments + New Debt issues
    • Debt Ratio
    • FCFE = Net Income - (1-Debt Ratio)[(Capex-Dep.)+
    • (Change in WC)]
    • Dividends v/s FCFE
    • a. Desire for Stability, b. Future investment needs
    • c. Tax Factors d. Signaling Prerogatives
  • Example: ACC Ltd. – 2004-05 (Rs.in cr.)
    • Net Income = Rs.379 ; Dep.= Rs.225 .Capex= Rs.291.7 ;
    • Debt= Rs.1492 ; Cap.Emp.= Rs.3318 ; Chg.inWC= Rs.76.4
    • Debt Ratio = Debt/Cap.Emp = 0.45
    • FCFE = 379 - (1-0.45)[(291.7 - 225.7)+(100.19 - 23.76)]
    • = 379 - (0.55)[(66)+(76.43)]
    • = 379 - 78.33 = Rs.300.67 cr.
    • Dividend paid = Rs.125.3 cr.
    • Dividend – FCFE ratio = 125.3/300.67*100 = 41.67%
    • Retained Cash = 457.3 – 125.3 = Rs. 175.37 cr.
    FCFE Model
  • Stable Growth FCFE Model
    • Stable Growth Rate
    • Model: P o = FCFE 1 /r – g n
    • where P o - Value of stock today
    • FCFE 1 - Expected FCFE next year
    • r - Cost of Equity of the firm
    • g n - Growth rate in FCFE forever
    • Assumptions:
    • a. Nominal Growth rate; b. Average Risk
    • c. Capex is offset by Depreciation
    • Suitability
    FCFE Model
  • Example: AT&T – 1993-94 ($)
    • DPS = 1.32 ; FCFE per share = 2.49 ; EPS = 3.15 ;
    • Capex/sh.= 3.15 ; Dep./sh.= 2.78 ; Debt Fin.ratio= 25%;
    • Ch.in WC per share = 0.50
    • Earnings, Capex, Dep., WC to grow at 6% a year
    • Beta = 0.90 , Treasury bond rate (Rf) = 7.5%
    • Cost of Equity = 7.5% + (0.9*5.5%) = 12.45%
    • FCFE = EPS – ( 1-0.25 )[(Capex - Dep.)+(Change in WC)]
    • = 3.15 – (0.75)[(3.15 – 2.78)+(0.5)]
    • = 3.15 – (0.75)(0.87) = 3.15 – 0.6525 = 2.49
    • Value per share = 2.49*1.06/(0.1245 - 0.06) = 41
    FCFE Model
  • Rationale
    • Too big a company
    • Growth in tandem with economy
    • Pays much less dividends
    FCFE Model
  • 2 Stage FCFE Model
  • 2 Stage FCFE Model
    • Faster & constant growth initially
    • Later, a stable growth rate
    • Model:
    • PV of stock = PV of FCFE per year + PV of Terminal Price
    • =  FCFE t / (1+r)^t + P n / (1+r)^n
    • where FCFE t - FCFE in year t
    • P n – price at end of extra-ordinary growth period
    • r – Req.ROR in high growth period
    • Terminal Value: P n = FCFE n+1 /(r n – g n )
    • where g n – growth rate after terminal year forever
    • r n – Req.ROR in stable growth period
    2 Stage FCFE Model
  • 2 Stage FCFE Model
    • Assumptions
    • a. Growth is high initially & then becomes stable
    • b. Consistency in Terminal year
    • Suitability
    • Better results than Dividend Discount Model
    2 Stage FCFE Model
  • Example: Amgen Inc. – 1993-94
    • Rev./sh.= $12.4 ; EPS = $3.1 ; Capex/sh.= $1; Dep./sh.= $0.6
    • High growth period: 5 years ; ROE = 18.78%; Beta = 1.3;
    • Retention Ratio = 100%; Growth rate = 18.78%;
    • Bond rate = 7.5%; Debt ratio = 18.01%; WC = 20%Rev.;
    • Capex, dep., Rev. to grow at 18.78%
    • Cost of Equity = 7.5% + 1.3(5.5%) = 14.65%
    • Stable growth period: Growth rate = 6%; Beta = 1.1;
    • Capex to offset dep.; WC to be 20% of Rev.;
    • Debt ratio = 18.01%
    • Cost of Equity = 7.5% + (1.1*5.5%) = 13.55%
    2 Stage FCFE Model
  • Example: Amgen Inc. – 1993-94 PV of FCFE during high growth phase = 2.54+2.63+2.72+2.82+2.92 = $13.64 2 Stage FCFE Model ($) Year 1 Year 2 Year 3 Year 4 Year 5 Earnings 3.68 4.37 5.19 6.17 7.33 (-)(Capex-Dep.)* (1-1.3) 0.39 0.46 0.55 0.65 0.78 (-)(Chg.in WC)* (1-1.3) 0.38 0.45 0.54 0.64 0.76 = FCFE 2.91 3.46 4.11 4.88 5.79 Present Value (14.65%) 2.54 2.63 2.72 2.82 2.92
  • Example: Amgen Inc. – 1993-94
    • Terminal Price = Exp. FCFE n+1 /(r-g n )
    • Exp.EPS 6 = $7.33 * 1.06 = $7.77
    • Exp.FCFE = EPS 6 – Ch.in WC (1-Debt Ratio)
    • = $7.77 - $0.35(1-0.1801) = $7.48
    • Terminal price = $7.48/(0.1355 – 0.6) = $99.07
    • Ch.in WC is 10% of change in revenue in year 6
    • PV of Terminal Price = $99.07/1.1465 5 = $50.01
    • PV today = PV of FCFE (high growth)+ PV of TP
    • = 13.64 + 50.01 = $63.65
    2 Stage FCFE Model
  • Rationale
    • History of Extra-ordinary growth
    • Growth is moderating due to:
    • a. A much larger company,
    • b. Maturing products
    • No dividends paid
    • FCFE to increase over a period of time
    2 Stage FCFE Model
  • Price/Earnings Multiples
  • Price/Earnings Multiples Price/Earnings Multiples
    • Simple to compute - popular
    • Eliminates need to make assumptions of:
    • a. risk, b. growth, c. payout ratios
    • Reflects market moods & perceptions
    • Weaknesses
    • a. avoidance of risk & growth factors
    • b. wrong judgement
    • PE Ratio is:
    • a. increasing function of Payout ratio & growth rate,
    • b. decreasing function of riskiness of the firm.
  • PE Ratio Price/Earnings Multiples
    • Firm growing at a rate similar to economic growth rate
    • Determined by:
    • a. Payout ratio – PE increases with increase in PR
    • b. Riskiness – PE lowers as riskiness increases
    • c. Expected growth rate in Earnings
    • Since DPS = EPS 0 (Payout Ratio)(1+g n )/(r-g n ),
    • Value of Equity P 0 = EPS 0 (Payout Ratio)(1+g n )/(r-g n )
    • PE Ratio = P0/EPS0 = (Payout Ratio)(1+gn)/(r-gn)
  • Example: Deutsche Bank (DM) Price/Earnings Multiples
    • EPS = 46.38 ; DPS = 16.50 ; Beta = 0.92
    • Growth in Earnings & Dividends = 6%; Bond rate = 7.5%
    • Premium = 4.5%
    • Div.Payout Ratio = 16.5/46.38*100 = 35.58%
    • Cost of Equity = 7.5% + (0.92*4.5%) = 11.64%
    • PE Ratio = 0.3558*1.06/(0.1164 – 0.6) = 6.69
    • If FCFE = 25 per share ; Beta = 0.93 , then COEq.= 11.69%
    • FCFE Payout ratio = 25/46.38*100 = 53.9%
    • PE Ratio = 0.6105*1.06/(0.1169 – 0.06) = 11.37
  • Price/Book Value Multiples
  • Price/Book Value Multiples Price/Book Value Multiples
    • What is Book Value?
    • Book Value v/s Market Value
    • Advantages:
    • a. Simple benchmark for comparison
    • b. Firms with negative earnings can use P/B value
    • Disadvantages:
    • a. Affected by accounting policies across firms & nations
    • b. Not of any use to Service firms
  • PBV Ratio Price/Book Value Multiples
    • Growth rate similar or lower than economic growth rate
    • P 0 = DPS 1 /r-g n (Gordon growth model)
    • Substituting EPS 0 [Payout ratio( 1 +g n )] for DPS 1,
    • P 0 = EPS 0 *Payout ratio*( 1 +g n )/(r-g n )
    • Since ROE = EPS 0 /BV of Equity,
    • P 0 = BV 0 *ROE*Payout Ratio*(1+g n )/r-g n
    • PBV = P 0 /BV 0 = ROE*Payout ratio*(1+g n )/(r-g n )
    • If ROE is based on Exp.earnings in next time period,
    • PBV = P 0 /BV 0 = ROE*Payout ratio/(r-g n )
    • Relating growth to ROE, g = ROE(1-Payout ratio)
    • PBV = P 0 /BV 0 = ROE – g n /(r-g n )
  • PBV Ratio Price/Book Value Multiples
    • Determined by:
    • a. Difference between ROE & Req.ROR on projects
    • b. If ROE > Req.ROR, Price > BV of Equity
    • c. If ROE < Req.ROR, Price < BV of Equity
    • Used for firms not paying out dividends
  • Example: Amoco – 1993-94 ($) Price/Book Value Multiples
    • EPS = 3.82; DPR = 60%; ROE = 15%; Beta = 0.65
    • Growth rate in Earnings & Dividend = 6%
    • Treasury bond rate = 7.5%
    • Cost of Equity = 7.5% + (0.65*5.5%) = 11.08%
    • PBV Ratio based on fundamentals
    • = (0.15*0.6*1.06)/(0.1108-0.06) = 1.88
    • PBV Ratio based on return differential
    • = (0.15-0.6)/(0.1108-0.6) = 1.77
    • Amoco was selling at a PBV ratio of about 2 in March’95
  • PBV Ratio - ROE Price/Book Value Multiples ROE – Required Return PBV Ratio High High Low Overvalued Low ROE – High PBV High ROE – High PBV Low ROE – Low PBV Undervalued High ROE – Low PBV
  • Price/Sales Multiples
  • Price/Sales Multiples Price/Sales Multiples
    • Examines effects of Corporate strategy
    • Advantages:
    • a. Available to troubled firms,
    • b. Difficult to manipulate,
    • c. Not much volatile as PE
    • Disadvantages:
    • a. Stability of using Revenues
    • b. Revenues may not decline inspite of drop in Earnings
  • PS Ratio Price/Sales Multiples
    • Put EPS 0 (Payout Ratio)(1+g n ) in place of DPS in GordonM
    • Profit Margin(PM) = EPS 0 /Sales per share
    • Hence, P 0 = Sales 0 *PM*Payout Ratio*(1+g n )/(r-g n )
    • PS = P 0 /Sales 0 = PM*Payout Ratio*(1+g n )/(r-g n )
    • If PM is based on expected earnings in next time period,
    • PS = P 0 /Sales 0 = PM*Payout Ratio/(r-g n )
    • It is increasing function of PM, Payout Ratio & growth rate
    • It is decreasing function of riskiness of the firm
  • International Multifoods – 1993-94 ($) Price/Sales Multiples
    • Rev./sh.= 134.7 ; EPS = 1.5 ; Payout Ratio = 55%;
    • Beta = 0.8 ; Treasury bond rate = 7.5% ;
    • Growth rate in earnings & dividend = 6%
    • Net Profit Margin = Net Income/Revenues
    • = 1.5/134.7*100 = 1.11%
    • Cost of Equity = 7.5% + (0.8+5.5%) = 11.9%
    • PS Ratio = 0.011*0.55*1.06/(0.119 – 0.06) = 0.1097
    • The co. was selling at PS ratio of 0.14
  • PS Ratio Price/Sales Multiples
    • PS Ratio is determined by:
    • a. Net Profit Margin – EPS/RPS,
    • b. Payout ratio,
    • c. Riskiness, and
    • d. Expected growth
  • P/E & Growth Ratio
  • P/E & Growth Ratio (PEG) PEG Ratio
    • Assumption – P/E = EPS rate of growth
    • Annualised rate of Growth
    • Comparison with current market price
    • Future growth makes sense
    • Growth of ABC over next 2 yrs is 10% & P/E = 10
    • then PEG for ABC = 1 (fair value)
    • If P/E = 5, PEG = 0.5; If P/E = 20, PEG = 2
    • Used for Growth companies
  • Year-ahead P/E & Growth Ratio
  • Year-ahead P/E & Growth Ratio (YPEG) YPEG Ratio
    • Valuing larger, established firms
    • Looks at 5-year growth rates
    • If P/E is 10, growth over next 5 yrs.is exp.to be 20%
    • then YPEG = 0.5
    • Be Creative
    • Sometimes standard valuation ratio will simply not be available and you simply have to devise your own.
    • E.g. In 1990s some analyst valued Retail Internet firms based on the no. of Hits their sites received. As it turns out, they valued these firms using too generous “Price to hits” ratio.
    OTHER MULTIPLES …For Relative Valuation
  • Black & Scholes Model Black & Scholes Model
    • The model can be written as:
    • Value of the call = SN(d 1 ) – K e -rt N(d 2 )
    • where d 1 = [ln(S/K) + (r+ σ 2 / 2 )*t]/σ(sq.root of t)
    • d 2 = d 1 - σ(sq.root of t)
    • S – current value of underlying asset;
    • K – strike price of the option;
    • t - life to expiration of the option;
    • r – riskless interest rate corresponding to life of option;
    • σ 2 – variance in the ln(value) of underlying asset.
  • CASE STUDY …Tata Steel Ltd .
    • COMPANY SNAPSHOT:
    • The Tata Iron and Steel Company Limited was formed in 1907 at Mumbai.
    • The Company manufactures rails, fishplates, bars, light structurals, heavy structurals, plates, black sheets, galvanised sheets, tin bars, sleeper bars, sleepers, blooms, billets, sheet bars, wheels, tyres and axles, skelp and strip, and special steels tools such as picks, beaters, hammers and shovels and red-oxide, coal tar, sulphate of ammonia, etc.
  • FINANCIAL DATA …Tata Steel Industry avg PE : 10.3 Tata Steel PE : 5.8 Economy Growth Rate : 7.0% Risk Free Rate of Return : 6.25%(Reserve Bank of India) Beta (ß) for Tata Steel : 1.13 (besindia.com)   FY00-01 FY01-02 FY02-03 FY03-04 FY04-05 Equity Share Cap   3,679.70   3,679.70   3,679.70   3,691.80   5,536.70 Res & Surplus    43,804.60   30,779.90   28,168.40   41,466.80   65,062.50 No. of Equity shares o/s    367,771,901   367,771,901   367,771,901   367,771,901   553,472,856 Dividend/ Share   5.00 4.00 8.00 10.00 13.00
  • ASSUMPTIONS
    • Company is growing at the same rate as the economy. (Hence g = 7%).
    • Expected market Rate of Return E(r m )= 12%
  • CALCULATIONS
    • k = RISKFREE RETURN + BETA * (MARKET RISK PREMIUM)
    • k = 6.25% + 1.13 (12 - 6.25%) = 12.75%
    • V 0 = D 0 (1+g) / (k-g) = D 1 / (k-g)
    • = 13(1 + 0.07)/(0.1275 - 0.07)
    • = Rs 241.91
    • As on 4 th Nov. 05’ the market value of Tata steel share was Rs 347.70. Hence we can say the share is over valued at Rs 347.70.
  • INFERENCES
    • The P/E ratio for Tata Steel is 5.8 as against the industry average of 10.3, hence we can say that the investors do not consider that Tata Steel has a potential for further growth as is reflected by their lower PE Ratio.
    • Also the market value of TSL stock is overvalued as we have seen and hence, the market is likely to correct itself in near future.
  • In Short… Relative Valuation using multiples
    • Firm Value / Sales
    • Firm Value / EBIT
    • Firm Value / BV
    • EV / Sales
    • EV / EBITDA
    • P/E
    • P/BV
    • P/CF
    • P/Sales
    Value Of Stock
    • FCFF
    • Estimate CF
    • Dividends
    • FCFE
    • B/S method
    • Adj. BV method
    • EV
    • WACC
    • Calc.Cost of equity
    • CAPM
    • APM
    Value of Firm Value of Firm Value of Equity Asset Based DCF approach Value Of Firm
    • Firm Value / Sales
    • Firm Value / EBIT
    • Firm Value / BV
    • EVA, MVA, RVG
  • THANK YOU