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Stock valuation methods for equity analysis

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Stock valuation Part-II Prof. Trilochan Tripathy XLRI- Xavier school of Management,Jamshedpur
Cash Flow of Bond vs. Equity Investor Firm Equity Debt Net Income Interest (fixed income) May Pay Dividend (variable residual income) Retained Earnings
Cash Flow of Bond vs. Equity Investor Bond Investorcash Flow 𝑃𝑉 = 𝐢1 1 + π‘Ÿ 1 + 𝐢2 1 + π‘Ÿ 2 + β‹― + 100 + 𝐢𝑛 1 + π‘Ÿ 𝑛 β€’ Predictable Coupon Cash flow β€’ Predictable Terminal Value Equity Investor cash flow 𝑉 = 𝐢1 =? 1 + π‘Ÿ =? 1 + 𝐢2 =? 1 + π‘Ÿ =? 2 + β‹―+ 𝑇𝑉 =?+𝐢𝑛 =? 1 + π‘Ÿ =? 𝑛 β€’ Cash flow to Owner is Unpredictable β€’ Difficult to Predict Terminal Value
Why Cash Flows are uncertain for equity investor? β€’ Dividend and dividend growth β€’ Interestrate risk β€’ Reinvestmentrisk β€’ Credit/defaultrisk β€’ Inflationary risk β€’ Liquidity risk β€’ Exchange rate risk β€’ Politicalrisk β€’ Etc.
What Causes Stock Prices to Go Up and Down? Can you Guess?? Can we value the stock?
Can we value the stock?
Equity Shares Characterization & Valuation – Equity shares in general are characterized by: β€’ Ownership and management β€’ Entitlement to residual cash flows β€’ Limited liability β€’ Infinite life β€’ Substantiallydifferent risk profile -Thus, equity shares valuation is not that easy like bonds.
Efficient market Hypothesis Efficient Market Hypothesis -Security are in equilibrium, which means they are fairly priced (expected returns= required returns) -Security prices accurately reflect available information, and respond rapidly to new information as soon as it becomes available” -Securities are fairly priced and there is no undervaluation or over valuation – Weak form efficiency:pricesincorporateinformation aboutpast prices – Semi-strongform: incorporateall publicly available information – Strongform: all information,includinginsideinformation Stock price move in Random: Random Walk Hypothesis
However, we try to predict the value of a stock amidst wide arrays of uncertainty !
Alternative Stock valuation Models DCF β€’ Dividend Discounted Model β€’ FCFF and FCFE Relative Valuation Model β€’ P/E β€’ P/S β€’ EV/EBITDA etc. Asset Based Valuation β€’ BV β€’ LV
Common stock valuation: DDM-Three Special Cases β€’ Constant (Zero growth) dividend – The firm will pay a constantdividend forever – This is like preferred stock – The price is computed using the perpetuity formula 𝑉0 = 𝑑=1 ∞ 𝐷𝑑 (1+π‘Ÿ)𝑑= D / r β€’ Constant dividend growth – The firm will increase the dividend by a constantpercentevery period – The price is computed using the growing perpetuity model 𝑉0 = 𝑑=1 ∞ 𝐷𝑑 (1+π‘Ÿ)𝑑 = 𝑑=1 ∞ 𝐷0(1+𝑔)𝑑 (1+π‘Ÿ)𝑑 = 𝐷1 π‘Ÿβˆ’π‘” β€’ Supernormal growth – Dividend growth is not consistentinitially, but settles down to constantgrowth eventually – The price is computed using a multistagemodel ( example two stage) 𝑉0 = 𝑑=1 𝑛 𝐷0 1 + 𝑔𝑆 𝑑 (1 + π‘Ÿ)𝑑 + 𝐷0 Γ— 1 + 𝑔𝑆 𝑛 Γ— (1 + 𝑔𝐿) (π‘Ÿ βˆ’ 𝑔𝐿) Γ— (1 + π‘Ÿ)𝑛
Value of a stock in a two-stage growth DDM Given g1 35% g2 10% r% 15% D0 50 Year AnticipatedDiv HGP LGP Sum of DCFs 1 58.69565217 2 68.90359168 3 80.88682502 4 94.95409893 5 111.4678553 414.9080231 6 …...infanite 1219.222936 2452.292816 1634.130959 Thus, the expectedstock price is Rs. 1634.13 Suppose a company is providinginitial amountof dividendof Rs. 50 The company CFO is anticipatingto pay year on year dividendgrowthby 35% up to five years From 6yr onwards it isanticipatedby the CFO of the company that the company can pay 10% incremental dividendgrowthyearafteryear till the life of the company if the requiredrate of return on thiskind of riskyasset is 15% , what shouldbe the expectedstockprice of the company today?
Part II
Why Free Cash flow Valuation?  Many firms pay no, or low, cash dividends  Dividends are paid at discretion of the board of director; therefore, it may be poorly aligned with the firm's long-run profitability  If a company is views as acquisition target, free cash flow is more appropriate measure because the new owners will have discretion over future dividend.  Free cash flow may more related to long-run probability of the firm compared to dividend
Free Cash flow valuation model β€’ The free cash flow model is based on the same premise as the dividend valuation models except that we value the firm’s free cash flows rather than dividends.
FCFE Growth Model Constand Growth Model V0= 𝐹𝐢𝐹𝐸1 π‘Ÿβˆ’π‘” = 𝐹𝐢𝐹𝐸0 Γ—(1+𝑔) π‘Ÿβˆ’π‘” Two-Stage Free Cash Flow to Equity (FCFE) Discount Model 𝑉0 = 𝑑=1 𝑛 𝐹𝐢𝐹𝐸0 1 + 𝑔𝑆 𝑑 (1 + π‘Ÿ)𝑑 + 𝐹𝐢𝐹𝐸0 Γ— 1 + 𝑔𝑆 𝑛 Γ— (1 + 𝑔𝐿) (π‘Ÿ βˆ’ 𝑔𝐿) Γ— (1 + π‘Ÿ)𝑛 Equity Value = FCFE discounted at the required return on equity Return on equity= Risk-free rate of return + beta Γ— (Market rate of returnβˆ’Risk-free rate of return)
Free Cash flow valuation model β€’ The free cash flow valuation model estimates the value of the entire company and uses the cost of capital as the discount rate. β€’ As a result, the value of the firm’s debt and preferred stock must be subtracted from the value of the company to estimate the value of equity. VE =VC - VD-VPS β€’ Equity Value = Firm Value – Market Value of Debt- Market Value of Preferred stock  FCFF = EBIT 1βˆ’ Tax rate + Dep – FC Investment –dWC Investment  Firm Value (VF) = FCFFdiscountedat WACC
How to calculate FCFF in a real-world scenario ? Formula 1 Formula 2 Formula 3 Formula 4 NI (+) EBIT*(1-t) (+) EBITDA*(1-t) CFO + NCC (+) NCC (+) NCC*t (+) dWC Inv (-) dWC Inv (-) dWC Inv (-) Int(1-t) (+) Int (1-t) + FC inv (-) FC inv (-) FC inv (-) FC inv (-) FCFF FCFF FCFF FCFF β€’ 𝐹𝐢 𝐼𝑛𝑣 = 𝑒𝑛𝑑𝑖𝑛𝑔 π‘”π‘Ÿπ‘œπ‘ π‘  𝑃𝑃&𝐸 βˆ’ 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 π‘”π‘Ÿπ‘œπ‘ π‘  𝑃𝑃&𝐸 β€’ π‘ŠπΆ πΌπ‘›π‘£π‘’π‘ π‘‘π‘šπ‘’π‘›π‘‘ = πΌπ‘›π‘£π‘’π‘›π‘‘π‘œπ‘Ÿπ‘¦π‘‘ + π‘…π‘’π‘π‘’π‘–π‘£π‘Žπ‘π‘™π‘’π‘ π‘‘ βˆ’ π‘ƒπ‘Žπ‘¦π‘Žπ‘π‘™π‘’π‘‘ - (πΌπ‘›π‘£π‘’π‘›π‘‘π‘œπ‘Ÿπ‘¦π‘‘βˆ’1 + π‘…π‘’π‘π‘’π‘–π‘£π‘Žπ‘π‘™π‘’π‘ π‘‘βˆ’1
Try with an example Items (Rs. In billion) Sales 100 Operatingcost 20 EBITDA 80 NCC(depreciation) 20 EBIT 60 Interest 30 EBT 30 Tax (@40%) 12 EAT 18 dWC Investment -10 FC Investment 0 Principal repayment 10 No. of Common share outstanding .3 in % WACC 12% re 9% g 6%
Solution Sign Fourmula 1 Values (bn) Sign Formula 2 Values (bn) NI 18 EBIT*(1-t) 36 + NCC 20+ NCC 20 - WC Inv -10- WC Inv -10 + Int(1-t) 18+ - FC inv 0- FC inv 0 FCFF 46 FCFF 46 sign Formula 3 Values (bn) sign Formula 4 Values (bn) EBITDA*(1-t) 48 CFO 28 + NCC*t 8 - WC Inv -10 + + Int (1-t) 18 - FC inv 0 FCFF 46 FCFE 46
Solution for FCFE sign Formula 4 Values (bn) CFO 28 + Int (1-t) 18 FCFF 46 - Int (1-t) -18 - Principal repayment -10 FCFE 18 Suppose the concerned company’s FCFE is growing at the rate g=6% here onwards 9 Just an approximation) Total Future value of cash flows= CurrentYr. FCFE + Future FCFE= 18+ 18*((1+6%)/(9%-6%))= = 654 billoin Value per share= 654 billion/3 billion share outstanding=Rs. 218
FCFF is a Financial performance Indicator β€’ Free cash flow to the firm (FCFF) represents the cash flow from operations available for distribution after accounting for depreciation expenses, taxes, working capital, and investments. β€’ Free cash flow is arguably the most important financial indicator of a company's stock value. β€’ A positive FCFF value indicates that the firm has cash remaining after expenses. β€’ A negative value indicates that the firm has not generated enough revenue to cover its costs and investment activities.
Some Relative Valuation methods β€’ This method estimates the value of the firm’s stock as a multiple of some measure of firm ’ s performance, such as the firm’s earnings per share, book value per share, sales per share, cash flow per share, where the multiple is determined by the multiples observed from comparable companies. β€’ The most common metrics are: – Earnings Per Share and – Book value per Share – Liquidation value per share
Common Stock valuation by PE Ratio β€’ P/E ratio is a relative value model because it tells the investor how many dollars investors are willing to pay for each dollar of the company’s earnings. π‘‡π‘Ÿπ‘Žπ‘–π‘™π‘–π‘›π‘” 𝑃/𝐸 = π‘€π‘Žπ‘Ÿπ‘˜π‘’π‘‘ π‘π‘Ÿπ‘–π‘π‘’ π‘π‘’π‘Ÿ π‘ β„Žπ‘Žπ‘Ÿπ‘’ 𝐸𝑃𝑆 π‘œπ‘£π‘’π‘Ÿ π‘π‘Ÿπ‘’π‘£π‘–π‘œπ‘’π‘  12 π‘šπ‘œπ‘›π‘‘β„Žπ‘  πΉπ‘œπ‘Ÿπ‘€π‘Žπ‘Ÿπ‘‘ 𝑃/𝐸 = π‘€π‘Žπ‘Ÿπ‘˜π‘’π‘‘ π‘π‘Ÿπ‘–π‘π‘’ π‘π‘’π‘Ÿ π‘ β„Žπ‘Žπ‘Ÿπ‘’ 𝐸𝑃𝑆 π‘œπ‘£π‘’π‘Ÿ 𝑛𝑒π‘₯𝑑 12 π‘šπ‘œπ‘›π‘‘β„Žπ‘ 
Other Relative valuation measures π‘ƒπ‘Ÿπ‘–π‘π‘’ π΅π‘œπ‘œπ‘˜ π‘…π‘Žπ‘‘π‘–π‘œ = 𝑃0 𝐡𝑉0 Price-to-sale Ratio= (P/S)
Common Stock valuation by PE Ratio β€’ Suppose XYZ company’ had last year earnings of $1.65 per share for the 12-month period ended in March, 2016. XYZ’s CFO estimates that company earnings for 2017 will be $1.83 a share. The current P/E ratios for three comparable firms are 26.85, 18.79 & 22.18 and thus the comparable average PE ratio is 22.61. Based on above information, estimate the value of the common stock? – Ans: $41.38
Common Stock valuation: BV per Share Value of Common Stock (Vc)= π‘‡π‘œπ‘‘π‘Žπ‘™ π‘Žπ‘ π‘ π‘’π‘‘βˆ’π‘‡π‘œπ‘‘π‘Žπ‘™ πΏπ‘–π‘Žπ‘π‘–π‘™π‘–π‘‘π‘¦ π‘π‘œ.π‘œπ‘“ 𝐢𝑆 π‘†β„Žπ‘Žπ‘Ÿπ‘’π‘  π‘œπ‘’π‘‘π‘ π‘‘π‘Žπ‘›π‘‘π‘–π‘›π‘” Example: At year end XYZ company balance sheet shows total asset of Rs. 600,0000 , total liability of Rs. 450,0000 and 100,000 of share of common share outstanding. Find the value of the common stock? Ans: Rs.15 per share
Common Stock Valuation: LV per Share Value of Common Stock = π‘‡π‘œπ‘‘π‘Žπ‘™ π‘™π‘–π‘žπ‘’π‘–π‘‘π‘Žπ‘‘π‘’π‘‘ π‘Žπ‘ π‘ π‘’π‘‘βˆ’π‘‡π‘œπ‘‘π‘Žπ‘™ πΏπ‘–π‘Žπ‘π‘–π‘™π‘–π‘‘π‘¦ π‘π‘œ.π‘œπ‘“ 𝐢𝑆 π‘†β„Žπ‘Žπ‘Ÿπ‘’π‘  π‘œπ‘’π‘‘π‘ π‘‘π‘Žπ‘›π‘‘π‘–π‘›π‘” β€’ Example: XYZ company is on verge of liquidation and an investment bank estimated that upon liquidation the total asset of the company is Rs. 525,0000 total liability of Rs. 450,0000 and 100000 of share of common share outstanding. Find the liquidation value of the common stock? Ans: Rs. 7.5
Preferred Stock β€’ Claims on Assets and Income – In the event of bankruptcy, preferred stockholders have priority over common stock. However, they have lower priority than the firm’s debt holders. – Firm must pay dividends on preferred stock prior to paying dividend on common stock. – Most preferred stock carry a cumulative feature. Cumulative feature requires that all past unpaid dividends to be paid before any common stock dividends can be declared. – Thus, preferred stocks are less risky than common stocks but more risky than bonds.
Preferred Stock β€’ Preferred Stock as a Hybrid Security – Like common stocks, preferred stocks do not have a fixed maturity date. Also, like common stocks, nonpayment of dividends does not lead to bankruptcy of the firm. – Like debt, preferred stocks have a fixed dividend. Also, most preferred stocks are periodically retired even though there is no stated maturity date.
Preferred Stock β€’ Dividend: – Unlike common stockholders, preferred stockholders receive the same fixed dividend regardless of how well the firm does. – In general, size of preferred stock dividend is fixed, and it is either stated as a dollar amount or as a percentage of the preferred stock’s par value. – Multiple Classes: If a company chooses, it can issue more than one class of preferred stock, and each class can have different characteristics.(Cumulative, Participating, Convertible, Callable and Adjustable-rate: try yourself no time)
Valuing Preferred Stock Since preferred stockholders generally receive a fixed dividend and the stocks are perpetuities (non- maturing), it can be valued using the present value of perpetuity equation.
Example β€’ Consider XYZ company’s preferred stock issue, which pays an annual dividend of $5.00 per share, does not have a maturity date, and on which the market’s required yield or promised rate of return (rps) for similar shares of preferred stock is 6.02%. What is the value of the XYZ’s preferred stock?
Try Yourself β€’ What is the present value of a preferred stock that pays a dividend of $12 per such stock if the market’s yield on similar issues of preferred stock is 8%? Ans: $150
Example β€’ What will be the yield on XYZ’s preferred stock if the company has promised annual dividend of $1.20 per share and each share is currently selling for $32.50?
Thank you
Practice problems β€’ RETURN ON INVESTMENT β€’ Q1. Diksha bought a share at a price of Rs.100. The price of the stock moved to Rs.200 a year later. During the period, Ramesh received a dividend of Rs.8 per share. – What is the % return Diksha received a year later? – If she has paid 40% of the investment amount as margin money to her broker while the rest amount is funded by an overdraft borrowed at 15%, what is the return for her a year later?
Solution Return for Ramesh for a period of 1 year Purchaseprice =Rs.100.00 Selling priceafter one year=Rs.200.00 Profit = Rs.100.00 Dividend duringthe period = Rs.8 % Return may be computed usingthe following formula: Return (%) = [(P1-P0+Do)/P0]Γ— 100= =108% (b) Own fundsinvested(%) =40% Own investment(Equity)= Rs.40 Profit and dividend earned=Rs.108 less: Interestpaid =15% on Rs.60 = Rs.9 Return on equity = Rs.99 Return on equity % =Return/Owninvestmentx 100 = (99/40)Γ—100 = 248%
Practice problems ( Try Yourself) β€’ A share of the firm is trading at Rs. 350 currently. The market that the price next year is going to be Rs.420. (a) What is the growth in price of the share? (b) If the currentdividend isRs.20 per share,what is the dividend expected fromthe firm in the coming year?(c) What is the expectation of return by the investors?Would it be the same as growth in the priceof the share?Why and why not? (d) If investordecidesto sell the share prior to the anticipated dividend at what price would he sell his share? (e) Would therebe any differencein return if investor sellsbefore or after the dividends? Why and why not? Note: Do you need any other information to solvethe problem.If so you may assume such an info and solve the problem]
Practice problems Q. Suppose the market value of the firm rs.416.94 million, firm has Rs. 40 million total debt and preferred stock and has 10 million of common share outstanding. Find the value per share? Solution: β€’ MV Equity= MV of the firm – MV debt and preferred stock β€’ MV of equity =Rs.(416.94-40)million =Rs.376.94 million β€’ Value per share= MV of equity/No. of shares= Rs.376.94 million/10 million= Rs37.69
Extra
What Causes Stock Prices to Go Up and Down? – The most recent dividend (D0): The more, the higher …. – Expected rate of growth in future dividends (g): The higher, the higher….. – Investor’s required rate of return (rcs ): The higher, the lower….. – Since most recent dividend (D0) has already been paid, it cannot be changed. Thus, variations in the other two variables, rcs and g, can lead to changes in stockprices. – Interest rate risk, Reinvestment risk, Credit risk, Inflation, Liquidity risk, Currency risk, price risk, Political risk etc.

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Stock valuation methods for equity analysis

  • 1. Stock valuation Part-II Prof. Trilochan Tripathy XLRI- Xavier school of Management,Jamshedpur
  • 2. Cash Flow of Bond vs. Equity Investor Firm Equity Debt Net Income Interest (fixed income) May Pay Dividend (variable residual income) Retained Earnings
  • 3. Cash Flow of Bond vs. Equity Investor Bond Investorcash Flow 𝑃𝑉 = 𝐢1 1 + π‘Ÿ 1 + 𝐢2 1 + π‘Ÿ 2 + β‹― + 100 + 𝐢𝑛 1 + π‘Ÿ 𝑛 β€’ Predictable Coupon Cash flow β€’ Predictable Terminal Value Equity Investor cash flow 𝑉 = 𝐢1 =? 1 + π‘Ÿ =? 1 + 𝐢2 =? 1 + π‘Ÿ =? 2 + β‹―+ 𝑇𝑉 =?+𝐢𝑛 =? 1 + π‘Ÿ =? 𝑛 β€’ Cash flow to Owner is Unpredictable β€’ Difficult to Predict Terminal Value
  • 4. Why Cash Flows are uncertain for equity investor? β€’ Dividend and dividend growth β€’ Interestrate risk β€’ Reinvestmentrisk β€’ Credit/defaultrisk β€’ Inflationary risk β€’ Liquidity risk β€’ Exchange rate risk β€’ Politicalrisk β€’ Etc.
  • 5. What Causes Stock Prices to Go Up and Down? Can you Guess?? Can we value the stock?
  • 6. Can we value the stock?
  • 7. Equity Shares Characterization & Valuation – Equity shares in general are characterized by: β€’ Ownership and management β€’ Entitlement to residual cash flows β€’ Limited liability β€’ Infinite life β€’ Substantiallydifferent risk profile -Thus, equity shares valuation is not that easy like bonds.
  • 8. Efficient market Hypothesis Efficient Market Hypothesis -Security are in equilibrium, which means they are fairly priced (expected returns= required returns) -Security prices accurately reflect available information, and respond rapidly to new information as soon as it becomes available” -Securities are fairly priced and there is no undervaluation or over valuation – Weak form efficiency:pricesincorporateinformation aboutpast prices – Semi-strongform: incorporateall publicly available information – Strongform: all information,includinginsideinformation Stock price move in Random: Random Walk Hypothesis
  • 9. However, we try to predict the value of a stock amidst wide arrays of uncertainty !
  • 10. Alternative Stock valuation Models DCF β€’ Dividend Discounted Model β€’ FCFF and FCFE Relative Valuation Model β€’ P/E β€’ P/S β€’ EV/EBITDA etc. Asset Based Valuation β€’ BV β€’ LV
  • 11. Common stock valuation: DDM-Three Special Cases β€’ Constant (Zero growth) dividend – The firm will pay a constantdividend forever – This is like preferred stock – The price is computed using the perpetuity formula 𝑉0 = 𝑑=1 ∞ 𝐷𝑑 (1+π‘Ÿ)𝑑= D / r β€’ Constant dividend growth – The firm will increase the dividend by a constantpercentevery period – The price is computed using the growing perpetuity model 𝑉0 = 𝑑=1 ∞ 𝐷𝑑 (1+π‘Ÿ)𝑑 = 𝑑=1 ∞ 𝐷0(1+𝑔)𝑑 (1+π‘Ÿ)𝑑 = 𝐷1 π‘Ÿβˆ’π‘” β€’ Supernormal growth – Dividend growth is not consistentinitially, but settles down to constantgrowth eventually – The price is computed using a multistagemodel ( example two stage) 𝑉0 = 𝑑=1 𝑛 𝐷0 1 + 𝑔𝑆 𝑑 (1 + π‘Ÿ)𝑑 + 𝐷0 Γ— 1 + 𝑔𝑆 𝑛 Γ— (1 + 𝑔𝐿) (π‘Ÿ βˆ’ 𝑔𝐿) Γ— (1 + π‘Ÿ)𝑛
  • 12. Value of a stock in a two-stage growth DDM Given g1 35% g2 10% r% 15% D0 50 Year AnticipatedDiv HGP LGP Sum of DCFs 1 58.69565217 2 68.90359168 3 80.88682502 4 94.95409893 5 111.4678553 414.9080231 6 …...infanite 1219.222936 2452.292816 1634.130959 Thus, the expectedstock price is Rs. 1634.13 Suppose a company is providinginitial amountof dividendof Rs. 50 The company CFO is anticipatingto pay year on year dividendgrowthby 35% up to five years From 6yr onwards it isanticipatedby the CFO of the company that the company can pay 10% incremental dividendgrowthyearafteryear till the life of the company if the requiredrate of return on thiskind of riskyasset is 15% , what shouldbe the expectedstockprice of the company today?
  • 14. Why Free Cash flow Valuation?  Many firms pay no, or low, cash dividends  Dividends are paid at discretion of the board of director; therefore, it may be poorly aligned with the firm's long-run profitability  If a company is views as acquisition target, free cash flow is more appropriate measure because the new owners will have discretion over future dividend.  Free cash flow may more related to long-run probability of the firm compared to dividend
  • 15. Free Cash flow valuation model β€’ The free cash flow model is based on the same premise as the dividend valuation models except that we value the firm’s free cash flows rather than dividends.
  • 16. FCFE Growth Model Constand Growth Model V0= 𝐹𝐢𝐹𝐸1 π‘Ÿβˆ’π‘” = 𝐹𝐢𝐹𝐸0 Γ—(1+𝑔) π‘Ÿβˆ’π‘” Two-Stage Free Cash Flow to Equity (FCFE) Discount Model 𝑉0 = 𝑑=1 𝑛 𝐹𝐢𝐹𝐸0 1 + 𝑔𝑆 𝑑 (1 + π‘Ÿ)𝑑 + 𝐹𝐢𝐹𝐸0 Γ— 1 + 𝑔𝑆 𝑛 Γ— (1 + 𝑔𝐿) (π‘Ÿ βˆ’ 𝑔𝐿) Γ— (1 + π‘Ÿ)𝑛 Equity Value = FCFE discounted at the required return on equity Return on equity= Risk-free rate of return + beta Γ— (Market rate of returnβˆ’Risk-free rate of return)
  • 17. Free Cash flow valuation model β€’ The free cash flow valuation model estimates the value of the entire company and uses the cost of capital as the discount rate. β€’ As a result, the value of the firm’s debt and preferred stock must be subtracted from the value of the company to estimate the value of equity. VE =VC - VD-VPS β€’ Equity Value = Firm Value – Market Value of Debt- Market Value of Preferred stock  FCFF = EBIT 1βˆ’ Tax rate + Dep – FC Investment –dWC Investment  Firm Value (VF) = FCFFdiscountedat WACC
  • 18. How to calculate FCFF in a real-world scenario ? Formula 1 Formula 2 Formula 3 Formula 4 NI (+) EBIT*(1-t) (+) EBITDA*(1-t) CFO + NCC (+) NCC (+) NCC*t (+) dWC Inv (-) dWC Inv (-) dWC Inv (-) Int(1-t) (+) Int (1-t) + FC inv (-) FC inv (-) FC inv (-) FC inv (-) FCFF FCFF FCFF FCFF β€’ 𝐹𝐢 𝐼𝑛𝑣 = 𝑒𝑛𝑑𝑖𝑛𝑔 π‘”π‘Ÿπ‘œπ‘ π‘  𝑃𝑃&𝐸 βˆ’ 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 π‘”π‘Ÿπ‘œπ‘ π‘  𝑃𝑃&𝐸 β€’ π‘ŠπΆ πΌπ‘›π‘£π‘’π‘ π‘‘π‘šπ‘’π‘›π‘‘ = πΌπ‘›π‘£π‘’π‘›π‘‘π‘œπ‘Ÿπ‘¦π‘‘ + π‘…π‘’π‘π‘’π‘–π‘£π‘Žπ‘π‘™π‘’π‘ π‘‘ βˆ’ π‘ƒπ‘Žπ‘¦π‘Žπ‘π‘™π‘’π‘‘ - (πΌπ‘›π‘£π‘’π‘›π‘‘π‘œπ‘Ÿπ‘¦π‘‘βˆ’1 + π‘…π‘’π‘π‘’π‘–π‘£π‘Žπ‘π‘™π‘’π‘ π‘‘βˆ’1
  • 19. Try with an example Items (Rs. In billion) Sales 100 Operatingcost 20 EBITDA 80 NCC(depreciation) 20 EBIT 60 Interest 30 EBT 30 Tax (@40%) 12 EAT 18 dWC Investment -10 FC Investment 0 Principal repayment 10 No. of Common share outstanding .3 in % WACC 12% re 9% g 6%
  • 20. Solution Sign Fourmula 1 Values (bn) Sign Formula 2 Values (bn) NI 18 EBIT*(1-t) 36 + NCC 20+ NCC 20 - WC Inv -10- WC Inv -10 + Int(1-t) 18+ - FC inv 0- FC inv 0 FCFF 46 FCFF 46 sign Formula 3 Values (bn) sign Formula 4 Values (bn) EBITDA*(1-t) 48 CFO 28 + NCC*t 8 - WC Inv -10 + + Int (1-t) 18 - FC inv 0 FCFF 46 FCFE 46
  • 21. Solution for FCFE sign Formula 4 Values (bn) CFO 28 + Int (1-t) 18 FCFF 46 - Int (1-t) -18 - Principal repayment -10 FCFE 18 Suppose the concerned company’s FCFE is growing at the rate g=6% here onwards 9 Just an approximation) Total Future value of cash flows= CurrentYr. FCFE + Future FCFE= 18+ 18*((1+6%)/(9%-6%))= = 654 billoin Value per share= 654 billion/3 billion share outstanding=Rs. 218
  • 22. FCFF is a Financial performance Indicator β€’ Free cash flow to the firm (FCFF) represents the cash flow from operations available for distribution after accounting for depreciation expenses, taxes, working capital, and investments. β€’ Free cash flow is arguably the most important financial indicator of a company's stock value. β€’ A positive FCFF value indicates that the firm has cash remaining after expenses. β€’ A negative value indicates that the firm has not generated enough revenue to cover its costs and investment activities.
  • 23. Some Relative Valuation methods β€’ This method estimates the value of the firm’s stock as a multiple of some measure of firm ’ s performance, such as the firm’s earnings per share, book value per share, sales per share, cash flow per share, where the multiple is determined by the multiples observed from comparable companies. β€’ The most common metrics are: – Earnings Per Share and – Book value per Share – Liquidation value per share
  • 24. Common Stock valuation by PE Ratio β€’ P/E ratio is a relative value model because it tells the investor how many dollars investors are willing to pay for each dollar of the company’s earnings. π‘‡π‘Ÿπ‘Žπ‘–π‘™π‘–π‘›π‘” 𝑃/𝐸 = π‘€π‘Žπ‘Ÿπ‘˜π‘’π‘‘ π‘π‘Ÿπ‘–π‘π‘’ π‘π‘’π‘Ÿ π‘ β„Žπ‘Žπ‘Ÿπ‘’ 𝐸𝑃𝑆 π‘œπ‘£π‘’π‘Ÿ π‘π‘Ÿπ‘’π‘£π‘–π‘œπ‘’π‘  12 π‘šπ‘œπ‘›π‘‘β„Žπ‘  πΉπ‘œπ‘Ÿπ‘€π‘Žπ‘Ÿπ‘‘ 𝑃/𝐸 = π‘€π‘Žπ‘Ÿπ‘˜π‘’π‘‘ π‘π‘Ÿπ‘–π‘π‘’ π‘π‘’π‘Ÿ π‘ β„Žπ‘Žπ‘Ÿπ‘’ 𝐸𝑃𝑆 π‘œπ‘£π‘’π‘Ÿ 𝑛𝑒π‘₯𝑑 12 π‘šπ‘œπ‘›π‘‘β„Žπ‘ 
  • 25. Other Relative valuation measures π‘ƒπ‘Ÿπ‘–π‘π‘’ π΅π‘œπ‘œπ‘˜ π‘…π‘Žπ‘‘π‘–π‘œ = 𝑃0 𝐡𝑉0 Price-to-sale Ratio= (P/S)
  • 26. Common Stock valuation by PE Ratio β€’ Suppose XYZ company’ had last year earnings of $1.65 per share for the 12-month period ended in March, 2016. XYZ’s CFO estimates that company earnings for 2017 will be $1.83 a share. The current P/E ratios for three comparable firms are 26.85, 18.79 & 22.18 and thus the comparable average PE ratio is 22.61. Based on above information, estimate the value of the common stock? – Ans: $41.38
  • 27. Common Stock valuation: BV per Share Value of Common Stock (Vc)= π‘‡π‘œπ‘‘π‘Žπ‘™ π‘Žπ‘ π‘ π‘’π‘‘βˆ’π‘‡π‘œπ‘‘π‘Žπ‘™ πΏπ‘–π‘Žπ‘π‘–π‘™π‘–π‘‘π‘¦ π‘π‘œ.π‘œπ‘“ 𝐢𝑆 π‘†β„Žπ‘Žπ‘Ÿπ‘’π‘  π‘œπ‘’π‘‘π‘ π‘‘π‘Žπ‘›π‘‘π‘–π‘›π‘” Example: At year end XYZ company balance sheet shows total asset of Rs. 600,0000 , total liability of Rs. 450,0000 and 100,000 of share of common share outstanding. Find the value of the common stock? Ans: Rs.15 per share
  • 28. Common Stock Valuation: LV per Share Value of Common Stock = π‘‡π‘œπ‘‘π‘Žπ‘™ π‘™π‘–π‘žπ‘’π‘–π‘‘π‘Žπ‘‘π‘’π‘‘ π‘Žπ‘ π‘ π‘’π‘‘βˆ’π‘‡π‘œπ‘‘π‘Žπ‘™ πΏπ‘–π‘Žπ‘π‘–π‘™π‘–π‘‘π‘¦ π‘π‘œ.π‘œπ‘“ 𝐢𝑆 π‘†β„Žπ‘Žπ‘Ÿπ‘’π‘  π‘œπ‘’π‘‘π‘ π‘‘π‘Žπ‘›π‘‘π‘–π‘›π‘” β€’ Example: XYZ company is on verge of liquidation and an investment bank estimated that upon liquidation the total asset of the company is Rs. 525,0000 total liability of Rs. 450,0000 and 100000 of share of common share outstanding. Find the liquidation value of the common stock? Ans: Rs. 7.5
  • 29. Preferred Stock β€’ Claims on Assets and Income – In the event of bankruptcy, preferred stockholders have priority over common stock. However, they have lower priority than the firm’s debt holders. – Firm must pay dividends on preferred stock prior to paying dividend on common stock. – Most preferred stock carry a cumulative feature. Cumulative feature requires that all past unpaid dividends to be paid before any common stock dividends can be declared. – Thus, preferred stocks are less risky than common stocks but more risky than bonds.
  • 30. Preferred Stock β€’ Preferred Stock as a Hybrid Security – Like common stocks, preferred stocks do not have a fixed maturity date. Also, like common stocks, nonpayment of dividends does not lead to bankruptcy of the firm. – Like debt, preferred stocks have a fixed dividend. Also, most preferred stocks are periodically retired even though there is no stated maturity date.
  • 31. Preferred Stock β€’ Dividend: – Unlike common stockholders, preferred stockholders receive the same fixed dividend regardless of how well the firm does. – In general, size of preferred stock dividend is fixed, and it is either stated as a dollar amount or as a percentage of the preferred stock’s par value. – Multiple Classes: If a company chooses, it can issue more than one class of preferred stock, and each class can have different characteristics.(Cumulative, Participating, Convertible, Callable and Adjustable-rate: try yourself no time)
  • 32. Valuing Preferred Stock Since preferred stockholders generally receive a fixed dividend and the stocks are perpetuities (non- maturing), it can be valued using the present value of perpetuity equation.
  • 33. Example β€’ Consider XYZ company’s preferred stock issue, which pays an annual dividend of $5.00 per share, does not have a maturity date, and on which the market’s required yield or promised rate of return (rps) for similar shares of preferred stock is 6.02%. What is the value of the XYZ’s preferred stock?
  • 34. Try Yourself β€’ What is the present value of a preferred stock that pays a dividend of $12 per such stock if the market’s yield on similar issues of preferred stock is 8%? Ans: $150
  • 35. Example β€’ What will be the yield on XYZ’s preferred stock if the company has promised annual dividend of $1.20 per share and each share is currently selling for $32.50?
  • 37. Practice problems β€’ RETURN ON INVESTMENT β€’ Q1. Diksha bought a share at a price of Rs.100. The price of the stock moved to Rs.200 a year later. During the period, Ramesh received a dividend of Rs.8 per share. – What is the % return Diksha received a year later? – If she has paid 40% of the investment amount as margin money to her broker while the rest amount is funded by an overdraft borrowed at 15%, what is the return for her a year later?
  • 38. Solution Return for Ramesh for a period of 1 year Purchaseprice =Rs.100.00 Selling priceafter one year=Rs.200.00 Profit = Rs.100.00 Dividend duringthe period = Rs.8 % Return may be computed usingthe following formula: Return (%) = [(P1-P0+Do)/P0]Γ— 100= =108% (b) Own fundsinvested(%) =40% Own investment(Equity)= Rs.40 Profit and dividend earned=Rs.108 less: Interestpaid =15% on Rs.60 = Rs.9 Return on equity = Rs.99 Return on equity % =Return/Owninvestmentx 100 = (99/40)Γ—100 = 248%
  • 39. Practice problems ( Try Yourself) β€’ A share of the firm is trading at Rs. 350 currently. The market that the price next year is going to be Rs.420. (a) What is the growth in price of the share? (b) If the currentdividend isRs.20 per share,what is the dividend expected fromthe firm in the coming year?(c) What is the expectation of return by the investors?Would it be the same as growth in the priceof the share?Why and why not? (d) If investordecidesto sell the share prior to the anticipated dividend at what price would he sell his share? (e) Would therebe any differencein return if investor sellsbefore or after the dividends? Why and why not? Note: Do you need any other information to solvethe problem.If so you may assume such an info and solve the problem]
  • 40. Practice problems Q. Suppose the market value of the firm rs.416.94 million, firm has Rs. 40 million total debt and preferred stock and has 10 million of common share outstanding. Find the value per share? Solution: β€’ MV Equity= MV of the firm – MV debt and preferred stock β€’ MV of equity =Rs.(416.94-40)million =Rs.376.94 million β€’ Value per share= MV of equity/No. of shares= Rs.376.94 million/10 million= Rs37.69
  • 41. Extra
  • 42. What Causes Stock Prices to Go Up and Down? – The most recent dividend (D0): The more, the higher …. – Expected rate of growth in future dividends (g): The higher, the higher….. – Investor’s required rate of return (rcs ): The higher, the lower….. – Since most recent dividend (D0) has already been paid, it cannot be changed. Thus, variations in the other two variables, rcs and g, can lead to changes in stockprices. – Interest rate risk, Reinvestment risk, Credit risk, Inflation, Liquidity risk, Currency risk, price risk, Political risk etc.