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Valuation

What are Equity Securities?


Equity securities represent ownership
on business.
Give right to participate in the profitability
of the business.
Have no specified maturity date (infinite
life)
Equity securities may pay dividends from
after-tax earnings at the discretion of the
board of directors
Give control over the corporation through
voting rights.

What is Valuation?
Valuation is the art/science of
determining what an assets/security
is worth.
The value of a security or asset
depends on the model,
assumptions and bias.

What is Valuation?
Valuation give a foundation for
deciding whether to buy, sell or held
When we compare the market price
against the value, we can say whether
a security is over or undervalue.

Issues on Valuation
IS VALUATION AN OBJECTIVE SEARCH FOR
TRUE VALUE?
All valuations are biased. The only question
is how much and in which direction.
The direction and magnitude of the bias in
your valuation is directly proportional to
who pays you and how much you are paid.

Issues on Valuation
IS IT TRUE THAT THE MORE INPUTS IN A
MODEL, THE BETTER THE VALUATION?
Simpler valuation models do much
better than complex ones.
Understanding valuation is inversely
proportional to the number of inputs
required for the model.

Issues on Valuation
DOES A GOOD VALUATION PROVIDES A
PRECISE VALUE?
There are no precise valuations, only good
or bad estimates.
A valuation without risk analysis is a bad
one.
Risk Analysis provides a range of possible
values (maximum, minimum, mean, standard
deviation, probability distributions)

Equity Valuation Models

MARKET VALUE METHOD


The market value per share is the the price for
which the share can be traded on the market.
Market price is determined by the forces of supply
and demand and is the same for all investors.
Information about the firm is reflected in market
price by investors decisions.
Investors collective moods, emotions and
feelings impact on market price, and thats why
market price can be overvalued or undervalued.

BOOK VALUE METHOD


This method relies on accounting data included in
the firms balance sheet.
The book value per share is equal to the total
shareholders' equity divided by the number of
shares outstanding.
A major disadvantage of this method is the lack
of consideration of a firms earnings potential.
Shareholders Equity
BV
Number of Outstanding Shares

LIQUIDATION METHOD
It considers the actual market value that could be
obtained if the firms assets are sold.
Then calculates the residual value after all debts are
paid.
The residual value is available for distribution to
shareholders
The value of a share is calculated by dividing the residual
value by the number of outstanding common shares.
This method does not take into account the earnings
potential of the firm.

DISCOUNTED CASH FLOW (DCF) VALUATION METHOD


Focuses on future free cash flows.
The value of the firm is determined by the stream of cash flows that
the operations will generate the future.
The value can differ among investors depending on how optimistic
they are regarding the future of a firm.
Under DCF investors judge managers ability to generate free cash
flows in the futures.

V0 = Value
1

CF1

CF2

CF3

CFn

DISCOUNTED CASH FLOW (DCF) VALUATION METHOD

CF1
CF2
CFn
V0

...
1
2
(1 k) (1 k)
(1 k) n

CFt
V0
t
(1

k)
t 1

DISCOUNTED CASH FLOW (DCF) VALUATION


METHOD
VALUE OF THE FIRM = Present Value of Free Cash Flows from
Operations discounted at the Weighted Average Cost of capital
Free cash flows from operation (FCFO) are the expected cash flows
generated by firms operations after considering the amount of
investment in working capital and fixed assets to sustain the business
operations, but before payments of debt and interest expenses (without
considering how the firm is financed)
FCFO are available to debtholders and shareholders thats why must be
discounted at a rate that includes the cost of debt and the cost of equity
(weighted average cost of capital).
VALUE OF EQUITY = Present value(PV) of Free Cash Flows
available to Shareholders discounted at the Cost of Equity
Free cash flow to shareholder is the cash flow actually available for
distribution to investors after the firm has made all the investments in
fixed assets or working capital necessary to sustain the ongoing
operations, and paid its debt and interest.
VALUE OF THE FIRM = VALUE OF EQUITY

FREE CASH FLOWS FROM OPERATION AND TO


SHAREHOLDERS
Net Income
+ Interest (1 Tax)
+ Dep. & Amort.
- Investment in Working Capital
- Investment in Fixed Assets
= Free Cash Flow from Operations (FFCO) (1)
- Debt Payments
- Interest Payments
= Free Cash Flow to Shareholders
(1) Available to debtholders and shareholders

FCFO shall be discounted at the weighted average cost of


capital
n
V= FCFOt / (1+k)t + TVt / (1+k)
t=1

Where:
V= value of the firm
FCFOt= Free cash flow from operations in period t
TV t= Terminal value of investment in period t
k= weighted average cost of capital of the firm
FCF to shareholder shall be discounted at the cost of equity

Dividend Valuation Method (DVM)


DVM is appropriate if the firms:
a) Pay dividends
b) Have a stable growth rate in earnings
c) Have a stable payout ratio|
d) Maintain a stable capital structure (mix of debt and equity)

This method has two assumptions: 1)all dividends are paid annually at
the end of each year, 2) risk is incorporated in the investors
required rate of return.
If shares are purchased at the beginning of the term and held for t
years the value as per DVM is :

n
P 0=

Dt/ (1+k)t + Pt/ (1+k)t


t=1

P0 is the intrinsic value of the stock, Dt are the expected dividends, Pt


is the expected future market price and k is the cost of equity.

Dividend Discount Model (DDM)


The DDM says the intrinsic value of the stock is
equal to the sum of the present value of all
future dividends to be received.
n
Dn
Dt
D1
D2
P0

...

1
2
n
t
(1 k ) (1 k )
(1 k )
(
1

k
)
t 1

Once estimaded the intrinsic value, it is


compared with the actual stock price in the
market to determine whether the stock is
UNDER, OVER, or FAIRLY valued

DIVIDEND DISCOUNT MODEL


When the firms dividends are growing a constant
rate, and reasonably can be expected to do so for
the foreseeable future, we use the constant growth
dividend discount model.
D0 (1 g )1 D0 (1 g ) 2
D0 (1 g ) n
P0

...
[ 7-6]
1
2
(1 k )
(1 k )
(1 k ) n

Which can be simplified to get:


D0 (1 g )
P0
[ 7-7]
kc g

PRICE EARNINGS METHOD


This method assumes that a firms earnings after
taxes are valued in the same way as those of
the industry to which the firm belongs.
If the industry P/E ratio is obtained, the market value
per share is:
Value per share= Industry P/E ratio x Expected
Earnings Per Share of the Firm
This approach takes into account the firms expected
earnings.