Information about the different types of equity valuations

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Information about the different types of equity valuations

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Financial Management

Professor Schozer

May 5, 2015

Equity Valuation

Equity valuations are used to objectively value a firm. There are three majors groups of

equity valuations comparable multiples, discounted cash flows, and asset-based valuation

models. Using equity valuation allows an investor to determine a companys intrinsic value.

From the intrinsic value, it can be determined whether the company is undervalued, fairly

valued, or overvalued. The most investment opportunity lies within companies that are

undervalued, while overvalued companies offer the best opportunity to sell. Equity valuations

are very useful for an investor looking to profit.

Comparable multiples are an equity valuation tool that is useful when comparing

companies within the same industry. These are helpful in identifying which companies are most

opportune to invest in and which are not. Comparable multiples use share price and enterprise

value multiples. Some examples of share price multiples are price/earnings and price/sales.

Examples of enterprise value multiples are enterprise value/EBITDA and enterprise value/sales.

Discounted cash flows, also known as present value models, value a firm based on the

present value of its expected future cash flows. The dividend discount model presents an

intrinsic value based on expected future cash flows to shareholders. The free-cash-flow-toequity model provides a value based on cash flows available to shareholders after current

liabilities and working capital needs are met. There are a number of models based on this

method, but two of the most commonly used are the Gordon growth model and the two-stage

dividend discount model. The Gordon growth model is based on a firms constant rate of growth

and constant rate of return. This method is best used with mature companies that pay a dividend

and are insensitive to fluctuations in the economy. The two-stage dividend discount model is

appropriate for companies that are growing rapidly or have expected changes in growth. This

method considers the likely fact that a company will grow quickly at its outset, as it expands, but

will eventually reach maturity and a constant growth rate.

Asset based valuation models use the estimated value of a firms assets minus the value

of its liabilities and preferred shares to find the intrinsic value of its common shares. This

method assumes that the value of a company is equal to the sum of the value of the businesss

assets.

To exemplify equity valuations, I will be valuing and comparing Nike, Under Armour,

and Lulu Lemon. These three companies are all well known sports apparel manufacturers based

in North America. Nike and Under Armour both trade on the NYSE, while Lulu Lemon trades

on the NASDAQ. For the purposes of this paper, differences in these exchanges should be

insignificant.

Using the current market price of a stock and numbers of outstanding shares and bonds,

the market value of an entity can be determined. Shares of Nike currently trade at $100.53.

There are 682.19 million shares outstanding. This means that the market value of Nikes

common stock is $68.58 billion. Nike has three bond issues outstanding. The first is for $500

million, currently selling at 98.5. Another is for $500 million, currently selling at 96.7. The last

is for $100 million, currently selling for 102.1. The market value of Nikes debt is $1.078

billion. The sum of market value of Nikes debt and equity is $69.66 billion, which is Nikes

market value.

I used the same methodology to find the market value of both Under Armour and Lulu

Lemon. Under Armour currently trades at $77.05. The market value of UAs equity is $13.82

billion, and they have no outstanding bonds, which puts UAs market value at $13.82 billion.

Lulu Lemon currently trades at $64.44. The market value of LULUs equity is $8.71

billion, and the company has no debt, therefore, LULUs market value is $8.71 billion.

Using present value models, the values of these companies can be ascertained via the

Gordon growth model or the Free Cash Flows to Equity model. The Gordon growth model is a

discounted cash flow approach to valuation. This method uses dividends as the metric, and

assumes a constant perpetual growth rate. This method is best used for companies that pay

dividends, are at the mature growth phase, and are insensitive to economy cycles. This method

can be used for Nike, but not for Under Armour or Lulu Lemon, as neither pays dividends.

To estimate Nikes value using the Gordon growth model, we first start with the formula:

(Dividend most recently paid*(1-dividend growth rate))/(rate of return dividend growth rate).

For the dividend growth rate, we can use the companys estimated growth rate over the next five

years of 12.15%. We could also use the formula of earnings retention rate * return on equity to

find the dividend growth rate. The earnings retention rate is equal to 1 dividend payout ratio.

For Nike, the dividend growth rate = (1 30%)*26.43% = 18.50%. To compute the required

rate of return, I will use CAPM. The CAPM rate is equal to the risk-free rate + (beta*market risk

premium). For the CAPM, we will use the market risk premium calculated by NYU Stern of

5.78% and the current rate on a 10 year treasury bond of 2.19% for the risk free rate. Nikes beta

is .51, therefore the companys CAPM is 5.138%. Now we would estimate Nikes value using

the Gordon growth model: ($1.12*(1 - .1850))/(.05138 - .1850). Because the required rate of

return is less than the dividend growth rate, the Gordon growth model cannot be used for Nike.

Neither Under Armour nor Lulu Lemon distributes dividends, so we cannot use the

Gordon growth model to estimate their values. However, there is value in comparing each of

these companys required rates of return. Nikes CAPM is 5.138%. We will use the same market

risk premium and risk free rate for Under Armour and Lulu Lemon. UAs beta is -.04%,

therefore, their CAPM is 1.959%. LULUs beta is .35, which puts their CAPM at 4.213%. Of

these three companies, Nike has the highest required rate of return, which means that it has the

highest cost of capital. We can use the residual income method of value which equals

income/discount rate to value these firms. Nikes EBITDA is $4.80 billion. The companys

residual income value is $4.80 billion/.05138 = $93.42 billion. Under Armours residual income

value is $437.15 million/.01959 = $22.31 billion. Lulu Lemons residual income value is

$428.02 million/.04213 = $10.16 billion. Nikes residual income value is highest because its

EBITDA is much higher than that of the other two companies. Compared to its EBITDA, Under

Armour is most highly valued using this method because its required rate of return is so low, due

to its near-zero beta coefficient. This beta means that this stock carries basically no risk; it is

about equivalent to the risk of money in a savings or checking account. Of these companies,

Nike has the highest beta, and therefore carries the most risk of fluctuation. However, all of

these have betas of less than 1, which means that they carry less risk than the market as a whole.

Using the values given by the residual income method, we can determine an intrinsic

value per share for each company by dividing the value found by number of shares outstanding.

For Nike, each share should be worth $93.42 billion/682.19 million shares outstanding, which

equals $136.94. Under Armours shares should be worth $124.42. Lulu Lemons shares should

be worth $76.88. Using this methodology, all of these companies are undervalued. A share of

Under Armour would be undervalued by nearly $50.

To compare these companies values, we can also use comparable multiples. The

price/earnings ratio evaluates a company by comparing its share price to its per share earnings.

Nikes P/E ratio is 28.70, UAs P/E ratio is 82.17, and LULUs P/E ratio is 38.74. This value is

what it costs for $1 of current earnings. Comparing these ratios, it is clear that investors are most

willing to pay for Under Armours earnings, which suggests that there is expected growth in the

future, or it could suggest that Under Armour is overvalued.

Another comparable price multiple is price/sales. The price to sales ratio compares a

companys equity at market value with its total revenues. This can also be expressed as what

investors are paying for $1 of sales. Nikes price/sales ratio is 2.87, UAs is 5.10, and LULUs is

5.12. A lower price/sales ratio is generally preferable, as it means that the company is generating

more return on their equity.

The price/book ratio compares market value of a share to its book value. Nikes

price/book is 7.01, UAs price/book is 11.96, and LULUs price/book is 8.44. These high values

mean that all of these shares are trading at more than book value. One reason for this is that a

large part of the value of all of these companies is due to intellectual value the value of the

brand and its associated intellectual property. A company can also have a high price/book ratio

because it has been consistently earning a high return or because it is overvalued. We can

compare the price/book with the return on equity to evaluate the companys growth. Nikes ROE

is 26.43%, UAs ROE is 16.54%, and LULUs ROE is 21.87%. For comparison, the average

ROE for the S&P 500 is 18.15%. Under Armours growth is less than the average market

growth, but it has the highest price/book ratio. This is a sign that Under Armour is overvalued,

especially when compared to similar companies.

Enterprise value ratios can also be used to compare companies. The enterprise

value/revenue multiple compares a companys enterprise value to its revenues. Nikes enterprise

value/revenue multiple is 2.74, Under Armours is 5.64, and Lulu Lemons is 4.88. Nikes

enterprise value is most closely related to its revenues, while Under Armours enterprise value is

about 5.5 times its revenues.

The enterprise value to EBITDA multiple values a company by relating its enterprise

value as a multiple of its earnings. Nikes EV/EBITDA multiple is 17.26, Under Armours is

41.91, and Lulu Lemons is 20.50. A lower multiple means that a company may be undervalued

while a higher multiple means that a company may be overvalued.

Comparable multiples can be used to determine which stock or stocks within an industry

are best to invest in. It is typically best to invest in an undervalued stock, unless a stock is

undervalued because the company is failing. Multiples can also be used to find which stocks are

overvalued. Sometimes a stock is simply overvalued, and sometimes it has a high value because

it is expected to have high growth in the future. After considering the comparable multiples of

Nike, Under Armour, and Lulu Lemon, it seems that Nike offers the best value, and that Under

Armour is somewhat overvalued. It is important to note that Nike does not offer the best value

because it is the most valuable in terms of sheer assets, but rather because generates the highest

return on its assets and has a lower stock price as a multiple of earnings. On the other hand,

Under Armour seems like a poor investment currently, because its stock price is much higher as a

multiple of its earnings. This may be because investors deem that it is poised for growth in the

future. For someone who already owns Under Armour, this may be a good time to sell because

the value of the company is high compared to its current returns and the current returns in the

industry.

In conclusion, there are a number of methods for valuing a company based on its equity.

A companys gross market value can be determined easily by combining the market value of its

debt and equity. An intrinsic value of the companys equity can be determined using dividend

discount models which consider the present value of the companys expected cash flows. To get

an idea of a companys value compared to its peers, comparable multiples are very useful.

Comparable multiples also give insight to how fairly a company is valued, and are a very reliable

measure due to their simplicity. No matter the method used, equity valuations are an important

measure because they allow an investor to objectively consider the value of an investment.

Works Cited:

1. Implied Equity Risk Premiums for US Market. (2015, January 5). Retrieved May

3, 2015, from

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/implpr.html

2. Daily Treasury Yield Curve Rates. (2015, May 5). Retrieved May 5, 2015, from

http://www.treasury.gov/resource-center/data-chart-center/interestrates/Pages/TextView.aspx?data=yield

4. Nagorniak, J., & Wilcox, S. (n.d.). Equity Valuation: Concepts and Basic Tools.

In Investments: Principles of Portfolio and Investment Analysis.

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