SECURITY VALUATION @ Security Valuation Study Session 2 TOTAL EARNINGS Note: Total Earnings mean Earnings available to equity share holders Less: Less: Fixed cost excluding Dep. EBITDA Less: Depreciation and Amortization EBIT Less: Interest EBT Less: Tax EAT Less: Preference Dividend Earnings Available to Equity Share holders Less: Equity Dividend T/F to R&S __ Total earning available to equity shareholders ee ‘Total number of equity shares: Total dividend paid to equity shareholders DPS = E = Total numberof equity shares . __ Total Market Value/ Market Capitalization/ Market Cap 2 bei ~ ‘Total number of equity shares: ___Totat Retained earnings a ~ Total number of equity shares OR REPS = EPS - DPS + Dividend Yield = _piidendper share x 100 = Market price per shareANT (22) SECURITY VALUATION “Dividend pay-out Ratio = Dtidendpershare 199 Earning per share Dividend per share + Dividend Rate we value persbarg % 100 = Eomina Yj __Barning per share & Eaming Yield = Fare raratene * 100 . ‘ = Mes + P/E Ratio - Oye = Retained Earning per share 199 Earning per share _ BPS— pps = Ps X 100 OR + Retention Ratio — Dividend Payout Ratio Not “Relationship Between DPR & RR: RR + DPR = 100% or 1 + Dividend yield and Earning Yield is always calculated on annual basis. * Dividend is 1" paid to preference share holder before any declaration of dividend to equity shareholders. “Dividend is always paid upon FV(Face Value) not on Market Value. Cash Dividends: As the name implies, are payments made to shareholders in cash. They come in 3 forms: () Regular Dividends: Occurs when a company pays out a portion of profits on a consistent basis. E.g. Quarterly, Yearly, ete. Special Dividends: They are used when favourable circumstances allow the firm to make a one-time ‘cash payment to shareholders, in addition to any regular dividends. E.g. Cyclical Firms ) Liquidating Dividends: Occurs when company goes out of business and distributes the proceeds to shareholders. ‘Stock Dividends (Bonus Shares) : ‘Stock Dividend are dividends paid out in new shares of stock rather than cash. In this case, there will be more shares outstanding, but each one will be worth less. * Stock dividends are commonly expressed as a percentage. A 20% stock shareholder gets 20% more stock. idend means every Stock Splits + Stock Splits divide each existing share into multiple shares, thus creating more shares. There are now more shares, but the price of each share will drop correspondingly to the number of shares created, so there is no change in the owner's wealth. Splits are expressed as a ratio. In a 3-for-1 stock s ;, each old share is split into thrae new shares. oe Stock splits are more common today than stock dividends. ° ee URSECURITY VALUATION ® + Paying a cash dividend decreases assets (cash) and shareholders’ equity (retained earnings) .Other things equal, the decrease in cash will decrease a company's liquidity ratios and increase its debt-to- ‘assets ratio, while the decrease in shareholders’ equity will increase its debt-to-equity ratio. “Stock dividends, stock splits, and reverse stock splits have no effect on a company’s leverage ratio or li ratios or company's assets or shareholders’ eq + A sound investment decision depends on the correct use and evaluation of the rate of return. Some of the different concepts of return are given as below: Required Rate of Return: ‘An asset's required return is the minimum return an investor requires given the asset's risk. A more risky asset will have a higher required return. Required return is also called the opportunity cost for investing in the asset. If expected return is greater (less) than required return, the asset is undervalued (overvalued). Price Convergence Ifthe expected return is not equal to required return, there can be a "return from convergence of price to intrinsic value." Letting Vo denote the true intrinsic value, and given that price does not equal that value : 4 Bu jelo=Po (i.e., Vo # Po), then the return from convergence of price to intrinsic value is-—"2 If an analyst expects the price of the asset fo converge to its intrinsic value by the end of the horizon, then Yor Po is also the difference between the expected return on an asset and its required return: Expected Retui Example: ‘Suppose that the current price of the shares of ABC Lid. is 730 per share. The investor estimated the intrinsic value of ABC Ltd.'s share to be 235 per share with required return of 8% per annum. Estimate the expected return on ABC Ltd. Solution : Intel's expected convergence return is (35 - 30)/30* 100 = 16.67%, and let's suppose that the convergence happens over one year. Thus, adding this return with the 8% required return, we obtain an expected return of 24.67%, Discount Rate Discount Rate is the rate at which present value of future cash flows is determined. Discount rate depends on the risk free rate and risk premium of an investment. Internal Rate of Return Internal Rate of Retum is defined as the discount rate which equates the present value of future cash flows to its market price. The IRR is viewed as the average annual rate of return that investors earn over their investment time period assuming that the cash flows are reinvested at the IRR. ° ee UR(24) SECURITY VALUATION Deowse, = les over a risk free rate, such as retum from tax free government bonds. This excess return compensates investors for taking on the relatively higher risk of investing in equity shares of a company. Calculating the Equity Risk Premium To calculate the equity risk premium, we can begin with the capital asset pricing model (CAPM), which is usually written: R. = Re + Bs (Ry - Ri) Where: R, = required return on investment in "x"(company x) R ik-free rate of return B. = beta of "x" Ry = required return of market Equity Risk Premium = Ry - Ry = Bx (Rey ~ Ri) Mined (aire) Goa) Gow 9 Cash Flow: oS ame) | | Conversion of Real Cash Flow into Money Cash Flow & Vice-versa ‘Money Cash Flow = Real Cash Flow (1 + Inflation Rate)" Or Money Cash Flow Real Cash Flow = SO™yCst ow GHinftation Ratey™ © BB600T8 OaSECURITY VALUATION @ Picea { Real piscountR Pee nore Discount Rate Itexcludes inflation It Includes inflation Conversion of Real Discount Rate into Money Discount Rate & Vice-versa ' (1 + Money Discount Rate) = (1+ Real Discount Rate) ( 1+Inflation Rate) py Ea ec cic) By discounting real cash flow ‘By discounting money cash flow by real discount rate. by money discount rate. Discount rate selection in Equity Valuation + While valuing equity shares, only nominal cash flows are considered. Therefore, only nominal discount rate is considered. The reason is that the tax applying to corporate earnings is generally stated in nominal terms. Therefore, using nominal cash flow in equity valuation is the right approach because it reflects taxes accurately. Moreover, when the cash flows are available to Equity Share Holders only, nominal cost of Equity is used. And when cash flows are available to all the companies capital providers, nominal after tax weighted average cost of capital is used + If Question is Silent, always Assume Ex- Dividend price of share. + If cum-dividend price is given, we must deduct dividend from it. ‘It may be noted that in all the formula, we consider Ex-Dividend & not Cum-Dividend. Walter’s Model Walter's supports the view that the of the share. plays an important role in determining the market price He emphasis two factors which influence the market price of a share:~ (i) Dividend Payout Ratio. (ii) The relationship between Internal return on Retained earnings (r) and cost of equity capital (K.)(26) SECURITY VALUATION ANT We iter classified all the firms into three cat. @) Growth Firm: + If (> K.). In this case, the shareholder's would like the company to retain maximum amount i.e. to keep payout ratio quite low. + In this case, there is negative correlation between dividend and market price of share. + fr > K., Lower the Dividend Pay-out Ratio Higher the Market Price per Share & vice-versa: b) Declining Firm: + If (F< K4) In this case, the shareholder's won't like the firm to retain the profits so that they can get higher return by investing the dividend received by them. + In this case, there is positive correlation between dividend and market price of share. * If Ke Negative 0% 100 % Constant r=Ke No Correlation Every payout is Every retention is Optimum Optimum | Decline r 010 = Pras => P/E Ratio = 10 times QUESTION NO. 4A ‘The firm was started a year ago with an equity capital of € 20 Lacs [Earning of the firm | %2,00,000 | | Dividend paid @1,50,000 | | P/E Ratio 12.5 Number of the shares outstanding, 20,000 @ % 100 each. The firm is expected its current rate of earning on investment. a) Ascertain whether the company's D/P rati is optimal according to Walter. b) What should be the P/E ratio at which the dividend pay-out ratio will have no effect on the value of the share? «Will your decision change if the P/E ratio is 8, instead of 12.5? ® 8860017983 OsIHANT/EA) Sze] TENS NEC LUO)! ® (QUESTION NO. 4B A Lid. has a book value per share of 8 137.80. Its return on equity is 15% and it follows a policy of retaining 60% of its earnings. If the opportunity cost of capital is 18%, what is price of share today. QUESTION NO. 4¢ X Lid has an internal rate of return @ 20%. It has declared dividend @18% on its equity shares, having face value of % 10 each. The payout ratio is 36% and Price Earning Rai according to Walter's Model and hence determine the limiting value of its shares in case the payout rati is varied as por the said model. LOS 13: Over — Valued & Under — Valued Shares Cases Value Decision PV Market Price < Actual Market Over - Valued Sell PV Market Price > Actual Market Price Under — Valued Buy PV Market Price = Actual Market Correctly Valued Buy / Sell ¥ (Capital gain Yield / Return) (Dividend Yield / Return) QUESTION NO. 54 Tata is to pay dividend of ® 2.15 at the end of the year and itis expected to grow at 11.2% per year forever, and the required rato of return on Tata stock is 15.2% per annum a) What is its intrinsic value? b) IF the current stock price of Tata is equal to its intrinsic value, what is the next years expected price? ¢)_ Ian investor wants to buy Tata stock now and sell it after receiving € 2.15 dividend a year from now, what is the expected capital gain in % terms? What is the dividend yield and what is the holding period return? QUESTION NO. 5B (Om Tech Ltd. engaged in the manufacturing of engineering goods, expects a moderate growth in coming years dividend for the last year has just been paid and the company is contemplating to pay a 18 after one year. The equity shares are currently traded at 200 per share. If the equity ca is 14% then what would be the market price of the share after one year. Assume that Capital gains tax rate applicable to an investor is 20%. He buys one share today and sells after one year after dividend receipt What is his after tax rate of return or Holding Period Return.® SECURITY VALUATION ANT + Growth model is used under the assumption of g = constant. + When more than one growth rate is given, then we will use this concept. or Ifg>K. ‘A firm may temporarily experience a growth rate that exceeds the required rate of return on firm’s ‘equity but no firm can maintain this relationship indefinitely. Value of a dividend- paying firm that is experiencing temporarily high growth = PV of dividends expected during high growth period. + PV of the constant growth value of the firm at the end of the high growth period. a GKot * Ke * Dy Pn value Tor * Teo + When P, = “80 QUESTION NO. 68 MNP Ltd. has declared and paid annual dividend of @ 4 per share. It is expected to grow @ 20% for the next two years and 10% thereafter. The required rate of return of equity investors is 15%. Compute the current price at which equity shares should sell Present Value Interest Factor (PVIF) @ 15%: For year 1 = 0.8696, For year 2 = 0.7561 QUESTION NO. fed, just declared a dividend of 214.00 per share. Mr. B is planning to purchase the share of X imited, anticipating increase in growth rate from 8% to 9%, which will continue for three years He also expects the market price of this share to be % 360.00 after three years You are required to determine: 2) The maximum amount Mr. B should pay for shares, if he requires a rate of return of 13% per annum b) The maximum price Mr. B will be willing to pay for share, if he is of the opinion that the 9% growth can be maintained indefinitely and require 13% rate of return per annum <) The price of share at the end of three years, if 9% growth rate is achieved and assuming other conditions remaining same as in (i) above. Calculate rupee amount up to two decimal points. Year-1_| Year-2 | Year-3 FVIF @ 9% 1.09 1.188 | 1.295 FVIF@13% —/1.13 | 1.277 | 1.443 PVIF@13% 0.885 | 0.783__—| 0.693 QUESTION NO. 6¢ X Lid. is a Shoes manufacturing company. It is all equity financed and has @ paid-up Capital %10,00,000 (€10 per share)Peme@ SECURITY VALUATION (13) X Lid. has hired Swastika consultants to analyze the future earnings. The report of Swastika consultants states as follows 1. The earnings and dividend will grow at 25% for the next two years. 2. Earnings are likely to grow at the rate of 10% from 3rd year and onwards. 3. Further, if there is reduction in earnings growth, dividend payout ratio will increase to 50% The other data related fo the company are as follows Year EPS(%) | Net Dividend per share() | Share Price (2) 2010 6.30 2.52 63.00 2011 7.00 2.80 46.00 2012 7.70 3.08 63.75 2013, 8.40 3.36 68.75 2014 9.60 3.84 93.00 You may assume that the tax rate is 30% (not expected to change in future) and post-tax cost of capital is 15%. By using the Dividend Valuation Model, calculate a) Expected Market Price per share b) PER QUESTION NO. 6D Soawell Corporation, a manufacturer of do-it-yourself hardware and housewares, reported earnings per share of € 2.10 in 2003, on which it paid dividends per share of €0.69. Earnings are expected to grow 15% @ year from 2004 to 2008, during this period the dividend payout ratio is expected to remain unchanged. After 2008, the earnings growth rate is expected to drop to a stable rate of 6%, and the payout ratio is expected to increase to 65% of earnings. The firm has a beta of 1.40 currently, and is expected to have a beta of 1.10 after 2008. The market risk premium is 5.5%. The Treasury bond rate is 6.25%. (a) What is the expected price of the stock at the end of 2008? (b) What is the value of the stock, using the two-stage dividend discount model? QUESTION NO. 6E SAM Lid. has just paid a dividend of € 2 per share and it is expected to grow @ 6% p.a. After paying dividend, the Board declared to take up a project by retaining the next three annual dividends. It is expected that this project is of same risk as the existing projects. The results of this project will start coming from the 4" year onward from now. The dividends will then be 2 2.50 per share and will grow @ 7% p.c. ‘An investor has 1,000 shares in SAM Ltd. and wants a receipt of at least % 2,000 p.c. from this investment. Show that the market value of the share is affected by the de« ion of the Board. Also show as to how the investor can maintain his target receipt from the investment for first 3 years and improved income thereafter, given that the cost of capital of the firm is 8%. IRR is the discount rate that makes the present values of a project's estimated cash inflows equal to the Present value of the project’s estimated cash outflows. ‘At IRR Discount Rate => PV (inflows) = PV (outflows) + The IRRis also the discount rate for which NPV of a project is equal to Zero. 4 IRR technique is used when, K . is missing in the Question * Lower Rateypy IRR = Lower Rate + (oer Rate wry ~ Higher Ratoypy ~ Dferenc in Rate(1) SECURITY VALUATION ANT QUESTION NO. 7, Piyush Ltd presently pay a dividend of Re. 1.00 per share and has a share price of % 20.00. a) If this dividend were expected to grow at a rate of 12% per annum forever, what is the firm’s expected or required Cost of Equity using a dividend-discount model approach? b) Instead of this situation in part (i), suppose that dividend were expected to grow at a rate of 20% p.c. for 5 years and 10% per year thereafter. Now what is the firm's expected, or Cost of Equity? PutDy Soon QUESTION NO. 8 P Lid. Industries has been growing at the rate of 15% per year and this trend is expected to continue for 5 more years. Thereafter itis likely to grow at the rate of 8% which is the industry average. The investors expect return of 12%. The dividend paid per share last year (Do) corresponding to period 0 (t) is @ 5. Determine at what price an investor at period tobe ready to buy the shares of the company at the end of period ty (now) and simultaneously price he is going to pay at fy, tz, ts, and ts. Present value of Re. | at 12% Year 1 2 3 4 5 PY. 0.893 0.797 0.712 0.636 0.567 If Positive Grows, then Po = Bite . _ Do(t-8) If Negative Growth, then m= ete Note: We Know g = RR x ROE Case l EPS > DPS Retention is Positive Case EPS < DPS _ Retention is Negative Case Ill EPS = DPS No Retention: (QUESTION NO. 94 On the basis of the following information: Current dividend (D.) © 2.50 Discount rate (k.) 10.5% Growth rate (@) 2%SECURITY VALUATION (17) a) Calculate the present value of stock of ABC Lid b) Is this stock overvalued if stock price is % 35, ROE= 9% and EPS = %2.252 Show detailed caleulation. QUESTION NO. 9B Given the following information: Current dividend = 5.00 Discount rate 10% Growth rate 2% a) Calculate the present value of the stock. b) Is the stock over valued if the price is 7 40, ROE = 8% and Current EPS = % 3.00. Show your calculations under the PE Multiple approach and Earnings Growth model. The earnings growth of most firms does not abruptly change from a high rate to a low rate as in the two stage model but tends to decline over time as competitive forces come into play. The H-model ‘approximates the value of a firm assuming that an initially high rate of growth declines linearly over a specified period. The formula for this approximation is: jh-growth period length of high growth period short-term growth rate long-term growth rate required return QUESTION NO. 10 Omega Foods currently pays a dividend of €2.00. The growth rate, which is currently 20%, is expected to decline linearly over the next ten years to a stable rate of 5% thereafter. The required return is 12%, Calculate the current value of Omega. __ Earning Before Interestand Tax Interest Coverage Ratio Taterest Profit after Tax Preference Dividend Coverage Ratio = Po ARET __ Profit after Tax - Preference Dividend Equity Dividend Coverage Ratio * Dividend payable to equity share holders: The Higher the Better. These Ratios indicates the surplus profit left after meeting all the fixed obligation. © 8860017983 Ooi en(13) SECURITY VALUATION QUESTION NO. 11 Tiger Lid. is presently working with an Earning Before Interest and Taxes (EBIT) of € 90 lacs. Its present borrowings are as follows: Zin lacs 12% term loan 300 Working capital borrowings: From Bank at 15% 200 Public Deposit at 11 % 100 The sales of the company are growing and to support this, the company proposes to obtain additional borrowing of & 100 lacs expected to cost 16%. The increase in EBIT is expected to be 15%. Calculate the change in interest coverage ratio after the additional borrowing is effected and comment on the arrangement made. QUESTION NO. 12 ‘Mr. Ais thinking of buying shares at € 500 each having face value of € 100. He is expecting a bonus at the ratio of 1:5 during the fourth year. Annual expected dividend is 20% and the same rate is expected to be maintained on the expanded capital base. He intends to sell the shares at the end of seventh year at an expected price of € 900 each. Incidental expenses for purchase and sale of shares are estimated to be 5% of the market price. He expects a minimum return of 12% per annum. Should Mr. A buy the share? If so, what maximum price should he pay for each share? Assume no fax on dividend income and capital gain. = es Fro Gash Flows for the firm without ‘any distribution to debentures / preference shares and equity shares Froe Cash Flows for the Equity after ‘distribution to debentures / preference shares! Long term loans + + E—- + Galculation of FCFF EBITDA. 0K Less : Depreciation & Amortisation (NCC) 10x EBIT OK Less : Tax 00 NOPAT. OOKSECURITY VALUATION (713) BB iene ‘Add : Depreciation (NCC) Less : Increase in Working Capital (WCInv) Less : Capital Expenditure (FCinv) Free Cash Flow For Firm (FCFF) BREE @) Based on its Net Income: FCFF= Net Income + Interest expense *(1-tax) + Depreciation -/+ Capital Expenditure -/+ Change in Non-Cash Working Capital b) Based on Operating Income or Earnings Before Interest and Tax (EBIT): FCFF= EBIT *(1 - tax rate) + Depreciation -/+ Capital Expenditure -/+ Change in Non-Cash Working Capital ©) Based on Earnings before Interest, Tax , Depreciation and Amortisation (EBITDA): FCFF = EBITDA* (1-Tax) +Depreciation* (Tax Rate) -/-+ Capital Expenditure - /+ Changs Working Capital d) Based on Free Cash Flow to Equity (FCFE): FCFF = FCFE + Interest* (1-1) + Principal Prepaid - New Debt Issued + Preferred Dividend e) Based on Cash Flows: FCFF = Cash Flow from Operations (CFO) + Interest (1-1) -/+ Capital Expenditure Non-Cash Calculation of FCFE Method 1 : If Debt financing ratio is give EBITDA Less : Depreciation & Amortisation EBIT Less : Interest EBT Less : Tax PAT ‘Add : Depreciation x % Equity Invested Less: Increase in Working Capital x % Equity Invested Less: Capital Expenditure x % Equity Invested Free Cash Flow for Equity (FCFE) FERRER REESE Method 2 : If Debt financing ratio is not give EBITDA Less : Depreciation & Amortisation EBIT Less : Interest EBT Less : Tax PAT ‘Add : Depreciation (NCC) Less: Increase in Working Capital (WCInv) Less: Capital Expenditure (FCInv) ‘Add : Net Borrowings FERRER ERE EEE Free Cash Flow for Equity (FCFE) ° ee URANT ® SECURITY VALUATION a) Calculating FCFE from FCFF FCFE = FCFF - [ Interest ( 1- tax rate) ] + Net borrowing b) Calculating FCFE from net income FCFE = NI + NCC - FCInv - WCinv + net borrowing ©) Calculating FCFE from CFO FCFE = CFO - FCInv + net borrowing JUESTION NO. 13A : Calculating FCinv with no long-term asset sales Airbrush, Inc. financial statements for 2009 include the following information: Selected Financial Data 2009 2008 Gross PP&E $5000 $4150 Accumulated depreciation $1500 $1200 Net PP&E $3500 $2950 There were no sales of PP&E during the year; depreciation expense was $300. Calculate Airbrush’s FCInv for 2009. QUESTION NO. 138 : Calculation of FCFF & FCFE EBITDA $1,000 Depreciation expense $400 Interest expense $150 Tax rate 30% Purchases of fixed assets $500 Change in working capital $50 Net borrowing $80 Common dividends $200 UESTION NO. 13C : Calcul FCFF and FCFE ‘Anson Ford, CFA, is analysing the financial statements of Sting's Delicatessen. He has a 2009 income statement and balance sheet, as well as 2010 income statement & balance sheet (as shown in the tables below). Assume there will be no sales of long-term assets in 2010. Calculate forecasted free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) for 2010. Sting’s Income Statement [Income Statement 2010 Forecast Sales $300 Cost of goods sold 120 Gross profit 180 SGBA 35 Depreciation 50 EBIT 95 Interest expense 15 Pre-tax earnings 80 Taxes (at 30%) 24 Not income 56SECURITY VALUATION ® eons Sting's Balance Sheet | Balance Sheet 2010 Forecast 2009 Actual | Cash $10 35 ‘Account Receivable 30 15 Inventory 40 30 Current Assets $80 $50 Gross property, plant and equipment 400 300 Accumulated depreciation 190 140 Total Assets $290 $210 Account Payable $20 $20 Short Term Debt 20 10 Current Liabilities $40 $30 Long Term Debt 114 100 Common Stock 50 50 Retained earnings 86 30 Total lial and owners’ equity $290 $210 1. P/E Multiple Approach _MPS = EPS x P/E Ratio 2. Enterprise ValvetoSales = 27 ev 3. Enterprise Valueto EBITDA = Ferg EV market ‘of common stock + market value of preferred equity + market value of dobt + minority interest - cash & cash equivalents and Equity investments, investment in any co. & also Long term investments. EBITDA === _—EBIT + depreciation + amortization (QUESTION NO. 14 ‘An analyst gathered the following data for Boulevard Industries Recent share price 22.50 Shares outstanding I 40 Lakhs Market value of debt 7137 Lakhs Cash and marketable secu: % 62.30 Lakhs Investments I 327 Lakhs Net income 2137.50 Lakhs Interest expense 26.90 Lakhs Depreciation and amortization [ % 10.40 Lakhs Taxes 95.90 Lakhs for Boulevard Industries. on this information, calculate #® SECURITY VALUATION Notes