CF Session 4 - Pricing of Equity

Avijit Bansal
Indian Institute of Management Calcutta

January 8, 2023

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What is an Equity?

Equity is a piece of ownership in a corporation

Owning equity in a corporation makes you eligible for payouts in the form of

▶ Cash dividends

▶ Stock Dividends

▶ Cash when the firm repurchases its stock

▶ Do all firms pay dividends?

Equity can held in a publicly traded corporation or even in a private firm

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Characteristics of Common Stock?

Residual Claimants after all other obligations are settled

Limited Liability

Voting Rights

Secondary markets to buy/sell and even short sell

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What are the key differences between bond and a
stock?

In case of a bond we are certain about the magnitude of the payout as well as
the timings In case of the stock, both the magnitude and the timing of the
payout is uncertain

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Valuation of Equity

P0 Price of the stock today (ex-dividend)

Dt Dividend at year t
E0 [ ] Expectation/forecast about the future based on information
available today
rt Discount rate for cashflow at t, commensurate with the risk of
the cashflow. It is also known as risk-adjusted cost of equity

E0 [DIV1 ] + E0 [P1 ] E0 [DIV1 ] E0 [DIV2 ] + E0 [P2 ]

P0 = = +
1 + r1 1 + r1 (1 + r2 )2

In general

E0 [DIV1 ] E0 [DIV2 ] E0 [DIVH ] + E0 [PH ]

P0 = + + ··· +
1 + r1 (1 + r2 )2 (1 + rH )H
H
X E0 [DIVt ] E0 [PH ]
P0 = +
(1 + rt )t (1 + rH )H
t=1

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Extending the horizon to ∞

∞
X E0 [DIVt ]
P0 =
(1 + rt )t
t=1

This is also known as the dividend discount model

What if a company does not pay dividends, how would you value a company in that
case?

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Free cash flow to Equity (FCFE) investors

FCFE is an estimate of the potential dividend that a company can pay. It is defined as
the cash left after accounting for operating expenses, interest expenses, net debt
payments, and reinvestment requirements.

Unlike dividends, FCFE can be negative. How?

H ∞
X E0 [FCFEt ] E0 [PH ] X E0 [FCFEt ]
P0 = + =
(1 + rt )t (1 + rH )H (1 + rt )t
t=1 t=1

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Valuation of equity with a constant growth rate

E0 [DIV1 ]
P0 =
r −g

Can you infer the cost of equity capital?

DIV1
r = +g
P0

What can we infer from this expression?

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What drives the value of the firm?

Assets in place (dividend yield) plus all the potential growth opportunities that a
company can undertake in the future. Hence, growth prospect is essential in the
valuation of the firms.

How do we estimate the growth rate?

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Estimating the growth rate

Growth Rate = plowback ratio × Return on Equity

DIV
g = (1 − ) × Return on Equity
EPS

Is assuming a constant growth rate justified?

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Is assuming a constant growth rate justified?

Growth rate of a firm is closely linked to its life cycle

A young firm typically has many valuable projects to undertake, as a result, the
investors are happy when such firms reinvest their money and do not pay any
dividends. Such firms have very high growth rates, which are not sustainable

Using such high growth rates in the constant growth model can overestimate
the value of the firm

For a mature company a growth rate is more likely to be stable

It is more sensible to use two-stage models with high growth rates in the first
stage and a sustainable steady growth rate in the second stage (similar to
horizon value)

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Two stage model

FCF1 FCF2 FCFH PVH

PV = + + ··· + +
1+r (1 + r )2 (1 + r )H (1 + r )H

FCFH × (1 + g)
PVH =
r −g

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Linking Price to EPS and growth opportunities

P0 = Value of assets in place + Present value of growth opportunities

If a company is reinvesting back its profits, will PVGO always be positive?

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Numerical example

Assume that a company can generate EPS of 10 at t = 1 and pay it out as

dividends in perpetuity. The risk-adjusted cost of equity investors is 10%.
What will be the share price at t = 0?

If the company generates return on equity for its investors to the extent
of 10% and decides to plough back 50% of its earnings into the company,
what will be the share price?

What happens to the share price when the ROE jumps to 12%?

What inference can be drawn from this example?

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Harley-Davidson case

Who is the protagonist?

What is the job of the protagonist?

What is the decision that has to be undertaken?

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Harley-Davidson case

Aditi Basu is a buy-side analyst at Dimensional Wealth Group(DWG). She has to

recommend whether DWG should increase/decrease/not change its position in
Harley-Davidson(HOG).

What is the job of a buy-side analyst?

What do you know about Harley-Davidson from the case?

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Buy side versus sell side analyst

Buy side analyst

▶ Work for an institutional investor

▶ Their reports are typically used by the internal team members where they
are employed. Not available publicly

▶ Their job is to identify the best investment opportunities for their

organization

Sell-side analyst

▶ Work for an investment bank/brokerage firm

▶ Follow a specific company/industry

▶ Forecast EPS and identify the target price

▶ Issue buy/sell/hold recommendations. Their reports are available publicly

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What does Harley-Davidson do?

Source: Harley-Davidson Inc., “Stock Prices for Harley-Davidson, Inc.,” Standard & Poor’s Capital IQ, accessed July 29, 2019.

EXHIBIT 2: HARLEY-DAVIDSON INC. BUSINESS DESCRIPTION

Harley-Davidson Inc. primarily manufactures and sells cruiser and touring motorcycles. The company
operates through two segments, motorcycles and related products, and financial services. The motorcycles
and related products segment designs, manufactures, and sells wholesale on-road Harley-Davidson
motorcycles, as well as motorcycle parts, accessories, general merchandise (e.g., MotorClothes apparel),
and related services. This segment also licenses the Harley-Davidson name and other trademarks. It sells
its products to retail customers through a network of independent dealers as well as ecommerce channels
in the United States, Canada, Latin America, Europe, the Middle East, Africa, and Asia-Pacific. The financial
services segment provides wholesale and retail financing services as well as insurance and insurance-
related programs primarily to Harley-Davidson dealers and retail customers in the United States and
Canada. Harley-Davidson Inc. was founded in 1903 and is based in Milwaukee, Wisconsin.

Source: Harley-Davidson Inc., “Business Description for Harley-Davidson, Inc.,” Standard & Poor’s Capital IQ, accessed July 29, 2019.

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What is the present situation of HD?

Page 5 9B20N012

EXHIBIT 3: HARLEY-DAVIDSON INC. REVENUE BY GEOGRAPHIC SEGMENT, 2009–2017

US Revenue Non-US Revenue
Year ($) US Growth ($) Non-US Growth Total ($) Total Growth
2017 3,913.9 (8.4)% 1,733.33 0.5% 5,647.22 (5.8)%
2016 4,271.9 (3.5)% 1,724.55 9.8% 5,996.46 0.0%
2015 4,425.0 0.6% 1,570.45 (14.1)% 5,995.40 (3.7)%
2014 4,400.4 5.5% 1,828.10 5.8% 6,228.51 5.6%
2013 4,172.4 5.1% 1,727.45 7.4% 5,899.87 5.7%
2012 3,971.5 5.2% 1,608.96 4.7% 5,580.51 5.1%
2011 3,774.8 8.8% 1,536.89 10.7% 5,311.71 9.3%
2010 3,470.9 2.8% 1,388.46 (1.2)% 4,859.34 1.6%
2009 3,376.3 1,405.65 4,781.91
8-Year Annual
1.9% 2.7% 2.1%
Compound Growth
Note: All dollar amounts are in US dollars.
Source: Harley-Davidson Inc., “Revenue by Geographic Segment for Harley-Davidson, Inc.,” Standard & Poor’s Capital IQ,
accessed July 29, 2019.

EXHIBIT 4: HARLEY-DAVIDSON FINANCIAL STATEMENTS, DECEMBER 2015–JULY 2018

(US$ MILLIONS)
Balance Sheet 19
 Balance Sheet Date 183.9 174.6 166.5 166.6
What is the present situation of HD?
Note: EBT = earnings before taxes.
Source: Harley-Davidson Inc., “Financial Statements for Harley-Davidson, Inc.,” Standard & Poor’s Capital IQ, accessed July 29, 2019.

EXHIBIT 5: HARLEY-DAVIDSON INC. KEY FINANCIAL RATIOS, DECEMBER 2015–JULY 2018

12 Months 12 Months 12 Months LTM 12 Months
For the Fiscal Period Ending:
Dec-31-2015 Dec-31-2016 Dec-31-2017 Jul-01-2018
Profitability
Return on Assets (%) 7.5 7.0 5.2 4.7
Return on Common Equity (%) 40.9 36.0 28.3 22.8
Gross Margin (%) 38.2 36.4 35.1 34.8
Net Margin (%) 12.9 11.9 9.5 9.1
EBIT Margin (% 20.4 18.4 16.4 15.3
Asset Turnover* (%) 58.6 58.9 54.9 51.7
Liquidity & Efficiency
Current Ratio 1.4× 1.3× 1.2× 1.4×
Quick Ratio 1.2× 1.2× 1.1× 1.2×
Average Days Receivable 15.5 17.9 22.0 22.5
Average Days Inventory 59.2 49.2 55.4 47.8
Average Days Payable
Outstanding 23.8 23.2 23.4 29.5
Cash Conversion Cycle 50.9 43.9 54.0 40.8
Long-Term Solvency
EBIT ÷ Interest Expense 98.3× 36.1× 28.9× 26.8×
Assets ÷ Equity 5.4× 5.2× 5.4× 4.9×
Note: LTM = last 12 months; EBIT = earnings before interest and taxes; *asset turnover = revenue ÷ assets.
Source: Case writer analysis based on Harley-Davidson Inc., “Financial Statements for Harley-Davidson, Inc.,” Standard &
Poor’s Capital IQ, accessed July 29, 2019.

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 3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

H-D Owners Total Owners

Source: https://investor.harley-davidson.com/static-files/1bdc12c4-f26d-49d7-8ddd-bcb4e44d3ede

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 U.S. Grand American Touring -2%
Avg. global population 1% 3%
U.S. Adventure Touring/Traditional 7%

Europe Adventure Touring / Traditional 5%

Urban population 2% 5%
Asia small 150-400 cc 6%

2% U.S. Brick & Mortar 2%

16% U.S. Online Retail 16%

Source: https://investor.harley-davidson.com/static-files/1bdc12c4-f26d-49d7-8ddd-bcb4e44d3ede

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Key changes to the strategy

Developing innovative electric motorcycles

Expanding their presence in the global markets

Would Harley-Davidson’s existing customer base like the transition to electric

motorcycles?

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EPS and Dividends
Page 8 9B20N012

EXHIBIT 7: HARLEY-DAVIDSON INC. ANNUAL DIVIDEND AND EARNINGS HISTORY, 1994–2017

Dividends per Earnings per Dividend Dividend Earnings

Year
Share (US$) Share (US$) Payout (%) Growth (%) Growth (%)
2017 1.460 3.020 48 4.3 21.2)
2016 1.400 3.830 37 12.9 3.8
2015 1.240 3.690 34 12.7 (4.9)
2014 1.100 3.880 28 31.0 18.3
2013 0.840 3.280 26 35.5 20.6
2012 0.620 2.720 23 30.5 6.7
2011 0.475 2.550 19 18.8 311.3
2010 0.400 0.620 65 0.0 (358.3)
2009 0.400 (0.240) (69.0) (108.6)
2008 1.290 2.790 46 21.7 (25.4)
2007 1.060 3.740 28 30.9 (4.8)
2006 0.810 3.930 21 29.6 15.2
2005 0.625 3.410 18 54.3 13.7
2004 0.405 3.000 14 107.7 20.0
2003 0.195 2.500 8 44.4 31.6
2002 0.135 1.900 7 17.4 32.9
2001 0.115 1.430 8 17.9 26.5
2000 0.098 1.130 9 11.4 30.6
1999 0.088 0.865 10 12.9 25.4
1998 0.078 0.690 11 14.8 22.1
1997 0.068 0.565 12 22.7 2.7
1996 0.055 0.550 10 22.2 46.7
1995 0.045 0.375 12 28.6 9.3
1994 0.035 0.343 10
Average Annual Dividend Growth, 1995–2017 (%) 22.3
Average Annual Dividend Growth, 2012–2017 (%) 21.1
Compound Annual Dividend Growth, 1995–2016 (%) 17.6
Compound Annual Dividend Growth, 2012–2016 (%) 18.7
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What has HD announced in the regulatory filings
on 25/6/2018?

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Statement from Harley-Davidson On EU Tariff
Resolution on 30/10/2021

Today’s news is a big win for Harley-Davidson and our customers, em-
ployees and dealers in Europe. Our thanks go out to President Biden,
Secretary Raimundo and the U.S. Administration, for their efforts in this
negotiation. We are excited that this brings an end to a conflict that was
not of our making, and in which Harley-Davidson had no place. This is
an important course correction in U.S.-EU trade relations, that will allow
us to further Harley-Davidson’s position as the most desirable motorcycle
brand in the world.

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References I

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