Equity Valuation

Dr Deepika Upadhyay
Equity Valuation
Techniques of fundamental equity valuation
I. Balance Sheet Methods / Techniques
Utilize the balance sheet information to value a company.

1. Book Value Method

In this method, book value as per balance sheet is considered the value of equity.

Net worth of the company.

Net Worth = Equity Share capital + Preference Share Capital + Reserves & Surplus
– Miscellaneous Expenditure (as per B/Sheet) – Accumulated Losses.
2. Liquidation Value Method
Liquidation value is considered the value of equity.
Liquidation value is the value realized if the firm is liquidated today.

Liquidation Value = Net Realizable Value of All Assets – Amounts paid to All
Creditors including Preference Shareholders.
3. Replacement Cost Method
The value of equity is the replacement value.
The cost that would be incurred to replace a firms asset.
James Tobin Tobin’s Q:
Equals the market value of a company divided by its assets' replacement cost.
Which tends to become 1 Equilibrium state
A low Q ratio—between 0 and 1—
Cost to replace a firm's assets > value of its stock stock is undervalued.
A high Q ratio -- greater than 1---
Cost to replace a firm's assets < value of its stock stock is overvalued (firm's stock is
more expensive )
Intrinsic Value versus Market Price

Intrinsic value
The present value of a firm’s expected future net cash flows discounted by
the required rate of return.

• Intrinsic value > Market price (Undervalued) buy

• Intrinsic value < Market price (Overvalued) sell
• In market equilibrium
II. Discounted Cash Flow Methods / Techniques
1. Dividend Discount Model
PV of equity is
the PV of expected future dividends plus
the PV of the sale proceeds of the share at the end of the holding period.

a. Single period Model

b. Multi-period Model
c. Constant Growth Model
d. Two Stage Growth Model
Dividend Discount Models
a. Single period Model (One Period Case )

= Present value of the stock

= Dividend paid at the end of one year
K = Required return on equity investments
= Selling price at the end of period one
Example 1:
An investor would like to get a dividend of 16 paisa from a share and want to sell it
next year for Rs. 60 after keeping it for one year. The required rate of return is 12%.
What will be the present value of this share.
=?

= 0.16
K = 0.12

= 60

Here, if the stock is selling for 53.71 or less, it would be better to purchase it.
Example 2:
A share is currently selling for Rs. 65. The company is expected to pay a dividend of Rs.
2.50 on the share at the end of the year. It is reliably estimated that the share will sell for Rs.
78 at the end of the year. Assuming that the dividend and price forecasts are accurate; would
you buy the share to hold it for one year, if your required rate of return were 12%?
=?

= 2.50
K = 0.12

= 78

Here, the current price is 65 which is lower than the present value, the share is under-priced
and can be bought.
b. Multi period valuation model:

Equity shares have no maturity period.

Expected to bring dividend for infinite duration.
Example 1:
An investor expects to get a dividend of Rs. 3, 4, and 5 from a share during the next three
years and hope to sell it at Rs. 80 at the end of the third year. The required rate of return is
20%. What will be the present value of share to the investor.

or (3*.833)+(4*.694)+(5*.579)+(80*.579)
 Dividend Growth Models
In most of the cases, dividend per share grows because of the growth in earnings of
a company.

Assumptions:
1. Dividends grow at a constant rate in future (Constant growth assumption)
2. Growth is not constant over time Dividends grow at varying rates in future.
(Multiple growth model)
C. The Constant Growth Model: (Gordons Share valuation Model)
(Gordon Growth Model)
Assumes stable growth of earnings and stable dividend policy.
Next years expected dividend
Diff between discount rate and expected dividend growth rate
Example 1:
A company expected to announce its dividend as Rs. 4 next year. In the later years
the dividend is expected to grow at 10% per year. If the required rate of return is
15% per year, what should be its price? The current market price of the share is Rs.
90. Advise the investor whether to buy it or not.

=4
K = .15
g = .10
= 80

Its overvalued stock. It is not advisable to buy this share now as the actual value is less
than the current market price
Example 2:
Last years dividend of a company is Rs. 40. The expected growth rate is 5%. Rate of
return is 10%. Find the value of equity share.

g = .05
k = .10

= Rs. 840
d. The Multiple growth model:
More realistic than constant growth model.
Different types of companies grow at different rates.
Therefore, the dividend pay-out ratio can also differ.

The two stage growth model

Future period = two different growth segments (two periods) .

Extraordinary growth (V1)
Constant growth (V2)
Intrinsic value is the present value of the two periods.
Up to N period growth is variable and after which it is constant.
The intrinsic value of share = PV of two dividend flows.

V1 = Up to N

The second face N + 1

Discounting the second phase
As per Gordons formula
Example 1:
A company paid a dividend of Rs. 1.75 per share during the current year. It is expected to
pay a dividend of Rs. 2 per share during the next year. Investors forecasts a dividend of Rs.
3 and Rs. 3.50 per share respectively during the two subsequent years. After that it is
expected that annual dividends will grow at 10% per year into an indefinite future. Investors
required rate of return is 20%. What is the intrinsic value of the share.

= 5.78

10% V2
V2 present value at time zero, from 4th year to infinity.

= 22.28

= 5.78 + 22.28 = 28.06

Example 2: A company is currently paying a dividend of Rs. 4.24 per share. The
dividend is expected to grow at a 18% annual rate for 5 years and then at 12% for
ever. What is the present values of the share, if the capitalisation rate is 14%.

V1 =
Example 2: A company is currently paying a dividend of Rs. 4.24 per share. The
dividend is expected to grow at a 18% annual rate for 5 years and then at 12% for
ever. What is the present values of the share, if the capitalisation rate is 14%.

OR

= (5*.877) + (5.90 *.769) + (6.97 * .675) + (8.22*.592) + (9.70*.519)

= 4.39 + 4.54 + 4.70 + 4.87 + 5.03 = 23.53

.
Discounting the second phase:

Intrinsic value = 23.52 + 281.82 = 305. 08

Relative Valuation Methods / Earnings Multiple or Comparable
These techniques attempt to determine the value of a company’s shares on the basis
of relative valuation ratios of firm’s industry or similar firms.
These can be used to value shares for which Dividend Discount Models fail.

Well-known methods used for such comparison.

• Price to Earnings Ratio (P/E Ratio)
• Price to Book Value Ratios
• Price to Sales Ratio
Price to Earnings Ratio (P/E Ratio)
As P/E ratio is the most common measure of how expensive a stock is.

P/E Ratio = Market Price per Share / Earnings per Share

Earnings per Share (EPS): Total earnings of a company / The total number of
shares outstanding at the end of the year.

The lower the P/E ratio, Undervalued (the better it is for the business and
for potential investors).

A high P/E ratio overvalued

The current EPS of a share is Rs. 8 and the investor feels that the appropriate P/E Ratio
for the share is 12. What would be the intrinsic value of the share.
Intrinsic value of a share = Expected earnings per share × price earnings multiplier.
V0 = 8 × 12 = 96.

The investors decision to buy or sell the share would be taken after comparing the
intrinsic value with the current market price of the share.
Estimating Dividend Growth Rates

g = growth rate in dividends

ROE = Return on Equity for the firm
b = ploughback or retention percentage rate
i.e.(1- dividend payout percentage rate)
The determinants of P/E Ratio can be determined from the Dividend Discount Model
Constant Growth Dividend Discount Model

b = plough back ratio

i.e.(1- dividend payout percentage rate)

(1-b) = The dividend pay-out ratio

k = The required rate of return
ROE × b = The expected growth rate
Q1.The book value per share of a company is Rs. 145.50 and its rate of return on
equity is 10 percent. The company follows a dividend policy of 60% pay out. What
is the price of its share if the capitalization rate is 12 percent?

Earning per share (EPS) = 145.50 × 10/100 = Rs. 14.55

Dividend per share (D1) = 14.55 × 60/100 = Rs. 8.73

i.e.(1- dividend payout percentage rate)

= 8.73/(0.12 – 0.04)

= 8.73/0.08
= Rs. 109.13
Q2. b = 60% ROE = 15% k = 12.5% E1 = $2.73

= 31.14