Topic 5: Equity Valuation

Overview of the securities selection

Top-down,
Three-step Bottom-up,
Approach: Two Stock Valuation,
economy, Approaches Stock Picking
industry, Approach
firm

Dragon capital view on the Vietnamese stock market on righ after COVID-19
https://www.youtube.com/watch?v=Sk8eKylRtOo

11-2
General Economic Influences

• Tax • Money
Credits/Cuts
•Government Supply
spending •Interest
Fiscal Monetary Rate
Policy
Policy

Inflation International
Events
• Real vs • War
• Monetary
nominal
•Spending, Devaluation
saving
The situation of Vietnam’s economy://globaledge.msu.edu/countries/vietnam/economy
https://www.mckinsey.com/industries/public-and-social-sector/our-insights/the-10-trillion-dollar-rescue-how-governments-can-deliver-impact

https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-impact-of-covid-19-on-capital-markets-one-year-in#
 The Stock Market and the Business Cycle

o Different industries react to economic changes

at different points in the business cycle

Consumer
Basic
Staples
Industries Excel
Excel
Capital
Consumer
Goods Durables
Excel Financial Excel
Stock
Excel
https://translate.google.com/translate?sl=auto&tl=en&u=https://cafef.vn/song-khoe-giua-dai-dich-ngan-hang-len-huong-20210607074206922.chn
11-5
Valuation of Common Stock
• Two General Approaches

o Discounted Cash-Flow Techniques

Stream Of Required
Expected Cash Rate Of
Flows discounted cash Return
flow model

Value Of The Asset

11-8
Stream of Expected Cash Flows

Form: Dividends, Free Cash Flow To Equity

Time Pattern: yearly (most common)

Growth Rate: 5%, 10%, 15%, etc.

11-9
Types of Cash Flows
Cash Flows Definition
Dividends Cash Flows That Go Straight To Investors

Free Cash Flow To Cash Flows Available To Equity

Equity Holders After Payments To Debt
Holders
Operating Free Cash Flows Available To All Suppliers
Cash Flow Of Capital, i.e. debt and equity holders
(not covered)

11-17
Required Rate of Return

Risk-free
Rate

Required
Rate of
Return
Expected Risk
Inflation Premium

(Refer to Topic 3: CAPM and multifactor model)

11-10
Investment Decision Process
• A Comparison of Estimated Values and Market Prices

o If Estimated Value > Market Price, Buy

o If Estimated Value < Market Price, Don’t Buy

o Example: MWG valuation from Eikon

11-11
Limitation of DCF Valuation
• Estimates highly dependent on:

o The growth rates of cash flows

o The estimated discount rate

• GIGO (garbage in garbage out)

, i.e. incorrectly input will always produce unreasonable pricing

Solution? Sensitivity analysis and different pricing approaches

11-18
Valuation of Common Stock
• Two General Approaches:
o Relative Valuation Techniques
• Value estimated by comparing stocks to similar stocks
using relative ratios.
• These ratios compare stock price to variables such
as earnings, cash flows, book values and sales.

11-13
Examples (aside)

Country P/E Ratio Industry (US) P/E Ratio Company P/E Ratio
(2016) (2016) (2016)

Russia 9.1 Advertising 23.48 Microsoft 22.44

Italy 31.5 Bank 14.91 Apple 14.39

France 23.4 Computer 80.05 Yahoo! 161.96

Germany 18.7 Medicine 182.25 Sony 29.68

China 7.2 Entertainment 34.22 Google 35.30

Hong Kong 15.3 Environment 468.68 Amazon 168.51

Singapore 13.3 Furniture 21.04 Facebook 37.35

Japan 19.4 Insurance 39.68 Alibaba 58.83

Star Capital (2016) Damodaran Online (2016) NASDAQ(2016)

11-21
Why Relative Valuation Techniques
•Provides information about how the market is
currently valuing stocks
o Aggregate market

o Alternative industries

o Individual stocks within industries

11-19
Which approach to use?
• No need to choose!

• The best approach is to use both approaches to

come up with the best valuation estimate possible.

11-22
The Dividend Discount Model (DDM)

• The value of a share of common stock is the present

value of all future dividends
D D D D
V j  1
 2
 3
 ...  

(1 k) (1 k) 2
(1 k) 3
(1 k) 

∞
  Dt
 t  1 ( 1  k)t

where:
Vj = value of common stock j
Dt = dividend per share during time period t
k = required rate of return on stock j

11-25
The Dividend Discount Model (DDM) (cont)

• The N-Period Model

o If the stock is held for only N period, e.g. 2

years, and a sale at the end of year 2 would
imply:
D1  SPj2
Vj 
D2 k) (1
 (1 (1
k)
D
2
D k)2 D
SPj2  3 4
 ... 

1   1 2
 1 

k k  2 is crucial,
k Year
The expected selling price, SP , of stock j at the end of
j2
which is in fact the present value of future expected dividends
 11-26
Example
• You expect Blum Foods Ltd. to pay a dividend of $0.30
next year. The shares will be sold after the dividend
for
$5.20. Assume ke=15%. The PV of one share is:
D P
P V  1
 1

( 1  k e ) ( 1  k e )
$ 0 . 3 0 $ 5
 
( 1  0 . 1 5 ) ( 1 . 2 0 . 1 5 )
 $ 4 .7 8

11-28
The Dividend Discount Model (DDM) (cont)

• Infinite Period Model (Constant Growth Model)

o Assumes a constant growth rate for estimating all

of future dividends
D
  (1 g) D (1 g)2 D (1 g)
Vj 
(1 k)  (1 k)2  ... 
0 0 0
(  1  k )
  =

where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends and g < k
k = required rate of return on stock j
n = the number of periods, which we assume to be infinite 11-29
Valuation with Temporary Supernormal
Growth
• Suppose a 14% required rate of return, a dividend of $2
with the following dividend growth pattern

Dividend
Year
Growth Rate
1-3 25%
4-6 20%
7-9 15%
10 on 9%

11-32
Valuation with Temporary Supernormal
Growth (cont)

• The Value of the Stock

2 3
2.00(1.25) 2.00(1.25) 2.00(1.25)
Vi  1.14  1.14 2  1.14 3
3 3 2
2.00(1.25) (1.20) 2.00(1.25) (1.20)
 1.14 4  1.14 5
3
3 3
2.00(1.25) (1.20)  2.00(1.25) (1.20) (1.15)
3
 1.14 6 1.14 7
3 3 2 3
2.00(1.25) (1.20) (1.15) 2.00(1.25)
3 (1.20) (1.15)3
 
1.14 8 1.14 9
2.00(1.25) 3 (1.20) 3 (1.15) 3 (1.09)


(.14  .09)
(1.14) 9
11-33
Valuation with Temporary Supernormal
Growth (cont)
Year Dividend Discount Factor Present Value
(14 per cent)
1 $2.50 0.8772 $2.193
2 3.12 0.7695 2.401
3 3.91 0.6750 2.639
4 4.69 0.5921 2.777
5 5.63 0.5194 2.924
6 6.76 0.4556 3.080
7 7.77 0.3996 3.105
8 8.94 0.3506 3.134
9 10.28 3.161
0.3075b
price at year 0.3075
$224.20
9
Total value=$94.355

11-34
Expected Growth Rate (g)
• Estimating Growth From Fundamentals

oIn the short run, dividends can grow at a different

rate than earnings if the firm changes its dividend
payout ratio (total dividend/total net income) over time
o For mature firms

g = (Retention Rate)x(Return on Equity) =

RRxROE

11-60
Dividend Discount Models
• What if the stock does not pay any dividends?

o A firm with a non-dividend paying stock is

reinvesting its capital in profitable projects so that its
earnings stream will be larger in the future

11-36
Example
•Great Plains Corporation plans to reinvest its profits
for the next 6 yrs. In yr 7, the company will pay its first
dividend of $0.20, after which constant growth is
expected at a rate of 5% p.a. If k e= 15% p.a. what is the
‘value’ of Great Plains?
• PV of dividend stream at year 6:

D7/(k - g) = 0.2/(0.15 - 0.05) = 2

• Discount $2.00 back to present:
2/(1.15^6) = 0.86

11-38
Present Value of FCFE

• The N-Period Model

o If the stock is held for only N period, e.g. 2

years, and a sale at the end of year 2 would
imply:
FCFE1 FCFE2 SPj2
Vj 
 (1 k) (1 (1
k)
FCFE
2
FCFE k)2
FCFE
SPj2  3 4
 ... 

1   1 2
 1 

k k k
 11-26
Present Value of FCFE (cont)

FCFE (can be on per share basis) If the FCFE is assumed

to grow at the constant rate
g in the future:
= Net Income

+ Depreciation Expense
  V =
- Capital Expenditures
- change in Working Capital

- Principal Debt Repayments

+ New Debt Issues

Working capital = (Current Assets – cash) – (Current Liabilities – short-term debt)

11-42
FCFE in practice
Cash Flow
Industry - Annual Standardised in Millions of Vietnamese Dong
Vie tje t Av ia tio n JS C | Ca s h Flo w 0 7 -Ju l-2 0 2 1 1 5 :4 6 2019 2020
Cash Flow-Operating Activities (VND Millions)
Net Income/Starting Line 4,568,651 (244,493)
Depreciation/Depletion 175,156 141,435
Depreciation 175,156 141,435
Amortization -- --
Amortization of Intangibles -- --
Non-Cash Items 432,578 (378,063)
Unusual Items (1,245,532) (741,819)
Equity in Net Earnings (Loss) 91,807 --
Other Non-Cash Items 1,586,303 363,755
Changes in Working Capital (7,203,348) (2,726,837)
Accounts Receivable (7,459,150) (1,032,209)
Inventories (279,169) 35,805
Prepaid Expenses (970,059) (218,645)
Accounts Payable 2,298,995 (824,444)
Other Operating Cash Flow (793,965) (687,344)
Cash from Operating Activities (2,026,963) (3,207,957)

Cash Flow-Investing Activities (VND Millions)

Capital Expenditures (2,594,038) (293,760)
Purchase of Fixed Assets (2,594,038) (293,760)
Other Investing Cash Flow Items, Total (506,541) 1,436,850
Sale of Fixed Assets -- 397,277
Sale/Maturity of Investment 1,400 709,757
Investment, Net -- --
Purchase of Investments (715,757) 0
Other Investing Cash Flow 207,816 329,816
Cash from Investing Activities (3,100,578) 1,143,090

Cash Flow-Financing Activities (VND Millions)

Financing Cash Flow Items 600,000 --
Other Financing Cash Flow 600,000 --
Total Cash Dividends Paid (543,112) 0
Cash Dividends Paid - Common (543,112) 0
Issuance (Retirement) of Stock, Net (2,347,121) 0
Sale/Issuance of Common -- --
Repurchase/Retirement of Common (2,347,121) 0
Common Stock, Net (2,347,121) 0
Issuance (Retirement) of Debt, Net 5,690,029 (369,287)
Total Debt Issued 37,007,640 17,804,331
Total Debt Reduction (31,317,611) (18,173,618) 11-43
Cash from Financing Activities 3,399,796 (369,287)
Relative Valuation Techniques

Determine Value By Comparing To Similar

Stocks Using Ratios

Price/Earning (P/E) ; Price/Cash Flow (P/CF);

Price/Book Value (P/BV) & Price/Sales (P/S)

P/E Is The Most Popular

11-44
Implementing the Relative Valuation
Technique

Calculate the valuation ratios from other stocks

in the same industry

Identify Main Factors Affecting earnings, book

value, etc.

Apply the valuation ratio with the estimate

of earnings, sales, etc.

11-57
Earnings Multiplier Model
• P/E Ratio: This values the stock based on expected
annual earnings
• P/E Ratio = Earnings Multiplier

Cur r en t M a r k e t Price

E x p ec ted 1 2 - M o n th E arn ing s

11-45
Earnings Multiplier Model
• Combining the Constant DDM with the P/E ratio
approach by dividing earnings on both sides of DDM
formula to obtain

P

D1 /E1 E1
k  g

11-46
The Price-Sales Ratio
• Sales is subject to less manipulation than other
financial data
• This ratio varies dramatically by industry

⇨Relative comparisons using P/S ratio should be

between firms in similar industries

However, price/sales ratio is less commonly public

11-55
The Price-Sales Ratio
• The Formula
Pt
P/S j 
S t1

where:
o P/Sj = the price to sales ratio for Firm j

o Pt = the price of the stock in Period t

o St+1 = the expected sales per share for Firm j

11-56
Earnings Multiplier Model (Aside)
• Assume the following information for AGE stock:
(1) Dividend payout = 50% (2) Required return
= 12%
(3) Expected growth = 8% (4) D/E = .50 and the growth
rate, g=.08. What is the stock’s P/E ratio?
0.50
P/E   0.50/0.04 
0.12 - 12.5
0.08

11-48
Earnings Multiplier Model (Aside)
• What if the required rate of return is 13%

0.50
P/E   0.50/0.05 
0.13 - 10.0
0.08
• What if the growth rate is 9%

0.50
P/E   0.50/0.03 
0.12 - 16.7
0.09

11-49
The Price-Book Value Ratio (Aside)
• Widely used to measure bank values

• The Formula P
t
P/BV 
j
where: BVt 1
o P/BVj = the price/book value for firm j

o Pt = the end of year stock price for firm j

o BVt+1 = the estimated end of year book value

per share for firm j

11-52
Reference(s)

o Reilly, FK & Brown, KC 2011, Investment Analysis & Portfolio

Management, 10th edn, South-Western Cengage Learning,
Mason, Ohio.
o Bodie, Z, Kane, A & Marcus, AJ 2013,
Essentials of investments, 9th edn, McGraw-
Hill/Irwin, New York.
o Jones, CP 2010, Investments Principles and Concepts, 11th
edn, International student version, Wiley, Hoboken, N.J.

RMIT University Vietnam 64