BAFI3184 – Business

Finance
Topic Three - Part 2

Valuation Of Financial Assets - EQUITY

Debt versus equity
• Equity is a security which:

1. Pays a variable rate of return (dividends)

2. Has an indefinite life

3. In the event of insolvency of a company, owners are entitled

to the residual proceeds from sale of the assets after creditors
have been paid.
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Methods For The Valuation Of Common Stock
(Equity)
1. Dividend Valuation model

2. Constant dividend growth model

3. Non-constant plus constant dividend growth model

Valuing Common Stocks (1)
• COMMON STOCK VALUE DEPENDS ON:

a) Future Cash Flow Pattern (Dividends) paid to shareholders

b) Expected Return - The percentage yield that an investor forecasts from

a specific investment over a set period of time. Sometimes called the
market capitalization rate.

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Valuing Common Stocks (2)
• One period expected return is,

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Valuing Common Stocks (3)
• Example of ‘Expected Return:
o If Fledgling Electronics is selling for $100 per share today and is
expected to sell for $110 one year from now, what is the expected return
if the dividend one year from now is forecasted to be $5.00?

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Valuing Common Stocks (4)
• Example of ‘Expected Return:

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 Valuing Common Stocks (5)
• Expected return is a function of risk.
• The riskier the company the higher should be the expected return
• ‘Expected return, in this instance, can also be called that the
‘Required Return to the shareholder given the risk(s) of investing in
the company.

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Valuing Common Stocks (6)
1. Dividend Valuation Model
• If the cash flow pattern (Dividends) is a never ending and a constant
$1.50 p.a., and the required rate of return is 0.10 (10.00%)
• Worked Example
• In this example
$1.50 $1.50 $1.50 $1.50
o Yr 0 1 2 3 Infinity
• This is a ‘PERPETUITY’ Model. Use the PV of PERPETUITY to
determine the value of the share
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Valuing Common Stocks (7)
• Present Value of the share

• PV of Perpetuity = $Div1 / re

• PV of Perpetuity = $1.50 / 0.10

• PV of Perpetuity = $15.00

• P0 = $15.00

Where P0 = price of share

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 Valuing Common Stocks (8)
• Note that this model implicitly
assumes no growth. Therefore,
all earnings must be paid out as
dividends.

• This model can also be written

as:

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Valuing Common Stocks (9)
2. Constant Growth Model
• What if the cash flow pattern (Dividends) is a constantly growing
dividend with Div1 = $1.50 growing 4%pa forever, and the required
rate of return is 0.10 (10.00%)
• Worked Example
• In this example, the $1.50 grows at 4.0%pa forever
o $1.50 $1.56 $1.6224 $????
Yr0 1 2 3 Infinity
• This is a ‘CONSTANT GROWTH’ Model. Use the PV of CONSTANT
GROWTH model to determine the value of the share
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 Valuing Common Stocks (10)
2. Constant Growth Model
• PV of Constant Growth = $Div1 /(re – g)
• where re (or sometimes titled “ke”) is the required return to equity
(shareholder), and g is the rate of constant growth
• PV of Constant Growth = $1.50 / (0.10 – 0.04)
• PV of Constant Growth = $1.50 / 0.06
• PV of Constant Growth = $25.00
• P0 = $25.00
• Why is this share valued at an extra $10.00 relative to the
‘Perpetuity’ model?
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Rate of Return Observable

• The required rate is also

sometimes called the
‘Market Capitalisation rate’.
In case of the PERPETUITY
model

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Capitalization Rate

• In case of the ‘Constant

Growth’ Model

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Valuing Common Stocks (11)

• What if the Dividends and

share price can be
forecasted?

• In this case, the forecast the

future cash flows to
shareholders:
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Valuing Common Stocks (12)
• What if the Dividends and share price can be forecasted?
• In this case, the forecast the future cash flows to shareholders:
• Example : Forecastable Cash Flows (Part 1)
o Current forecasts are for XYZ Company to pay dividends of $3,
$3.24, and $3.50 over the next three years, respectively. At the
end of three years you anticipate selling your stock at a market
price of $94.48. What is the price of the stock given a 12%
expected return?

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Valuing Common Stocks (13)

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Valuing Common Stocks (14)
3. Non-constant growth model

Example : Forecastable Cash Flows (Part 2)

Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and
$3.50 over the next three years, respectively. In year 4 and onwards, it will
grow at a constant rate of 4.0% forever. What is the price of the stock given a
12% expected return?

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Valuing Common Stocks (15)
3. Non-constant growth model

Example : Forecastable Cash Flows (Part 2)

Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and
$3.50 over the next three years, respectively. In year 4 and onwards, it will
grow at a constant rate of 4.0% forever. What is the price of the stock given a
12% expected return?

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Valuing Common Stocks (15)

• This problem is
solved in two
parts.

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Valuing Common Stocks (16)
• Year 3* PV3 = Div4 / (re –g) = $3.64 / (0.12 – 0.04) =
$3.64 / 0.08 = $45.50

• Discount PV3 to PV0 using the discount rate of 12%

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Worked Example
• A company has just paid a dividend of 15 cents per share
and that dividend is expected to grow at a rate of 20% per
annum for the next 3 years and at a rate of 5% per annum
forever after that.

• Assuming a required rate of return of 10%, calculate the

current market price of the share.
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Solution (1)

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Solution (2)

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Solution (3)

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Price to earnings (P/E ratio)
• Price-Earnings ratio
o The price of a share divided by its earnings per share
o Used to determine whether a stock is overpriced or
underpriced

where:
o ρ = the dividend payout ratio

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P/E ratios (2)
• Note that the left-hand side of this equation represents the
prospective P/E ratio because the current share price is
divided by the one-year-ahead (not historical) EPS

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 P/E ratios (3)

• A stock trading at $40 per share with an EPS of $2 would have a P/E ratio of 20
($40 divided by $2), as would a stock priced at $20 per share with an EPS of $1
($20 divided by $1) same price-to-earnings valuation.

• However, what if a stock earning $1 per share was trading at $40 per share?
Then we’d have a P/E ratio of 40 instead of 20, which means the investor would
be paying $40 to claim a mere $1 of earnings.

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P/E ratios (4)
• These different figures would indicate that:

1. Shareholders were paying too much for one of the stocks,

and/or

2. The other was relatively underpriced by the market

• The question arises: are the differences in the P/E ratios

economically justifiable?
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Valuing Common Stocks (Other Issues) (1)
a) Growth
o If a firm elects to pay a lower dividend, and reinvest the funds,
the stock price may increase because future dividends may be
higher assuming all other things constant.
• Why? Look at impact on
1. Payout Ratio - Fraction of earnings paid out as dividends i
2. Plowback Ratio - Fraction of earnings retained and reinvested
by the firm.
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 Valuing Common Stocks (Other Issues) (2)
• Growth can be derived from applying the return on equity to
the percentage of earnings plowed back into operations.

• where g = return on equity * plowback ratio

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Valuing Common Stocks (Other Issues) (3)
Example:
• Our company forecasts to pay a $8.33 dividend next year,
which represents 100% of its earnings. This will provide
investors with a 15% expected return. Instead, we decide
to plow back 40% of the earnings at the firm’s current return
on equity (ROE) of 25%.
• What is the value of the stock before and after the plowback
decision?

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Valuing Common Stocks (Other Issues) (4)
Solution:
• No growth:

• With growth:

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Valuing Common Stocks (Other Issues) (5)

b) Present Value of Growth Opportunities (PVGO)

o If the company did not plowback some earnings, the stock
price would remain at $55.56. With the plowback, the price
rose to $100.00.
o The difference between these two numbers is called the
Present Value of Growth Opportunities (PVGO).

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Valuing Common Stocks (Other Issues) (6)

(Present Value of Growth Opportunities (PVGO)

• PVGO represents the Net Present Value of a firm’s future
investments.

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Valuing a Business (1)
• Valuing a Business or Project
• The value of a business or Project is usually computed as
the discounted value of Free Cash Flows out to a valuation
horizon (H).
• The valuation horizon is sometimes called the terminal
value and is calculated like PVGO.

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Valuing a Business (2)
• Valuing a Business or Project

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Free Cash Flow – FCF (1)
• A measure of financial performance:
• Calculated as operating cash flow minus capital
expenditures
• Free cash flow (FCF) represents the cash that a company is
able to generate after laying out the money required to
maintain or expand its asset base
• Free cash flows  allow a company to pursue opportunities
that increase shareholder value.

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Free Cash Flow – FCF (2)
• FCF is calculated as

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Valuing a Business (3)

• Example

o Given the cash flows for

Concatenator Manufacturing
Division, calculate the PV of
near term cash flows, PV
(horizon value), and the total
value of the firm. r=10% and
g= 6% on average

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Valuing a Business (4)
• Solution

o Given the cash flows for Concatenator Manufacturing Division,

calculate the PV of near term cash flows, PV (horizon value),
and the total value of the firm. r=10% and g= 6%

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Valuing a Business (5)
• Solution

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Valuing a Business (6)
• It is important to note that Concatenator’s positive cash flow
is largely a result of the Horizon value of the later term cash
flows.

• ARE THESE CASH FLOWS ACCURATE???

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