Share Valuation

Session 11

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 History
• John Burr Williams (1938). 
• First to challenge the "casino" view that economists held of financial
markets and asset pricing—where prices are determined largely by
expectations and counter-expectations of capital gains 

• Recognized as a founder and developer of fundamental analysis for his

pioneering analysis of stock prices as reflecting their “intrinsic
value”. PhD Dissertation “The Theory of Investment Value”

• The founding father of a new field of corporate finance.

Session 1: Introduction 2
John Burr Williams
• The intrinsic value of a company is equal to the present value of its
future dividends, not earnings.

Session 1: Introduction 3
 Valuation
• The intrinsic (real) value of a business (or any investment security)
is the present value of all expected future cash flows, discounted
at the appropriate discount rate.
Valuation
Expected Cash Flow

Growth of the company RISK But what determines

risk in Valuation?????

Required Rate of
If risk is how, investor ask for high return Return
and vice versa
Types of Valuation
• Relative Valuation
• Residual Income
• Discounted Cash Flow (DCF)
• Dividend Discount Model (DDM)
Types of Valuation
• Relative Valuation
• A relative valuation model compares a firm's value to that of its competitors
to determine the firm's financial worth. 
• One of the most popular relative valuation multiples is the price-to-earnings
(P/E) ratio.
• There are many different types of relative valuation ratios, such as price to
free cash flow, enterprise value (EV), operating margin etc.
• A relative valuation model differs from an absolute valuation model which
makes no reference to any other company or industry average.
• A relative valuation model can be used to assess the value of a company's
stock price compared to other companies or an industry average.
Types of Valuation

• Residual Income Method

• Value of a company's stock equals the present value of future residual
incomes discounted at the appropriate cost of equity
• Residual Income = Net Income – Equity Charge

• Equity Charge = Equity Capital x Cost of Equity

Types of Valuation
• Residual Income Method
How stock market function?

One of the funny things about the stock market is that every time one
person buys, another sells, and both think they are astute (smart).
William Feather
Types of Value of share
There are several types of value, of which we are concerned with three:
• Book Value - The asset’s historical value

• Market Value - The price of an asset as determined in a competitive

marketplace

• Intrinsic Value - The present value of the expected future cash flows of
the share discounted at the decision maker’s required rate of return

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Philosophical basis for Intrinsic valuation
• There have always been investors in financial markets who have
argued that market prices are determined by the perceptions (and
misperceptions) of buyers and sellers
• The price we pay for any asset should reflect the cash flows it is
expected to generate.
"Price is what you pay, value is what you get“.
Benjamin Graham
• An investor does not pay more for an asset than it is worth
Cash flows for shareholders
• If you buy a share of stock, you can receive cash in two ways

• The company pays dividends

• You sell your shares, either to another investor in the market or back to
the company

• The price of the stock is the present value of these expected cash
flows
Intrinsic valuation of Shares
• The process by which the underlying (intrinsic) value of a share is
established on the basis of its forecasted risk and return
performance.
• In intrinsic valuation, the value an asset (share) is depends upon
its intrinsic characteristics of the company.
• Depends upon the magnitude of the expected cash flows (either
dividend or capital gain) on the share over its lifetime and the
uncertainty about receiving those cash flows.
Determinants of Intrinsic Value
• There are two primary determinants of the intrinsic value of an asset to
an individual:
• The size and timing of the expected future cash flows
• The individual’s required rate of return (this is determined by a
number of other factors such as risk/return preferences, returns on
competing investments, expected inflation, etc.)
• Note that the intrinsic value of an asset can be, and often is, different
for each individual (that’s what makes markets work)
Intrinsic Value and Stock Price
• The most important issue in the share valuation process is
the future.
• Institutional and individual investors estimate intrinsic value
to help determine which stocks are attractive to buy and/or
sell.
• Stocks with a price below (above) its intrinsic value are
undervalued (overvalued).
Dividend
• Dividends are not a liability of the firm until a dividend has
been declared by the Board
• Firms are not obligated to pay the dividend
Common Stock Valuation:
Dividend Discount Model
 Valuation

• The value of a stock today (its current price) is in theory equal to the
present value of all future dividends plus that of the selling price.
 Example
The expected dividend per share on the equity share of
Roadking Limited is Rs 2.00. The dividend per share of Roadking
Limited has grown over the past five years at the rate of 5 % per
year. This growth rate will continue in future. Further, the market
price of the equity share of Roadking Limited, too, is expected to
grow at the same rate. What is a fair estimate of the intrinsic
value of the equity share of Roadking Limited if the required rate
is 15% ?
 Problem
• That was the generalized multi-period valuation formula –
which is general enough to permit any dividend pattern –
constant, rising, declining or randomly fluctuating.
• But dividends may grow at different rates.
• For practical applications, it is helpful to make simplifying
assumptions about the pattern of dividend growth.
Notations
P
^ 0 = Actual market price of the share
P0 = Intrinsic value

rs = Required rate of return

g = Growth rate.
D0 = Dividend today.
D1 = Expected dividend in year 1

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 Assumptions / Generalization

There can be three cases:

1. Normal/ Constant growth case
2. Zero growth case
3. Supernormal growth case
Constant Growth Model
Assumptions
• The stock price is expected to grow at this same rate.
• The expected dividend yield is constant
• The expected capital gain is also constant and it is equal to g.
• Also known as Gordon Model (Myron J Gordon)
 Constant Growth Model
• Infinite period model assumes a constant growth rate for estimating
future dividends (Gordon Method)
Implications of this Model

• If D1 increases, then P0 increases.

• If r decreases, then P0 increases.
• If g increases, then P0 increases.
Gordon Growth Model
• Widely used valuation methods
• The required rate of return and growth should reflect the long term
expectation
• Therefore model values are very sensitive to both the required rate of
return and expected dividend growth rate
Requirement
• Expected Dividend
• Growth Rate
• Required Rate of Return
Estimation of Growth
• The growth rate in dividends (g) can be
estimated in following ways.
 Using the company’s historical average growth rate.
 Using an industry median or average growth rate.
 Sustainable growth
 Sustainable Growth
• Company’s rapid growth and increased sales are dependent on financial
resources.
• However, to grow, firm will need new assets, which can be financed
through an increase in owners’ equity (retained earnings).
• The sustainable growth is the one when a company’s
maximum growth rate in sales/ revenues achieved using internal financial
resources, while not having to increase debt or issue new equity.
• It tells us how fast the firm can grow, without increasing financial leverage.
The Sustainable Growth Rate

Return on Equity (ROE) = Net Income / Equity

Payout Ratio = Proportion of earnings paid out as dividends
Retention Ratio = Proportion of earnings retained for investment

Suppose a company has an ROE of 15% and a dividend payout ratio

of 40%.
ROE: 0.15×(1−0.60 Dividend Payout Ratio)SGR: 0.06 Or 6%​
Required rate of return: beta = 1.2, Rm = 12%, rRF = 7%,

Use the SML to calculate rs:

rs = rRF + (Rm- rRF )bFirm
= 7% + (12%-7%)X (1.2)
= 13%.

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For a constant growth stock:

D1 = D0(1+g)1
D2 = D0(1+g)2
Dt = D0(1+g)t

If g is constant and less than rs, then:

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Projected Dividends
• Company just paid Dividend (D0 =2)
• Growth (g)=6%
Calculate expected dividend
• D1 = D0(1+g) = 2(1.06) = 2.12
• D2 = D1(1+g) = 2.12(1.06) = 2.2472
• D3 = D2(1+g) = 2.2472(1.06) = 2.3820

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Intrinsic Stock Value: D0 = 2.00, rs = 13%, g = 6%.

Constant growth model:

^ D0(1+g) D1
P0 = =
rs - g rs - g

2.12
=
0.13 - 0.06
2.12
= Rs.30.29.
0.07
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Expected value one year from now:
• D1 will have been paid, so expected dividends are
D2, D3, D4 and so on.
Rearrange model to rate of return form:

^ D1 ^ D1
P0 = to rs = + g.
rs - g P0

^
Then, rs = 2.12/30.29 + 0.06
= 0.07 + 0.06 = 13%.

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What happens if g > rs?

^ D0(1+g)1 D0(1+g)2 D0(1+rs)∞

P0 = + +…+
(1+rs)1 (1+rs)2 (1+rs)∞

If g > rs, then (1+g)t ^

> 1, and P0 = ∞.
(1+rs)t

So g must be less than rs to use the constant growth

model.
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2. Zero growth case: What would P0 be if g = 0?

The dividend stream would be a perpetuity.

0 rs=10% 1 2 3

Po=? Rs.10 Rs.10 Rs.10

D1 Rs.10
P0 = = = Rs.100
rs-g 0.10 - 0
Multistage Dividend Growth Model
• For many companies, growth falls into three phases.
• In the growth phase, a company enjoys an abnormally high growth rate in earnings
per share, called supernormal growth.
• FCF generally negative due to heavy expansion of business
• Dividends are secondary
• In the transition phase, earnings and growth slows due to the competitions.
• Positive FCF
• Increasing Dividend
• In the mature phase, the company reaches an equilibrium in which factors such as
earnings growth and the return on equity stabilize at levels that can be sustained
long term.
• Analysts often apply multistage DCF models to value the stock of a firm with
multistage growth prospects.
Method of computing intrinsic value of the stock - Super normal
growth

• Estimate the expected dividends for each year during the period of non constant
growth.

• Find the price of the stock at the end of the non-constant growth period, at which
point it has become a constant growth

• Add these two components to find the intrinsic value of the stock.
Non-constant growth followed by constant
growth (D0 = 2):

rs=13%
0 1 2 3 4
g = 30% g = 30% g = 30% g = 6%
2.60 3.38 4.394 4.6576

2.3009
2.6470
3.0453
46.1135 = 66.5371 = Terminal
^ Value41
54.1067 = P0
Expected Dividend Yield and Capital Gains
Yield (t = 0)

At t = 0:
D1 2.60
Dividend yield = = = 4.8%.
P0 54.11

CG Yield = 13.0% - 4.8% = 8.2%.

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 Expansion Plan: Valuing the entire firm
• In the previous section, it is assumed that all firms pay dividends.

• Although most larger firms do pay a dividend, some firms, even

highly profitable ones such as Microsoft, have never paid a
dividend.

• How can the value of such a company be determined?

Expansion Plan: Valuing the entire firm
• Similarly, suppose you start a business, & someone offers to buy
it from you. How could you determine its value?

• In such cases, we cannot use the dividend growth model.

However we could use the total company, or corporate valuation
model.

• For the purpose, we need to determine free cash flow.

Corporate value model
• Also called the free cash flow method. Suggests the value of the
entire firm equals the present value of the firm’s free cash flows.
• Remember, free cash flow is the firm’s after-tax operating income
less the net capital investment
• FCF = NOPAT – Net capital investment
We Use Free Cash Flow of Equity Approach
• FCFE= NOPAT– Net investment in OC

• Suppose, free cash flows (FCF) are:

• Year 1 FCF = - Rs. 5 million.
• Year 2 FCF = Rs. 10 million.
• Year 3 FCF = Rs. 20 million.
• FCF grows at constant rate of 6% after year 3.
• The corporate cost of capital, is 10%.
• The company has 10 million shares of stock outstanding.
• Debt Rs.40 million
• Find current value of operation & price per share.
Find the value of operations by discounting the free cash flows at the cost of
capital.

0 1 2 3 4
ro=10% g = 6%

FCF = -5m 10m 20m 21.2m

-4.545
8.264 Vop3=FCF4/(ro- g)

15.026
398.189
• Find the price per share of common stock?
Value of Equity (E)= VoP-VoD
Where
• VoP= Value of Operations
• VoD= Value of Debt

= Rs.416.934m - Rs.40m = Rs.376.934 m.

Price per share= Value of Equity/ No of Shareholders

Price per share = Rs. 376.94 m / 10 m = Rs. 37.69.

What is market equilibrium?
• In equilibrium, stock prices are stable and there is no general
tendency for people to buy versus to sell.
• In equilibrium, two conditions hold:
• The current market stock price equals its intrinsic value (P0 = P0).
• Expected returns must equal required returns.

^
Intrinsic Value and Market Price
• Intrinsic Value
– Self assigned value of future discounted cash flows
– Requires understanding of how markets works
Trading Signal
– IV > MP Buy
– IV < MP Sell
– IV = MP Hold or Fairly Priced
Misconceptions about Valuation
Myth 1: A valuation is an objective search for true value
• Truth 1.1: All valuations are biased. The only questions are “how much” and in
which direction.
• Truth 1.2: The direction and magnitude of the bias in your valuation is directly
proportional to who pays you and how much you are paid.

Myth 2.: A good valuation provides a precise estimate of value

• Truth 2.1: There are no precise valuations.
• Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
Myth 3: . The more quantitative a model, the better the valuation
• Truth 3.1: Simpler valuation models do much better than complex ones.