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VALUATION OF EQUITY SHARES

To realize the value of ONE YEAR. ask a student who failed a grade To realize the value of ONE MONTH.. ask a mother who gave birth to a premature baby To realize the value of ONE WEEK ask the editor of a weekly newspaper To realize the value of ONE HOUR ask the lovers who are waiting to meet.

To realize the value of ONE MINUTE.. ask a person who missed the train. To realize the value of ONE SECOND. ask a person who just avoided an accident. To realize the value of ONE MILLISECOND.. ask the person who won a silver medal in the Olympics.

Why

Valuation. Valuation: Act of determining the value of something. Features: True worth, Futuristic prospective, Time & Purpose specific. Price: What you pay to get something. Value Vs. Price. Valuation- dynamic and forward looking.

History of valuation
Before 1930: Assumptions: (i) Earning would grow at historical growth rate. (ii) Value of the assets of the business remain same. Benjamin Graham proposed Asset based approach (value of the assets at their replacement cost) John Blurr William (1938): Theory of Investment Value Anticipation of future returns drives the investors to purchase an assets. Present value of such future returns should be the price the investor would be willing to pay.

Balance Sheet method


1. Book value method: The book value per share is simply the net worth divided by number of shares. Advantage: The book value is firmly rooted in financial accounting, and hence can be established easily. Limitations (a) This is based on historical balance sheet figures. (can be divergent from current economic value & rarely reflects the earning power). (b) Can book value represents the floor for the stock price?

2. Liquidation value: This represents the amount of money that could be realized by selling the assets, repaying the debt. Limitations: (a) In reality the notional liquidation value is differ from actual. (b) This value does not reflect the earning capacity. Replacement cost: This is the ratio of current market value of the company divided by replacement costs of all the assets of that company. A low q ratio is implies that the stock is undervalued and high q ratio is implies that the stock is overvalued.
3.

Dividend Discount Model


According to this model the value of a security is equal to the present value of the future expected dividend. Why only dividend?
THE STABLE GROWTH DDM: GORDON GROWTH MODEL The Model: Value of Stock = DPS1 / ( r - g)

Where, DPS1 = Expected Dividends one year from r = Required rate of return for equity investors g = Annual Growth rate in dividends forever

Two insights for stable growth

First: since the growth rate in the firms dividends is expected to last forever, the firms other operating measures (including revenue & earnings) can also be expected to grow close the same rate. Second: issues related to what growth rate is reasonable as a stable growth rate.

A BASIC PREMISE
This infinite growth rate cannot exceed the growth rate for the overall economy (GNP) by more than a small amount (1-2%) Estimate for the US Upper end: Long term inflation rate (5%) + Growth rate in real GNP (3%) =8% Lower end: Long term inflation rate (3%) + Growth rate in real GNP (2%) = 5% If the company is a multinational, the real growth rate will be the growth rate of the world economy, which is about one percent higher. The inflation rate used should be consistent with the currency being used in the valuation

Cyclical Firms

Expected to have year-to-year swing in earnings & hence in growth rate but has an average growth rate say 3% can be used in Gordon Model without loss of generality.
The Expt. Growth rate in EPS = RoE (1- payout ratio)

WORKS BEST FOR


firms with stable growth rates firms which pay out dividends that are high and approximate FCFE firms with stable leverage

Some obvious candidates for the Gordon Growth Model


Regulated Companies, such as utilities, because I. their growth rates are constrained by geography and population to be close to the growth rate in the economy in which they operate II. they pay high dividends, largely again as a function of history III. they have stable leverage (usually high)

Large financial service companies, because

Their size makes its unlikely that they will generate extraordinary growth. Free cash flows to equity are difficult to compute. They pay large dividends. They generally do not have much leeway in terms of changing leverage.

Limitations:
1. 2.

If the firm does not pay any dividend. If the growth rate is equal or more than the required rate then the value of the stock become infinite or negative.

Two Stage Dividend Discount Model


The model is based upon two stages of growth, an extraordinary growth phase that lasts n years, and a stable growth phase that lasts forever after that.
Extraordinary growth rate: g% each year for n years Stable growth: gn forever
|____________________________________________|____________________>

Value of the Stock = PV of Dividends during extraordinary phase + PV of terminal value Example:

X Ltd. is a growing company and assume for the first 5 years it will maintain similar growth prospect. During first 5 years the pay-out ratio would be 12%. The current of RoE is 21%. Beyond 5 years the competitive pressure will bring down RoE to 11%. Also assume a stable growth rate 5% during this period. The beta of X Ltd. is 1.3 for the first 5 years and beyond 5 years it will decline to 1.1. The average risk free rate in the economy is 5% and risk premium is 4%. The current EPS is Rs.11.30. Calculate the value of X Ltd. using DDM.

H Model
This model was presented by Fuller & Hsia (1984). Assumption; Earning growth rate starts at a high initial rate (ga) and decline linearly over extraordinary growth rate to a stable growth rate (gn). Also assume dividend payout and cost of equity are constant over time and not affected by shifting growth rate.

Three Stage DDM

Z Ltd. an Indian firm registering a rapid growth & reported RoE is 26% current year & paid out DPS of Rs.3.76 and reported EPS Rs.25.51. Lets assume its protected position will allow the company to maintain its current RoE & retention ratio for the next 5 years. The beta of the company during the high growth period is 1.55, the Rf is 6% & risk premium is 7%. After 5 years, assume the beta will decline to 1.15 in stable growth (which will occur after 10 years) & risk premium will drop to 5.5%. Also assume competitive pressure will pull down RoE to 12% by the 10th year. The estimated stable growth rate is 4.5%.

Value during high growth phase


Yr EPS Expt. Pay-out DPS Growth ratio rate Cost of Equity Cumlati PV of ve Ke DPS

Current

25.51

1
2 3 4 5

31.20
38.12 46.57 56.89 69.51

22.17%
22.17% 22.17% 22.17% 22.17%

14.74%
14.74% 14.74% 14.74% 14.74%

4.60
5.62 6.87 8.39 10.25

16.85%
16.85% 16.85% 16.85% 16.85%

1.1685
1.3654 1.5955 1.8643 2.1784

3.94
4.12 4.31 4.50 4.71 21.68

Value during transition phase


Yr EPS Expt. Pay-out DPS Growth ratio rate 18.64% 24.29% 20.03 Cost of Equity 15.95% Cumula PV of tive Ke DPS 2.5259 7.93

82.46

7
8 9 10

94.92
105.92 114.44 119.53

15.11%
11.58% 8.05% 4.5%

33.84%
43.39% 52.94% 62.5%

32.12
45.96 60.58 74.71

15.05%
14.15% 13.25% 12.33%

2.9060
3.3172 3.7568 4.22

11.05
13.86 16.13 17.70 66.67

Patterns of Dividend Policy


Dividends are sticky Dividends follows earnings Buyback as an alternative of dividends Strength of DDM: Simplicity & Intuitive logic Need fewer assumptions Conservative estimate of floor value

Why firm may pay out less than available?


Desired stability Future investment need Tax factor Signaling Managerial self interest.

Relative Valuation
The objective is to value an asset based on how similar assets are currently priced by the market. In relative valuation, we are making a judgment on how much an asset is worth by looking at what the market is paying for similar asset. Two Components: To value assets on a relative basis, prices have to be standardized, usually by converting price into multiples of some common variables. To find similar assets, which is challenging, since no two assets are exactly alike.

Popularity & Pitfalls


Less time & resource intensive Easy to explain & sell Easy to defend (in DCF long lists of explicit assumptions) Market imperative (reflect more the current mood of the mkt not the intrinsic value) Key variables: risk, growth, cash flow potentials are ignored.

Basic Steps to use multiple

Multiples are defined differently by different analysts. Consistency in numerator & denominator. Types of multiple. Sense of high value & low value for the multiple in the market. (distributional characteristic like mean, median, S.D. & S.E.)

Price Earning Multiplier Approach


Two inputs MPS and EPS. PE : Price per share divided by earning per share. The variation comes in earning part. Forward PE: Stocks current price divided by expected EPS. Forward PE will be lower than current PE if earnings are expected to grow in future. Trailing PE Vs. Forward PE

Interpreting PE
(i)

(ii)

Very Low PE after long bull run. Check out dividend payout ratio. Low PE (less than 5) is considered as underpriced? High PE: Standalone case. Turnaround case.

Company Tata Steel Infosys SBI L&T

PE Multiple 7.96 23.71 17.49 26.72

Industry Average 9.6 22.10 8.97 15.38

Dr. Reddy
NTPC

24.57
15.96

11.43
18.17

Price Earning Growth

(i) (ii)

Calculation: Current PE ratio / Expected earning growth. (not operating earnings) PEGs utility lies in that it urges you to look forward. The number are around 1, either a little more or somewhat less. Thumb rule: PEG around 1 or less for large firms. PEG 0.5 for mid & small firms.

Dividend Yield
Calculation: Dividend per share / price per share. It tells you what income flow you are getting on your holding & gives strong downside support. *** Always be calculated on current market price not your price of purchase. Check: (i) Business must atleast not shrink in future. (ii) Past dividend record. Rule of thumb: More than 1.5 times of the market yield.

Sample of High dividend stocks


Company HCL Info ITC Castrol Chennai petro VST India Prism Cement Binani Cement Dividend 5 Yrs avg. Yield Payment 7.98 5.83 5.51 5.06 4.83 4.75 4.21 45% 49% 75% 25% 56% 18% 21% CAGR Sales (%) 36% 18% 15% 26% 11% 50% 40% CAGR PBDIT (%) 30% 21% 23% 11% 6% 69% 42%

Price to Book Value Ratio:


Calculation: Market Price/Book value per share.

Drawbacks: (i) Not of much help when it is Greater than 1. (if less than 1 means either undervalued or company is in a declining business.) (ii) If the firm does not have significant fixed assets the book value may not be meaningful. e.g. FMCG, IT. (iii) Meaning for banking sector. (needs to maintain minimum CAR which act as a capital to grow).

Price to Sales Ratio


Calculation: Current stock price/ Revenue per share. Sales is more strictly defined figure than earning. PSR essentially reflects what the market is willing to pay per rupee of sales. Advantages: (i) Unlike earnings, revenue for a company is difficult to manipulate. (ii) This ratio can never be negative. (iii) The ratio is not influenced by the accounting methods.

Comparable Firm Approach


Analysis of firm. Identification of comparable firm. Comparison & analysis. Valuation of firm.

Compute the value of the Zigma Ltd. using the comparable firm approach . Sales Rs.100 cr. PAT Rs.15cr. BV Rs.60cr. The analyst feels that 50% weightage should be given to earning in the valuation process. Sales and Book value may be given equal weights. The analyst has identified three firms which are comparable to the operation of Zigma Ltd.

Particulars Sales PAT Book Value Market Value

A Ltd 80 12 40 120

B Ltd. 120 18 90 150

C Ltd. 150 25 100 240

Solution
A Ltd. P/E P/BV P/Sales 10.00 3.00 1.50 B Ltd. 8.33 1.66 1.25 C Ltd. 9.60 2.40 1.60 Average Parameter 9.31 2.35 1.45 15 60 100 Value 139.65 141.00 145.00

The weighted average = (139.650.50)+(141.000.25)+(145.000.25) = Rs.141.32 crore

Variables to be considered in relative valuation


Capacity to generate cash flows Expected growth in these cash flows Uncertainty associated with these cash flows.

Intuitively, the firm with high growth, less risk and great cash flow generation potential should trade at a higher multiple than other firms with opposite trait.

Comparable Firms

A comparable firm is one with cash flows, growth potential and risk similar to the firm being valued. Relationship between multiples and fundamentals.

Relationship between multiples & fundamentals

A firm reported net income Rs.15 million on revenue of Rs.150 million last year. The net worth is Rs.75 million. The firm paid 10% of its earnings as dividend Analysts expect RoE to be continued at 20%. The high growth would expected to continue for next 5 years After 5th year the expected growth rate would drop to 4%. Expected beta of the firm would 1 in the long run and risk free rate is 5% and risk premium is 4%.

Relationship between multiples & fundamentals: Growth rate effect


Growth rate during high growth period (%) 0% 6% 10% 14% 18% 22% 26% 30% 34% P/E 11.20 14.93 17.93 21.40 25.38 29.94 35.13 41.03 47.69 PEG 2.49 1.79 1.53 1.41 1.36 1.35 1.37 1.40 P/BV 2.24 2.99 3.59 4.28 5.08 5.99 7.03 8.21 9.54 P/S 1.12 1.49 1.79 2.14 2.54 2.99 3.51 4.10 4.77

38%
40%

55.20
59.29

1.45
1.48

11.04
11.86

5.52
5.93

Growth period effect (cash Flow potential)


Growth year PE PEG P/BV P/S

0
1 2 3

16.64
18.12 19.73 21.46

0.92
1.01 1.10 1.19

3.33
3.62 3.95 4.29

1.66
1.81 1.91 2.15

4
5 6 7

23.34
25.38 27.58 29.97

1.30
1.41 1.53 1.66

4.67
5.08 5.52 5.99

2.33
2.54 2.76 3.00

8
9 10

32.55
35.35 38.38

1.81
1.96 2.13

6.61
7.07 7.68

3.26
3.53 3.84

Risk effect
Beta Cost of Equity PE PEG P/BV P/S

0.50
0.75 1.00 1.25

7.00%
8.00% 9.00% 10.00%

45.91
33.04 25.38 20.32

2.55
1.84 1.41 1.13

9.18
6.61 5.08 4.06

4.59
3.30 2.54 2.03

1.50
1.75 2.00 2.25

11.00%
12.00% 13.00% 14.00%

16.74
14.09 12.05 10.44

0.93
0.78 0.67 0.58

3.35
2.82 2.41 2.09

1.67
1.41 1.20 1.04

2.50

15.00%

9.14

0.51

1.83

0.91

Discounted Cash Flow Model

Free Cash Flow to Equity = Net Income Capital Expenditure in Working Capital Principal Debt Repayment + New Debt Issue.

Free Cash Flow to Firm = Operating Income less adjusted tax* + Depreciation Capital Expenditure in Working Capital in other asset. * EBIT Less Adjusted tax.

Step I: Determine the explicit forecasted period & stabilize growth rate. Step II: Calculation of cost of capital. Step III: Computation of continuing value. Step IV: Computation of value under DCF method.

Year

Sales (Rs.Lk) 4653 4736 5095 5931

Net Depn CapX Income 256 309 358 414 481 112 128 148 163 180 -194 -299 -318 -377 -499

W.C.

Princip. New Repay Debt -86 -8 -9 0 -3 0 0 3 0 0

FCFE

2000 2001 2002 2003

-32 -55 -98 -118 32

56 75 84 82 191

2004
2005 2006 2007 2008 2009 2010

6743
7652 8005 10876 12287 14322 15630

579
725 887 992 1116 1274

194
230 263 308 376 442

-674
-712 -1218 -1384 -977 -768

-127
-216 -187 -539 -796 -883

0
0 0 0 0 0

0
0 0 0 0 0

-28
27 -255 -623 -281 65

Year

Growth Rate

FCFE

PV of FCFE

2011 2012 2013 2014 13% 13% 13%

280.0 316.4 357.5 404.0

259.3 271.3 283.8 297.0

2015
2016 2017 2018

13%
13% 12% 11%

456.5
515.9 577.8 641.3

310.7
325.1 337.1 346.5

2019
2020 2021 2022 2023

10%
9% 8% 7% 6%

705.5
769.0 830.5 888.6 941.9

352.9
356.2 356.2 352.9 346.3

Constant Growth period Value = 941.9 (1.06)/(0.08-0.06) = Rs.49,921

PV of Constant Growth Period Value =Rs.8,356

How long a firm will be able to maintain high growth?


Size of the firm Existing growth rate and excess returns Magnitude of competitive advantage

Benjamin Graham Formula

Value= EPS (8.5+2g)

Eg. SBI: Price = 2276; EPS=130.15 g = 4.5% SBI need to grow at 4.5% next 7-10 years to sustain its respective price.