Equity 2

Equity Investment – II
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Mapping to Curriculum
 Reading 36: Overview of Equity Securities

 Reading 37: Introduction to Industry and Company Analysis
 Reading 38: Equity Valuation – Concepts and Basic Tools

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc. 2
Reading 36: Overview of Equity Securities

Learning Outcomes
The candidate should be able to:

a. Describe characteristics of types of equity securities;
b. Describe differences in voting rights and other ownership characteristics among different equity
classes;
c. Distinguish between public and private equity securities;
d. Describe methods for investing in non-domestic equity securities;
e. Compare the risk and return characteristics of different types of equity securities;
f. Explain the role of equity securities in the financing of a company’s assets;
g. Distinguish between the market value and book value of equity securities;
h. Compare a company’s cost of equity, its (accounting) return on equity, and investors’ required rates
of return.

Types of Equity Shares
Types of Equity
Shares
Callable vs
Common Preference
Putable
Equity Shares
Shares
Non- Non-
Cumulative Participating Convertible
cumulative participating

Common Equity Shares
 Common equity shares represent an ownership stake in the company and is the most predominant
form of equity.
 It is also known as the real owners of the business.
 Common shares are eligible for –
a) Annual profits after paying interest for debt and preference dividend (EAESH); and
b) Liquidation dividend after paying principle for debt and preference share capital.
 Common shares may be putable or callable.
Other Important Points:

1. Proxy Voting allows a designated party to vote on a shareholder‘s behalf in his absence.
2. Voting method –
a) Statutory voting is when each shareholder has only one vote and
b) Cumulative voting is when the shareholders can direct their total voting rights to a single candidate
as opposed to evenly allocating them to all the candidates.
 Total voting rights are dependent on the number of shares owned, multiplied by the number
of board directors who need to be elected.

Callable vs Putable Common Shares
Callable Shares:
 Shares that can be called back (re-purchased by the company) are called callable shares.
 The basic features of callable shares and bonds are similar.
 Since the risk of the investor is more, callable shares trade at a relatively lower value as compared
to a normal share.
 To compensate the investor for this extra risk taken, higher dividend yield is given.
Putable Shares:
 Shares which can be sold back by the investors to the company are called putable shares.
 The basic features of putable shares and bonds are similar.
 Since the risk of the investor is less, putable shares trade at a relatively higher value as compared
to a normal share.
 The dividend yield is generally lower in these shares.

Different Classes of Common Shares
 The common shares can be divided into more than one homogenous class.
• For instance, Tata Motors in India has more than one class of common shares.
 One class may have comparatively greater voting powers.
 Any particular class may have a prior claim over the firm’s assets in terms of:
a) Annual dividends and
b) Liquidation dividends.
 Every company needs to decide the rights and obligations of each class at the time of issue itself.
 This information is available on the website of the Exchange Regulator, and on the company’s
website.

Preference Shares
 Shares that include the following two preferences over the common shares are called preferred
stock.
1. Annual Dividend is paid before being paid to the common shareholders.
2. Liquidation Dividend is paid before being paid to the common shareholders.
 Voting: Do not receive operating performance and cannot vote.
 They have the characteristics of both debt securities and common shares:
• Amount of return is fixed (like Debt);
• While the certainty of payment is not fixed (like Equity).
Special Categories of Preference Shares:

1. Cumulative – Dividends, if not paid for a particular year, does not lapse. It is accumulated and
whenever paid, it is paid cumulatively for the all the previous periods.
2. Non-cumulative – This has no such provision.

Preference Shares
3. Participating shares – These are a step closer to the equity in their basic nature.
• These are entitled to some extra compensation if the company has made a large amount of annual
profits.
• At the time of liquidation also, these shares are entitled for some claim over and above their share
capital contribution, if the company has surplus assets over its liabilities.
4. Non-participating preference shares – These do not give the shareholders any right to get any
share from the profits of the company.
5. Convertible shares – These allow the shareholders to convert their shares into common shares.
Advantages: These shares –
• Allow investors to earn a higher dividend if they invested in the company’s common shares;
• Allow investors the opportunity to share the profits of the company;
• Benefit the investors from the price increase of the common shares through the conversion option;
• Have less volatile price than that of the underlying common shares, because the dividend payments
are known and are more stable; and
• Are better for the investors to get funding of risky venture capital and private equity firms.

Public vs Private Equity
Public Equity Shares:

 These shares can be bought and sold by any investor.
 These are issued and traded in the public markets and exchanges.
 Public Equity Market: Place where public shares can be bought and sold is a Public Equity Market.
This:
a) Allows companies to raise larger amounts of money;
b) Provides liquidity for trading in the shares of the company;
c) The global public equity market is very large as compared to the global private equity markets;
d) Public markets incentivize companies to adopt best practices in corporate governance.
 Management often feels the pressure of focussing on short-term gains, instead of operating the
company in a long-term sustainable revenue and earnings growth mode.

Public vs Private Equity (Cont.)
Private Equity Shares:

 These shares cannot be bought and sold by any investor.
 These can be purchased only by the ones to whom it is offered (by invitation).
 Since public is not involved at large, there is No active secondary market, thus it is difficult to price.
 Size of the private equity market is smaller in comparison to that of the public equity market.
 Management is more likely to concentrate on the long-term sustainable growth strategies,
instead of focussing on the short-term growth.
 There are three types of private equity investments:
i. Venture capital (VC);
ii. Leverage buyouts or management buyouts (LBO and MBO); and
iii. Private investments in public equity (PIPE) issued by a public company to a private investor after
approvals –
‒ High-growth opportunity;
‒ Large amount of debt and
‒ Financial distress.

International/Non-domestic Equity Markets
 Globalization and the integration of the international economy, with the increased use of
technology in all financial transaction, has made foreign investments an important part of any
country‘s economy.
 Over the past two decades there have been three dominant trends:
1. Increasing number of companies investing in foreign markets (GM of the US investing in India);
2. Number of companies listed in foreign equity markets has increased (Infosys is listed in NASDAQ) and
3. Increase in the number of companies that are dual listed (Infosys is listed in India as
well as in the US).
 Advantages of being listed in a foreign country:

1. Increased publicity of the firm‘s products and services;
2. Increased liquidity due to access to a wider base of investor and
3. Greater transparency due to strict listing requirement.

Methods of Investing in International Equity Market
Direct Investing (a US firm buying equity shares in UK of a firm listed in LSE):

 The straight forward way to do this is to buy/sell securities directly in the foreign markets;
 Investors need to be aware of the local trading rules, clearing and settlement regulations, and
procedures; and
 This often leads to more volatility and less accountability.
Depository Receipts (DR) (a US investor buying a security in US representing a company listed in

LSE):
 These trade as normal shares and represent an economic interest in a foreign company;
 The depository bank acts as a custodian and as a registrar; handles dividend payments, stock
splits, etc.;
 The short-term valuation discrepancies between shares traded on multiple exchanges, often
represent an arbitrage opportunity.
 A DR can be:
• Sponsored (initiated by the company) or
• Unsponsored (not initiated by the company, but by any other third party).

Types of Depository Receipts
1. Global Depository Receipts (GDR): These are issued by companies globally, excluding the US
market and the issuer’s home country.
• Note: It is not listed in the US, but is denominated in the USD as it is a convenient medium of exchange
internationally.
• The GDRs are not subject to foreign ownerships and capital flow restrictions imposed by the home
country.
2. American Depository Receipts (ADR): These are denominated in the USD and enlisted on the
American exchanges.
• These are based on the security of a non-US based company that plans to raise capital from the US.
• The ADRs are issued on the ADS shares, the former are traded in the firm’s local market.
3. Global Registered Shares (GRS): Common shares that are listed on the stock exchanges around
the world in different currencies are the GRS.
4. Basket of Listed Depository Receipts (BLDR): An ETF which is based on a portfolio of depository
receipts is known as BLDR.

Risk and Returns Characteristics of Equity Securities
1. Preference shares are less risky than the common shares and the least amount of return is known.
2. Non-cumulative PS is more risky than the cumulative PS, where the dividend for a year once
ignored, lapses forever.
3. Putable shares are less risky than the callable shares (investor’s point of view) and can be sold
back to the company anytime, even in the absence of a buyer in the secondary market.
4. Callable shares are less risky than Putable shares (from the issuer’s point of view) and can be
called back any time, as per the viability.
5. International investment is more risky than the domestic investment. Foreign exchange risk is added
to the equity risk:
• An equity security‘s total return is calculated as follows:
Dt
𝑇 𝑜𝑡𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 ( 𝑅 𝑡 ) =P t − P t − 1+
P t −1
• Thus, the returns from an equity investment comprise of the following:
i. Price appreciation and
ii. Dividends.
• For foreign investors, foreign exchange gains is another source of income.

Market Value And Book Value of Equity Securities
 The book value of a security reflects the value in the balance sheet of the company and is equal to
the BV of Assets – BV of Liabilities.
 Market Value is the price at which the traders become all willing to transact.
 Book Value is the result of historical operating and financing decisions of its management.
 The market value represents not only the historical operating and financing decisions, but also the
collective assessment of the future performance of the company.
 For a good performing company, market value is often higher than its book value.
 The price-to-book ratio is often used to analyse companies and it reflects the investor‘s outlook of
the industry, through:
• Value Stocks: Companies with low Price to Book Value ratio and
• Growth Stocks: Companies with high Price to Book Value ratio.

Returns Terminologies associated with Equity
1. Accounting Return on Equity (also called as Return on Equity):
𝑅𝑜𝐸 𝑡= ( 𝑁𝐼 𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐵𝑉𝑡
¿ )
• Average BV = (Opening BV + Closing BV) / 2.
• If Closing BV is not available, we can take only the OPENING in the Denominator.
• DuPont Analysis done in FRA explains the reasons for a high or low ROE.
• Greater the ratio, the better it is for the firm.
2. Expected Cost of Equity:
𝐾 𝑒= ( 𝐷1
𝑃0
+𝐺 )
• It is the return which an investor can EXPECT to get, with the given ACTUAL price of the equity share
of the day (Po).
• Return for an equity investor includes dividend yield + capital gain.
• It is the rate (IRR) which will equate PV of future cash inflows to the ACTUAL price of the share of the
day.

Returns Terminologies associated with Equity (Cont.)
3. Required Return on the Equity:
𝑅𝑒=R f +𝛽[𝑅 ( 𝑅𝑚 ) −𝑅𝑓 ]

• This is the minimum return which an investor may want to invest in a particular security.
• This is NOT based on the ACTUAL price in the market.
• Future Cash Flows when discounted by the Minimum Required Return equates to the Justified or
Intrinsic or Fair Value of the security.
• This Fair Value is compared to the Actual Price, then the suitable investment action (buy or sell) is
taken.
• This is explained in the Securities Market Line under Portfolio Management.
In case of Equilibrium, required return = Expected Return.

Therefore, Actual Price = Fair Value.

Summary of Reading 36
 Common equity shares represent an ownership stake in the company and is the most predominant
form of equity.
 Shares which can be called back (re-purchased by the company) are called callable shares.
 Shares which can be sold back by the investors to the company are called putable shares.
 Shares that include two preferences (annual and liquidating dividends) over the common shares are
called preferred stock.
 Public equity shares are those which can be bought and sold by any investor.
 Private equity shares are those which can be purchased only by the ones to whom it is offered (by
invitation).
 Depository receipts are securities that trade like ordinary shares on a local exchange, but which
depict an economic interest in a foreign company.

Knowledge Check

Knowledge Check
1. Which of the following is least likely to be correct, regarding the participating preference shares?
A. Smaller and riskier firms issue participating preference shares
B. Participating preference shareholders are paid only fixed dividends
C. Participating preference shareholders may receive a value greater than the par value of the preferred
stock on liquidation
2. Which of the following is least likely a characteristic of private equity as compared to public equity?
A. Less liquidity
B. Lower reporting cost
C. Stronger corporate governance
3. Which of the following is most likely a characteristic of cumulative voting?
A. Through cumulative voting, minority shareholders have more proportional representation on the board
B. Under cumulative voting, each share is allotted one vote at the time of the election of each member of
the board of directors
C. Under cumulative voting, shareholders can vote for only one candidate

Solution
 Solution: 1. B.
They have a share in the firm’s profit, so they can receive extra dividends in addition to the fixed
rate of dividend.
 Solution: 2. C.
Compared to the public equity, a private equity has a weaker corporate governance, lower reporting
cost, and less liquidity.
 Solution: 3. A.
Under cumulative voting, shareholders can allot the votes they hold to more than one candidate of
their choice. Hence, it makes it possible for the minority shareholders to have better proportional
representation on the board.

Knowledge Check
4. Which of the following statements with regard to country risk premium is the most accurate?
A. Country risk is the result of expected economic and political events
B. Exchange rate risk is very nominal and can be ignored
C. Firms in different countries take significantly different financial risk
5. Which of the following is the most frequently used in case of financing venture capital and private
equity firms?
A. Debt
B. Common stock
C. Convertible preference shares
6. For a company, ABC Ltd, ROE over the years has been increasing. Which of the following is the
least likely a cause of worry for the equity holders on this issue?
A. The company has repurchase shares by issuing debt
B. Book value of equity has decreased more proportionately than the decrease in the net income
C. Book value of equity has increased less proportionately than the increase in the net income

Solution
 Solution: 4. C.
Country risk arises from unexpected (not expected) economic and political events. Exchange rate
risk must always be taken into account.
 Solution: 5. C.
The conversion feature gives the compensation for the additional risk taken when investing in such
firms.
 Solution: 6. C.
When a firm issues debt and repurchase shares, although the ROE increases, yet the firm becomes
more risky. Hence, the equity holders ask for more return. The ideal situation in such a case is when
the net income increases more proportionately than the increase in the book value of the equity.

Knowledge Check
7. Calculate the total return on a share of equity using the following data:
Purchase price: $50
Sale price: $42
Dividend paid during holding period: $2
A. 12.0%
B. 14.3%
C. 16.0%
8. Which of the following statements is the most accurate to describe a company’s book value?
A. Book value increases when a company retains its net income
B. Book value is usually equal to the company’s market value
C. The ultimate goal of management is to maximize book value
9. A company’s cost of equity is often used as a proxy for investors’:
A. Average required rate of return
B. Minimum required rate of return
C. Maximum required rate of return

Solution
 Solution: 7. A.
Solution:
The formula states Rt = (Pt – Pt–1 + Dt)/Pt–1.
Therefore, total return = (42 – 50 + 2)/50 = –12.0%.
 Solution: 8. A.
A company’s book value increases when a company retains its net income. The book value can be
different from the market value and the aim of the management is always to maximize the market
value of the stock.
 Solution: 9. B.
Companies try to raise funds at the lowest possible cost. Therefore, cost of equity is used as a
proxy for the minimum required rate of return.

Reading 37: Industry and Company Analysis

Learning Outcomes

a. Explain uses of industry analysis and the relation of industry analysis to company analysis;
b. Compare methods by which companies can be grouped;
c. Explain the factors that affect the sensitivity of a company to the business cycle and the uses and
limitations of industry and company descriptors such as 'growth,' 'defensive,' and 'cyclical’;
d. Describe current industry classification systems, and identify how a company should be classified,
given a description of its activities and the classification system;
e. Explain how a company’s industry classification can be used to identify a potential 'peer group' for
equity valuation;
f. Describe the elements that need to be covered in a thorough industry analysis;
g. Describe the principles of strategic analysis of an industry;
h. Explain the effects of barriers to entry, industry concentration, industry capacity, and market share
stability on pricing power and price competition;
i. Describe industry life cycle models, classify an industry as to life cycle stage, and describe
limitations of the life-cycle concept in forecasting industry performance;

Learning Outcomes (Cont.)
j. Describe macroeconomic, technological, demographic, governmental, and social influences on

industry growth, profitability, and risk;
k. Compare characteristics of representative industries from the various economic sectors;
l. Describe the elements that should be covered in a thorough company analysis.

Use of Industry Analysis
 Ultimately, it is the share price of the company that matters to an investor, because that grows and
enables wealth creation.
 However, to better understand the company and forecast its fundamentals better, it is important that
the analyst understands the overall environment in which the company operates.
 The use of Industry Analysis include the following:
1. Understanding a company’s business and business environment –
‒ Helps in assessing growth opportunities, competitive dynamics, and business risks of the issuer.
2. Identifying active equity investment opportunities –
‒ Investors using a top-down approach to investing would utilize industry analysis to find out the
industries with positive, neutral, or negative perspective for profitability and growth.
3. Portfolio performance attribution –
‒ At the feedback stage of Portfolio Management, difference in industry weights is an important
source of difference between Portfolio's return and Benchmark’s return.

Three Approaches of Grouping the Companies
Company Classification is the process to categorize different companies into different heads based on
some rationale.
There are three approaches/rationale behind the categorization:
1. Products/Services supplied (Company >> Industry >> Sectors)
• Industries with similar or related products are grouped into sectors.
• Classification schemes place a company in a group if their principal business activity is the same (in
case of conglomerates like Mahindra and Mahindra).
• Some examples include:
i. Global Industry Classification Standard (GICS);
ii. Russel Global Sectors (RGS) and Industry Classification Benchmark.
2. Business-cycle sensitivities:
These are applicable where:
• Companies are grouped as per their sensitivity of Sales with respect to the Business Cycle and
• Firms are clubbed into two major categories – cyclical and non-cyclical.

Three Approaches of Grouping the Companies
3. Statistical similarities:
• Companies are grouped based on the correlation of their past year’s return.
• They use the cluster analysis to form groups.
• However, this can result in non-intuitive grouping of companies (totally mechanical).
• Disadvantages of this grouping:
i. Falsely indicating a relationship when none exists;
ii. Falsely excluding a relationship that is actually significant and
iii. The grouping of firms may not remain the same over time and across countries.

Business-cycle Sensitivities (Approach 2)
 Based on the sensitivity to the business cycles (not-Industry cycle), firms can be divided into:
1. Cyclical companies are the one that have earnings which are highly correlated with the stage of
business cycle.
‒ The sales of these firm are dependent on the economy’s performance.
‒ Due to boom time, these firms show excess sales and thus, large profits. During slowdown these
firms incur a lot of losses due to the operating leverage.
‒ E.g. Automobile, Industrial Products, Consumer Discretionary, etc.
2. Non-cyclical companies are those which have their performance is largely independent on the
business cycle.
‒ The sales of these firm are independent of the economy’s performance.
‒ E.g., Health Care, Education, Consumer Staples (like Salt), Utilities, etc.
 More than the firm’s own fundamental and performance, it is the firm’s sector that defines whether a
firm is cyclical or non-cyclical.

Business-cycle Sensitivities (Approach 2) (Cont.)
 Non-cyclical industries (or sectors) can also be categorized as:

1. Defensive Industries: The product has a staple demand irrespective of the stage of business cycle.
E.g., Utilities and Consumer Staples.
2. Growth Industries: The demand of the product is so robust that currently, the sales are largely
uncorrelated with the business cycle. E.g., Sales of iPhone 5 was robust while the US is still facing
slowdown in its economy.

Industry Classification Systems (Method 1)
 An analyst might create its own independent classification of industries, but that is a very lengthy
process. Some widely accepted classifications already exist.
 Classification of companies by the industries may be done by:
1. Commercial Classifications – This is done by several index providers (like CMIE in India).
‒ Sectors are divided into Industries which are further divided into Sub-industries.
‒ E.g., Global Industry Classification Standard, Russell Global Sectors, and Industry Classification
Benchmark.
2. Government Classifications – This is done by the government (like in the Economic Survey in India).
‒ It is done to organize the collected and published data.
‒ It also helps them to compare different industries.
‒ E.g., Industry Standard Industrial Classification of all Industrial Activities; viz. ISIC, Statistical
Classification of Economic Activities in the European Community; viz. NACE, Australian and New
Zealand Standard Industrial Classification; viz. ANZSIC, North American Industry Classification
System; viz. NAICS.

Weaknesses of Current Systems
 Limitations of the government classification systems versus the commercial ones:

• Government laws may prohibit the disclosure of individual companies activities;
• Commercial classification systems are frequently updated than the government systems;
• Government classification systems do not make any distinction between profit and non-profit
organizations, and public and private companies; and
• The smallest unit of classification may be macro, hence may not be the peer group for the company.

Constructing a Peer Group
 Peer Group (used in Equity Valuation under Comparables) is a concept similar to industry
classification.
 Companies in a peer group are similar with respect to:
1. Business activities;
2. Economic drivers and
3. Cost structure.
 Analyst can start from one of the commercial classification systems to generate a peer group.
• Annual Report of the subject company can also indicate the competitors of the company, which can be
safely included in the peer group.
 Constructing a peer group is a subjective process and the results may differ significantly.
Peer group will be required at the last stage, when the company valuation has been done
(after industry analysis and company analysis) and it needs to be compared with related companies.

Aspects to be Included in Industry Analysis
1. An analyst will study all statistical relationships between the trends of the industry and different
types of economic and business variables.
2. Investment managers will always assess performance of industry in comparison to other
industries to find out the industries with better returns and determine the:
a) Degree of consistency and stability; and
b) Risk in returns in the industry over the period of time.
3. Analysis of external influence on the industry’s growth and profitability is also done.
4. Analyst also classifies the companies according to the:
a) Industry life-cycle (to be done later) and
b) Experience curves to classify companies as per the cost per unit, relative of the output.
5. All analysis performed should be forward looking and it should prove that the company is creating
value by providing a rate of return higher than the cost of capital (Economic Value Addition).
6. Analysis of the competitive environment, with specific focus on the impact of corporate strategy is
known as strategic analysis.

External Influences on an Industry (Step 3)
These are the forces/factors/trends that impact the growth, profitability, and risk in the industry.
1. Macroeconomic Influences:
• Overall economic activity trends can have a major impact on the demand for the products and services
of the industry.
• These trends also are cyclical.
a) Some economic variables that normally affect an industry’s revenues and profits are:
a) GDP – increase in GDP increases demand;
b) Interest rates – increase in the rates increases the cost of debt;
c) Availability of credit – would impact business and consumer spending and financial solvency;
and
d) Inflation – showcases the changes in prices of goods and services, and would impact the costs,
rate of interest and confidence of the business and consumers.
2. Technological Influences:
• New technology can have a significant effect on an industry.
• E.g., Micro-processor industry, cellular phones, photographic industry, education, etc.

External Influences on an Industry (Cont.)
3. Demographic Influences:
• Changes in population size, distribution of age and gender, and other demographic characteristics
can have a major impact on the industry.
• The baby boom after the second World War created a huge demand for products.
• Similarly the increase in the number of pensioners in Japan increases the demand for health services.
4. Governmental Influences:
• The government’s influence on the industries revenues and profits is very pervasive.
• Taxes can erode profitability of the industry.
• Policy reforms can take an industry to a high growth phase (like the automobile industry in India saw a
drastic growth after the Liberalization in 1991).
5. Social Influences:
• Societal changes have a major impact on the demand.
• E.g., Tobacco, working women, etc.

Industry Life Cycle (Step 4a)
Demand 4
3 5
2
1
Time
Embryonic Growth Shake-out Mature Decline
1. Embryonic (Inception/Pioneer stage):

• An industry that has just begun to develop falls under this step;
• Typical characteristics include slow growth and high prices, as companies are unable to achieve
economies of scale;
• Customers are unaware about the product/service features;
• The key strategic initiatives are increasing awareness about the products and service, and developing
distribution channels; and
• Substantial investments and risk of failure are very high.

Industry Life Cycle (Cont.)
Demand 4
3 5
2
1
Time
2. Growth:
• There is rapid increasing demand, improved profitability, falling down of prices, and very low
competition;
• Demand is backed by new customers in the market;
• Threat of new entrants is very high as barriers of entry are low;
• Expansion of demand gives the companies a chance to increase revenues without the need of
capturing the competitors market share and
• Profitability increases as volume increases and economies of scale are achieved.

Demand 4
3 5
2
1
Time
3. Shakeout:
• Usually masked by slow growth, intense competition and declining profitability;
• Demand may approach saturation levels – almost 90% of the demand is replacement demand;
• Excess capacity develops and industry profitability declines as companies cut prices (price wars);
• Companies concentrate on cutting costs and building brand loyalty; and
• Some companies may decide to merge while others will simply disappear.

Demand 4
3 5
2
1
Time
4. Mature:
• There is little or no growth (100% demand is from replacement);
• There is very high barriers to entry;
• Mature industries often consolidate and become oligopolies to get an efficient cost structure;
• They also understand their interdependence and try to avoid price wars; and
• Companies with better products or services have more chance to gain market share, and experience
growth and profitability above the industry peers.

Demand 4
3 5
2
1
Time
5. Decline:
• There is excess capacity in the system and competition also increases;
• Demand may reduce due to technological substitution or other reasons like social changes and
global competition;
• Demand falls, excess capacity results in lower prices and
• Companies merge or start failing, others re-deploy their capital.

Limitations of the Industry Life Cycle
 An industry may not evolve in a predictable pattern and various factors can make a few stages
shorter or longer, or a company may simply skip a few steps.
 There may be exceptions to this cycle time, as:
1. Technological changes may lead an industry to move straight from growth to decline (e.g., computer
came and typewriter went);
2. Changes in regulation can also impact the structure of the industry;
3. Social changes can also impact the profile of the industry and
4. Demographic changes like the baby boomer, gen Z, etc., can create demand for a number of new
services.
 Companies in the same industry may not experience similar performances.
 A particular firm may be an out-performer and therefore, may not behave like a typical average firm
in the industry life cycle (firm does not act his age).

Strategic Analysis – Porter’s Five Forces (Step 6)
 Strategic analysis is an understanding of the competitive environment within an industry.

 This analysis helps in understanding the attractiveness of the industries in which the company
operates, plus it helps to understand the positioning of the firm within the industry.
 Within an industry, a company’s market share is indicative of its relative competitiveness.
 In general, greater the sustainable competitive advantage of a company, greater is its value.
 Porter’s Five Forces can be a classic starting point for strategic analysis:
1. Threat of substitute products: A lot of substitute products are available in the market.
2. Bargaining power of customers: Similar products from the other companies are available.
3. Bargaining power of suppliers: A lesser number of suppliers have the specified resources available
with them.
4. Threat of new entrants: New companies producing similar product are entering the market.
5. Intensity of rivalry: Currently many other companies are producing similar product, thereby creating
competition.
This analysis focuses more on the industry’s structure and its long-term profitability, rather
than looking at the competitive position of the firm vis-à-vis its competitors.

Impact on Pricing Power
1. Ease of Entry:
• An industry can sustain high profitability only if there are high barriers to entry.
• New competitors can easily grab away a large share of the economic profits.
• Example: In businesses like e-commerce or other such businesses which run on internet, there are low
barriers to entry.
• However, the vice versa is not true as the high barriers of entry do not necessary mean high profitability
due to the stiff competition within the industry, like Petroleum, Telecom, etc.
2. Industry Concentration:
• Industries with a greater concentration experience relatively less price competition, and thus better
pricing power in the hands of players with a greater market share.
• However, exceptions exist, such as the aircraft manufacturing industry which has only two major
manufacturers, both competing aggressively to acquire new contracts.
• Companies in a fragmented industry are less likely to co-ordinate among themselves to control prices.

Impact on Pricing Power (Cont.)
3. Industry Capacity:
• Tight/limited capacity gives the participants more pricing power, while overcapacity will lead to under-
cutting in the prices.
• We should remember that capacity is fixed in the short-term, while it is variable in the long-term.
• Also capacity can be physical ( e.g. as in manufacturing capacity), which is difficult to increase in a
short time; while financial and human capital can be quickly shifted from one user to the other.
4. Market Share Stability:
• A stable market share indicates continued leadership, and thus a better pricing power.
• A fluctuating market share mean that no player is willing to increase the prices and risk the loss of the
market share.
• In a fluctuating market share industry, the players are more vulnerable to resort to the price cuts, in turn
to gain market share.
5. Ease of Exit:
• Industries with a greater ease of exit will see a better pricing power, as compared to the industries
where capacities once committed cannot be put to any other alternative use.
• In such a case, the manufacturer is more likely to resort to price wars and disturb the profitability
pattern of the entire industry.

Company Analysis
Company analysis entails the study and analysis of the financial position of the company, its products
and/or services, and its competitive strategy.
Porter identifies two chief competitive strategies:
1. Cost leadership or low cost strategy –
a) Firm seeks to have the lowest price in the industry;
b) Competition is on prices and prices wars are likely;
c) Firms may resort to predatory pricing (only for the short-term) and
d) To earn profits, mass production and efficiency in cost are extremely critical.
2. Differentiation strategy –
a) Firm tries to distinguish and separate its products from the competitors, on parameters like type,
quality, delivery mechanism, post-sales service level, etc.;
b) There is a premium for differentiation;
c) Price wars are unlikely and
d) To earn profits, differentiation premium should be high.
Environment includes opportunities and threats.

Company Analysis (Cont.)
 A research report covering a company should have the following particulars:

1. An overview of the company which would include the basic understanding of the business, investment
transactions, corporate governance, and strengths and weaknesses;
2. Important industry characteristics;
3. An analysis of the demand for the company’s products and services;
4. An analysis of the supply of products and services, including cost analysis;
5. An analysis of the pricing environment of a company;
6. Presentation and interpretation of the relevant financial ratios, which would also include comparisons
over the period of time and comparisons with competitors; and
7. Projected financial statement and firm valuation.

 Company and industry analysis together can give valuable piece of information into sources of
industry revenue growth and competitors’ market shares and thus, the future of an individual
company’s top-line growth and bottom-line profitability.
 Industry analysis is used to understand a company’s business and business environment; identify
active equity investment opportunities; formulate an industry or sector rotation strategy; and portfolio
performance attribution.
 The companies are classified on the basis of 3 approaches – products and/or services supplied;
business-cycle sensitivities; and statistical similarities.
 A peer group is a group of companies which are doing similar business activities.
 The framework for strategic analysis known as 'Porter’s five forces' can provide a useful starting
point.
 Industry life cycle model can be used to analyze industry, which identifies the sequential stages that
an industry typically goes through namely, embryonic, growth, shakeout, mature, and decline.

Knowledge Check

Knowledge Check
1. Cluster analysis groups the companies:

A. Operating in the same region
B. Having correlated returns
C. In the same industry
2. Top-down approach to security valuation begins with the analysis of:
A. Company’s financials
B. Industry’s prospects
C. Economy’s projected performance
3. Which of the following statements is the least accurate?
A. Returns of defensive stocks have high correlation with the returns of the market
B. Cyclical companies often have high business or financial risk
C. Value stocks are often characterized by low P/B ratios

Solution
 Solution: 1. B.
Cluster analysis is done by grouping the companies whose past returns correlations are high.
 Solution: 2. C.
Top-down approach to security valuation begins with the analysis of economy.
 Solution: 3. A.
Returns of defensive stocks have low correlation with the returns of the market. Defensive
stocks do not decline much when the overall market declines.

Knowledge Check
4. Which of the following industries is the least likely to be classified as cyclical?

A. Utilities
B. Autos
C. Housing
5. TriOne Biotech is researching a gene therapy for cancer. A2Z Inc. is a high growth company. For the
last three quarters, the stock has been an outperformer. The future projections are negative. The
two companies are the most likely:
TriOne A2Z
A Speculative company Growth stock
B Growth company Defensive stock
C Speculative company Speculative stock
6. Which industry classification system uses a three-tier classification system?

A. Russell Global Sectors
B. Industry Classification Benchmark
C. Global Industry Classification Standard

Solution
 Solution: 4. A.
Non-cyclical industries are those for which demand is less sensitive to the business cycles, like for
companies in the industries of utilities, health care, and food and beverages.
 Solution: 5. C.
TriOne is engaged in research, which is a speculative activity. A2Z was a growth stock and is over-
valued. As the future projections are uncertain, it is a speculative stock.
 Solution: 6. A.
The Russell system uses three tiers, whereas the other two systems are based on four tiers or
levels.

Knowledge Check
7. Which of the following is the least likely to be a characteristic of low cost competitive strategy?
A. Operational efficiency
B. Highly differentiated products
C. Mass Volume production
8. Comment on the following statements about defensive stocks.
i. A stock’s rate of return is not expected to decline during an overall market decline is considered as
defensive stock.
ii. A stock with small positive beta may be considered as defensive stock.
A. Statement I is true and statement II is false
B. Both statements are false
C. Both statements are true
9. Which of the following is the least likely to be associated with the Shakeout stage in an industry life-
cycle?
A. Intense Competition
B. Slowing Growth
C. Increased profitability

Solution
 Solution: 7. B.
Low-cost leadership is characterized by high operational efficiency, mass volume production of
undifferentiated products.
 Solution: 8. C.
Defensive stocks are those stocks which expose an investor to lower risk in response to overall
market, and thereby provides lower returns as well against the same. They have a systematic risk
(BETA) lower than that of overall market.
 Solution: 9. C.
Slowing growth, intense competition, industry overcapacity, declining profitability, cost cutting,
increased failures are the characteristics of a Shakeout stage in an industry life-cycle.

Knowledge Check
10. With regard to forming a company’s peer group, which of the following statements is not correct?
A. Comments from the management of the company about competitors are generally not used when
selecting the peer group
B. The higher the proportion of revenue and operating profit of the peer company derived from business
activities similar to the subject company, the more meaningful the comparison
C. Comparing the company’s performance measures with those for a potential peer group company is of
limited value when the companies are exposed to different stages of the business cycle
11. If the technology for an industry involves high fixed capital investment, then one way to seek higher
profit growth is by pursuing:
A. Economies of scale
B. Diseconomies of scale
C. Removal of features that differentiate the product or service provided
12. Which of the following companies most likely has the greatest ability to quickly increase its
capacity?
A. Restaurant
B. Steel producer
C. Legal services provider

Solution
 Solution: 10. A.
A is the correct answer, because it is a false statement. Reviewing the annual report to find
management’s discussion about the competitive environment and specific competitors is a
suggested step in the process of constructing a peer group.
Seeking economies of scale would tend to reduce per-unit costs and increase profit.
 Solution: 12. C.
The capacity increases in providing legal services would not involve several factors that would be
important to the other two industries, including the need for substantial fixed capital investments or,
in the case of a restaurant, outfitting rental, or purchased space. These requirements would tend to
slow down, respectively, the steel production and restaurant expansion.

Knowledge Check
13. An industry experiencing slow growth and high prices is best characterized as being in the:
A. Mature stage
B. Shakeout stage
C. Embryonic stage
14. Which of the following statements about the industry life-cycle model is the least accurate?
A. The model is more appropriately used during a period of rapid change, than during a period of relative
stability
B. External factors may cause some stages of the model to be longer or shorter than expected, and in
certain cases, a stage may be entirely skipped
C. Not all the companies in an industry will experience similar performance, and very profitable
companies can exist in an industry with below-average profitability

Solution
Both slow growth and high prices are associated with the embryonic stage. High price is not a
characteristic of the mature or shakeout stages.
The least accurate statement is: The model is best used during a period of relative stability rather
than during a period of rapid change.

Reading 38: Equity Valuation – Concepts and Basic
Tools

Learning Outcomes

a. Evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly
valued, or undervalued by the market;
b. Describe major categories of equity valuation models;
c. Describe regular cash dividends, extra dividends, stock dividends, stock splits, reverse stock splits,
and share repurchases;
d. Describe dividend payment chronology;
e. Explain the rationale for using present value models to value equity and describe the dividend
discount and free-cash-flow-to-equity models;
f. Calculate the intrinsic value of a non-callable, non-convertible preferred stock;
g. Calculate and interpret the intrinsic value of an equity security based on the Gordon (constant)
growth dividend discount model or a two-stage dividend discount model, as appropriate;
h. Identify characteristics of companies for which the constant growth or a multistage dividend discount
model is appropriate;

Learning Outcomes (Cont.)
i. Explain the rationale for using price multiples to value equity, how the price to earnings multiple
relates to fundamentals, and the use of multiples based on comparables;
j. Calculate and interpret the following multiples: price to earnings, price to an estimate of operating
cash flow, price to sales, and price to book value;
k. Describe enterprise value multiples and their use in estimating equity value;
l. Describe asset-based valuation models and their use in estimating equity value;
m. Explain advantages and disadvantages of each category of valuation model.

Models for Equity Valuation
 Need to value equity: An investment manager needs to identify misprices securities, i.e., whose
market price (actual) is different from its fair value (should be).
 If actual price > fair value Security is overpriced Should be Sold
 If actual price < fair value Security is underpriced Should be bought
 If an analyst is unable to establish a time frame for convergence of market price towards the fair
value, a practical decision cannot be made based on the perceived mispricing.
 Following are the different models that are used to value the equity of a company:
1. Discounted Cash Flow Method –  An analyst can find a justified value or the fair value
a) Dividend Discount Model and of the share, based on fundamentals and formulae.
b) Free Cash Flow Discount Model.  The actual price is determined by other factors like
2. Multiplier Model – speculations as well.
1. Price Multiples and  Whenever lost in the formulae, always remember
that we are trying to find out a justified/fair value of
2. Enterprise Value Ratio.
the share of a company.
3. Asset Approach.

Meaning of Dividends
Three main decisions to be taken by a Finance Manager: Common Objective:

1. Financing Decision: How to raise most optimum finance; To maximize
the shareholders’ wealth
2. Investment Decision: How to make most optimal investments; and
3. Dividend Decision: How to distribute profits in the most optimal manner.
Share or stock is the risk capital invested in the business –

 Bonds, Bank Loan, and Debentures are the examples of borrowed capital.
Dividends –
 Every capital provider expects some return for contributing his capital in the business;
 Return (in any form) paid by the company to its stockholders is called dividend.
Source of capital Type of Return
Equity Common Dividend
Preference Preference Dividend
Debt Interest

Order of Distribution of Returns to Different Capital Providers
Particulars
Sales
(Less) COGS
(Less) Selling Exp
(Less) Administrative Exp
(Less) General Exp Profit and Loss Account
EBITDA
(Less) Depreciation
EBIT
1 (Less) Interest on Debt
EBT
(Less) Income Tax Expense
PAT
2 (Less) Preference Dividend
Earning Attributable to Common stockholders Profit and Loss Appropriation
(Less) Common Dividends
Account
3
Retained Earnings

Dividend Payment Chronology
Holder of
Declaration Date Ex-dividend Date Record Date Payment Date
1. Declaration Date: The date on which the corporation declares a specific dividend – BOD approves
in board meeting is the declaration date.
2. Ex-dividend Date: This is the first day when the share trades without the dividend value (share
price falls generally).
• Any investor who buys shares on, or after this date, does not get the dividend.
3. Holder of Record Date: The date on which the shareholder whose name is mentioned in the
records of company would be eligible for ownership is the holder of record date.
• This is generally two business days after the ex-date.
• Settlement date for stocks is after three business days from the date-of-trade (T + 3).
4. Payment Date: This is the date on which the dividends are actually paid out.

Dividends: Forms
Cash Distributions Non-cash Distributions
Regular Cash Dividend Stock Dividend
Extra Dividend Stock Split
Liquidating Dividend Reverse Stock Split

Types of Dividends
1. Regular Dividends –
• Paid out of annual profits as a return on the capital employed by shareholders.
• Different dividend policies – Fixed per share, Fixed Payout %, Hybrid model, etc.
• Companies that pay regular cash dividends ensure that they increase the dividends over a period of
time.
• Consistent dividend paying companies are also considered as good investments.
2. Special Dividends –
• These are paid by a company on special occasions.
• It supplements regular cash dividends with extra payment.
• Companies, especially in cyclical industries, choose to use special dividends as a means of distributing
more earnings only during strong earnings years.
3. Liquidating Dividends –
• When a company liquidates its business, the net assets are distributed to all the shareholders.
• A portion of the business can be sold for cash and distributed amongst all the shareholders.
• This is the last dividend paid by the company during its lifetime.
• Liquidating dividend is taken as a return on the capital, and are treated as capital gains.

Forms of Dividends
Cash Dividend Stock Dividend
Paid from cash balances Additional Shares issued increase paid in capital;
Reserves reduces Reserves reduces
Capital Structure deteriorated No change in capital Structure
Total Book Value and Market Value of Company

No Change in Book Value or Market value
falls
Tax implications – vary across countries Not taxed at issuance; however, taxed at sale
Cash paid out indicating no other possible avenues Stock dividend likely to have a positive impact on
of investment the shareholders and market value

Important Terms related to Shares
1. Stock Split – TOTAL Book Value and Market

Value of the company DOES NOT
a) Division of basic denomination (face Value) is known as stock split. change.
b) If a company announces a two-for-one stock split, each shareholder will be issued an additional share
for each currently owned share.
c) Stock Split does not affect – PER SHARE Book Value and
a) The shareholders’ proportionate ownership in the company, nor Market Value falls since the
number of shares increase.
b) The value of each shareholders’ ownership position.
d) The P/E and Dividend Yield remain the same.
e) A two-for-one stock split is basically the same as a 100% stock dividend, but are accounted for
differently.
2. Stock Consolidation or Reverse-Split –
• Combining or adding the basic denomination (face value) to a stock is known as stock consolidation.
• The objective is to increase the price of a share.
• Companies going into or coming out of financial distress use the reverse stock split.
• Points (c) and (d) given above hold true in case of a reverse split as well.

Important Terms related to Shares
3. Share Repurchase (Buy-back):

• This is when a company buys back its own shares using corporate cash; TOTAL Book Value and
Market Value of the
leading to a reduced cash balance.
company falls.
• Shares bought back are cancelled, leading to a reduction in share capital.
• Tax on capital gain (= Repurchase price – Issue price) to be paid PER SHARE Book Value change
BUT Market Value DOES NOT.
by the investor.
• It can be viewed as an alternative to cash dividends.
Reasons for Corporations to engage in Share Repurchasing:

a) Communicate that the management perceives the share price to be undervalued;
b) Increase the value of shares by reducing supply;
c) Purchased back through tender offer or open market;
d) Tax efficiency in distributing cash, in markets where cash dividends are taxed higher than capital gains
tax;
e) Regain control – absorb increase in outstanding shares due to ESOPs and
f) Accumulation of more cash than required for business use.

Methods of Share Repurchase
Following are four common methods in which shares are repurchased:

1. Buy in the open market –
• This approach is very flexible for the company;
• Allows the company to purchase shares from the open market at the current market price and
• The company can time its purchases to exploit any perceived under evaluation in the market.
2. Buy fixed number of shares at fixed price –
• The company offers a fixed price tender to the existing shareholders to repurchase a specific number of
shares at a fixed price;
• The company may offer to buy shares at some premium on the prevailing market prices.
3. Dutch Auction –
• Similar to a fixed price buy, except when a company announces a band of prices instead of the fixed
price;
• Provides the company with the minimum cost at which it can repurchase the shares.
4. Repurchase by Direct Negotiation –
• If any shareholder has a large stake, the company can negotiate directly with that shareholder.

Method 1A – Dividend Discount Model (DDM)
 The basic principle is that the value of a stock is simply the:

a) Present value of its future dividends and
b) Discounted at an appropriate rate (required rate of return).
A. Preferred Stock
B. Common Stock:
1. One year holding period;
2. Two year holding period;
3. Multi-year holding period and
4. Infinite year holding period (constant growth model).

Valuing Preferred Stock using DDM
 Preferred Stock are characterized by the constant payment of dividend each year. The formulae is:
DP DP DP DP
Preferred Stock Value= + +…+ =
( 1+𝑘 𝑃 ) 𝑘𝑃
1 2 x
( 1+𝑘 𝑃 ) ( 1+𝑘𝑃 )
 Important points:
1. Dividends should be discounted using a rate commensurate to the risk involved with the preferred stock
(which is generally lower than common shares).
2. If the subject share is a special category of preferred stock like participating, convertible, etc., then the
total dividends and the discount rate will change accordingly.
Example: Calculate the value of a preferred stock when Discount rate (k) = 8% and dividend is $4.

Valuing Common Stock using DDM
Valuing common stock is more difficult because:

1. The size of the cash flows are uncertain when compared to the cash flows on a preferred stock;
2. Timing of cash flows are also uncertain and
3. To top it all, the required rate of return (Ke) is unknown.
1 year holding period –

 It is expected that the investor will sell the share at the end of the first year.
 As future inflows, he receives the dividend for first year and the sale value of share. The formulae is:
Where, Ke (Required return)= R(f) + β [R(market) – R(f)].

Valuing Common Stock using DDM (Cont.)
2-year Holding Period –

 It is expected that the investor will sell the share at the end of the 2 nd year.
 As future inflows, he receives the dividend for the 1 st and 2nd year and the sale value at T2.
D1 D2 P2
Value= 1
+ 2
+ 2
( 𝑒 ) ( 𝑒 ) ( 𝑒)
1+𝑘 1+𝑘 1+𝑘
 Multiple year (N) Holding Period –
D1 D2 D N +P N
Value= 1
+ 2
+ … N
( 1+𝑘𝑒 ) ( 1+ 𝑘𝑒 ) ( 1+ 𝑘𝑒)

Valuing Common Stock using DDM (Cont.)
 Infinite Period –
D1 D2 D∞
Value= 1
+ 2
+ …+ ∞
( 1+𝑘𝑒 ) ( 1+ 𝑘𝑒 ) ( 1+𝑘𝑒 )
 If we assume that the dividends grow at a constant rate of ‘g’, the above is simplified as:
D 0(1+ gc ) D1
Value = =
( 𝑘𝑒 −𝑔 𝑐 ) ( 𝑘𝑒 − 𝑔𝑐 )
 This is called Constant Growth DDM or the Gordon Growth Model.
 The value of share is arrived at a time zone preceding the year for which dividend has been
taken in the Nr.
 We can apply the above formula only from the year in which the growth rate becomes constant.
 Using the above model for preference share valuation, the value of g = 0.

Example Problem
Gordon Growth Model in the Case of No Current Dividend

 A company does not currently pay a dividend, but is expected to begin to do so in five years (at t =
5). The first dividend is expected to be $4.00 and to be received five years from today. That dividend
is expected to grow at 6 percent into perpetuity. The required return is 10 percent. What is the
estimated current intrinsic value?

Solution
 The analyst can value the share in two pieces:

1. The analyst uses the Gordon growth model to estimate the value at t = 5; in the model, the year-
ahead dividend is $4(1.06). Then the analyst finds the present value of this value as of t = 0.
2. The analyst finds the present value of the $4 dividend not 'counted' in the estimate in Piece 1
(which values dividends from t = 6 onward). Note that the statement of the problem implies that D0, D1,
D2, D3, and D4 are zero.
Piece 1: The value of this piece is $65.818:

Solution (Cont.)
Piece 2: The value of this piece is $2.484:
The sum of the two pieces is $65.818 + $2.484 = $68.30.

Company experiencing Temporary Supernormal Growth
 These stocks are valued using the Multistage Dividend Discount model.
D1 D2 Dn Pn
Value= 1
+ 2
+…+ n
+ n
( 𝑒) ( 𝑒)
1+𝑘 1+𝑘 ( 𝑒) ( 𝑒)
1+𝑘 1+𝑘
Where:
• Dn = Last dividend of the supernormal growth period;
• Dn+1 = First dividend affected by the constant growth rate, gc; and
• Pn = Dn+1 / (ke-gc) the first period’s dividend after constant growth begins.
 The terminal value at TN is added after discounting the same to T 0.

 The similar model can be applied in the following two cases also:
1. Company pays dividends, but has two or more growth rates; and
2. Company does not pay any dividend during the initial years.
Under all the cases above, it is assumed that after a (short) period,
the growth rate will become constant.

Example Problem
Two-Stage Dividend Discount Model

 The current dividend, D0, is $5.00. Growth is expected to be 10 percent a year for three years and
then 5 percent thereafter. The required rate of return is 15 percent. Estimate the intrinsic value.

Solution
The solution is:

Corollary 1 to the DDM – P/E ratio
We know that P0 = D1/(k-g). Here:

 Dividing both sides by Earnings(E1): We get P0/E1 = D1/E1 /(k-g).
 From the above we can conclude that the value of the stock will increase when there is:
1. An increase in the dividend payout ratio;
2. An increase in the growth rate and
3. A decrease in the required rate of return.
 Contradictory Results:
g = RoE*(1-payout ratio) or g = RoE*Retention Ratio where RoE : Return on Equity
An increase in the payout ratio will result in a decrease in ‘g’ on one hand and will increase the price of the
share on the other. The overall affect maybe an increase or decrease in the value of the stock.

Corollary 2 to the DDM – Required Rate of Return
 Required rate of return consists of:

1. Risk free rate of return (Rf);
Concept already covered
2. Inflation Premium (IP) and under Reading 5 of Quants
3. Risk Premium (RP).
 Required rate of return (Ke) = (1+ R f)(1+IP)(1+RP)-1.
Alternate approach:
 Rf-NOMINAL = (1+Rf-REAL) (1+IP) – 1
 Ke = Rf-NOMINAL + RP
 Ke = Rf-NOMINAL + β[E(RMARKET - Rf-NOMINAL)]
 International equities: Country Risk Premium (CRP) is also added in the market risk premium.

Corollary 3 to the DDM – Value of Growth Opportunities
Value of Growth = Value of share including Growth (Less) Value of Share excluding Growth.
D1 D1
Value = Value =
( 𝑘𝑒 − 𝑔𝑐 ) ( 𝑘𝑒 )

Method 1B – Free Cash Flow (to Equity) Method
FCFE 1 FCFE 2 FCFE ∞

Value= 1
+ 2
+…+ ∞
( 1+𝑘𝑒 ) ( 1+𝑘𝑒 ) ( 1+𝑘𝑒 )
 Free Cash Flow to Equity is a better approach when the:
1. Evaluation is being done at the time of acquiring a major stake in the company (control’s point of view)
and
2. Company does not have stable dividends.
 Since FCFE is to be discounted, Ke is a better discount rate than WACC.
 Ke can be calculated by CAPM or by Bond Yield Premium Approach (covered under Corporate
Finance – Cost of Capital).
Recap – Free Cash Flow to Equity:

FCFE = Net income – incr in WC + (-) non-cash adjustments – Net capex + Net borrowings
= CFO – Net capex + Net borrowings
FCFE = FCFF – Interest Paid (1 - Tax) – Principle Repaid + New Loan taken

Method 2 – Multiplier Method
 A multiplier is a number by which if the parameter of a company is multiplied, the product is the
Market Price of the share of that company.
 If the multipliers are based on actual prices prevailing in the market, it is called an actual multiplier.
 If the multipliers are based on fair value calculated by analysis, it is called justified or fair multiplier.
 If Actual Multiplier > fair value multiplier Share is overpriced Share should be Sold
 If Actual Multiplier < fair value multiplier Share is underpriced Share should be bought

Method 2A – Price Multipliers
Comparison can be made in Two ways (explanation given using P/E):

1. Comparables: Company’s ACTUAL P/E ratio is compared with the ACTUAL P/E ratio of the peer
group or P/E ratio of competitors, or P/E ratio of Market, etc.
2. Fundamentals: Company’s ACTUAL P/E ratio is compared with the Justified P/E ratio, which is
based on Fair value of the stock. The components are:
• Estimate projected dividend payout ratio (D/E);
• Estimate ROE : k = RFR + β (R market – RFR);
• Estimate growth rate: g = Retention Rate * ROE (Retention rate = 1 - D/E) and
• Estimated P/E = (D/E)/ (k-g).
Conclusion: If Actual Multiplier > Benchmark multiplier, the share is overpriced and thus, should be
sold, and vice versa.

Evaluating P/E as a Valuation Method
Why P/E?
 EPS is the primary determinant of investment valuation.
 It is preferred by the investors.
 Studies show that P/E is significantly related to the long run average stock returns.
Why not P/E?
 It results into negative earnings.
 The management can distort the earnings.
 Earnings are more volatile (than Cash).
Trailing P/E= MPS/EPS over the previous 12 months
Forward P/E= MPS/Forecast EPS over the next 12 months
Some care to take for EPS:
 Consider recurring EPS only, exclude asset sales, other income, FX gains, etc.
 Use 'normalized earnings' over an entire cycle.
 Take care of accounting differences, FIFO versus LIFO, dilution of shares, etc.

Evaluating Price to Book Value (P/B) as a Valuation Method
A. Multiplier based on Book Value (P/B) –

• P/BV = Market Price per share/Book Value per share.
• Book Value = Net Worth = Total Assets – Total Liabilities – Pref. stock.
• Tangible BV = Normal BV – Intangible assets (goodwill, patent).
• When calculating BV, adjust for off B/S items and Accounting quirks: LIFO, leasing, etc.
• Why P/B?
1. Book Value is generally positive even when the company suffers loss.
2. BV is more stable than EPS.
3. This has the appropriate ratio to calculate NAVs for financial firms.
4. It is useful in the valuation of liquidating companies.
• Why not P/B?
1. It does not capture the intangibles (example: Human capital).
2. Difference in production techniques may show different asset intensity among companies.
3. There are chances of accounting distortions (example: R&D expensing).
4. Inflation and tech change can make BV obsolete (example: Coca Cola versus Typewriting Co.).

Evaluating Price to Sales (P/S) as a Valuation Method
B. Multiplier based on Sales (P/S) –

• P/S = Market Price per share/ Sales per share.
• Why P/S?
1. Sales is always positive unlike EPS or even BV.
2. Sales is less easy to manipulate as compared to EPS or BV.
3. It is less volatile.
4. P/S is useful for mature or cyclical stocks and start-ups.
• Why not P/S?
1. Growth in sales may not boil down to earnings and a question would remain as to how the sales
was funded.
2. Cost structures and production techniques are not captured.
3. Sales can sill be distorted. There could be an end period jacking up of orders and pushing it to the
sales channel.

Evaluating Price to Cash Flow (P/CF) as a Valuation Method
C. Multiplier based on Cash Flow (P/CF) –

• P/CF = Market Price per share/Cash Flow per share
• Why P/CF?
1. Manipulation of cash flow becomes difficult.
2. P/CF is more stable than P/E.
3. The quality of reported earnings can be ignored.
• Why not P/CF?
1. It has at least four definitions for 'Cash Flow’, due to which some actual cash flow may get
ignored.
2. FCFE is better, though more volatile.
• Four CF measures:
1. CF = Net Income + Depreciation + Amortization.
2. Adjusted CFO = CFA + [(Net cash interest outflow)*(1 - tax rate).
3. Free Cash flow to Equity (FCFE) = PAT + non-cash charges – FA change – WC change.
4. EBITDA.

Method 2B – Enterprise Value Multiplier
 Enterprise Value = Market value of common stock + market value of preferred equity + market
value of debt + minority interest – cash and investments.
 The reason why cash and investments is subtracted is that a buyer’s net price paid for an
acquisition target would be reduced by the amount of the liquid assets of the target.
 Company’s multiplier is compared to competitors or average industry’s multiplier, and then the
decision is taken.
 EV is used when:
1. Comparing firms with varying degrees of financial leverage (comparison needs to be made at the
enterprise level);
2. EBITDA is mostly positive even when EPS is negative and
3. EBITDA is useful when capital intensive business with high levels of depreciation and amortization are
being valued.

Method 3 – Asset-based Valuation Method
Fair value of Equity = Fair Value of Assets (Less) fair value of liabilities
 Asset-based valuation would be useful for companies that do not have a high proportion of
intangibles.
 They are frequently used with multiplier models for private companies.
 As public companies make more fair-value disclosures, asset based valuation models may become
popular.
 Important points –
1. Companies with assets whose fair value is not easily determinable are difficult to analyze using asset
valuation models.
2. Asset and liability fair values can be significantly different from the values that are carried on the
balance sheet.
3. This method can be followed when only a few intangibles are shown on the books of the company.
4. If a company has significant intangibles, then the declared value should be considered only as the
minimum, or then the floor value for the Equity and some other valuation method needs to be used.
5. Asset values may not be easy to calculate in a hyper-inflationary environment.

 The estimation of intrinsic value is implicitly questioning the market’s estimate of value.
 If the estimated value exceeds the market price, then the security is undervalued.
 If the estimated value equals the market price, then the security is fairly valued.
 If the estimated value is less than the market price, then the security is overvalued.
 There are 3 major types of equity valuation models- present value (Dividend and Free Cash Flow),
multiplier, and asset-based valuation.
 Present value models estimate value as the present value of expected future benefits.
 Multiplier models estimate intrinsic value based on a multiple of some fundamental variable.
 Asset-based valuation models estimate value based on the estimated value of assets and liabilities.
 The key input for dividend valuation models is regular cash dividends.
 There are 4 Key dates in dividend chronology – declaration date, ex-dividend date, holder-of record
date, and payment date.

Knowledge Check

Knowledge Check
1. An analyst calculates the price of XYZ using the infinite period DDM as $50. The market price is
$60. The analyst should:
A. Issue a buy recommendation
B. Issue a sell recommendation
C. The given information is insufficient to make a decision
2. The DDM model for infinite period assumes that:
A. g<k
B. g>k
C. g >= k

Solution
 Solution: 1. B.
The intrinsic value of $50 is lower than its market price of $60, which means the stock is overvalued
and anything which is overvalued should be sold.
 Solution: 2. A.
The formula of DDM with infinite period is:
This above formula assumes that growth (g) would be lower than the cost of equity (k or r).

Knowledge Check
3. For a firm ABC Ltd, consider the following details:

Stock Price.............................................................$10.00
Stocks outstanding................................................$100,000
Market value of long term debt............................$250,000
Book value of the long term debt.........................$400,000
Cash.......................................................................$40,000
Marketable Securities...........................................$30,000
The enterprise value of the firm is the closest to:
A. $ 1,180,000
B. $ 1,250,00
C. $ 1,220,000

Solution
 Solution: 3. A.
Enterprise value (EV) of the firm = market value of common stock + market value of debt – cash and
short-term investments.
EV = $10 x 100,000 + $250,000 - $40,000 - $30,000
= $1,180,000

Knowledge Check
4. Find out the value of a preferred stock which offers an annual dividend of $5.50 and has a current
market yield of 75 basis points above the current T-Bond, at the rate of 7%.
A. $42.63
B. $78.57
C. $70.97
5. What is the least likely to be used to calculate stock price, based on the free cash flow for equity?
A. Required rate of return on equity
B. Weighted average cost of capital
C. None of the above
6. Current dividend = $2 Expected dividend growth rate forever = 5%
Risk free rate = 6% Expected return on the market = 14%,
Stock β = 1.4
With the given aspects, the intrinsic value of the company is calculated to be:
A. $24.50
B. $21.25
C. $17.21

Solution
 Solution: 4. C.
kpreferred = base yield + risk premium = 0.07 + 0.0075 = 0.00775
ValuePreferred = Dividend / kpreferred
Value = 5.50 / 0.0775 = $70.97
 Solution: 5. B.
As the valuation is done for equity, the cost of capital with regard to equity financing would be used not for
total source of financing (total capital).
 Solution: 6. C.
Cost of Equity =6%+(14%-6%)*1.4 = 17.2%
Intrinsic Value =2*(1+5%)/(17.2%-5%) = 17.21

Knowledge Check
7. The value of the stock of company ABC is $ 44. It is projected that the company will pay dividends
equal to $ 5 , $ 6 and $ 8 in the next three years. The value of the stock three years from now is
expected to be $ 62. The cost of capital for the company is 12%. Using DDM, evaluate if the stock is
overvalued or undervalued.
A. Overvalued
B. Undervalued
C. Correctly valued
8. XYZ company paid a dividend of $3 last year. It has a payout ratio of 40% and a ROE of 12%. If the
required return is 14% what is the value of the stock?
A. $47.29
B. $65.69
C. $60.69
9. The value of the dividends is $2, and they are expected to grow at 5% and the cost of capital is 8%.
The value of the stock using the GGM is the closest to:
A. 70
B. 65
C. 62

Solution
 Solution: 7. B.
The net present value of the dividends:
 Solution: 8. A.
Retention Rate = 1-40% = 60%
SGR (Growth) =60%*12% = 7.2%
Intrinsic Value =2*(1+5%)/(17.2%-5%) = 47.29

 Solution: 9. A.
Using the GGM the value of the stock is:

Knowledge Check
10. A company reports a net profit per share of $5.6 and the return on equity as 18%, and announces a
dividend of $2.1 per share. Find the growth rate of the company.
A. 6.75%
B. 11.25%
C. 10%
11. The following information pertains to XYZ:
• Reported Earnings $50 million
• Forecasted EPS over the next 12 months $3.00
• No of shares outstanding 25 million
• Market Price per share $12
What are the Trailing and Leading P/E multiples, respectively, for XYZ?
A. 6 and 4
B. 4 and 6
C. 6 and 8

Solution
 Solution: 10. B.
The retention rate is ($5.6 - $2.1)/$5.6 = 0.0625.Growth rate = 0.0625 * 18% = 11.25%.
EPS at time '0' = 50 million/25 million = 2
Trailing P/E =12/2 = 6
Leading P/E Current Market Price/Forecasted EPS
=12/3 = 4

Knowledge Check
12. Which of the following is the most difficult to manipulate?

A. Earnings
B. Sales
C. Cash Flows
13. The major problem with P/CF ratio is:
A. Different accounting standards across companies
B. Multiple ways in which cash flows can be calculated
C. Negative book value of the company

Solution
Cash flows are the most difficult to manipulate in comparison to the manipulation of sales and
profits.
 Solution: 13. B.
The calculation of cash flow would differ depending upon the choice of reporting standards used as
US GAAP and IFRS have different reporting options for items like interest and dividend.

Knowledge Check
14. You are given the following information regarding XYZ:

• Share Price $30, Net worth $150 million,
• Number of share 10 million, Retention rate 50%,
• ROE 12%, Sales $45 million,
• Operating expenses $21 million, Depreciation $1,800,000
1. XYZ P/BV ratio is:
A. 2.00
B. 2.25
C. 2.50
2. XYZ P/S ratio is:
A. 5.40
B. 6.67
C. 6.30
3. XYZ P/CF ratio (using EBITDA for cash flow) is:
A. 12.50
B. 13.27
C. 13.51

Solution
14. Solution: 14. 1. A.
BV / share =150/10 = 15
Share Price =30
P/BV (30/15) =2
15. Solution: 14. 2. B.
Sales / Share =45/10 = 4.5

Share Price =30
P/Sales (30/4.5) =6.67

Solution
14. Solution: 14. 3. C.
Sales 45
Operating Expense -21
Depreciation -1.8
Net Income 22.2
Add back: Depreciation 1.8
CF 24
No. of Shares 10
2.4
Share Price 30
P/CF (30/2.4) 12.5

Knowledge Check
15. An analyst is attempting to value shares of the Dominion Company. The company has just paid a
dividend of $0.58 per share. Dividends are expected to grow by 20 percent next year and 15 percent
the year after that. From the third year onward, dividends are expected to grow at 5.6 percent per
year indefinitely. If the required rate of return is 8.3 percent, the intrinsic value of the stock is closest
to:
A. $26.00
B. $27.00
C. $28.00

Solution
The current price of €22.56 is less than the intrinsic value (V0) of €24.64; therefore, the stock
appears to be currently undervalued. According to the two-stage dividend discount model:

Knowledge Check
16. An analyst gathers the following information about similar companies in the banking sector:
First Bank Prime Bank Pioneer Trust
P/B 1.10 0.60 0.60
P/E 8.40 11.10 8.30
Which of the companies is most likely to be undervalued?

A. First Bank
B. Prime Bank
C. Pioneer Trust

Solution
Relative to the others, Pioneer Trust has the lowest P/E multiple and the P/B multiple is tied for the
lowest with Prime Bank. Given the law of one price, similar companies should trade at similar P/B
and P/E levels. Thus, based on the information presented, Pioneer is most likely to be undervalued.

Thank You!
For queries, write to us at: care@edupristine.com

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc.

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Equity Investment – II

© EduPristine For [CFA® Program Level-I] (Confidential)

 Reading 36: Overview of Equity Securities

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

The candidate should be able to:

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

Other Important Points:

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

 One class may have comparatively greater voting powers.

© EduPristine For [CFA® Program Level-I] (Confidential)

 Voting: Do not receive operating performance and cannot vote.

Special Categories of Preference Shares:

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

Public Equity Shares:

© EduPristine For [CFA® Program Level-I] (Confidential)

Private Equity Shares:

© EduPristine For [CFA® Program Level-I] (Confidential)

 Advantages of being listed in a foreign country:

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Direct Investing (a US firm buying equity shares in UK of a firm listed in LSE):

Depository Receipts (DR) (a US investor buying a security in US representing a company listed in

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

1. Accounting Return on Equity (also called as Return on Equity):

© EduPristine For [CFA® Program Level-I] (Confidential)

3. Required Return on the Equity:

𝑅𝑒=R f +𝛽[𝑅 ( 𝑅𝑚 ) −𝑅𝑓 ]

In case of Equilibrium, required return = Expected Return.

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

The candidate should be able to:

© EduPristine For [CFA® Program Level-I] (Confidential)

j. Describe macroeconomic, technological, demographic, governmental, and social influences on

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

 Non-cyclical industries (or sectors) can also be categorized as:

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© EduPristine For [CFA® Program Level-I] (Confidential)

 Limitations of the government classification systems versus the commercial ones:

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© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

1. Embryonic (Inception/Pioneer stage):

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