Equity Valuation

How to make money in stocks?

• Capital gains: buy low/sell high– Growth companies

• Dividend yields: income stream–Matured (value) companies

Equity Valuation

• Equity analysts employ two kinds of analysis i.e. fundamental analysis and technical analysis.

• Fundamental analysts assess the fair market value of equity shares by examining the assets, earnings prospects, cash flow projections and dividend potential.

• Technical analysts rely on price and volume trends and other market indicators to identify trading opportunities.

Techniques of fundamental equity valuation

Balance sheet techniques

• Book Value• Liquidation Value• Replacement Cost

Discounted Cash Flow Techniques

• Dividend discount model•Free cash flow model

Relative Valuation Techniques

• Price earning ratio•Price-book value ratio•Price-sales ratio

Balance Sheet Valuation Methods

• Book Value: The book value per share is the net worth of the company (which is equal to the paid up equity capital plus reserves and surplus) divided by number of equity shares outstanding.

• Liquidation Value: The liquidation value per share is:

Value realised from liquidating all the assets of the firm

Amount to be paid to all the creditors and preference shareholders -

Number of outstanding equity shares

• Replacement Cost : The use of this method is based on the premise that the market value of the firm cannot deviate too much from its replacement cost. If it did so, competitive pressure will tend to align the two.

• Tobin q is the ratio of market price to replacement cost.

Intrinsic Value versus Market Price

• Intrinsic value --The present value of a firm’s expected future net cash flows discounted by the required rate of return.

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•V0 (intrinsic value) > P0 (market price) Þ buy

•V0 (intrinsic value) < P0 (market price) Þ sell or sell short

•In market equilibrium, V0 = P0

•k is the market capitalization rate which equates V0 and P0

•If V0 ¹ P0, then EMH implies the estimate of k is wrong

Dividend discount model• According to Dividend discount model, the

value of equity share is equal to the present value of dividends expected from its ownership plus the present value of the sale price expected when the equity share is sold.

• Assumptions: dividends are paid annually. The first dividend is received one year after

the equity share is bought.

• Single period valuation:

Po = D1 + P1

(1 + r) (1 + r)

A’s equity share is expected to provide a dividend of Rs. 2.00 and fetch a price of Rs. 18.00 a year hence. What price would it sell for now if investors required rate of return is 12 percent?

Po = Rs. 17.86

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, 1 100

Constant Growth DDM (Gordon’s Model)

The expected dividend per share on the equity share of queen limited is Rs. 2.00. The dividend per share of queen limited has grown over the past five years at the rate of 5 percent per year. Further market rate is expected to grow at same rate. What is the fair estimate of the intrinsic value of the equity share of queen limited if required rate of return is 15 percent?

= 2 / 0.15 – 0.05 = Rs. 20

Multi-period Case:

HHH

kPD

kD

kDV

1

...11 2

210

Where D1,…, DH and PH are expected values

Price-Earning (P/E) Ratios• Ratio of Stock price to its earnings per share• Useful for firm valuation:

EPEP

Problems:Forecasts of EForecasts of P/E

Other Valuation Ratios & Approaches

• Price-to-book = market price per share at time t / Book value per share at time

t

• Price-to-cash flow• Price-to-sales• Present Value of Free Cash Flow