Chapter 13 Equity Valuation
Chapter 13 Equity Valuation
Chapter 13 Equity Valuation
OUTLINE
Balance Sheet Valuation Dividend Discount Model Earnings Multiplier Approach Earnings Price Ratio, Expected Return, and Growth Other Comparative Valuation Ratios
LIQUIDATION VALUE
REPLACEMENT COST
Pn + (1+r)n
(1+r)n
r - g2
(1+r)n
1.20 1 1.15 P0 = 2.40 .15 - .20 1 - 1.291 = 2.40 -0.05 = 13.968 + 65.289 = RS.79.597
1 (1.15)6
H Model
ga gn
H D0 PO = r - gn D0 (1+gn)
2H
=
r - gn
+
r - gn PREMIUM DUE TO ABNORMAL GROWH RATE VALUE BASED ON NORMAL GROWTH RATE
Illustration: H Ltd D0 = 1 ga = 25% gn = 15% + 0.18 - 0.15 = 38.33 0.18 - 0.15 + 16.67 = 55.00 P/E = 27.5 H=5 r = 18%
1 (1.15)
P0 =
1 x 5(.25 - .15)
IF E = 2
RS. 2.00
NORMALGROWTH FIRM PO = 0.20 - 0.10 RS. 2.00 SUPERNORMAL GROWTH FIRM PO = = RS.40.00 5.0% 15.0% 13.33 = RS.20.00 10.0% 10.0% 6.67
0.20 - 0.15
EV=
FCF1 (1+WACC)
FCF2 (1+WACC)2
++
FCFH (1+WACC)H
VH (1+WACC)H
DETERMINANTS OF m (P / E)
D1
P0 = r-g
E1 (1 - b)
= r - ROE x b (1 - b) P0 / E1 = r - ROE x b
1
NOMINAL INTEREST RATE
1
= 8.33 .12 1 = 5.00
.20
1 = 16.67 .06 0.5 = 16.67 PAYOUT RATIO 1 REAL RETURN 1 = 25 .04
.18 - .15
CASE A NO GROWTH DISCOUNT DISCOUNT RATE: 20% RATE: 25% 20 / 0.20 = 100 100 / 20 = 5.0 20 / 0.25 = 80 80 / 20 = 4.0
10
CASE B GROWTH DISCOUNT RATE: 20% 10 / (0.20 - 0.10) = 100 100 / 20 = 5.0
11
DISCOUNT RATE: 15% VALUE 20 / 0.15 = 133.3 PRICEEARNINGS MULTIPLE 133.3 / 20 = 6.67
r = 15%
P0 =
0.15
= 100
INVESTMENT .. RS. 15 PER SHARE IN YEAR 1 EARNS 15% 2.25 NPV PER SHARE = - 15 + = 0 0.15
RATE OF RETURN
IMPACT ON SHARE PRICE SHARE PRICE IN YEAR 0, IN YEAR 0 P0 -8.70 -4.35 0 4.35 8.70 91.30 95.65 0 104.35 108.70
E1/P0
IN GENERAL, WE CAN THINK OF THE STOCK PRICE AS THE CAPITALISED VALUE OF THE EARNINGS UNDER THE ASSUMPTION OF NO GROWTH PLUS THE PRESENT VALUE OF GROWTH OPPORTUNITIES (PVGO).
FROM THIS EQUATION, IT IS CLEAR THAT : EARNINGS-PRICE RATIO IS EQUAL TO r WHEN PVGO IS ZERO. EARNINGS-PRICE RATIO IS LESS THAN r WHEN PVGO IS POSITIVE. EARNINGS-PRICE RATIO IS MORE THAN r WHEN PVGO IS NEGATIVE.
PBV ratio =
Book value per share at time t
The PBV ratio has always drawn the attention of investors. During the 1990s Fama and others suggested that the PBV ratio explained to a significant extent the returns from stocks.
D1 = E1 (1 b) = E0 (1 + g) (1 b)
E0 (1 + g) (1 b) P0 = rg
E0 = BV0 x ROE
P0 = BV0 (ROE) (1 + g) (1 b) rg P0 BV0
PBV ratio =
ROE (1 + g) (1 b) r-g
PS ratio
Po S0
Looking at these equations, we find that there is one variable that dominates when it comes to explaining each multiple it is g for P/E, ROE for PBV, and NPM for PS. This variable the dominant explanatory variable is called the companion variable.
Taking into account the importance of the companion variable, investment practitioners often use modified multiples which are defined below.
:
: :
P/E
g PBV ROE PS Net profit margin
SECURITY SELECTION
USE OF A SPECIALISED CONCEPT
SMRn =
[DYn + EGn]
Investment return
+ [(PEn / PE0)1/n 1]
Speculative return
where : SMRn = annual stock market return over a period of n years DYn EGn = annual dividend yield over a period of n years = annual earnings growth over a period of n years
Illustration
Suppose you want to forecast the annual return from the stock market over the next five years (n is equal to 5). You come up with the following estimates. DY5 = 0.025 (2.5 percent), EG5 = 0.125 (12.5 percent), and PE5 = 18. The current PE ratio, PEo, is 15. The forecast of the annual return from the stock market is determined as follows: SMR5 = [0.025 + 0.125] + [(18/15)1/5 1] = [0.15] + [0.037] = 15 percent + 3.7 percent = 18.7 percent 15 percent represents the investment return and 3.7 percent represents the speculative return.
SUMMING UP
While the basic principles of valuation are the same for fixed income securities as well as equity shares, the factors of growth and risk create greater complexity in the case of equity shares.
Three valuation measures derived from the balance sheet are: book value, liquidation value, and replacement cost.
According to the dividend discount model, the value of an equity share is equal to the present value of dividends expected from its ownership. If the dividend per share grows at a constant rate, the value of the share is : P0 = D1/ (r g) A widely practised approach to valuation is the P/E ratio or earnings multiplier approach. The value of a stock, under this approach, is estimated as follows: P0 = E1 x P0/E1
In general, we can think of the stock price as the capitalised value of the earnings under the assumption of no growth plus the present value of growth opportunities (PVGo) E1 P0 = + PVGO
r
Apart from the price-earnings ratio, price to book value (PBV) ratio and price to sales (PSR) ratio are two other widely used comparative valuation ratios
Two broad approaches are followed in managing an equity portfolio : passive strategy and active strategy.
Stock market returns are determined by an interaction of two factors : investement returns and speculative returns.