Chapter 13EQUITY VALUATION How to Find Your Bearings Outline • Balance Sheet Valuation • Dividend Discount Model • Earnings Multiplier Approach • Earnings – Price Ratio, Expected Return, and Growth • Other Comparative Valuation Ratios • Equity Portfolio Management • Forecasting the Aggregate Stock Market Return Techniques of Fundamental Equity Valuation Balance Sheet Techniques • Book Value • Liquidation value • Replacement Cost Techniques of Fundamental Equity Valuation Discounted Cash Flow Techniques • Dividend discount model • Free cash flow model Relative Valuation Techniques • Price earnings ratio • Price-book value ratio • Price-sales ratio Balance Sheet Valuation • Book Value • Liquidation Value • Replacement Cost . Dividend Discount Model • Single Period Valuation Model D1 P1 P0 = + (1+r) (1+r) Mufti .Period Valuation Model Dt P0 = t=1 (1+r)t Zero Growth Model D P0 = r Constant Growth Model D1 P0 = r-g • • • . g2 .1+g1 1+r P0 Where Pn D1 (1+g1)n-1 (1+g2) 1 (1+r)n = D1 r .g1 n Pn + (1+r)n = (1+r)n r .Two-Stage Growth Model 1 . 05 = 13.00.15 P0 = 2.76 2.20 1 1.05 1 (1. VERTIGO IS EXPECTED TO ENJOY AN ABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6 YEARS.. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISE AT 10 PERCENT.968 + 56.20)5 (1. WE GET THE INTRINSIC VALUE ESTIMATE AS FOLLOWS : 6 1.2(1.4322] .40 PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL.1.488)(1. EQUITY INVESTORS REQUIRE A RETURN OF 15 PERCENT.79 = RS.15 .Two-Stage Growth Model: Example EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OF VERTIGO LIMITED IS RS.2.20 1 .40 . WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OF VERTIGO ? THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE : g1 = 20 PERCENT g2 = 10 PERCENT n = 6 YEARS r = 15 YEARS D1 = D0 (1+g1) = RS.15 .40 (2.291 = 2.70.20) = 2.40 -0.10 2.15)6 [0.40 (1.10) + ..10) + . gn) [(1+gn) + H (ga .H Model ga gn H 2H D0 PO = r .gn Value based on normal growth rate + r .gn Premium due to abnormal growth rate .gn D0 (1+gn) D0 H (ga .gn)] = r . 15 + 16.00 P/E = 27.25 .15) = 0.18 .33 IF E = 2 ..15) P0 H=5 r = 18% 1 x 5(.67 = 55.5 = 38.0.18 .Illustration: H Ltd D0 = 1 ga = 25% gn = 15% 1 (1.15 + 0.0. Returns. 2.20 .0.00 10.05 RS.0% 5.20.33 0.00 (D1 / PO) Dividend Yield Capital Gains Yield (P1 .40.0.0% 10.33 .00 0.15 = RS.20 .44 Normal Growth Firm PO = = RS. and P/E Ratio Price D1 PO = r-g RS.Impact Of Growth On Price.00 15.13.PO) / PO Price Earnings Ratio (P / E) Low Growth Firm PO = = RS.0% 13.00 5.0% 6.10 RS.0% 4.0. 2.0% 15.67 Supernormal Growth Firm PO = 0. 2.20 . Free Cash Flow Model The enterprise value (EV) according to the free cash flow model is: EV= FCF1 + FCF2 +…+ FCFH + VH (1+WACC) (1+WACC)2 (1+WACC)H (1+WACC)H Present value of horizon value Present value of the FCF during the explicit forecast period . in crore Liabilities Shareholders’ funds Equity capital (10 crore shares of Rs. Rs.Illustration The balance sheet of Azura Limited at the end of year 0 (the present point of time) is as follows. 10 each) Reserves and surplus Loan funds rate (9 percent) 250 Assets 100 Net fixed assets Net working capital 400 100 150 250 500 500 . The weighted average cost of capital is: 4. Exhibit 13.1 86.4 12 8 3.08) = Rs.08 FCFH (1+g) = 0.1 130.333) = 11 percent The horizon value of the firm is FCFH+1 VH = r–g + 0.0) 20 2 600.4 Free Cash Flow Forecast Year Asset value (Beginning) NOPAT Net investment FCF Growth rate (%) 1 500. The free cash flow forecast for the explicit forecast period is given in Exhibit 13.1562.08 43.0 (48.4.4 crore .7 1083.7 43.7 12 Rs.0) 20 3 720.7 103.0 100.0 72.4 144.0 120.0 86. In crore 5 6 967.1 116.4 (1.6) 20 4 864.0 (57.0 60.0 (40.5 x 9 (1-0.0 103. The explicit forecast period is 6 years because the firm reaches a steady state at the end of 6 years. 2.11 – 0. WACC = 0.11 – 0.5 x 16 + 0.Based on the above information we can calculate the intrinsic value of the equity share as follows: 1.2 116. 11)5 + (1.6 + 0 (1. 491.4 Crores Enterprise value 7.4 48 (1.4 crore / 10 crore = Rs.11)3 1562. The equity value of Azura is: Preference value = 741.00 = (1.11)6 + (1. 741.4 – 250.11)6 = Rs.11)4 + (1.11) 0 (1. 49. EV The enterprise value of Azura is: -40.4 crores 6. .5. The value per share of Azura is: Rs. 491.11)2 43.4 57.0 = Rs. ROE x b .ROE x b (1 .b) P0 / E1 = r .b) = r .Earnings Multiplier Approach P0 = m E1 Determinants of m (P / E) D1 P0 = r-g E1 (1 . • Why 1.Cross -Section Regression Analysis P/E g b • • = = = = 8. of % eps change Every conceivable variable & combination of variables . but less successful … in selecting appropriate .... Dev .2 + 1.7b .5g + 6. explaining stock prices . buy .. at a point .. Market Tastes Change • Weights Change 2... sell.. highly successful . time. Almost .. Input values change over time • Div … & growth in earnings 3. all … these models .2 Growth rate for ‘normalized’ eps Payout ratio Std. stocks ... There are firm effects not captured by the model . tried.. P / E Benchmark Rules Of Thumb • Growth rate in earnings 10% • 1 Nominal interest rate 15% 20% 1 = 8.67 Payout ratio .00 .06 • 0.18 .33 .12 1 = 5.20 • 1 Real return 1 = 25 .5 = 16. Rate .gr.04 25% 35% 1 = 16.15 Req. Ret .67 .. 7 66.3 Priceearnings multiple 133.10) = 66.0 .Growth And P / E Multiple Case A : Year 0 Total Assets Net Worth Sales Profit After Tax Dividends Retained Earnings 100 100 100 20 20 No Growth Year 1 100 100 100 20 20 Case B : Year 0 100 100 100 20 10 10 Percent Growth Year 1 110 110 110 22 11 - Case A No Growth Discount Discount Rate: 20% Rate: 25% 20 / 0.10) = 200 200 /20 = 10.3 / 20 = 6.0 10 11 Case B Growth Discount Discount Rate: 20% Rate: 25% 10 / (0.10) = 100 100 / 20 = 5.20 = 100 100 / 20 = 5.33 Discount Rate: 15% Value 20 / 0.0.0 20 / 0.20 .25 .15 .0.15 = 133.0 10 / (0.7 / 20 = 3.0.25 = 80 80 / 20 = 4.67 Discount Rate: 15% 10 / (0. 65 0 104.35 8.E / P. RS.15 .15 0.15 0.15 0.35 108..25 0. IN YEAR 0 P0 -8.35 0 4.144 0. Expected Return.20 0.70 -4.138 0.30 95. E2 = D2 = 15 15 P0 = 0. 15 Per Share in Year 1 … Earns 15% 2.15 0.75 0.70 91.10 0.15 0.25 Npv Per Share = .15 0.164 0. And Growth 1 E1 = D1 = 15 2 …….15 + = 0 0.70 E1/P0 r 0.25 3.75 1.15 RATE OF RETURN INCREMENTAL CASH FLOW PROJECT'S NPV IN YEAR 1 -10 -5 0 5 10 IMPACT ON SHARE PRICE SHARE PRICE IN YEAR 0..157 0.05 0.15 = 100 r = 15% Investment .50 2..00 3. WE GET E1 = P0 r 1 P0 PVGO + PVGO FROM THIS EQUATION. 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). EARNINGS-PRICE RATIO IS LESS THAN r WHEN PVGO IS POSITIVE. EARNINGS-PRICE RATIO IS MORE THAN r WHEN PVGO IS NEGATIVE. E1 P0 = r MANIPULATING THIS A BIT.IN GENERAL. IT IS CLEAR THAT : EARNINGS-PRICE RATIO IS EQUAL TO r WHEN PVGO IS ZERO. . Price To Book Value Ratio (PBV Ratio) Market price per share at time t 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. Determinants Of The PBV Ratio D1 P0 = r–g D1 = E1 (1 – b) = E0 (1 + g) (1 – b) P0 = E0 (1 + g) (1 – b) r–g E0 = BV0 x ROE P0 = BV0 (ROE) (1 + g) (1 – b) r–g PBV ratio = P0 = ROE (1 + g) (1 – b) BV0 r-g . . • Portfolios of low PSR stocks tend to outperform portfolios of high PSR stocks.Price To Sales Ratio (PSR Ratios) • In recent years PSR has received a lot of attention as a valuation tool. • It makes more sense to look at PSR/Net profit margin as net profit margin is a key driver of PSR. The PSR is calculated by dividing the current market value of equity capital by annual sales of the firm. Determinants of the PS Ratio PS ratio = Po S0 = NPM (1+g) (1-b) r-g . we find that there is one variable that dominates when it comes to explaining each multiple – it is g for P/E.Companion Variables and Modified Multiples Let us look at the equations for P/E ratio. and PS ratio. This variable – the dominant explanatory variable – is called the companion variable. and NPM for PS.b) r–g PBV = ROE (1 + g) (1 – b) (r – g) PS = NPM (1 + g) (1 – b) r-g Looking at these equations. P/E = (1 . PBV ratio. ROE for PBV. . P/E to growth multiple. investment practitioners often use modified multiples which are defined below. referred to as PSM : PS Net profit margin . referred to as PEG • : P/E g • PBV to ROE.Taking into account the importance of the companion variable. referred to as value ratio : PBV ROE • PS to NPM. 3.Sum of the Parts Method Many companies have subsidiaries or associate companies in which they have significant equity stakes that usually range between 25 percent and 100 percent. and for unlisted subsidiaries. To do this. 2. Determine the value per share attributable to the core business. One way to do is to calculate the earnings per share from the core business and apply a suitable multiple to it. The SOTP method involves the following steps: 1. 4. In computing this value a discount factor of 15 to 20 percent is generally applied to the observed market value of the equity stake in the listed subsidiary. Add the per share values for the core business. to get the total value per share. Find the value per share for each of the listed subsidiaries. the analyst has to first estimate the market value using an earnings multiple or some other basis as there is no observed market value and then apply a discount factor of 15 to 25 percent to the same. . To ascertain the intrinsic value per share of such companies the sum of the parts (SOTP) method of valuation is commonly employed. Assess the value per share for each of the unlisted subsidiaries. for listed subsidiaries. 2 11.7 48.8 SOTP Valuation – Based on FYO8E Business M&M Multiple Parameter Discount Per share stake Core auto business Mahindra and Mahindra financial services Mahindra GESCO developer Tech Mahindra Mahindra Ugine steel co ltd Mahindra forgings Mahindra holidays and resorts 39% 44% 55% 47% 100% Market cap Market cap Market cap Market cap Pat 68% (%) 10.0 Mahindra holdings and finance Total subsidiaries value Total value per share (Rs.6 250.) Source: company.8 Exhibit 13.3 840.An illustrative sum of the parts (SOTP) valuation of Mahindra and Mahindra. is given in exhibit 13.6 20% 20% 20% 20% 25% 27.0 .6 37. done in 2007.5 Eps Market cap 20% value 451.2 5.0 388. CSEC research 100% Pat 25% 8. Equity Portfolio Management Passive Strategy • Buy and hold strategy • Indexing strategy Active Strategy • Market Timing • Sector Rotation • Security Selection • Use of a Specialised Concept . Forecasting The Aggregate Stock Market Return Stock market returns are determined by an interaction of two factors : investment returns and speculative returns. . • In formal terms : 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 = annual dividend yield over a period of n years EGn PEn PE0 = annual earnings growth over a period of n years = price-earnings ratio at the end of n years = price-earnings ratio at the beginning of n years. 5 percent). The forecast of the annual return from the stock market is determined as follows: SMR5 = [0.7 percent represents the speculative return.037] = 15 percent + 3.125] + [(18/15)1/5 – 1] = [0. DY5 = 0.5 percent).15] + [0.Illustration Suppose you want to forecast the annual return from the stock market over the next five years (n is equal to 5). .7 percent = 18. is 15. PEo.025 + 0. You come up with the following estimates. and PE5 = 18.025 (2.125 (12. The current PE ratio. EG5 = 0.7 percent 15 percent represents the investment return and 3. is estimated as follows: • • • • P0 = E1 x P0/E1 . According to the dividend discount model. the value of an equity share is equal to the present value of dividends expected from its ownership. Three valuation measures derived from the balance sheet are: book value. and replacement cost. If the dividend per share grows at a constant rate.Summing Up • While the basic principles of valuation are the same for fixed income securities as well as equity shares. liquidation value. The value of a stock. the factors of growth and risk create greater complexity in the case of equity shares. 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. under this approach. • In general. Two broad approaches are followed in managing an equity portfolio : passive strategy and active strategy. 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. Stock market returns are determined by an interaction of two factors : investment returns and speculative returns.