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Stock Valuation

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92 views7 pages

Stock Valuation

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STOCK VALUATION

A “stock” or a “share of stock” is a piece of paper which says that you own part of a company.
Stock valuation is the process of determining the intrinsic value of a share of common stock of a
company.
The purpose of stock valuation is to find the value of a common share which is justified by the
company earnings and growth potential, identify undervalued and overvalued stocks, overweight
or underweight them in an investment portfolio and generate alpha i.e. excess return.
Types of stock

1. Common stock
- provides the permanent long-term financing of a firm
- represents the true residual ownership of a firm
- carries the right to vote on corporate policy and the composition of the board of
directors

2. Preferred stock
- carries no voting rights
- has preference over common stock in the payment of dividends and claims on
assets
- usually has a fixed dividend.

STOCK VALUATION MODELS


1. The Basic Stock Valuation Equation

Scenario A (Basic Stock Value)


*Let’s say a stock is now selling in the stock exchange at P24 per share. It has dividend of P2 per
year. You plan to sell it after 3 years. In 3 years, the price of the stock is expected to go up to
P25. Discount rate is 11%. What is the value of stock?
𝑆𝑡𝑜𝑐𝑘 𝑣𝑎𝑙𝑢𝑒 = 2(1.11)−1 + 2(1.11)−2 + 2(1.11)−3 + 25(1.11)−3
= P 23.17
Scenario B (Basic Stock Value)
*What if the same stock’s dividends would grow by 3% per year? What would be its new value
now?
Year 1 = 2
Year 2 = 2 x 1.03 = 2.06
Year 3 = 2.06 x 1.03 = 2.12

𝑆𝑡𝑜𝑐𝑘 𝑣𝑎𝑙𝑢𝑒 = 2(1.11)−1 + 2. 06(1.11)−2 + 2. 12(1.11)−3 + 25(1.11)−3


= P 23.30

2. Zero Growth Model


The zero dividend growth model assumes that the stock will pay the same dividend each year,
year after year.

Scenario C (Zero Growth)


What if dividend stayed at P2 per year, but you planned to keep the stock forever, and not sell it?
The discount rate is 11%.
Now we use the Perpetuity formula:
𝑆𝑡𝑜𝑐𝑘 𝑣𝑎𝑙𝑢𝑒 = P 2 / .11
= P 18.18

3. Constant Growth Model


The constant dividend growth model assumes that the stock will pay dividends that grow at a
constant rate each year—year after year forever.
Scenario D (Constant Growth)
What if dividend started at P2 per year and will grow by 3% per year, and you planned to keep
the stock forever, and not sell it? The discount rate is 11%.
Now we use the this formula:
𝑆𝑡𝑜𝑐𝑘 𝑣𝑎𝑙𝑢𝑒 = D / (r – g)
= 2 / (.11-.03)
= P 25
4. Variable Growth Model
The variable-growth model assumes that the stock will pay dividends that grow at one rate during
one period, and at another rate in another year or thereafter.
Example:
The most recent annual (2006) dividend payment of Warren Industries, a rapidly growing boat
manufacturer, was P1.50 per share. The firm’s financial manager expects that these dividends
will increase at a 10% annual rate, g1, over the next three years. At the end of three years (the
end of 2009), the firm’s mature is expected to result in a slowing of the dividend growth rate to
5% per year, g2, for the foreseeable future. The firm’s required return, ks, is 15%.

5. Free Cash Flow Model


The free cash flow model is based on the same premise as the dividend valuation models except
that we value the firm’s free cash flows rather than dividends.

6. Other Approaches to Stock Valuation: Price/Earnings (P/E) Multiples


Some stocks pay no dividends—using P/E ratios are one way to evaluate a stock under these
circumstances.
The model may be written as:

P = (EPS ) X (Industry Average P/E)


0 t+1

For example, Lamar’s expected EPS is $2.60/share and the industry


average P/E multiple is 7, then P = $2.60 X 7 = $18.20/share.
0

Table Summary of Key Valuation Definitions and Formulas for Common Stock
“Valuation analysis: The price should be right”

SUITS THE C-SUITE By Bernadette T. Cauan


Business World (08/29/2019)

Valuation is a vital part of management decision making, particularly in relation to


acquisitions, divestments, financial reporting, tax planning and compliance, dispute
resolution, business strategy, and performance management.

Regardless of the purpose and/or subject of the valuation, there are general
approaches and methods to performing valuation analysis.

General valuation approaches, as well as valuation methods more commonly used,


are described in this article.

INCOME APPROACH

This approach is anchored on the concept that value can be estimated by


determining the present value of expected future net cash flows to be generated,
based on the anticipated timing of its receipt.

The Discounted Cash Flow (“DCF”) analysis is commonly used in performing a


valuation based on the income approach. Since the resulting range of values is
substantially influenced by the amounts of anticipated future net cash flows and the
discount rate to be used, the financial projections are subjected to rigorous review,
and the range of discount rates to be used are carefully derived.

Prior to finalizing the net cash flows to be used for the DCF analysis, underlying
assumptions are analyzed vis-à-vis historical figures, financial results or key
performance indicators of peer compa nies, and the relevant sector outlook. Selected
key assumptions used in preparing the financial projections are also benchmarked
against available documents or reports.

MARKET APPROACH

The market approach is predicated on the concept that value can be esti mated
through a comparison of companies, shares, or assets that have similar features.

The usual challenge in utilizing this approach is the availability of relevant


information to be used in the valuation analysis.

The market approach is implemented throu gh two methods:

• Guideline Company Method — Here, relevant comparable companies are identified


through an iterative process.
Appropriate multiples are selected, adjustments, if any, are implemented, and then
an indication of value is derived based on the selected multiples.

The Guideline Company Method necessitates meticulous analysis to be able to


identify appropriate comparable companies.

Among the areas considered are the nature of business operations, business
segments, financial results, cash flow pat terns, key performance indicators and other
corporate statistics.

In case of enterprise value (“EV”), common multiples include EV to sales or


revenues, EV to earnings before interest, taxes, depreciation and amortization
(“EBITDA”) or EV to earnings before interest and taxes (“EBIT”), whereas in the case
of equity value, usual multiples include price -to-earnings (P/E) ratio, and the price -
to-book value (P/B) ratio.

• Similar Transaction Method — In this method, an indication of value is derived


based on the actual price paid by acquirers in comparable transactions.

The process for implementing the Similar Transaction Method is similar to the
Guideline Company Method.

COST APPROACH

This approach is founded on the principle of substitution, specifically, that no rational


buyer will pay for a company more than the cost of acquiring the corresponding net
assets that have similar condition and function.

The Adjusted Net Asset Value (“NAV”) method is typically used to derive value based
on the cost approach.

The NAV method requires restating all of the assets and liabilities of the company
from their historical cost basis to the appropriate standard of value, which is most
often either its fair market value or fair value.

The cost approach is commonly used to value holding companies, capital -intensive
companies, loss-making businesses or companies facing imminent liquidation.

However, it is not the best approach to value companies with predictably robust cash
flows or those with significant intangible value.

In practice, it is advisable to select a primary valuation approach, as well as a


secondary approach for purposes of cross -checking.

Ideally, the resulting range of values should be within a relatively tight range.
If the results are substantially far apart, it may suggest that the valuation analysis
needs to be revisited.

The selection of the valuation approaches and methods to be applied are normally
influenced by the condition and attributes of the subject of the valua tion and the
availability of information.

Inherent, of course, to performing valuation analysis will be the exercise of


professional judgment based on experience and market practice.

Moreover, valuation analysis involves estimation based on accepted models and


market practice.

This process necessitates an understanding of underlying assets, risks, potential


premiums, business models, industry practices, regulatory frameworks and the
market environment.

Hence, valuation is often said to be a combination of a rt and science.

(Bernadette T. Cauan is a Partner of SGV & Co.)


This article was originally published in the BusinessWorld newspaper. It is for
general information only and is not a substitute for professional advice where the
facts and circumstances warrant. The views and opinion expressed above are those
of the author and do not necessarily represent the views of SGV & Co.

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