B.

Equities - Fundamentals

Contents

1. Equity markets

2. Equity valua6on

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 B1. Equity markets
• Real versus Financial assets

− Real assets: those assets that can be used to produce goods and service
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Land, buildings, machines, knowledge, etc
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Generate net income to the economy

− Financial assets: are claims to the income generated by real assets

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Stocks (equity), bonds (fixed income), etc
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Do not generate any income: Financial assets simple define the
alloca6on of income or wealth

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B1. Equity markets
• Equi6es

− The most basic of financial instruments is the equity (aka stock or share)

− An equity represents a claim to a small piece of a company

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You could raise capital and launch a company by selling off future
profits in the form of a stake in the company

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Once your business is up and running, you could raise further capital
by issuing new shares

− Typically, this is how small businesses begin

− Once the small business has become large, shares in the company may be
sold to a wider audience or even the general public

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B1. Equity markets
• Equi6es

− In contrast to fixed income instruments, stocks represent ownership in a

corpora6on
− The performance of equity investments is 6ed to the success of the firm and
its real assets
1) Increase in equity value
2) Dividend payment
− Equi6es typically have:
− no maturity
− promise no fixed payments
− are not redeemed unless the company ceases opera6on

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B1. Equity markets
• Common versus preferred stocks

− Common stock usually en6tles the owner the right to vote at shareholder
mee6ngs and to receive dividends

− It has two significant features:

I. limited liability: the most shareholders can lose in the event of a

failure is their ini6al investment

II. residual claim: stockholders are the last in line of all those who have a
claim on the assets and income of the corpora6on

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B1. Equity markets
• Common versus preferred stocks

− Preferred stock has a prior claim on any dividend paid by the company and
to the net assets in the event of liquida6on

− Preferred stock has features similar to both equity and debt:

− It does not carry vo6ng rights
− It promises to pay its holder a fixed amount of income each year
− The firm retains the right to withhold dividends
− Unpaid dividends are cumula6ve and must be paid in full before any
dividend is paid to common stock holders
− In the event of liquida6on, preferred stock is junior to debt and senior
to common stocks
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 B1. Equity markets
• Issuing Financial Securi6es
− By issuing stocks and/or bonds, firms can raise capital

− Newly issued claims are exchanged on the primary market with funds flowing
from the investors to the issuers

− Types of primary market issues of common stocks

− IPO (ini6al public offering): stocks issued by a formerly private company
that is going public
“selling to the public for the first 6me”
− SEO (Seasoned equity offering): offered by companies that already have
floated equity
− Private Placements: sale to a rela6vely small number of ins6tu6onal or
wealthy investors; it requires no registra6on and can be less costly than a
public offering. Privately placed instruments have limited liquidity

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B1. Equity markets
• Securi6es Trading

− Once issued, securi6es are traded amongst investors on secondary markets:

• Organized securiFes exchanges:

• regulated markets approved by securi6es and markets authori6es
e.g. NYSE, Amex, Euronext (formerly known as the Paris Bourse)
• par6cipants must meet membership requirements and securi6es
need to conform to lis6ng and maintenance requirements

• Over the Counter markets:

• informal, decentralized market of brokers and dealers
• there is no membership requirement for trading and no lis6ng
requirements for securi6es but intermediaries need to be licensed
by authori6es

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B1. Equity markets
• Securi6es Trading
Buying on margin:

– An investor borrowing part of the purchase price of securi6es from a

broker

– The ini6al margin is the por6on of the purchase price that must be
contributed by the investor

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B1. Equity markets
• Securi6es Trading: MARGIN TRADING EXAMPLE
€22 Purchase Price 1000 Shares Purchased
50% Ini6al Margin 40% Maintenance Margin
Ini6al Posi6on

Stock price falls to €14 per share...

New Posi6on

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B1. Equity markets
• Securi6es Trading
Short Sale:

– An investor borrowing securi6es from a dealer and selling them

– The investor will need to buy these back on the market to return them
to the lender

– The purpose is to profit from an expected price decline.

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B1. Equity markets
• Securi6es Trading: SHORT SELLING EXAMPLE
€22 Ini6al Price 1000 Shares borrowed & shorted
50% Ini6al Margin 30% Maintenance Margin
Ini6al Posi6on

Stock rises to €28 per share...

New Posi6on

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B1. Equity markets
• Securi6es Trading

− Trading involving dealers and brokers:

− Normally we observe two prices for the same stock: Bid-Ask

Stock Bid Ask

Tesla, Inc. 390$ 395$

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Bid price: the price at which a market-maker or dealer is prepared to
buy securi6es or other assets
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Ask price: the price at which a market-maker or dealer is prepared to
sell securi6es or other assets

− the bid-ask spread represents a dealer’s profit margin and is an implicit

cost of trading

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B2. Equity valua6on

Equity Valua@on

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 B2. Equity valua6on
• Equity valua6on

− If we could predict the behavior of stock prices then we would be

very rich

− Many people have claimed to be able to predict prices

− However, no one has yet made a completely convincing case

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 B2. Equity valua6on
• Equity valua6on models

− Suppose that ENGIE’s market price per share is 15€

− The ques6ons we would like to answer are:

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Is this stock value “correct”?

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What assump6ons could jus6fy this value?

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Is this market behavior consistent with a ra6onal valua6on model

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B2. Equity valua6on
• Valua6on approaches

− ValuaFon by comparables
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The basic premise is that an equity’s value should present some
resemblance to other equi6es in a similar class

− Dividend discount models (DDM)

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A stock is worth the sum of all of its future dividend payments,
discounted back to their present value

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B2. Equity valua6on
• Valua6on by comparables

− The method of comparables is the most widely used approach for analysts
repor6ng valua6on judgments

− The economic ra6onale underlying the method of comparables is the law of

one price:

“IdenFcal assets should sell for the same price”

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B2. Equity valua6on
• Valua6on by comparables

− The methodology involves using a price mul@ple to evaluate whether an

asset is fairly valued, undervalued, or overvalued in rela6on to a benchmark

− The term price mul@ple refers to a ra6o that compares the share price with
some sort of monetary flow or value to allow evalua6on of the rela6ve
worth of a company’s stock

− Choices for the benchmark mul6ple include

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the mul6ple of a closely matched individual stock
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the average or median value of the mul6ple for the stock’s industry
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some analysts perform trend or 6me-series analyses and use past or
average values of a price mul6ple as a benchmark

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B2. Equity valua6on
• Valua6on by comparables
− Iden6fying individual companies or even an industry as the “comparable”
may present a challenge

− Many large corpora6ons operate in several lines of business, so the scale

and scope of their opera6ons can vary significantly

− The analyst should be careful to iden6fy companies that are most similar
according to a number of dimensions
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overall size
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product lines
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growth rate
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etc

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B2. Equity valua6on
• Valua6on by comparables

- Observable financial data:

• Price to earnings raFo

• Price to Book raFo
• Price to Sales raFo
• Price to Cash flow raFo

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B2. Equity valua6on
• Valua6on by comparables

− Price to earnings raFo (P/E or PER)

− P/E is the ra6o of the stock price to earnings per share.

− Earnings per share (EPS) is calculated as the company’s profit divided by the
outstanding shares of its common stock

− EPS measures the profitability of a company

− P/E is arguably the price mul6ple most frequently cited by the media and
used by analysts and investors

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B2. Equity valua6on
• Valua6on by comparables

− Price to Book raFo (P/B): it is the ra6o of the stock price to book value per
share

− Price-to-sales raFo (P/S): this measure is the ra6o of stock price to sales per
share

− Price-to-cash-flow raFo (P/CF): this measure is the ra6o of stock price to

some per-share measure of cash flow

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B2. Equity valua6on
• Valua6on by comparables

− A common cri6cism of all of these mul6ples is that they do not consider the
future

− Prac66oners seek to counter this cri6cism by forecas6ng fundamental

values one or more years into the future
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The analyst es6mates the earnings per share (EPS) of the stock for the
forthcoming year
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The intrinsic value is the EPS 6mes the “normal level” of the PER for
the stock

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B2. Equity valua6on
• Price-earnings ra6o

− Example:

• In May 2010, the consensus EPS for Renault was €11.5

• European automo6ve stocks traded at an average PER of 10
• Using the industry average as the normal level for Renault’s PER:

Renault’s intrinsic value = 11.5 x 10 = 115 €/share

• The stock was then trading at €68 and over 80% of analysts had a buy
or overweight recommenda6on

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 B2. Equity valua6on
• Price-earnings ra6o

– The PER is a reflec6on of the market’s op6mism concerning a firm’s growth

prospects

– The analyst must decide whether he/she is more or less op6mis6c than the
market

– The PER is also used as a compara6ve valua6on ra6o to comment about the
rela6ve valua6on of firms within the same industry

“VW PER = 13.3 is expensive rela@ve to Renault PER = 5.9”

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 Concrete Case - Nyrstar
Analysts Recommenda6ons

Source: Bloomberg, 18 Feb 2013.

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B2. Equity valua6on
• Dividend discount models

− The key underlying concept is that:

“The value of any financial asset is the present value of

the future cash-flows”

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B2. Equity valua6on
• Dividend discount models

− The owner of the stock owns a piece of the company

− The value in holding the stock comes from

1. Dividends
2. Any growth in the stock’s value

− Dividends are lump sum payments, paid out to the stock holder

− The amount of the dividend varies from 6me to 6me depending on

the profitability of the company

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B2. Equity valua6on
• The 6me value of money

− The most fundamental concept in finance is that

1$ today is worth more than 1$ in a year’s @me

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B2. Equity valua6on
• Appendix: Present and Future value

− Future value: is what a certain euro amount today, if invested, will be

worth to you at some 6me in the future
− The future value of the cash flow depends both on the amount and
how far into the future you are looking

− Present value: is the amount that you would need to invest today to build
up certain future cash flow
− Present value provides a basis for assessing the fairness of any future
financial benefits or liabili6es

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B2. Equity valua6on
• Appendix: Present and Future value

− Example: Future value

− Assume you have 100€ and can invest at 8% per year

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Value in 1 year = 100 € ∗ ( 1+0.08 )=108 €

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Value in 2 years = 100 € ∗ ( 1+0.08 ) ∗ ( 1+0.08 )=108 € ∗ ( 1+0.08 ) =100 € ∗ ( 1+ 0.08 )2=116.64 €

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Value in n years = 100 € ∗ ( 1+0.08 ) ∗ ( 1+0.08 ) ∗ ...∗ ( 1+0.08 ) =100 € ∗ ( 1+0.08 )
n

− In general the future value in n years of a P euros invested today is

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B2. Equity valua6on
• Appendix: Present and Future value

− Example: Present value

− With an interest rate of 6%, what is the PV of 100€ received one year
from now?

PV =100 € / ( 1+0.06 )=94.34 €

− What if the interest rate is 10%?

PV =100 € / ( 1+0.10 )=90.91 €

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B2. Equity valua6on
• Appendix: Present and Future value

− Example: Present value

− With an interest rate of 10%, what is the Present Value of 100€
received two years from now?

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PV =100 € / ( 1.10 ) =82.64 €

− In general, with an interest rate of r , and a future cash flow F payable in n

years, the present value is:

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B2. Equity valua6on
• Appendix: Present and Future value

− Remarks:

I. The higher the interest rate, the lower the present value
II. The longer the 6me un6l the cash flow, the lower the present value

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B2. Equity valua6on
• Present value models

− These models assume that the stock is bought, held for some 6me and then
sold

− The stock is valued as the present value of the expected dividend

distribu6on and the expected proceeds from the sale

− AssumpFon: The investor expects a return consis6ng of cash dividends and

capital gains or losses from the sale

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B2. Equity valua6on
• Dividend Discount Models
− The intrinsic value of a share is the present value of the dividend to be
received at the end of the first year and the expected sales price

− But, what is the expected sales price at t = 1

− Hence,

− Now, is fair to ques6on what is the forecast price at t = 2 and so on

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B2. Equity valua6on
• Dividend Discount Models

− In general, for a holding period of n years, the intrinsic stock value is

− Since the price at which you can sell a stock in the future depends on
dividend forecast at that 6me, we can say that

− This formula is called the dividend discount model (DDM)

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B2. Equity valua6on
• Dividend Discount Models

− Note that, DDM formula is rather useless since it requires dividend

forecast for every year into the indefinite future

− We need to introduce some simplifying assump6ons

“Constant growth dividends”

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B2. Equity valua6on
• Dividend Discount Models

− Constant growth dividend discount model (aka Gordon model):

• V is the intrinsic value

0
• D is the last dividend paid by the firm
0
• k the required rate of return
• g the growth rate of dividend

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B2. Equity valua6on
• Dividend Discount Models

− This model represents a Growing Perpetuity

− A growing perpetuity pays D, then D (1+g), then D (1+g)2, then…
− For example:
D1 = $100
D2 = $100 (1 + 10%) = $110
D3 = $100 (1 + 10%)2 = $121
…

Growing Perpetuity

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B2. Equity valua6on
• Dividend Discount Models
− MulFstage growth model:
• Growth rates are generally not constant
• Analysts prefer determining the intrinsic value by:
− forecas6ng dividends over a given 6me horizon
− assuming constant growth therearer

D1 D2 D3 Dt + Vt
V0 = + + + ... +
1 + k (1 + k ) 2 (1 + k ) 3 (1 + k ) t

Dt (1 + g )
Vt =
k−g
Dividends aSer @me t are assumed to have a constant growth rate of g

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Exercise 1
• Suppose that the expected dividends for the next three years are given
as follow:

Year Dividend
1 100$
2 120$
3 150$

After the third year dividends are expected to grow 5% a year forever

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Exercise 1
a. What is the intrinsic value if the appropriate rate of return is 10%.

b. What is the expected sale price at t = 3, right after the third year
dividend payment?

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Exercise 2
• Dividend Discount Models
− Example of DDM using a capitaliza6on rate:

AssumpFons

• At t = 0, Company X has already paid a dividend of 100$

• Discount Rate: 10%

• Growth Rate first 5 Years: 12%

• Growth Rate arer first 5 Years: 5%

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Exercise 2
• Dividend Discount Models
− Example of DDM using a capitaliza6on rate:

Last Dividend paid = 100

5-year g = 0,12
a^er 5-year g = 0,05
Discount rate = 0,1

t 1 2 3 4 5
Cash Flow
Growing Perpetuity
Discount Factor
CF Present Value

Intrinsic Value =

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