POST GRADUATE CERTIFICATE PROGRAMME MANAGEMENT

Financial Econometrics

PGP I : Term 2

Finance - I
Session # 10

Equity Valuation. . .

Any Questions ??
Stock Valuation
Different types of cash flows
-- Lump sum (one time)
-- Annuity (fixed amount every period for certain duration)
-- Growting annuity
-- Perpetuity (fixed amount every period forever!
-- Growing Perpetuity

 Perpetuity
 A perpetuity is a constant cash flow at regular intervals forever. The present
value of a perpetuity is-

PV of Perpetual cash flows : CF / r

 Forever may be a tough concept for human beings to grasp, but it makes
the mathematics much simpler.
 Growing Perpetuities
 A growing perpetuity is a cash flow that is
expected to grow at a constant rate forever. The
present value of a growing perpetuity is -
CF1
PV of Growing Perpetuity =
(r - g)

where
 CF1 is the expected cash flow next year,
 g is the constant growth rate and
 r is the discount rate.
 Discounted Cash Flow Valuation
 What is it: In discounted cash flow valuation, the value of an asset is the
present value of the expected cash flows on the asset.
 Philosophical Basis: Every asset has an intrinsic value that can be
estimated, based upon its characteristics in terms of cash flows, growth
and risk.
 Information Needed: To use discounted cash flow valuation, you need
 to estimate the life of the asset
 to estimate the cash flows during the life of the asset
 to estimate the discount rate to apply to these cash flows to get present value

 Market Inefficiency: Markets are assumed to make mistakes in

pricing assets across time, and are assumed to correct themselves over
time, as new information comes out about assets.
 I.Equity Valuation
 The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting
all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required
by equity investors in the firm.

t =
CF to Equity t
Value of Equity = 
t =1 (1 + k e ) t

where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity

 Forms: The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present
value of expected future dividends.
 Generic DCF Valuation Model
DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Net Income/EPS Firm is in stable growth:
Equity: After debt
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

 Burke Tires just paid a dividend of D0 = $1.32. Analysts expect the
company's dividend to grow by 30% this year, by 10% in Year 2, and
at a constant rate of 5% in Year 3 and thereafter. The required return
on this low-risk stock is 9.00%. What is the best estimate of the
stock's current market value?
Year 0 1 2 3….
Growth rates: 30.0% 10.0% 5.0%
Dividend $1.32 $1.716 $1.888 $1.982
Terminal value = D3/(rs - g3) = 49.550
Total CFs $1.716 $51.437
PV of CFs $1.574 $43.294
rs = discount rate= 9.0%
Terminal growth rate is the constant rate at which the Eq is expected to grow for ever.
Terminal value = Horizon value= PV of CF from year 3 to infinity
= Last cash flow forecast / (discount rate – terminal growth rate)

Stock price = $44.87

 First, list down the timeline of cash flows

 Terminal value of the stock: 59.625


 PV of Yr 3 cash flow: 0.751315
 PV of Yr 4 cash flow: 1.02452
 PV of Yr 5 cash flow: 38.41951

 Present value of the stock : $ 40.19534
 II. Firm Valuation
 Cost of capital approach: The value of the firm is obtained by
discounting expected cashflows to the firm, i.e., the residual
cashflows after meeting all operating expenses and taxes, but prior to
debt payments, at the weighted average cost of capital, which is the
cost of the different components of financing used by the firm,
weighted by their market value proportions.

t =
CF to Firm t
Value of Firm =  t
t =1 (1 + WACC)
 Suppose Crum Inc. had a free cash flow of $200million at the end of the most recent
year and Crum’s FCFs are expected to grow at a constant rate of 5% per year forever.
Further assume that the Crum’s WACC is 9% and cost of equity is 12%. The firm
currently holds $100million as short term investments in marketable securities. In
the recent year balance sheet, Crum Inc. shows a long term debt of $3000 million and
a preferred stock holders valuing at $100millions. Crum Inc. balance sheet shows 325
million shares as common shares outstanding. Determine Crum’s firm value and
equity value.
 Total corporate value is sum of value of operations and value of non-operating assets.
Debt holders have first claim. Preferred stockholders have the next claim. Any
remaining value belongs to stockholders.
 Operating Value of Crum Inc.

Total value of Crum Inc. = Op.Value + NonOpValue

= 5,250 + 100 = $5350mln

Equity Value = Total Value of firm – Claims of Debt holders – Claims

of Preferred share holders

= 5,350-3000-100 = $2,250mlns.

Equity value per share = 2250 / 325 = $6.92

 Based on the DCF valuation model, the value of Weidner Co.'s operations is
$1,200 million. The company's balance sheet shows $80 million in accounts
receivable, $60 million in inventory, and $100 million in short-term
investments that are unrelated to operations. The balance sheet also shows
$90 million in accounts payable, $120 million in notes payable, $300 million
in long-term debt, $50 million in preferred stock, $180 million in retained
earnings, and $800 million in total common equity. If Weidner has 30
million shares of stock outstanding, what is the best estimate of the stock's
price per share?
Assuming that the book value of debt is close to its market value,
the total market value of the company is:
Total market value = Value of operations + Value of non-operating assets
= $1,200 + $100 = $1,300.

Value of Equity = Total MV - Long- and Short-term debt and preferred = $830
Stock price = Value of Equity/Shares outstanding = $27.67

The book value of equity figures are irrelevant for this problem. Also, the working capital
account numbers are not relevant because they were netted out when the FCF was
calculated.
 Relative Valuation
 What is it?: The value of any asset can be estimated by looking
at how the market prices “similar” or ‘comparable” assets.
 Philosophical Basis: The intrinsic value of an asset is
impossible (or close to impossible) to estimate. The value of an
asset is whatever the market is willing to pay for it (based upon
its characteristics)
 Information Needed: To do a relative valuation, you need
 an identical asset, or a group of comparable or similar assets
 a standardized measure of value (in equity, this is obtained by dividing the price by a
common variable, such as earnings or book value)
 and if the assets are not perfectly comparable, variables to control for the differences

 Market Inefficiency: Pricing errors made across similar or

comparable assets are easier to spot, easier to exploit and are
much more quickly corrected.
Variations on Multiples
 Equity versus Firm Value
 Equity multiples (Price per share or Market value of equity)
 Firm value multiplies (Firm value or Enterprise value)
 Scaling variable
 Earnings (EPS, Net Income, EBIT, EBITDA)
 Book value (Book value of equity, Book value of assets, Book value of capital)
 Revenues
 Sector specific variables
 Base year
 Most recent financial year (Current)
 Last four quarters (Trailing)
 Average over last few years (Normalized)
 Expected future year (Forward)
 Comparables
 Sector
 Market
 Alternative Valuations: Relative Valuation
 Mr Ranger looked at the market valuation of a comparable business on
the Western India, Molly Sports. Molly’s shares were currently priced
at 50% above book value and were selling on a prospective price-
earnings ratio of 12 and RangerSports has a equity book value of
Rs40.71 Cr. Currently, the books of Ranger Sports reports 200k
outstanding shares and a net profit of 4.66cr in recent annual year.

 Book value = 40.71 Cr / 200k = 2036

 Market value = 40.71cr*1.5 times / 200k = 3053
 PE multiple = 12*4.66 Cr / 200k = 2796
Stocks X and Y have the following data.
Assuming the stock market is efficient and the stocks are in equilibrium,
which of the following statement is CORRECT?

X Y
Price $25 $25
Expected dividend yield 5% 3%
Required return 12% 10%

a. Stock X pays a higher dividend per share than Stock Y.

b. One year from now, Stock X should have the higher price.
c. Stock Y has a lower expected growth rate than Stock X.
d. Stock Y has the higher expected capital gains yield.
e. Stock Y pays a higher dividend per share than Stock X.

ANS: A
Stock X has a dividend yield of 5% versus a yield of 3% for Y.
Since they both have the same stock price, X must pay a higher dividend.
Dividend = Yield *Price: X dividend = $1.25 Y dividend = $0.75
A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00.
The dividend is expected to decline at a rate of 5% a year forever (g = -5%).
If the company is in equilibrium and its expected and required rate of return is
15%, which of the following statement is CORRECT?
a. The company's dividend yield 5 years from now is expected to be 10%.
b. The constant growth model cannot be used because the growth rate is negative.
c. The company's expected capital gains yield is 5%.
d. The company's expected stock price at the beginning of next year is $9.50.
e. The company's current stock price is $20.

ANS: D
Note that P0 = $2/(0.15 + 0.05) = $10. That price is expected to decline by 5% each year, so
P1 must be $10(0.95) = $9.50. Therefore, answer d is correct, while the others are all false.
 Risk & Return
Rates of Return
 Different Asset classes
 Financial performance = Return
 Make sure to use Adjusted Closing Prices while calculating returns
 Adjusted for dividends, bonus, rights and other corporate events

 Holding Period Returns

 Continuous compounding Returns
 Nominal vs Real Returns
 Gross vs Net Returns

 Historical vs Expected Returns

 Expected Return
 The future is uncertain.
 Investors do not know with certainty whether the economy / stock will be
growing rapidly or be in recession.
 Investors do not know what rate of return their investments will yield.
 Therefore, they base their decisions on their expectations concerning the
future.
 The expected rate of return on a stock represents the mean of a
probability distribution of possible future returns on the stock.
 Expected Return
The table below provides a probability distribution for the returns on stocks A and B

State Probability Return On Return On

Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%

 The state represents the state of the stock growth one period in the future

 The probability reflects how likely it is that the state will occur. The sum of the probabilities
must equal 100%.
 The last two columns present the returns or outcomes for stocks A and B that will occur in
each of the four states.
Expected Return
 Given a probability distribution of returns, the expected return
can be calculated using the following equation:
N

E[R] =  (piRi)
i=1

 Where:
 E[R] = the expected return on the stock
 N = the number of states
 pi = the probability of state i
 Ri = the return on the stock in state i.
 Expected Return
 In this example, the expected return for stock A would be
calculated as follows:

E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%

E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%

 So Stock B offers a higher expected return than Stock A.

 However, that is only part of the story; we haven't considered
risk.
 Risk
 Risk is an uncertain outcome or chance of an adverse outcome.
 Concerned with the riskiness of cash flows from financial assets.
 The variability of returns from those that are expected

 Investor’s view of risk

 Risk Averse-
 Risk Neutral-
 Risk Seeking-
 Measuring Risk
 Risk reflects the chance that the actual return on an investment may be
different than the expected return.
 One way to measure risk is to calculate the variance and standard
deviation of the distribution of returns.

State Probability Return On Return On

Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
• E[R]A = 12.5%
• E[R]B = 20%
Measures of Risk
 Given an asset's expected return, its variance can be calculated
using the following equation:
N
Var(R) = 2 =  pi(Ri – E[R])2
i=1

 Where:
 N = the number of states
 pi = the probability of state i
 Ri = the return on the stock in state i
 E[R] = the expected return on the stock
 Measures of Risk
 The variance and standard deviation for stock A is calculated as follows:

2A = .2(.05 -.125)2 + .3(.1 -.125)2 + .3(.15 -.125)2 + .2(.2 -.125)2 = .002625

 = () =  = 

2B = .2(.50 -.20)2 + .3(.30 -.20)2 + .3(.10 -.20)2 + .2(-.10 - .20)2 = .042

 = () =  = 

 Although Stock B offers a higher expected return than Stock A, it also is riskier since its
variance and standard deviation are greater than Stock A's.
 This, however, is still only part of the picture because most investors choose to hold
securities as part of a diversified portfolio.
Coefficient of Variation
 The Coefficient of Variation (CV) scales risk per unit of
expected return.
 CV = /E(r)
 Risk per unit of return
 CV is a measure of relative risk, where standard deviation
measures absolute risk.
Coefficient of Variation – a relative measure of risk
Suppose you are comparing two investments; investment A has an
expected return of 15% and a standard deviation of 36%, while
investment B has an expected return of 8% and a standard deviation of 24%.

CV = coefficient of variation
CV =  / Er

CV A = .36 / .15 = 2.4

CV B = .24 / .08 =3.0
We conclude that even though investment A has more absolute risk,
investment B has greater risk per unit of return. This is a way of determining
if the extra risk is being compensated for by the extra return. In this example,
investment A has 2.4 units of risk per unit of expected return,
while investment B has 3 units of total risk for each unit of expected return.
While A has higher absolute risk, B has higher relative risk, and a less
favorable risk-reward trade-off.

A manager can use this information to decide if they believe the higher
expected return offered by investment A is worth the extra risk exposure.
Characteristics of Probability Distributions

1) Mean: most likely value

2) Variance or standard deviation
3) Skewness – asymmetric returns
4) Kurtosis – fat tails

If a distribution is approximately normal, the distribution is described

by characteristics 1 and 2
Normal Distribution

s.d. s.d.

r
Symmetric distribution
Skewed Distribution: Large Negative Returns Possible

Median

Negative r Positive
Skewed Distribution: Large Positive Returns Possible

Median

Negative r Positive
Probability distribution
Stock X

Stock Y

Rate of
-20 0 15 50 return (%)
◼ Which stock is riskier? Why?
 A B

A = B , but A is riskier because mean return is lower.


k̂