Valuation of Shares

Abhinav Rajverma
 Introduction
Company Act 2013
 Common Equity Shares
 Preference Shares

Common Equity Share

 Enjoy Voting Rights
 Can attend AGMs
 Entitled to company’s surplus
*Equity shares with differential voting rights may be issued.

In 2008, Tata Motors issued DVR shares enjoying only 10%

voting right, but additional 5% dividends compared to its
ordinary counterpart.
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 Preference Share
Preference Share
 No voting rights
 Generally, a fixed dividend (pre-decided) for a fixed tenure
 Liquidation preference over common share
 Convertibility (predetermined number of common shares)

Valuation Model
 

= +

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 Example: Preferred Stock
• 
Problem: If a preferred stock with an annual dividend
of Rs 5 (fixed) sells for Rs 50, what is the expected
annual return?

Solution:
= +
=> = = [n = ∞]
Expected Return (r) = 𝐷/ = 5/50 = 10%

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 Equity Markets

Primary Market
 Initial Public Offering (IPO)
 Follow-on Public Offering (FPO)

Secondary Market
 Trading of securities
 Stock Exchange

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 Valuation Concepts: Shares

Book Value
 Equity Paid-up Capital
 Reserves & Surplus

Intrinsic Value
 PV of CFs
 Discounting Rate

Market Value
 Share Price

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 Common Share: Valuation
The intrinsic value of an equity share

Absolute Valuation
 Dividend Discount Model: PV of future dividends
 Discounted Cash Flow Model: PV of company’s FCF

Relative Valuation
 Price-to-earnings (P/E)
 Price-to-book value (P/B)
 Enterprise value-to-EBITDA
 Price-to-sales

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 Dividend Discount Model
•   Price = PV of expected dividends
Share
= +

Zero Growth Model

=
=

Constant Growth Model

== [growth rate (g)= b*ROE]
b = Retention Ratio

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 Example: Constant Dividend Growth
• 
Problem: A firm paid dividend of Rs. 2 per share and cost of
equity is 13%. Find the value of the stock today for g = 0 and g =
6%.

Solution:
For g = 0
= =
=> = 2/0.13 = 15.38

For g = 6%
= = = 2 * 1.06/0.07 = 30.29

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 Example: Gordon Growth Model
• 
Problem: A firm paid dividend of Rs. 2 per share and cost of
equity () is 13%. Assuming constant growth (YoY) of 6%, find
a. The expected share price in one year from now
b. The expected dividend yield, capital gains, and total return
during the first year

Solution: = = 30.29

a) =  = 32.10

b) DY = / = 7%
CG = (- )/ = 6%
Total Return = DY + CG = 13%

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 Example: Dividend Growth Not Constant
Problem: A firm paid dividend of Rs. 2 per share and cost of
equity is 13%. For a growth of 30% for 3 years before achieving
long-run growth of 6% YoY, calculate the value of stock today.
Solution:

0 1 2 3 4
g = 30% g = 30% g = 30% g = 6% ...

D0 = 2.0 2.6 3.38 4.394 4.658

  = = 4.658/0.07 = 66.54
= + [n = 3]
= 54.108

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 Example: Growth Rate
Problem: A firm reported net earnings of Rs 5,00,000 and plans
to retain 30% of its earning. ROE as per historical data is 25%
which is expected to continue. What is the expected growth rate
of the firm?

Solution:
Retention ratio (b) = 30%
Growth rate (g) = b * ROE = 0.30 * 0.25 = 7.5%

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 Discounted Cash Flow
•   Approach: Better measurement of CFs than dividend and EPS
FCF
Unlike dividends, FCFF and FCFE are not readily available
FCFF Approach: =
Equity Value = Firm Value – Market Value of Debt
 Firm Value = PV of future FCFs to firm (FCFF)
 WACC = Weighted-average cost of capital
 WACC = ke * We + kd * (1 – Tax) * Wd
where, ke = CoE; kd = CoD;
We = weight of equity; Wd = weight of debt

FCFE Approach: =
 Equity Value = PV of future FCFs available to shareholders

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 FCFF and FCFE
FCFF calculation
FCFF = NOPAT + D&A – Capex – ΔWorking Capital
NOPAT = Net Operating Profit after Tax = EBIT * (1 – Tax)
*NOPAT enhances comparability by removing the impact of
capital structure

FCFE calculation
FCFE = Cash from Operations – Capex + ΔNet debt
Cash from Operations = PAT + D&A – ΔNWC

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 Terminal Value Calculation
•  +
FCFF Valuation
Terminal Value (TV) =
= LT constant growth rate in FCFF

FCFE Valuation
Terminal Value (TV) =
= LT constant growth rate in FCFE

*Terminal value should be added to FCF at T = n (one period before the first
FCF selected on the timeline). Now, calculate the aggregate PV at T = 0.

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 Relative Valuation

P/E Ratio
P/B Ratio
Price-to-Sales
EV-to-EBITDA
Other Valuation Approaches
 Installed Capacity
 Number of Subscribers

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 Example: P/E Valuation
• 
Problem: A company forecasts to pay a Rs 5.00 dividend next
year, which represents 100% of its earnings. This will provide
investors with a 10% expected return. Instead, the company
decides to plow back 40% of the earnings at the firm’s current
return on equity of 20%. What is the value of the stock before
and after the plowback decision?
Solution:
Given: = 5; r = 10%; ROE = 20%
Scenario 1: = 5 => g = b*ROE = 0 [No Growth]
= /r = 5/0.10 = Rs. 50
Scenario 2: Growth (g) = b*ROE = 40% * 20% = 8%
= /(r – g)
= (1 – b) * = Rs. 3
= 3/(0.10 – 0.08) = Rs. 150
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 Takeaways

Valuation of Shares
Types of Shares
Valuation Concepts
Valuation Approaches
FCFF and FCFE
Terminal Value

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Thank You
for
Your Time

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Dividend Models

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 Dividend Models
Lintner Model
Long-term target payout ratio
Walter Model
Dividend Policy influences firm value
Gordon Model
Relevance of dividend policy
Modigliani-Miller Model
Dividend Irrelevance

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 Walter Model
•Share
  price (P) is influenced:
DIV & relation between IRR (r) & cost of capital (K)

Assumptions:
All investments are financed through retained earnings
Earnings are either distributed or reinvested immediately.
Internal rate of return (r) and cost of capital (k) are constant
EPS & DPS are assumed to remain constant forever
Problem: A firm has an EPS of Rs. 15 and DPS of Rs. 5. The
applicable discount rate is 12.5% and retained earnings are
reinvested at 10% (IRR). Calculate the market price of the share.
Solution:
P = 5/0.125 + (15-5)/0.125 * 0.10/0.125
= 40 + 64 = 104
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 Gordon Growth Model
•   share price (P) equals to the present value of an infinite
The
stream of dividends to be received:
=
Assumptions (additional):
 The growth rate (g) of the firm = Retention ratio (b) * IRR (r)
 The cost of capital (k) is constant and greater than growth rate (g).
Problem: Anand purchased a stock for Rs. 60 per share and
received a dividend of Rs. 5 per share in the following year
which investors expect to grow 4% YoY. Assuming firm requires a
rate of return of 14%, comment on the valuation of the stock.
Solution:
Intrinsic Value of a share = 5/(0.14 - 0.04) = 50
The stock is overvalued.

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 Modigliani-Miller Model
•The
  MM theorem states that firm value is affected by earnings
which results from the investment policy.
Assumptions: The rate of return (r) equals the cost of capital (k).
Expected Return (r) = Dividend Yield + Capital Gains

Retained Earnings (RE) = Earnings (E) – n

Additional Fund Required = Invest – RE
Additional equity (m* )= Invest – (E - n
+ [m*- (Invest– E+ n)]/(1+k)
=> V = [(n + m) * - (Invest – E )]/(1+k)

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 Example: MM Model
•Problem:
  A firm’s stock is trading at Rs. 150 apiece
at the beginning of the year and the firm declares a
dividend of Rs. 10 per share in the year end. The
discount rate applicable is 10%. Calculate share
price (year-end) using the MM model.

Solution:

Share Price (year-end) = 150 * (1.10) – 10 = 155

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Knowledge
Enhancers

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 Trading Jargon

Bid Price Intraday Trading Tick Size

Offer Price Market Order PAR Value
Bid-ask Spread Limit Order Premium
Basis Point GTC Order Averaging
Spread over govt. Stop Loss Booking Loss
Right Issue Circuit Breaker Margin
Expiry Market Maker Margin call

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 Candlestick Chart

 Candlesticks reflect investor sentiments and help the analyst to

determine when to enter and exit trades.
 Long white/green candlesticks indicate there is strong buying
pressure; this typically indicates price is bullish
 Long black/red candlesticks indicate there is significant selling
pressure. This suggests the price is bearish.

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 Technical Indicators

Simple Moving Averages

Exponential Moving Averages
Fibonacci Levels - 23.6%, 38.2%, 50%, 61.8%, 100%
RSI Index
Bollinger bands – Price & Volatility
N (20) periods MA
Generally, 2-SD from MA line
MACD - (Signal, Fast, Slow)

https://charting.bseindia.com/#

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Equity Valuation
Addendum

Abhinav Rajverma
 Adjusted Present Value Approach
  APV = NPV (all equity)+ Benefits of financing (PV)
= +T*
Problem. Project A requires one-time investment of Rs. 5.50 lakh and
expected operating income (annual) till perpetuity is Rs. 1.50 lakh. Discuss if
project can be accepted. Tax Rate = 30% and CoC (all equity) = 20%.
What if project is finance by 30% debt?
 Solution: Operating Income (annual) = Rs. 1.50 lakh
Unlevered Cash flow (UCF) = Operating Income – Tax = Rs. 1.05 lakh
PV projects = UCF/CoC = Rs. 5.25 lakh (Value of unlevered firm )
NPV projects = PV projects - Investments = Rs. (-)25,000 => Not feasible
 Debt = 0.30*(Debt + Equity) = 0.30 ; Tax-shield = 0.30*Debt = 0.09
= - T * = 0.91 = Rs. 5.25 lakh
Þ = Rs. 576,923
Þ Debt = 0.30 = Rs. 173,077 [Total = 5.50 lakh; Equity = 376,923]
Tax-shield = Debt * Tax Rate = Rs. 51,923
APV = NPV (all equity) + Tax-shield = Rs. 26,923 => Project is feasible
 Flow to Equity (FTE) Approach
Problem. Investment = Rs. 5.50 lakh; Operating Income = Rs. 1.50 lakh;
Tax Rate = 30% and CoC (all equity) = 20%. Project is finance by 30%
debt and cost of debt is 10%.

  = * D/E

Solution:
Debt = Rs. 173,077; Interest Expense @ 10% = Rs. 17,308
Income after Interest = Rs. 1.50 lakh – Rs. 17,308 = Rs. 132,692
Levered Cash flow (LCF) = Rs. 132,692 – Tax = Rs. 92,885

CoE = 20% + (20% - 10%)* (1-30%) * (30/70) = 23%

PV of Project’s LCF = LCF/CoE = Rs. 403,846
Equity Investments = Rs. 376,923 (Ref slide APV Approach)
NPV projects (levered) = Rs. 403,846 – Equity investments = Rs. 26,923
 WACC Approach
Problem. Investment = Rs. 5.50 lakh; Operating Income = Rs. 1.50 lakh;
Tax Rate = 30% and CoC (all equity) = 20%. Project is finance by 30%
debt and cost of debt is 10%.

 Solution: D/V = 0.3; E/V = 0.7; T = 30%

WACC =

WACC = 0.7 * 0.23 + 0.3 * (1-30%) * 0.10 = 18.20%

UCF = Operating Income – Tax = Rs. 1.05 lakh

PV of the project = Rs. 1.05 lakh /18.20% = Rs. 576,923

NPV projects = Rs. 576,923 – Total Investments = Rs. 26,923

 Example: Leverage and Stock Price
Problem: Firm A, all equity, has total assets worth Rs. 5 crores against
five lakh equity shares. Management decides to raise Rs. 2 crore debt to
buyback Rs. 2 crore worth of stocks. Assuming corporate tax of 30%,
find new share price and total shares repurchased.

 Solution:
Value of all equity firm () = Rs. 5 crores; Number of Shares = 5 lakh
Share Price = Rs. 100;
New Debt = Rs. 2 crores; Tax-shield = T * D = Rs. 60 lakhs
Þ Value of levered firm () = Rs. 5.60 crore
Note: As soon as management takes the decision, market will react and share
price changes.
New share price = /no. of shares = Rs. 112 apiece
Total equity shares repurchased = Rs. 2 crore/Rs. 112 = 1.786 lakh
Equity shares remaining = 3.214 lakh
New Debt-Equity Ratio = D/E = 2 crore/3.6 crore = 0.556
Thank You
for
Your Time

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