Chapter 4 Stock Valuation
Chapter 4 Stock Valuation
LEARNING to:
• Why stock valuation is necessary
The intrinsic value of a stock is therefore the fair value or the expected worth of the stock
on paper as opposed to its actual market or book value.
This intrinsic value represents the maximum price the investors are willing to pay for the
stock, or if the investors already own stocks, the minimum price they are willing to sell for
the stocks in hand.
Stocks that are judged to be undervalued should be purchased, while stocks that are
deemed to be overvalued should be sold.
The Need for Stock Valuation
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Stock Valuation Approaches
Income-based
Cash flow-based methods.
methods. Where the value of a Net assets-based
Where the intrinsic stock is estimated methods.
value of the stock is based upon its current Where the value of a
estimated based upon price relative to stock is estimated
the present value of variables considered to based on the value on
some measure of future be significant to the company’s net
stream of cash flow valuation, such as assets
such as dividends earnings, cash flow,
book value or sales
Discounted Cash Flow Methods
• The discounted cash flow valuation techniques are obvious choices for valuation because they
estimate value based on the present value of expected cash flows (they consider the time value
of money).
• The following three factors are necessary to be determined first in order to carry out the
valuation:
1. The investor’s required rate of return on the stock because this rate becomes the discount
rate in the discounted cash flow techniques. This is usually represented by the cost of equity
ke.
2. The investor’s estimates of future cash streams from the investment of the stock, e.g.
dividends, and free cash flows.
3. The estimated growth rate (g) of the variable used in the valuation technique, e.g. growth
rate of dividends and earnings.
Discounted Cash Flow Methods
• All of the discounted cash flow techniques are based on the basic valuation model,
which asserts that the intrinsic value of an asset (can be stock or bond) is the sum of
present values of its expected future cash flows as follows:
n CF
V0or P = ∑ t
(1 + k e) t
t=1
0
where,
V0 or P0 = Present value of stock n = Life of the asset
CFt = Cash flow in period t
ke = The discount rate that is equal to the investors’ required rate of return
Discounted Cash Flow Methods
• Using a one-year investment horizon, the dividend discount model (this will be discussed in
detail below) and a forecast that the stock can be sold at the end of the year at price P 1, the
intrinsic value or the price of the stock, V0 or P0, can be computed as follows:
where,
E(D1) = Expected dividend payment at the end of the period of investment
E(P1) = Expected stock price at the end of the period of investment
ke = The discount rate that is equal to the investors’ required rate of return
Discounted Cash Flow Methods
• Example 1
• Kulim Bhd is forecasted to pay a RM0.50 dividend at the end of year one and a RM0.60
dividend at the end of year two. At the end of the second year, the stock will be sold for
RM4.50. If the discount rate (rate of return required) is 12%, what is the intrinsic value
(IV) of the stock today?
Cash Flow (RM) PVIF*/ Present Value (PV)
Year PVIFA**@12% (RM)
1 0.50 0.8929 0.45
2 0.60 0.7972 0.48
2 4.50 0.7972 3.59
P0 (IV) 4.52
Discounted Cash Flow Methods
• Example 2
• Assume a one-year holding period. At the end of the year, APEX stock has an expected dividend per share
of RM0.40. The current price of a share is RM4.80, and the expected price at the end of the year is RM5.20.
Suppose that the current risk-free rate, rf = 6%, the market risk premium (E(rM) – rf ) = 5%, and the beta
of APEX is 1.2. Compute the intrinsic value of the APEX stock and decide whether investors should buy the
stock.
Because the intrinsic value, RM5, exceeds current price, RM4.80, we conclude the stock is undervalued in the
market. Therefore, investors will want to buy and include more APEX stock in their portfolios.
Discounted Cash Flow Methods
• Example 3
• Heap Bhd stock is currently trading for RM5.20 per share. You expect the company to pay a
dividend next year of RM0.15, in year 2 of RM0.16, and in year 3 of RM0.17. If you expect
Heap’s stock to sell for RM6 in three years and the required rate of return is 9%, evaluate
whether the stock is undervalued or overvalued?
Cash Flow (RM) Present Value (PV)
Year PVIF/PVIFA@9% (RM)
1 0.15 0.9174 0.14
2 0.16 0.8417 0.13
3 0.17+6 0.7722 4.76
P0 (IV) 5.03
As the intrinsic value of RM5.03, is below the current price of RM5.20, the stock is
overvalued.
Dividend Valuation Model (DVM)
• The DVM is appropriate for mature and profitable companies that have a history of
dividend payments and a consistent dividend policy which is related to earnings.
• It is less suitable for companies that are engaged in a fast-growing segment of the
economy in which the focus is more on share price appreciation overtime for a capital
gain objective.
• The general dividend model can be formulated to make it more practical if the
company’s dividends are expected to follow these three basic patterns:
1. Zero growth
2. Constant growth
3. Differential growth
Zero-Growth DVM
• This model assumes a constant dividend every year (dividends are expected not to
grow; zero growth), i.e. the same amount of dividend is paid every year.
• It also assumes that the required rate of return for the share remains constant at ke
which is equal to the cost of equity for that company.
• The resulting dividend stream is therefore a simple perpetuity, and the intrinsic price of
stock can be represented as follows:
where,
D = Constant annual dividend
ke = Investors’ required rate of return
Zero-Growth DVM
• Example 4
• Find the price of a share of preferred stock given that the par value is RM10 per share,
the preferred dividend rate is 8%, and the required return rate is 10%.
Constant-Growth DVM
• The constant-growth DVM model is often useful for valuing stable-growth, dividend paying companies.
• As before, it assumes that the company is in a steady state and issues a dividend that has a current
value of D0 that grows at a constant rate g.
where,
D0 = The most recent dividend paid
g = Constant growth rate in dividends
D0(1 + g) = Expected dividend in one year’s time (D1)
Constant-Growth DVM
• Example 5
• Eurix Bhd has just paid its shareholders a dividend of RM0.10 per share. The required rate of
return is 8% and dividends are expected to grow at 5% in perpetuity. Compute the intrinsic
value of Eurix’s stock. You are a shareholder of the company, and if the current market price
is RM4.50, should you buy more of Eurix’s shares for your investment portfolio?
We can conclude that as the intrinsic value of RM3.50 is below the current price of RM4.50, the
stock is overvalued. Thus, no additional purchase of Eurix’s stock is necessary.
Constant-Growth DVM
• Example 6
• Brecon Bhd’s stock dividend at the end of this year is expected to be RM2.15 per share,
and it is expected to grow at 11.2% in perpetuity. If the required rate of return on
Brecon Bhd stock is 15.2% per year, what is its intrinsic value?
• If Brecon Bhd’s current market price is equal to this intrinsic value, what is next year’s
expected price?
• If an investor were to buy Brecon Bhd stock now and sell it after receiving the RM2.15
dividends a year from now, what is the expected capital gain (i.e. price appreciation) in
percentage terms? What is the dividend yield and what would be the holding-period
return?
Constant-Growth DVM
Constant-Growth DVM
• In some cases, the constant-growth model can be used to derive market- based
estimates of the required rate of return for stocks or the cost of equity ke.
• After manipulation of the constant-growth DVM model, the required return, ke can be
shown as:
• The required return, ke, therefore consists of dividend yield (D1/P0) plus the rate of
growth (g) due to capital appreciation. For example, if a company is expected to pay a 2%
dividend yield and that dividends will grow at 8% per year, a market-based estimate of
the investor’s required rate of return is 10% per year.
Constant-Growth DVM
• Based on the equation, it is therefore important for an investor to forecast the
expected growth of dividends, g. The simplest way to estimate g is by looking at the
historical pattern of growth in dividends and earnings. Study the following example.
• Example 7
• Zoom Bhd has the following data pertaining to dividend payments and earnings for the
period 2016-2020. The company is totally financed by equity and there are 1,000,000
shares in issue, each with a current market value of RM6.70. Determine the cost of
equity ke for Zoom Bhd assuming at present the year is 2020.
Constant-Growth DVM
Dividends Earnings • Dividends have risen from
Year RM RM
RM300,000 in 2016 to
2016 300,000 800,000
RM524,700 in 2020. The
2017 384,000 510,000
increase represents a four-
2018 412,000 1,100,000
year growth. The average
2019 490,000 1,300,000 growth rate, g, may be
2020 524,700 1,400,000 calculated as follows.
Constant-Growth DVM
• Alternatively, we can use the earnings retention model to estimate g.
• The earnings retention model is based on the premise that the higher the company’s
level of retentions, the greater is the potential growth rate.
• It follows from looking at the rate of growth of retained earnings. It is argued, if all
measures are constant, then it may be shown that the rate of growth of dividends, is
equal to the rate of growth of earnings, is equal to the rate of growth of stock prices,
etc.
• The rate of growth of dividends, g, can be estimated by the following equation:
where,
g=bxr b = the expected retention rate equal to 1 – D/E (Dividend Payout
Ratio) r = the expected accounting rate of return or return on
capital employed (ROCE) or return on investment (ROI) or return
on equity (ROE)
Constant-Growth DVM
• The retention rate is a decision by the board of directors based on the investment
opportunities available to the firm.
• The theory suggests that the firm should retain earnings and reinvest them as long as the
expected rate of return on the investment exceeds the firm’s cost of capital.
• Example 8
• Chrome Bhd is expecting earnings of RM5 per share in the coming year. The required rate of
return demanded by investors is estimated to be 14%. Assume that the company practices
a dividend payout ratio of 40%. Now, suppose that the company engages in an all equity
financed project worth RM100 million that generates a return on investment of 15% and
that there are currently 3 million of the company’s shares in issue. Compute the intrinsic
value of Chrome Bhd’s stock.
Constant-Growth DVM
• Return on investment or equity (ROE) = 15%
• Total earnings = ROE x RM100 million = 0.15 x RM100 million = RM15 million Earnings
per share (EPS) = RM15 million/3 million shares = RM5.
• This confirms the expected EPS.
• Dividend per share = EPS x Dividend Payout Ratio = RM5 x 0.4 = RM2 The retention ratio
b = 1 – 0.4 = 0.6 or 60%
• The growth rate of the dividends, therefore, is: g = ROE x b = 0.15 x 0.6 = 0.09 = 9%
• If the stock price equals its intrinsic value, it should sell at:
Variable-Growth DVM
• To assume that dividends will grow at a constant rate in perpetuity may not be reasonable. A
more realistic version might be that dividends might grow at different growth rates.
• Therefore, when growth rates vary, investors must use a variable growth rate model to find
the intrinsic value of stocks.
• Many companies like to assume that dividends in the short-term will be different (either
lower or higher) than those in the long-term.
• However, the long-term dividend growth rate is expected to be more stable and predictable.
This is when the constant-growth DVM will apply.
• Due to these two different growth rates (variable rate in the early years and constant rate in
the later years), this model is also known as the Two-stage Growth DVM or Non- constant
Growth DVM.
Variable-Growth DVM
• Example 9
• Jam Bhd is a fast-growing company and has paid a dividend this year of RM1.50 per share. The
dividends are expected to grow at 25% for two years. Thereafter, the growth rate will be 8% until
perpetuity. If investors ask for a 10% required rate of return, what is the price of this stock?
• Stage 1: Compute the Present Value (P1) of future dividend stream for the first two years when g is
25%.
D0 = RM1.50 Year Dividend (RM) PVIF/PVIFA@10% PV
P1 3.6415
Variable-Growth DVM
• Stage 2: Compute the Present Value (P2) for the dividend stream after year 2 when g is
8% until foreseeable future (perpetuity).
Dividend in year 3, i.e. D3 = D2(1.08) = 2.3438(1.08) = 2.5313
Variable-Growth DVM
• Example 10
• Macy Bhd paid RM1.50 dividends per share last year. The company’s policy is to allow its dividend to grow
at 5% for the first four years and then the rate of growth changes to 3% from year 5 onwards until
perpetuity. What is the price of Macy’s stock if the required rate of return is 8%?
• Stage 1: Compute the Present Value (P1) of future dividend stream for the first four years when g is 5%.
D0 = RM1.50
Year Dividend (RM) PVIF/PVIFA@8% PV
1 1.5750 (1.5 x 1.05) 0.9259 1.4583
2 1.6538 (1.5750 x 1.05) 0.8573 1.4178
3 1.7365 (1.6538 x 1.05) 0.7938 1.3784
4 1.8233 (1.7365 x 1.05) 0.7350 1.3401
P1 5.5946
Variable-Growth DVM
• Stage 2: Compute the Present Value (P2) for the dividend stream after year 4 when g is
3% until foreseeable future (perpetuity).
Dividend in year 5, i.e. D5 = D4(1.03) = 1.8233(1.03) = 1.8780
Free Cash Flow Model
• Many fast-growing companies do not pay a dividend simply because the additional cash retained could
be used to expand the activities of the business. The additional investment of fund into profitable
business opportunities and projects will hopefully create value and increase the market price of the
companies’ stocks.
• Therefore, for non-dividend-paying stock, some investors, instead of using dividend stream to value the
stock price, use what we call the free cash flow (FCF) of the company to replace dividend. Thus, the price
of shares is to treat its value as the sum of future discounted free cash flow.
• The FCF model is also appropriate for common stock valuation if the company’s dividend policy does not
reflect the company’s long run profitability.
• The model is also best for valuing firms for takeovers or in situations that have a reasonable chance for a
change in corporate control.
• As controlling stockholders can change the dividend policy, they are interested in estimating the
maximum residual cash flow after meeting all financial obligations and investment needs.
Free Cash Flow Model
• There are two versions of FCF: free cash flow to the firm (FCFF) and free cash flow to
equity (FCFE).
• The FCFF is the cash flow available to the company’s suppliers of capital after all
operating expenses (including taxes) have been paid and operating investments have
been made.
• The FCFF can be computed as follows:
Free cash flow to the firm = Net income available to common shareholders Plus: Net non-
cash charges Plus: Interest expense x (1 – Tax rate) Less: Capital expenditure Less: Change
in net working capital
• The FCFF valuation approach estimates the value of the company as the present value of
future FCFF discounted at the weighted average cost of capital (WACC):
Free Cash Flow Model
• The FCFF is discounted using the WACC because FCFF is the cash flow available to all
suppliers of capital, e.g. common stockholders, bondholders and perhaps by preferred
stockholders.
• Therefore, discounting using the WACC gives the total value of all the company’s
capital.
Free Cash Flow Model
• On the other hand, FCFE is cash flow available to equity holders only. It is thus
necessary to reduce FCFF by interest paid to debt holders and to add any net increase
in borrowing (subtract any net decrease in borrowing).
• Free cash flow to equity = Free cash flow to the firm Less: Interest expense x (1 – Tax
rate) Plus: Net borrowing
Or,
• FCFE = FCFF – Interest (1 – Tax rate) + Net borrowing
Free Cash Flow Model
• FCFE is the cash flow remaining for equity holders after all other claims have been
satisfied, so discounting FCFE by k (the required rate of return on equity) gives the
value of the company’s equity.
• Therefore, the valuation of the company can be formulated as follows:
Free Cash Flow Model
• If the company finances part of its capital through debt, then the company’s equity value
(EV) can be computed by taking the total value (V 0) less the market value of debt (MVD).
• To get the stock’s intrinsic price, we simply divide the EV by the number of shares (NOS)
outstanding. Using the FCFE as the basis, the model can be presented as follows:
Free Cash Flow Model
• Example 11
• Kleene Bhd, a local company which specialises in the manufacturing of surgical
instruments, had recently been listed on the ACE Market of Bursa Malaysia. It has
embarked on an aggressive strategy for expanding its activities into overseas market.
Since a lot of cash is required to fund this ongoing venture, the company has decided not
to pay any dividend to its shareholders. At least none are expected in the near future.
• The company is expected to earn RM2 million in net free cash flow next year. This cash
flow is expected to grow at 10% during the next four years and then grow at 8% per year
indefinitely. The company has RM20 million in debt and 500,000 shares outstanding.
Calculate the intrinsic value of the stock using a 15% discount rate.
Free Cash Flow Model
Free Cash Flow Model
• Investors often use free cash flow as a basic measure of profitability that anticipates a
company’s earnings improvement.
• Just like the P/E ratio which will be discussed below, we can formulate a ratio between the price
and the free cash flow of a particular stock. The end result is the price-free cash flow ratio.
• This is an example of what we normally call the relative valuation technique (this is discussed
below). In this case, the ratio measures the relationship between a company’s stock price and
the amount of net cash generated by company operations.
• For example, if a company generates RM5 per share in free cash flow and has a stock price of
RM20, it has a price- free cash flow ratio of 4 and a cash-to-price rate of return of 25%.
Companies with low price-free cash flow ratios are often the target of takeovers or risk
becoming a candidate for restructuring.
Relative Valuation Methods
• The relative valuation techniques bring the idea that it is possible to determine the value of a company by
comparing it to another on the basis of several relative ratios that compare its stock price to relevant variables
that affect a stock’s value, such as earnings, cash flow, book value and sales.
• In practice, the relative valuation techniques are commonly known as price multiples. Price multiples are ratios
of a stock’s market price to some measure of value per share. The intuition behind price multiples is that we
cannot evaluate a stock’s price, i.e. determine whether it is correctly valued, overvalued or undervalued without
knowing what a share buys in terms of assets, earnings or some other measure of value.
• A major advantage of the relative valuation techniques is that they provide information about how the market
is currently valuing stock at several levels, i.e. the aggregate market, alternative industries and individual stocks
within industries.
• A price multiple therefore summarises in a single number the valuation relationship between a stock’s price
and a common quantity, such as earnings, sales or book value per share. As valuation indicators, price multiples
have the appealing qualities of simplicity in use and ease in communication.
The Price/Earnings Ratio
• The ratio works on the basis of investors’ perception on the earnings of a company. The net
earnings are the return that investors are entitled to. Therefore, one way that investors can
estimate the value of common stocks is by determining how many ringgits they are willing
to pay for a ringgit of expected earnings.
• For example, if investors are willing to pay 5 times the expected earnings, they would value
a stock from which they expect to earn RM0.50 a share during the following year at
RM2.50.
• The earnings multiplier which is the P/E ratio is formulated as follows:
The Price/Earnings Ratio
• Example 12
• For 2020, Kaolin Bhd earned profit after tax and available for common stockholders of
RM50 million. The company currently has 100 million shares in issue and each share has a
current price of RM5. What is the prevailing earnings multiplier for Kaolin?
The Price/Earnings Ratio
• Example 13
• If Troy Bhd’s stock has an expected dividend payout of 40% and an expected growth rate
for dividends of 6%, what is the appropriate earnings multiplier? Assume a required rate of
return of 10% is used.
The Price/Earnings Ratio
• In practice, there are two versions of the P/E ratio, namely historical P/E (trailing P/E) and forward P/E
(leading P/E).
• Historical or trailing P/E uses earnings over the most recent 12 months in the denominator, while
forward or leading P/E ratio (also known as forward or prospective P/E) uses the next year’s estimated
earnings.
• In short:
The Price/Earnings Ratio
• On paper, the forward P/E has more appeal as it reflects the future growth of the company and is consistent
with the view that all shares are priced based on their future earnings and not on their past earnings.
• However, past earnings are sometimes a good indicator for future earnings and consequently, in practice,
the historical P/E is still widely used.
• The P/E ratio is useful because it produces an earnings-based valuation of stocks. By selecting a suitable
P/E ratio and multiplying this by the EPS of shares which are being valued, we can easily obtain the market
price per share or the the total value of a company.
• Using the formula above, the market valuation or capitalisation of a listed company can be computed as
follows:
The Price/Earnings Ratio
• Example 14
• The latest financial statements of food retail company Kesang Bhd, show earnings per
share of RM0.20 and the average P/E for companies in the same industry is quoted at a
ratio of 15 at the time of valuation.
• A possible value could be computed as follows:
The market price per ordinary share is RM3 (RM0.20 x 15).
The Price/Earnings Ratio
• To make the application of the P/E ratio-based valuation more effective, it is better to
assign the average P/E ratio, based on the expected earnings of all competitors to the
company’s expected earnings for the next period.
• Here, two assumptions are made:
1. The method assumes future earnings are an important determinant of a company’s value.
2. It also assumes that the growth in earnings of a company in future years will be similar to
that of the industry.
The Price/Earnings Ratio
• Example 15
• Bronx Bhd is expected to generate earnings of RM1 per share next year. The mean ratio of
share price to expected earnings of competitors in the same industry is 14. What is the
valuation of the company’s shares according to the P/E method?
• Value per share = EPS x Average industry P/E = RM1 x 14 = RM14
The Price/Earnings Ratio
• Historical P/E may not be the appropriate choice for forecasting and valuation if the
company’s business has changed (e.g. as a result of a takeover).
• Forward P/E may not be relevant if earnings are volatile, making it difficult to forecast next
year’s earnings with any degree of accuracy.
• Note that the EPS can be negative, and the P/E ratio does not make economic sense with a
negative denominator.
• Also, management discretion, within allowed accounting practices, can distort reported
earnings, and thereby reduce the comparability of P/Es across companies.
The Price/Earnings Ratio
• Example 16
• Assume Hibiscus Bhd has a current P/E ratio of 10 and its current EPS is RM1.10. It has
increased its EPS by 4% annually in the past and this rate is likely to continue for some
time. If the P/E ratio is expected to increase to 15 in five years, what is the stock price
expected to be in year 5?
• Pt = 15 x RM1.10 x (1.04)5 = RM20.07
• Therefore, the stock price is expected to be RM20.07 in five years.
The Price/Cash Flow Ratio
• Some investors believe that cash flow ratios are a better measurement of a stock’s value than P/E ratio
because they give an accurate picture of a company’s ability to generate cash.
• Earnings based measures are reported on an “accrual basis” which are not necessarily cash based
because they include some arbitrarily applied items such as stock valuation and depreciation, and
subjective estimates such as provisions for bad debts.
• These charges, which reduce net income, do not present outlays of cash so they artificially reduce the
company’s reported cash. By adding back these charges, the company has more cash than what the net
income figure indicates.
• Because of this, it is also argued that companies can engage in earnings “smoothing” so as to make their
earnings more attractive or acceptable to investors. This is a form of manipulation.
• Cash flow is generally less prone to manipulation. In fact, cash flow values are much more important in
finding the intrinsic values of financial assets as supported by the dividend discounts models and the
pricing of bonds.
The Price/Cash Flow Ratio
• The general price to cash flow ratio is given as:
• Two variables need to be considered when applying this valuation ratio, namely:
• In practice, there are three different ways of valuing the net assets of a firm namely valuation
based on the book value of net assets, the net realisable value of net assets and the replacement
value of net assets.
• Can easily be found from the • Represents what would be left • Assumes the buyer of a
ANY QUESTION???