INTERNATIONAL

FINANCIAL MARKETS

E Q U I T Y VA L U AT I O N
EQUITY MARKETS
• The stock market consists of:

1. Primary market

- The primary market is the place where securities are made. It is in this market that organizations sell new securities and stock for the first time. The first sale of
stock, or Initial Public Offerings (IPO), is an illustration of a primary market

- Costs are frequently unpredictable in the primary market since the demand is quite difficult to foresee when security is issued first

- All issues on the primary market are dependent upon severe guidelines. Organizations should record proclamations with the Securities and Exchange Commission
(SEC)

2. Secondary market

- The secondary market is commonly referred to as the stock market as well in order to buy the equities. This incorporates the New York Stock Exchange (NYSE),
Nasdaq, and all significant trades around the globe

- In the secondary market, the characteristic that describes it the best is that investors do their trading amongst themselves.

- The secondary market is further broken down into two branches that are the auction market and the dealer market.
Primary vs Secondary market
 STOCK VALUATION A share of common stock is more difficult to value in practice
than a bond for at least three reasons:
Stock valuation is the process of valuing companies and 1. Not even the promised cash flows are known in advance.
comparing the valuation to the current market price to see
whether a stock is over- or undervalued. 2. The life of the investment is essentially forever because
common stock has no maturity.

3. There is no way to easily observe the rate of return that the

market requires.
Models attempt to find the intrinsic or "true" value of an
investment based only on fundamentals – asset-based
Absol
ute approach, income approach
Nonetheless, there are cases in which we can come up with the
valuati
on present value of the future cash flows for a share of stock and
thus determine its value.
Models attempt to find the intrinsic or "true" value of an
investment based only on fundamentals – market
Relati
ve approach
valuati
on

4
STOCK VALUATION - Models
Discounted Dividend Model Multiples

Discounted Cash Flow

Present value of the future cash flows

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DIVIDEND DISCOUNT MODEL - DDM

1. Imagine that you are considering buying a share of stock today. You plan to sell the stock in one year. You somehow know that the stock
will be worth $70 at that time. You predict that the stock will also pay a $10 per share dividend at the end of the year. If you require a 25
percent return on your investment, what is the most you would pay for the stock?

P at t1 = 70 $

D at t1= 10 $

N= 1 year

R= 25%

What is the present price? -> P0 = (D1+P1)/(1+R) = 80/1.25= 64$

Therefore, the current price of the stock is the present value of its future cash flows, which in this case, these are represented by the future
dividend and the future price at which we will sell.
Formulas
We start from this:

If the dividend is a fixed amount for a number of fixed year, we can write it as an annuity:

If the dividend is a fixed amount for a number of year, we can write it as a perpetuity/consol:
2. Imagine that you buy shares from Company X that you will hold for three years. The current price of the one share is 50$ and you want to
know if it is valued correctly. The required rate oof return is 5%.

a) One share pays 5 $ in dividends each year

b) It pays 5 $ in dividends for each year and you decide to hold it for indefinite time

c) It pays 5 $ in year 1, 5.1$ in year and 5.2$ in the third year

What is the current price of one share of Company X? Is it over or under valued?

a) P0 = 5/(1+0.05) + 5/(1+0.05)^2 + 5/(1+1.05)^3

We can write it as:

P = 5 * ((1-(1/(1+0.05)^3)/0.05) =
GORDON GROWTH MODEL (DDM with constant growth rate)

• To respond to point c) from previous example, we should consider the following that the dividend is growing at a constant rate, 2%.

• This would result in a growing perpetuity which can be written as follows:

Cases
• Zero growth -> ordinary perpetuity P0 = D/ R

• Constant growth -> growing perpetuity P0 = D/R-g where g is the contant growth rate

• Nonconstant growth ->

3. Suppose you have come up with the following dividend forecasts for the next three years:

Year Dividend ($)

1 1
2 2
3 2.5

After the third year, the dividend will grow at a constant rate of 5 percent per year. The required return is 10 percent. What is the value of the
stock today?

The value of the stock is the present value of all the future dividends. To calculate this present value, we first have to compute the present
value of the stock price three years down the road, just as we did before. We then have to add in the present value of the dividends that will be
paid between now and then. So what will be the price in three years?
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Problems

1. The Brigapenski Co. has just paid a cash dividend of $2 per share. Investors require a 16 percent return from investments such as this. If
the dividend is expected to grow at a steady 8 percent per year (hint: constant growth rate), what is the current value of the stock? What
will the stock be worth in five years? What will be the amount of dividend received in year five (hint: future value of dividend)?

2. Grateful Eight Co. is expected to maintain a constant 3.7 percent growth rate in its dividends indefinitely. If the company has a dividend
yield of 5.6 percent, what is the required return on the company’s stock?
Sugested videos/readings
• https://www.youtube.com/watch?v=W-Q9AOp2FW8

• https://www.youtube.com/watch?v=ZCFkWDdmXG8
DISCOUNTED CASH FLOW - DCF

The most widely used model to estimate the value of common stock is the discounted cash flow
(DCF) model.

Cash flows are discounted to take into account the fact that 1$ to be received some time in the
future is worth less today than 1$ received immediately -> time value of money

Two reasons:
• Cash-in-hand is certain therefore less risky
• Opportunities to invest cash today to earn interest
• The DCF model takes as its fundamental input variable, the expected free cash flows to the firm, which are defined as operating cash
flows net of the expected new investments in net operating assets (such as property, plant and equipment) that are required to support the
business.

• The DCF model first estimates the value of the company (the enterprise value) as the present value of the expected free cash flows to the
firm and then, determines the shareholders’ portion, or the equity value as the enterprise value less the value of the company’s debt.

Company Value = Market value of equity + Debt – Cash

• The expected free cash flows to the firm include cash flows arising from the firm’s operating activities.

• Importantly, free cash flows to the firm do not include the cash flows from financing activities.
 A tax shield is a reduction in taxable income by claiming allowable deductions
such as mortgage interest and medical expenses.

Tax Shield = Total Tax - Deductibles * tax rate

Free cash flow to the firm - FFCF Tax Shield on Int = Interest expense * tax rate (T)

• There are two main approaches to calculating FCF:

1. From operating cash flows

 Change in CA - CL is also called Net Working Capital NWC

2. From EBIT (earnings before interest and tax) or net income before int and tax
Terminal Value - VN

FCFN  1  1  g FCF 
VN      FCFN
rwacc  g FCF  (rwacc  g FCF ) 

Or VN = FCFN * (1+g)/rwacc - g

Future value of FCF at t=0 which is the value of FCF at t=1

The terminal value of the FCF is an actual a growing perpetuity

 Problems

1. Suppose that after several years (N) the final FCF will
be 1000$ with an WACC of 15% and a growth rate of
6%. What is the terminal value of the FCF?

Vn = 1000*(1+0.06)/(0.15-0.06) = 130,864.2 $

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Problems 2. Assume that you are analyzing a company with the
following cashflows for the next five years (table right)
Year CF to Equity Int Exp CF to Firm
Assume also that the cost of equity is 13.625% and the
1 50 40 90 firm can borrow long term at 10%. (The tax rate for the
firm is 50%.)
2 60 40 100
The current market value of equity is $1,073 and the
3 68 40 108
value of debt outstanding is $800.
4 76.2 40 116.2
The number of shares outstanding is 1000.
5 83.49 40 123.49 What is the Price of a share?
Terminal Value 1603 2363.008

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Method 1: Discount CF to Equity at Cost of Equity to get value of equity
• Cost of Equity = 13.625%
• PV of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 + 76.2/1.136254 + (83.49+1603)/1.136255 = $1073

Method 2: Discount CF to Firm at Cost of Capital to get value of firm

rd (Cost of Debt) = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%
Then we calculate WACC:
WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94%
Then we calculate the PV of all future cash flows:
PV of Firm (PV (FCFF)) = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 + (123.49+2363)/1.09945 = $1873
PV of Equity = PV of Firm - Market Value of Debt = $ 1873 - $ 800 = $1073
P0 = 1073/1000 = 1.07$/share
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Estimating Inputs: Discount Rate
• Critical ingredient in discounted cashflow valuation. Errors in estimating the discount rate or mismatching cashflows and
discount rates can lead to serious errors in valuation.
• At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cashflow being
discounted. •
1. Equity versus Firm: If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a cost of
equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital. •
2. Currency: The currency in which the cash flows are estimated should also be the currency in which the discount rate is
estimated.
3. Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e., reflect expected inflation), the
discount rate should be nominal

The cost of equity should be higher for riskier investments and lower for safer investments.
The cost of debt is the rate at which you can borrow at currently, It will reflect not only your default risk but also the level
of interest rates in the market.
3. Titan Cement has a book value of equity of 135,857 million $ and a book value of debt of
200,000 million $. The risk-free rate is 6%, the market return is 20.53% and beta is 0.71. Estimate
the cost of capital considering that the cost of debt pretax is 12.5% and tax rate is 33.45%.

Total Assets = 335,857 $

Liab weight = 60%
Eq weight = 40%

Re = 6% + 0.71* (20.53%-6%) = 16.32%

WACC = 16.32%*.4 + 12.5% *(1-.3345)*(0.6) = 12%