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Equity Valuation

Finding Mispriced Securities


Finding undervalued securities is not easy in efficient markets.

However, opportunities exist as markets not perfectly
efficient.

Fundamental analysis aims at determining fair market value of
a companys stock based on present and future profitability.

To identify mispriced securities, fundamental analysis looks at
some measure of true value derived from observable
financial data.

Alternative Measures of Value

Valuation by Comparables
Book Value
Liquidation Value
Replacement Cost
Tobins q
Intrinsic Value

Intrinsic Value
Intrinsic Value (V
0
) of a share is the present value of
all cash payments to the investor in the stock,
including dividends as well as the proceeds from the
ultimate sale of the stock, discounted at the
appropriate risk-adjusted interest rate, k.

Whenever the intrinsic value exceeds the market
price, the stock is considered undervalued and a
good investment.

The Valuation Process
Understand the business through macro-economic and
industry analysis.
Forecast company performance
Select the appropriate valuation model (absolute valuation
models such as DCF models or relative valuation models).
Convert a forecast to a valuation
Make investment recommendation.
Dividend Discount Models
The intrinsic value of common stock is viewed as the present value of its
expected future cash flows.

The most widely used definitions of cash flows associated with common
stock are dividends and free cash flows.

The dividend discount models define cash flows as dividends.

A discounted dividend approach is most suitable for dividend paying
stocks in which the companies have a discernible dividend policy that has
an understandable relationship to the companys profitability, and the
investor has a non-control (minority ownership) perspective.

These include seasoned profitable companies operating outside the
economys fastest growing subsectors.


Dividend Discount Models
When you buy stock in a publicly traded firm, the only cash
flow you receive directly from this investment is expected
dividends.
The DDM builds on this simple proposition and argues that
the value of a stock has to be the present value of expected
dividends over time.


1 2
0
2
(1)
(1 ) (1 ) (1 )
n
n
D D D
V
k k k


Dividend Discount Models
The DDM in the form of equation (1) showing the discounted
value of future dividends is not useful in valuing a stock
because it requires dividend forecasts for every year into the
indefinite future.
To make the model practical, it is assumed that dividends
trend upward at a stable growth rate g.
The equation for V
0
can be simplified as:


Equation (2) is called the constant growth DDM or the Gordon
Model.


1
0
(2)
D
V
k g

Dividend Discount Models


Growth comes from retention and reinvestment of profits. If b
denotes the retention ratio and r denotes the ROE, the growth
rate g =b*r

If the dividends are not expected to grow, then the dividend
stream will be a simple perpetuity and the valuation formula will
be V
0
= D
1
/k.

Since D
1
for a no growth company is E
1
, V
0
is also equal to E
1
/k.

In case of preferred stock, the constant growth rate of dividend
is zero. If a preferred stock pays a fixed dividend of Rs.10 per
share and the discount rate is 8%, the price will be Rs.10/0.08 =
Rs.125.


Implications of Constant Growth DDM

1. The model implies that a stocks value will be greater:
the larger the expected dividend per share
the lower the market capitalization rate, k.
the higher the expected growth rate of dividends.

2. The stock price is expected to grow at the same rate as
dividends.

Example
Expected dividend (D
1
) =4.00 k=0.10 g = 0.05

P
0
= 4/(0.10-0.05) = 80
D
2
= 4.20 P
1
= 4.20/(0.10-0.05) =84

The price has increased by 5%, the same rate as
growth rate of dividends.

Implications of Constant Growth DDM
From


When P
0
=V
0
, the market capitalization rate can be
calculated using the above relationship.
The constant growth dividend discount model cannot be
used when g >k
It is best suited for firms with well established dividend
payout policies and which are growing at a rate equal to
or lower than the growth in the economy

1
0
D
P
k g

1
0
(3)
D
k g
P

Two-Stage DDM
This model allows for two stages of growth-an initial phase
where the growth rate is not a stable growth rate and a
subsequent steady phase where the growth rate is stable and
is expected to remain so for the long-term.

The growth rate in the initial phase can be higher or lower
than the stable growth rate.

This model is best suited for firms that are in the high growth
and expect to maintain that growth rate for a specific period
after which the sources of high growth are expected to
disappear (expiry of patents, disappearance of barriers to
entry).

Two-Stage DDM
0
0
1
(1 ) (1 ) 1
(1 ) (1 )
t
n
s n c
t n
t
c
D g D g
V
k k g k

Where:
D
0
= Current Dividend
g
s
= Sub-normal or Super-normal Growth rate of Dividend
g
c
= Constant growth rate of Dividend
D
n
=Dividend at the end of the normal growth period
k = required rate of return

Example Two Stage DDM
Given D
0
= Rs.1.00, g
s
= 12%, g
c
=6%, n=3 and k=10%
V
0
=

= 1.02+1.04+1.05+27.97
= 31.08

2 3 3
2 3 3
1(1.12) 1(1.12) 1(1.12) 1(1.12) (1.06) 1
(1.10) (1.10) (1.10) (0.10 0.06) (1.10)

Two-Stage DDM
There are two major problems in applying the two-stage DDM
Defining the length of the extraordinary growth period. There
are three major considerations:
Size of the firm
Existing growth rate
Magnitude of sustainable competitive advantage
Deciding on the shift from high to stable rate. The two-stage
model is suited to firms with moderate growth only where the
shift will not be dramatic.
For firms with high growth rates, the transition should be
gradual and multi-stage growth models should be used.
Multistage Growth Models
These models allow dividends per share to grow at several different
rates as the firm matures.

They assume an initial period of high dividend growth, a final period
of sustainable growth and a transition period between the two
during which the initial high growth rate tapers off to the ultimate
sustainable rate.

These models are similar to the two-stage models but require a
larger number of inputs.

The three-stage DDM with declining growth in stage 2 has been
widely used. It has also been adopted by Bloomberg LP, a financial
services company that provides Bloomberg terminals to
professional investors and analysts.
Limitations of DDM
The models are extremely sensitive to the inputs for the
growth rate.
They can lead to misleading results as the growth rate
converges to the discount rate.
The focus on dividends can lead to skewed estimates of value
for firms that are not paying out what they can afford to in
dividends.
In particular, they will underestimate the value of firms that
accumulate cash and pay out too little in dividends.

Free Cash Flows
The second definition of stock returns used in DCF techniques of
stock valuation is free cash flows.
Whereas dividends are the cash flows actually paid to stockholders,
free cash flows are the cash flows available for distribution to
shareholders.
Analysts like to use free cash flow as the return whenever one or
more of the following conditions is present:
(1) The company does not pay dividends. (2) The company pays
dividends but does not have a discernible dividend policy that has
an understandable relationship to the companys profitability. (3)
Free cash flows align with profits within a reasonable forecast
period. (4) The investor has a control perspective.

FCFF and FCFE
There are two notions of free cash flows, free cash flow to the
firm (FCFF) and free cash flow to equity (FCFE).
FCFF is the cash flow available to companys suppliers of
capital after all operating expenses (including taxes) have
been paid and the necessary investments in working capital
(e.g., inventory) and fixed capital (e.g., equipment) have been
made.
FCFE is the cash flow available to the companys holders of
common equity after all operating expenses, interest and
principal payments have been made and necessary
investments in working and fixed capital have been made.
FCFF Approach
The free cash flow to the firm (FCFF) is the sum of the cash
flows to all claim holders in the firm including stockholders,
bondholders and preferred shareholders.
There are two ways of measuring FCFF:

1. FCFF =FCFE+ Interest expense (1-t) + Principal repayments
new debt issues + Preference dividend

2. FCFF = EBIT (1-t) + Depreciation- Capital expenditure
Changes in Working Capital

FCFF Approach
From the firm value, the value of the firms debt obligation is
deducted to arrive at the firms equity value.
FCFF models can also be constant growth, two stage or three-
stage models.
Under the constant growth FCFE model:


1
0
FCFF
FCFF
V
WACC g

Re Re ( )
FCFF
g investment Rate turnoninvested capital ROIC
Re
(1 )
Capex Depreciation WC
investment Rate
EBIT t

(1 ) EBIT t
ROIC
Total Capital

FCFE Approach
FCFE = Net income (capital expenditure-depreciation)-
(changes in non-cash working capital) + (new debt issued debt
repayments)

If it is assumed that the net capital expenditure and working
capital changes are financed using a fixed proportion ( ) of
debt, FCFE can be represented as:

FCFE = Net income (capital expenditure-depreciation)(1- ) -
(changes in non-cash working capital) (1- )

FCFE Approach
FCFE models can also be constant growth, two stage or three-
stage models.

Under the constant growth FCFE model:




Equity Reinvestment Rate =


1
0
e FCFE
FCFE
V
k g

FCFE
g Equity reinvestment rate ROE
Net capex WC Net debt issue
Net Income

Calculating Free Cash Flows
When finding the net increase in working capital for free cash
flow, we exclude cash and cash equivalents as well as notes
payable and the current portion of long-term debt.

Cash and cash equivalents are excluded because a change in
cash is what we are trying to explain.

Notes payable and the current portion of long-term debt are
excluded because these are liabilities with explicit interest
costs that make them financing items rather than operating
items.
Calculating Free Cash Flows
Changes in deferred tax liability should not be added back if
the liability is likely to reverse in the near future. The addition
may be done when a company is growing and has the ability
to indefinitely defer its tax liability.

Similarly changes in deferred tax asset should be subtracted
only when the company is expected to have this asset on a
continual basis.