VALUATION OF EQUITY SHARES

 Why

Valuation.  Valuation: Act of determining the value of something.  Features: True worth, Futuristic prospective, Time & Purpose specific.  Price: What you pay to get something.  Value Vs. Price.  Valuation- dynamic and forward looking.

History of valuation


Before 1930: Assumptions: (i) Earning would grow at historical growth rate. (ii) Value of the assets of the business remain same.  Benjamin Graham proposed Asset based approach (value of the assets at their replacement cost)  John Blurr William (1938): Theory of Investment Value Anticipation of future returns drives the investors to purchase an assets. Present value of such future returns should be the price the investor would be willing to pay.

Balance Sheet method

1.Book value method: The book value per share is simply the net worth divided by number of shares. Advantage: The book value is firmly rooted in financial accounting, and hence can be established easily. Limitations (a) This is based on historical balance sheet figures. (can be divergent from current economic value & rarely reflects the earning power). (b) Can book value represents the floor for the stock price?

2. Liquidation value: This represents the amount of money that could be realized by selling the assets, repaying the debt. Limitations: (a) In reality the notional liquidation value is differ from actual. (b) This value does not reflect the earning capacity.
3.

Replacement cost: This is the ratio of current market value of the company divided by replacement costs of all the assets of that company. A low q ratio is implies that the stock is undervalued and high q ratio is implies that the stock is overvalued.

Dividend Discount Model

According to this model the value of a security is equal to the present value of the future expected dividend. Why only dividend?
THE STABLE GROWTH DDM: GORDON GROWTH MODEL The Model: Value of Stock = DPS1 / ( r - g) Where, DPS1 = Expected Dividends one year from r = Required rate of return for equity investors g = Annual Growth rate in dividends forever

Two insights for stable growth



First: since the growth rate in the firms dividends is expected to last forever, the firms other operating measures (including revenue & earnings) can also be expected to grow close the same rate. Second: issues related to what growth rate is reasonable as a stable growth rate.

A BASIC PREMISE
This infinite growth rate cannot exceed the growth rate for the overall economy (GNP) by more than a small amount (1-2%) Estimate for the US Upper end: Long term inflation rate (5%) + Growth rate in real GNP (3%) =8% Lower end: Long term inflation rate (3%) + Growth rate in real GNP (2%) = 5% If the company is a multinational, the real growth rate will be the growth rate of the world economy, which is about one percent higher. The inflation rate used should be consistent with the currency being used in the valuation

Cyclical Firms


Expected to have year-to-year swing in earnings & hence in growth rate but has an average growth rate say 3% can be used in Gordon Model without loss of generality.
The Expt. Growth rate in EPS = RoE (1- payout ratio)

WORKS BEST FOR

 

firms with stable growth rates firms which pay out dividends that are high and approximate FCFE firms with stable leverage

Some obvious candidates for the Gordon Growth Model



Regulated Companies, such as utilities, because I. their growth rates are constrained by geography and population to be close to the growth rate in the economy in which they operate II. they pay high dividends, largely again as a function of history III. they have stable leverage (usually high)

Large financial service companies, because



 

Their size makes its unlikely that they will generate extraordinary growth. Free cash flows to equity are difficult to compute. They pay large dividends. They generally do not have much leeway in terms of changing leverage.

Limitations:
1. 2.

If the firm does not pay any dividend. If the growth rate is equal or more than the required rate then the value of the stock become infinite or negative.

Two Stage Dividend Discount Model

The model is based upon two stages of growth, an extraordinary growth phase that lasts n years, and a stable growth phase that lasts forever after that.
Extraordinary growth rate: g% each year for n years Stable growth: gn forever
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Value of the Stock = PV of Dividends during extraordinary phase + PV of terminal value Example:

X Ltd. is a growing company and assume for the first 5 years it will maintain similar growth prospect. During first 5 years the pay-out ratio would be 12%. The current of RoE is 21%. Beyond 5 years the competitive pressure will bring down RoE to 11%. Also assume a stable growth rate 5% during this period. The beta of X Ltd. is 1.3 for the first 5 years and beyond 5 years it will decline to 1.1. The average risk free rate in the economy is 5% and risk premium is 4%. The current EPS is Rs.11.30. Calculate the value of X Ltd. using DDM.

H Model
This model was presented by Fuller & Hsia (1984).  Assumption; Earning growth rate starts at a high initial rate (ga) and decline linearly over extraordinary growth rate to a stable growth rate (gn). Also assume dividend payout and cost of equity are constant over time and not affected by shifting growth rate.


Three Stage DDM



Z Ltd. an Indian firm registering a rapid growth & reported RoE is 26% current year & paid out DPS of Rs.3.76 and reported EPS Rs.25.51. Lets assume its protected position will allow the company to maintain its current RoE & retention ratio for the next 5 years. The beta of the company during the high growth period is 1.55, the Rf is 6% & risk premium is 7%. After 5 years, assume the beta will decline to 1.15 in stable growth (which will occur after 10 years) & risk premium will drop to 5.5%. Also assume competitive pressure will pull down RoE to 12% by the 10th year. The estimated stable growth rate is 4.5%.

Value during high growth phase

Yr EPS Expt. Pay-out DPS Growth ratio rate 22.17% 22.17% 22.17% 22.17% 22.17% 14.74% 14.74% 14.74% 14.74% 14.74% 4.60 5.62 6.87 8.39 10.25 Cost of Equity Cumlati PV of ve Ke DPS

Current 1 2 3 4 5

25.51 31.20 38.12 46.57 56.89 69.51 16.85% 16.85% 16.85% 16.85% 16.85% 1.1685 1.3654 1.5955 1.8643 2.1784 3.94 4.12 4.31 4.50 4.71 21.68

Value during transition phase

Yr EPS Expt. Pay-out DPS Growth ratio rate 18.64% 15.11% 11.58% 8.05% 4.5% 24.29% 33.84% 43.39% 52.94% 62.5% 20.03 32.12 45.96 60.58 74.71 Cost of Equity 15.95% 15.05% 14.15% 13.25% 12.33% Cumula PV of tive Ke DPS 2.5259 2.9060 3.3172 3.7568 4.22 7.93 11.05 13.86 16.13 17.70 66.67

6 7 8 9 10

82.46 94.92 105.92 114.44 119.53

Patterns of Dividend Policy

  

Dividends are sticky Dividends follows earnings Buyback as an alternative of dividends Strength of DDM: Simplicity & Intuitive logic Need fewer assumptions Conservative estimate of floor value

   

Why firm may pay out less than available?

    

Desired stability Future investment need Tax factor Signaling Managerial self interest.

Relative Valuation


The objective is to value an asset based on how similar assets are currently priced by the market.  In relative valuation, we are making a judgment on how much an asset is worth by looking at what the market is paying for similar asset. Two Components:  To value assets on a relative basis, prices have to be standardized, usually by converting price into multiples of some common variables.  To find similar assets, which is challenging, since no two assets are exactly alike.

Popularity & Pitfalls

  

Less time & resource intensive Easy to explain & sell Easy to defend (in DCF long lists of explicit assumptions) Market imperative (reflect more the current mood of the mkt not the intrinsic value) Key variables: risk, growth, cash flow potentials are ignored.

Basic Steps to use multiple



  

Multiples are defined differently by different analysts. Consistency in numerator & denominator. Types of multiple. Sense of high value & low value for the multiple in the market. (distributional characteristic like mean, median, S.D. & S.E.)

Price Earning Multiplier Approach

 

Two inputs MPS and EPS. PE : Price per share divided by earning per share. The variation comes in earning part. Forward PE: Stocks current price divided by expected EPS. Forward PE will be lower than current PE if earnings are expected to grow in future. Trailing PE Vs. Forward PE

Interpreting PE
    (i) (ii)

Very Low PE after long bull run. Check out dividend payout ratio. Low PE (less than 5) is considered as underpriced? High PE: Standalone case. Turnaround case.

Company Tata Steel Infosys SBI L&T Dr. Reddy NTPC

PE Multiple 7.96 23.71 17.49 26.72 24.57 15.96

Industry Average 9.6 22.10 8.97 15.38 11.43 18.17

Price Earning Growth



 (i) (ii)

Calculation: Current PE ratio / Expected earning growth. (not operating earnings) PEGs utility lies in that it urges you to look forward. The number are around 1, either a little more or somewhat less. Thumb rule: PEG around 1 or less for large firms. PEG 0.5 for mid & small firms.

Dividend Yield


Calculation: Dividend per share / price per share.  It tells you what income flow you are getting on your holding & gives strong downside support.  *** Always be calculated on current market price not your price of purchase. Check: (i) Business must atleast not shrink in future. (ii) Past dividend record.  Rule of thumb: More than 1.5 times of the market yield.

Sample of High dividend stocks

Company HCL Info ITC Castrol Chennai petro VST India Prism Cement Binani Cement Dividend 5 Yrs avg. Yield Payment 7.98 5.83 5.51 5.06 4.83 4.75 4.21 45% 49% 75% 25% 56% 18% 21% CAGR Sales (%) 36% 18% 15% 26% 11% 50% 40% CAGR PBDIT (%) 30% 21% 23% 11% 6% 69% 42%

Price to Book Value Ratio:

Calculation: Market Price/Book value per share. Drawbacks: (i) Not of much help when it is Greater than 1. (if less than 1 means either undervalued or company is in a declining business.) (ii) If the firm does not have significant fixed assets the book value may not be meaningful. e.g. FMCG, IT. (iii) Meaning for banking sector. (needs to maintain minimum CAR which act as a capital to grow).

Price to Sales Ratio

Calculation: Current stock price/ Revenue per share. Sales is more strictly defined figure than earning. PSR essentially reflects what the market is willing to pay per rupee of sales. Advantages: (i) Unlike earnings, revenue for a company is difficult to manipulate. (ii) This ratio can never be negative. (iii) The ratio is not influenced by the accounting methods.