Chapter 13

EQUITY VALUATION How to Find Your Bearings

Outline
Balance Sheet Valuation
Dividend Discount Model Earnings Multiplier Approach Earnings Price Ratio, Expected Return, and Growth

Other Comparative Valuation Ratios

Equity Portfolio Management Forecasting the Aggregate Stock Market Return

Techniques of Fundamental Equity Valuation

Balance Sheet Techniques
Book Value Liquidation value Replacement Cost

Techniques of Fundamental Equity Valuation

Discounted Cash Flow Techniques

Dividend discount model Free cash flow model

Relative Valuation Techniques Price earnings ratio Price-book value ratio Price-sales ratio

Balance Sheet Valuation

Book Value
Liquidation Value
Replacement Cost

Dividend Discount Model

Single Period Valuation Model D1 P1 P0 = + (1+r) (1+r)
Mufti - Period Valuation Model Dt P0 = t=1 (1+r)t Zero Growth Model D P0 = r Constant Growth Model D1 P0 = r-g

Two-Stage Growth Model

1 - 1+g1 1+r P0 Where Pn D1 (1+g1)n-1 (1+g2) 1 (1+r)n = D1 r - g1
n

Pn

+
(1+r)n

=
(1+r)n r - g2

Two-Stage Growth Model: Example

EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OF VERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY AN ABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6 YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISE AT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15 PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OF VERTIGO ? THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE : g1 = 20 PERCENT g2 = 10 PERCENT n = 6 YEARS r = 15 YEARS D1 = D0 (1+g1) = RS.2(1.20) = 2.40 PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THE INTRINSIC VALUE ESTIMATE AS FOLLOWS :
6

1.20 1 1.15 P0 = 2.40 .15 - .20 1 - 1.291 = 2.40 -0.05 = 13.968 + 56.79 = RS.70.76

2.40 (1.20)5 (1.10) + .15 - .10 2.40 (2.488)(1.10) + .05

1 (1.15)6

[0.4322]

H Model
ga gn

2H

D0
PO = r - gn D0 (1+gn) D0 H (ga - gn) [(1+gn) + H (ga - gn)]

=
r - gn
Value based on normal growth rate

+
r - gn
Premium due to abnormal growth rate

Illustration: H Ltd
D0 = 1 ga = 25% gn = 15% 1 (1.15) P0 H=5 r = 18% 1 x 5(.25 - .15)

=
0.18 - 0.15

+
0.18 - 0.15
+ 16.67 = 55.00 P/E = 27.5

= 38.33

IF E = 2

Impact Of Growth On Price, Returns, and P/E Ratio

Price D1 PO = r-g RS. 2.00 (D1 / PO) Dividend Yield Capital Gains Yield (P1 - PO) / PO Price Earnings Ratio (P / E)

Low Growth Firm

PO =

= RS.13.33 0.20 - 0.05

RS. 2.00

15.0%

5.0%

4.44

Normal Growth Firm

PO =

= RS.20.00 0.20 - 0.10 RS. 2.00

10.0%

10.0%

6.67

Supernormal Growth Firm

PO = 0.20 - 0.15

= RS.40.00

5.0%

15.0%

13.33

Free Cash Flow Model

The enterprise value (EV) according to the free cash flow model is:

EV=

FCF1

FCF2

++

FCFH

VH

(1+WACC)

(1+WACC)2

(1+WACC)H

(1+WACC)H
Present value of horizon value

Present value of the FCF during the explicit forecast period

Illustration
The balance sheet of Azura Limited at the end of year 0 (the present point of time) is as follows.
Rs. in crore
Liabilities Shareholders funds Equity capital (10 crore shares of Rs. 10 each) Reserves and surplus Loan funds rate (9 percent) 250 Assets

100

Net fixed assets Net working capital

400 100

150 250 500 500

Based on the above information we can calculate the intrinsic value of the equity share as follows: 1. 2. The explicit forecast period is 6 years because the firm reaches a steady state at the end of 6 years. The free cash flow forecast for the explicit forecast period is given in Exhibit 13.4. Exhibit 13.4 Free Cash Flow Forecast
Year Asset value (Beginning) NOPAT Net investment FCF Growth rate (%) 1 500.0 60.0 100.0 (40.0) 20 2 600.0 72.0 120.0 (48.0) 20 3 720.0 86.4 144.0 (57.6) 20 4 864.0 103.7 103.7 12 Rs. In crore 5 6 967.7 1083.2 116.1 130.1 116.1 86.7 43.4 12 8

3. The weighted average cost of capital is:

4.

WACC = 0.5 x 16 + 0.5 x 9 (1-0.333) = 11 percent The horizon value of the firm is
FCFH+1 VH = rg + 0.11 0.08 FCFH (1+g) = 0.11 0.08 43.4 (1.08)
= Rs.1562.4 crore

5.
EV

The enterprise value of Azura is:

-40.00 = (1.11) 0 (1.11)2 43.4 48 (1.11)3 1562.4 57.6 + 0 (1.11)4

+
(1.11)5

+
(1.11)6

+
(1.11)6

= Rs. 741.4 crores 6. The equity value of Azura is:

Preference value = 741.4 250.0 = Rs. 491.4 Crores

Enterprise value

7.

The value per share of Azura is: Rs. 491.4 crore / 10 crore = Rs. 49.

Earnings Multiplier Approach

P0 = m E1
Determinants of m (P / E)

D1
P0 = r-g

E1 (1 - b)

=
r - ROE x b (1 - b) P0 / E1 = r - ROE x b

Cross -Section Regression Analysis

P/E g b

= = = =

8.2 + 1.5g + 6.7b - .2 Growth rate for normalized eps Payout ratio Std. Dev .. of % eps change

Every conceivable variable & combination of variables .. tried..

Almost .. all these models .. highly successful .. explaining stock prices .. at a point .. time, but less successful in selecting appropriate .. stocks .. buy .. sell.

Why 1. Market Tastes Change Weights Change

2. Input values change over time Div & growth in earnings

3. There are firm effects not captured by the model

P / E Benchmark
Rules Of Thumb
Growth rate in earnings 10% 1 Nominal interest rate 15% 20% 1 = 8.33 .12 1 = 5.00 .20 1 Real return 1 = 25 .04 25% 35%

1
= 16.67 .06 0.5 = 16.67 Payout ratio

.18 - .15

Req. Ret - gr. Rate

Growth And P / E Multiple

Case A : Year 0 Total Assets Net Worth Sales Profit After Tax Dividends Retained Earnings 100 100 100 20 20 No Growth Year 1 100 100 100 20 20 Case B : Year 0 100 100 100 20 10 10 Percent Growth Year 1 110 110 110 22 11

Case A No Growth Discount Discount Rate: 20% Rate: 25% 20 / 0.20 = 100 100 / 20 = 5.0 20 / 0.25 = 80 80 / 20 = 4.0

10

11
Case B Growth Discount Discount Rate: 20% Rate: 25% 10 / (0.20 - 0.10) = 100 100 / 20 = 5.0 10 / (0.25 - 0.10) = 66.7 66.7 / 20 = 3.33

Discount Rate: 15% Value 20 / 0.15 = 133.3 Priceearnings multiple 133.3 / 20 = 6.67

Discount Rate: 15% 10 / (0.15 - 0.10) = 200 200 /20 = 10.0

E / P, Expected Return, And Growth

1
E1 = D1 = 15

2
... E2 = D2 = 15 15 P0 = 0.15 = 100

r = 15%

Investment .. RS. 15 Per Share in Year 1 Earns 15% 2.25 Npv Per Share = - 15 + = 0 0.15

RATE OF RETURN

INCREMENTAL CASH FLOW

PROJECT'S NPV IN YEAR 1 -10 -5 0 5 10

IMPACT ON SHARE PRICE SHARE PRICE IN YEAR 0, IN YEAR 0 P0 -8.70 -4.35 0 4.35 8.70 91.30 95.65 0 104.35 108.70

E1/P0

0.05 0.10 0.15 0.20 0.25

0.75 1.50 2.25 3.00 3.75

0.164 0.157 0.15 0.144 0.138

0.15 0.15 0.15 0.15 0.15

IN GENERAL, WE CAN THINK OF THE STOCK PRICE AS THE CAPITALISED VALUE OF THE EARNINGS UNDER THE ASSUMPTION OF NO GROWTH PLUS THE PRESENT VALUE OF GROWTH OPPORTUNITIES (PVGO).

E1 P0 = r MANIPULATING THIS A BIT, WE GET E1 = P0 r 1 P0 PVGO + PVGO

FROM THIS EQUATION, IT IS CLEAR THAT : EARNINGS-PRICE RATIO IS EQUAL TO r WHEN PVGO IS ZERO. EARNINGS-PRICE RATIO IS LESS THAN r WHEN PVGO IS POSITIVE. EARNINGS-PRICE RATIO IS MORE THAN r WHEN PVGO IS NEGATIVE.

Price To Book Value Ratio (PBV Ratio)

Market price per share at time t

PBV ratio =
Book value per share at time t The PBV ratio has always drawn the attention of investors. During the 1990s Fama and others suggested that the PBV ratio explained to a significant extent the returns from stocks.

Determinants Of The PBV Ratio

D1
P0 = rg

D1 = E1 (1 b) = E0 (1 + g) (1 b) P0 = E0 (1 + g) (1 b) rg E0 = BV0 x ROE
P0 = BV0 (ROE) (1 + g) (1 b) rg

PBV ratio = P0 = ROE (1 + g) (1 b) BV0 r-g

Price To Sales Ratio (PSR Ratios)

In recent years PSR has received a lot of attention as a
valuation tool. The PSR is calculated by dividing the current market value of equity capital by annual sales of the firm. Portfolios of low PSR stocks tend to outperform portfolios of high PSR stocks. It makes more sense to look at PSR/Net profit margin as net

profit margin is a key driver of PSR.

Determinants of the PS Ratio

PS ratio

Po S0

NPM (1+g) (1-b) r-g

Companion Variables and Modified Multiples

Let us look at the equations for P/E ratio, PBV ratio, and PS ratio.
P/E = (1 - b)

rg
PBV = ROE (1 + g) (1 b) (r g) PS = NPM (1 + g) (1 b) r-g

Looking at these equations, we find that there is one variable that dominates when it comes to explaining each multiple it is g for P/E, ROE for PBV, and NPM for PS. This variable the dominant explanatory variable is called the companion variable.

Taking into account the importance of the companion variable, investment practitioners often use modified multiples which are defined below.
P/E to growth multiple, referred to as PEG

P/E
g

PBV to ROE, referred to as value ratio

PBV
ROE

PS to NPM, referred to as PSM

PS Net profit margin

Sum of the Parts Method

Many companies have subsidiaries or associate companies in which they have significant equity stakes that usually range between 25 percent and 100 percent. To ascertain the intrinsic value per share of such companies the sum of the parts (SOTP) method of valuation is commonly employed. The SOTP method involves the following steps:

1. Determine the value per share attributable to the core business. One way
to do is to calculate the earnings per share from the core business and apply a suitable multiple to it. 2. Find the value per share for each of the listed subsidiaries. In computing this value a discount factor of 15 to 20 percent is generally applied to the observed market value of the equity stake in the listed subsidiary. 3. Assess the value per share for each of the unlisted subsidiaries. To do this, the analyst has to first estimate the market value using an earnings multiple or some other basis as there is no observed market value and then apply a discount factor of 15 to 25 percent to the same. 4. Add the per share values for the core business, for listed subsidiaries, and for unlisted subsidiaries, to get the total value per share.

An illustrative sum of the parts (SOTP) valuation of Mahindra and Mahindra, done in 2007, is given in exhibit 13.8 Exhibit 13.8 SOTP Valuation Based on FYO8E
Business M&M Multiple Parameter Discount Per share

stake Core auto business

Mahindra and Mahindra financial services Mahindra GESCO developer Tech Mahindra Mahindra Ugine steel co ltd Mahindra forgings Mahindra holidays and resorts 39% 44% 55% 47% 100% Market cap Market cap Market cap Market cap Pat 68%

(%) 10.5 Eps

Market cap 20%

value 451.7
48.6

20% 20% 20% 20% 25%

27.6 250.2 5.2 11.6 37.0

Mahindra holdings and finance

Total subsidiaries value Total value per share (Rs.) Source: company, CSEC research

100%

Pat

25%

8.0
388.3 840.0

Equity Portfolio Management

Passive Strategy Buy and hold strategy

Indexing strategy

Active Strategy Market Timing Sector Rotation Security Selection Use of a Specialised Concept

Forecasting The Aggregate Stock Market Return

Stock market returns are determined by an interaction of two factors : investment returns and speculative returns.

In formal terms :
SMRn = [DYn + EGn] Investment return + [(PEn / PE0)1/n 1] Speculative return

where : SMRn = annual stock market return over a period of n years DYn = annual dividend yield over a period of n years

EGn
PEn PE0

= annual earnings growth over a period of n years

= price-earnings ratio at the end of n years = price-earnings ratio at the beginning of n years.

Illustration
Suppose you want to forecast the annual return from the stock market over the next five years (n is equal to 5). You come up with the following estimates. DY5 = 0.025 (2.5 percent), EG5 = 0.125 (12.5 percent), and PE5 = 18. The current PE ratio, PEo, is 15. The forecast of the annual return from the stock market is determined as follows: SMR5 = [0.025 + 0.125] + [(18/15)1/5 1] = [0.15] + [0.037] = 15 percent + 3.7 percent = 18.7 percent 15 percent represents the investment return and 3.7 percent represents the speculative return.

Summing Up

While the basic principles of valuation are the same for fixed income securities as well as equity shares, the factors of growth and risk create greater complexity in the case of equity shares.
Three valuation measures derived from the balance sheet are: book value, liquidation value, and replacement cost. According to the dividend discount model, the value of an equity share is equal to the present value of dividends expected from its ownership. If the dividend per share grows at a constant rate, the value of the share is : P0 = D1/ (r g) A widely practised approach to valuation is the P/E ratio or earnings multiplier approach. The value of a stock, under this approach, is estimated as follows:

P0 = E1 x P0/E1

In general, we can think of the stock price as the capitalised value of the earnings under the assumption of no growth plus the present value of growth opportunities (PVGo) E1 P0 = + PVGO

r
Apart from the price-earnings ratio, price to book value (PBV) ratio and price to sales (PSR) ratio are two other widely used comparative valuation ratios. Two broad approaches are followed in managing an equity portfolio : passive strategy and active strategy. Stock market returns are determined by an interaction of two factors : investment returns and speculative returns.