Security Analysis and Portfolio

Management
Equity Valuation
 Equity Valuation
• A financial analyst primarily conducts two types of analysis for
evaluation of equity investment decisions viz. fundamental
and technical analysis.

• The technical analysis analyses the charts and graphs of the

market prices of a stock to understand the sentiments of the
market. It believes in a fact that history repeats itself.

• On the other hand, fundamental equity valuations methods

attempt to find the fair market value of equity share. it involves
a study of the assets, earning potential, future prospects,
future cash flows, magnitude and probability of dividend
payments etc.
 Fundamental Analysis Techniques
1. Balance Sheet Techniques:-
• Book value
• Liquidation value
• Replacement cost
2. Discounted Cash flow Techniques:-
• Dividend discount model
• Free cash flow model
3. Relative Valuation Techniques:-
• Price-earnings ratio
• Price-book value ratio
• Price-sales ratio.
 1.Balance Sheet Techniques
Balance sheet methods are the methods which utilize the
balance sheet information to value a company. These
techniques consider everything for which accounting in the
books of accounts is done.
It includes following techniques:-
• Book value
• Liquidation value
• Replacement cost
 Book Value
• Book value of an asset is the value at which the asset is carried on
a balance sheet and calculated by taking the cost of an asset minus
the accumulated depreciation. Book value is also the net asset value of a
company, calculated as total assets minus intangible assets (patents,
goodwill) and liabilities.

• Net Worth = Equity Share capital + Preference Share Capital + Reserves &
Surplus – Miscellaneous Expenditure (as per B/Sheet) – Accumulated
Losses.

• For example, in the general ledger account, Automobile, is the automobile's

cost of $22,000. In the contra asset account, Accumulated Depreciation on
Automobile, is a credit balance of $16,000. The net of those two amounts
($22,000 minus $16,000) is the book value or the carrying value of the
automobile. In this example the $6,000 is the amount being reported on the
company's books.
• As the accounting value of a firm, book value has two main uses:

• 1. It serves as the total value of the company's assets that

shareholders would theoretically receive if a company were
liquidated.

• 2. When compared to the company's market value, book value can

indicate whether a stock is under- or overpriced.
In personal finance, the book value of an investment is the price
paid for a security or debt investment. When a stock is sold, the
selling price less the book value is the capital gain (or loss) from the
investment.
• Book Value (per share)

– The Book Value is Equity / shares outstanding

• Example: Ford
Assets 243,283 million
Liabilities 219,736 “
Owners Equity 23,547 “
Shares Outstanding 1,169 “

– What is the Book Value per share?

$23,547/1,169 = Book value of $20.14 per share

• Caution: Be careful as book value does not tell you

depreciation methods or the true value of the assets
(they may actually be worthless)
• Liquidation Value

– Liquidation value is the total worth of a

company's physical assets when it goes out of business
or if it were to go out of business. Liquidation value is
determined by assets such as real estate, fixtures,
equipment and inventory. Intangible assets are not
included in a company's liquidation value.

– Liquidation value does not include intangible

assets. Intangible assets include a business's intellectual
property, goodwill and brand recognition. However, if a
company is sold rather than liquidated, both liquidation
value and intangible assets are considered
• Liquidation Value = Net Realizable Value of All Assets
– Amounts paid to All Creditors including
Preference Shareholders.

• Example
Liquidation is the difference between some value of
tangible assets and liabilities. As an example, assume
liabilities for company A are $550,000. Also assume the
book value of assets found on the balance sheet is $1
million, the salvage value is $50,000 and the estimated
value of selling all assets at auction is $750,000, or 75
cents on the dollar. The liquidation value is calculated by
subtracting liabilities from the auction value, which is
$750,000 minus $550,000, or $200,000.
• Replacement Cost

• Replacement value method takes into account ‘the amount required to replace
the existing company’ as the valuation of a company. In other words, if one is
to create a similar company in the same industry; all costs required to do so
will form part of the value of the firm. This is also called as “Substantial Value”.

Replacing an asset can be an expensive decision, and companies analyze

the net present value (NPV) of the future cash inflows and outflows to
make purchasing decisions. Once an asset is purchased, the company
determines a useful life for the asset and depreciates the asset's cost over
the useful life.

Equity Value = Replacement Cost of Assets – Liabilities

 •As per the table above, the book value comes out to be $ 2400 Mio.
In the same case, let us calculate the replacement cost, given the following
assumptions:

1. 20% of the fixed assets are unused.

2. The market value of the assets is 50% higher than the accounting value
carried in the balance sheet.
The replacement cost adjusted balance sheet will now have fixed assets value
as follows:
• Tobin’s Q
– Tobin’s Q is the ratio of a firm’s price to its estimated
replacement cost

• In the long run, the market price to replacement cost

will tend toward 1 as investors correctly value the
replacement cost of the assets

– Logic: Investors will be willing to purchase the company

as long as the company’s market price is below the
replacement cost. As soon as its price is greater than
the replacement cost, competition will come in, dropping
the price to close to its replacement cost.
• Concerns: Differences may remain over time
• COMPARISON BETWEEN LIQUIDATION AND
REPLACEMENT VALUE METHOD

• Replacement cost method of equity valuation assumes that

the company continues to operate as against shutting down
of business. Whereas liquidation value method of equity
valuation assumes that the company will be shutting down
its business and hence the value of the company under this
method will be its salvage value.
• In the case of replacement cost method, generally,
replacement cost excludes those assets which are not being
used by the company for its daily operations; while in the
case of liquidation value method all assets are taken into
consideration.
• Liquidation value method may be prone to distress pricing
which is not the case with replacement cost method.
Conclusion
Replacement value method is the more refined
way of calculating the value of the company;
however, it comes with the drawback of
incorrect estimation. The use of replacement
value method will be incomplete if we do not
compare it with Q ratio, which is also called
Tobin’s Q. Using Q ratio based on replacement
cost adds value to the investment
decision process.
 Challenges of Balance Sheet
Models
- What are the major challenges of Balance Sheet
Models?
- It may be difficult to determine the real value of
the assets, i.e. depreciated cost versus real
value
- It is uncertain how long it will take for
replacement cost to move toward unity. The time
factor is a real concern
- It may be difficult to determine the value of
intangible assets, which may be significant in
some companies
 2.Discounted Cash Flow
techniques
Discounted cash flow methods are based on the fact that
present value all future dividends and the future price
represent the market value of equity.
It includes following techniques:-
• Dividend discount model
• Free cash flow model
 Dividend Discount Models
• These are models which take into account discounting
expected future cash flows to gain a reference for the value
of a company
– These are the oldest and simplest present value
approach to valuing a stock
• Primary Dividend Discount Models
General Model
Constant Growth Model
 Dividend Discount Model

The dividend discount model (DDM) is a procedure for valuing the

price of a stock by using the predicted dividends and discounting them
back to the present value. If the value obtained from the DDM is higher
than what the shares are currently trading at, then the stock is
undervalued.

These are the oldest and simplest present value approach to valuing a
stock.
1. Dividend discount model with no growth in dividends.
2. Dividend discount model with constant dividend growth.
3. Dividend discount model with multiple dividend growth .
 No Growth Model
ASSUMPTION
-The future dividend remains constant such that
D1=D2=D3=D4=……………….DN
Vo= Sum [(Dt+ Pt) /(1+k)t ]

V0 = Value of Stock
Dt = Dividend at time t
Pt = Expected Price at time t
k = Required return on the stock

The value of a company is the discounted value of dividends and the

eventual sale of the company stock

( Dt  Pt )
Vo   Vo 
( D1)
 ... 
( Dt )

( Pt )
t 1 (1  k ) t
(1  k )1
(1  k ) t
(1  k ) t
If g=o
Applying to V
V=D1/K
Example

If Zinc Co. is expected to pay cash dividends of $8 per

share and the firm has a 10% required rate of
return,what is the intrinsic value of the stock?

Value of stock= 8/.10

=$80
If the current market price is $65, then the stock is
underpriced.

Recommendation BUY
 Constant Growth Model

Constant (or Gordon) Growth Rate Model

Vo = Do * (1+g)
(k - g)

This is for stocks that are growing at a constant growth rate (this
rate is assumed in perpetuity)
g = constant perpetual growth rate
b = plowback or retention ratio (rr)

g = ROE x b
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
Internal Growth Rate (ROE x (1-payout))
For example, Company X paid a dividend of $1.80 per share this year. The
company expects dividends to grow in perpetuity at 5% per year, and the
company's cost of equity capital is 7%. Current market price $120

The $1.80 divided is the dividend for this year and needs to be adjusted by
the growth rate to find D(1), the estimated dividend for next year.

Vo = Do * (1+g)
(k - g)

D(1) = D(0) x (1 + g)
= $1.80 x (1 + 5%) = $1.89.
value of stock = $1.89 / ( 7% - 5%) = $94.50.
As the current market price is $120, the stock is overpriced.

Recommendation Sell
 Multi-stage dividend discount
model
Multi-stage dividend discount model is a technique used to calculate
intrinsic value of a stock by identifying different growth phases of a
stock, projecting dividends per share for each the periods in the
high growth phase and discounting them to valuation date,
finding terminal value at the start of the stable growth phase using
the Gordon growth model, discounting it back to the valuation date
and adding it to the present value of the high-growth phase
dividends
The basic concept behind the multi-stage dividend discount model
is the same as constant-growth model, i.e. it bases intrinsic value on
the present value of expected future cash flows of a stock. The
difference is that instead of assuming a constant dividend growth
rate for all periods in future, the present value calculation is broken
down into different phases
Intrinsic value = PV of high growth phase dividends + PV of stable growth
phase dividends.

To calculate the present value of dividend payments in the high growth phase,
dividend per share for each year is individually projected and then discounted.

Dividend per share in year 1 = current dividend × (1 + growth rate in year 1).

It is discounted one year back to valuation date (i.e. time=0).

Dividend per share in Year 2 = dividend per share in year 1 * (1 + growth rate
in year 2).
It is discounted 2 years back to t=0.

D1 D2 D3 Dn
PV of high
growth + + + ... +
dividends = (1+r) (1+r)2 (1+r)3 (1+r)n
Example
Flamingo Communications (FC) is fast-growing IT startup specializing in social-
media marketing. You are a financial analyst at AH Ventures, a diversified
conglomerate, which has 10% stake in the company.

Your in-house economist projects that FC dividends are expected to grow at 25%,
20%, 15% and 10% and 5% for the next 5 years. From 6th year onwards a stable
growth rate of 5% is expected.

If FC’s current stock price is $41, its most recent dividend per share was $1.5 per
share and its cost of equity is 10%, what would you recommend to your CFO
regarding what to do with the investment?

Solution

In the first step, you need to project dividend expectation for each year in the
high-growth phase.
 The following table summarizes the calculations:

Year Growth rate Dividend per share Phase Formula

Time 0 1.50
Year 1 25% 1.88 High-growth = 1.5 * (1 + 25%)

Year 2 20% 2.25 High-growth = 1.88 * (1 + 20%)

Year 3 15% 2.59 High-growth = 2.25 * (1+15%)

Year 4 10% 2.85 High-growth = 2.59 * (1 + 10%)

Year 5 5% 2.99 High-growth = 2.85 * (1 + 5%)

Year 6 5% 3.14 Stable growth = 2.99 * (1 + 5%)

The first 5 years make the high-growth phase. Dividend per share expected
for each of the first 5 years must be discounted back to t=0 individually as
follows:

Dividend per
Year Growth rate PV at t=0 Formula
share
Year 1 25% 1.88 1.70 = 1.88 / (1 + 10%)

Year 2 20% 2.25 1.86 = 2.25 * (1 + 10%)^2

Year 3 15% 2.59 1.94 = 2.59 * (1+10%)^3

Year 4 10% 2.85 1.94 = 2.85 * (1 + 10%)^4

Year 5 5% 2.99 1.86 = 2.99 * (1 + 5%)^5

Sum 9.31
Year 6 onwards is the stable growth phase.

Using the Gordon growth model formula, you can arrive at the present value of
perpetual dividends from 6th year onwards at the start of the stable growth phase.
This value is called terminal value.

Terminal value = PV of perpetual dividends 6th year onwards = $3.14/(10% - 5%)

= $62.8
Since the PV calculated above is at the end of 5th year (i.e. start of stable growth
phase), it must be discounted back 5 years as follows:

PV at t=0 = $62.8/(1+10%)^5 = $39

Intrinsic value of the stock

= PV of dividends in high-growth phase + PV of terminal value

= $9.31 + $39
= $48.3
Since the current stock price is $41 and the intrinsic value is $48.3, AH Venture
should keep invested in the company because it has upward potential.

Recommendation BUY
 Challenges of Dividend Discount Models

Major challenges to DDMs include:

-A slight change in the discount rate can have a huge
change in the result
-It is difficult to determine the terminal value of the stock
-A small change in the termination value (i.e., the PE
multiple) can have a large change in the result
-Not all firms have dividends
• Free Cash Flow to the Firm (FCFF)

– FCFF is the cash flow available to the suppliers of capital

after all operating expenses (including taxes) are paid and
working and fixed capital investments are made (i.e. less
capital expenditures)

• FCFF = cash prior to the payment of interest to the debt

holders
FCFF = EBIT - taxes + depreciation (non-cash costs)
– capital spending – increase in net working capital
– change in other assets + terminal value

– Discount this at the firm’s WACC

- Firm Value = Operating free cash flow
WACC – growth OFCF
• Free Cash Flows to Equity (FCFE)

– FCFE is the cash flow available after all operating

expenses, interest, and principle repayments have been
made and necessary investments in working capital and
fixed capital have been made

• FCFE = Adjusts operating cash flows for debt

repayments

• FCFE = EBIT – interest - taxes + depreciation (non-

cash costs) – capital expenditures – increase in net
working capital – principal debt repayments + new debt
issues + terminal value. Discount at k = required
return on equity
– Firm Value = Free CF to Equity/(k – growth FCFE)
• Calculation Methodology for Discounting:
– Determine the appropriate discount rate
– Set up each of the individual cash flows
– Discount each of the individual cash flows
– Discount the final cash flow assuming a constant growth rate
= cash flow / (k – g)
• The question remains whether the final cash flow
representative of all future cash flows
– Sum all the discounted cash flows
– Make adjustments as required
 Challenges of Discounting Models
- Major challenges of Discounting Models include:
- A slight change in the discount rate can have a huge
change in the result
- A small change in the terminal growth rate can have a
large change in the result
- You must be very careful of your choice of discount rates
and capitalization rates
 3. Relative Value Models
• Relative value models assume that companies have a
fair-value trading range versus the market and versus
their respective indices
– Companies that trade within their fair-value ranges
are correctly valued by the market
– When companies are outside their fair value ranges,
this gives information that the company should be
looked at, either to buy or sell
– The fair trading PE range times EPS times the
market PE gives the price per share.
 Relative Value Models
• Benefits
– Easy to calculate
– Identifies when stock appreciation is due to general
market movement versus the benchmark
– Works for many different types of companies
– Can be compared to the market and industry
benchmarks
• Challenges
– Not all companies trade versus the market index in the
same way
– May not be useful if the market is at extreme valuation
levels
 Price Earnings Ratios
• P/E Ratios are a function of two factors
– Required Rates of Return (k)
– Expected growth in Dividends
• Uses
– Valuation of new companies
– Relative valuation versus market and industry
• Note: this is used extensively in the industry.
Research has found that low PE stocks have given
a higher return to Investors than high PE stocks
over the last 70 years
 Price Earnings Ratios
(continued)
• Price Earnings Key Terms
– Price Earnings = Price per share/Average Common
diluted Earnings Per Share
– Forward or Prospective PE = Current Price / Forward
EPS
– Historic PE = Year-end Price/Year-end EPS
– Normalized PE = Current Price/normalized earnings
(earnings adjusted to take into account the cycles in the
economy)
– Earnings Yield (E/P) = 1 / Price Earnings
Challenges of Price Earnings
Models
– Benefits
• Used extensively in the industry
• Generally low PE firms outperform high PE firms
– Pitfalls
• Earnings are accounting earnings, which can be
manipulated through depreciation, inventory, etc.
• Earnings can fluctuate widely around a trend
• You cannot know if the PE is high or low unless you
compare it to a trend, to long-run growth prospects,
to an industry, or to the market
 C. Understand the Key
Valuation Metrics in
Valuing Securities
• What are the key valuation metrics?
 PE, PBV, PS, DY, POCF, PEBIT, PEVITDA, P/IGR, and
P/EGR
• Why are they important?
 They relate the current market price to key profitability
variables
 They relate the company’s PE ratio to certain types of
growth
 1. Price/Earnings (PE=P/EPS)
• PE Ratio
– The most common measures of a firm’s stock price
relative to its earnings--what you are paying for $1 of
earnings.
• How is it analyzed?
– Versus its historical average
• If lower that than its history, it may indicate it is
moving into more attractive territory, i.e., growth is
increasing
– Versus the market.
• Gives a historical view. If it is trading at a lower
relative PE, it may be becoming more attractive.
– Versus the industry
• If the relative PE versus the Industry is declining, it
may indicate the stock is becoming more attractive.
 2. Price/Book (PB=P/BVS)
 P/BV or PB or Market to Book
 Gives the relationship between the stock price and the
book value of the firm (i.e. owners equity).
 How it is analyzed?
 If the PB ratio is high when compared to peer firms, the
stock may be overvalued, all else being equal.
 If the PB is negative, the firm is in serious trouble.
 Remember that owners’ equity is based on
accounting depreciation and may not have relevance
to the actual value of the assets of the company.
 Generally, the higher the P/BV (or the lower its inverse,
Book to Price) the more expensive the company.
 3. Price/Sales (PS=P/SPS)
 Price to Sales
 Sales multiples are indicator of growth in sales and
hence a future indicator of growth in profits.
 How it is analyzed?
 Can be positive or negative
 Note that growth in sales translates into growth in
profits only if the other drivers of profits are sustained,
i.e. profit margins, turnover, etc.
 New companies
 New companies like PS ratios when they don’t have
any earnings. But if earnings fail to materialize, then
PS ratios are irrelevant.
 Generally, the lower the PS ratio, the more attractive the
company, all else being equal
Thank You