Stock Valuation

Why do Stock Valuation

Estimate Intrinsic value (IV)

Compare with market price (MP)
If MP < IV, then stock is undervalued by the market and you should buy
If MP > IV, then stock is overvalued by the market and you should sell
CIPLA
 Book value vs Market value

Assets – Liability = Owners Equity

CIPLA’s last balance sheet showed Rs.14605 Crore as owners equity
Nearly 80 crores shares are outstanding
Per share book value of equity is 181
Is this CIPLA’s share price?
 Constant growth model

P0 = D1/(1+r) + D1*(1+g)/(1+r)^2 + D1*(1+g)^2/(1+r)^3 +…..

= D1/(r-g)

This model assumes that dividend will grow at a constant rate till
eternity
very strong assumption and is generally not true

Often used because of simplicity

 Problem

Company ABC has just given a div of Rs 3. The dividend is expected to

constantly grow at 10%. Estimate ABC’s share price if discounting rate is
15%.
Ans - 66
Part B: Change the growth rate to 11%
Ans - 83
 Differential growth model

XYZ corp is expected to give dividend of Rs 1, a year from now. Currently

in heavy growth phase the dividends are expected to grow at 15% for
the next 4 years. Thereafter, it expected to grow at 5% forever. The
discounting rate is 10%. Estimate XYZ’s share price.
Ans – 25.7

Hint: Use the form

P0 = σ𝑡1 𝐷𝑖/(1 + 𝑟)^𝑖 + 𝑃𝑡/(1 + 𝑟)^𝑡
 Where goes g come from?

The growth rate in dividends is a sensitive parameter

In practice, often estimated by analysts
Under certain conditions, we get an endogenous estimate of g
g = (1-div payout ratio)*ROE
 Important facts about g

a. growth rate in the stable period cannot exceed the economic growth
rate
b. growth rate cannot exceed cost of capital in the long run
 Where does R come from

R is Cost of equity
CAPM
Under constant growth assumption,
R = D1/P0 + g Dividend yield
 Problem (previous years paper)

XYZ is in the business of supplying electricity to Udaipur city. The current

EPS and DPS are INR 3.13 and INR 2.19, respectively. The return on
equity for XYZ is 11.63%. The beta for XYZ is 0.90; the risk free rate is
5.4% and market risk premium is 4%. What should be the share price for
XYZ?
Ans – 41.1
 Two extremes
1. No dividends. All earnings are reinvested
(Google stock)

2. All earnings paid out as dividends

g=0
P0 = DPS/r
= EPS/r , Only for no growth opportunity firm

P0 = EPS/r + PVGO, for all firms

PVGO: Present value of growth opportunity
When company enters in a profitable project the share price rises by the NPV
of the project.
For Income stocks the 1st term contributes to higher share of price
For growth stocks, the 2nd term contributes to higher share of price
 Growth or Income Stock?
BAJAJ FINANCE
Next year EPS forecast: 63.04
(https://quotes.wsj.com/IN/500034/research-ratings)

Beta: 1.5 (Approx.)

Cost of equity (r) = 7% + 1.5*5% = 14.5% (Approx.)

Current share price : 2412

2412 = 63.04/0.145 + PVGO

PVGO = 1977.2

81% of Bajaj Finance share price is due to future growth opportunity

 PVGO example

Next year EPS = 10 r = 10%

Let us suppose the firm has no growth opportunities and pays out all
earnings as div
Means next year Div = 10
Then we can use P0 = DPS1/(r – g)= DPS1/r as g = 0
= EPS1/r = 10/0.1 = 100

 Each year the firm earns 10, 10, 10,……….

and each year the firm pays out 10, 10, 10,……..
 PVGO example (Contd.)
Let us suppose the firm identifies a growth opportunity which amounts to
retaining and reinvesting 30% of the earnings each year, starting next year.
Suppose after the growth opportunity arises the ROE would increase to 20%.
g = 0.3*0.2 = 6%
EPS1 = 10 but DPS1 = 7
Share price also jumps to = DPS1/(r – g)
= 7/(0.1-0.06) = 175
Note that EPS1/r still remains 10/0.1 = 100
No growth firm had a share price of 100, but once growth opportunity
surfaced it jumped to 175
Thus, PVGO = 75
However, EPS1/(r-g) = 10 /(0.1-0.06) = 250 is a wrong use and gives
overestimate of the share price
What the wrong formula says => Every year the firm pays out 10,10.6,
11.2,……..
While the firm earns these amounts each year, it only pays out 7,7.42, 7.87,……
 PVGO example (Contd.)

Once growth opportunity surfaces the firm has two choices in the next
and each subsequent year.
a. Earn 10 next year and pay out 10. This leaves 0 to reinvest and.
Nothing goes to retained earnings to increase the owners equity and
the firm earns 10 in the subsequent year also. In this case the
market also does not value the growth and the company share price
is 10/0.1 = 100

b. Earn 10 next year and pay out 7. This leaves 3 to reinvest and this
amount is added to owners equity and you earn 3*20% = 0.6 extra
the subsequent year making your earnings 10+0.6 = 10.6. In this
case the market also does value the growth and the company share
price is 175
 Problem

The next year EPS is expected to be 2.49 and the company is expected
to continue its payout ratio of 50%. If the growth rate is 8% and
opportunity cost of capital is 12% then what is PVGO?

Ans – 10.25
 Problem

Real Corp expects to earn 71 million per year in perpetuity if does not
undertake any new projects. The firm has an opportunity to invest 16
million today and 5 million in one year in a project that will generate 11
million in perpetuity, beginning two years from today. The firm has 15
million shares of common stock outstanding and the required rate of
return is 12%.
a. Price of the stock if the firm does not undertake new investment.
ans – 39.44
b. what is per stock value if firm takes on the investment.
ans – 39.44 + 4.09
 Some food for thought on DDM

Dividends are less volatile than earnings and other return concepts, the
relative stability of dividends may make DDM values less sensitive to
short-run fluctuations in underlying value

However, Dividend policy can be arbitrary and not linked to value added
– “Sticky dividends”.
 Is dividend discount model applicable?

Firm A
EPS 0.41 0.12 −0.36 1.31 1.86 0.39 0.88 1.58 4.26 4.92
DPS 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

Payout ratio 244% 833% NA 76% 54% 256% 114% 63% 23% 20%
Firm B
EPS 0.62 0.66 0.77 0.79 0.52 0.72 0.93 1.11 1.2 1.3
DPS 0.18 0.22 0.25 0.29 0.3 0.39 0.32 0.33 0.35 0.37

Payout ratio 29% 33% 32% 37% 58% 54% 34% 30% 29% 28%
 Free cash flow valuation

Valuation of the entire business

FCF = Profit after tax – net investment
Net investment = capital expenditure + net working capital investment
- Depreciation
PV of business = FCF1/(1+r) + FCF2/(1+r)^2 +….FCFH/(1+r)^H
+ PV of business at Year H/(1+r)^H
 Problem

Year 1 Year 2 Year 3

Revenue 20000 30000 35000
Cost 18000 20000 24000
Capex 1500 4000 4500
Investment in 200 500 500
WC
Depreciation 400 1000 1200

After 3 years, The free cash flow is expected to grow at a constant rate
of 5%. Find firm value if cost of capital is 10% (Tax rate = 10%)
 FCFE vs FCFF (Good to know)
The FCF in the text book is FCFF (Free cash flow to the firm)
This needs to the discounted by the cost of capital (WACC) and not the
cost of equity to arrive at the firm value
If you subtract total debt to arrive at equity value

FCFE (Free cash flow to equity) is FCFF + net borrowings

This needs to be discounted at cost of equity to arrive at equity value
 Valuation by comparable

Stock A is trading 3 times its book value – that means its Price to book
ratio is 3.
Assumption: If two firms are similar in all respect then the market would
price them similarly in terms of comparable ratios (P/B , P/E)

Two uses –
1. Find IV and compare with market price
2. Find a price where one does not have one
 Valuation by comparable

Let firm A have 4 comaparable companies E,I,O and U.

Let their P/E ratio
E 5.1
I 6.3
O 4.6
U 8.0
Thus average P/E ratio of comparable firms is 6.0
If A’s EPS is 30, then the price of A by P/E comparables method is 6*30 =
180
 P/E

If the stock’s current P/E ratio is high relative to its average P/E ratio for
last several years, is the stock in question expensive?

What factors may have driven the P/E ratio high

a. Lower interest rates compared to past => cost of equity has
decreased
b. The beta of the firm has decreased compared to the past => cost of
equity has decreased
c. Company has seen new potential growth due to new technology
 Justified forward P/E

A justified P/E ratio is the price to earnings ratio which is justified by the
company’s underlying fundamentals, i.e. growth rate and cost of equity,
etc.
𝐷𝑖𝑣0 𝐷𝑖𝑣1
𝑃0 𝐸1
∗(1+𝑔) 𝐸1 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜
= = =
𝐸1 𝑟−𝑔 𝑟−𝑔 𝑟−𝑔

If the market price is different from the value of a firm, then the actual
P/E would be different from the P/E ratio justified by the fundamentals
 Justified forward P/E

Current stock price is $54.51

EPS expected in next 12 months is $2.15
Dividend payout ratio is 48%, cost of equity is 9.5% and growth rate is
5.6%

Justified forward P/E = 12.31

Actual forward P/E = 25.35

Undervalued or Overvalued?
 Problem

JSC earned 18 million for the fiscal year ending yesterday. The firm also
paid out 30% of its earnings yesterday. The firm is expected to continue
this rate in future. The remaining 70% of the earnings is retained by the
company for use in projects. The company has 2 million shares of
common stock outstanding. The current price 93. The ROE is expected
to remain at 13%. What is the required return for the stock?

Ans – 12.27%
 Types of markets

Primary vs Secondary
When a company is looking to raise capital by issuing shares to public
then these are called transactions in primary market. When the first
time a company does this exercise this is called initial public offering or
IPO. From the 2nd time onwards this is known as follow on public
offering (FPO).
When investors who already hold shares of a company sells to other
investors these transactions are known as transactions in the secondary
market. All trading volume in the world is the result of secondary market
transactions.