Week 5: Equity Valuation

Paul Dou

Objectives and learning outcomes from this module Explain the characteristics of equity securities. Understand some financial ratios. Understand how equity securities are valued. Identify the expected return on equity securities.

Introduction to and characteristics of equity securities Equity is a claim on the residual assets of the issuer.

Initial public offerings (IPO) is when a company (that has been privately owned) sell shares to the public for the first time. Transactions that occur prior to the IPO may not be efficient.

Introduction to and characteristics of equity securities Book value: original cost accumulated depreciation. of the asset minus

Liquidation value: minimum value of the asset (when the company is liquidated). It does not capture the going-concern value of the business. Intangible value: impounded into market price. While it is valuable for the going-concern purpose, it may have no value in a forced liquidation.

Introduction to and characteristics of equity securities

Market value: Amount the investors are willing to pay in the market. It depends on the earning power of todays assets and the expected payoff from future investment. If market value = book value, it is only by mere coincident.

Introduction to and characteristics of equity securities

The discussions of this module are based on ANZ banking group, which is listed on the ASX (http://au.finance.yahoo.com/q?s=ANZ.AX).

Information for ANZ Banking Group

Table 1, Source: Yahoo Finance 24 March 2011

Some financial ratios

Dividend for last financial year is 126 cent per share or cps (this information is obtained from ANZ annual report).
Dividend Yield Dividend current share price 1.26 5.43% 23.21

DPS 1.26 Dividend payout ratio 70%; EPS 1.79 Plowback ratio 1 Dividend payout ratio 30%

Some financial ratios

current share price 23.21 12.97; EPS 1.79 where EPS earning per share; P / E ratio EPS 1.79 (this value is obtained from annual report ) price to book ratio Market valueof equity 59.41B 1.74 Book valueof equity 34.16B

return on equity

Net profit 4.5B 13.2% Book valueof equity 34.16B

Book value 34.16B (this value is obtained from annual report )

Valuing equity securities

In general, there are two approaches:

Dividend Discount Model (DDM) Comparable approach

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Dividend Discount Models (DDM) Recall:

In general, the value (price) of an asset is the present value of the expected future cash flows on the asset.

Under DDM, we generally have three scenarios:

Dividends have zero growth; Dividends have a constant growth; and Dividends have non-constant growth.

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DDM : Dividends have zero growth

Suppose ANZ has no growth (i.e. it does not invest in new project that adds value to the firm). In this case, clearly, the firm can distribute all its earnings as dividends.

Therefore, EPS0 = EPS1 = = D0 = D1 = . = $1.79

2010 2011 D1 = 1.79 2012 D2 = 1.79 2013 D3 = 1.79

P0
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DDM : Dividends have zero growth

How to value ANZs current share price?

Solution: Use the perpetuity formula!!

Suppose we believe that the current actual share price of $23.21 represents its true, fair price. Thus, we can back-out the implied cost of equity (return demanded by shareholders for investing in ANZ) of re

D1 D1 1.79 P0 re 7.71 % re P0 23 .21

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DDM : Dividends have zero growth

When a company issues preferred shares, it creates an obligation to pay a fixed (constant) stream of dividends to the shareholders. Concept check:

Suppose all shareholders of ANZ hold preferred shares, with annual dividend of $1.79 per share. Further assume a cost of equity of 7.71%. How much should ANZs share be trading in such a case?

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DDM: Dividends have constant growth Suppose that ANZs earnings (and accordingly its dividends) are growing at a constant, stable rate of g% p.a. How to calculate g? Use the following equation: g = ROE from investment x retention rate
where ROE = return on equity from (new) investment or project; retention rate = reinvestment or plowback rate.

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DDM: Dividends have constant growth The ROE of ANZs new investment is 13% (From previously calculated). Current dividend (D0) is $1.26. Current EPS0 = $1.79. Thus, current dividend payout ratio = D0/EPS0 70%. That is, retention rate = 1 dividend payout ratio = 30%. Hence, g = 0.13 x 0.3 = 3.9% p.a.

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DDM: Dividends have constant growth

Thus, the dividend stream of ANZ is:
2010 2011 D1 = D0(1+g) =1.26(1.039) =1.31 P0 2012 D2 = D1(1+g) = 1.36 2013 .

D3 = D2(1+g) =1.41

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DDM: Dividends have constant growth Using Gordon Growth Model (i.e. growing perpetuity formula), we can compute the current share price of P0. The GGM is given by
P0 D (1 g ) D1 0 , where re g re g re g

Assume re = 9.5%.

Implication: ??
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DDM: Dividends have constant growth

Suppose the current actual share price of $23.21 is the true, fair price. Thus, we can back-out the implied cost of equity:
D1 D1 P0 re g re g P0 1.31 re 0.039 0.0564 0.039 9.54 % 23 .21
Dividend yield

Growth in dividend
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 In what follows, we continue to assume re = 9.5%

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DDM: Dividends have constant growth

Turning to another issue. ANZ grows at a rate of g=3.9% p.a, due to the fact that the firm is reinvesting (plowing back) some of its earnings into new investments. What is ANZs present value of growth opportunities (PVGO)? In other words, how much is the new investment worth to ANZ?

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DDM: Dividends have constant growth

To calculate PVGO, use a 3-step strategy:
Step 1: Calculate P0 assuming the firm is not reinvesting. (i.e. the firm distributes all its earnings as dividends).

P0

D1 EPS 0 1.79 $18 .84 re re 0.095

Step 2: Calculate Po when the firm is reinvesting (current g = 3.9%)

P0

1.31 $23.39 0.095 0.039

Step 3: PVGO = Step 2 Step 1

PVGO 23 .39 18 .84 $4.55

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DDM: Dividends have constant growth

The current ROE for ANZs new investment is 13%, which is greater than its cost of equity of re = 9.5%. What if the new investments ROE < the re of the firm? In such a case, investors would prefer the firm to distribute its earnings as dividends rather than reinvest its earnings in new projects. This allows investors to use the distributed dividends elsewhere.

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DDM: Dividends have constant growth For example, suppose the ROE of ANZs new investment is 7% instead of 13%.
Thus, g = ROE x retention rate = 0.07 x 0.30 = 2.1%.
1.26(1.021) P0 $17.38 $18.84 PVGO $1.46 0.095 0.021
No reinvestment Firm reinvests in projects with ROE = 7%

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DDM: Dividends have constant growth

So far, we calculated g=3.9%. Implicitly, we assume that ANZ can sustain such a high growth rate of 3.9% p.a. forever. Australia GDP growth rate on average is at 2~3% p.a. If ANZ can sustain such a high growth rate of 3.9% p.a. forever, it will gradually represent the economy of Australia. This does not make sense.

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DDM: Dividends have non-constant growth

Thus, we turn to another framework, which assumes that dividends grow at a non-constant growth rate. Intuitively, the growth rate of ANZ should be higher for the first few years (during its growing stage), before slowing down to a lower level in the later years (during its matured stage)

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DDM: Dividends have non-constant growth Therefore, ANZ has two stages of growth. Suppose, in the first stage (from year 2010 to 2013), g1 = 3.9% and dividend payout ratio = 70%. In the second stage (from year 2013 onwards), g2 = 2% and dividend payout ratio = 80%.
g1 = 3.9%, payout ratio = 70% 2010 2011 2012 g2 =2%, payout ratio = 80% 2013 2014

D1=1.31

D2=1.36

D3=1.41

D4 = 1.64..

D4 = EPS4 x dividend payout ratio = EPS3 (1+g2) x 0.80 = EPS0 (1+g1)3 (1+g2) x 0.80 = 1.79(1.039)3(1.02) x 0.80 = 1.64

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DDM: Dividends have non-constant growth

g1 = 3.9%, payout ratio = 70% 2010 2011 D1=1.31 2012 D2=1.36 g2 =2%, payout ratio = 80% 2013 D3=1.41 2014 D4 = 1.64..

D4 1.64 Applying GGM , P3 $21 .84 re g 2 0.095 0.02

P0 D3 P3 D1 D2 (1 re )1 (1 re ) 2 (1 re ) 3 (1 re )3

1.31 1.36 1.41 21.84 (1.095)1 (1.095) 2 (1.095) 3 (1.095)3 $20.04

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Comparable approach: P/E multiple

Another popular method commonly used to value share price is the P/E multiple (comparable) approach. For instance, suppose the banking (industry) sector has an average P/E multiple of 12.

Thus, the current share price for ANZ is

P0 = Industry P/E multiple x EPS of ANZ = 12 x 1.79 = $21.48

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Summary of this module

Explain the characteristics of equity securities. Understand some financial ratios. Understand how equity securities are valued. Identify the expected return on equity securities.

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