Session 04
Session 04
Session 04
Semester VII
Intrinsic Value
(Session 04)
SENANI THENUWARA
DEPARTMENT OF FINANCE
FACULTY OF MANAGEMENT AND FINANCE
UNIVERSITY OF COLOMBO
Intrinsic Value
The intrinsic value approach states;
Value of equity
Value of a business
Value of the entire
firm
Growth Assets
Equity
Debt Investments
Principles of Valuation
1. Consistency Principle
CFs to equity - Discounted with WACC x - upward biased estimate of value of equity
CFs to firm - Discounted at Ke x - downward biased estimate of value of equity
Principles of Valuation
2. Nominal Vs Real value
D1 = Dividend paid at t1
Example:
Stock A has an expected growth rate of 7%. Each share has just received an annual Rs.2.50 dividend per
share. The required rate of return is 12%. Determine the value of the common stock?
Dividend Discount Model – Recap
Zero Growth model
The constant growth dividend model calls for an expected dividend growth rate, g, of zero.
𝑫𝟏 D1 = Dividend paid at t1
V=
𝑲𝒆
Ke = Required rate of return on equity
Example:
Stock Z has an expected growth rate of 0%. Each share of stock just received an annual Rs. 2.50 dividend per share.
The appropriate discount rate is 10%. What is the value of the common stock?
Dividend Discount Model – Recap
Growth Phase Model
This assumes that dividends will grow at different phases (two or more) at different growth rates
Example:
A Stock has an expected growth rate of 12% for the first 3 years and 10% thereafter. Each share of
stock just received an annual Rs.3.50 dividend per share. The appropriate discount rate is 15%. What
is the value of the common stock under this scenario?
Dividend Discount Model – Recap
∞
0 1 2 3 4
Consider two
separate time
lines in the
valuation.
D1 D2 D3 D4
Net income is converted in to cashflow by adjusting for reinvestment needs of the firm.
Free Cashflows to Equity (FCFE)
Adjusting net capital expenditure
Net effect of repayment of old debts against the issue of new debts
Net income adjusted for net capital expenditure, WC changes and net change of debt will result
in Free Cash Flows to Equity.
Free Cashflows to Equity (FCFE)
Free Cashflows to Equity = Net income – (Capital expenditure-Depreciation) – Change in WC
+ ( New debt issue- Repayments)
Equity Reinvestments
Equity Reinvestments = Capital expenditure-Depreciation + Change in WC - New debt issue + Repayments
Equity Reinvestments rate = (Capital expenditure-Depreciation + Change in WC - New debt issue + Repayments)
Net Income
FCFE Growth Estimations
Expected growth rate = Retention ratio * Return on equity
Equity Reinvestments = (Capital expenditure-Depreciation + Change in WC Non cash ROE= Net Income – after tax income from cash and marketable securities
Rate -New debt issue + Repayments) / Net Income Book value of equity - cash and marketable securities
Expected growth rate in FCFE = Equity reinvestment rate * Non cash ROE
Dividends to FCFE
Conventional measure – Dividend payout ratio
▪Future investments
▪Taxation
▪Signaling effect
▪Managerial interests
FCFE Valuation Models
Assumptions
2. Expected growth rate will include growth in income generated from operating assets but not
the income growth stems from increase in marketable securities.
Constant growth model
Value of equity is a function of expected FCFE under a stable growth rate discounted at required rate of return.
Constant growth model
There are two conditions to be met in using this model in valuation
1. Growth rate should be less than or equal to economic growth rate
( if nominal COC – nominal economic growth rate / real COC – real economic growth rate)
2. Characteristics of the firm t be consistence with the stable growth rate assumptions.
Two Stage FCFE Model
Value of the stock – present value of FCFE for an extraordinary growth period plus the present
value of the terminal price at the end of the period
Expected growth Income growth from operating and Growth in income from operating
cash assets are considered assets
Adjustments for cash and marketable Built in to earnings. No special Include income from cash and
securities adjustments needed. marketable securities to income
projections and equity value estimation
Or