THE EQUITY MARKETS

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 Overview of Stock Markets
• Primary stock markets allow suppliers of funds to raise equity capital
• Secondary stock markets are the most closely watched and reported of all
financial markets
• Stockholders are the legal owners of a corporation
– have a right to share in the firm’s profits (e.g., through dividends)
– are residual claimants
– have limited liability
– have voting rights (e.g., to elect board of directors)

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 Stock Returns
• The returns on a stock over one period (Rt) can be divided into capital gains
and dividend returns:

Pt − Pt −1 Dt
Rt = +
Pt −1 Pt −1

Pt = stock price at time t

Dt = dividends paid over time t – 1 to t
(Pt – Pt – 1) / Pt – 1 = capital gain over time t – 1 to t
Dt / Pt – 1 = return from dividends paid over time t – 1 to t

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 Equity/Stock
Valuation/Common Stock

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 Estimated Value and Market Price
• By comparing estimates of value and market price,
an analyst can arrive at one of three conclusions:
The security is
– undervalued,
– overvalued, or
– fairly valued in the market place.

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Estimated Value and Market Price

Intrinsic
Undervalued: value >
market price
Intrinsic
Fairly valued: value =
market price
Intrinsic
Overvalued: value <
market price

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 Why estimates of value differ from market price

• Because model appropriateness and the correct value of inputs.

– An analyst’s final conclusion depends not only on the comparison of the
estimated value and the market price but also on the analyst’s confidence in the
estimated value (i.e., in the model selected and the inputs used in it).

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Equity Valuation Models

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 Major Categories of Equity Valuation Models

Present value Multiplier Asset-based

models models valuation
• Dividend • Share price models
discount models multiples • Adjustments to
• Free cash flow • Enterprise value book value
models multiples

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 Present Value Model
1. Present value models (synonym: discounted cash flow models).
❑These models estimate the intrinsic value of a security as the present
value of the future benefits expected to be received from the security.
❑In present value models, benefits are often defined in terms of cash
expected to be distributed to shareholders (dividend discount models) or in
terms of cash flows available to be distributed to shareholders after meeting
capital expenditure and working capital needs (free-cash-flow-to-equity models).

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 Present Value Model
➢ Dividend discount model (DDM)
➢Is suitable for dividend paying company
➢To use a DDM, the analyst needs to predict the timing and amount of
the first dividend and all the dividends or dividend growth thereafter.
➢Making these predictions for non-dividend-paying stock accurately is
typically difficult, so in such cases, analysts often resort to FCFE (free-cash-
flow-to-equity models) models.

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 Valuing Common Stock
• A firm’s earnings growth rate can be computed as follows:

– Growth of Earning = retention ratio x ROE

• Growth = earnings growth rate

• Retention ratio = 1 – dividend payout ratio

• ROE = Return on Stockholders Equity

 Valuing Common Stock
• For example, what is a firm’s earnings growth rate if it pays 40%
of earnings as dividends and earns a 20% return on
stockholders equity?

– Growth = retention ratio x ROE

– Growth = (1 – 40%) x 20% = 60% x 20% = 12%

 General Dividend Valuation Model
• The value of common stock is the PV of the expected dividends
to be received plus the PV of the expected price the stock is sold
for in the future:

d1 d2 dn Pn
P0 = + ..... +
(1 + k e ) (1 + k e ) (1 + k e ) (1 + k e )n
2 n

• For simplicity we will assume a firm pays out dividends just once a
year.
 General Dividend Valuation Model
• Suppose an investor expects a common stock’s dividends to be
$1.00, $1.05, and $1.10 at the end of each of the next 3 years and
expects to sell the stock for $15 in 3 years. If the investor requires
a 15% rate of return, what is the stock’s value today?

$1.00 $1.05 $1.10 $15.00

P0 = + + + = $12.25
(1 + 15%) (1 + 15%) (1 + 15%) (1 + 15%)
2 3 3
 Zero-Growth Dividend Valuation Model
• If a company’s dividends are not growing, but the company is paying out
a constant dividend every year, this is similar to investing in preferred
stock. The value of the common stock would be the PV of a
perpetuity. d
P0 =
ke
• Suppose a company expects earnings of $5 per share and because
they do not expect to grow, all earnings are paid out as dividends.
Thus all future dividends are expected to be $5.00 per share. If
investors require a 10% rate of return, the stock’s value today is:
$5.00
P0 = = $50.00
10%
 Zero-Growth Dividend Valuation Model
• Treating zero-growth common stock as a perpetuity seems to
imply an investor will hold the stock forever!
• What if the investor just plans to hold the stock for 2 years and then sell it?

• What would the stock’s selling price be in 2 years?

$5.00
P2 = = $50.00
10%
 Zero-Growth Dividend Valuation Model
• This investor expects to receive a $5 dividend for each of 2 years
and then sell the stock for $50 in 2 years. The value of the stock
today is:

$5.00 $5.00 $50.00

P0 = + + = $50.00
(1 + 10%) (1 + 10%) (1 + 10%)
2 2

• The investor’s holding period does not affect the stock’s value.
Then
 Constant-Growth Dividend Valuation Model

• A company with a constant dividend payout ratio and constant return on

equity will have a constant growth rate.

• For example, what is the growth rate for a company earning 12%
on equity and a 40% dividend payout ratio?

– Growth = (1 – 40%) x 12% = 60% x 12% = 7.2%

 Constant-Growth Dividend Valuation Model
• If we expect this company to have earnings of $5 per share in the
coming year ,the 7.2% constant growth rate and with a 40%
dividend payout ratio, we can compute the common stock value
to an investor requiring a 10% return with the following constant
growth model:
d1
P0 =
(k e − g )
 Constant-Growth Dividend Valuation Model
• The company’s dividend in the coming year must be $2.00 per
share:

– d1 = $5.00 x 40% = $2.00

• And thus the value of the stock is:

$2.00 $2.00
P0 = = = $71.43
(10.0% - 7.2% ) 2.8%
 Constant-Growth Dividend Valuation Model
• Why is the value in this example higher than for the zero-
growth example?

• Both examples assume earnings of $5 per share and a 10% rate

of return.

– The 7.2% growth rate makes the stock in the constant-growth example
worth more!
 Constant-Growth Dividend Valuation Model

• Notice in the constant-growth example we made no assumptions

about the investor’s holding period.
• As we illustrated in the zero-growth valuation model, how long the
investor plans to hold the stock should not affect the stock’s value today!
• The constant-growth model provides good estimates of common stock
value when a company’s future growth is expected to be stable.
• The constant-growth model provides less accurate estimates when growth
is difficult to estimate or large systematic differences year to year are
expected in growth.
 Multistage Dividend Discount Model

Company will
pass through
different stages
of growth
Growth is
Rapidly growing expected to
companies improve or
moderate

Use
multistage
dividend
discount
model

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 Multistage Dividend Discount Model
• The two-stage valuation model assumes that dividends will
exhibit a high rate of growth during the initial period.

• It values the dividends over the short-term period of high growth

and the terminal value (sustainable growth )at the end of the
period of high growth.

• The short-term growth rate, gS, lasts for n years.

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 Multistage Dividend Discount Model
• The intrinsic value per share in year n, Vn, represents the year n value of
the dividends received during the sustainable growth period or the terminal
value at time n.
• Vn can be estimated by using the Gordon growth model, where gL
is the long-term or sustainable growth rate.
• The dividend in year n+1, Dn+1, is determined by assuming n years
of growth at rate gS followed by 1 year of growth at gL.

Dn +1 = D0 (1 + g S ) (1 + g L )
n

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 The Two-Stage Dividend Discount Model

Dividends grow at rate gS for n years and rate gL thereafter:

n
D0 (1 + g S )t Vn
V0 = 
t =1 (1 + r ) t
+
(1 + r ) n
Dn +1
Vn =
r − gL
Dn +1 = D0 (1 + g S )n (1 + gL )

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 Valuing Stock with Multiple Growth Rates

• Now we will consider how to estimate the value of common

stock when several different growth rates are expected and the
growth rates can be forecast with some degree of accuracy.

• What if a company expects to pay a $2.15 dividend in a year

and expects growth of 15% through the end of year 2? After
year 2 growth is expected to decrease to 7.2% and stabilize at
7.2%.
 Valuing Stock with Multiple Growth Rates

• We can picture the growth rates and cash flows

as follows:

• 0 g = 15% 1 g = 15% 2 g = 7.2%

|________|________|___________________
_____
– $2.15 $2.47

• What is the value of this stock to an investor

requiring a 10% rate of return?
 Valuing Stock with Multiple Growth Rates
• Remember, an investor’s holding period does not affect the value
of common stock value.

• Thus, in our example, we can use any holding period and it

should not change the value of the stock!

• To make the computation as easy as possible we will assume a 2-

year holding period. The investor expects to receive 2 dividends
(d1 and d2) and the selling price of the common stock in 2 years
(P2).
 Valuing Stock with Multiple Growth Rates

• If we can estimate the common stock selling

price in 2 years, then we can use the general
dividend valuation model to compute the stock
value as follows:

d1 d2 Pn
P0 = + +
(1 + 10%) (1 + 10%) (1 + 10%)
2 3
 Valuing Stock with Multiple Growth Rates

• Notice the growth rate in this example is constant

at 7.2% annually after 2 years. This allows us to
adapt the constant-growth model to estimate the
price in 2 years.

• The original constant-growth model is:

d1
P0 =
(k e − g )
 Valuing Stock with Multiple Growth Rates
• The constant-growth model can be viewed more
generally as:

d n +1
Pn =
(k e − g )
• Adapting this to our example, we can estimate the
stock’s price at the end of 2 years:
d3
P2 =
(k e − g )
 Valuing Stock with Multiple Growth Rates
• Estimate d3 by growing d2 at the 7.2% growth rate.
Dn+1 = D0 (1 + g S ) (1 + g L )
n

– d3 = $2.47 x (1 + 7.2%) = $2.65

• Use this along with the 7.2% growth rate after
year 2 to estimate the price in 2 years:
Dn +1
Vn =
r − gL

$2.65 $2.65
P2 = = = $94.64
(10% − 7.2% ) 2.8%
 Valuing Stock with Multiple Growth Rates

• Now use the selling price in year 2 ($94.64) along

with the expected dividends in the first 2 years
($2.15 and $2.47) to estimate the value of the
stock today:

$2.15 $2.47 $94.64

P0 = + + = $82.21
(1 + 10%) (1 + 10%) (1 + 10%)
2 3
 Present value models

• Problems of DDM :
– Companies that do not pay dividends.
– No clear relationship between dividends and profitability

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 Free-cash-flow-to-equity (FCFE)
➢ Free-cash-flow-to-equity (FCFE)
➢ In practice, many analysts prefer to use a free-cash-flow-to-equity (FCFE)
valuation model.
➢These analysts assume that dividend-paying capacity should be reflected
in the cash flow estimates rather than expected dividends.
➢FCFE is a measure of dividend-paying capacity.
➢Analysts may also use FCFE valuation models for a non-dividend-paying stock.
➢FCFE = CFO – FCInv + Net borrowing...
• Fixed capital investment (FCInv)
• CFO = Net Income + Non-cash Expense + Changes in Working Capital.
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 FCF valuation
• PV of FCFF is the total value of the company.
• Value of equity = PV of FCFF - the market value of outstanding debt.
OR
• PV of FCFE is the value of equity.

• Discount rate for FCFF is the WACC.

• Discount rate for FCFE is the cost of equity (required rate of return
for equity).
 FCF (continued)
• FCF valuation is most suitable when:
❖the company is not dividend-paying.

❖the company is dividend paying but dividends significantly differ from

FCFE.

❖The company’s FCF’s align with company’s profitability within a

reasonable time horizon.

❖the investor has a control perspective.

• FCF valuation is very popular with analysts.
 Present Value Models

Value of an investment = present

value of expected future benefits

Future benefits Future benefits

= dividends = free cash flow

 
Dt FCFE t
V0 =  V0 = 
t =1 (1 + r ) t
t =1 (1 + r ) t

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 2. Multiplier models (MARKET MULTIPLE MODELS).
• These models are based chiefly on
✓share price multiples
✓ enterprise value multiples
✓ Other ratio
2.1. Share price multiples model estimates intrinsic value of a common share
from a price multiple for some fundamental variable, such as revenues, earnings, cash
flows, or book value.

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 Price multiples Methods
• Price-to-earnings ratio (P/E).
✓This measure is the ratio of the stock price to earnings per share.
✓P/E is arguably the price multiple most frequently used.
✓ It essentially depicts the amount of money that can be spent so as to generate $1 in profits.
✓As such, a low P/E ratio can imply that a stock is undervalued.
✓ A high P/E ratio implies that a company spends a lot more so as to generate $1 in profits. This
could be a sign that a stock is overvalued.

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 Price multiples Methods
• Price-to-book ratio (P/B).
✓The ratio of the stock price to book value per share.
✓ The book value of a company is simply its total assets minus its total
liabilities. Thus, the book value per share is the book value divided by
the total number of outstanding shares.
✓ A low P/B ratio (under 1) implies that a stock is undervalued.
✓ A high P/B ratio simply means that a company’s market price is widely
diverged from its true book value. This is a sign of an overvalued stock.

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 Price multiples Methods
• Price-to-sales ratio (P/S).
✓This measure is the ratio of stock price to sales per share.
• Price-to-cash-flow ratio (P/CF).
✓ This measure is the ratio of stock price to some per-share measure of cash flow.
✓The measures of cash flow include free cash flow (FCF) and operating cash flow
(OCF).

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 2.2. Enterprise value Multiple
✓ Enterprise multiple, also known as the EV multiple, is a ratio used to
determine the value of a company.
✓ EV is most frequently determined as market capitalization(Equity market
capitalization is the sum total of all the outstanding shares of a company)
Equity value + market value of debt - cash and cash equivalents +
minority interest

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 Enterprise Value Multiples

Market value
Market Market value Cash and Enterprise
of preferred
capitalization of debt equivalents value
stock

Enterprise
EBITDA EV/EBITDA
value (EV)

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 2.2. Enterprise value Multiple
✓Application
– EV is most useful when comparing companies with significant differences in
capital structure.
– In mergers and acquisitions, tactical portfolio management
– looks at a company the way a potential acquirer would by considering the
company's debt.
– What's considered a "good" or "bad" enterprise multiple will depend on
the industry.
– Higher enterprise multiples are expected in high-growth industries and
lower multiples in industries with slow growth.

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 Other ratio Model
• Debt-to-equity ratio (D/E)
A high D/E ratio essentially means that a company is highly leveraged
financially compared to its peers in the same industry.
▪ This could be a strong sign that a stock is overvalued.
• Return-on-equity ratio (ROE)
A low ROE implies that a company generates very little returns from
shareholder investment.
– This means that the underlying stock is likely overvalued.

A high ROE, therefore, implies that a stock is likely undervalued.

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 3. Asset-based valuation models.
❑These models estimate intrinsic value of a common share from the estimated value of
the assets of a corporation minus the estimated value of its liabilities and preferred shares.
=Est Value of Asset-Est Value of Liab-Prefered Stock
❑The estimated market value of the assets is often determined by making adjustments to the
book value (synonym: carrying value) of assets and liabilities.

❑The theory underlying the asset-based approach is that the value of a business is
equal to the sum of the value of the business’s assets.

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 Asset-Based Valuation
Book value of assets and liabilities

Estimation process or processes

Market value of assets and liabilities

Market value of equity = market value of assets –

market value of liabilities

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 Comparison of Valuation Methods
• Theoretically appealing and provide a
Present value direct computation of intrinsic value
models • Input uncertainty can lead to poor
estimates of value
• Ratios are easy to compute and analysis is
easily understood
Multiplier models • Problems with selecting a peer group or
“comps”

• Consistent with the notion that a

Asset-based business is worth the sum of its parts
valuation • Difficulties determining market value
and the value of intangible assets
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