Stock valuation

Prof. Trilochan Tripathy

XLRI- Xavier school of Management, Jamshedpur
 What is Valuation?
– Valuation is the analytical process to determine
the present value of an asset or a company.
– Valuation is the mechanism that helps trade cash
for claims
– Stock Exchange provides miraculous services?
• Exchange cash today for future claim on CFs via share
• Defer consumption now in order to consume more in future
• Sell claim otherwise to gain cash today for appropriation of opportunities

– Is valuing an asset (portfolio of assets) easy or

difficult?
 Why Valuation?
• Do you know what a share in Maruti, Infy or
Adani Green/Sushant villa…. is worth today?
– Should you care about valuation of assets?
– Is it a prerequisites for successful investing?
• If one wants to invest thoughtfully, must learn the arts
and science of valuation
– Does it help you to make more informed
judgements?
 How to motivate for Valuation
• Know price of everything but value of nothing
• Understand Price Risks affect value and market
sets this price
• Postulates of sound investing- doesn’t pay
more than worth of the asset.
– This postulate motivates to value an asset before
buying
• Valuation models can be filled with details,
however the value of any company rests on a
few key drivers.
What method one should prefer to conduct
valuation? Intrinsic or relative?
– Intrinsic value of an asset is determined by expected
CFs and associated risks over the life of the asset.
– Assets with high and stable cashflows worth more
than assets with low and volatile CFs
– Relative value of an asset is determined by looking at
how market prices similar assets?
– Investing in a stocks that are undervalued not only on
the intrinsic basis but also on a relative one.
– Simpler can be better- parsimony always lies in the
roots
– Investor comes to market with diverse philosophies
 A Financial Balance sheet
Sign Measure Explanations
Deployed assets Value of invests already made- demonstrates their
current cash flow potential
+ Growth Assets Rests on the perception of growth opportunities
= Total Enterprise value Sum of the values of deployed assets and growth assets
- Debt Lenders get first claim on CFs during operation, and cash
proceeds in liquidation
= Value of equity Residual earners
Equity Shares Characterization & Valuation

– Equity shares in general are characterized by:

• Ownership and management
• Entitlement to residual cash flows
• Limited liability
• Infinite life
• Substantially different risk profile
-Thus, equity shares valuation is not that easy like
bonds.
What Causes Stock Prices to Go Up
and Down?

Can you Guess??

Can we value the stock?
 What Causes Stock Prices to Go Up and Down?

– The most recent dividend (D0): The more, the higher ….

– Expected rate of growth in future dividends (g): The higher,
the higher…..
– Investor’s required rate of return (rcs ): The higher, the
lower…..
– Since most recent dividend (D0) has already been paid, it
cannot be changed. Thus, variations in the other two
variables, rcs and g, can lead to changes in stock prices.
– Interest rate risk, Reinvestment risk, Credit risk, Inflation,
Liquidity risk, Currency risk, price risk, Political risk etc.
Cash Flow of Bond vs. Equity Investor

Retained
Earnings

Equity Net Income May Pay

Firm Dividend
(variable residual
Debt Interest income)
(fixed income)
 Cash Flow of Bond vs. Equity Investor
Bond Investor cash Flow

𝐶1 𝐶2 100 + 𝐶𝑛
𝑃𝑉 = 1
+ 2
+ ⋯+
1+𝑟 1+𝑟 1+𝑟 𝑛

• Predictable Coupon Cash flow

• Predictable Terminal Value

Equity Investor cash flow

𝐶1 =? 𝐶2 =? 𝑇𝑉 =? +𝐶𝑛 =?
𝑉= 1
+ 2
+ ⋯+
1 + 𝑟 =? 1 + 𝑟 =? 1 + 𝑟 =? 𝑛

• Cash flow to Owner is Unpredictable

• Difficult to Predict Terminal Value
 Why Cash Flows are uncertain for
equity investor?
• Dividend and dividend growth
• Interest rate risk
• Reinvestment risk
• Credit/default risk
• Inflationary risk
• Liquidity risk
• Exchange rate risk
• Political risk
• Etc.
Can we value the stock?
 Efficient market Hypothesis
Efficient Market Hypothesis
-Security are in equilibrium, which means they are fairly priced
(expected returns= required returns)
-Security prices accurately reflect available information, and
respond rapidly to new information as soon as it becomes
available”
-Securities are fairly priced and there is no undervaluation or over
valuation
– Weak form efficiency: Past prices, volume and earnings predict
future prices
– Semi-strong form: incorporate all publicly available information
– Strong form: all information, including inside information
Stock price move in Random: Random Walk Hypothesis
However, we try to predict the value of
a stock amidst wide arrays of
uncertainty !
Alternative Stock valuation Models
DCF
• Dividend Discounted Model
• FCFF and FCFE

Relative Valuation Model

• P/E
• P/S
• EV/EBITDA etc.

Asset Based Valuation

• BV
• LV
 Common stock valuation: DDM-Three Special Cases
• Constant (Zero growth) dividend
– The firm will pay a constant dividend forever
– This is like preferred stock
– The price is computed using the perpetuity formula
𝐷
𝑉0 = σ∞ 𝑡
𝑡=1 (1+𝑟)𝑡 = D / r
• Constant dividend growth
– The firm will increase the dividend by a constant percent every period
– The price is computed using the growing perpetuity model
∞ 𝐷𝑡 ∞ 𝐷0 (1+𝑔)𝑡 𝐷1
𝑉0 = σ𝑡=1 = σ𝑡=1 =
(1+𝑟)𝑡 (1+𝑟)𝑡 𝑟−𝑔
• Supernormal growth
– Dividend growth is not consistent initially, but settles down to constant growth
eventually
– The price is computed using a multistage model ( example two stage)

𝑛 𝑡
𝐷0 1 + 𝑔𝑆 𝐷0 × 1 + 𝑔𝑆 𝑛 × (1 + 𝑔𝐿 )
𝑉0 = ෍ +
(1 + 𝑟)𝑡 (𝑟 − 𝑔𝐿 ) × (1 + 𝑟)𝑛
𝑡=1
 Why Free Cash flow Valuation?
▪ Many firms pay no, or low, cash dividends
▪ Dividends are paid at discretion of the board of
director; therefore, it may be poorly aligned with the
firm's long-run profitability
▪ If a company is views as acquisition target, free cash
flow is more appropriate measure because the new
owners will have discretion over future dividend.
▪ Free cash flow may more related to long-run
probability of the firm compared to dividend
 Free Cash flow valuation model
• The free cash flow model is based on the same
premise as the dividend valuation models except that
we value the firm’s free cash flows rather than
dividends.
 FCFE Growth Model
Constand Growth Model
𝐹𝐶𝐹𝐸1 𝐹𝐶𝐹𝐸0 ×(1+𝑔)
V0 = 𝑟−𝑔
= 𝑟−𝑔

Two-Stage Free Cash Flow to Equity (FCFE) Discount Model

𝑛
𝑡
𝐹𝐶𝐹𝐸0 1 + 𝑔𝑆 𝐹𝐶𝐹𝐸0 × 1 + 𝑔𝑆 𝑛 × (1 + 𝑔𝐿 )
𝑉0 = ෍ +
(1 + 𝑟)𝑡 (𝑟 − 𝑔𝐿 ) × (1 + 𝑟)𝑛
𝑡=1

Equity Value = FCFE discounted at the required return on equity

Return on equity= Risk-free rate of return + beta × (Market
rate of return−Risk-free rate of return)
 Free Cash flow valuation model
• The free cash flow valuation model estimates the value of the
entire company and uses the cost of capital as the discount
rate.
• As a result, the value of the firm’s debt and preferred stock
must be subtracted from the value of the company to
estimate the value of equity.
VE =VC - VD-VPS
• Equity Value = Firm Value – Market Value of Debt- Market
Value of Preferred stock
❖ FCFF = EBIT 1 − Tax rate + Dep – FC Investment – dWC Investment
❖ Firm Value (VF) = FCFF discounted at WACC
 How to calculate FCFF in a real-world
scenario ?

Formula 1 Formula 2 Formula 3 Formula 4

NI (+) EBIT*(1-t) (+) EBITDA*(1-t) CFO +
NCC (+) NCC (+) NCC*t (+)
dWC Inv (-) dWC Inv (-) dWC Inv (-)
Int(1-t) (+) Int (1-t) +
FC inv (-) FC inv (-) FC inv (-) FC inv (-)
FCFF FCFF FCFF FCFF
• 𝐹𝐶 𝐼𝑛𝑣 = 𝑒𝑛𝑑𝑖𝑛𝑔 𝑔𝑟𝑜𝑠𝑠 𝑃𝑃&𝐸 − 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑔𝑟𝑜𝑠𝑠 𝑃𝑃&𝐸
• 𝑊𝐶 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠𝑡 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑡 - (𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡−1 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠𝑡−1
− 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑡−1 )
 Try with an example
Items (Rs. In billion)
Sales 100
Operating cost 20
EBITDA 80
NCC(depreciation) 20
EBIT 60
Interest 30
EBT 30
Tax (@40%) 12
EAT 18
dWC Investment -10
FC Investment 0
Principal repayment 10

No. of Common share outstanding .3

in %
WACC 12%
re 9%
g 6%
 Solution
Sign Fourmula 1 Values (bn) Sign Formula 2 Values (bn)
NI 18 EBIT*(1-t) 36
+ NCC 20+ NCC 20
- dWC Inv 10- dWC Inv 10
+ Int(1-t) 18+
- FC inv 0- FC inv 0
FCFF 46 FCFF 46
sign Formula 3 Values (bn) sign Formula 4 Values (bn)

EBITDA*(1-t) 48 CFO 28
+ NCC*t 8

- dWC Inv 10
+ + Int (1-t) 18
- FC inv 0
FCFF 46 FCFE 46
 Solution for FCFE
sign Formula 4 Values (bn)
CFO 28
+ Int (1-t) 18

FCFF 46
- Int (1-t) 18

- Principal repayment 10
FCFE 18
Suppose the concerned company’s FCFE is growing at the rate g=6%
here onwards 9 Just an approximation)
Total Future value of cash flows= Current Yr. FCFE + Future FCFE=
18+ 18*((1+6%)/(9%-6%))= = 654 billoin
Value per share= 654 billion/3 billion share outstanding= Rs. 218
 FCFF is a Financial performance
Indicator
• Free cash flow to the firm (FCFF) represents the cash flow
from operations available for distribution after accounting for
depreciation expenses, taxes, working capital, and
investments.
• Free cash flow is arguably the most important financial
indicator of a company's stock value.
• A positive FCFF value indicates that the firm has cash
remaining after expenses.
• A negative value indicates that the firm has not generated
enough revenue to cover its costs and investment activities.
 Some Relative Valuation methods
• This method estimates the value of the firm’s stock
as a multiple of some measure of firm’s performance,
such as the firm’s earnings per share, book value per
share, sales per share, cash flow per share, where
the multiple is determined by the multiples observed
from comparable companies.
• The most common metrics are:
– Earnings Per Share and
– Book value per Share
– Liquidation value per share
 Common Stock valuation by PE Ratio
• P/E ratio is a relative value model because it
tells the investor how many dollars investors
are willing to pay for each dollar of the
company’s earnings.

𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑇𝑟𝑎𝑖𝑙𝑖𝑛𝑔 𝑃/𝐸 =
𝐸𝑃𝑆 𝑜𝑣𝑒𝑟 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 12 𝑚𝑜𝑛𝑡ℎ𝑠

𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃/𝐸 =
𝐸𝑃𝑆 𝑜𝑣𝑒𝑟 𝑛𝑒𝑥𝑡 12 𝑚𝑜𝑛𝑡ℎ𝑠
 Common Stock valuation by PE Ratio
• Suppose XYZ company’ had last year earnings of $1.65 per
share for the 12-month period ended in March, 2016. XYZ’s
CFO estimates that company earnings for 2017 will be $1.83 a
share. The current P/E ratios for three comparable firms are
26.85, 18.79 & 22.18 and thus the comparable average PE
ratio is 22.61. Based on above information, estimate the value
of the common stock?
– Ans: $41.38
Other Relative valuation measures
𝑃0
𝑃𝑟𝑖𝑐𝑒ൗ𝐵𝑜𝑜𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐵𝑉0
Price-to-sale Ratio= (P/S)
Common Stock valuation: BV per Share
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡−𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
Value of Common Stock (Vc)=
𝑁𝑜.𝑜𝑓 𝐶𝑆 𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Example: At year end XYZ company balance sheet

shows total asset of Rs. 600,0000 , total liability of Rs.
450,0000 and 100,000 of share of common share
outstanding. Find the value of the common stock?
Ans: Rs.15 per share
 Common Stock Valuation: LV per Share
𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡−𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
Value of Common Stock =
𝑁𝑜.𝑜𝑓 𝐶𝑆 𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

• Example: XYZ company is on verge of liquidation and an

investment bank estimated that upon liquidation the
total asset of the company is Rs. 525,0000 total liability
of Rs. 450,0000 and 100000 of share of common share
outstanding. Find the liquidation value of the common
stock?
Ans: Rs. 7.5
 Valuing Preferred Stock
Since preferred stockholders generally receive a fixed
dividend and the stocks are perpetuities (non-
maturing), it can be valued using the present value of
perpetuity equation.
 Example
• Consider XYZ company’s preferred stock issue, which
pays an annual dividend of $5.00 per share, does not
have a maturity date, and on which the market’s
required yield or promised rate of return (rps) for
similar shares of preferred stock is 6.02%. What is
the value of the XYZ’s preferred stock?
Thank you