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Equity Valuation

Equity Valuation. FIL 404 Keldon Bauer, PhD. Equity Valuation. Two types of equity Common stock: Ownership, residual claims on income. Can have different classes - A, B, etc. Preferred stock: Preferred pay-out benefit, but lesser control of company. Common Stock. Represents ownership.

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Equity Valuation

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  1. Equity Valuation FIL 404 Keldon Bauer, PhD

  2. Equity Valuation • Two types of equity • Common stock: Ownership, residual claims on income. • Can have different classes - A, B, etc. • Preferred stock: Preferred pay-out benefit, but lesser control of company.

  3. Common Stock • Represents ownership. • Ownership implies control. • Stockholders elect directors. • Directors hire management. • Since managers are “agents” of shareholders, their goal should be: Maximize stock price.

  4. Classified Stock • Classified stock has special provisions. • Could classify existing stock as founders’ shares, with voting rights but dividend restrictions. • New shares might be called “Class A” shares, with voting restrictions but full dividend rights.

  5. Tracking Stock • The dividends of tracking stock are tied to a particular division, rather than the company as a whole. • Investors can separately value the divisions. • Its easier to compensate division managers with the tracking stock. • But tracking stock usually has no voting rights, and the financial disclosure for the division is not as regulated as for the company.

  6. Initial Public Offering (IPO) • A firm “goes public” through an IPO when the stock is first offered to the public. • Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers.

  7. Seasoned Equity Offering (SEO) • A seasoned equity offering occurs when a company with public stock issues additional shares. • After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq.

  8. Valuation Approaches • Dividend growth model • Using the multiples of comparable firms • Free cash flow method (covered in Chapter 13)

  9. Equity Valuation • Definition of terms:

  10. Equity Valuation • Definition of terms - continued:

  11. Equity Valuation • Because equity has no stated maturity, the value of the security can be seen as the present value of a kind of perpetuity:

  12. Equity Valuation • To use the equation above, one would have to forecast every dividend (or cash flow) forever, which is not realistic. • To estimate the equity value, simplifying assumptions can be made. • If we allow dividends (cash flows) to grow at a constant rate. • If rs is fixed over the life of the stock.

  13. Equity Valuation • The Gordon Constant Growth Model:

  14. Gordon Constant Growth Model • Subtracting [2] from [1]:

  15. Gordon Constant Growth Model • Solving for PV:

  16. Gordon Constant Growth Model • Assumptions: • g must be less than rs (or P0→¥) • rs must be fixed • Dividend growth must be smooth (constant) • Note that this model works for any growth rate less than rs - including g ≤ 0

  17. Gordon Growth Model-Example • If a share currently pays $1.50 in annual dividends, is expected to grow at a rate of 5% per year, and has a required return of 14%, what should its share price be?

  18. Equity Valuation • The Gordon Growth Model suggests that valuation is a function of: • Dividend (or free cash flow), • Growth in dividends (or free cash flows), • Discount rate. • How does current stock news affect the market’s estimates of these three measures?

  19. Expected Return on Equity • Using the Gordon Constant Growth Model and solving for ks, we can find the expected return based on observed prices:

  20. Expected Rate of Return-Example • If a stock has a current price of $100, an expected dividend for the next year of $5 and a constant growth rate of 10%.

  21. Expected Rate of Return-Example

  22. Expected Rate of Return • This model for expected rate of return is derived from the Gordon Growth Model, and has the following assumptions: • Dividend (and stock price) is expected to grow @ constant rate. • Expected dividend yield is constant. • Expected capital gains yield is constant = g • E[rs]=E[dividend yield] + g

  23. Non-Constant Growth Valuation • Since constant growth is unlikely, we will now consider how to value stock under non-constant growth. • First, project dividends (or free cash flows) as far as practical. • From there estimate a constant growth rate. • Then take the PV as in chapter 2.

  24. Non-Constant Growth - Example • If Buford’s Bulldozer is expected to pay the following dividends, and then grow indefinitely at 4.5% (assuming a discount rate of 14.50%), what would its stock value be?

  25. Non-Constant Growth - Example • First we consider the price of the stock at time five.

  26. Non-Constant Growth - Example • Next we sum all period cash flows.

  27. $ 1.09 2 3 4 5 0 1 14.5% $ 2.10 $ 1.00 $ 1.63 $1.25 $2.75 $1.50 $2.80 $36.64 $18.62 Non-Constant Growth - Example $24.44 = Present Value

  28. Stock Market Equilibrium • The CAPM has a different way of finding ks. • In this case it is required return. • rs=rRF+(rM-rRF)bs • For stock prices not to have a tendency to move:

  29. Equilibrium - Example • If a stock has a beta of 2, the risk-free rate is 2%, the rM is 8%, it is currently selling at $30, with the last dividend of $2.86 and an expected constant growth rate of 5%, should you buy or sell? • A train left Chicago going 70 MPH . . .

  30. Equilibrium - Example • Step 1 – Find Required Return: • Step 2 – Find Expected Return:

  31. Equilibrium - Example • The two are not equal. • Therefore, the price of the stock would be bid up, until the expected return equals the required return. • In this instance it will take a price of $33.36 to bring the market to equilibrium.

  32. Using Entity Multiples • The entity value (V) is: • the market value of equity (# shares of stock multiplied by the price per share) • plus the value of debt. • Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. • Calculate the average entity ratio for a sample of comparable firms. For example, • V/EBITDA • V/Customers

  33. Using Entity Multiples (Continued) • Find the entity value of the firm in question. For example, • Multiply the firm’s sales by the V/Sales multiple. • Multiply the firm’s # of customers by the V/Customers ratio • The result is the total value of the firm. • Subtract the firm’s debt to get the total value of equity. • Divide by the number of shares to get the price per share.

  34. Problems with Market Multiples • It is often hard to find comparable firms. • The average ratio for the sample of comparable firms often has a wide range. • For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers?

  35. Changing the Required Return • The required return is determined by the CAPM. • rs=rRF+(rM-rRF)bs • Three things affect the required return: • Market interest rates (through kRF), • The market risk premium, • The systematic risk inherent in the stock. • As these change, so should the stock price.

  36. Efficient Market Hypothesis • The Efficient Market Hypothesis (EMH) states: • Stocks are always in equilibrium, • It is impossible to consistently beat the market, • The market protects fools. • There are three forms of market efficiency.

  37. Weak-form EMH • Can’t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but “technical analysis” is still used.

  38. Semistrong-form EMH • All publicly available information is reflected in stock prices, so it doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true.

  39. Strong-form EMH • All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.

  40. Markets are Generally Efficient • 100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for firms like Fidelity, Merrill, Morgan, and Prudential. • These analysts have similar access to data and megabucks to invest. • Thus, news is reflected in P0 almost instantaneously.

  41. Preferred Stock • Hybrid security. • Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. • However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.

  42. $5 Vps = $50 = ^ rps $5 ^ rps = 0.10 = 10.0% = $50 Expected return, given Vps = $50 and annual dividend = $5

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