Stock Valuation Jiajun Chen

Value the cash flows or earnings under new ownership Value the dividends under the existing management Value the assets MAX MIN

Introduction Ask: if stock market is efficient? Y N E=market value Company Valuation Instrinsic valuation of equity NAVP/E ratio CFBFCF

Content 1.Asset valuation bases 2.Income-based valuation bases 3.Cash flow based valuation models

There are a number of different ways of putting a value on a business, or on shares in an unquoted company. It makes sense to use several methods of valuation, and to compare the values they produce. METHODSMETHODS Net asset based Income based Cash flow based

Content 1.Asset valuation bases 2.Income-based valuation bases 3.Cash flow based valuation models

Asset valuation bases V Net tangible asset Number of shares

Asset valuation bases The summary statement of financial position of Cactus is as follows.

Asset valuation bases The difficulty in an asset valuation method is establishing the asset values to use. Going concern basis Break-up basis

Asset valuation bases As a measure of the 'security' in a share value. As a measure of comparison in a scheme of merger

Content 1.Asset valuation bases 2.Income-based valuation bases 3.Cash flow based valuation models

Income-based valuation P/E ratio Market value EPS EY Market value EPS P/E ratio (earnings) method Earnings yield method

P/E ratio (earnings) method Market value per share EPSP/E ratio Earnings per Share (EPS) Profit / loss attributable to ordinary shareholders Weighted average number of ordinary shares

P/E ratio (earnings) method 01 A high P/E ratio may indicate: Expectations that the EPS will grow rapidly. A high price is being paid for future profit prospects Security of earnings If a quoted company made a share for share takeover bid for an unquoted company, it would normally expect its own shares to be valued on a higher P/E ratio than the target company's shares.

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P/E ratio (earnings) method A company has the following results. 20X1 20X2 20X3 20X4 $m $m $m $m Profit after tax The company's earnings yield is 12%.

Content 1.Asset valuation bases 2.Income-based valuation bases 3.Cash flow based valuation models

Cash flow based valuation models 1 32 Dividend valuation model Dividend growth model Discounted cash flow basis 1. The future expected stream of income from the security; 2. Discounted at a suitable cost of capital Present value of the discounted future cash flows of revenues from the share 1. One company intends to buy the assets of another company; 2. to make further investments in order to improve cash flows in the future

Cash flow based valuation models 1 32 Dividend valuation model Dividend growth model Discounted cash flow basis MV (ex div) Step 1 Step 2 Estimate the cash flows that will be obtained each year from the acquired business Discount these cash flows at an appropriate cost of capital.

The dividend growth model Gordon's growth approximation Rate of growth in dividends: G=b*r Where G is the annual growth rate in dividends b is the proportion of profits that are retained r is the rate of return on new investments

Dividend valuation model 1&2 Assumptions: (a) Investors act rationally and homogenously. (b) The current year's dividend(D 0 ) does not vary significantly from the trend of dividends. (c) The estimates of future dividends and prices used and also the cost of capital are reasonable. (d) Investors' attitudes to receiving different cash flows at different times can be modelled using discounted cash flow arithmetic. (e) Directors use dividends to signal the strength of the company's position. (f) Dividends either show no growth or constant growth. (g) Other influences on share prices are ignored. (h) The company's earnings will increase sufficiently to maintain dividend growth levels. (i) The discount rate used exceeds the dividend growth rate.

The dividend growth model Weak ness Cost Results Taxation Capital gains DividendsRisk

Cash flow based valuation models Discount cash flows Find appropriate cost of capital Estimate the cash flows Company A wishes to make a bid for B. B makes after-tax profits of $40,000 a year. A believes that if further money is spent on additional investments, the after-tax cash flows could be as follows: Year Cash flow (net of tax) $ 0 (100,000) 1 (80,000) 2 60, , , ,000 The after-tax cost of capital of A is 15% and the company expects all its investments to pay back, in discounted terms, within five years. Q: What is the maximum price that the company should be willing to pay for the shares of B? Year Cash flows Present value $ $ 0 (100,000) (100,000) 1 (80,000) (69,600) 2 60,000 45, ,000 65, ,000 85, ,000 74,550 Maximum purchase price 101,910

Selection of an appropriate cost of capital (a)The business risk of the new investment may not match that of the investing company (b) The method of finance of the new investment may not match the current debt/equity mix of the investing company, which may have an effect on the cost of capital to be used.

Thank You Jiajun Chen