EQUITY VALUATION

Claims on Cash Flows of Firm Investors forego consumption and invest expecting future returns Risk is associated with the investment Investors are differ in their Risk/return tolerance Priority on claims to cash flows in the case of bankruptcy

Claims in Bankruptcy 1. Administrative expenses related to bankruptcy 2. Expenses after filing and before assignment of Trusted 3. Wages, Salaries, Commissions 4. Contribution to employee benefit plan 5. Consumer claim 6. Government Tax claims 7. Payment to unsecured creditors 8. Payment to preferred stock holders 9. Payment to common stock holders

Scope of Equity Valuation Valuation is the estimation of an asset’s value. Equity valuation can be used in a number of ways Stock Selection Inferring market expectation Evaluation of corporate events Evaluating business strategies and models Appraising private business Valuation Process Unders tanding the business Forecasting Performance Selecting Valuation model

Understanding Business Industry size and growth potential Recent development in industry Overall supply demand balance Qualitative factors including legal and regulatory

Valuation Methods Valuation by Comparison Dividend Discount Model Constant Growth Dividend Discount Model Life Cycles and Multistage Growth Models Price-Earnings Ratio Free Cash Flow Valuation

Valuation by Comparison Value of the firm is estimated by comparing some elements of the financial statements of the company with other firms in the same industry Price to Earnings (P/E ratio) Price to Book Value Price to Sales Price/Cash Flow Book Value uses historical numbers and includes depreciation Liquidation Value Replacement cost Tobin q = Market Value/Replacement cost (mainly of interest to economists)

Dividend Discount Model Assume one year holding period Let P 1 be value at end of investment horizon Let D 1 be Dividend P 0 = (D 1 + P 1 )/(1+k) k = Market Capitalization Rate P 1 = (D 2 + P 2 )/(1+k) P 0 = D 1 /(1+k) + (D 1 + P 1 )/(1+k) 2 If we assume constant dividend P 0 = D/(1+k)+D/(1+k) 2 + …. = D/k

Constant-Growth DDM Assume dividend grows at constant rate of g P 0 = D/(1+k) + D(1+g)/(1+k) 2 + D(1+g) 2 /(1+k) 3 + …. P 0 = D/(1+k) [ 1+(1+g)/(1+k) + (1+g) 2 /(1+k) 2 + …. P 0 = D/(k-g) Life Cycle and Multi-Stage Growth Model

Investment Opportunities Investment opportunities with returns higher than market capitalization rates create value Such opportunities can be funded using retained earnings Company ABC, fully equity funded $100 MM 3,000,000 Shares 15% ROE 12.5% Market Capitalization Rate Dividend/Share = $100 MM * 15%/3,000,000 = $5 Share value based on DDM = $5/12.5% = $40

Project with 15% Return Fund project internally Earnings Retention Ratio 60% (Plowback Ratio) Dividend Payout Ratio 40% New Dividend = Capital * 15% * 40%/3MM Earning growth rate 15% * 60% = 9% Earning/Share after n period $100MM *(1+9%) n * 15% * 40% /3MM= $2*(1+9%) n Share Price = $6/(12.5% - 9%) = $57.17 Price = No Growth Value /Share + PVOG (PV of growth opportunities) $57.17 = $40 + $17.17

P/E Ratio P/E = Price-earnings multiple a common way to value a stock as the multiple of its earnings Earnings is challenging to forecast as it depends on macro-economics, business cycle, industry,… P/E varies over time and across industries Price = No Growth Value /Share + PVOG P= E/k + PVOG → P/E=1/k[1+(PVOG/E/k)] P/E increases as growth opportunities of the company increase

P/E Ratio Interpretation Consider a company with Earning = E Market Capitalization Rate = k Earning Retention Ratio = b Dividend Payout Ratio = 1- b P/E = (1-b)/( k – ROE * b) Riskier stocks should have higher k hence lower P/E Companies with higher growth opportunities (ROE) will have higher P/E Higher plowback increases P/E only if ROE > k P/E proxy for Earnings Growth

Ratio Analysis P/E is based on accounting earnings that is impacted by Depreciation method Inflation Earning management Pro Forma reporting Business Cycle Other Ratios Price-to-Book Price-to-Cash-Flow Price-to-Sales …….

Free Cash Flow Variation Consider a company with EBIT= Earnings before interest and taxes T = Corporate Tax Rate NWC = Net Working Capital FCFF= Free Cash Flow to Firm FCFF = EBIT (1-T) + Depreciation – Capital Expenditure – Increase in NWC Firm Value = FCFF/(WACC –g) P = Firm Value – Market Value of Debt Alternatively P = FCFF/(k E –g) k E = cost of equity