Valuation Models
regular cash dividend
a cash dividend that is paid on a regular basis, typically quarterly. Regular cash dividends are customarily declared and paid out quarterly in the United States and Canada; semiannually in Europe and Japan; and annually in some other countries, including China.
The following steps must be followed to value stocks of companies that experience temporary supernormal growth:
1. Estimate the amount and duration of dividends during the supernormal growth phase. 2. Forecast the normal, constant growth rate in dividends (gc) that will occur once the supernormal growth period ends. 3. Project the first dividend after the commencement of normal growth. 4. Calculate the price of the stock at the end of the supernormal growth period using the infinite-period DDM. The first dividend after commencement of normal growth will be the numerator. 5. Determine the cost of equity, ke. 6. Calculate the present value of supernormal growth-period dividends and the terminal stock price (the stock price at the end of supernormal growth).
preferred stock
A form of equity (generally, non-voting) that has priority over common stock in the receipt of dividends and on the issuer's assets in the event of a company's liquidation. It may have a stated maturity date at which time payment of the stock's par (face) value is made or it may be perpetual with no maturity date; additionally, it may be callable or convertible.
Dividend displacement of earnings
A lower earnings retention ratio translates into a lower growth rate
Retraction Option on a preferred stock
A retraction option is essentially a put option that enables the holder of a preferred stock to sell it back to the issuer before maturity at a predetermined price. This option is valuable to the investor, and hence, increases the value of the preferred stock.
when to use a 3 stage DDM?
A three-stage DDM is used to value fairly young companies that are just entering the growth phase. Their development falls into three stages—growth (with very high growth rates), transition (with decent growth rates), and maturity (with a lower growth into perpetuity).
When to use a 3 stage DDM?
A two-stage DDM can be used to value a company currently undergoing moderate growth, but whose growth rate is expected to improve (rise) to its long-term growth rate.
Free Cash Flow to Equity valuation Model
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. 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 models.
Gordon Growth Model
An economic model to compute the value of a stock assuming the stock will have constant dividend growth. Gordon Growth Model = D1/(r-g). The Gordon growth model estimates intrinsic value as the present value of a growing perpetuity. If the growth rate, g, is assumed to be zero, it reduces to the expression for the present value of a perpetuity The Gordon growth model estimate of intrinsic value is extremely sensitive to the choice of required rate of return r and growth rate g. The Gordon growth model assumes that the growth rate cannot be greater than the required rate of return.
two-stage DDM
Assumes that at some point the company will begin to pay dividends that grow at a constant rate, but prior to that time the company will pay dividends that are growing at a higher rate than can be sustained in the long run. That is, the company is assumed to experience an initial, finite period of high growth, perhaps prior to the entry of competitors, followed by an infinite period of sustainable growth. T The two-stage DDM thus makes use of two growth rates: a high growth rate for an initial, finite period followed by a lower, sustainable growth rate into perpetuity. The Gordon growth model is used to estimate a terminal value at time n that reflects the present value at time n of the dividends received during the sustainable growth period. A multistage dividend discount model is best used for firms with abnormal levels of dividend payouts
Book Value of Common Shareholder's Equity
Book value of common shareholders' equity = (Total assets − Total liabilities)− Preferred stock
Price to Book Value Advantages
Book value usually remains positive even when the company reports negative earnings. Book value is typically more stable over time compared to reported earnings. For financial sector companies that have significant holdings of liquid assets, P/BV is more meaningful, as book values reflect recent market values. P/BV is useful in valuing a company that is expected to go out of business. Studies suggest that differences in P/BV ratios over time are related to differences in long term average returns on stocks.
Price to Book Value Disadvantages
Book values ignore nonphysical assets such as the quality of a company's human capital and brand image. P/BV can lead to misleading valuations if significantly different levels of assets are being used by the companies being studied. Accounting differences can impair the comparability of P/BV ratios across companies. In most cases, book values of assets are based on historical cost adjusted for accumulated depreciation. However, over time, inflation and changes in technology may result in significant differences between accounting book values and actual values of a company's assets.
For the infinite-period DDM model to work, the following assumptions must hold:
Dividends grow at a constant growth rate. Required rate of return must be greater than the dividend growth rate.
FCFE =
CFO - FCInv + Net borrowing reported capital expenditure is taken to represent FCInv
Asset-based valuation works well for:
Companies that do not have a significant number of intangible or "off-the-book" assets, and have a higher proportion of current assets and liabilities. Private companies, especially if applied together with multiplier models. Financial companies, natural resource companies, and companies that are being liquidated.
The assumptions of the Gordon model are as follows:
Dividends are the correct metric to use for valuation purposes. The dividend growth rate is forever: It is perpetual and never changes. The required rate of return is also constant over time. The dividend growth rate is strictly less than the required rate of return.
Enterprise Value (EV)
Enterprise value (EV) is calculated as the market value of the company's common stock, plus the market value of outstanding preferred stock if any, plus the market value of debt, less cash and short term investments (cash equivalents). It can be thought of as the cost of taking over a company. An estimate of common share value can be obtained indirectly from enterprise value by subtracting liabilities and preferred shares from it and adding cash and short-term investments to it.
Three stage ddm
For most publicly traded companies (that is, companies beyond the start-up stage), practitioners assume growth will ultimately fall into three stages: 1) growth, 2) transition, and 3) maturity. This assumption supports the use of a three-stage DDM, which makes use of three growth rates: a high growth rate for an initial finite period, followed by a lower growth rate for a finite second period, followed by a lower, sustainable growth rate into perpetuity.
How to value companies with two or three stages of supernormal growth?
If a company has two or three stages of supernormal growth, we must calculate the dividend for each year during supernormal growth separately. Once the growth rate stabilizes below the required rate of return, we can compute the terminal value of the firm by using the constant growth DDM
Reverse stock split
Involves a reduction in the number of shares outstanding with a corresponding increase in share price. In a one-for-two reverse stock split, each shareholder would receive one new share for every two old shares held, thereby reducing the number of shares outstanding by half.
stock split
Involves an increase in the number of shares outstanding with a consequent decrease in share price. An example of a stock split is a two-for-one stock split in which each shareholder is issued an additional share for each share currently owned.
Holder-of-record date
It follows the ex dividend date. It is the date that a shareholder listed on the company's books will be deemed to have ownership of the shares for purposes of receiving the upcoming dividend; the amount of time between the ex-date and the holder-of-record date is linked to the trade settlement cycle in force
FCFE
Many analysts assert that a company's dividend-paying capacity should be reflected in its cash flow estimates instead of estimated future dividends. FCFE is a measure of dividend paying capacity and can also be used to value companies that currently do not make any dividend payments. FCFE can be calculated as: FCFE=CFO−FC Inv+Net borrowing
Asset-based valuation may not be appropriate when:
Market values of assets and liabilities cannot be easily determined. The company has a significant amount of intangible assets. Asset values are difficult to determine (e.g., n periods of very high inflation). Market values of assets and liabilities significantly differ from their carrying values.
Net Sales Equation
Net sales are calculated as gross sales less returns, customer discounts, and any dealer commissions.
P/E Valuation
P0/E1= (D1/E1)/r−g = p/r−g where p = dividend payout ratio This equation indicates that the P/E is inversely related to the required rate of return and positively related to the growth rate; that is, as the required rate of return increases, the P/E declines, and as the growth rate increases, the P/E increases. The P/E and the payout ratio appear to be positively related. This relationship may not be true, however, because a higher payout ratio may imply a slower growth rate as a result of the company retaining a lower proportion of earnings for reinvestment. This phenomenon is referred to as the dividend displacement of earnings.
Value of puttable preferred stock
Preferred stock issues can also include a retraction option that enables the holder of the preferred stock to sell the shares back to the issuer prior to maturity on prespecified terms. Essentially, the holder of the shares has a put option. Such put options tend to increase the value of a preferred issue to an investor because the option to retract will be exercised by the investor when it is in the investor's favor and ignored when it is not.
The relation between ke and gc in Gordon Growth Model?
The relation between ke and gc is critical: As the difference between ke and gc increases, the intrinsic value of the stock falls. As the difference narrows, the intrinsic value of the stock rises. Small changes in either ke or gc can cause large changes in the value of the stock.
EV/EBITDA
The EV/EBITDA multiple is often used when comparing two companies with different capital structures. Loss-making companies usually have a positive EBITDA, which allows analysts to use the EV/EBITDA multiple to value them. The P/E ratio is meaningless (negative) for a loss-making company, as its earnings are negative.
when to use the gordon model
The Gordon growth model is highly appropriate for valuing dividend-paying stocks that are relatively immune to the business cycle and are relatively mature (e.g., utilities). It is also useful for valuing companies that have historically been raising their dividend at a stable rate.
FCFE
The calculation of FCFE starts with the calculation of cash flow from operations (CFO). CFO is simply defined as net income plus non-cash expenses minus investment in working capital. FCFE is a measure of cash flow generated in a period that is available for distribution to common shareholders. What does "available for distribution" mean? The entire CFO is not available for distribution; the portion of the CFO needed for fixed capital investment (FCInv) during the period to maintain the value of the company as a going concern is not viewed as available for distribution to common shareholders. Net amounts borrowed (borrowings minus repayments) are considered to be available for distribution to common shareholders. Thus, FCFE can be expressed as FCFE = CFO - FCInv + Net borrowing
What valuation model should be used to value "supernormal growth" companies?
The correct valuation model to value such "supernormal growth" companies is the multistage dividend discount model that combines the multi-period and infinite-period dividend discount models. Value=D1/(1+ke)^1 + D2/(1+ke)^2 +...+ Dn/(1+ke)^n + Pn/(1+ke)^n where:Pn = Dn+1/Ke−gc Dn = Last dividend of the supernormal growth period Dn+1 = First dividend of the constant growth period
Terminal stock value (i.e., terminal value)
The expected value of a share at the end of the investment horizon—in effect, the expected selling price.
Value of Callable preferred stock
The intrinsic value of preferred stock would be lower if the issue were callable.
How to calculate Cost of Equity (Ke)?
The required rate of return on equity (ke) is usually estimated using the capital asset pricing model (CAPM). Another approach for calculating the required return on equity simply adds a risk premium to the before-tax cost of debt of the company.
Multiplier Models/Market Multiple Models
These models are based chiefly on share price multiples or enterprise value multiples. The former 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. Examples of the multiples include price to earnings (P/E, share price divided by earnings per share) and price to sales (P/S, share price divided by sales per share). The fundamental variable may be stated on a forward basis (e.g., forecasted EPS for the next year) or a trailing basis (e.g., EPS for the past year), as long as the usage is consistent across companies being examined. Price multiples are also used to compare relative values. The use of the ratio of share price to EPS—that is, the P/E multiple—to judge relative value is an example of this approach to equity valuation.
Asset-based 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. 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.
Present Value 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).
Criticism of price multiples
They do not consider the future in that their values are calculated from trailing or current values of the divisor. For example a company's price to earnings ratio may be calculated by dividing the current market price by the company's earnings per share (EPS) over the most recent four quarters. To counter this criticism, analysts make forecasts of fundamental values (e.g., earnings) into the future and use forward-looking or leading multiples. For example, the leading P/E ratio may be calculated as the current stock price divided by expected EPS over the next four quarters.
How is the required rate of return for use in present value models estimated?
To estimate the required rate of return on a share, analysts frequently use the capital asset pricing model (CAPM): Required rate of return on share= risk free rate of return * Beta[Market (equity) risk premium] the required rate of return on a share is the sum of the current expected risk-free rate plus a risk premium that equals the product of the stock's beta (a measure of non-diversifiable risk) and the market risk premium (the expected return of the market in excess of the risk-free return, where in practice, the "market" is often represented by a broad stock market index). However, even if analysts agree that the CAPM is an appropriate model, their inputs into the CAPM may differ. Thus, there is no uniquely correct answer to the question: What is the required rate of return?
Asset-Based Valuation
Uses market values of a company's assets and liabilities to determine the value of the company as a whole.
two-stage DDM formula
V0= (D0*(1+gS)^t/ (1+r)t) + Vn/(1+r)^n Vn=Dn+1/ r−gL Dn+1 = D0*(1+gS)^n * (1+gL)
Dividend Discount Model
a model that values shares of a firm according to the present value of the future dividends the firm will pay The dividend discount model is generally ineffective in valuing equities with high and growing levels of dividends and can even be rendered useless if dividends grow faster than the discount rate.
Extra Dividend (special dividend)
a supplemental dividend paid in years when the firm does well, and excess funds are available for distribution
Share Repurchase
a transaction in which a company uses cash to buy back its own shares. Shares that have been repurchased are not considered for dividends, voting, or computing earnings per share. A share repurchase is viewed as equivalent to the payment of cash dividends of equal value in terms of the effect on shareholders' wealth, all other things being equal. Company managements have expressed several key reasons for engaging in share repurchases—namely, (1) signaling a belief that their shares are undervalued (or, more generally, to support share prices), (2) flexibility in the amount and timing of distributing cash to shareholders, (3) tax efficiency in markets where tax rates on dividends exceed tax rates on capital gains, and (4) the ability to absorb increases in outstanding shares because of the exercise of employee stock options.
How do you calculate the growth rate of dividends?
g = RR × ROE where RR= earnings retention rate = (1 - Dividend payout ratio) ROE=return on equity
Enterprise Value Multiples
have the form (Enterprise value)/(Value of a fundamental variable). Two possible choices for the denominator are earnings before interest, taxes, depreciation, and amortization (EBITDA) and total revenue. Enterprise value, the numerator, is a measure of a company's total market value from which cash and short-term investments have been subtracted (because an acquirer could use those assets to pay for acquiring the company). An estimate of common share value can be calculated indirectly from the EV multiple; the value of liabilities and preferred shares can be subtracted from the EV to arrive at the value of common equity.
Ke formula from Gordon Growth Model
ke=D1/ PV0 + gc This expression for the cost of equity tells us that the return on an equity investment has two components: The dividend yield (D1/P0). Growth over time (gc).
How to value non-callable perpetual preferred stock?
present value of a perpetuity
Declaration Date of Dividends
the day that the company issues a statement declaring a specific dividend
Ex-Divdend Date
the first date that a share trades without (i.e., "ex") the dividend. Any investor who holds the stock on the ex-dividend date or who purchased it the day before the ex-dividend date is entitled to receive the dividend.
stock dividend
type of dividend in which a company distributes additional shares of its common stock (typically, 2%-10% of the shares then outstanding) to shareholders instead of cash. A stock dividend divides the "pie" (the market value of shareholders' equity) into smaller pieces without affecting the value of the pie or any shareholder's proportional ownership in the company. Thus, stock dividends are not relevant for valuation.
payment date
which is the day that the company actually mails out (or electronically transfers) a dividend payment to shareholders.
