Reading 48- Overview of Equity Securities
Enterprise Value p. 288-289
market capitalization of common stock+ market value of preferred stock + market value of debt - cash & short-term investments cost of turnover in the event of a buyout
The Asset-Based Valuation Model is most applicable when
market value of the corporate assets is readily determinable & intangible assets (which are typically difficult to value) are a small proportion of the corporate's assets
common shares
most common form of equity -ownership interest -residual claim on firm assets if firm is liquidated -dividends (optional) -vote for board of directors -can vote by proxy
Multiples vs. fundamentals
multiples= law of one price fundamentals= takes into account future expectations
Which model is the best for comparing similar companies?
multiplier model
increase in return on equity is a good sign when
net income is increasing at faster rate than book value of equity
depository receipts
ownership in a foreign firm traded in markets of other countries -depository bank= custodian; managed dividends and other corporate events
Estimate the intrinsic value of a retractable term preferred share p. 278-279 ex. 5
# quarters= 34 quarterly dividend= (5%*$25 par value/4 quarters)= .3125 required rate of return PER QUARTER= 15.5%/4= 3.875% PER QUARTER V0=.3125/(1.03875)+.3125/(1.03875)^2+...+.3125/(1.03875)^34 =$12.71
implications of Asset-Based Valuation Models
1. companies that do not have easily determinable market (fair) values- companies that don't have property, plant, equipment- are very difficult to analyze 2. asset & liability fair values can be different from values on balance sheets 3. may not include "intangible" assets--> "floor" value 4. asset values difficult to estimate in hyper-inflation events
(3) major categories of Equity Valuation models p. 270-271
1. present (discount) value model= present value of future benefits expected to receive from the security -dividend discount models or free-cash flow-to-equity models 2. multiplier model (market multiple model)= EPS, P/E share price multiples enterprise value multiples EBITDA (earnings before interest, tax, depreciation, amortization) 3. asset-based valuation models= sum of value of business' assets book value (carrying value)= Shareholder's equity= A-L
alternatives to the Gordon growth model (3)
1. use a more robust DDM (Dividend Discount Model) bc sometimes companies don't actually pay out dividends in times of financial stress 2. use cash flow instead of dividends in the equation 3. use a multiplier method for valuation
A security that represents an equity share in a foreign firm and for which the voting rights are retained by the depository bank, is a(n): A) unsponsored depository receipt. B) American depository share. C) global registered share.
A In an unsponsored DR, the depository bank retains the voting rights of the equity shares of the foreign firm. In a sponsored DR, the investor in the DR has the voting rights. For an American depository receipt, an American depository share is the underlying security that trades in the issuing firm's domestic market. A global registered share is an equity security that trades in the local currencies on stock exchanges around the world.
preferred stock (preference shares)
A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. dividend that must be paid out before dividends to common shareholders, and *the shares usually do not carry voting rights* -like common stock- increase in price & debt- pays fixed dividends
non-callable, non-convertible Perpetual Preferred Share intrinsic value
V0= D0/r D0= annual dividend r= required rate of return *intrinsic value is just dividends divided by required rate of return*
Other things equal, which of the following types of stock has the most risk from the investor's perspective? A) Callable preferred share. B) Callable common share. C) Putable common share.
B Callable shares have more risk than putable shares because the issuer can exercise the call option (which limits the investor's potential gains) while the investor can exercise the put option (which limits the investor's potential losses, assuming the firm is able to meet its obligation). Preferred shares have less risk for the investor than common shares because preferred shares have a higher priority claim on the firm's assets in the event of liquidation, and because preferred dividends typically must be paid before common dividends may be paid.
Global depository receipts are most likely issued: A) outside the issuer's home country and denominated in the exchange's home currency. B) outside the issuer's home country and denominated in U.S. dollars. C) in the United States and denominated in U.S. dollars.
B Global depository receipts are issued outside the U.S. and the issuer's home country and are most often denominated in U.S. dollars. Depository receipts issued in the United States and denominated in U.S. dollars are called American depository receipts. Global registered shares are denominated in the home currencies of the exchanges on which they trade
Private equity securities most likely: A) trade in over-the-counter dealer markets. B) are illiquid and do not have quoted prices. C) are issued to individual investors.
B Private equity securities are illiquid and do not trade in public securities markets. Holders of private equity must negotiate with other investors to sell the securities. Private equity securities are typically issued to qualified institutional investors.
Hodges Fund provides mezzanine stage financing to private companies. In which type of private equity investing is Hodges Fund most likely involved? A) Leveraged buyout. B) Venture capital. C) Private investment in public equity.
B Venture capital providers invest in firms that are early in their life cycles. Stages of venture capital financing include seed stage, early stage, and mezzanine financing. In a leveraged buyout, an investor purchases all of a public firm's equity, taking the firm private. In a private investment in public equity (PIPE), an investor purchases private equity issued by a public firm.
estimated intrinsic value of a non-callable, non-convertible, Preferred Share
V0= Dt/(1+r)^t + F/(1+r)^n P price is replaced by F preferred stock's par value
Pearl River Heavy Industries shows the following information in its financial statements: Total Assets HK$146,000,000 Total Liabilities HK$87,000,000 Net Income HK$27,000,000 Price per Share HK$312 Shares Outstanding 200,000 The equity securities of Pearl River have a: A) book value of HK$62,400,000. B) market value of HK$146,000,000. C) book value of HK$59,000,000.
C Book value = Total assets − total liabilities = 146,000,000 − 87,000,000 = HK$59,000,000 Market value of equity = Market price per share × shares outstanding = HK$312 × 200,000 = HK$62,400,000
Two seats on a board of directors are to be elected. A voting system in which the owner of 100 shares may cast 100 votes in each of the board elections is a: A) cumulative voting system. B) proportional voting system. C) statutory voting system.
C In a statutory voting system, a shareholder can vote in each separate board election based on the number of shares she owns. Under cumulative voting, the shareholder may choose to cast her total number of votes (200 in this example) for a candidate in one of the elections.
Preference shares will have the most risk for the investor if the shares are: A) non-callable and non-cumulative. B) callable and cumulative. C) callable and non-cumulative.
C Preference shares (preferred stock) has more risk for the investor if they are non-cumulative than if they are cumulative, because with cumulative preference shares the firm must pay the holder any omitted dividends before it can pay any dividends to common shareholders. Callable shares have more risk for the investor than non-callable shares because the call option limits their potential for price appreciation.
Dividends on non-participating preference shares are typically: A) a contractual obligation of the company. B) lower than the dividends on common shares. C) a fixed percentage of par value.
C Similar to the interest payments on a debt security, dividends on non-participating preference shares (preferred stock) are typically fixed. Unlike the interest payments on a debt security, the company is not contractually obligated to pay preferred dividends. Preferred dividends are typically higher than a firm's common dividends.
P0/E1=
[D1/(r-g)]/E1 =(D1/E1)/(r-g) =p/(r-g) suggests that dividend payout ratio (p) is the ratio of dividends to earnings
FCFE discounted cash flow
Cash Flow from Operations (Net Income + Non-cash expenses- working capital) -Fixed Capital Investment +Net Borrowing
multi-stage (2-stage) Dividend Discount Model (DDM)
Dn+1= D0(1+g short term)^n*(1+g Long term)
Equity Value=
EV- Debt + Cash
Assumption of the Gordon growth model (4)
Growth rate cannot be greater than the required rate of return 1. dividends are correct metric to use for valuation 2. dividend growth rate is forever, perpetual, & never changes 3. required rate of return is constant 4. *dividend growth rate is strictly LESS than required rate of return*
ROE=
Net Income/ Average Book Value
____ may be used instead of EBITDA.
Operating Income
Estimate Nestle's justified forward P/E. p. 291 ex. 11 Multiplier Model
P0/E1= p/(r-g)= .45/(.12-.088) p & r are given in the problem. calculate g= (1-Dividend payout ratio p) x ROE given in the problem =(1-.45)x.16 =.088
An analyst finds that nearly all companies in a market segment have common shares which are trading at market prices above the analyst's estimate of the shares' values. This market segment is widely followed by analysts. Which of the following statements describes the analyst's most appropriate first action?
Reexamine the models & inputs used for the valuations.
How much does the dividend growth assumption add to the intrinsic value assumption? *
Solution: V0- D/r
American depository receipts (ADRs)
US dollar-denominated security that trades like a common share on U.S. exchanges ex. Nokia, a European company, ADR denominated in USD
What model do we use to valuate private companies?
asset-based
Gordon Growth Model
assumes dividends grow infinitely at a constant rate appropriate for valuing a dividend-paying company that is INSENSITIVE TO THE BUSINESS CYCLE & in a MATURE growth phase (ex. staple bread food product, electric utility in a slow growing area) V0= D0(1+g)/(r-g)= D1/(r-g) *note D0= current most recent annual dividend per share vs. D1
3- stage Dividend Discount Model (DDM)
assumes growth is in 3 stages: growth, transition, maturity
The choice of equity valuation model depends on (2)
availability of information confidence in information & appropriateness of model
direct investing
buy a foreign firm's securities in foreign markets (-) exchange rate illiquid stock exchange market less strict analysis
Which stock appears to be undervalued when compared with the others?
choose the company with the LOWEST P/S
Global registered shares (GRS)
common share that is traded in different stock exchanges around the world in different currencies same share purchased on Swiss exchange for franc can be sold on Tokyo exchange for yen
Important factor in using Enterprise Value method
debt
The P/E is ____ related to the dividend growth rate & payout ratio.
directly
A higher _____ or _____ suggests a higher P/E when comparing Boeing P/E to EADS P/E.
dividend growth rate OR payout ratio
Free cash flow equity (FCFE) valuation model *
dividend paying *capacity* should be reflected in the cash flow estimates rather than expected dividends *equity valuation model that focuses on capacity to pay dividends
non-participating preference shares
do not allow shareholders to share in the profits of the company. get initial investment + accrued dividends in liquidation event
statutory voting
each share represents one vote in election of board of directors
The change in sales will be less than the change in earnings in % terms because
earnings are heavily influenced by fixed operating and financing costs p. 293
convertible preference shares
entitle shareholders to convert their shares into a specified number of common shares (+) may earn a higher dividend than common stock -investors share profits -rise in price of common shares -less risk than common shares
g= (1-div payout) x ROE
equation to use when r changes
An analyst, using a number of models and a range of inputs, estimates a security's value to be between ¥250 and ¥270. The security is trading at ¥265. The security appears to be:
fairly valued.
Gordon Growth Model in the case of No Current Dividend p. 283 ex. 7
find V5 first, then plug in V5 to find V0
callable common shares (hint: buy-call)
firm has right to repurchase stock at pre-specified call price -this repurchase of shares allows firm to reduce dividend payments
Preferred stock
form of equity (generally, non-voting) that has priority over common stock in the receipt of dividends and on issuer's assets in the event of company liquidation may have maturity date OR perpetual may be callable or convertible
growth rate equation
g= b x ROE g= dividend growth rate b= earnings retention rate= (1- Dividend payout ratio) ROE= return on equity
A high EPS growth rate supports a p.290 ex. 10
high P/E
A higher payout ratio supports a p.290 ex. 10
higher P/E
Other factors to consider when evaluating a company's P/E:
higher depreciation higher interest costs higher tax burden
The economic rationale underlying the method of comparables is the law of one price, which is
identical assets should sell for the same price.
venture capital (1. private equity)
illiquid
Dividend Discount Model (DDM) p.273 *
intrinsic value of a share is the present value of expected future dividends value= dividend + price aka terminal stock value (expected value of share at end of investment horizon time t) *equity valuation model that focuses on the capacity to pay dividends, expected dividends
The P/E is ____ related to the required rate of return.
inversely
participating preference shares
investors receive extra dividends if firm profits exceed level
leveraged buyout (2. private equity)
investors use a large amount of debt to purchase all the outstanding common shares of a publicly traded market. *management buyout= attracted to undervalued assets, high cash flows*
global depository receipts (GDRs)
issued outside of the company's home country & outside the U.S. no capital flow restrictions
private equity
issued to institutional investors -highly illiquid bc no market-determined (quoted) price -share price negotiated -less financial disclosure -weaker corporate governance -focus on long-term prospects -greater return once firm goes public
Very small changes in inputs, such as r & g, can result in
large changes to valuation model output.
putable shares are _____ than non-putable shares
less risky
cumulative shares are _____ than non-cumulative preference shares
less risky because investors can receive unpaid dividends before dividends are paid to common shareholders
Retractable term preferred shares
preferred shareholders have the option to SELL BACK their shares to the issuer at par value shares are "retractable" or "putable"
ex. 2 An analyst is examining the intrinsic value of a new company. The analyst has 1 year of financial statements for the company and has calculated the average values of a variety of price multiples for the industry in which the company operates. The analyst plans to use at least one model from each of the three categories of valuation models. The analyst is least likely to rely on estimate(s) from the ___ model.
present value model bc there is only 1 year of data available, and analyst is least likely to be confident in the inputs for the present value model. Instead, he uses the multiplier model & asset-based valuation model.
the more optimistic investors are, the more
price-to-book ratio
Multiplier Models price multiple
ratio that compares share price to cash flow P/E (price to earnings) P/B (price to book) P/S (price to sales) P/CF (price to cash flow) limitation= doesn't consider the future
Callable preferred shares tend to
reduce the intrinsic value of a preferred issue to the investor *option to redeem/ call is only valuable to the issuer and is in his interest
The Gordon growth model estimate of intrinsic value is extremely sensitive to
required rate of return r and growth rate g
ex. 9 p. 285-286
review
callable shares are _____ than non-callable shares
riskier because issuer has option to redeem shares at pre-determined price
preferred stock is less _____ than common stock
risky because: 1. dividends on preference shares are known & fixed vs. common stock is unknown 2. preference shareholders receive dividends before common shareholders 3. the amount shareholders receive is liquidated
private investment in public equity (PIPE) (3. private equity)
selling of publicly traded common shares or some form of preferred stock or convertible security to private investors
putable common shares (hint: put-sell)
shareholder has right to sell the shares back to firm at a specific price -places a floor under share value (+) shareholders get higher prices from selling shares
cumulative voting
shareholders can allocate their votes to one or more candidates
Two investors with different holding periods but same expectations and required rate of return for a company are estimating the intrinsic value of a common share of the company. The investor with the shorter holding period will most likely estimate a:
similar intrinsic value bc *The intrinsic value of a security is independent of the investor's holding period.
How to find the most undervalued company? p. 299
take the company with the lowest EV/OI (Enterprise Value/ Operating Income) ex. -EV/OI= -55.0
market value of equity
total value of firm's outstanding equity shares
An analyst finds that all securities analyzed have estimated values higher than their market prices. The securities all appear to be
undervalued. market price < intrinsic value
cumulative preference shares
unpaid dividends accrue and must be paid in full before dividends on common shares can be paid
How to estimate the required rate of return in present value model:
use CAPM model: E(Ri)= Rf+ ß*[E(R(m)-Rf]
book value of equity
value of firm's assets on balance sheet- market value difference between financial statement value of firm's assets and liabilities (A-L) (+) retained earnings increase value reflect firm's past operating & financing choices