CHAPTER FIVE

Stock or Equity Valuation

By Ayitenew T. (MSc.)
 Stock Characteristics
• Stocks (also called shares or equities) represent ownership in a
corporation.
• The have the following key features.
• Ownership and Control: Each share gives its holder ownership rights
and voting power in shareholders’ meetings (usually one vote per
share).
• Dividends: Payments made to shareholders from a company’s
earnings. Dividends can be cash, stock, or property.
• Capital Gains: The profit made when a stock is sold at a higher price
than its purchase price.
• Risk and Return: Stockholders face higher risk than bondholders but
have the potential for higher returns.
• Types of Stocks:
• Common Stock: Entitles shareholders to dividends and voting rights.
• Preferred Stock: Priority in dividend payments and asset claims, but usually no
voting rights.
Preferred Stocks
• Preferred stock is a hybrid—it is similar to bonds in some points and to
common stock in other.
• It captures the characteristics of bond and common stock.
• Like bonds, preferred stock has a par value and a fixed amount of
dividends.
• But, like a common stock a failure to make this payment will not
lead to bankruptcy.
Common stock
❖The common stockholders are the owners of a corporation. Because
of this they have certain rights and privileges.
• Control of the firm.
• Preemptive Right.
• High profit potential.
 Market Value vs Intrinsic Value of stocks

• Market Value: is the current price at which a stock is bought or sold

in the stock market.
• It represents what investors are willing to pay for a share at a given moment.
• Determined by the forces of demand and supply in the market, affected by
investor perceptions, news, economic conditions, and market sentiment.
• Changes constantly during trading hours. It m may not always reflect the true
worth of a company.
• Can be influenced by speculation or temporary market trends.
• Intrinsic Value: is the true or fair value of a stock based on the
company’s fundamentals, such as earnings, dividends, growth
prospects, and risk.
• It is determined by computing the present value of the payment
stream on the security discounted at an appropriate discount rate.
• It represents what the stock should be worth according to financial analysis.
• It reflects long-term value.
• Is based on financial and economic analysis, not just market emotion.
• Is often different from the current market price.
 Relationship Between the Mkt Value and Intrinsic Value

Situation Comparison Investor Action

Buy (stock is cheap relative
Undervalued Stock Intrinsic Value > Market Value
to its true worth)

Overvalued Stock Intrinsic Value < Market Value Sell (stock is expensive)

Hold (price reflects true

Fairly Valued Intrinsic Value ≈ Market Value
value)
 Equity valuation models

❖Stock valuation means determining the intrinsic value of the stock.

❖Stock Valuation is more difficult than Bond Valuation because

❖stocks do not have a finite maturity date and
❖the finite future cash flows, i.e., dividends, are not specified.

• Because of the complexity and importance of valuing common

stock, various valuation methods have been used. Broadly it
classified in to as follows:
1. Dividend discount model
2. Free cash flow model
3. Earning multiplier model
 1. Dividend Discount Model
• The Dividend Discount Model values a stock by discounting
expected future dividends to their present value.
• Dividend discount models are designed to compute/calculate the
intrinsic value of a common stock.
• The intrinsic value of the security is equal to the present value of the
payment stream on the security discounted at an appropriate discount rate.
• According to the dividend discount model, the value of an equity
share is equal to
• the present value of expected dividends plus
• the present value of the sale price expected when the equity share
is sold.
❖To apply the dividend discount model, we will make the
following assumptions:
1. Dividends are paid annually
2. The first dividend is received one year after the equity share is
bought.
3. The investor’s required rate of return (r) (or cost of equity) is
known and remains constant over time.
4. No taxes or costs affecting dividends or discounting, to keep
calculations simple.
5. Growth rate of dividends is predictable.
• The model assumes that dividends grow at a constant rate (g) or a
predictable pattern (for multi-stage models).
• For the Gordon Growth Model, this growth rate must be less than the
required rate of return (r > g).
 I. Single Period Valuation Model
 This model is used when the investor expects to hold the equity
share for only one year. In this case, the price of the equity share
will be:
𝑫𝟏 𝑷𝟏
𝑷𝒐 = +
𝟏+𝒓 𝟏+𝒓
Where
• Po = Intrinsic value of a stock
• P1= next year price of the stock
• r = an investor’s required rate of return
• D1 = next period dividend

• Example: Assume that the equity share of a company is expected to

provide a dividend of Br 2 and get a price of Br 18 at the end of the
year. At What price would it sell for now if investors’ required rate of
return is 12%?
Po = 2.0÷ (1.12) + 18÷ (1.12) = Br 17.86
 II. Multi-Period Valuation Model
❑If you anticipate holding the stock for several years and then selling it,
the valuation estimate is harder.
❑You must forecast several future dividend payments and estimate the
sale price of the stock several years in the future.
𝑫𝟏 𝑫𝟐 𝑫𝒏 𝑷𝒏
𝑷𝒐 = + + +
𝟏+𝒓 𝟏+𝒓 𝟐 𝟏+𝒓 𝒏 (𝟏+𝒓)𝒏
• Example: an investor plans to hold a stock for 2 years. The company
expects to pay its shareholders common equity, Br 0.25 per share over
the next two years. The investor anticipates that a stock will sell at the
end of 2nd year at Br 40 per share.
Given a rate of return 10%, what is the value of the stock having two-
year time period?
Po = 0.25÷ (1.1) + 0.25÷ (1.1)2 + 40 ÷ (1.1)2 = Br 33.5
• Exercise: Assume that an investor expects a Br 3
dividend for each of 10 years and a selling price of Br
60 at the end of 10 years, and the discount rate is 10%,
the value today of the stock is:

• Po = Br 41.61
 III. Infinite Period Model
• When an investment on equity is held for infinite period, there are
three cases of growth in dividends.
A) zero growth;
B) constant growth; and
C) non-constant, or supernormal growth.
A. Zero growth Model: A constant growth (like preferred stock)
model has an expected growth rate, g, of zero.
• It is assumed that
• The dividend amount will be constant forever.
• D0 = D1 = D2 = D = Constant
• If we assume that the dividend per share remains constant year after
year at a value of D, the shares do not have maturity date; that is they
go to perpetuity.
Po = D/ r
• Example: Hindu Manufacturing Ltd. Has distributed a constant
dividend of Br. 30 on each Equity share for years. The expected rate
of return is 35%. Calculate the current market price of share?

Po = 30/ 0.35 = Br 85.71

• Example: Consider that Norms Company preferred stock pays an
annual dividend of Br 3.5. The investor required rate of return is 7%.
Find its value.
Po = Br 3.5 /.07= Br 50
B. Constant Growth Stock Valuation (Gordon Model)

• dividends are expected to grow at a constant rate (g) in the future.

• This condition fits for many firms, which grow over the long run at the

same rate as the economy, fairly well.

• Where; D1 = Do + (Do * g ) = Do(1 + g), then

𝑫𝟏(1 + g)
𝑷𝒐 =
r−g
• Example; Assume that you have purchased the shares of a company,
which is expected to grow at the rate of 6% per annum. The dividend
expected on your share at the end of year one is Br 2. What price will
you put on it if your required rate of return for this share is 14%?

• The price for your share can be calculated as;

Po = 2.00/(0.14-0.06) = Br 25
❖Common equity can be valued;
✓directly by using FCFE or
✓indirectly first estimate the value of the firm by using FCFF model and then
subtracting the value of non - common - stock capital (usually debt)
from FCFF to arrive at an estimate of the value of equity.

A. Free cash flow to the firm (FCFF)

Θ is the cash flow available to the company’s suppliers of capital
after all operating expenses have been paid and necessary
investments in working capital (e.g., inventory) and fixed capital
(e.g., equipment) have been made.
• Process:
• Forecast FCFF (cash available to all investors).
• Discount FCFF at the Weighted Average Cost of Capital (WACC).
• Result is Firm Value.
• Subtract Market Value of Debt to get Equity Value.
 Θ FCFF is the cash flow from operations minus working and fixed
capital expenditures.
▪ FCFF = EBIT(1 - Tax Rate) + Depreciation - ΔNWC - CapExp
OR
▪ FCFF = NI+ Interest(1-tax rate)+ depreciation – ΔNWC – CapExp

Θ A company’s suppliers of capital include common stockholders,

bondholders, and sometimes, preferred stockholders.
• Why do we add back after-tax interest when calculating FCFF?
• It is because:
FCFF is the cash flow available to both debt holders and equity
holders But Net Income (NI) is the cash flow available only to equity
holders, because interest has already been deducted.
▪ FCFF is the cash flow going to all suppliers of capital to the firm.
▪ Therefore, the value of firm is estimated by discounting FCFF at the
weighted average cost of capital (WACC).

• Therefore, the value of equity is the value of the firm minus the
market value of its debt:
Equity value = Firm value - Market value of debt
• To find the value per share dividing the total value of equity by the
number of outstanding shares.
• WACC is the weighted average of the required rates of return for
debt and equity.
• The formula for WACC is;

MV(Debt) and MV(Equity) are the current market values of debt

and equity, not their book values in the WACC formula.
B. Free cash flow to equity
• is the cash flow available to the company’s holders of common equity after
all operating expenses, interest, and principal payments have been paid and
necessary investments in working and fixed capital have been made.
• Process:
• Forecast FCFE (cash available to equity holders after debt payments).
• Discount FCFE at the Cost of Equity (rₑ).
• Result is Equity Value directly.
• To forecast FCFE use eighter of the following formula

▪ FCFE=Net Income+Depreciation−Capital Expenditures−ΔNWC+Net Borrowing

OR
▪ FCFE=FCFF−Interest(1−t)+Net Borrowing
OR
FCFE = EBIT(1 - Tax Rate) + Depreciation - Interest (1 - Tax Rate) - ΔNWC - CapExp
• The second step is discounting FCFE.
• The present value of future FCFE is the value of the equity.
• To get the present value, future FCFE must be discounted at the
required rate of return on equity, r.

• Dividing the total value of equity by the number of outstanding

shares gives the value per share.
• Like dividend, there is an assumption that free cash flows
grow at a constant rate.
A. Constant - Growth FCFF Valuation Model
• Assume that FCFF grows at a constant rate, g, such that FCFF in any
period is equal to FCFF in the previous period multiplied by (1 + g):

If FCFF grows at a constant rate,

B. Constant - Growth FCFE Valuation Model

• The constant - growth FCFE valuation model assumes that FCFE

grows at constant rate g. FCFE in any period is equal to FCFE in the
preceding period multiplied by (1+ g ):

FCFE t = FCFE t-1 (1 + g)

• The value of equity if FCFE is growing at a constant rate is;

• The discount rate is r, the required rate of return on equity.

 • Illustration: Assume the following for Company ABC:
Using the Constant-Growth
Item Amount FCFF Valuation Model
Revenue $1,000,000 Determine the value of the
Cost of Goods Sold (600,000) equity:
Gross Profit 400,000 • Using FCFF
Operating Expenses (200,000)
• Using FCFE
EBIT (Operating Income) 200,000
Interest Expense (56,000)
Earnings Before Tax (EBT) 144,000
Taxes (30%) (43,200)
Net Income $100,800

Additional information: • Cost of equity = 11.2%

• Pre-tax Cost of Debt = 7%
• Depreciation = 40,000 • Long-term growth rate of the firm = 4%
• Capital Expenditure = 70,000 • Number of outstanding shares=50,000
• Capital structure= 40% debt and 60%
• Increase in Working Capital = 20,000
equity.
• Net Borrowing = New Debt − Debt Repayment =
+32,000
• Solution 1: Calculate Equity Value from FCFF approach
1 determine Free Cash Flow to the Firm (FCFF)
FCFF =EBIT(1−tax rate)+Depreciation−Cap. Expend.−ΔWC
= 200,000(1-30%)+40,000-70,000-20,000
= $90,0000
2 Firm Value using FCFF (Gordon Growth Model)
Calculate WACC: WACC=we×re+wd×rd×(1−T)
= 0.60 × 0.112 + 0.40 × 0.07 × 1 − 0.30
= 0.0672 + 0.40 × 0.07 × 0.70
= WACC = 0.0868 8.68%

90,000 × 1.04 93,600

= =
0.0868 − 0.04 0.0468
Firm Value = 𝟐, 𝟎𝟎𝟎, 𝟎𝟎𝟎
Then Equity value from from FCFF approach is
• We don’t have market value of debt directly, but we can approximate using
the capital structure:
If firm value = 2,000,000, and debt is 40% of firm value:
Debt Value = 0.40 × 2,000,000 = 800,000
Equity Value = 2,000,000 − 800,000
= 𝟏, 𝟐𝟎𝟎, 𝟎𝟎𝟎
• Equity Value per share =$1,200,000/50,000 shares
= $24/share
• Solution 2: Equity Value from FCFE Approach
1 determine FCFE from FCFF
FCFE=FCFF−Interest×(1−T)+Net Borrowing
FCFE=90,000−[56,000×(1−0.30)]+32,000
= 90,000 − 39,200 + 32,000
FCFE = 𝟖𝟐, 𝟖𝟎𝟎
OR
Determine FCFE from Net Income approach
• FCFE=NI+Dep−Capex−ΔNWC+Net Borrowing
• = 100,800 + 40,000 − 70,000 − 20,000 + 32,000
• = 50,800 + 32,000
FCFE= 𝟖𝟐, 𝟖𝟎𝟎
Then find Equity Value using FCFE (Gordon Growth Model)

82,800 × 1.04 86,112

= =
0.112 − 0.04 0.072
Equity Value = 1,196,000
•Summary: Equity Value using
•FCFF approach → = 1,200,000
•FCFE approach → = 1,196,000
The $4,000 difference is because in the FCFF method, the debt ratio is
exactly 40% of the derived firm value, but in the Gordon growth for FCFE,
we used the first-year FCFE with exact NB = 32,000, causing a slight
mismatch.
 3. Earning multiplier approach
❖Also called Price-to-Earnings (P/E) Ratio Approach.
❖ P/E ratio is another alternative to value a stock and used to identify
stocks for possible purchase.
• It's a relative valuation method that values a company's equity by
comparing its earnings to the market price of similar companies. The
"multiplier" is the P/E Ratio.
• Formula:
• Equity Value = Earnings × P/E Multiple
• Implied Share Price = EPS × P/E Multiple
• For example, if the financial analyst determines that the
appropriate P/E ratio is 10 and the firm will earn $4.50 per
share,
• the value of the stock is; (10)($4.50) = $45.
• The implication is that;
• if the stock is currently selling for $35, it is undervalued and should be
purchased.
• If it is selling for $55, it is overvalued and should be sold.
• Investment Decision:
• If Estimated Intrinsic Value > Market Price, Buy or Hold it if you
Own It.
• If Estimated Intrinsic Value < Market Price, Don’t Buy or Sell it if
you Own It.
The End of Chapter Five!