Presented by:
Shahzada Zaheer Ahmad
Muhammad Kamran
Zain
Umar
Valuation definition:
The value of a share of common stock is
equal to the present value of all future cash
flows (dividends) that it is expected to
provide.
𝐷1 𝐷2 𝐷3
V= + + ………..
1+𝑟 1 1+𝑟 2 1+𝑟 3
where
P0 = value of common stock
D = per-share dividend expected at the end of year t
r = required return on common stock
Valuation of stock
We can valuate the stock on the basis of
three given model:
Dividend based model
Cash flow based model
Relative model
1. Dividend Based model:
Dividend discount models are designed to
compute the intrinsic value of a share of
common stock under specific assumptions :
as to the expected growth pattern of future
dividends
the appropriate discount rate to employ
Dividend based model can be used when:
zero growth
Constant growth
Variable growth rate
Zero dividend growth model
The zero dividend growth model assumes
that the stock will pay the same dividend
each year, year after year.
𝐷1
𝑷𝟎 =
𝑘𝑒
The equation shows that with zero growth, the value of a
share of stock would equal the present value of a perpetuity
of D1 dollars discounted at a rate rs
Example:
Chuck Swimmer estimates that the dividend of
Denham Company, an established textile producer, is
expected to remain constant at $3 per share
indefinitely.
• If his required return on its stock is 15%, the stock’s
P0=3/0.15
P0= $20 per share
Constant growth model:
The constant-growth model is a widely cited dividend
valuation approach that assumes that dividends will
grow at a constant rate, but a rate that is less than the
required return.
𝐷1
𝑷𝟎 =
𝐾𝑒−𝑔
The Gordon model is a common name for the
constant-growth model that is widely cited in dividend
valuation.
Example:
Expected next year dividend of ABC company is 3 Rs per
share. It is expected it will grow at the constant growth of
10% p.a in future. Find out the intrinsic value of stock if
required rate of return is 15%.
Solution:
𝑫𝟏
𝑽=
𝒌−𝒈
3
𝑉=
0.15 − 0.10
V= 𝟔𝟎 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆.
Variable growth rate:
The variable-growth model is a dividend valuation
approach that allows for a change in the dividend growth
rate.
when dividend growth is expected to differ
during various phases of a firm’s development, the
present value of dividends for various growth phases
can be determined and summed to produce the
stock’s intrinsic value.
𝐷4
𝐷1 𝐷2 𝐷3 𝐾𝑒−𝑔
V= + + ……[ ]
1+𝑟 1 1+𝑟 2 1+𝑟 3 1+𝐾𝑒 𝑛
Example:
DIVIDEND TO BE RECEIVED OVER FIRST 5 YEARS
END OF PRESENT VALUE CALCULATION PRESENT VALUE
YEAR (dividend × PVIF14%,T) OF DIVIDEND
1 $2(1.10) 1 = $2.20 × 0.877 = $1.93
2 2(1.10) 2 = 2.42 × 0.769 = 1.86
3 2(1.10) 3 = 2.66 × 0.675 = 1.80
4 2(1.10) 4 = 2.93 × 0.592 = 1.73
5 2(1.10) 5 = 3.22 × 0.519 = 1.67
= $8.99
Dividend at the end of year 6 = $3.22(1.06) = $3.41
Value of stock at the end of year 5 = D6 /(ke − g) =
$3.41/(0.14 − 0.06) = $42.63
Present value of $42.63 at end of year 5 =
($42.63)(PVIF14%,5) = $22.13
PRESENT VALUE OF STOCK
V = $8.99 + $22.13 = $31.12
2. Cash flow based model:
There are two approaches to find out the
value of the company and stock on the basis
of cash flows of the company generating
from operations, investing and financing.
These two approaches are:
Free cash flows model/ WACC(weighted average capital
cost) model
Residual equity cash flows model
Free cash flows model/ WACC(weighted
average capital cost) model
Definition:
The free cash flow is the cash flow generated from
the operating activities and investing activities
without taking into account the financing activities.
It is the money that is available to the company after
covering fixed asset investments and working
capital requirement.
Assumption of FCF is:
No debt(financing)
No financial expenses.
Formula’s for FCF:
𝑭𝑪𝑭 = 𝐸𝐵𝐼𝑇 1 − 𝑇𝑎𝑥 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 ±
𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒\𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 −
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
𝐹𝐶𝐹0 1 + 𝑔
𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒄𝒐𝒎𝒑𝒂𝒏𝒚 =
𝑊𝐴𝐶𝐶 − 𝑔
𝑾𝑨𝑪𝑪 = 𝑊1 𝐾𝑑 1 − 𝑡𝑎𝑥 + 𝑊2 𝐾𝑒
𝑴𝑽 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 = 𝑀𝑉 𝑜𝑓 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 − 𝑀𝑉 𝑜𝑓 𝑑𝑒𝑏𝑡
𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑴𝑽 𝒐𝒇 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 =
𝑁𝑜 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠
WACC: weighted average capital cost
In order to calculate the value of the company, FCF approach
use weighted average of debt and weighted average cost of
equity:
𝑾𝑨𝑪𝑪 = 𝑊1 𝐾𝑑 1 − 𝑡𝑎𝑥 + 𝑊2 𝐾𝑒
The WACC is calculated with respect to the capital structure
of the company.
WACC is the appropriate rate to calculate MV of the company
as a whole debt + equity.
Residual equity free cash flows:
Definition:
The free cash flow is the cash flow generated
from the operating activities, investing activities
and financing activities.
It is the cash flow that is available to the
shareholder after covering fixed asset
investments and working capital requirement
and also after paying the debt cost.
When we use REFCF, we are valuing the
company’s equity. Therefore the appropriate
required rate is Ke (cost of equity).
Formula's:
𝑹𝑬𝑭𝑪𝑭
= 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
± 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒\increase 𝑖𝑛 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 − 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒
± 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒\decrease 𝑖𝑛 𝑑𝑒𝑏𝑡
𝑅𝐸𝐹𝐶𝐹 1 + 𝐺
𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 =
𝐾𝑒 − 𝑔
𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑀𝑉 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 =
𝑁𝑜 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠
Relative model for valuation:
Using fundamentals
Valuation related to fundamentals of business
being valued that are:
Relates multiples to fundamentals of business
being valued, eg earnings, profit
Shows relationships between multiples and
firm characteristic
Using comparable:
Valuation is estimated by comparing business with
a comparable fit:
Review of comparable firms to estimate value
Advantages:
Simple and easy to use
Useful when data of comparable firms
and assets are available. Require less time
and efforts
Easier to justify and sell.
Closer to the market value (more value if
the comparable firm is getting more in the
market)
Limitations:
Easy to misuse
Selection of comparable can be subjective
Errors in comparable firms get factored
into valuation model RGC (Risk, Growth,
Cash Flow) may be ignored.
Have a short shelf life (compared to
fundamentals)
Multiples of relative valuation
method:
These are following:
Price\earning ratio:
𝑀𝑃𝑆
𝑃\E =
𝐸𝑃𝑆
Market to book value ratio:
𝑀𝑃𝑆
𝑀𝐵𝑅 =
𝐵𝑉 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Dividend to price ratio:
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑒𝑑
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 =
𝑀𝑃𝑆
Sale to price ratio:
𝑠𝑎𝑙𝑒 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑆\P =
𝑀𝑃𝑆
Cash to price ratio:
𝑐𝑎𝑠ℎ 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐶𝑎𝑠ℎ 𝑡𝑜 𝑝𝑟𝑖𝑐𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Valuation decision:
Intrinsic
value > Undervalued Buy/No Sell
Market price
Intrinsic
Buy/Sell/No
value = Fairly valued
Action
Market price
Intrinsic
value < Overvalued Sell/No Buy
Market price
Any
Question?
