10 Pdfsam EDITED UOL FM Topic 9 Posted

Earnings-Based Approach
This method requires us to estimate the

earning power of a company.

Typically, we use the price-to-earning ratio
(PER) as an indication of the growth potential

Historic PER =
Current market price of share
Last year's earnings per share

= pt
Et 1
PER = = = 1X
google
Price per share $100
EPS $1000
PER = = = 100X
Price per share $50
EPS $0.50
facebook
Example:
How many times of earnings are investors
willing to pay for the shares?

PER = $10 / $1 = 10 times

For PER of 10x, it could also be argued that
you are buying 20 years of constant profits.

1
For a company with a high PER, the market is
expecting it to show a faster growth in earnings in the
future.

P = D1 [Gordons Model: to be explained later]
r g

Dividing both sides by EPS,

P / E = [ D/E] / ( r g )

= Payout ratio / ( r g )


PER has 3 determinants

1. Growth potential
2. Risk level
3. Payout ratio

Investors can analyse the historic PER of a
company and determine the future price.

SG p. 101, Example 9.1
The following data relates to Company A plc:
Use of PER in business valuation:
How many times of earnings are you willing
to pay for the stock?

Est. share price = PER x Est. EPS

As Average PER (2007-2010)=10.425 times
Estimated (prospective) EPS = 0.75

Estimated share price (historic PER)
= 10.425 x 0.75 = 7.82 (TP, target price).
one way is EPS x (1+g) = 0.75
0
Shortcomings of PER approach
i. SG: We assume that the PER of a
company stays constant over time. But
history tells us that PER fluctuates

Practice: Analysts use the historic high / low
PER and average PER to derive three
estimates of fair values

OR use industry PER as benchmark
Refer to Handout 9.2 on valuation
approaches (UOB Limited)

Here, we are using historical ranges (band) of
UOBs price-multiples to estimate the high and low
values of UOB.
Approaches used are:
1. PER approach
Example: UOBs highest (lowest) value
= Forecasted EPS x Highest (lowest) PER
2. Price-Book Multiple
3. Price-Net tangible asset (NTA) Multiple

(not given)
ii. We assume that the stock market knows
how to value companies correctly in the past
and that the PER has been correctly
computed
This assumption that stock market analysts
have a view of an appropriate PER for each
company seems to be unfounded.

A good example of this is the internet bubble
between 1998 and 2000. Prices for some
internet companies were too high relative to
their earnings.

Shortcomings of PER approach
Priceearnings ratio approach
to Value a Target Firm
Value Target
= P/E ratio Prospective EPS of target firm

Problem here is which P/E ratio to use.
If prospective EPS is not available, use the
current EPS

to Value a Target Firm

If acquirer believes performance of target
company will be similar to its own, it can apply
its own PER

Value of Target plc using Acq.s PER:

= Acq.s PER x Targets Current Earnings
Find the estimated price of Stock A (unquoted)

Step 1: Compute the Price-earnings ratio (PER) of a
similar firm (Stock B)
If Bs PER = 10 x, investors are willing to pay a stock
price that is 10 times of Bs earnings
If A and B are similar firms, then investors should also
be willing to pay a price that is 10 times of As
earnings
(Unquoted shares)
Step 2: Estimate Stock As value using its
own EPS and Stock Bs PER
Stock s A value = As EPS x Bs PER
(Unquoted shares)
Discounted Cash Flow Approach
A company is typically engaged in a number
of investments or activities that are financed
by, roughly speaking, debt and equity
NPV
$$
$$
$$
$$
V = Worth of Equity + Worth of Debt
Treat valuation of firm as a complex capital budgeting
project

DCF value of target
= PV of incremental cash flows gained by acquirer

Problems
Difficult to quantify expected benefits from operating and
financial synergies
Difficult to choose appropriate time horizon and terminal
value for target
Which discount rate should be used?
Example: Targets data
Current cash flows = 38m
Cash flow growth rate = 4% per year
Surplus assets sold in two years = 60m

WACC of Acquirer = 7% per year

(38 1.04) = 1317.3
(0.07 0.04)
60/1.07
2
= 52.4
DCF value = 1369.7
DEBT
Why do firms borrow?

4 forms of debt
Irredeemable Debt (Bonds / Loan Stock)
Redeemable Debt (Bonds / Loan Stock)
- Bond Characteristics
- Interest Rates and Bond Prices
- Yield to Maturity
Zero coupon bonds
Bank loans

Why do firms borrow?
A. Cost of debt lower than cost of equity because
debtholders face lower risk than shareholders
Cost of debt is fixed; any excess return belongs to
shareholders

B. Interest payments are tax deductible
The after-tax cost of debt is lower than the pre-tax
cost of debt (either bank interest rate or a bonds
YTM)

Income Statement: Tax shield
effect
Sales
Less Cost of Goods Sold
Gross Profit
Less: Operating Expenses
Less Depreciation Expense
Earnings Before Int. and Tax (EBIT)
Less Interest Expense
Net Profit Before Tax
Less Taxes
Net Profit After Tax

Bonds / Loan Stock / Debentures
These represent loans extended by investors to
corporations and/or the government.

These are issued by the borrower, and
purchased by the lender.

Bond Issue: $100m
Bonds issued: 100,000 units

12 units:
Loan =
$12,000
1 units
par
value =
$1,000
Irredeemable Debt:
These bonds involve a constant annual payment in
perpetuity.

No principal repayment
Use perpetuity equation
Note: Interest is before tax
Rd is also before tax

cost of debt hence,
Irredeemable bonds/loan stock

K
dAT
K
d

K
d
= cost of debt (before tax)
K
dAT
= cost of debt (after tax)
PMT = annual interest payment in $$
P
0
= value of bond
note that interest is tax-deductible.
PMT (1-T)
Po
=
PMT
=
recall: Topic 2 Slide 64
What is the after-tax cost of debt?

(same answer)

K
d
= cost of debt (before tax) = PMT / Po
K
dAT
= cost of debt (after tax)
PMT = annual interest payment in $$
P
0
= current ex-interest market price
0
P
PMT (1-T)
K
dAT
=
Kd(1-T) or K
dAT
=
K =
d
PMT
P
Calculating the (current) cost

10% irredeemable bonds (par value = 100)
Ex-interest market price: 72
Corporation tax: 30%

K
id
(before tax) = PMT/Po =10/ 72 = 13.9%
K
id
(after tax) = 13.9% (1 0.3) = 9.7%
OR: K
id
(after tax)= 10x(10.3)/72 = 9.7%
(same)

T
method 1
method 2
Key Features
The par (or face or maturity) value is the amount
repaid (excluding interest) by the borrower to the lender
(bondholder) at the end of the bonds life. The par value
for U.S. corporate bonds is $1000.

The coupon rate (pa) determines the interest
payments. Total annual amount = coupon rate x par
value. Bonds can pay coupons, annual, semi-annually
or quarterly

A bonds maturity is its remaining life, which decreases
over time. Original maturity is its maturity when its
issued. The firm promises to repay the par value at the
end of the bonds life (also called maturity).
Redeemable bonds/loan stock
Treasury Bond: Example
Temasek Financials Bond

Listed: 27 Oct 2009
Tenure: 10 years
Size : SGD1.5 bn (application: USD4 bn)
Rating: AAA (S&P); Aaa (Moodys)
Coupon: 4.3% (<1% above US T-Bond)
Collatoral: Nil (guaranteed by Temasek)
Purpose: Mid-term Operational needs

The bonds fair value is the present value of the
promised future coupon and principal payments.

At issue, the coupon rate is set such that the fair
value of the bonds is very close to its par value.

Later, as market conditions change, the fair
value may deviate from the par value.
Redeemable bonds: Valuation
The price of a bond
= Present Value of all cash flows
generated by the bond
i.e. coupons and redemption value (RV)
discounted at the cost of debt, rd
t
r
RV cpnInt
r
cpnInt
r
cpnInt
PV
) 1 (
) (
....
) 1 ( ) 1 (
2 1
+
+
+ +
+
+
+
=

SG:

Value of a bond is accurately
determined because all figures are
pre-determined
, except Rd.
Bond traders act on interest rate
forecasts on the bond
R can be known as the required return on bond
d
n n
n
r) (1
RV

r) (1 (r)
1 r) (1
PMT
PV
+
+
(
+
+
=
Bond Value:
PV = PV(coupon payments) + PV(RV)
= PV (Annuity) + PV (Single sum)
Note: $10 is ____________ interest expense

15 percent is the __________ cost of debt

SG example:
Rd =cost of debt = 15%
before
before
Semi-annual coupon payment
= [coupon rate / 2] x par value
= [0.09 / 2] x $1,000 = $45
Number of payments = 12 x 2 = 24
Semiannual required rate of return = 3%
Find the fair value of a bond with a $1,000 par value,
a remaining life of 12 years, and a coupon rate of 9%
per year paid semi-annually. The required return on
bonds like this one is currently 6%.
Redeemable bonds: Example
left
^
$1,254.03
(1.03)
$1,000

(1.03) (0.03)
1 (1.03)
45 $
B
24 24
24
0
=
+
(

=
Bond Value:
B
0
=PV(coupon payments) +PV(par value)
= PV (Annuity) + PV (Single sum)
Redeemable bonds: Example
> 1000 (par value)
Bonds: IMPORTANT NOTE:
The coupon rate IS NOT the discount
rate used in the Present Value
calculations.

The coupon rate is used to calculate the
periodic cash flow from the bond issuer.

The coupon rate is determined at the time of
bond issue (reflects issuers risk level then).

The market discount rate changes over time
according to the risk on the bond/issuer.
discount rate = current cost of debt
Bond Values and Discount Rate
(Required Return)

Required Return

Bond Value

6.0 %
9.0 %
12.0 %
$ 1, 254.03
$ 1,000.00
$ 811.74
premium bond
par bond
discount bond

Coupon rate = 9% per year.
Coupon = $90 per year ($45 per 6 months)

So, the higher the required return, the lower
the present value of the bond (bond price)
Yield To Maturity
(YTM always on per annum basis)
The Yield to Maturity is the investors return if
the bond is held till maturity

It is equivalent to the IRR in capital budgeting

-1000 +1000
$45 $45 $45
t = 24
return ytm = 9% p.a
$45 $45 $45
t = 24
-1254 +1000
return ytm = 6% p.a
before tax
Redeemable bonds
The before-tax cost of redeemable bonds is the
YTM of the bond.
Is after-tax cost of debt =YTM (1-T)? No.

Applying the tax effect of (1-T) to the coupon
payment [Coupon$(1-T)] is more accurate than
multiplying the before-tax cost of debt by (1 T),
since the redemption value is not tax-
deductible.

The cost of debt can be found using linear
interpolation.
YTM; return ytm include capital item which do not have tax shield effect
Redeemable Debt:
After-tax cost of debt
Find the Yield to Maturity (YTM) of a bond with:
Par value = $1,000
Remaining life = 12 years. Tax rate = 30%
Coupon rate = 9% per year paid semi-annually.
The bond is currently selling for $1,076.23.

After-tax PMT = $45(1-0.3) = $31.50
Using a financial calculator,
after-tax cost of debt

= 2.71% per 6-months
= 5.42% per year
24 24
24
YTM/2) (1
1,000

YTM/2) + (1 (YTM/2)
1 YTM/2) + (1
31.5 1,076.23
+
+
=
(
Redeemable Debt:
Using interpolation (similar to IRR interpolation)

Try YTM/2 (after tax) = 2% => LHS = + 141
Try YTM/2 (after tax) = 5% => LHS = - 332

Interpolate: Estimated YTM/2 (after tax)
= 2% + [141 / (332+141)] x [ 5 - 2 ] = 2.89%

Est. YTM (after tax) = 2.89 x 2= 5.78%

24 24
24
YTM/2) (1
1,000

YTM/2) + (1 (YTM/2)
1 YTM/2) + (1
31.5 1,076.23 0
+
+
+ =
(
Redeemable Debt:
Zero Coupon Bonds (ZCB)
No interest payments to bondholder
Issued at deep discount and traded at a discount

TVM: Single sum problem

What is the price of a ZCB with a par value
$1,000 yielding 3 percent p.a. for 6 years?
PV = FV / (1+r)^t
= 1,000 / (1.03)^6
= $837.48
PV < FV
Zero Coupon Bonds (ZCB)

What is the YTM of the same ZCB is the
investor bought the bond at $700?

r = (FV/PV)^ 1/n - 1
= (1000/700)^ 1/6 - 1
= 0.061 (6.1%)
cannot be done for UOL exam
Slide: 54
Bank loan $1.0m $0.8m
Interest paid $80000 $60000
Year 1 Year 2
[60K + 80K]/2
[1.0m + 0.8m]/2
=
= = 7.7%
formula for
cost of debt
Average interest
Average Loan
Cost of Bank loan
for year 2 [before tax]
After-tax debt cost = 7.7% x (1 - T)
Bank borrowings
Bank borrowings are not traded and have no
market value that interest can be related to.

Cost of bank borrowings can be found by dividing
average interest paid by average borrowings for
a given period.

Alternatively, the cost of traded debt may be used
as the best approximation.

Appropriate adjustment for taxation is needed.
Preferred Stock (Preferred Shares)
Claims of preferred stockholders are junior
to claims of debtholders, but senior to
those of common stockholders.
Limited voting rights compared to common
stock.
Preferred stock has a par value and a
dividend rate.
Failure to pay the dividend does not force
the issuing firm into bankruptcy.
Irredeemable Preferred Stock:
Valuation
Consider a $100 par value share of
preferred stock with an 8% dividend rate
(paid quarterly). The required return is
12% pa.

Find the preferred shares fair value
today.

Preferred Stock: Irredeemable
This preferred stock is a perpetuity

Then the value would be:

PV = C / i
= $2 per quarter / 0.03 per quarter
= $66.67
Preferred shares: Irredeemable
The cost of preference shares (constant
annual payment in perpetuity) can be found
by dividing the preference dividend by the ex
dividend market price:

K
ps
= cost of preference shares
P
0
= current ex div preference share price
D
p
= preference dividend.
0
P
D
K
p
ps
=
Preferred shares: Irredeemable
Calculating the cost of preference shares:

9% preference shares, nominal value: 100p
Current ex dividend market price: 67p

K
p
= (0.09 100)/67 = 0.134
K
p
= 13.4%.
Preferred Stock: Redeemable
If the preferred stock is redeemable after
x years, the valuation follows that of a
bond:

PV = PV (Annuity of Pref Dividends)
+ PV (Par value)
Preferred shares: Redeemable
The cost of this is found in the same
manner as redeemable bonds EXCEPT
that there is no tax adjustment.

n
r) (1
Par
PVIFA * Div Pref
PV
+
+ =
Cost of Redeemable
Preference Shares
Use interpolation as per redeemble
bonds except do not apply (1-T) to
the preference dividends

Share Valuation

PER Approach (covered)

Dividend Discount Model
Earnings Yield Approach
Dividend Yield Approach
Market Value Approach

Dividend Discount Model (DDM)
The value of a share of stock is the
present value of the expected dividends
over the holding period plus the
expected sale price at the end of the
holding period.
n
n
n
n
r
P
r
D
r
D
P
) 1 ( ) 1 ( ) 1 (
1
1
0
+
+
+
+ +
+
=
Po on LHS = Fair Value
P on RHS = Market price

Example
Current forecasts are for XYZ Company to pay dividends
of $3, $3.24, and $3.50 over the next three years,
respectively.

At the end of three years you anticipate selling your
stock at a market price of $94.48.

The required return on this stock = 12%

How much would you be prepared to pay for this stock?
That is, what is the intrinsic (fair) price of the stock?
PV
PV
=
+
+
+
+
+
+
=
300
1 12
324
1 12
350 94 48
1 12
00
1 2 3
.
( . )
.
( . )
. .
( . )
$75.
DDM - SG, p. 103
DDM - SG, p. 103

The value of a share is the present
value of all future dividends
The Dividend Discount Model
....
) 1 ( ) 1 ( ) 1 (
2
2
1
1
0
+
+
+ +
+
+
+
=
n
n
r
D
r
D
r
D
P

The company may pay dividends to
common stockholders.

However, it is not required to do so.
Moreover, there is no pre-set dividend rate.
Future dividends are uncertain.
We need a way to forecast future dividends.
Gordons Model(Constant Growth)
( )
( ) ( )( ) ( )
( )
( )
1
1
3
1
4
2
1 1 2 3
1 2
1
1
1 1 1 1
1
+ =
+ =
+ = + + = + =
+ =
t
t
g D D
g D D
g D g g D g D D
g D D
Assume dividends are growing at a constant

percentage rate of g per year.
Constant Growth (Gordons Model)
For a stock with with constant growth forever
after time t:
( ) g r
D
P
t
t
=
1
Dt = first constant growth dividend
Given any combination of variables in the
equation, you can solve for the unknown variable.
P
Div
r g
0
1
=
r = cost of equity
Important Features of the Constant
Growth Model
stocks total return

0
1
P
D
dividend yield ( = ) plus

capital gains yield ( = g)
0
1
P
D
+ g
r =
Under Gordons Model, g is also the
growth rate in the stock price
g =
[P1 - P0]
P0
Constant dividends where g=0
Cost of equity
Cost of equity (rate of return required by
stockholders) can be derived in two ways:

* Gordons Model: r = (D1/Po) + g

* CAPM (SML equation): Rf + (Rm Rf) x Beta

Earnings yield approach (to be discussed later
under business valuation)

Refer to Handout 9.1 on UOLs preference
equity
*
in the past
*
Stock Valuation: Example
The per share annual dividend on a common
stock is expected to be $3.00 one year from
today. Stockholders require a 12% rate of
return. Find the fair value of the stock for each of
the following cases:

1. Zero Growth: dividends are constant every year.
2. Five-Percent Growth: dividends are growing at a
constant rate of 5% per year forever
3. Supernormal growth
Div1
1. Zero Growth (g = 0)
$25.00
0.12
3.00 $

r
D
P
1

0
= = =
With g = 0, the dividends of $3.00 per share form a
perpetuity.
2. Five-Percent Constant Growth
( )
86 . 42 $
05 . 0 12 . 0
00 . 3 $

0
=
= P
Recall that D
1
= $3.00; r = 12%; and g = 5%
3. Supernormal Growth
An analyst forecasts Stock Xs dividends to grow at 15%
per year for the next 2 years. Thereafter, dividends are
expected to grow constantly at 10%. The last paid DPS
was $1. The cost of equity is 12%. What is the stocks
fair value?

D1 = 1 (1.15) = 1.15
D2 = 1 (1.15)^2 = 1.32
D3 = 1.32 (1.1) = 1.45

Fair value = PV (D1) + PV(D2) + PV(P2)
= 1.15/1.12^1 + 1.32/1.12^2
+ [1.45 / (0.12 0.10)]/1.12^2
= $59.88
t = 0 1 2 3
D1 = D0 x (1 + gs)
P2
P0 = PVC (future dividends) = PV (D1,D2...Dinfinity)
D3
r - g
gs = 15%
gc = 10%
P2
= PV(D1) + PVC(D2) + PV [P2 + ]
Gordon's growth
D0 = $1 D2 = D0(1 + gs) D3
Source of Dividend Growth
If the Payout Ratio (POR) is constant, growth
in dividends depends on the growth in
earnings.
The growth in earnings depends on:
the plowback ratio or retention ratio (1 - POR),
and
the return on investment, i ( = ROA)
i also can be Return on Equity (ROE)

Sustainable growth rate
g = (1 - POR) i

g = (1 - POR) x ROE
ROA = ROE
note:
BMA textbook
uses ROE
Example
Our company forecasts to pay a $3.00
dividend next year, which represents 100%
of its earnings. This will provide investors
with a 12% expected return.

Instead, we decide to plow back 40% of
the earnings at the firms current return on
equity of 20%. What is the value of the
stock before and after the plowback
decision?
00 . 25 $
12 .
3
0
= = P
No Growth
With Growth
00 . 75 $
08 . 12 .
3
08 . 40 . 20 .
0
=
=
= =
P
g
A firm with more growth prospects is worth more!
g = (1 - POR) x ROE
Tested in UOL finals May 2013
Stock Valuation: Other methods


Dividend Yield Approach

Market Value Approach

IGNORING GROWTH,

Value of Target = Annual maintainable earnings
Earnings Yield

OR

Targets share price = EPS
Earnings yield

EPS =
[NPAT - Pref Divi]
number of shares outstanding

Example Target plc
Acquirers earnings yield
= EPS/share price
= (25p/250p) 100 = 10%

Assume Target plc enjoys same yield.
Targets earnings yield value
= Targets Earnings/Acq.s earnings yield
= 10m/0.10
= 100m.
WITH GROWTH = 2%

Growth can be included by adapting the dividend
growth (Gordons) model.

P = D1 / (k g)

Earnings yield value
= (10m 1.02) = 127.5m.
(0.10 0.02)
Earnings Yield

Earnings yield is also used as a proxy for cost of equity:

Eg. Cost of equity = 10%

Cost of equity (to firm) = Return to shareholders
Return (%) = Return in $ / Price paid to earn the return
So, 10% = EPS /market price

This is the earnings yield equation
The PER approach is the mirror image
of the Earnings yield approach

Since PER = Market price / EPS,
Then, PER = 1/ 0.1 = 10X
[Investors are willing to pay a multiple of 10
times for the firms earnings]

So, Cost of Equity
= Earnings Yield
= 1 / PER
Price EPS
EPS Price
PER inversely proportional to Earnings Yield
how many times of
dividends willing to pay
Price DPS
DPS Price
inversely proportional to Earnings Yield
Dividend Yield Approach:
- Price paid as a multiple of gross dividends

(how many times of dividends are investors willing to pay?)
Price / dividends = 10 times

Find the estimated price of Stock A

Step 1: Compute the dividend yield of a similar firm (Stock B)
Gross dividends
Market price

If A and B are similar firms, then the two firms should
have similar dividend yields (Dividends/price)
(comparative approach):
(unquoted)

Step 2: Estimate Stock As value

Stock s A value
= As Gross dividend per share
Bs Dividend yield

= As Gross DPS * Number of times of DPS


Dividend Yield
Find Allenby Ltds (unquoted firm) value
using a quoted firms Dividend Yield.
Tax rate= 20%

Allenbys value per share
= Allenbys Gross Div per share / Quoted Stocks Div Yield
= [Allenbys Net DPS / (1-Tax rate)] / Dividend Yield
= ($0.80/ 0.8) / 0.10
= $10 [ or $1 * 10times = $10]
Market Price Approach
Value = Number of shares x market price

Fair price if market is efficient, but not fixed
Quoted price reflects marginal trading

Cannot be used for unquoted shares
Useful starting point in negotiations

Market Value does not reflect acquirer
intentions

Homework
Cost of capital components
Attempt FM 2009 Prelim Exam, Question 1
(Alpha plc)

Valuation Methods
(Sources of financing and valuation)

(Essay on valuation methods in a takeover)

Session 16
Topics 8 and 9: Past Exam Questions

Session 17- Class test 2
Scope: Topics 6 to 9

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Earnings-Based Approach

This method requires us to estimate the

Assume dividends are growing at a constant

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