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Outline
Balance Sheet Valuation
Dividend Discount Model Earnings Multiplier Approach Earnings Price Ratio, Expected Return, and Growth
Relative Valuation Techniques Price earnings ratio Price-book value ratio Price-sales ratio
Pn
+
(1+r)n
=
(1+r)n r - g2
1.20 1 1.15 P0 = 2.40 .15 - .20 1 - 1.291 = 2.40 -0.05 = 13.968 + 56.79 = RS.70.76
1 (1.15)6
[0.4322]
H Model
ga gn
2H
D0
PO = r - gn D0 (1+gn) D0 H (ga - gn) [(1+gn) + H (ga - gn)]
=
r - gn
Value based on normal growth rate
+
r - gn
Premium due to abnormal growth rate
Illustration: H Ltd
D0 = 1 ga = 25% gn = 15% 1 (1.15) P0 H=5 r = 18% 1 x 5(.25 - .15)
=
0.18 - 0.15
+
0.18 - 0.15
+ 16.67 = 55.00 P/E = 27.5
= 38.33
IF E = 2
PO =
15.0%
5.0%
4.44
PO =
10.0%
10.0%
6.67
PO = 0.20 - 0.15
= RS.40.00
5.0%
15.0%
13.33
EV=
FCF1
FCF2
++
FCFH
VH
(1+WACC)
(1+WACC)2
(1+WACC)H
(1+WACC)H
Present value of horizon value
Illustration
The balance sheet of Azura Limited at the end of year 0 (the present point of time) is as follows.
Rs. in crore
Liabilities Shareholders funds Equity capital (10 crore shares of Rs. 10 each) Reserves and surplus Loan funds rate (9 percent) 250 Assets
100
400 100
Based on the above information we can calculate the intrinsic value of the equity share as follows: 1. 2. The explicit forecast period is 6 years because the firm reaches a steady state at the end of 6 years. The free cash flow forecast for the explicit forecast period is given in Exhibit 13.4. Exhibit 13.4 Free Cash Flow Forecast
Year Asset value (Beginning) NOPAT Net investment FCF Growth rate (%) 1 500.0 60.0 100.0 (40.0) 20 2 600.0 72.0 120.0 (48.0) 20 3 720.0 86.4 144.0 (57.6) 20 4 864.0 103.7 103.7 12 Rs. In crore 5 6 967.7 1083.2 116.1 130.1 116.1 86.7 43.4 12 8
4.
WACC = 0.5 x 16 + 0.5 x 9 (1-0.333) = 11 percent The horizon value of the firm is
FCFH+1 VH = rg + 0.11 0.08 FCFH (1+g) = 0.11 0.08 43.4 (1.08)
= Rs.1562.4 crore
5.
EV
+
(1.11)5
+
(1.11)6
+
(1.11)6
Enterprise value
7.
The value per share of Azura is: Rs. 491.4 crore / 10 crore = Rs. 49.
D1
P0 = r-g
E1 (1 - b)
=
r - ROE x b (1 - b) P0 / E1 = r - ROE x b
= = = =
8.2 + 1.5g + 6.7b - .2 Growth rate for normalized eps Payout ratio Std. Dev .. of % eps change
P / E Benchmark
Rules Of Thumb
Growth rate in earnings 10% 1 Nominal interest rate 15% 20% 1 = 8.33 .12 1 = 5.00 .20 1 Real return 1 = 25 .04 25% 35%
1
= 16.67 .06 0.5 = 16.67 Payout ratio
.18 - .15
Case A No Growth Discount Discount Rate: 20% Rate: 25% 20 / 0.20 = 100 100 / 20 = 5.0 20 / 0.25 = 80 80 / 20 = 4.0
10
11
Case B Growth Discount Discount Rate: 20% Rate: 25% 10 / (0.20 - 0.10) = 100 100 / 20 = 5.0 10 / (0.25 - 0.10) = 66.7 66.7 / 20 = 3.33
Discount Rate: 15% Value 20 / 0.15 = 133.3 Priceearnings multiple 133.3 / 20 = 6.67
2
... E2 = D2 = 15 15 P0 = 0.15 = 100
r = 15%
Investment .. RS. 15 Per Share in Year 1 Earns 15% 2.25 Npv Per Share = - 15 + = 0 0.15
RATE OF RETURN
IMPACT ON SHARE PRICE SHARE PRICE IN YEAR 0, IN YEAR 0 P0 -8.70 -4.35 0 4.35 8.70 91.30 95.65 0 104.35 108.70
E1/P0
IN GENERAL, WE CAN THINK OF THE STOCK PRICE AS THE CAPITALISED VALUE OF THE EARNINGS UNDER THE ASSUMPTION OF NO GROWTH PLUS THE PRESENT VALUE OF GROWTH OPPORTUNITIES (PVGO).
FROM THIS EQUATION, IT IS CLEAR THAT : EARNINGS-PRICE RATIO IS EQUAL TO r WHEN PVGO IS ZERO. EARNINGS-PRICE RATIO IS LESS THAN r WHEN PVGO IS POSITIVE. EARNINGS-PRICE RATIO IS MORE THAN r WHEN PVGO IS NEGATIVE.
PBV ratio =
Book value per share at time t The PBV ratio has always drawn the attention of investors. During the 1990s Fama and others suggested that the PBV ratio explained to a significant extent the returns from stocks.
D1 = E1 (1 b) = E0 (1 + g) (1 b) P0 = E0 (1 + g) (1 b) rg E0 = BV0 x ROE
P0 = BV0 (ROE) (1 + g) (1 b) rg
PS ratio
Po S0
rg
PBV = ROE (1 + g) (1 b) (r g) PS = NPM (1 + g) (1 b) r-g
Looking at these equations, we find that there is one variable that dominates when it comes to explaining each multiple it is g for P/E, ROE for PBV, and NPM for PS. This variable the dominant explanatory variable is called the companion variable.
Taking into account the importance of the companion variable, investment practitioners often use modified multiples which are defined below.
P/E to growth multiple, referred to as PEG
P/E
g
PBV
ROE
1. Determine the value per share attributable to the core business. One way
to do is to calculate the earnings per share from the core business and apply a suitable multiple to it. 2. Find the value per share for each of the listed subsidiaries. In computing this value a discount factor of 15 to 20 percent is generally applied to the observed market value of the equity stake in the listed subsidiary. 3. Assess the value per share for each of the unlisted subsidiaries. To do this, the analyst has to first estimate the market value using an earnings multiple or some other basis as there is no observed market value and then apply a discount factor of 15 to 25 percent to the same. 4. Add the per share values for the core business, for listed subsidiaries, and for unlisted subsidiaries, to get the total value per share.
An illustrative sum of the parts (SOTP) valuation of Mahindra and Mahindra, done in 2007, is given in exhibit 13.8 Exhibit 13.8 SOTP Valuation Based on FYO8E
Business M&M Multiple Parameter Discount Per share
value 451.7
48.6
100%
Pat
25%
8.0
388.3 840.0
Indexing strategy
Active Strategy Market Timing Sector Rotation Security Selection Use of a Specialised Concept
In formal terms :
SMRn = [DYn + EGn] Investment return + [(PEn / PE0)1/n 1] Speculative return
where : SMRn = annual stock market return over a period of n years DYn = annual dividend yield over a period of n years
EGn
PEn PE0
Illustration
Suppose you want to forecast the annual return from the stock market over the next five years (n is equal to 5). You come up with the following estimates. DY5 = 0.025 (2.5 percent), EG5 = 0.125 (12.5 percent), and PE5 = 18. The current PE ratio, PEo, is 15. The forecast of the annual return from the stock market is determined as follows: SMR5 = [0.025 + 0.125] + [(18/15)1/5 1] = [0.15] + [0.037] = 15 percent + 3.7 percent = 18.7 percent 15 percent represents the investment return and 3.7 percent represents the speculative return.
Summing Up
While the basic principles of valuation are the same for fixed income securities as well as equity shares, the factors of growth and risk create greater complexity in the case of equity shares.
Three valuation measures derived from the balance sheet are: book value, liquidation value, and replacement cost. According to the dividend discount model, the value of an equity share is equal to the present value of dividends expected from its ownership. If the dividend per share grows at a constant rate, the value of the share is : P0 = D1/ (r g) A widely practised approach to valuation is the P/E ratio or earnings multiplier approach. The value of a stock, under this approach, is estimated as follows:
P0 = E1 x P0/E1
In general, we can think of the stock price as the capitalised value of the earnings under the assumption of no growth plus the present value of growth opportunities (PVGo) E1 P0 = + PVGO
r
Apart from the price-earnings ratio, price to book value (PBV) ratio and price to sales (PSR) ratio are two other widely used comparative valuation ratios. Two broad approaches are followed in managing an equity portfolio : passive strategy and active strategy. Stock market returns are determined by an interaction of two factors : investment returns and speculative returns.