Investment Valuation

• The value of an asset corresponds to the present value of its anticipated returns.
• Converting the stream of revenues to a value requires discounting, which uses a required rate of return.
• To do this well, accurate estimates of expected returns and their required rate are needed.

Stream of Expected Returns (Cash Flows)

• Earnings, dividends, interest payments, and capital gains are all accepted forms of returns.
• The timing and growth rate of income are major factors.

Investment Decision Process

• Involves comparing computed intrinsic values and market prices.
• Next, figure out the investment's intrinsic value using the required rate of return.
• Compare the calculated intrinsic value with the current market price.
• To increase profit, buy or retain if the estimated value exceeds the market price.
• If the estimated value is less than the market price, do not buy.

Valuation of Alternative Investments

• Bonds, preferred stock (preference shares), and common stock (ordinary shares) are examples of securities that a company may offer.
• These securities may be traded on the secondary market.

Valuation of Bonds

• Bond valuation is simple because the number of cash flows and their time pattern are known.
• Usually, interest payments are made every six months.
• The coupon rate times the face value equals one-half of the interest paid.
• The bond's maturity date determines when the principle is repaid.
• Bond value is defined as the face value of a bond.
• In 2019, a P10,000 par value bond due in 2034 with a 10% coupon will pay P500 every six months for its 15-year life.
• The bond price can be computed assuming the required rate of return is 10%
• The present value of the interest payments: P500 x 15.3725 = P7,686
• The present value of the principal: P10,000 x .2314 = P2,314
• Therefore, the bond value = P7,686+P2,314=P10,000
• The P10,000 is the amount an investor should pay for the bond, given the required rate of return on a bond of 10%.
• Bond value will vary inversely if the necessary rate of return varies.
• What is the bond value if the return is 12%? The answer is P6,882 (P500 x 13.7648)

Valuation of Preferred Stock

• Owners of preferred stock get a commitment to receive a set dividend forever.
• Because payments are made after bond interest payments, there is more uncertainty of returns.
• To compute the value, simply divide the annual dividend by the necessary rate of return on preferred stock (kp).
• Using the following formula: V = Dividend/kp
• Assuming a preferred stock has a P100 par value and a dividend of P8 a year and a required rate of return of 9 percent
• V = P8/.09 = P88.89

Common Stock Valuation

• Two ways to estimate intrinsic value:
• Discounted Cash-Flow Techniques: Present value of cash flow, such as dividends, operating, or free cash flow
• Relative Valuation Techniques: Value is calculated using metrics such as profits, cash flow, book value, and sales

Estimating Intrinsic Value

A. Present value of cash flows (PVCF)

• Present value of dividends (DDM)
• Present value of free cash flow to equity (FCFE)
• Present value of Operating free cash flow (FCFF)

B. Relative valuation techniques

• Price earnings ratio (P/E)
• Price cash flow ratios (P/CF)
• Price book value ratios (P/BV)
• Price sales ratio (P/S)
• Investor's required rate of return on stock significantly impacts these approaches and valuation methodologies.
• The required rate of return is the discount rate or a major component of it.
• Estimated growth rate affects all valuation methods.

Why Discounted Cash Flow Approach

• Discounted cash flows are common to use because they represent the present value of future cash flows
• Dividends: Cost of equity is used as the discount rate.
• Operating cash flow: WACC or Weighted Average Cost of Capital
• Free cash flow to equity: The cost of equity is used as the discount rate.
• Values depend on growth and discount rates.

Why Relative Valuation Approach

• Provides data on how the market values shares at various levels.
• Includes aggregate market, alternative industries, and individual stocks within industries.
• There is no advice on whether current prices are appropriate (whether too high or too low).
• It is best when used with comparable entities, especially when aggregate market and company's industry are not at a valuation.

Discounted Cash Flow Valuation Approach

• The general formula is: Vj = Summation from t=1 to n of CFt / (1+k)^t
  • Vj = Value of stock j
  • n = Life of the asset
  • CFt = Cash flow in period t
  • k = Discount rate equal to investor's required rate of return for asset j

Dividend Discount Model (DDM)

• The value of a common stock share is the present value of all future dividends.
• Formula: Vj = D1/(1+k) + D2/(1+k)^2 + D3/(1+k)^3 + ...+ D∞/(1+k)^∞
• This can be simplified to: Summation from t=1 to n of Dt / (1+k)^t
  • Vj = Value of common stock j
  • Dt = Dividend during time period t
  • k = Required rate of return on stock j

Infinite Period Model (Constant Growth Model) DDM

• This assumes the constant growth rate when estimating future dividends.
• Vj = D0(1+g), D0(1+g)^2 / (1+k)^2 +...+ D0(1+g)^n / (1+k)^n
• Where:
• Vj = value of stock j
• D0 = dividend payment in the current period
• g = the constant growth rate of dividends
• k = required rate of return on stock j
• n = the number of periods, which we assume to be infinite

Constant Growth Rate

• Given the constant growth rate, the earlier formula can be reduced to:
• Vj = D1 / k-g
• Based on several assumptions:
  • Dividends grow at a constant rate
  • The constant growth rate will continue for an infinite period
  • The required rate of return (k) is greater than the infinite growth rate (g)

DDM and Growth Companies

• Growth firms can earn more on investments than their required rate of return.
• Firms will reinvest, and their earnings rise faster than those of standard firms.
• When g>k in high-growth periods, the DDM assumptions of constant growth are not consistent.
• Assess supernormal growth years before utilizing DDM to compute remaining years at a sustainable rate.
• For example, XYZ Limited, with a 14% required return, recently paid a dividend of P2 per share.
• The dividend growth pattern as as follows: year 1-3: 25%, year 4-6: 20%, year 7-9: 15%, year 10 onward 9%.
• The intrinsic value can be computed as follows:
• V subscript i equals (2.00 multiplied by 1.25 divided by 1.14) plus (2.00 multiplied by 1.25 quantity squared divided by 1.14 squared) plus (2.00 multiplied by 1.25 quantity cubed, divided by 1.14 cubed) plus (2.00 multiplied by 1.25 quantity cubed, multiplied by 1.20 divided by 1.14 to the fourth power) plus (2.00 multiplied by 1.25 quantity cubed, multiplied by 1.25 squared divided by 1.14 to the fifth power) plus (2.00 multiplied by 1.25 quantity cubed, multiplied by 1.20 cubed divided by 1.14 to the 6th power) plus (2.00 multiplied by 1.25 quantity cubed, multiplied by 1.20 cubed, multiplied by 1.15 divided by 1.14 to the 7th power) plus (2.00 multiplied by 1.25 quantity cubed, multiplied by 1.20 cubed, multiplied by 1.15 squared divided by 1.14 to the 8th power) plus (2.00 multiplied by 1.25 quantity cubed, multiplied by 1.20 cubed, multiplied by 1.15 cubed divided by 1.14 to the ninth power) plus (2.00 multiplied by 1.25 quantity cubed, multiplied by 1.20 cubed, multiplied by 1.15 cubed, multiplied by 1.09 divided by 0.14 minus .09 all divided by 1.14 to the ninth power).
• Based on the computations, V XYZ equals P94.21

Earnings Multiplier Model

• The value of an investment is the present value of future returns.
• The company net profit represents common stockholders' revenues.
• Investors can estimate stock value by determining how much they will pay for expected earnings.
• Earnings are represented by an estimate of "normalized earnings".
• Valuing stock at P20 implies the assumption that the investor is willing to spend 10 times expected revenues.
• P/E Ratio: number of times an investor will pay for expected revenues.
• Formula for Price/Earnings Ratio = Market Price / EPS = Earnings Multiplier
• Estimated Value = Earnings Multiplier * Expected 12-Month Earnings

Estimating Earnings Multiplier

• By dividing earnings on both sides of the equation the P/E ratio approach for constant DDM is:
  • P/E = D1 / E1 all divided by k-g
• Therefore, the components in determining the estimate are:
  • Expected dividend payout ratio
  • Required rate of return on the stock (k)
  • Expected growth rate of dividends (g)
• For example, assume AGE stock with the following: Dividend payout = 50%, required return = 12%, expected growth = 8%, D/E = 0.50 and the growth rate, g=0.08.
• Questions
  • What is the stock's P/E ratio?
  • What is the P/E ratio if the required rate of return is 13%?
  • What is P/E ratio if the growth rate is 9%?
• The spread between rate of return (k) and expected growth (g) is what determines the P/E ratio

Consider the Previous Example

• Take dividend payout = 50%, required rate of return = 12%.
• Estimate current earnings of P2.00, growth rate of 9%, and market price of P30.
• The P/E ratio would equal 0.5/(0.12 – 0.09) or 16.7.
• Estimated E1 would equal (2x 1.09) or P2.18
• Intrinsic value equals =16.7 x P2.18 =P36.41
• Estimating intrinsic value (P36.41) is greater than the Market price (P30), therefore it's undervalued.

Asset Based Valuation Approach

• Valuing the company by the worth of its net assets.
• Next, the net asset value for the company ought to be derived using the assets' realisable values.
• This amount would equal what would be left for the shareholders if the assets were sold off and the liabilities settled.
• Net asset value per share= Net Asset Value / No. of shares in issue
• For example, using Minergy Limited: What is the intrinsic value per share?

Rate of Return

• An investor's return must be computed.
• The selected method or technology has no effect on this.
• This is the discount rate and also affects relative valuation.
• Return depends on:
  • The economy’s real risk-free rate (RRFR)
  • The expected rate of inflation (I)
  • A risk premium (RP)

Real Risk Free Rate

• The minimum rate an investor should demand.
• Depends on real economy growth.
• Invested capital should rise faster than the economy

Expected Rate of Inflation

• Investors seek real returns that will increase consumption.
• Required nominal risk-free rate of return (NRFR) must represent anticipated inflation.
• NRFR formula: = [1+RRFR][1+E(I)] - 1, where E(I) represents expected rate of inflation

Nominal Risk Free Rate

• NRFR is the minimum rate of return an investor requires after taking into account expected inflation.
• Estimate NRFR by yield to maturity for government treasury bills or bonds with a similar maturity period to the investor's holding period
• Government treasury bills or bonds are are risk free.

Risk Premium

• Measures such as business risk, financial risk, liquidity risk, exchange rate risk, and country risk can all assist in estimating the risk premium.
• Each firm's risk measures may be compared to similar data from major competitors, industry dynamics, and the overall market.
• Next, determine if the company require a higher or lower risk premium.

Estimate Using CAPM

• Market-based risk estimate i.e. beta can be used.
  • This is estimated by regressing market returns on the stock's returns.
  • Formula is: Rstock = α + βstock Rmarket.
    • Rstock = monthly rates of return for stock
    • α = constant term
    • βstock =beta coefficient for stock = Covstock,market / σ2market Market return represents the monthly rates of return for a market proxy.
• The required rate of return can be estimated using the CAPM when β stock is available, using formula: E(Rstock) = E(RFR) + βstock [E(Rmarket) – E(RFR)].

Estimate Growth Rate

• The growth rate of dividends is determined by earnings growth.
• Next, estimate the proportion of earnings paid out as dividends i.e. payout ratio
• Growth of equity earnings or ROE only requires determining dividend and earnings trends. Earnings growth equals percentage of net earnings retained times a return on equity.
• g=(Retention Rate)x(Return on

ROE

• ROE represents the relationship of Net Income with Assets.
• ROE is computed by Sales (Profit Margin) x Total Assets (Asset Turnover) x Equity (Financial Leverage)
• Company's dependency on management factors in calculating ROE.
• Operating performance and financial leverage impact on ROE.
• Components include: - Revenue or net profit margin, means the firm's profits on sales - Second part, total asset turnover, reflects asset efficiency i.e. use of capital - Managing finance is third component i.e. how finance fits

Estimating the Average

• Average growth happens when previous dividends have been stable for 5 - 10 years. Next, a constant rise can be assumed.
• Next, compare actual growth with previous years.
  • g = nth square root of Dn / D0 – 1
• May need adjusting with current economy of industry and company.

Earning Per Share

• Company reports on its financial success with EPS.
• EPS can predict margin or sales.
• Analyze the relationship with sales, economics, and data with established firms.

Sales Figure

• Personal care with sales depends on industry i.e. drugs.
• The same is said for consumption with expenditures.
• Create the regression line with established sales.
• Estimate the equation with sales, for personal care, and least squares to be established.
• Also determine if equation calls that the increase of PCT Indicator to increase.

Forecast

• Obtain forecasts with economists for estimates on indicators
• Based on this, the PCE indicator will grow by 4.1% next year.
  • Change company sales using formula = new + B(4 PCE) Forecast the net profit by industry.
• Take into account company's strategy which would determine the forecast and competition.
  • Assumes Net Profit margin to be 5% with a forecast of 5.13 million + .05 = 256,500

Tax Rate

• Tax can be estimated based on current or recent.
  • Assumes current to be 22% Earnings can be obtained by taking the amount from taxes.
• Company shares the earning shares which is why EPS are used. Model shows it is earnings on both sides of DDM.

Estimate P/E ratios

• Estimate this with market with industry
  • The PE ratio that can be that of a company that is similar with respect regarding financial business growth.

Beta

• Beta can be obtained through covariance/ market by average
• Next beta can correlate methods.