Valuation: Theory of Valuation, University of Botswana PDF

VALUATION Lame Bakwenabatsile Office 245/234 University of Botswana Department of Accounting and Finance  Theory of Valuation The value of an asset is the present value of its expected returns To convert this stream of returns to a value for the security, you mus...

VALUATION Lame Bakwenabatsile Office 245/234 University of Botswana Department of Accounting and Finance  Theory of Valuation The value of an asset is the present value of its expected returns To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return This requires estimates of: – The stream of expected returns, and – The required rate of return on the investment  Theory of Valuation Stream of Expected Returns (Cash Flows) Form of returns Earnings Dividends Interest payments Capital gains (increases in value) Time pattern and growth rate of returns When the returns (Cash flows) occur At what rate will the returns grow  Theory of Valuation Investment Decision Process: A Comparison of Estimated (Intrinsic) Values and Market Prices You have to estimate the intrinsic value of the investment at your required rate of return and then compare this estimated intrinsic value to the prevailing market price – If Estimated Value > Market Price, Buy or Hold it if you own it – If Estimated Value < Market Price, Don’t  Valuation of Alternative Investments A company might have the following securities in issue and trading on the secondary market; – Bonds – Preferred stock (preference shares) – Common stock (ordinary shares)  Valuation of Bonds Valuation of Bonds is relatively easy because the size and time pattern of cash flows from the bond over its life are known: – Interest payments are made usually every six months equal to one-half the coupon rate times the face value of the bond: – The principal is repaid on the bond’s maturity date The bond value is defined as the  Valuation of Bonds Assume in 2019, a P10,000 par value bond due in 2034 with 10% coupon will pay P500 every six months for its 15- year life. What is the bond price if the required rate of return is 10%? Present value of the interest payments P500 x 15.3725 = P7,686 The present value of the principal P10,000 x.2314 = P2,314 The bond value P7,686+P2,314=P10,000  Valuation of Bonds The P10,000 valuation is the amount that an investor should be willing to pay for this bond, given the required rate of return on a bond of 10% If the required rate of return changes, then bond value will change inversely. What is the bond value if the return is 12%? P500 x 13.7648 = P6,882  Valuation of Preferred Stock Owners of preferred stock receive a promise to be paid a stated dividend, in perpetuity. Since payments are only made after the firm meets its bond interest payments, there is more uncertainty of returns The value is simply the stated annual dividend divided by the required rate of return on preferred stock (kp)  Valuation of Preferred Stock Dividend V kp Assume a preferred stock has a P100 par value and a dividend of P8 a year and a required rate of return of 9 percent P8 V.09 = P88.89 Common Stock Valuation Two General Approaches for Estimating Intrinsic Value Discounted Cash-Flow Techniques Present value of some measure of cash flow, such as dividends, operating cash flow, and free cash flow Relative Valuation Techniques Value estimated based on its price relative to significant variables, such as earnings, cash flow, book value, or sales  Estimating Intrinsic Value A. Present value of cash flows (PVCF) 1. Present value of dividends (DDM) 2. Present value of free cash flow to equity (FCFE) 3. Present value of Operating free cash flow (FCFF) B. Relative valuation techniques 1. Price earnings ratio (P/E) 2. Price cash flow ratios (P/CF) 3. Price book value ratios (P/BV) 4. Price sales ratio (P/S) Estimating Intrinsic Value Both of these approaches and all of these valuation techniques have several common factors: – All of them are significantly affected by investor’s required rate of return on the stock because this rate becomes the discount rate or is a major component of the discount rate; – All valuation approaches are affected  Why Discounted Cash Flow Approach These techniques are obvious choices for valuation because they are the epitome of how we describe value—that is, the present value of expected cash flows – Dividends: Cost of equity as the discount rate – Operating cash flow: Weighted Average Cost of Capital (WACC) – Free cash flow to equity: Cost of equity as the discount rate Estimated values are dependent on growth rates and discount rates  Why Relative Valuation Approach Provides information about how the market is currently valuing stocks at several levels aggregate market alternative industries individual stocks within industries However, there is no guidance as to whether current valuations are appropriate (whether too high or too low) Best used when we have comparable entities and, aggregate market and company’s industry are not at a valuation  Discounted Cash Flow Valuation Approach The General Formula t n CFt Where: V j  t 1 (1  k ) t Vj = value of stock j n = life of the asset CFt = cash flow in period t k = the discount rate that is equal to the investor’s required rate of return for asset j,  The Dividend Discount Model (DDM) The value of a share of common stock is the present value of all future dividends D1 D2 D3 D Vj    ...  (1  k ) (1  k ) 2 (1  k )3 (1  k )  n Dt  t 1 (1  k ) t where: Vj = value of common stock j Dt= dividend during time period t k = required rate of return on stock j  The Dividend Discount Model (DDM Infinite Period Model (Constant Growth Model) Assumes a constant growth rate for estimating all of future dividends D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) n Vj   2 ...  (1  k ) (1  k ) (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  The Dividend Discount Model (DDM) Given the constant growth rate, the earlier formula can be reduced D to:1 Vj  k g Assumptions of DDM: 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)  Infinite Period DDM and Growth Companies Growth companies have opportunities to earn return on investments greater than their required rates of return To exploit these opportunities, these firms generally retain a high percentage of earnings for reinvestment, and their earnings grow faster than those of a typical firm During the high growth periods where g>k, this is inconsistent with the constant growth DDM assumptions.  Infinite Period DDM & Growth Companies First evaluate the years of supernormal growth and then use the DDM to compute the remaining years at a sustainable rate Assume XYZ Limited has a recently paid dividend of P2 per share and has a 14% required rate of return with the following dividend growth pattern. Year Dividend Growth Rate 1-3 25% 4-6 20% 7-9 15% 10 on 9% What is the intrinsic value per share for XYZ Limited.  Infinite Period DDM and Growth Companies The intrinsic Value per share of XYZ V  2.00(1.25) 2.00(1.25)   2 2.00(1.25) 3 i 1.14 1.14 2 1.143 2.00(1.25) 3 (1.20) 2.00(1.25) 3 (1.20) 2  4  1.14 1.145 2.00(1.25) 3 (1.20) 3 2.00(1.25) 3 (1.20) 3 (1.15)   1.146 1.14 7 2.00(1.25) 3 (1.20) 3 (1.15) 2 2.00(1.25) 3 (1.20) 3 (1.15) 3   1.148 1.149 2.00(1.25) 3 (1.20) 3 (1.15) 3 (1.09) (.14 .09)  (1.14) 9 V = P94.21 XYZ  Earnings Multiplier Model This model uses the basic concept that the value of any investment is the present value of future returns. Common stockholders’ returns are the net earning of the company. An investors can estimate stock value by determining how many times they are willing to pay for a pula of expected earnings (represented by the estimated earnings during the following year or an estimate of “normalized earnings”)  Earnings Multiplier Model For example if an investor is willing to pay 10 times for expected earnings, they would value a stock with expected earnings of P2 a year from now at P20 (10 x 2). P/E Ratio is the number of times an investor is willing to pay for expected earnings.  Earnings Multiplier Model Market Price/Earnings Ratio Price  EPS = Earnings Multiplier Estimated (Intrinsic) Value = Earnings Multiplier x Expected 12-Month Earnings  Estimating Earnings Multiplier Combining the Constant DDM with the P/E ratio approach by dividing earnings on both sides of DDM formula to obtain Pi D1 / E1  E1 k g Thus, the Earnings Multiplier is determined by; Expected dividend payout ratio Required rate of return on the stock (k) Expected growth rate of dividends (g)  Earnings Multiplier Model Assume the following information for AGE stock Dividend payout = 50% Required return = 12% Expected growth = 8% D/E = 0.50 and the growth rate, g=0.08. i. What is the stock’s P/E ratio? ii. What is the P/E ratio if the required rate of return is 13%? iii. What is P/E ratio if the growth rate is 9%? The spread between k and g is the main determinant of the size of P/E ratio.  Earnings Multiplier Model Consider the previous example, with Dividend payout = 50% Required return = 12% Assume current earnings of P2.00, growth rate of 9% and current market price of P30. What would be the estimated intrinsic value?  Earnings Multiplier Model Given D/E =0.50; k=0.12; g=0.09 P/E = 0.5/(0.12 – 0.09)=16.7 You would expect E1 to be (2x 1.09) =P2.18 Intrinsic value estimate =16.7 x P2.18 =P36.41 Intrinsic value estimate (P36.41) > Market price (P30) therefore its undervalued.  Asset Based Valuation Approach The company is also estimated as being worthy the value of its net assets. The net asset value for the company should be estimated using the net realisable values. This amount would represent 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  Asset Based Valuation Approach Minergy Limited Statement of comprehensive income for the year ended 30 June 2018 Revenue - Cost of sales - Gross Profit - Operating expenses (18,077,019.00) (18,077,019.0 Operating loss 0) Finance income 1,598,248.00  Asset Based Valuation Approach Minergy Limited Statement of financial position as 31 June 2018 ASSETS Non-current assets Property, plant & equipment 1,918,090.00 Mineral exploration & evaluation expenditure 27,272,920.00 Deferred tax assets 6,660,454.00 35,851,464.00 Current assets Trade and other receivables 404,011.00  Asset Based Valuation Approach EQUITY AND LIABILITIES Capital and reserves Stated capital 109,779,735.00 Accumulated loss (19,327,743.00) Total equity 90,451,992.00 Current liabilities Trade and other payables 1,694,821.00 1,694,821.00 Total equity and liabilities 92,146,813.00  Asset Based Valuation Approach What is the intrinsic value per share of Minergy Limited.  Required Rate of Return (k) The investor’s required rate of return must be estimated regardless of the approach selected or technique applied This will be used as the discount rate and also affects relative-valuation Three factors influence an investor’s required rate of return: – The economy’s real risk-free rate (RRFR) – The expected rate of inflation (I) – A risk premium (RP) Required Rate of Return (k) The Economy’s Real Risk-Free Rate Minimum rate an investor should require Depends on the real growth rate of the economy (Capital invested should grow as fast as the economy) Required Rate of Return (k) The Expected Rate of Inflation Investors are interested in real rates of return that will allow them to increase their rate of consumption The investor’s required nominal risk- free rate of return (NRFR) should be increased to reflect any expected inflation: NRFR [1  RRFR][1  E (I)] - 1 where: E(I) = expected rate of inflation  Required Rate of Return (k) The Nominal Risk-Free Rate (NRFR) NRFR is the minimum rate of return an investor requires after taking into account expected inflation. The yield to maturity or promised return for government treasury bills or bonds with a similar maturity period to that of the investor’s holding period could be used as an estimate of NRFR. The government treasury bills or bonds are considered to be risk free.  Required Rate of Return The Risk Premium (k) The risk premium can be estimated based on the ratios that measure business risk, financial risk, liquidity risk, exchange rate risk and country risk. These risk measures for a firm can be compared against its major competitors, industry and overall market. The comparison will determine whether it requires a higher or lower risk premium as compared to its competitors, industry and overall market. Required Rate of Return (k) Estimate Required Return using CAPM Market-based risk estimate, beta could be used. It is estimated by regressing market returns on the stock’s returns. Rstock = α + βstock Rmarket where: Rstock = monthly rates of return for stock α = constant term βstock =beta coefficient for stock = Covstock,market σ2market Rmarket= monthly rates of return for a market proxy Required Rate of Return (k) The required rate of return can be estimated using the CAPM when βstock is available. E(Rstock) = E(RFR) + βstock [E(Rmarket) – E(RFR)]  Expected Growth Rate The growth rate of dividends is determined by the growth rate of earnings and the proportion of earnings paid out as dividends (payout ratio). Assuming that the payout ratio is fairly stable in the long run the growth rate of equity earnings (ROE) only requires to be estimated to determine earnings and dividend growth rate. The growth rate of earnings is equal to percentage of net earnings retained multiply by the rate of return on equity. g=(Retention Rate)x(Return on  Expected Growth Rate The retention rate of a company is dependent on decisions of management (dividend policy). Changes on ROE result from the company’s operating performance or financial leverage. ROE can be divided into three components: ROE =Net Income x Sales x Total Assets = Sales Profit x Total Asset x Total Assets Equity Financial Margin Turnover Leverage  Expected Growth Rate The first operating ratio, net profit margin, indicates the firm’s profitability on sales The second component, total asset turnover is the indicator of operating efficiency and reflect the asset and capital requirements of business. The final component measure financial leverage. It indicates how management has decided to finance the firm Using the three ratios and based on the firm’s past results and future expectations, ROE can be estimated.  Expected Growth Rate Average Growth Rate If the stock has had fairly constant dividend growth over the past 5 to 10 years, the constant growth rate could be estimated using the actual growth of dividends over the previous years. Formula Dn g n 1 D0 This historical growth rate may require to be adjusted to take into account the findings from the analyses of the economy, industry and company. Earnings per Share (EPS) An estimate of the company EPS is a function of the sales forecast and the estimated profit margin. To estimate the sales forecast an analysis of the relationship of the company sales to relevant economic and industry series (indicators) should be established first. The company’s past sales figure are compared with various economic and industry indicators to establish an indicator that has a strong linear relationship with the sales. Earnings per Share (EPS) Assuming it’s a company in the drugs retail industry we would expect there to be a strong relationship of the company sales with Personal Consumption Expenditure (PCE) Medical Care series (indicator). Based on the % change of the company historical sales and % change of the PCE medical care series an equation for the least squares regression is established.  Earnings per Share (EPS) Assuming that the equation for the least squares regression line relating to annual % change in PCE Medical indicator and company sales for the previous years considered is:  %Δ Company Sales = α + β(%Δ PCE)  %Δ Company Sales = −0.059 + 2.072 %Δ PCE Given the equation an estimate for the growth of PCE medical care for the following year is required. The estimate for PCE indicator could be easily obtained from estimates done by economists Earnings per Share (EPS) Assuming that the PCE indicator will grow by 4.1% next year. The %Δ in company sales will be:  %Δ Company Sales = αi + βi(%Δ PCE)  %Δ Company Sales = −0.059 + 2.072 (0.041) = 2.60% Assuming that the company sales for the previous year were P5 million  Earnings per Share (EPS) Once the sales figure has been estimated the next estimate is the profit margin. This can done using a direct estimate of net profit margin based on recent trends. However, this should be done after taking into account the company’s competitive strategy and the firm’s relationship with its industry that should indicate whether its past performance is attributable to the industry or unique to the firm. Assuming the net profit margin is 5% therefore forecast net profit margin will be P5.13million x 0.05 = P256,500. Earnings per Share (EPS) The tax rate also should be estimated based on the current tax rate and any recent tax legislation that affect the company’s business. If the estimate of the tax rate is 22%. The Net Profit after tax will be P256,500 x (1 – 0.22) = P200,070. If the company has 2,000,000 ordinary shares in issue. Therefore the Earnings per Share (EPS): 200,070 = P0.10 2,000,0000  Earnings Multiplier Model Combining the Constant DDM with the P/E ratio approach by dividing earnings on both sides of DDM formula to obtain Pi D1 / E1  E1 k g Thus, the P/E ratio estimate is determined by; Expected dividend payout ratio Required rate of return on the stock (k) Expected growth rate of dividends (g)  Earnings Multiplier The PE ratio that can be used for a valuation could be that of a company (or avera ge of several companies) that are similar with respect to: business risk – i.e. in the same indust ry growth – are growing at about the sa me rate finance risk i.e. have approximately t