Summary INV3701- Equity Asset Valuation STUDY NOTES.

INV3701- Equity Asset Valuation STUDY NOTES. EQUITY - Equity is what the shareholders own from an entity e.g. ordinary shares, preference shares & Retained earnings. JUSTIFY VALUATION Valuation is the estimation of an asset’s value based on: 1. Variables perceived to be closely related to future investment returns such as * interest rates * Price appreciation * Management 2. Comparison with closely similar assets * shares of similar companies * industry (benchmarking) DEFINE VALUE In simple terms value means or answers the question: How much is an asset worth looking into the future? a) INTRINSIC VALUE – The value of an asset given complete understanding of the asset’s investment characteristics, a number of factors are considered when calculating intrinsic value and these differ from investor to investor. b) MARKET PRICE – The value of an asset which is determined by the forces of demand and supply in the market (trading price of the asset) The difference between intrinsic value and market price is called mispricing, if MP IV asset is overvalued, (mispriced) if MP IV asset is undervalued (mispriced), if MP = IV asset is fairly valued. c) GOING CONCERN VALUE – The value of a company (intrinsic value) under a going concern assumption. Assumption: The company will continue its business activities into the foreseeable future *focus of the module d) LIQUIDATION VALUE- Value of a firm’s assets if it were to be dissolved and its assets sold individually *not as a unit USES OF VALUATION Stock selection – Investors need to value assets to be used in a portfolio, valuation helps to select assets that the investor desires. Extracting market expectations – When an asset is overvalued or undervalued we expect mispricing to be corrected (Price increase or decrease) Evaluating co-operate events – Companies ought to be valued pre and post certain corporate events such as: mergers and acquisitions Expression of fairness – Is the asset fairly valued? Overvalued or undervalued? Communication tool – Valuation acts as a communication tool for *management * Shareholders * Analysts Evaluation if business strategies and models – corporate strategies and business models determine the value placed on a company THE VALUATION PROCESS 1. UNDERSTANDING THE BUSINESS 2 Compiled by: M Tshuma • Evaluate industry prospects – Economic and technological factors • Competitive position – Companies compete with each other for sales, what’s the company’s competitive advantage? • Corporate strategies – What does the firm intend to do? 2. FORECASTING COMPANY PERFOMANCE • Top down approach • Bottom up approach 3. SELECTING THE APPROPRIATE VALUATION MODEL a) ABSOLUTE VALUATION MODELS – These models specify the intrinsic value of an asset, they are also called present value models * Dividend discount valuation models * Residual income model * FCFF and FCFE b) RELATIVE VALUATION MODELS – The models compare values of similar assets (benchmarking) * Price multiples * Enterprise value multiples 4. CONVERTING FORECASTS INTO A VALUATION MODEL - The forecasted fundamentals (inputs to the model) are used to calculate the intrinsic value. *Dividends forecast – Dividend Discount Model *Cash flow forecast – FCFF or FCFE Models *Residual Income – Residual Income Model 5. MAKE THE INVESTMENT DECISION - After valuing the asset is it worth investing in it? Undervalued (MP IV) Buy the asset, Overvalued (MP IV) Sell it or don’t buy. DEFEND THE ROLE OF ANALYSTS IN CAPITAL MARKETS • Analysts collect, organise, analyse and communicate corporate information • Recommend appropriate investment actions based on their analysis • Contribute to the efficient functioning of capital markets • Contribute to the welfare of shareholders by monitoring the actions of management - Macro-Economic factors e.g. Exchange rates, inflation - Industry Forecasts – Economic & technology factors - Company Forecasts – Use financial statements - Macro-Economic factors e.g. Exchange rates, inflation - Industry Forecasts – Economic & technology factors - Company Forecasts – Use financial statements 3 Compiled by: M Tshuma RETURN CONCEPTS a) HOLDING PERIOD RETURN - Return earned from investing in an asset over a specified time period ( Ending value/Beginning value)-1 or ( Ph/Po)-1 or (Ph + Ct/Po)-1 or Ph- Po/ Po Po – Beginning investment value Ph – Ending investment value Ct – Cash inflow from the investment Realized Return (Actual) – Selling price (Ph) and Cash inflow (Ct) are known Expected Return – Selling price and cash inflows are not known they are just estimates b) ALPHA CONCEPT - Alpha is an asset’s excess risk adjusted return, the value by which the returns exceed risk * risk is measured by the required return Ex ante alpha = Expected HPR – Required Return Ex post alpha = Actual HPR- Required Return Alpha *simple terms = Return – Required Return c) REQUIRED RETURN - The minimum level of Expected return that an investor requires in order to invest, given the asset’s riskiness - Expected return Required return **undervalued** buy asset, opp is true - The required return is also known as the cost of equity (common stock) and the cost debt (debt securities) - As required return in the minimum level of expected return, this simple means that the expected return is made up of required return + certain elements (price convergence to value) Therefore, expected return = Required Return + ( IV- MP/MP) - e.g. Required return- 7.6%, Market price- R63.16, Intrinsic value- R71.00 *Calculate expected return & Alpha E.R = 7.6% + (71- 63.16/63.16) = 20% Alpha = 20% - 7.6% = 12.4% 4 Compiled by: M Tshuma d) DISCOUNT RATE - Any rate used to find the present value of a future cash flow, this can be the required return, or weighted average cost of capital (WACC) - The discount rate reflects the compensation to investors for delaying consumption of their funds e) INTERNAL RATE OF RETURN - The discount rate that equates the present value of the asset’s expected future cash flows to the asset’s price CF/1+r = P.V IRR will be the r* that makes P.V equal to Price f) THE EQUITY RISK PREMIUM - The incremental return (premium), that investors require for holding equities rather than risk free assets - Required Return – Risk free Return = EQRP - Required return = EQRP + Risk free return g) RISK FREE RETURN/RATE - Long term government bonds or short term bond’s yields or returns, government securities are assumed to be risk free. h) THE REQUIRED RETURN ON EQUITY - The analyst can estimate the required return on equity of a particular issuer through: • Capital asset pricing model (CAPM) • Multifactor models ( Farma French Model) • Build-up Models (Bond yield plus Risk premium) CAPM - The model that links non diversifiable risk and return for all assets, basically provides a way of calculating required return based on systematic risk (beta) Required return = Risk Free + Beta (Equity risk premium) e.g. Rf – 5%, beta – 1.20, EQRP – 4.5% R.R = 5 + 1.20 (4.5) = 10.4% FARMA FRENCH MODEL - The CAPM describes risk incompletely as it adds a single risk premium to the risk free rate - The multifactor models aim to explain that returns are affected by a lot of variables/factors - The FFM adds two more factors to the CAPM *SMB (Small – Big) portfolio size factor *HML (High – Low) portfolio value factor 5 Compiled by: M Tshuma r = CAPM + Bsize (SMB) + Bvalue (HML) e.g RF * 4.7%, Beta * 1.14, EQRP * 5.5%. Size beta * -0.222, Size Premium * 2,7% Value beta * -0.328, Value Premium * 4.3% r = 4.7 + 1.14 (5.5) + (-0.222 x 2.7) + (-0.328 x 4.3) = 8.96% - The FFM can be extended to include the liquidity premium (Extended FFM BOND YIELD RISK PREMIUM - Required return can be calculated by adding a bond return + a risk premium, usually long term government bond yields are used. e.g Long term Treasury bond yield – 10% Equity risk premium – 3% R.R = 10% + 3% = 13% i) WEIGHTED AVERAGE COST OF CAPITAL - WACC is the total cost of capital expressed in percentage form (cost of debt + cost of equity) - Used to discount the value of the whole firm WACC = (We x Ce) + (Wps x Cps) + (Wd x Cd(1-t) We – Weight of equity (common stock) Ce – Cost of equity Wps – Weight of preference shares Cps – Cost of preference shares Wd – Weight of debt Cd – Cost of debt t – Tax rate e.g We – 50%, Ce – 13% , Wps – 10%, Cps – 10%, Wd – 40%, Cd(before tax) – 14%, tax rate – 30% WACC = (0.50 x 13) + (0.10 x 10) + (0.40 x 14(1-0.30) = 11.42% 6 Compiled by: M Tshuma STUDY UNIT 2: CHAPTER 3: DIVIDEND DISCOUNT VALUATION MODELS - On the previous study unit, valuation was defined and the different types of value were discussed. It was stated as well that we focusing on calculating intrinsic value based on the going concern assumption. - The value of any asset is the present value of its expected future cash flows *dividends *residual income * free cash flow Value = Cash flow/1 + r r = discount rate used - The dividend discount valuation model (DDM) is most suitable for dividend paying stock, with a clearly defined dividend policy - The model is also useful if the investor has a non-control perspective (minority ownership position) - Given a finite holding period return (n) the general expression for DDM is: Value = D1/(1+r)n + Pn/(1+r)n - Dividends grow in different patterns, therefore this results in different DDMs to value shares a) ZERO GROWTH MODEL - If the stock is a perpetuity (fixed dividend), the formula for calculating value is as follows: Value = Dividend /required return - The z growth model is used to value preference shares and other no growth stock. b) GORDON/COSTANT GROWTH MODEL - This model assumes that dividends grow @ a constant rate forever, required return is always assumed to be greater than growth rate (rg) Value = D0 (1 + g)/ r – g or Value = D1/ r – g D0 – is the recent/current year dividend/previous year dividend D1 –Next year/ Expected dividend - We use D1 when evaluating, if given D0 we adjust for growth rate as done above to get D1 - Example: R.R – 10%, Dividend paid – R10, Growth rate – 5% Value = R10 (1.05)/0.10 - 0.05 = R210.00 7 Compiled by: M Tshuma GORDON GROWTH MODEL CONCEPTS - The Gordon model can be used to calculate other fundamentals such as: return, implied growth rate, PVGO RETURN CALCULATION r = D1 / P0 + growth or D0 (1 + g)/ P0 + growth e.g D0 – R10, M.Price – R10, growth rate – 5% Expected Return = R10 (1.05)/ R50 + 0.05 = 0.26 or 26% VALUING SHARES WITH NEGATIVE GROWTH - The GGM can be used as well to value shares with negative growth, worked example below Expected dividend – R4.25, dividends will decline @ 10% forever, required return – 12% Value = R4.25/ 0.12 – (-0.10) = R19.32 IMPLIED GROWTH RATE - The GGM can be used to infer the market’s implied growth rate for a stock, given the other variables of GGM, we can calculate what growth rate is implied by the market price. Example Beta – 1.1, RF – 5.6%, ERP – 6%, D0 - R2, g – 5%, M.price – R40 *Determine stock value *Determine the rate of growth required to justify the market price of R40 VALUE RR = 5.6 + 1.1 (6) = 12.2% **used CAPM** Value = D0 (1 + g)/ r – g = R2 (1.05)/ 0.122 – 0.05 = R29.17 - The growth rate of 5% gives R29.17, therefore a higher growth rate is required to justify the MP of R40 GROWTH RATE 40 = 2(1 + g) / 0.122 – g *cross multiply 8 Compiled by: M Tshuma 4.88 – 40g = 2 + 2g 4.88 – 2 = 40g + 2g 2.88 = 42g 2.88/42 = 42g/42 6.86 = g growth rate implied is 6.28% THE PRESENT VALUE OF GROWTH OPPORTUNITIES - The value of a stock can be analysed as 1. The value of company without earnings reinvestment (No growth) 2. The present value of growth opportunities (PVGO) - If a company has a chance of investing in projects that yield a positive NPV, analysts place a high value on it (PVGO) compared to a company with no growth opportunities Value = Earnings/required return + PVGO e.g. EPS – R0.79, R.R – 9.25%, Price R18.39 *Calculate PVGO R18.39 = R0.79/0.0925 + PVGO R18.39 – R0.79/0.0925 = PVGO = R9.35 *NB: Value is the same as price, you can be further asked to determine the fraction or percentage value contributed by PVGO * R9.35/R18.39 = 0.5084 or 51% GORDON GROWTH MODEL AND THE PRICE TO EARNINGS RATIO - P/E is a price multiple valuation model, used to value companies on a relative basis, this is covered in detail on the last study unit - It can be used as well to determine fairness of the value expressed in the market and intrinsic value - P/E can be expressed in terms of the trailing 12 months EPS and can also be expresses in terms of the leading (forward) E.PS *next 12 months - Calculating P/E using the above (trailing and forward EPS) gives the actual P/E *All the infor used is obtained from the actual financial and pro forma statements - P/E can also be obtained by using the forecasts of the inputs to the GGM * r, g, div*, if these forecasts are used we get the justified P/E (Both trailing and leading) VALUE No growth value + PVGO 9 Compiled by: M Tshuma - The justified P/E can then be compared to the actual P/E to determine whether a company is undervalued, overvalued or fairly valued JUSTIFIED LEADING P/E P/E = ( D /EPS) / r – g or 1 – b / r – g JUSTIFIED TRAILING P/E P/E = (D/EPS) (1 + g) / r – g or (1 – b) (1 + g) / r – g P – Price, E – Earning per share, D – dividend, b – Retention ratio, D/E – Dividend pay-out ratio, 1 – b * Dividend pay-out ratio. EXAMPLE Stock price – R47.46, Annual EPS – R3.22, Dividends – R1.03, Growth rate – 7%, RF – 4.4%, EQRP – 6.39%, Beta – 0.72 *Calculate justified leading and trailing P/E *Determine whether the company is fairly valued or not? SOLUTIONS Determine required return *r = 4.4 + 0.72 (6.39) = 9% Leading P/E = (R1.03/R3.22) / 0.09 – 0.07 = 16 Trailing P/E = (R1.03/R3.22) (1.07) / 0.09 – 0.07 = 17.11 Actual P/E = R47.46 / R3.22 = 14.74 *EPS given is the 12 months trailing EPS *When comparing the justified and actual P/E, treat justified as intrinsic value and actual as the MP, if these two are not equal then there is mispricing (under/overvalued) Justified Trailing P/E (17.11) Actual Trailing P/E (14.74) *Company is undervalued *Intrinsic value Market price = Undervalued *Intrinsic value Market price = Overvalued c) MULTI-STAGE DIVIDEND DISCOUNT MODEL - A stable growth assumed by the constant growth model is not realistic for many companies, they experience different stages of growth and the dividend paid is determined accordingly. - Growth Phase – Supernatural growth, dividends pay-out is low more funds are retained - Transition Phase – At this stage the dividend pay-out increases, the firm transitions to a mature growth phase - Maturity Phase – The dividends become stable, GGM is suitable to value stock at this stage 10 Compiled by: M Tshuma TWO STAGE DDM - Two versions exist 1. General two stage model 2. The H model, both versions assume constant growth at the maturity phase. GENERAL TWO STAGE MODEL - Stage 1 represents abnormal growth e.g. 15%, the transition to mature growth is general abrupt (e.g. 15% to 2%) STEPS FOLLOWED Find the value of dividends in all growth stages Find the terminal value using the Gordon growth model Find the present value of the dividends and the terminal value Value = ∑ Div/1 + r + Terminal value/1 + r Example Current dividend – R 0.14, Growth rate 15% for 5 years then after that growth settles to a constant growth rate of 5%, required return – 9.7% STEP ONE STEP TWO D00 - R0.14 Terminal VL = D6/ r - g D1 - R0.14(1.15) = R0.1610 = R0.2957/ 0.097-0.05 D2 - R0.1610(1,15) = R0.1852 = R6.2914 D3 - R0.1852(1.15) = R0.2129 D4 - R0.2129(1.15) = R0.2449 D5 - R0.2449(1.15) = R0.2816 D6 - R0.2816(1.05) = R0.2957 STEP THREE Cflo0 - 0 I/YR - 9.7% Cflo1 - R0.1610 NPV - R4.7685 or R4.77 Cflo2 - R0.1852 VALUE = NPV Cflo3 - R0.2129 VALUE = R4.77 Cflo4 - R0.2449 Cflo5 - R0.2816 + R6.2914 11 Compiled by: M Tshuma THE H-MODEL - The H-model assumes a smoother transition to the mature growth phase, growth begins at a high rate and then declines linearly throughout the supernatural growth phase until a constant rate is achieved (low normal rate) Value = Do (1+gL) + Do (H) (gs – gL) / r – gL H – Half the number of years of the high growth period gs – Short term dividend growth (Initial) gL – Normal long term growth rate Do – Dividend paid Example Share price – R57, Dividend – R1.57, Initial growth – 24% which declines linearly over 12 years, long term growth rate – 6%, required return – 10%