EXECUTIVE SUMMARY

A hypothesize of sound investing is that an investor does not pay more for an asset
than it is worth. This statement may seem logical and obvious, but it is forgotten and
rediscovered at some time in every generation and in every market. There are a
number of factors that affect a stock’s price and its value to investors.
Valuation plays a key role in many areas of finance -- in corporate finance, in
mergers and acquisitions and in portfolio management. There are three basic,
though not mutually exclusive, approaches to equity valuation. The simplest model
for valuing equity is the dividend discount model -- the value of a stock is the
present value of expected dividends on it.
The second model is discounted cash flow valuation, where cash flows are
discounted at a risk-adjusted discount rate to arrive at an estimate of value. The
analysis can be done purely from the perspective of equity investors, by discounting
expected cash flows to equity at the cost of equity, or it can be done from the
viewpoint of all claimholders in the firm, by discounting expected cash flows to the
firm at the weighted average cost of capital.

The third model is relative valuation, where the value of the equity in a firm is based
upon the pricing of comparable firms relative to earnings, cash flows, book value or
sales.

Overall, the results of the empirical analysis indicate that widely used models for
equity valuation are Dividend Discount Model and Free Cash Flow to the Equity.
But the main question arises that which approach we will use. If there is a
probability that a firm can be taken over or its management changed, the market
price will reflect that likelihood and the appropriate benchmark to use is the value
from the FCFE model. As changes in corporate control become more difficult, either
because of a firm's size and/or legal or market restrictions on takeovers, the value
from the dividend discount model will provide the appropriate benchmark for
comparison.
But why this equity valuation is too important despite of fallen stock market. As we
seen in the last month, a sharp drop in the prices of stocks, worldwide. These
movements have had an impact in India also. However many analyst says that
Current equity valuations are cheap so this is the best time to accumulate equity.

RESEARCH METHODOLOGY

TITLE: “Risk &Returns to Equity Valuation”

OBJECTIVES OF THE STUDY

The objectives of the study are as follows:

 Explain the methodology for determining the value of the firm and the value
of equity.

 Show the use of the present value concepts in the valuation of shares and
bonds.

 Learn about the linkage between the share values, earnings and dividends
and the required rate of return on the share.

 Finally to know the valuation of Indian stock market.

SCOPE

In order to examine the different Equity Valuation Models secondary market data
has been used. Various practical problems have been analyzed for selecting stock,
inferring market expectation, rendering fairness opinion etc.

LIMITATION
There was no live data available for equity valuation. Due to various approaches
available it was not possible to arrive at a single valuation. Volatility in the market
economy equity valuation of many organizations is not up to the mark.

EXECUTIVE SUMMARY

A hypothesize of sound investing is that an investor does not pay more for an asset
than it is worth. This statement may seem logical and obvious, but it is forgotten and
rediscovered at some time in every generation and in every market. There are a
number of factors that affect a stock’s price and its value to investors.

Valuation plays a key role in many areas of finance -- in corporate finance, in

mergers and acquisitions and in portfolio management. There are three basic,
though not mutually exclusive, approaches to equity valuation. The simplest model
for valuing equity is the dividend discount model -- the value of a stock is the
present value of expected dividends on it.

The second model is discounted cash flow valuation, where cash flows are
discounted at a risk-adjusted discount rate to arrive at an estimate of value. The
analysis can be done purely from the perspective of equity investors, by discounting
expected cash flows to equity at the cost of equity, or it can be done from the
viewpoint of all claimholders in the firm, by discounting expected cash flows to the
firm at the weighted average cost of capital.

The third model is relative valuation, where the value of the equity in a firm is based
upon the pricing of comparable firms relative to earnings, cash flows, book value or
sales.

Overall, the results of the empirical analysis indicate that widely used models for
equity valuation are Dividend Discount Model and Free Cash Flow to the Equity.
But the main question arises that which approach we will use. If there is a
probability that a firm can be taken over or its management changed, the market
price will reflect that likelihood and the appropriate benchmark to use is the value
from the FCFE model. As changes in corporate control become more difficult, either
because of a firm's size and/or legal or market restrictions on takeovers, the value
from the dividend discount model will provide the appropriate benchmark for
comparison.
But why this equity valuation is too important despite of fallen stock market. As we
seen in the last month, a sharp drop in the prices of stocks, worldwide. These
movements have had an impact in India also. However many analyst says that
Current equity valuations are cheap so this is the best time to accumulate equity.
 INTRODUCTION TO THE TOPIC

EQUITY VALUATION : RISK &RETURNS

We are now on session three of Equity Instruments. This session continues the discussion of
the discounted cash flows valuation model.

Professor Damodaran explains that cash flows to equity are cash flows after debt payments
and that cash flows to firm are cash flows before debt payments. When valuing a company
using cash flows to firm, one needs to use the cost of capital when discounting the cash flows
and then you need to subtract out debt.

and stick with it. Don’t mix and match. I must admit that in the past I’ve gotten confused and
probably mixed and match components of valuing stocks by discounting cash flows to equity
and valuing stocks by discounting cash flows to firm. The professor point out three main
mistakes that you need to watch out for, which include:

Discounting cash flows to equity at the cost of capital to get equity value

Discounting cash flows to firm at cost of equity to get firm value

Discounting cash flows to firm at cost of equity, forget to subtract out debt, and get too high
a value for equity

Make sure that you don’t make any of these mistakes the next time you try to value a stock.
When you see net income being used to value a company, you can tell that what is being
discounted is the cash flows to equity and that the cost of equity should be used for the
discounting. These distinctions are important because the cost of debt is cheaper than equity.

Professor Damodaran breaks down discounted cash flows (DCF) valuation into 5 steps on
slide 11 of the course presentation. This a very important slide that I recommend you review
it. DCF boils down to:

Getting the current cash flows.

Getting the growth rate for those cash flows in the near term.
Determining when the company will enter stable growth

Choose a discount rate to apply to the cash flows

The dividend discount model is the most basic DCF model. This model strictly looks at the
flows of cash flows to equity in terms of dividends paid to shareholders. This method was
detailed in 1938 by John Burr Williams in his classic book, The Theory of Investment Value.

There are several problems with this dividend discount technique. It is not a problem if a
company is not able to pay a dividend right now, but if the company will be unable to pay a
dividend in the future this method breaks down. Companies that payout dividends that are
different than what they can afford to payout are a real problem under this method.

The dividend discount model often will result in too low a value since cash flows left over
after paying dividends are considered burned up. One way around this drawback is to focus
on what a company could have paid out in dividends. You just replace actual dividends with
potential dividends. This then basically becomes the cash flows to equity model.

The other DCF approach looks at cash flow to the firms. This is predebt cash flows. All you
value is operating income. Then you add back other assets like cash and subtract out the
debt. This is basically the method I often use when I value stocks by discounting future free
cash flows (operating cash flows minus capital expenditures).

After briefly reviewing the main valuation models, the course shifts gear into looking at DCF
inputs. The rest of this session focuses on the discount rate. Professor Damodaran admits
that discount rates are not as critical as getting the cash flows right and the growth rates of
those cash flows. I tend to give very little attention to discount rates when I value a
company. However, I am curious as to how the “professionals” determine discount rates.

The professor makes a few points about cash flows. First you pick the currency that will be
used for both cash flows and for determining the discount rate. Also, if you do your cash
flows in nominal terms, then your discount rate needs to be in nominal terms. Nominal
simply means that the rates haven’t been adjusted for inflation. For the most part, you will
likely use nominal rates because they are the easiest to get directly.
Damodaran thinks its irrelevant to think in terms of how much risk we individually see in a
company when valuing it. I don’t agree with that point. If institutional investors do not see
much risk in a particular company, but my own research of a company results in me seeing
lots of risk and I’m right about that risk, then my individual view on risk is indeed important.

Professor Damodaran also briefly discussed the major ways the costs of equity is determined.
The models include CAPM, Arbitrage Pricing Model (APM), multi factor, and the proxy
model. The CAPM method is made up of three factors:

Beta – Risk in the stock that cannot be diversified away

Risk free rate – The average rate on risk free securities

Risk premium

I personally do not think it is worth spending too much effort on determining the cost of
equity for discounting future cash flows. I’d rather assume a constant discount rate for all
equities and then adjust my margin of safety to address company specific risk. Max left a
comment in the previous lesson that also questions estimating cost of capital using betas and
country risk premiums.

I did find the discussion of the risk free rate to be of interest. The risk free rate should have
no default risk. This excludes corporate bonds, so we are really looking at government bonds.
However, not all government bonds are risk free.

In addition, the risk free rate should have no reinvestment risk associated. This reinvestment
risk comes from the potential that when for example a six month T-bill needs to be
reinvested, there is the real risk that interest rates on T-bills could drop. Professor Damodaran
recommends that we should match up cash flow lengths to the length of bonds used to
determine the risk free rate. I tend to use the 10 year U.S. Treasury Note for my risk free rate.
Basically for equity valuation, the risk free rate should be derived from long term securities
that are default free and match the currency of cash flows. The U.S. geometric average risk
free rate from 1994-2004 is 4.51%. Professor Damodaran mentions that using the U.S. rate
for risk premium could be biased since the U.S. equity market was the most successful in the
twentieth century. A lower risk premium of 4% over a range of countries may be more
appropriate (see slide 28).
share price per dollar of real capital will be relatively high. This induces managers to issue
more shares in order to raise funds to create additional real assets in their firm. The result is a
sequence of events that looks like market-timing. It is, however, fully rational as opposed to
the typical context in which that term is used.

Second, the apparent market market timing behavior by firms, coupled with the
exogenous labor capital supply shocks, leads to the return predictability of equity issuance.
Consider a positive labor created capital shock. When this occurs risk-averse investors
require a price discount on the stock that now owns the additional capital since they have to
accommodate a larger supply of the real underlying assets. However, this discount then
induces the firm to sell real assets (i.e. repurchase its own shares) to reduce its capital stock.
The o setting capital supply forces of labor and investment make each firm’s total capital
supply mean-reverting. Thus, negative shocks to the prices induce share repurchases
(negative net equity issuance), followed by an upward drift to the mean price levels on
average.

Third, the model quantifies the negative relation between net equity issuance and subse-
quent returns. Since this relation derives from a risk-return trade-o , the expected return is
proportional to the market price of the risk, which is further proportional to the variance of
investors’ future wealth. A cross-sectional implication, therefore, is that a unit equity
issuance leads to lower subsequent returns for more volatile stocks relative to their less
volatile coun-terparts. Conversely, controlling for the level of volatility, stocks with larger
equity issuance should experience stronger underperformance subsequently.

Before taking the model’s implications to the data, we demonstrate its empirical
relevance via calibration. The model is fit to the data by matching it to its two key quantities:
net equity issuance and return variance. From there additional empirical implications are
brought out

2
that allow it to be tested via market data using as yet unconducted tests.

Finally, the paper presents an empirical analysis of the model’s predictions. We form
portfo-lios by two dimensional sorting on net equity issuance and return volatility. Our equity
issuance measure is adjusted for nominal share changes such as stock dividends and splits
and therefore captures only real share changes. Consistent with the model’s predictions,
stocks with larger equity issuance experience lower subsequent returns controlling for
volatility. Similarly, stocks with higher return volatility earn substantially lower returns
controlling for the level of equity issuance. The returns on the zero investment portfolio that
goes long the least volatile stocks and short the most volatile stocks is 1.00% (t = 3.32)
monthly. The performance of this long-short portfolio is persistent as it earns a monthly
excess return of 0.57% (t = 2.03) even if it is held for the next six months. A concern,
however, is that these excess returns may represent reward for bearing known risk. To
examine this point, we compute risk-adjusted returns by re-gressing portfolio returns on the
market, size, value, and momentum factors. The risk-adjusted return, whose means equal the
alphas from the four factor model by construction, on the long-short volatility portfolio is
significant at all volatility levels and reaches 1.07% (t = 5.89) in the highest equity issuance
group. We further conduct panel regressions to test, and confirm, the cross-sectional
restriction that the model imposes.

Our paper makes three contributions to the existing literature. First, the theory produces
the market-timing behavior of firm managers and the negative return predictability of equity
issuance in an economy populated by only rational agents who optimally execute their trans-
actions. Second, the model numerically demonstrates these points using returns rather than
prices. This is useful since empirical work is conducted on returns and not the price changes
typically generated within the negative exponential utility-normal payo framework. Finally,

3
the empirical analysis confirms a novel prediction that, controlling for the equity issuance,
more volatile stocks earn lower future returns.

The rest of the paper is organized as follows. The next section sets up the model, solves
for an equilibrium, calibrates the parameters, and derives empirical implications. Section 2
presents empirical evidence. Section 3 provides extensions and discussions. The final section
concludes.
The economy contains K firms. Each firm lives forever. As in most overlapping generations
models people live for two periods. Those born in period t come endowed with labor capital
that they sell to firms which convert it to corporate capital. In period t + 1 the old generation
sells its holdings of stocks and bonds, consumes its claim to the economy’s single
consumption good and then dies.

At the beginning of period t, capital units pay a vector of random dividends of the con-
sumption good,
Dt = Dt−1 + δt,

where δt is a K vector of dividend shocks. The δt vector is distributed multivariate

normally

with mean zero and variance-covariance matrix Σδ .

The size of the firms’ production base, Nt varies over time. For example, firms purchase
new

machinery and equipment during expansions and scale back during contractions. This portion
of changes in the production base, as a result of the firm managers’ optimal choices, is
denoted
by yt. Expansions are financed with equity sales and contractions with equity
repurchases.

In the model real assets Nt also vary randomly with the new generation’s
(random) en-

dowment of labor capital. In each period the new generation arrives with labor capital that
can be sold to firms which will then convert it into ηt units of corporate capital. The model

assumes all agents and firms act competitively which implies that labor capital is sold to
firms at that period’s equilibrium market price for the corporate capital it will produce. With
these assumptions, the production base vector, Nt, evolves through the following dynamics:

Nt = Nt−1 + ηt + yt. (1)

Stocks are claims to these production technologies. For analytical tractability it is useful to
set the number of shares in a firm equal to its capital stock. Therefore, Nt also represents
number

of shares outstanding. Thus, yt equals net equity issuance to investors, and ηt the
payment in

shares to labor in exchange for selling their supply shock to the firm. All these variables are
K vectors. The model also assumes that ηt is distributed multivariate normally with mean
zero
and variance-covariance matrix Ση .

The riskless bond is in perfectly elastic supply and pays r > 0 units of the consumption
good as interest at the beginning of each period. It serves as numeraire for the economy and
thus always sells for the price of unity. The gross interest rate is denoted by R = 1 + r.

In each period, a new generation is born. They have a mass of unity and as described
above come endowed with a personal share of labor supply and units of the bond. People
derive utility from consumption of the single good. They possess a negative exponential
utility with a constant absolute-risk aversion parameter θ. After the stocks and the bond pay
their owners
at the beginning of period t, trading takes place. All agents form rational expectations about
the market prices of stocks.

Each firm manager seeks to maximize proceeds from the issuance or repurchase of his
own firm’s shares. Investors provide liquidity to the market by absorbing the shares issued.
All agents observe current prices, dividends, supply levels, shares issued, and the whole
history of these quantities.

1.2 Equilibrium

The model’s solution is found by conjecturing a price process, solving for its unknown
param-eters and verifying that the result is a Nash equilibrium. Market participants
conjecture that prices Pt follow,
Pt = ANt + BDt, (2)

where A and B are K by K matrices to be determined. This paper only examines stationary
equilibria in which these coe cient matrices are time invariant. Given the supply process of
real assets in (1), this price function implies that there is a price impact associated with new
capital purchases or sales Ayt. As will be seen below this comes about because risk averse
investors require a premium for holding real assets that are in relatively abundant supply.
Firm k’s manager decides the net issuance, ykt, of his own firm’s shares to maximize the
proceeds,
0 0
max yktpkt = ykt(ak Nt + bk Dt), (3)
y
kt

where pkt is his firm’s share price and a0k and b0k are the k’th row of the A and B matrices,
respectively. Note that the vector products inside the parentheses in Equation (3) are scalars.
 The investors maximize their expected utility. Let Xt be their stock position. The
investors’

future wealth, Wt+1, is

W
+1 = X0Q +1 + RW , (4)
t t t t

Q
t+1 ≡ Pt+1 + Dt+1 − RPt, (5)

where Wt is their exogenously given endowment. Qt+1 represents the vector of payo s
from the

zero-investment portfolio that purchases one share of each stock financed by a short position
in the bond. We call Qt+1 “excess payo s.” By the property of the negative exponential utility,
the investors’ utility maximization problem, maxEt[− exp(−θWt+1)], amounts to
maximizing

The second order condition is met if V art(Qt+1) is positive definite. Because investors
absorb

the shares issued in each period, they collectively hold the total shares outstanding at any
time
Xt = Nt. (8)

This is the usual equilibrium condition that prices equilibrate per capita demand and
supply.
 The following theorem characterizes the equilibrium prices and the managers’ equity-
issuance

strategy.

Theorem 1 (Equilibrium) There exists an equilibrium if the coe cient matrices in the price
function (2) are a real-valued solution to the following system of nonlinear matrix equations:

0 = AF −1A + rA + θDAF −1AΣη A0F 0−1DA

+ θ(I + DAF −1B)Σδ (I + DAF −1B)0, (9)

B = (AF −1 + rI)−1, (10)

F = A + DA , (11)

where DA is a negative definite diagonal matrix containing the principal diagonal of A. The
vector of optimal equity issuances is given by

yt = −DA−1Pt. (12)

Proof. All proofs are contained in the Appendix.

Note that, by substituting equations (10) and (11) into (9), the “system” of nonlinear
matrix equations presented in this theorem reduces merely to a single nonlinear matrix
equation for A. Since all diagonal elements of D A are negative in equilibrium, Equation (12)
immediately

When A is a diagonal matrix or a scalar, Equations (11) and (10) reduce to F = 2A and B =
2
1+2 r I, respectively. This can occur when there is a single security (K = 1) or when there

are multiple but independent securities whose supply and dividend shocks are cross-
sectionally uncorrelated (i.e., Σδ and Ση are diagonal). Substituting the simplified expressions
for F and

B into Equation (9) yields the following result.

Corollary 1 (Equilibrium with independent securities) When there is a single security (K = 1)

or multiple securities with cross-sectionally uncorrelated supply and dividend shocks (Σδ and
Ση
are diagonal), the equilibrium is characterized by the price function

2
P = AN + D,
t t 1 + 2r t (13)

where A is a diagonal matrix satisfying the following quadratic matrix equation:

2 −1 2
AΣη A + θ (1 + 2r)A + 4[1 + (1 + 2r) ] Σδ = 0. (14)

The A matrix is always negative definite if it is a solution to this equation. The vector of

optimal equity issuances is given by

yt = −A−1Pt. (15)
 Since all the diagonal elements of A are negative in equilibrium, Equation (15) again
implies that a firm’s manager issues more shares as the market price of his firm’s stock rises
and vice versa (Proposition 1). Additionally, explicit expressions allow us to examine the
relation
between the state variables of the economy and equity issuance. First, substituting the price
function (13) into Equation (15), we see that equity issuance and hence the supply of shares
to marginal investors depends on the fundamentals (dividends) inherent in prices. Thus, the
level of equity issuance can vary with the business cycle and rise in periods of good
economic conditions with strong output. This is another distinction of our model from
Spiegel (1998) and Watanabe (2008), in which supply of shares is exogenously given and is
independent of dividends.

Second, equity issuance (real capital investment) tracks stock price changes. The risk
neutral value equals the Dt term in Equation (13). Adding the “discount” ANt (recall that A is
negative
definite) yields the market prices on the left hand side. A smaller discount implies a higher
market price which induces the firm to create real assets by raising money through an equity
issuance. Importantly, this suggests that equity issuance predicts future returns, because
higher current prices imply lower expected returns. The next section examines this possibility
in detail.

1.4 RETURN PREDICTABILITY OF EQUITY ISSUANCE

So far the analysis has examined prices. But for empirical work the paper’s results need to be
reworked in terms of returns. Since investors are mean-variance optimizers (see Equation
(6)), the relationship between expected returns and risk is completely characterized by the
first two moments of the expected excess payo s. The following corollary calculates these
moments.

Corollary 2 (Expected excess payo s) The expected excess payo s are given by
Et[Qt+1] = −θV A−1DA yt + Dt, (16)
where V ≡ V art(Qt+1). In particular, when there is a single or multiple but
independent

securities (denoted by superscript “ind”), the expressions simplifies as

Et[Qindt+1] = −θV yt + Dt. (17)

Equation (17) for the expected excess payo s in independent markets is particularly in-
sightful. Note that V is diagonal in this case and all of its diagonal elements are positive.
Thus, ceteris paribus, larger net equity issuance (real capital investment) predicts lower
future returns. Furthermore, the magnitude of this e ect is stronger for high volatility stocks.

With this in mind, we derive empirical hypotheses using simulated returns from the
general model. Define the excess return vector, rt+1, and the relative net share change vector,
zt, as

rt+1 ≡ Qt+1 Pt = DP,t−1Qt+1, zt ≡

yt Nt−1 = DN,t−1−1yt,

where is the elementwise division operator and D P,t−1 and DN,t−1−1 are the diagonal matrices
containing Pt and Nt−1, respectively, in their main diagonal. Let the k’th element of r t+1 and zt
be rk,t+1 and zk,t, respectively. A regression analogue of Equations (16) and (17) using the
return is
V ar
t−1 (zk,t)

11
r
k,t+1 = γk,t−1zk,t + ε
k,t+1, (18)
γ
k,t−
1 = Covt−1(rk,t+1, zk,t) . (19)
The γ coe cient in Equation (19) involves a ratio of normals and can be computed most con-
veniently by simulation.2 In doing so, we carefully choose the parameter values of the model
to match the key quantities: the conditional variance of individual stock returns, σ r,k,t2−1 ≡ V
art−1(rk,t), and the mean normalized share change, zk,t−1 ≡ Et−1[zk,t]. These are the sorting keys
that we will use in the empirical analysis below. We choose parameter values so that
simulated σr,k,t2−1 = 0.00112 and zk,t−1 = 0.00549 in the high volatility equilibrium to be iden-
tified below. These are the monthly means over the 30 industry portfolios defined on
Kenneth French’s web site (the aggregate figures without first collapsing stocks to industry
portfolios are 0.00119 and 0.00579, respectively). We simulate 100, 000 draws at each set of
parameter values with moment matching and a variance reduction technique known as
antithetic sampling. An important consideration in a negative exponential utility-normal payo
framework is to ensure positive prices. The probability of such an event, however, can be
made arbitrarily small with proper parameter choices. We ensure that prices, dividends, and
supply at time t − 1, t, and
t + 1 are almost positive at any point in the simulation.3

Two caveats follow before proceeding further. First, Equation (18) is a univariate sim-ple
regression rather than a multivariate multiple regression that Equation (16) implies when A is
nondiagonal. Second, in Equation (16) yt is correlated with Dt (see Equation (A2) in

the Appendix), whose omission will generally bias the γ coe cient in Equation (18). These
assumptions are made for numerical tractability in the simulation and for empirical ease
when confronted with the data. In any case, our goal here is not to prove a proposition, but to
derive
2
The univariate distribution of a ratio of normals is known as the Fieller distribution
(Fieller (1932)). We need to go further and consider the joint distribution between the ratio of
normals, rk,t+1, and a normal variable, yk,t (scaled by 1/Nk,t−1 ), given the time t −1 information
set. Yatchew (1986) discusses how to obtain a joint density function involving ratios of
multivariate normals. Even if the density function has a closed form, moments may not; see
Yatchew (1985, 1986).
3
In our simulation, negative values of these quantities occur only a few out of
100,000 draws.
 refutable empirical hypotheses.
1 ρA
Figure 1 plots the elements of A = a . The parameter values are shown in
ρA 1

the caption. We numerically search for the range −0.99 ≤ ρA ≤ 0.99 and find two
equilibria.4

These equilibria exhibit contrasting levels of the common diagonal element, a (Panel A).
While it is negative in both equilibria, the equilibrium marked by stars yields a much larger
absolute value of a. Panel B indicates that the o -diagonal ratio, ρA, is zero in these equilibria.
Figure 2 plots simulated equilibrium quantities. Panels A and B present the common
2
variance (σr,k,t−1) and the cross-sectional correlation (ρr,t−1) of returns, respectively, where
ρ
2 1 r,t−1
V ar (r ) = σ
t−1 t r,k,t−1 . These panels tell us the following properties of the
ρr,t−1 1

two equilibriu:

• Stars: low volatility,

• Circles: high volatility.

While the return variance is almost invariant with the supply shock volatility in the low
volatility equilibrium, it decreases in the high volatility equilibrium (Panel A). At the
leftmost point in the high volatility equilibrium, the return variance takes the fitted value of
0.00112 (at that point, zk,t−1 also takes the fitted value of 0.00549, which is not depicted).
Panel B indicates

that cross-sectional return correlation is zero in both equilibria. This confirms the findings of
Spiegel (1998) and Watanabe (2008) using returns rather than the prices that they work with.
A new implication is presented in Panel C, which depicts the γ coe cient in Equation (19).

4
The number of equilibria is hard to pin down due to the lack of analytic solutions in the
general case. Spiegel (1998) and Watanabe (2008) find 2 K equilibria in a K-security model.
Trial computation at other parameter values indicates that there can be four equilibria, two of
which exhibit positive and negative return correlation even if all underlying shocks are cross-
sectionally uncorrelated. Such correlated equilibria are discussed in Watanabe (2008).
The coe cient is negative in both equilibrium, and in the case of high volatility equilibrium, the graph is
roughly the mirror image of the return variance in Panel A. Therefore, the implication from Equation
(17) appears to hold in return space as well. We summarize these results as the following empirical
hypothesis, which will be examined in the next section:

Hypothesis 1 (Equity issuance and expected return)

A. Controlling for return variance, stocks with higher normalized share changes (investment) have
higher subsequent returns.

B. Controlling for normalized share changes (investment), stocks with a higher return vari-ance have
higher subsequent returns.

The final part of this class looked at estimating the risk free rate using various techniques for other
countries, especially emerging markets. I’m not sure why using the average global rate would not be
more appropriate since using a country specific rate for an emerging country might be downwardly
biased.

Country Equity Risk Premiums

This week’s class started on the topic of country equity risk premiums on slide 32 of the Discounted
Cashflow Valuation presentation (pdf). Professor Damodaran started out by noting that India just
received an investment grade rating for the first time. One typically expects as country risk goes down
that usually expect equity values go up. This wasn’t really clear for India’s stock prices after the rating
increase earlier this year.

I had a few issues with the discussion of country equity risk premiums, so I’ll keep this short.

Assume that every company in the country is equally exposed to country risk.
Assume that a company’s exposure to country risk is similar to its exposure to other market risk (i.e.,
Beta).

Treat country risk as a separate risk factor and allow firms to have different exposures to country risk
(perhaps based upon the proportion of their revenues come from non-domestic sales)

I think the third approach made the most sense. In this approach, Damodaran creates a term he labels λ.
This lambda measures a company’s risk exposure to a country

based upon the proportion of its revenues that come from non-domestic sales, location of its production
facilities, and use of risk management products. The thought here is that a company’s country risk
exposure is determined by where it does business, not necesarily by where it is located. Really, the only
practical component of country risk that can be easily measured is the proportion of revenues generated
by a company in each country.

Damodaran looks at how sensitive a company is to country risk by regressing it its earnings to the
country’s bond rate. There is also a cross market risk factor. If the Russian stock market collapse, it still
causes impacts in far away Singapore. Damodaran believes there is a joint risk factor among emerging
markets. I think this is a reasonable assumption given how global markets have become and also based
on my experience at seeing how a market shock in China can ripple throughout all the world markets.

equity research analysts may be assigning too much risk to some emerging market companies that
generate most of their revenues in developed stable countries such as the US. He then lays out a
strategy for taking advantage of this potential miscalculation. He recommends identifying a few
companies in each country that generate most of their revenues in stable countries. Then under this
strategy we should wait for a crisis in an emerging market before investing. I like the concept of
waiting for a crisis, but I think two other things need to be factored in. First, I think in addition to
selecting emerging market companies that generate most of their revenues in stable countries, we
should also give preference to those companies that have global competitive advantages. Second, we
should be cautious in investing after a crisis in an emerging market if critical infrastructure utilized by a
selected company has been severely damaged or if property rights are in danger of collapsing.

Lower and more stable interest rates are good for equity risk. Shifting equity risk premiums comes
from investors’ stomachs. Each morning we wake up with a different gut sense of how risky the world
is and this collective gut sense impacts the mood of Mr. Market. Most daily fluctuations in stock prices
come from changes in our perceived risk.

I found it interesting that Damodaran notes that historical risk premiums (probably the most commonly
used) are too high and will result in you finding stocks to be overvalued. Using the current implied
equity risk premium is more market neutral. The average implied equity risk premium between 1960-
2003 in the United States is about 4%. When using the historical implied equity risk premium, you are
assuming that the market is correct on average but not necessarily at any given point in time.
Beta

Beta is probably the least useful topic in this course, but it is still good to know what it is. The standard
procedure for estimating betas is to regress stock returns against market returns. The slope of the
regression is Beta. In reality, regression beta calculations are a waste of time because they depend
highly on the index chosen.

There are a few non-regression based methods for estimating Beta. You could look at the standard
deviation in stock prices instead of regressing against an index. You could also regress accounting
earnings or revenues against those of an index. This seems somewhat more attractive but still probably
not worth the effort.

I recommend looking at slide 54, which has a diagram of beta of equity. I think this slide does a good
job at breaking down the sources of potential risk faced by companies. The diagram breaks risk down
into risks that come from the nature of the products and/or services provided by a company, the amount
of fixed costs in proportion to total costs, and obviously financial leverage. I would add a category for
the risks associated with bad management and the risks associated with loosing any competitive
advantages a company may have due to increasing competition or potential technological change.

This lecture ended on the topic of bottom up beta. This is Damodaran’s preferred method and what he
will discuss in the next lecture.

Often statements on the annual return of the stock market are made in order to show the percentage you
will receive if you put your money in stocks and leave them there to stay over the long term. However,
a 10% annual return is usually taken out of the context and as a result many beginner investors are
misled.

So, the next time you hear that the stock market generates 10% return on the investments made in the
stock market you should stop and ask which investments in particular will generate these returns.
Additionally, the purchase of several stocks will not guarantee you these returns but on the contrary
may bring you losses.
Additionally, no specification on which portion of the market will give you the dreamed 10% return.
For instance, if you purchase mutual funds, they will track the behavior of such indexes as the Russell
3000 or the Russell 5000, which represent a big portion of the market. But, looking at their
performance records, no significant results have been shown.

What is more, by purchasing individual stocks, you are not buying the market. So, the performance of
the market is of little concern to you.

What you should pay special attention to is the performance of your overall investment portfolio. You
can also make regular comparisons to different benchmarks (e.g. the S&P 500) to get a view on the
performance of your investments.

In order to achieve good financial results, you should stick to the purchase of quality stocks. The latter
should meet your financial goals ignoring the statements of the potential 10% stock market returns.

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VALUATION

The term “valuation “implies the task of estimating the worth/value of an asset, a security, or
a business. The price an investor or a firm (buyer) is willing to pay to purchase a specific
asset/security would be related to this value.

Therefore equity valuation is;

EQUITY VALUATION

“Determining the total value of a company involves more than reviewing assets and revenue
figures.”

An equity valuation takes several financial indicators into account; these include both
tangible and intangible assets, and provide prospective investors, creditors or shareholders
with an accurate perspective of the true value of a company at any given time.

Equity valuations are conducted to measure the value of a company given its current assets
and position in the market. These data points are valuable for shareholders and prospective
investors who want to find out if the company is performing well, and what to expect with
their stocks or investments in the near future.

Valuation methods based on the equity of a company typically include a thorough analysis of
cash accounts, as well as a forecast or projection of future dividends, future earnings
(revenue) and the distribution of dividends.
FEATURES OF EQUITY VALUATION

Following are the features of Equity Valuation;

 Equity Valuation is a highly specialized process.

 Like other assets in finance, the value of a stock is the Present Value of its Cash Flow’s.

 The total equity of a company is the sum of both tangible assets and intangible
qualities. Tangible assets include working capital, cash, and inventory and shareholder
equity. Intangible qualities, or intangible "assets," may include brand potential,
trademarks and stock valuations.

 The valuation may also take the firm's enterprise value (EV) into account; this is
calculated by combining the net debt per share with the price per share. Performance
indicators include the price/earnings ratio, dividend yield, and the Earnings Before
Interest, Depreciation and Amortization (EBIDA).

 Any company under consideration for sale needs proficient, objective valuation,
whether its stock is privately owned by one individual or publicly traded on one or
more of the major exchanges or in the over the counter market.

 Stocks are typically valued as perpetual securities as corporations potentially have an

infinite life, and thus can pay dividends forever.

NEED OF EQUITY VALUATION

There are several reason for which we need Equity Valuation,

 Initial Public Offer

 Merger and Demerger
 Purchase/sale of equity stake by joint venture partners
 Liquidation
 Separation
 Disinvestment ,etc

THE ROLE OF EQUITY VALUATION

Valuation is useful in a wide range of tasks. The role it plays, however, is different in different
arenas. The following section lays out the relevance of valuation in portfolio management, in
acquisition analysis and in corporate finance.

 PORTFOLIO MANAGEMENT

The role that valuation plays in portfolio management is determined in large part by the
investment philosophy of the investor. Valuation plays a minimal role in portfolio
management for a passive investor, (Passive investors, feel that simply investing in a market
index fund may produce potentially higher long-term results.) whereas it plays a larger role
for an active investor. (Activist investors take positions in firms that have a reputation for
poor management and then use their equity holdings to push for change in the way the
company is run. Their focus is not so much on what the company is worth today but what its
value would be if it were managed well. )
Among security selectors, valuation plays a central role in portfolio management for
fundamental analysts, and a peripheral role for technical analysts.

 VALUATION IN ACQUISITION ANALYSIS

Valuation should play a central part of acquisition analysis. The bidding firm or individual
has to decide on a fair value for the target firm before making a bid, and the target firm has to
determine a reasonable value for itself before deciding to accept or reject the offer.

 VALUATION IN CORPORATE FINANCE

There is a role for valuation at every stage of a firm’s life cycle. For small private businesses
thinking about expanding, valuation plays a key role when they approach venture capital and
private equity investors for more capital.

 VALUATION FOR LEGAL AND TAX PURPOSES

Though it may seem, most valuations, especially of private companies, are done for legal or
tax reasons. A partnership has to be valued, whenever a new partner is taken on or an old one
retires, and businesses that are jointly owned have to be valued when the owners decide to
break up or businesses have to be valued for estate tax purposes when the owner dies. While
the principles of valuation may not be different when valuing a business for legal
proceedings, the objective often becomes providing a valuation that the court will accept
rather than the “right” valuation.

BENEFITS OF EQUITY VALUATION

 A thorough analysis of tangible and intangible assets allows prospective investors,
shareholders and financial managers of a company to obtain critical performance data
about the company's business operations.

 When an investor attempts to determine the worth of her shares based on the
fundamentals, it helps her make informed decisions about what stocks to buy or sell.

 Valuation compares the benefits of a future investment decision with its cost.

 The equity valuation method takes several types of data into account, and can be used
as part of a prediction model to determine the economic future of the company.

 The valuation also provides some indication of the level of risk involved in investing in
the company.

 The determination of right value of equity is essential to maintain a long term success
of investment.
EQUITY VALUATION VERSUS FIRM VALUATION

The value the entire business, with both assets-in-place and growth assets; this is often termed
firm or enterprise valuation.
The second way is to just value the equity stake in the business, and this is called equity
valuation.

Therefore,
 Equity Valuation, value just the equity stake in the business
 Firm Valuation, value the entire firm, which includes, besides equity, the other
claimholders in the firm
COMMON TERMS FOR EQUITY VALUATION

 BOOK VALUE

Book value is the value at which assets are shown in the balance sheet. It is also referred to as
net worth.

Book value of a business refers to total book value of all valuable assets (excluding fictitious
assets such as accumulated losses and deferred revenue expenditure, like advertisement,
preliminary expenses, cost of issue of securities not written off) less all external liabilities
(including preference share capital).

 FACE VALUE

The nominal value of a security stated by the issuer. For stocks, it is the original cost of the
stock shown on the certificate. In the case of stock certificates, face value is the par value of
the stock.

 MARKET VALUE
Market value refers to the price at which an asset can be sold in the market. The market value
can be applied with respect to tangible assets only. Intangible assets (in isolation) more often
than not, do not have a sale value.

Market value of a business refers to the aggregate market value of all equity shares
outstanding.

Market value is relevant for listed companies only.

  INTRINSIC VALUE

The intrinsic value of a share is the present value of all future amounts to be received of the
ownership of that share, computed at an appropriate discount rate. The intrinsic value is
asset’s true value regardless of the market price. The determination of intrinsic value may be
subject to personal opinion and vary among individual analysts.

 FAIR VALUE

Fair value is the average of book value, market value and intrinsic value.

Fair Value = Book Value + Market Value + Intrinsic Value

3

 LIQUIDATION VALUE

Liquidation value represents the price at which each individual asset can be sold if business
operations are discontinued in the wake of liquidation of the firm.

In operational terms the liquidation value of business is equal to sum of

 Realizable value of assets and

 Cash and bank balance minus the payment required to discharge all external
liabilities.

Among all measures of value the liquidation value of asset/liabilities is the least.

 REPLACEMENT VALUE

Replacement value is the cost of acquiring a new asset of capital utility and usefulness.
  TIME VALUE OF MONEY

Time value of money refers to a concept that money available now is worth more than the
same amount in the future because of its potential earning capacity. As time pass there is cost
to using money. The sooner money is received the more valuable it is because it can be
invested an earn interest.

The value of money received today is different from the value of money received after some
time in future because of inflation, risk, personal consumption preference, investment
opportunities.

Present Value of money calculated as;

Present value = PV = FV
(1 + i) n

Where:

PV = present value (today's value),

FV = future value (a value or cash flow sometime in the future),

i = interest rate per period, and

n = number of compounding periods

And [(1 + i) n] is the compound factor.

  RATE OF RETURN

The required of return if found by Capital Asset Pricing Model (CAPM Method). The method
used to calculate an appropriate discount rate uses the investment's beta. This is a measure of
the amount of risk that the investment would have.

The discount rate used in a CAPM is:

R or Ke = rf + ( β × (rm - rf))

Where:

rf = risk free rate

rm = expected return on the market and

β = beta of the cash flows or security being valued.

The term rm - rf is the market risk premium. The term β×(rm - rf) is the risk premium on the
cash flows (or security) being valued.

If the securities being valued are shares it is usual to use the equity risk premium and the beta
of the share against the stock market.

Example:

Security J has a beta of 0.75. Calculate rate of return of security assuming that Rf = 5% and
expected market return = 14%.

Solution:

Rate of Return (Ke) = rf + ( β × (rm - rf))

= 5 + 0.75(14-5)
 = 11.75%

Therefore Rate of Return (Ke) = 11.75%

DISCOUNT RATE

The Discount Rate used in the present value models in the investor’s required rate of return.
This has to take into consideration the time value of money as well as the risk of security in
which the investment is proposed to be made. The time value of money is represented by the
risk free interest rate such as those on government securities. A premium is added to this risk
free interest rate to take care of the risk to be borne by the investor by investing in the
particular share. The more risky the investment the greater the risk premium that the investor
will require

EQUITY VALUATION MODELS

A good valuation model is simple and helps investors to make informed decisions. Analysts
use a wide range of models to value assets in practice, ranging from the simple to the
sophisticated. These models often make very different assumptions about pricing, but they do
share some common characteristics and can be classified in broader terms. There are several
advantages to such a classification -- it makes it easier to understand where individual models
fit into the big picture, why they provide different results and when they have fundamental
errors in logic.
 EQUITY VALUATION MODELS

Present Value Method Discounted Cash flow Asset Based Other Approaches
Approach
 1 Year Holding Period  Free Cash Flow to  EVA
the Equity  MVA
 Multi Year Holding
Period

Dividend Discount Model Methods of comparable

(Ratio Based)
 Gordon Model
 Multiple Growth Model  P/E Ratio
 PEG Ratio
 Relative P/E Ratio
 P/BV Ratio
 P/Sales ratio

1. PRESENT VALUE METHOD

The valuation model used to estimate the intrinsic value of a share is the present value model.
The intrinsic value of a share is the present value of all future amounts to be received of the
ownership of that share, computed at an appropriate discount rate. The major receipts that
come from the ownership of a share are the annual dividends and the sale proceeds of the
share at the end of holding period. These are to be discounted to find their present value
using a discount rate that is the rate of return required by the investor, taking into
consideration the risk involved and the investor’s other investment opportunities.

The investment decision of the fundamental analyst to buy or sell a share is based on the
comparison between the intrinsic value of a share and its current market price. If the market
price is lower than the intrinsic value then such a share is bought and is perceived to be under
priced. If the market price is higher than the intrinsic value then such a share would be
considered as overpriced and is sold.

Following are two methods in Present Value Method,

a. ONE YEAR HOLDING PERIOD

It is easy to start valuation with one year holding period assumption. Here an investor
intends to purchase a share now, hold it for one year and sell it off at the end of one year. In
this case the investor would be expected to receive an amount of dividend as well as the
selling price after one year.

Example:

If an investor expects to get Rs3.50 as dividend from a share next year and hopes to sell off the
share at Rs45 after holding it for one year and if his required rate of return is 25%, the present
value of this share to the investor can be calculated as follows;

Cash Inflow Discount Rate (PVIF @ 25%) Column 1 * 3

3.50 0.8 2.8
45 0.8 36
Total 38.8

Therefore Present Value of Share = Rs 38.8

 MULTIPLE YEAR HOLDING PERIOD
An investor may hold a share for a certain number of years and sell it off at the end of his
holding period. In this case he would receive annual dividends each year and the sale price of
the share at the end of the holding period.

For example:

If an investor expects to get Rs3.50, Rs4, and Rs4.50 as dividend from a share during the next
three years and hopes to sell it off at Rs75 at the end of the third year and if his required rate
of return is 25% the present value of the share to the investor can be calculated,

Year Cash Inflow Discount Rate (PVIF @ 25%) Column 2 * 3

1 3.50 0.8 2.8
2 4.0 0.64 2.56
3 4.5 0.512 2.304
3 75 0.512 38.4
Total 46.064

Therefore Present Value of Share = Rs 46.064

DRAWBACK OF THE PRESENT VALUE METHOD

 Probably the biggest drawback in the previous two examples was that we had to
predict a selling price.

 The buyer of the stock, when we sell it, will presumably go through a similar
procedure to value the stock – in other words the buyer will be using future dividends
to value the stock.

 The selling price of the stock should thus be the value of all future dividends.
Given investors can hold a common stock for over a year, it is useful to value a stock over the
investor’s expected holding period. In this case, the DDM model can be used.

2. DIVIDEND DISCOUNT MODEL

The simplest model for valuing equity is the dividend discount model. The only cash flow we
receive from a firm when we buy publicly traded stock is the dividend and appreciation of its
value. The appreciation of the value is nothing but the expected price of the stock. But the
expected price is itself determined by the future dividends. Hence the value of a stock is the
present value of expected dividends on it.

The General Model,

The rationale for the model lies in the present value rule - the value of any asset is the present
value of expected future cash flows discounted at a rate appropriate to the riskiness of the
cash flows.

∞
Value per share of stock = ∑ DPS
t=1 (1+ k)

There are two basic inputs to the model - expected dividends and the rate of return. To obtain
the expected dividends, we make assumptions about expected future growth rates in earnings
and payout ratios .To know more about DDM model first we have to understand growth
periods i.e. High growth period, transition period and stable growth period.
THINGS TO BE REMEMBER WHILE DETERMINING GROWTH RATES,

 Key premise:

A firm’s value can be approximated by the sum of the high growth period plus a stable
growth period.

 Key risk:

Sensitivity of terminal values to choice of assumptions about stable growth rate and discount
rate associated with that period.

 Stable growth rate:

The firm’s growth rate that is expected to last forever. Generally equal to or less than the
industry or overall economy’s growth rate. For multinational firms, the growth rate is the
world economy’s rate of growth.
  Length of the high growth period:

The greater the current growth rate of a firm’s cash flow relative to the stable growth rate, the
longer the high growth period.

There are several dividend discount models based on different assumptions for the
calculating the value of the stock. Some of them are,

a. GORDON MODEL
Gordon Model also known as Constant Growth Model. The Gordon growth model can be
used to value a firm that is in 'steady state' with dividends growing at a rate that can be
sustained forever. The Gordon growth model is best suited for firms growing at a rate
comparable to or lower than the nominal growth in the economy and which have well
established dividend payout policies that they intend to continue into the future. The
dividend payout of the firm has to be consistent with the assumption of stability, since stable
firms generally pay substantial dividends.

According to the model, the value of the stock is given by,

Value of the Stock = DPS (1+g)

r-g

Where,
DPS = Expected Dividends Per Share during next period
r = Required rate of return for equity investors
g = Growth rate in dividends forever

For Example:
XYZ Ltd. had earning per share of Rs.10.16 last year and paid out 52% of its earning as
dividends. It’s earning and dividend had given at 4% per year in the last 4 years and are
expected to grow at the same rate in the long-term. The required rate of return on the stock of
XYZ Ltd. is 12%. Compute the Value of the Stock using Gordon’s Model.

Solution:

EPS = Rs. 10.16

DPS = 0.52 (EPS)

= 0.52 (10.16)

= Rs. 5.28

Expected growth rate in earnings and dividends = 4%

Value of the Equity = DPS (1+ g)

r-g

= 5.28 (1+ 0.04)

(0.12- 0.04)
= 68.64

Therefore Value of Share of XYZ Ltd. = Rs 68.64

DRAWBACK OF THE GORDON METHOD;

 The use of this model is restricted to firms that are growing at a stable rate. The
assumption that the growth rate in dividends has to be constant over time is a difficult
assumption to meet, especially given the volatility of earnings.

 Assumed growth rate may be incorrect.

 The growth rate is equal to the required rate of return, then the value of the stock
approaches infinity. If the growth rate is higher then the required rate of return, then
the value of the stock becomes negative. A firm cannot grow in the long-term at a rate
in the economy.

 The false assumption is that investors will hold shares for infinite period of time.

b. MULTIPLE GROWTH MODEL

The constant growth assumption may not be realistic in many situations. The growth in
dividends may be at varying rates. A typical situation for many companies may be that a
period of extraordinary growth (either good or bad) will prevail for a certain number of years
after which growth will change to a level at which it is expected to continue indefinitely. This
situation can be represented by a Multiple Growth Model also known as - two stage growth
model.

In this model the future time period is viewed as divisible into two different growth segments
the initial extraordinary growth period and the subsequent constant growth period. During
the initial period growth rates will be variable from year to year while during the subsequent
years the growth rate will remain constant from year to year.

The model can be adapted to value companies that are expected to post low or even negative
growth rates for a few years and then revert back to stable growth. According to the model,
the value of the stock is given by,
 Value of the stock = PV of dividends during supernormal growth +
PV of terminal price

Example,

A company paid a dividend of Rs1.75 per share during the current year. It is expected to pay
a dividend of Rs2 per share during the next year. Investor forecast a dividend of Rs3 and
Rs3.50 per share respectively during the subsequent years. After that it is expected that
annual dividends will grow at 10% per year into an indefinite future. The required rate of
return is 20 %. Calculate the value of the stock.

Solution,

Calculation of PV of dividends during supernormal growth,

Year Future Value PVIF @ 20% PVIF * F.V

1 2.0 0.833 1.66
2 3.0 0.695 2.085
3 3.5 0.578 2.023
Total 5.77

Calculation of PV of Terminal Price,

Pn = DPS (1 + g)
(r – gn) (1 + k)^n
Where,
Pn = Price at the end of year n
DPS = Expected dividend per share in year t
0
r = required rate of return
gn = Steady state growth rate forever after year n

P3 = DPS (1 + g)
(r – gn) (1 + k)^3

= 3.50 (1+ 0.10)

(0.20 – 0.10) (1+ 0.20) ^3
= 22.28

Value of the stock = 5.77 + 22.28

= 28.05

Therefore value of the stock after supernormal growth period is Rs. 28.05

DRAWBACK OF THE MULTIPLE GROWTH MODEL;

There are three problems with the two-stage dividend discount model – the first two would
apply to any two-stage model and the third is specific to the dividend discount model.

 The practical problem is in defining the length of the extraordinary growth period.
Since the growth rate is expected to decline to a stable level after this period, the value
of an investment will increase as this period is made longer. It is difficult in practice to
convert these qualitative considerations into a specific time period.

 The second problem with this model lies in the assumption that the growth rate is high
during the initial period and is transformed overnight to a lower stable rate at the end
of the period. While these sudden transformations in growth can happen, it is much
more realistic to assume that the shift from high growth to stable growth happens
gradually over time.
  The focus on dividends in this model can lead to skewed estimates of value for firms
that are not paying out what they can afford in dividends. In particular, we will under
estimate the value of firms that accumulate cash and pay out too little in dividends.

3. DISCOUNTED CASH FLOW

The discounted cash flow (or DCF) approach describes a method of valuing a project,
company, or asset using the concepts of the time value of money. A valuation method used to
estimate the attractiveness of an investment opportunity.

All future cash flows are estimated and discounted to give them a present value. There are
different types of DCF model i.e. Cash flow to equity model, Cash flow to firm model,
adjusted present value model.

FREE CASH FLOW TO EQUITY (FCFE)

The free cash flow model estimates the value of equity as the present value of the expected
free cash flow to equity over time. This is a measure of how much cash can be paid to
the equity shareholders of the company after all expenses, reinvestment and debt repayment.
The free cash flow to equity is defined as the residual cash flow left over after meeting interest
and principal payment and providing for capital expenditure to maintain existing assets and
create new assets for future growth.
FCFE VALUATION WORKS BEST;

 This approach is easiest to use for assets (firms) whose

• Cash flows are currently positive and

• Can be estimated with some reliability for future periods, and

• Where a proxy for risk that can be used to obtain discount rates is available.

 It works best for investors who either

• Have a long time horizon, allowing the market time to correct its valuation
mistakes and for price to revert to “true” value or

• Are capable of providing the catalyst needed to move price to value, as would
be the case if you were an activist investor or a potential acquirer of the whole
firm

DRAWBACKS OF FCFE MODEL;

 Since it is an attempt to estimate intrinsic value, it requires far more inputs and
information than other valuation approaches.

 These inputs and information are not only noisy (and difficult to estimate), but can be
manipulated by the savvy analyst to provide the conclusion he or she wants.
 CONCLUSION

The Dividend Discount Model is the simplest of the valuation methods available. But it often
criticized as being of limited value. It is a conservative model that finds fewer applications in
today’s dynamic environment. However, since the valuation is based on the company’s
fundamentals, it is still considered to be a more reliable measure. Additional measure like
P/E Ratio, P/S Ratio, and P/BV Ratio are also discussed since they are based upon readily
available information in the financial statements of a firm. Measure which gained popularity
in the recent past such as EVA, MVA which are considered to be more reliable is also
explained. The impact of minority interest discounts, controls and other discounts on the
price of a security is dealt in depth.

Equity Valuation is very important in every aspect of financial management. However the
stock markets around the world are nearing the bottom and P/E Ratio is also cheap and
stocks are available at 1/10th of its peak value so if investor wants to invest for a long term
and also who is willing to bear some risk they can invest now.
RECOMMENDATIONS

 Investor should not make use of only one approach for valuation; they should go for
alternative approaches.

 They should also go for potential application to the valuation and testing for impairment of
acquisition of goodwill.

 If any investor or company wants to invest or takeover other firm then they should go for firm
valuation rather than equity valuation.

BIBLIOGRAPHY

 Magazines

 Indian Economy Review- Capital Market

 Books

 Equity Valuation and Analysis- ICFAI University

 Corporate Finance- By Aswath Damodaran
 Financial Management- By Khan and Jain
 Financial Management Analysis- By Frank .J. Fabozzi and Pamela. P. Pererson
 An empirical study of the discounted cash flow model (pdf)- by Martin
Edsinger, Christian Stenberg

 Web sites

 www.valueadder.com
 www.marketorcle.uk
 www.equitymaster.com
 http://moneyterms.co.uk/
 www.ehow.com
 www.bajajelectricles.com.