Equity valuation

Agenda Equity
Intrinsic value
Steps & application of equity valuation
Beta
Cost of equity
Wacc
Required Rate Of Return
Porters five forces
Phases of business

Agenda Equity
Valuation models
Stock Valuation Using The Dividend Discount

Model
Gordon Growth Model
Free Cash Flow Valuations
Road to the Intrinsic value

Intrinsic value
Finding the true value of an asset based on the assumption of
its tangible & intangible factors

Steps & application of equity

valuation

Understanding the business

Forecasting the company performance
Selecting the appropriate valuation model
Converting forecasts to a valuation
Applying the valuation conclusions

beta
Beta: A measure of the volatility, or systematic risk, of a
security or a portfolio in comparison to the market as a whole

Beta is calculated using regression analysis,

Beta is the tendency of a security's returns to

respond to swings in the market.

A beta of 1 indicates that the security's price will
move with the market.
A beta of less than 1 means that the security will be
less volatile than the market.
A beta of greater than 1 indicates that the security's
price will be more volatile than the market.

Cost of equity
COST OF
EQUITY

CAPM

MULTIFACTO
R MODEL

STATISTICAL
MODELS

Ri R f i ( Rm R f )

FAMA AND
FRENCH

MACRO
ECONOMIC
MODELS

Cov (i, m)
m2

BUILD UP
METHOD

PASTORS
STAMBAUGH
Model

BOND YEIL
PLUS RISK
PREMIUM

wacc
Weighted Average Cost Of Capital

Def: WACC is nothing but the total cost for the suppliers of

capital to the firm.

WACC is composed of :
Cost of Equity
Cost of Debt
So the calculation would be : amount of equity/ total capital x cost

of equity + amount of debt/ total capital x(1-t)= WACC

The tax rate should be the marginal tax rate
WACC is used for the valuation of the firm. For Eg. In FCFF

valuation the discount rate would be WACC.

Required Rate Of Return

Relevance Of Using A Particular
The rate at which we discount should be relevant to the

characteristics of the cash flows

Equity valuation: Since we are trying to find the value of

equity then we would use cost of equity

E.g.: Dividend Discount Valuation, Free Cash flow to Equity,
Residual Income Valuation
Firm valuation: If we are trying to value the firm as a

whole then we would use the WACC

E.g.: Free Cash flow to the firm

Competitive Factors- Impact On

Price & Cost Analysis
Porters
Threat
fiveof
forces
substitutes

Phases of business

Valuation models
Absolute valuation model:
An absolute valuation model
is one
that estimates an assets
intrinsic value,
which arises from its
characteristics
without comparing it with
other firms
E.g.: dividend discount
model,
free cash flow model etc
Relative valuation model:
This model values assets on
the basis
of its value compared to other
assets
E.g.: P/E ratio, P/B ratio etc.

VALUA

TION
MODE
LS

ABSOL

RELATI

UTE

VE

RESID
DDM

FCFF

THE APPROACH USES

THE PRESENT VALUE

OF THE FUTURE
CASHLOWS AND
FINDS THE VALUE OF
THE ASSET NOW

UAL
INCOM
E
MODE
L

P/E,

P/B.,P/
CF

IF THE RATIO IS

HIGHER THAN THE

BENCHMARK THEN
OVER VALUED ELSE
UNDERVALUED

Stock Valuation Using The Dividend

Discount Model
One Period DDM

V0

D1 P1
1 r

D1- Dividend at year end 1

P1- Price at year end 1

Multiple Period DDM

or

Dt
Pn
V0

t
(1 r ) n
t 1 (1 r )

Dt
t
t 1 (1 r )

V0

13

Gordon Growth Model

The GGM has four variables:
1 g
D1
1. Price
V0 D0 *

2. Dividend
rg rg
3. Growth rate
4. Required return
.If we have 3 variables we can solve for the fourth

14

Free Cash Flow Valuations-Approaches

FCFF
Used
Highly
Stable
Low
Approach
leverage
when
capital
levered
capital
structure
firmstructure is unstable
FreeFCFE
Cash
Flow

15

Free Cash Flow Valuations

Enterprise
Value

FCFFt

1 WACC
t 1

FCFF: cash available to shareholders and bondholders after taxes, capital investment

and Working Capital investment

FCFEt
Equity Value
t

r
t 1
e
Equity Value Firm Value MV of Outstanding Debt
FCFE: Cash available to share holders after payment to and from bondholders

16

FCFF AND FCFE: VARIOUS

APPROACHES TO CALCUATE

FCFF

={EBIT(1-T)+DEP-FCIinv-WCinv

={EBITDA(I-T)+DEP*TAX RATE- FCI inv-WCinv

=CFO+{Int*(1-Tax rate)- FCI inv

=NI+ Non Cash Charges+Int (I-T)- FCI inv-WCInv

FCFE

=FCFF-Int(1-t)+Net Borrowing

=CFO- FCI inv+Net Borrowing

=NI+ Non Cash Charges- FCI inv-WCI inv+Net Borrowing

Imp

Approaches To Calculate Free Cash Flow

Calculating
FCFF

Income Statement = EBITDA*(1-t) + Dep*t WCInv FCInv

Net Rev

100

COGS

30

EBITDA

70

= EBIT*(1-t) + Dep -WCInv FCInv Depreciation

= 60*(1-30%) + 10 10 30
= 12

= 70*(1-30%) + 10*30% 10 30
= 12

10

EBIT

60

Interest

10

NI/PAT

35

= NI + Dep + Int*(1-t) WCInv FCInv

= 35+10+10*(1-30%)-10-30

Cash Flow
Statement

= 12

= CFO + Int*(1-t) FCInv

WCInv

10

= 35 + 10*(1-30%) 30

CFO

35

= 12

FCInv

30

Tax Rate, t = 30%

18

Imp Cash
Approaches To Calculate Free
Flow
Calculating
FCFF

= NI + Dep WCInv FCInv + Net Borrow

Income Statement
Net Rev

100

COGS

30

EBITDA

70

FCFF Int*(1-t) + Net Borrowing

Depreciation
= 12-10*(1-30%)+15
= 20

= 20

10

EBIT

60

Interest

10

NI/PAT

= 35+101030+15

=
35NI (1-DR)*(FCInv - Dep) - (1-DR)* WCI
= 35-(1-0.5)*(30-10)-(1-0.5)*10

Cash Flow
Statement

= CFO FCInv + Net Borrowing

= 35-30+15
= 20

WCInv
CFO
FCInv
Net
Borrowing

= 20

10
35
30
15

Tax Rate, t = 30%

Target Debt Ratio, DR = 0.5
19

Road to the Intrinsic value

Step 1

Projection of B/S , P/L

Step 2

Assumption

Step 3

Revenue & Cost built up

Step 4

Debt built up

Step 5

Asset built up

Road to the Intrinsic value

Step 6

Other Calculation

Step 7

Cash flow statement

Step 8

Ratio analysis

Step 9

valuation