Finance

1. Stock valuation Part-II
Prof. Trilochan Tripathy
XLRI- Xavier school of Management,Jamshedpur

2. Cash Flow of Bond vs. Equity Investor
Firm
Equity
Debt
Net Income
Interest
(fixed income)
May Pay
Dividend
(variable residual
income)
Retained
Earnings

3. Cash Flow of Bond vs. Equity Investor
Bond Investorcash Flow
𝑃𝑉 =
𝐶1
1 + 𝑟 1 +
𝐶2
1 + 𝑟 2 + ⋯ +
100 + 𝐶𝑛
1 + 𝑟 𝑛
• Predictable Coupon Cash flow
• Predictable Terminal Value
Equity Investor cash flow
𝑉 =
𝐶1 =?
1 + 𝑟 =? 1 +
𝐶2 =?
1 + 𝑟 =? 2 + ⋯+
𝑇𝑉 =?+𝐶𝑛 =?
1 + 𝑟 =? 𝑛
• Cash flow to Owner is Unpredictable
• Difficult to Predict Terminal Value

4. Why Cash Flows are uncertain for
equity investor?
• Dividend and dividend growth
• Interestrate risk
• Reinvestmentrisk
• Credit/defaultrisk
• Inflationary risk
• Liquidity risk
• Exchange rate risk
• Politicalrisk
• Etc.

5. What Causes Stock Prices to Go Up
and Down?
Can you Guess??
Can we value the stock?

6. Can we value the stock?

7. Equity Shares Characterization & Valuation
– Equity shares in general are characterized by:
• Ownership and management
• Entitlement to residual cash flows
• Limited liability
• Infinite life
• Substantiallydifferent risk profile
-Thus, equity shares valuation is not that easy like
bonds.

8. Efficient market Hypothesis
Efficient Market Hypothesis
-Security are in equilibrium, which means they are fairly priced
(expected returns= required returns)
-Security prices accurately reflect available information, and
respond rapidly to new information as soon as it becomes
available”
-Securities are fairly priced and there is no undervaluation or over
valuation
– Weak form efficiency:pricesincorporateinformation aboutpast
prices
– Semi-strongform: incorporateall publicly available information
– Strongform: all information,includinginsideinformation
Stock price move in Random: Random Walk Hypothesis

9. However, we try to predict the value of
a stock amidst wide arrays of
uncertainty !

10. Alternative Stock valuation Models
DCF
• Dividend Discounted Model
• FCFF and FCFE
Relative Valuation Model
• P/E
• P/S
• EV/EBITDA etc.
Asset Based Valuation
• BV
• LV

11. Common stock valuation: DDM-Three Special Cases
• Constant (Zero growth) dividend
– The firm will pay a constantdividend forever
– This is like preferred stock
– The price is computed using the perpetuity formula
𝑉0 = 𝑡=1
∞ 𝐷𝑡
(1+𝑟)𝑡= D / r
• Constant dividend growth
– The firm will increase the dividend by a constantpercentevery period
– The price is computed using the growing perpetuity model
𝑉0 = 𝑡=1
∞ 𝐷𝑡
(1+𝑟)𝑡 = 𝑡=1
∞ 𝐷0(1+𝑔)𝑡
(1+𝑟)𝑡 =
𝐷1
𝑟−𝑔
• Supernormal growth
– Dividend growth is not consistentinitially, but settles down to constantgrowth
eventually
– The price is computed using a multistagemodel ( example two stage)
𝑉0 =
𝑡=1
𝑛
𝐷0 1 + 𝑔𝑆
𝑡
(1 + 𝑟)𝑡 +
𝐷0 × 1 + 𝑔𝑆
𝑛
× (1 + 𝑔𝐿)
(𝑟 − 𝑔𝐿) × (1 + 𝑟)𝑛

12. Value of a stock in a two-stage growth DDM
Given g1 35%
g2 10%
r% 15%
D0 50
Year AnticipatedDiv
HGP LGP Sum of DCFs
1 58.69565217
2 68.90359168
3 80.88682502
4 94.95409893
5 111.4678553 414.9080231
6 …...infanite 1219.222936
2452.292816 1634.130959
Thus, the expectedstock price is Rs. 1634.13
Suppose a company is providinginitial amountof dividendof Rs. 50
The company CFO is anticipatingto pay year on year dividendgrowthby
35% up to five years
From 6yr onwards it isanticipatedby the CFO of the company that the
company can pay 10% incremental dividendgrowthyearafteryear till
the life of the company
if the requiredrate of return on thiskind of riskyasset is 15% ,
what shouldbe the expectedstockprice of the company today?

13. Part II

14. Why Free Cash flow Valuation?
 Many firms pay no, or low, cash dividends
 Dividends are paid at discretion of the board of
director; therefore, it may be poorly aligned with the
firm's long-run profitability
 If a company is views as acquisition target, free cash
flow is more appropriate measure because the new
owners will have discretion over future dividend.
 Free cash flow may more related to long-run
probability of the firm compared to dividend

15. Free Cash flow valuation model
• The free cash flow model is based on the same
premise as the dividend valuation models except that
we value the firm’s free cash flows rather than
dividends.

16. FCFE Growth Model
Constand Growth Model
V0=
𝐹𝐶𝐹𝐸1
𝑟−𝑔
=
𝐹𝐶𝐹𝐸0 ×(1+𝑔)
𝑟−𝑔
Two-Stage Free Cash Flow to Equity (FCFE) Discount Model
𝑉0 =
𝑡=1
𝑛
𝐹𝐶𝐹𝐸0 1 + 𝑔𝑆
𝑡
(1 + 𝑟)𝑡
+
𝐹𝐶𝐹𝐸0 × 1 + 𝑔𝑆
𝑛
× (1 + 𝑔𝐿)
(𝑟 − 𝑔𝐿) × (1 + 𝑟)𝑛
Equity Value = FCFE discounted at the required return on equity
Return on equity= Risk-free rate of return + beta × (Market
rate of return−Risk-free rate of return)

17. Free Cash flow valuation model
• The free cash flow valuation model estimates the value of the
entire company and uses the cost of capital as the discount
rate.
• As a result, the value of the firm’s debt and preferred stock
must be subtracted from the value of the company to
estimate the value of equity.
VE =VC - VD-VPS
• Equity Value = Firm Value – Market Value of Debt- Market
Value of Preferred stock
 FCFF = EBIT 1− Tax rate + Dep – FC Investment –dWC Investment
 Firm Value (VF) = FCFFdiscountedat WACC

18. How to calculate FCFF in a real-world
scenario ?
Formula 1 Formula 2 Formula 3 Formula 4
NI (+) EBIT*(1-t) (+) EBITDA*(1-t) CFO +
NCC (+) NCC (+) NCC*t (+)
dWC Inv (-) dWC Inv (-) dWC Inv (-)
Int(1-t) (+) Int (1-t) +
FC inv (-) FC inv (-) FC inv (-) FC inv (-)
FCFF FCFF FCFF FCFF
• 𝐹𝐶 𝐼𝑛𝑣 = 𝑒𝑛𝑑𝑖𝑛𝑔 𝑔𝑟𝑜𝑠𝑠 𝑃𝑃&𝐸 − 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑔𝑟𝑜𝑠𝑠 𝑃𝑃&𝐸
• 𝑊𝐶 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠𝑡 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑡 - (𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡−1 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠𝑡−1

19. Try with an example
Items (Rs. In billion)
Sales 100
Operatingcost 20
EBITDA 80
NCC(depreciation) 20
EBIT 60
Interest 30
EBT 30
Tax (@40%) 12
EAT 18
dWC Investment -10
FC Investment 0
Principal repayment 10
No. of Common share outstanding .3
in %
WACC 12%
re 9%
g 6%

20. Solution
Sign Fourmula 1 Values (bn) Sign Formula 2 Values (bn)
NI 18 EBIT*(1-t) 36
+ NCC 20+ NCC 20
- WC Inv -10- WC Inv -10
+ Int(1-t) 18+
- FC inv 0- FC inv 0
FCFF 46 FCFF 46
sign Formula 3 Values (bn) sign Formula 4 Values (bn)
EBITDA*(1-t) 48 CFO 28
+ NCC*t 8
- WC Inv -10
+ + Int (1-t) 18
- FC inv 0
FCFF 46 FCFE 46

21. Solution for FCFE
sign Formula 4 Values (bn)
CFO 28
+ Int (1-t) 18
FCFF 46
- Int (1-t) -18
- Principal repayment -10
FCFE 18
Suppose the concerned company’s FCFE is growing at the rate g=6%
here onwards 9 Just an approximation)
Total Future value of cash flows= CurrentYr. FCFE + Future FCFE=
18+ 18*((1+6%)/(9%-6%))= = 654 billoin
Value per share= 654 billion/3 billion share outstanding=Rs. 218

22. FCFF is a Financial performance
Indicator
• Free cash flow to the firm (FCFF) represents the cash
flow from operations available for distribution after
accounting for depreciation expenses, taxes, working
capital, and investments.
• Free cash flow is arguably the most important financial
indicator of a company's stock value.
• A positive FCFF value indicates that the firm has cash
remaining after expenses.
• A negative value indicates that the firm has not
generated enough revenue to cover its costs and
investment activities.

23. Some Relative Valuation methods
• This method estimates the value of the firm’s stock
as a multiple of some measure of firm ’ s
performance, such as the firm’s earnings per share,
book value per share, sales per share, cash flow per
share, where the multiple is determined by the
multiples observed from comparable companies.
• The most common metrics are:
– Earnings Per Share and
– Book value per Share
– Liquidation value per share

24. Common Stock valuation by PE Ratio
• P/E ratio is a relative value model because it
tells the investor how many dollars investors
are willing to pay for each dollar of the
company’s earnings.
𝑇𝑟𝑎𝑖𝑙𝑖𝑛𝑔 𝑃/𝐸 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐸𝑃𝑆 𝑜𝑣𝑒𝑟 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 12 𝑚𝑜𝑛𝑡ℎ𝑠
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑃/𝐸 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐸𝑃𝑆 𝑜𝑣𝑒𝑟 𝑛𝑒𝑥𝑡 12 𝑚𝑜𝑛𝑡ℎ𝑠

25. Other Relative valuation measures
𝑃𝑟𝑖𝑐𝑒 𝐵𝑜𝑜𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝑃0
𝐵𝑉0
Price-to-sale Ratio= (P/S)

26. Common Stock valuation by PE Ratio
• Suppose XYZ company’ had last year earnings of $1.65 per
share for the 12-month period ended in March, 2016. XYZ’s
CFO estimates that company earnings for 2017 will be $1.83 a
share. The current P/E ratios for three comparable firms are
26.85, 18.79 & 22.18 and thus the comparable average PE
ratio is 22.61. Based on above information, estimate the value
of the common stock?
– Ans: $41.38

27. Common Stock valuation: BV per Share
Value of Common Stock (Vc)=
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡−𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
𝑁𝑜.𝑜𝑓 𝐶𝑆 𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
Example: At year end XYZ company balance sheet
shows total asset of Rs. 600,0000 , total liability of Rs.
450,0000 and 100,000 of share of common share
outstanding. Find the value of the common stock?
Ans: Rs.15 per share

28. Common Stock Valuation: LV per Share
Value of Common Stock =
𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡−𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
𝑁𝑜.𝑜𝑓 𝐶𝑆 𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
• Example: XYZ company is on verge of liquidation and an
investment bank estimated that upon liquidation the
total asset of the company is Rs. 525,0000 total liability
of Rs. 450,0000 and 100000 of share of common share
outstanding. Find the liquidation value of the common
stock?
Ans: Rs. 7.5

29. Preferred Stock
• Claims on Assets and Income
– In the event of bankruptcy, preferred stockholders have
priority over common stock. However, they have lower
priority than the firm’s debt holders.
– Firm must pay dividends on preferred stock prior to paying
dividend on common stock.
– Most preferred stock carry a cumulative feature.
Cumulative feature requires that all past unpaid dividends
to be paid before any common stock dividends can be
declared.
– Thus, preferred stocks are less risky than common stocks
but more risky than bonds.

30. Preferred Stock
• Preferred Stock as a Hybrid Security
– Like common stocks, preferred stocks do not have
a fixed maturity date. Also, like common stocks,
nonpayment of dividends does not lead to
bankruptcy of the firm.
– Like debt, preferred stocks have a fixed dividend.
Also, most preferred stocks are periodically retired
even though there is no stated maturity date.

31. Preferred Stock
• Dividend:
– Unlike common stockholders, preferred stockholders
receive the same fixed dividend regardless of how well the
firm does.
– In general, size of preferred stock dividend is fixed, and it is
either stated as a dollar amount or as a percentage of the
preferred stock’s par value.
– Multiple Classes: If a company chooses, it can issue more
than one class of preferred stock, and each class can have
different characteristics.(Cumulative, Participating, Convertible,
Callable and Adjustable-rate: try yourself no time)

32. Valuing Preferred Stock
Since preferred stockholders generally receive a fixed
dividend and the stocks are perpetuities (non-
maturing), it can be valued using the present value of
perpetuity equation.

33. Example
• Consider XYZ company’s preferred stock issue, which
pays an annual dividend of $5.00 per share, does not
have a maturity date, and on which the market’s
required yield or promised rate of return (rps) for
similar shares of preferred stock is 6.02%. What is
the value of the XYZ’s preferred stock?

34. Try Yourself
• What is the present value of a preferred stock that
pays a dividend of $12 per such stock if the market’s
yield on similar issues of preferred stock is 8%?
Ans: $150

35. Example
• What will be the yield on XYZ’s preferred
stock if the company has promised annual
dividend of $1.20 per share and each share is
currently selling for $32.50?

36. Thank you

37. Practice problems
• RETURN ON INVESTMENT
• Q1. Diksha bought a share at a price of Rs.100.
The price of the stock moved to Rs.200 a year
later. During the period, Ramesh received a
dividend of Rs.8 per share.
– What is the % return Diksha received a year later?
– If she has paid 40% of the investment amount as margin
money to her broker while the rest amount is funded by
an overdraft borrowed at 15%, what is the return for her a
year later?

38. Solution
Return for Ramesh for a period of 1 year
Purchaseprice =Rs.100.00
Selling priceafter one year=Rs.200.00
Profit = Rs.100.00
Dividend duringthe period = Rs.8
% Return may be computed usingthe following formula:
Return (%) = [(P1-P0+Do)/P0]× 100= =108%
(b) Own fundsinvested(%) =40%
Own investment(Equity)= Rs.40
Profit and dividend earned=Rs.108
less: Interestpaid =15% on Rs.60 = Rs.9
Return on equity = Rs.99
Return on equity % =Return/Owninvestmentx 100 = (99/40)×100 =
248%

39. Practice problems ( Try Yourself)
• A share of the firm is trading at Rs. 350 currently. The market
that the price next year is going to be Rs.420.
(a) What is the growth in price of the share?
(b) If the currentdividend isRs.20 per share,what is the dividend
expected fromthe firm in the coming year?(c) What is the
expectation of return by the investors?Would it be the same as
growth in the priceof the share?Why and why not?
(d) If investordecidesto sell the share prior to the anticipated
dividend at what price would he sell his share?
(e) Would therebe any differencein return if investor sellsbefore
or after the dividends? Why and why not?
Note: Do you need any other information to solvethe problem.If so
you may assume such an info and solve the problem]

40. Practice problems
Q. Suppose the market value of the firm rs.416.94
million, firm has Rs. 40 million total debt and preferred
stock and has 10 million of common share outstanding.
Find the value per share?
Solution:
• MV Equity= MV of the firm – MV debt and preferred
stock
• MV of equity =Rs.(416.94-40)million =Rs.376.94 million
• Value per share= MV of equity/No. of shares=
Rs.376.94 million/10 million= Rs37.69

41. Extra

42. What Causes Stock Prices to Go Up and Down?
– The most recent dividend (D0): The more, the higher ….
– Expected rate of growth in future dividends (g): The higher,
the higher…..
– Investor’s required rate of return (rcs ): The higher, the
lower…..
– Since most recent dividend (D0) has already been paid, it
cannot be changed. Thus, variations in the other two
variables, rcs and g, can lead to changes in stockprices.
– Interest rate risk, Reinvestment risk, Credit risk, Inflation,
Liquidity risk, Currency risk, price risk, Political risk etc.