Assets Valuation Methods
Valuation Techniques
• Using fundamental
techniques
analysis,
there
are
two
1. Discounted cash flow techniques
1.
2.
3.
Dividend Discounted Model (Income Method)
Free Cash flow to equity (Cash Flow Analysis)
Free Cash flow to firm (Cash Flow Analysis)
2. Relative Valuation technique [these techniques measure the
stocks while comparing with some bench mark (such as the
market, industry) or stocks own history over time]
–
–
Tobin’s q (Asset-based Approach)
Price/Earning Ratio (Market-based Technique)
Fundamental analysis
• Fundamental analysis is a term for studying a
company’s accounting statements and other
financial and economic information to estimate
the economic value of a company’s stock.
• The fundamental analysis was formally used to
analyze and evaluate the balance sheets, annual
reports, trend analysis, profitability ratios and
profit & loss figures in order to beat the market.
• The basic idea is to identify ‘undervalued’ stocks to
buy and ‘overvalued’ stocks to sell.
Intrinsic Value Vs Market Value
• Intrinsic Value (IV) is the estimated value of
the stock today derived from discounting the
future cash flows for a stock
• Market value (MV) is the current share price.
• If IV > MV = the assets is undervalued and
should be purchased.
• If IV < MV = the assets are overvalued and
should be sold
• If IV = MV, the assets are correctly valued.
Dividend Discounted Model (DDM)
• The basic idea behind the discounting model
is:
• Present Value =
Future Value
1+ Interest Rate
• OR
• Intrinsic Value of security =
Cash flow
1+RRR
Intrinsic Value
• As already mentioned that Intrinsic value of a share
is the present value of all cash payments to the
investor in the stock
• To calculate intrinsic value we need,
– All cash flows (dividend + closing price)
– Discount rate (required rate of return)
The Dividend Discount Model
• The Dividend Discount Model (DDM) is a method to
estimate the value of a share of stock by discounting all
expected future dividend payments. The DDM equation is:
D(1)
D(2)
D(3)
D(T )
IV 



2
3
1  k  1  k  1  k 
1  k T
• In the DDM equation:
– IV (Intrinsic Value) = the present value of all future
dividends
– D(t) = the dividend to be paid t years from now
– k = the appropriate risk-adjusted discount rate
6-7
Three Foms of DDM
1. Zero Growth Model
2. Constant Growth Model
3. Multi-growth rate model
Zero Growth Model of DDM
• If share produces same dividend over an
infinite period of time; then its become
perpetuity.
IV = D
K
Where IV = Intrinsic Value; D is the series of
equal dividend; K is the discounting rate
Constant Growth Model of DDM
• If there is constant forever growth in the
dividend; then the dividend will increase on
the basis of compound rate;
• Hence, the dividend next period (t + 1) is:
Constant Growth Model of DDM
• If there is constant forever growth in the
dividend; then the dividend will increase on
the basis of compound rate;
• Hence, the dividend next period (t + 1) is:
Dt  1or D1  Dt  1  g 
• As
D(1)
D(2)
D(3)
D(T )
IV 



2
3
1  k  1  k  1  k 
1  k T
6-11
Constant Growth Model of DDM
• Or it can be calculated like:
Do (1 g) Do (1 g) 2 Do (1 g) 3
D0 (1 g) T
IV 



2
3
1  k 
1  k 
1  k 
1  k T
• Using limit Theorem, the DDM formula for
constant growth becomes:
Do (1  g )
IV 
kg
D1
IV 
kg
• Or
• Where, K g is the growth factor
6-12
Estimating the Growth Rate
• The growth rate in dividends (g) can be
estimated in a number of ways.
– Using the company’s historical average growth
rate.
– Using an industry median or average growth rate.
6-13
The Multi growth rate model
Or
Two-Stage Dividend Growth Model
• The firm grow at the faster rate in the
beginning years and then slow down to
normal growth (constant growth)
• The two-stage dividend growth model
assumes that a firm will initially grow at a rate
g1 for T years, and thereafter grow at a rate g2
< k during a perpetual second stage of growth.
• The intrinsic value is calculated while
calculating the PV of different growth stages
and sum up both PV.
The Multi growth rate model
•
D1
D2
D3
Dt  P
IV 


...
2
3
1  k (1  k ) (1  k ) (1  k )t
• Where P is calculated using the constant growth
model of DDM
Dt (1  G )
P 
(k  g )
Example...
• Suppose a firm current dividend is Rs. 8 per
share, the dividend increases at 7% in the first
stage for 5 years and grows at a constant
growth of 4% thereafter, required rate of
return (discount rate) is 9%, calculate the
intrinsic value of the firm?
Relative Valuation Methods
Tobin’s Q:
– Tobin’s q is the ratio of the market value of a firm to the
replacement cost of its assets
– The replacement cost of an asset is the cost of acquiring
an asset of identical characteristics, such as the
production capacity of a plant:
Market value of firm
Tobin’s q
=
Replacement cost of its assets
or Total Assets Value
– For example the market value of a firm is Rs. 500 and the
replacement cost of its assets is Rs. 250, its q is 2
Relative Valuation Methods
Tobin’s Q (cont…):
• Tobin’s q has been used in investment context to spot
undervalued companies
• For example, a low Q (between 0 and 1) means that the cost
to replace a firm's assets is greater than the value of its stock.
This implies that the stock is undervalued.
• Conversely, a high Q (greater than 1) implies that a firm's
stock is more expensive than the replacement cost of its
assets, which implies that the stock is overvalued.
• This measure of stock valuation is the driving factor behind
investment
decisions
in
Tobin's
model.
Relative Valuation Methods
Price/Earning Ratio:
– Price/Earning Ratio (PER) also known as the earnings
multiplier, expresses the relationship between a firms
earnings for equity market capitalization
– P/E ratio means how much price investors are willing to
pay for one rupee of earning
– In practice, equity value is proxied by the market value of
companies equity:
PER
or
PER
=
=
Market value of equity
Earnings for equity
Share price
Earnings per share (EPS)
For Example
• OGDCL P/E ratio is = 500/50 = 10
• It means for one rupee earnings investors are willing
to pay Rs.10 for buying one share of OGDCL
• High P/E ratio refers that investors are paying for
money for shares for the same one rupee of
earnings. Similarly;
• Low P/E shares are cheap, investors have to pay
lesser price for the same one rupee of earnings,
• So it will be feasible for bidder to target the low P/E
ratio firm.
Relative Valuation Methods
• There are two decision criteria
– On the basis of firm’ own earnings estimates
– On the basis of industry P/E
Relative Valuation Methods
• Suppose OGDCL current earnings is Rs. 50
Million and current market price is Rs. 500
Million. It is expected that coming year
earnings will be Rs. 100 million. On the basis
of P/E ratio, whether OGDCL is suitable for
investment or not.
• OGDCL P/E ratio is = 500/50 = 10x
On the basis of firm’ own earnings estimates
• Current P/E is 10x
• Price = (P/E)x future Earnings
•
= 10x 100 = 10,00
• Current price is 500, so buyer should invest in
OGDCL.
On the basis of industry P/E
• Analysts usually calculate P/E ratio for an
industry or whole market
• An individual stocks’ P/E is compared with
others in the industry
• If it is traded at discount in relations to others,
then the stock is recommended for buying
Example on P/E ratio
• Firm’ OGDCL P/E ratio Vs Industry’ P/E ratio
10
10
10
=
Vs
Vs
10 (Correctly Valued)
15 (Under-Valued)
7 (Over-Valued)