Valuations summary of the textbook

Valuations summary of the textbook

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Jacqueline




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Chapter 6
Valuations
The valuation of ordinary equity
Valuation of ordinary shares is more difficult than valuing bonds or preference shares for the
following reasons:
o Future cash flows are uncertain- since earnings are dependent on factors such as:
 State of the economy
 Currency rates
 Operating costs
 Interest rates
 Product acceptance and
 The level of competition in the sector

o Ordinary shares have NO maturity-
 AND companies are assumed to have an indefinite life

o The cost of capital and cost of equity are subject to greater uncertainty than and more
difficult to observe than bond yields

 However the principles still remain the same:
o Valuation of companies remains… PV of future cash flows
o The future cash flows that will accrue to ordinary shareholders- dividends

 There are various methods available to determine the value of ordinary equity:
o Dividend growth model:
 The value of ordinary equity is determined by PV of future DIVIDENDS

o Price multiples- relative valuation (P/E ratio):
 Value of ordinary equity is determined by using price multiples such as
Price earnings ratio &
Market to book ratio

o Free cash flow method:
 Determine free cash flows to the firm and discount this at the firm’s cost of
capital
 The result is the value of the firm
 Deduct the value of debt from the value of the firm to arrive at the value of
ordinary equity
 We could ALSO discount the equity cash flows at the cost of equity

o EVA discount model:
 Requires that we discount a firm’s future EVA’s at the firm’s cost of capital (refer
to chapters 1 and 5 for additional information if needed)




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Dividend growth model:
 This model requires that we project the future dividends of the firm and discount the dividends
at the firm’s cost of EQUITY
 As the firm has an indefinite life and we can expect the earnings and dividends to grow overtime
o The computation of value is facilitated if we assume a constant growth rate in dividends
 Companies will normally only pay out a percentage of earnings and
o The balance is reinvested to generate increased earnings and dividends in future years

Constant growth in dividends:
 The assumption of constant growth rate means
o We can use the formula of a growing perpetuity to determine the value of equity

Formula:




Po =value of ordinary share
D1 = NEXT period’s dividend →D1=D0 *(1+g)
k= cost of EQUITY
g= growth rate in future dividends

How do we value share is future periods
 If we apply the constant growth dividend model, we need to determine the following 3 variables:
o The next year’s dividend (current dividend* (1+growth rate))
o The discount rate (cost of equity); and
o The growth rate in future dividends

 Dividends are a function of
o policy and
o prevailing economic environment

 The growth rate in dividends is often difficult to determine and the assumption of a constant
growth rate may NOT be realistic

 The dividend growth model may be more realistic when valuing a firm with a
o steady earnings growth
o operating in a mature industry sector

 The assumption of a real growth rate similar to
o the expected real GDP growth rate + expected inflation rate
o may be relevant for many companies operating in certain sectors

 We can also make further adjustments for productivity improvements




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