OVERVIEW INTRODUCTION HOW EQUITY IS VALUED ESTIMATING THE COST OF EQUITY EQUITY PRICE AND EARNINGS PER SHARE EXAMPLES CONCLUSION

Transcription

1 EQUITY VALUATION 1

2 OVERVIEW I II III IV V VI INTRODUCTION HOW EQUITY IS VALUED ESTIMATING THE COST OF EQUITY EQUITY PRICE AND EARNINGS PER SHARE EXAMPLES CONCLUSION 2 2

3 I. INTRODUCTION Equity is Issued at a stated par or nominal value and is limited by Authorised Capital, specified in firm s Articles of Association; Each share represents a share in ownership of company and carries voting rights; Dividends only paid after meeting all prior claims ; The liability for the firm s debts are limited to the amount invested and shareholders rank last in queue for distribution of proceeds in a liquidation. 3 3

4 INTRODUCTION It is important to appreciate the significance of corporate valuation of equity. Valuation is at the heart of the corporate finance concept. However, there are a number of the problems surrounding the equity valuation of both public and private companies. 4 4

5 INTRODUCTION We need to value equity for many reasons: to assess the impact of financial decisions; to value IPO floatations; to value privatisations; to value acquisition candidates; to value break-up situations and divestments; to value MBOs and MBIs. 5 5

6 II. HOW EQUITY IS VALUED The value of any equity is the present value of its future cash flows and is reflected in the DCF formula. Dividends represent the future cash flows of the firm. PV(Equity) = PV (expected future dividends) The Expected Return is the percentage yield that an investor forecasts from a specific investment over a set period of time (sometimes called the market capitalisation rate). 6 6

7 HOW EQUITY IS VALUED Expected Return = r = D1 + P1 P0 P0 D1 expected dividend per share; P0 current share price; P1 expected share price at the end of year; 7 7

8 HOW EQUITY IS VALUED Example If Fledgling Electronics Plc is selling for 100 per share today and is expected to sell for 110 one year from now, what is the expected return if the dividend one year from now is forecasted to be 5.00? Expected return = = 0.15 = 15% 8 8

9 HOW EQUITY IS VALUED The price of any share can be thought of as the present value of the future cash flows. For equity, the future cash flows are dividends and the ultimate equity sales price. Price = P0 = D1 +P1 1 + r For Fledgling Electronics Plc, D = 5 and P1 = 110. If the expected return for Fledgling is 15%, then today s price will be: P0 = =

10 HOW EQUITY IS VALUED Many shares will be safer than Fledgling and many will be riskier. Those with the same level of risk will have the same risk class where they will be priced to offer the same expected rate of return. If Fledgling s price were above 100 then investors would shift their investment to other securities and thereby force the price of Fledgling downwards. If Fledgling s price were less than 100 then investors would shift their investment Fledgling and thereby force the price of Fledgling upwards

11 HOW EQUITY IS VALUED Where we assess the value of equity beyond a single time horizon, it is referred to as the Dividend Discount Model. This states that the share value equals the present value of all expected future dividends and the ultimate equity sales price. P 0 D 1 (1 r) 1 D 2 (1 r) 2... D H P (1 r) H H H t1 Dt (1 r) t PH (1 r) H H Time Horizon 11 11

12 HOW EQUITY IS VALUED Example 1 Fledgling Electronics Plc is forecasted to pay a 5.00 dividend at the end of year one and a 5.50 dividend at the end of year two. At the end of the second year the equity will be sold for 121. If the discount rate is 15%, what is the current price of the equity? PV 5.00 (1.15) (1.15)

13 HOW EQUITY IS VALUED Example 2 Current forecasts are for BTG Plc to pay dividends of 3, 3.24, and 3.50 over the next three years, respectively. At the end of three years you anticipate selling the equity at a market price of What is the current price of the equity given a 12% expected return? PV 3.00 (1.12) (1.12) (1.12)

14 III. ESTIMATING THE COST OF EQUITY Estimating the cost of equity depends upon whether there is constant or non-constant dividend growth. Valuing Constant Dividend Growth P0 = D r g Where: P0 current share price; D expected dividend per share; r equity cost of capital; g dividend growth

15 ESTIMATING THE COST OF EQUITY Dividend Growth g = b x R Where: g dividend growth; b the retention ratio; R the Internal Rate of Return

16 ESTIMATING THE COST OF EQUITY Therefore: r = D + g P0 Where: r equity cost of capital; D expected dividend per share; g dividend growth; P0 current share price

17 ESTIMATING THE COST OF EQUITY Example Northwest Natural Gas has equity selling at at the beginning of 2012 with dividend payments being 1.49 per share with annual growth of 5.1%. r = D + g P0 = = = = 8.7% 17 17

18 ESTIMATING THE COST OF EQUITY Valuing Non-Constant Dividend Growth Growth rates can vary for many reasons. Sometimes growth is high in the short-run not because the firm is unusually profitable, but because it is recovering from an episode of low profitability. Any difference between the estimated and the actual share price may be due to inaccurate dividend forecasts. When there is a non-constant growth of dividends, it is important to treat each year s level of dividends separately

19 ESTIMATING THE COST OF EQUITY Example Phoenix Plc produces dividends in three consecutive years of 0, 0.31, and 0.65, respectively. The dividend in year four is estimated to be 0.67 and should grow in perpetuity at 4%. Given a discount rate of 10%, what is the price of the equity? 0 (1.1) (1.1) (1.1) 1 (1.1) P ( ) =

20 IV. EQUITY PRICE AND EARNINGS PER SHARE Investors separate growth shares from income shares. They buy growth shares primarily for the expectation of capital gains rather than next year s dividends. They buy income shares primarily for the cash dividends. If a company does not grow at all and does not retain any earnings, it will produce a constant stream of dividends. This equity would resemble a perpetual bond. Since all earnings are paid as dividends, the expected return is equal to the EPS

21 EQUITY PRICE AND EARNINGS PER SHARE Example If the dividend is 10 per share and the share price is 100. The expected return = dividend yield = EPS = D = EPS P = 10 = The expected return for growing firms can also equal the EPS ratio. The key is whether earnings are reinvested

22 EQUITY PRICE AND EARNINGS PER SHARE Example Kenmare Resources Plc forecasts to pay a 8.33 dividend next year, which represents 100% of its earnings. This will provide an Equity Cost of Capital of 15%. An alternative is to retain 40% of the earnings at the firm s current IRR of 25%. What is the value of Kenmare Resources equity before and after the retention decision? 22 22

23 EQUITY PRICE AND EARNINGS PER SHARE Without Dividend Retention (No Growth) P0 = D r g = =

24 EQUITY PRICE AND EARNINGS PER SHARE With Dividend Retention (Growth) g = b x R = 0.25 x 0.40 = 0.10 P0 = = The equity value will always be much higher when there is dividend growth

25 V. EXAMPLES Example 1 Consider the following three forms of equity: (a) (b) Equity A is expected to provide a dividend of 0.10 a share in perpetuity. Equity B is expected to provide a dividend of 5 next year. Thereafter, dividend growth is expected to be 4% a year perpetuity

26 EXAMPLES (c) Equity C is expected to provide a dividend of 5 next year. Thereafter, dividend growth is expected to be 20% a year for 5 years and zero thereafter. If the cost of capital for each equity is 10%, which equity is the most valuable? What if the equity cost of capital is 7%? 26 26

27 EXAMPLES 10% Equity Cost of Capital PA = D r = =

28 EXAMPLES PB = D r- g = =

29 EXAMPLES Pc = Equity C is the most valuable

30 EXAMPLES 7% Equity Cost of Capital PA = D r = =

31 EXAMPLES PB = D r- g = =

32 EXAMPLES Pc = DIV DIV DIV DIV DIV DIV DIV Equity B is the most valuable

33 EXAMPLES Example 2 Carillion Plc is about to pay a dividend of 1.35 per share. Future EPS and dividends are expected to grow with inflation at the rate of 2.75% per year. (a) What is Carillion Plc s current share price if the nominal cost of capital is 9.5%? (b) Redo (a) using forecasted real dividends and a real discount rate

34 (a) P0 = DIV0 + DIV1 r g = x = EXAMPLES (b) First, compute the real discount rate as follows: (1 + r nominal ) = (1 + r real ) (1 + inflation rate) = (1 + r real ) (1 + r real ) = (1.095/1.0275) 1 =.0657 = 6.57% In real terms, g = 0. Therefore: DIV 1.35 P = 1 DIV r g =

35 Example 3 EXAMPLES Lamprell Plc has an equity cost of capital is 14% and it has a 50% payout ratio with a current book value per share of 50. The equity cost of capital and payout ratio stay constant for the next four years after which the competition forces the equity cost of capital down to 11.5% and the payout ratio increases to 0.8. (a) How (b) What are Lamprell Plc s EPS and dividends next year? will EPS and dividends grow in each of the years after year one? What is Lamprell Plc s equity worth per share? How does that value depend on the payout ratio and growth rate after year 4? 35 35

36 EXAMPLES (a) Retention Ratio = 1 Payout Ratio = = 0.5 Dividend Growth Rate (g) = Retention Ratio (b) Equity Cost of Capital (r) = = 0.07 Equity Cost of Capital = EPS0/P = EPS0/ 50 EPS0 =

37 EXAMPLES Therefore: DIV 0 = payout ratio EPS 0 = = 3.50 Year EPS DIV = = = = = = = = = = = Year 5 Retention Ratio = 1 Payout Ratio = = 0.2 Year 5 Dividend Growth Rate (g) = b r = =

38 (b) P 0 EXAMPLES DIV DIV DIV DIV DIV The last term in the above calculation is dependent on the payout ratio and the growth rate after year

39 VI. CONCLUSION We looked at the reasons why equity valuation is important. Equity value calculations found by discounting dividends were undertaken. The differences between the case of zero, constant and differential growth was looked at. The link between equity Price and Earnings per Share were viewed. We looked at the price-earnings ratio form being a function of the firm s valuable growth opportunities, the risk of the equity and the accounting methods used by the firm