Copyright 2017 AN Valuations BV. All Rights Reserved. Learning outcome statements (LOS) are copyrighted by CFA Institute and have been reproduced and

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1 Copyright 2017 AN Valuations BV. All Rights Reserved. Learning outcome statements (LOS) are copyrighted by CFA Institute and have been reproduced and republished with permission from CFA Institute. No part of this publication may be reproduced or used in any other form or by any other means, including but not limited to graphic, electronic, or mechanical, including photocopying, recording, taping, or information storage and retrieval systems. No part of this publication may be posted on any online programs with open access given to the public.

2 Value the security to estimate intrinsic value Intrinsic value = market value: Fairly priced Intrinsic value < market value: Overvalued Intrinsic value > market value: Undervalued Intrinsic value is not a exact science. Analysts apply a margin of error that may increase or decrease depending on the reliability of applied information Comparison of intrinsic value to market value

3 Question 1 Market price of a security is EUR 25. Analyst estimates a value of EUR 20. Is security overvalued, undervalued or fair valued? Comparison of intrinsic value to market value

4 Question 1 Answer Market price of a security is EUR 25. Analyst estimates a value of EUR 20. Is security overvalued, undervalued or fair valued? Security is overvalued. Comparison of intrinsic value to market value

5 Present value models: present value of future benefits, usually in cash terms Dividend discount models = cash expected to be distributed Free cash flow models = cash available to be distributed Multiplier models: fundamental variable x multiple Equity model = multiple leads directly to equity value Enterprise value model = multiple leads to enterprise value, which then must be adjusted to equity value Asset based models: adjust book (shareholders equity) value to arrive at intrinsic value Categories of equity valuation models

6 Question 2 Analyst has 2 years of historical financial statements for a company and has gathered a variety of pricing multiples from similar listed companies. Which method is the analyst least likely to rely on? a) Present value model b) Multiplier model c) Asset based model Categories of equity valuation models

7 Question 2 Answer Analyst has 2 years of historical financial statements for a company and has gathered a variety of pricing multiples from similar listed companies. Which method is the analyst least likely to rely on? a) Present value model b) Multiplier model c) Asset based model Categories of equity valuation models

8 Present value approaches explicitly model future benefits and apply an investor s required rate of return Dividend discount model: discounts one or more future dividends to present value. It can be extended to include future sale price of equity V 0 = [D 1 /(1+r) 1 ] + + [D n /(1+r) n ] + [P n /(1+r) n ] Free cash flow to equity (FCFE) model: dividend-paying capacity should be reflected in the cash flow estimates rather than expected dividends FCFE = cash flow from operations capital investments net borrowings FCFE V 0 = Σ t t=1 (1+r) t Present value models: dividend discount and free-cashflow-to-equity models

9 Perpetual preferred share model: VV 0 = DD 0 rr DD 0 = Perpetual dividend r = required rate of return (preferred stock yield) Maturing preferred share model: VV 0 = DD tt = Dividend nn tt=1 r = required rate of return (preferred stock yield) F = par value DD tt (1+rr) tt + FF (1+rr) nn Intrinsic value of a non-callable, non-convertible preferred stock

10 Question 3 VV 0 = DD 0 rr The market price of Janssen Bakkerij non-callable, non-convertible preferred stock is EUR 15 with a par value of EUR 10. Preferred dividend is EUR 1. Yield for similar securities is 8%. What is the intrinsic value? Is the security overvalued or undervalued? Intrinsic value of a non-callable, non-convertible preferred stock

11 Question 3 Answer VV 0 = DD 0 rr The market price of Janssen Bakkerij non-callable, non-convertible preferred stock is EUR 15 with a par value of EUR 10. Preferred dividend is EUR 1. Yield for similar securities is 8%. What is the intrinsic value? Is the security overvalued or undervalued? EUR 1 / 0.08 = EUR 12.5 intrinsic value EUR 12.5 (Intrinsic value) < EUR 15 (Market value). Security is overvalued. Intrinsic value of a non-callable, non-convertible preferred stock

12 Question 4 VV 0 = nn tt=1 DD tt (1+rr) tt + FF (1+rr) nn Retractable preferred shares The market price of Royal Canadian Outerwear non-convertible preferred stock is EUR 25 with a par value of EUR 10. Preferred dividend is 5%. Yield for similar securities is 7%. Shares are redeemable by the company in 3 years. What is the intrinsic value? Is the security overvalued or undervalued? Intrinsic value of a non-callable, non-convertible preferred stock

13 Question 4 - Answer VV 0 = nn tt=1 DD tt (1+rr) tt + FF (1+rr) nn Retractable preferred shares The market price of Royal Canadian Outerwear non-convertible preferred stock is EUR 25 with a par value of EUR 10. Preferred dividend is 5%. Yield for similar securities is 7%. Shares are redeemable by the company in 3 years. What is the intrinsic value? Is the security overvalued or undervalued? N = 3; I = 7; PMT =.05*10; FV = 10 PV = EUR Stock is overvalued. Intrinsic value of a non-callable, non-convertible preferred stock

14 Gordon Growth model Assumes today s dividends grow at constant rate indefinitely. Not appropriate for companies with inconsistent growth rates or where dividends are not paid until a future year. VV 0 = DD 0(1+gg) = DD 1 rr gg rr gg gg = bb xx RRRRRR; wwwwwwwww bb = eeeeeeeeeeeeeeee rrrrrrrrrrrrrrrrrr rrrrrrrr Multistage Dividend Discount Models Company will pay dividends at a constant growth rate in the future, but before that time pays dividends at an unsustainable high rate. VV 0 = nn DD 0 (1+ gg ss ) tt tt=1 + (1+rr) tt VV nn = DD nn+1 rr gg LL VV nn (1+rr) nn Number of periods in 2 nd stage denominator = number of periods of high growth phase Gordon (constant) growth dividend discount model and twostage dividend discount model

15 Question 5 Gordon Growth model VV 0 = DD 0(1+gg) rr gg = DD 1 rr gg gg = bb xx RRRRRR; wwwwwwwww bb = eeeeeeeeeeeeeeee rrrrrrrrrrrrrrrrrr rrrrrrrr Dividends for the past 3 years from oldest to most recent are: 2, 2.10, Earnings retention rate is 80% and ROE is 7.5%. What is the dividend growth rate? Dividend this year was $4 and required return on equity is 12%. Calculate intrinsic value. Gordon (constant) growth dividend discount model and twostage dividend discount model

16 Question 5 - Answer Gordon Growth model VV 0 = DD 0(1+gg) rr gg = DD 1 rr gg gg = bb xx RRRRRR; wwwwwwwww bb = eeeeeeeeeeeeeeee rrrrrrrrrrrrrrrrrr rrrrrrrr Dividends for the past 3 years from oldest to most recent are: 2, 2.10, Earnings retention rate is 80% and ROE is 7.5%. What is the dividend growth rate? Dividend this year was $4 and required return on equity is 12%. Calculate intrinsic value. Avg dividend growth = 6%; g = 0.8 x = 6% 4(1+0.06) / ( ) = $70.67 Gordon (constant) growth dividend discount model and twostage dividend discount model

17 Question 6 Multistage Dividend Discount Models VV 0 = nn DD 0 (1+ gg ss ) tt tt=1 + (1+rr) tt VV nn = DD nn+1 rr gg LL VV nn (1+rr) nn Company will pay dividends for next 3 years at a growth rate of 10%, thereafter at a growth rate of 3%. Dividend this year was $4 and required return on equity is 12%. Calculate intrinsic value. Gordon (constant) growth dividend discount model and twostage dividend discount model

18 Question 6 - Answer Multistage Dividend Discount Models VV 0 = nn DD 0 (1+ gg ss ) tt tt=1 + (1+rr) tt VV nn = DD nn+1 rr gg LL VV nn (1+rr) nn r 12% g s 10% g L 3% Period Growth stage Growth Period rate Dividend V n cash flow Discount factor Present value Hi 10% Hi 10% hi 10% Lo 3% V 0 = Company will pay dividends for next 3 years at a growth rate of 10%, thereafter at a growth rate of 3%. Dividend this year was $4 and required return on equity is 12%. Calculate intrinsic value. Gordon (constant) growth dividend discount model and twostage dividend discount model

19 Some uses of multiples Screening mechanism for purchase/sale candidates within current portfolio Apply to an industry to identify attractive buys Multiples based on fundamentals: Derive a multiple based on market price and a fundamental value such as net income, book value, EBITDA, revenues, etc. Can a multiple be justified based on a company s earnings, growth and risk? Need to apply solid ratio analysis Multiples based on comparables: derive a multiple based on market prices and earnings of similar companies and then compare subject company Price multiples: multiples based on comparables versus multiples based on fundamentals

20 Calculate multiples for a company with the following data Market price of equity: $50 Earnings: $2.50 Operating cash flow: $3.00 Sales: $60 Book value: $20 Price multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value

21 Recalling the Gordon Growth formula: DD 1 PP 0 = rr gg Substituting payout ratio for dividend, we can inversely relate P/E to required rate of return and growth rate: DD 1 PP 0 EE1 = EE 1 rr gg Payout ratio is 85%, dividend growth is 3% and required return on equity is 8%. What is the P/E ratio? Present value models and multiplier models are mathematically linked to each other

22 Recalling the Gordon Growth formula: DD 1 PP 0 = rr gg Substituting payout ratio for dividend, we can inversely relate P/E to required rate of return and growth rate: DD 1 PP 0 EE1 = EE 1 rr gg Payout ratio is 85%, dividend growth is 3% and required return on equity is 8%. What is the P/E ratio? 0.85 / ( ) = 17x Present value models and multiplier models are mathematically linked to each other

23 Cost of Capital WACC = w d r d (1-t) + w p r p + w e r e w d = proportion of debt used for new funds r d = before tax marginal cost of debt t = company s marginal tax rate w p = proportion of preferred stock used for new funds r p = marginal cost of preferred stock w e = proportion of equity used for new funds r e = marginal cost of equity Weighted average cost of capital (WACC)

24 Cost of Capital Question 7 WACC = w d r d (1-t) + w p r p + w e r e WACC example: Capital structure: 10% preferred, 20% debt, 70% equity Marginal cost of preferred stock: 9% Before tax cost of debt: 6% Marginal cost of equity: 12% Marginal tax rate: 25% Weighted average cost of capital (WACC)

25 Cost of Capital Question 7 - Answer WACC = w d r d (1-t) + w p r p + w e r e WACC example: Capital structure: 10% preferred, 20% debt, 70% equity Marginal cost of preferred stock: 9% Before tax cost of debt: 6% Marginal cost of equity: 12% Marginal tax rate: 25% Answer: 0.2*0.06*(1-0.25) + 0.1* *0.12 = 10.2% Weighted average cost of capital (WACC)

26 Please sign up for the CFA exam Questions? Andrew S. Pike, CFA, ASA, RV

27 27 Disclaimer Copyright 2017 AN Valuations BV. All Rights Reserved. Learning outcome statements (LOS) are copyrighted by CFA Institute and have been reproduced and republished with permission from CFA Institute. No part of this publication may be reproduced or used in any other form or by any other means, including but not limited to graphic, electronic, or mechanical, including photocopying, recording, taping, or information storage and retrieval systems. No part of this publication may be posted on any online programs with open access given to the public.