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Week 5: Equity Valuation

Paul Dou

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Objectives and learning outcomes from this module

Explain the characteristics of equity securities. Understand some financial ratios. Understand how equity securities are valued. Identify the expected return on equity securities.

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Introduction to and characteristics of equity securities

Equity is a claim on the residual assets of the issuer.

Initial public offerings (IPO) is when a company (thathas been privately owned) sell shares to the public for

the first time. Transactions that occur prior to the IPOmay not be efficient.

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Book value: original cost of the asset minusaccumulated depreciation.

Liquidation value: minimum value of the asset (when

the company is liquidated). It does not capture thegoing-concern value of the business.

Intangible value: impounded into market price. While it

is valuable for thegoing

-concern

purpose, it may haveno value in a forced liquidation.

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Market value: Amount the investors are willing to pay inthe market. It depends on the earning power of todaysassets and the expected payoff from futureinvestment.

If market value = book value, it is only by merecoincident.

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The discussions of this module are based onANZ banking group, which is listed on the ASX(http://au.finance.yahoo.com/q?s=ANZ.AX).
http://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AXhttp://au.finance.yahoo.com/q?s=ANZ.AX

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Information for ANZ Banking Group

Table 1, Source: Yahoo Finance 24 March 2011

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Some financial ratios

Dividend for last financial year is 126 cent per share orcps (this information is obtained from ANZ annualreport).

%43.521.2326.1

pricesharecurrentDividendYieldDividend

%301

%;70

79.1

26.1

ratiopayoutDividendratioPlowback

EPS

DPSratiopayoutDividend

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Some financial ratios

)(16.34

%2.1316.345.4

74.116.34

41.59

)(79.1

;

;97.1279.1

21.23/

reportannualfromobtainedisvaluethisBvalueBook

BB

equityofvalueBookprof itNetequityonreturn

B

B

equityofvalueBook

equityofvalueMarketratiobooktoprice

reportannualfromobtainedisvaluethisEPS

shareperearningEPSwhere

EPS

pricesharecurrentratioEP

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Valuing equity securities

In general, there are two approaches:

Dividend Discount Model (DDM) Comparable approach

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Dividend Discount Models (DDM)

Under DDM, we generally have three scenarios:

Dividends have zero growth; Dividends have a constant growth; and Dividends have non-constant growth.

In general, the value (price) of an asset is thepresent valueof the expected future cash

flowson the asset.

Recall:

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DDM : Dividends have zero growth

Suppose ANZ has no growth (i.e. it does

not invest in new project that adds value to the firm).

In this case, clearly, the firm can distribute all itsearnings as dividends.

Therefore, EPS0 = EPS1 = = D0 = D1 = . = $1.79

2010 2011 2012 2013

D1 = 1.79 D2 = 1.79 D3 = 1.79

P0

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How to valueANZs current share price?

Solution: Use the perpetuity formula!!

Suppose we believe that the current actual share priceof $23.21 represents its true, fair price. Thus, we canback-out the impliedcost of equity (return demanded byshareholders for investing in ANZ) of re

%71.721.23

79.1

0

110

P

Dr

r

DP e

e

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When a company issues preferred shares, it creates anobligation to pay a fixed (constant) stream of dividendsto the shareholders.

Concept check:

Suppose all shareholders of ANZ hold preferred shares, withannual dividend of $1.79 per share. Further assume a cost ofequity of 7.71%. How much shouldANZs share be trading in

such a case?

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DDM: Dividends have constant growth

Suppose that ANZs earnings (and accordingly itsdividends) are growing at a constant, stable rate of g%p.a.

How to calculate g? Use the following equation:

g = ROE from investment x retention rate

where ROE = return on equity from (new) investment or project;retention rate = reinvestment or plowback rate.

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The ROE ofANZs new investment is 13%

(From previously calculated).

Current dividend (D0) is $1.26.

Current EPS0 = $1.79.

Thus, current dividend payout ratio = D0/EPS0 70%.That is, retention rate = 1 dividend payout ratio =30%.

Hence, g= 0.13 x 0.3 = 3.9% p.a.

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Thus, the dividend stream of ANZ is:

2010 2011 2012 2013 .

D1 = D0(1+g)=1.26(1.039)=1.31

D2 = D1(1+g)= 1.36

D3 = D2(1+g)=1.41

.

P0

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Using Gordon Growth Model (i.e. growing perpetuityformula), we can compute the current share price of P

0.

The GGM is given by

grwheregr

gD

gr

DP e

ee

,)1(01

0

Implication: ??

Assume re = 9.5%.

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Suppose the current actual share price of $23.21 is thetrue, fairprice. Thus, we can back-out the impliedcost ofequity:

%54.9039.00564.0039.021.23

31.1

0

110

e

e

e

r

gPDr

grDP

Dividend yield

Growth in dividend

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In what follows, we continue to assume re = 9.5%

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Turning to another issue. ANZ grows at a rate of g=3.9%p.a, due to the fact that the firm is reinvesting (plowingback) some of its earnings into new investments.

What is ANZs present value of growth opportunities(PVGO)? In other words, how much is the newinvestment worth to ANZ?

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To calculate PVGO, use a 3-step strategy:

Step 1: Calculate P0 assuming the firm is not reinvesting. (i.e. thefirm distributes all its earnings as dividends).

84.18$095.0

79.1010

ee

r

EPS

r

DP

Step 2: Calculate Po when the firm is reinvesting (current g= 3.9%)

39.23$039.0095.0

31.10

P

Step 3: PVGO = Step 2 Step 1

55.4$84.1839.23 PVGO

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The current ROE for ANZs new investment is 13%,which is greater than its cost of equity of re= 9.5%.

What if the new investments ROE < the reof the firm?

In such a case, investors would prefer the firm todistribute its earnings as dividends rather than reinvest itsearnings in new projects. This allows investors to use the

distributed dividends elsewhere.

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For example, suppose the ROE ofANZs new investmentis 7% instead of 13%.

Thus, g= ROE x retention rate = 0.07 x 0.30 = 2.1%.

46.1$84.18$38.17$021.0095.0

)021.1(26.10

PVGOP

No reinvestmentFirm reinvests in projectswith ROE = 7%

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So far, we calculated g=3.9%. Implicitly, we assume thatANZ can sustain such a high growth rate of 3.9% p.a.forever.

Australia GDP growth rate on average is at 2~3% p.a.

If ANZ can sustainsuch a high growth rate of 3.9% p.a.forever, it will gradually represent the economy of

Australia. This does not make sense.

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DDM: Dividends have non-constant growth

Thus, we turn to another framework, which assumes thatdividends grow at a non-constant growth rate.

Intuitively, the growth rate of ANZ should be higher for

the first few years (during its growing stage), beforeslowing down to a lowerlevel in the later years (during itsmatured stage)

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Therefore, ANZ has two stages of growth. Suppose, in

the first stage (from year 2010 to 2013), g1 = 3.9% anddividend payout ratio = 70%. In the second stage (fromyear 2013 onwards), g2 = 2% and dividend payout ratio =80%.

2010 2011 2012 2013 2014

D1=1.31 D2=1.36 D3=1.41

g1 = 3.9%, payout ratio = 70% g2 =2%, payout ratio = 80%

D4 = 1.64..

D4 = EPS4 x dividend payout ratio= EPS3 (1+g2) x 0.80= EPS0 (1+g1)

3 (1+g2) x 0.80= 1.79(1.039)3(1.02) x 0.80 = 1.64

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84.21$02.0095.0

64.1,2

43

grDPGGMApplyinge

04.20$

)095.1(

84.21

)095.1(

41.1

)095.1(

36.1

)095.1(

31.1)1()1()1()1(

3321

3

3

3

3

2

2

1

10

eeee r

P

r

D

r

D

r

DP

2010 2011 2012 2013 2014

D1=1.31 D2=1.36 D3=1.41

g1 = 3.9%, payout ratio = 70% g2 =2%, payout ratio = 80%

D4 = 1.64..

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Comparable approach: P/E multiple

Another popular method commonly used to value shareprice is the P/E multiple (comparable) approach.

For instance, suppose the banking (industry) sector has

an average P/E multiple of 12.

Thus, the current share price for ANZ is

P0

= Industry P/E multiple x EPS

of ANZ= 12 x 1.79= $21.48

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Summary of this module

Explain the characteristics of equity securities. Understand some financial ratios. Understand how equity securities are valued. Identify the expected return on equity securities.

week 5 %28paul dou%290

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