8/2/2019 Week 5 %28Paul Dou%290
1/30
Week 5: Equity Valuation
Paul Dou
8/2/2019 Week 5 %28Paul Dou%290
2/30
2
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.
8/2/2019 Week 5 %28Paul Dou%290
3/30
3
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.
8/2/2019 Week 5 %28Paul Dou%290
4/30
4
Introduction to and characteristics of equity securities
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.
8/2/2019 Week 5 %28Paul Dou%290
5/30
5
Introduction to and characteristics of equity securities
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.
8/2/2019 Week 5 %28Paul Dou%290
6/30
6
Introduction to and characteristics of equity securities
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.AX8/2/2019 Week 5 %28Paul Dou%290
7/30
7
Information for ANZ Banking Group
Table 1, Source: Yahoo Finance 24 March 2011
8/2/2019 Week 5 %28Paul Dou%290
8/30
8
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
8/2/2019 Week 5 %28Paul Dou%290
9/30
9
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
8/2/2019 Week 5 %28Paul Dou%290
10/30
10
Valuing equity securities
In general, there are two approaches:
Dividend Discount Model (DDM) Comparable approach
8/2/2019 Week 5 %28Paul Dou%290
11/30
11
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:
8/2/2019 Week 5 %28Paul Dou%290
12/30
12
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
8/2/2019 Week 5 %28Paul Dou%290
13/30
13
DDM : Dividends have zero growth
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
8/2/2019 Week 5 %28Paul Dou%290
14/30
14
DDM : Dividends have zero growth
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?
8/2/2019 Week 5 %28Paul Dou%290
15/30
15
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.
8/2/2019 Week 5 %28Paul Dou%290
16/30
16
DDM: Dividends have constant growth
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.
8/2/2019 Week 5 %28Paul Dou%290
17/30
17
DDM: Dividends have constant growth
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
8/2/2019 Week 5 %28Paul Dou%290
18/30
18
DDM: Dividends have constant growth
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%.
8/2/2019 Week 5 %28Paul Dou%290
19/30
19
DDM: Dividends have constant growth
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
8/2/2019 Week 5 %28Paul Dou%290
20/30
20
In what follows, we continue to assume re = 9.5%
8/2/2019 Week 5 %28Paul Dou%290
21/30
21
DDM: Dividends have constant growth
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?
8/2/2019 Week 5 %28Paul Dou%290
22/30
22
DDM: Dividends have constant growth
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
8/2/2019 Week 5 %28Paul Dou%290
23/30
23
DDM: Dividends have constant growth
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.
8/2/2019 Week 5 %28Paul Dou%290
24/30
24
DDM: Dividends have constant growth
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%
8/2/2019 Week 5 %28Paul Dou%290
25/30
25
DDM: Dividends have constant growth
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.
8/2/2019 Week 5 %28Paul Dou%290
26/30
26
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)
8/2/2019 Week 5 %28Paul Dou%290
27/30
27
DDM: Dividends have non-constant growth
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
8/2/2019 Week 5 %28Paul Dou%290
28/30
28
DDM: Dividends have non-constant growth
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..
8/2/2019 Week 5 %28Paul Dou%290
29/30
29
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
8/2/2019 Week 5 %28Paul Dou%290
30/30
30
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.