7

Equity Instruments and Their Valuation

Equity shares are floated in the market at face value, or at a premium, or at a discount. Only companies with a track record or companies floated by other firms/companies with a track record are allowed to charge a premium. The premium is normally arrived at after detailed discussions with the merchant bankers. This is the first exercise involving the valuation of share by the company itself.

Once shares are issued to the owners, the company may distribute its surplus profits as returns to investors. The returns to equity shareholders are in the form of distribution of business profits. This is termed as declaration of dividends. Dividends are declared only out of the profits of the company. Dividends are paid in the form of cash and are called cash dividends. When shares are issued additionally to the existing investors in the form of returns, they are called bonus shares. These decisions are taken in the annual general meeting of the shareholders. The announcement of dividend is followed by the book closure dates, when the register of shareholders maintained by the company is closed till the distribution of dividends. The shareholders whose names appear on the register on that date are entitled to receive the dividend payment. Cash dividend payments reduce the cash balance of the company while bonus share payments reduce the reserve position of the company.

Dividends are a direct benefit from the company to its owners. It is an income stream to the owners of equity capital. Many expectations surround the company’s quarterly announcement periods in terms of the dividend declared by the corporate enterprises to its shareholders. The payment of dividend itself is expected to influence the share price of the company. To the extent that cash goes out of the company, the book value of the company stands reduced and it is theoretically expected to lower the market price of the share. This is based on the argument that future expectations are exchanged for current benefits from the company in the form of dividends.

While bonus shares do not reduce the cash flow of the company, they increase the future obligations of the company to pay extra dividend in the future. Bonus shares result in an increase in the number of existing shares. Hence, the company has to pay dividend on its newly issued bonus shares in addition to its existing number of shares. These bonus shares are different from stock splits. Stock splits simply imply a reduction in the face value of the instrument with an increase in the quantity of stock. A stock split does not increase the value of current equity capital. Bonus shares, on the other hand, increase the value of equity capital to the company.

For example, a company with a paid up capital of Rs 10 crores (of Rs 10 each) and Rs 20 crores reserves, may issue one bonus share for every share held in the company. This will result in capitalising the reserves to the extent of Rs 10 crores into equity. The final book figures after the payment of bonus shares will comprise equity capital to the tune of Rs 20 crores (2 crore shares) and reserves of Rs 10 crores.

If the same company announces a stock split of two shares for every one share, the equity capital will be Rs 10 crores (2 crore shares of Rs 5 each) and reserves Rs 20 crores. The only effect of stock split will be an increase in the number of shares.

All these exercises by the company call for a renewed valuation of the shares traded in the secondary market. Hence, investment evaluation begins with the computation of the value of securities.

SHARE VALUATION

Share valuation is the process of assigning a rupee value to a specific share. An ideal share valuation technique would assign an accurate value to all shares. Share valuation is a complex topic and no single valuation model can truly predict the intrinsic value of a share. Likewise, no valuation model can predict with certainty how the price of a share will vary in the future. However, valuation models can provide a basis to compare the relative merits of two different shares.

Equity valuations could be classified into the following categories:

1. Earnings valuation
2. Revenues valuation
3. Cash Flow valuation
4. Asset valuation
5. Yield valuation
6. Member valuation

EARNINGS VALUATION

The most common way to value a company is to use its earnings. Earnings (net income or net profit) is the money left after a company meets all its expenditures. To allow for comparisons across companies and time, the measure of earnings is stated as earnings per share (EPS). This figure is arrived at by dividing the earnings by the total number of shares outstanding.

Thus, if a company has one crore shares outstanding and has earned Rs 2 crore in the past 12 months, it has an EPS of Rs 2.00.

EPS alone would not be able to measure if a company’s share in the market is undervalued or overvalued. Another measure used to arrive at investment valuation is the Price/Earnings (P/E) ratio that relates the market price of a share with its earnings per share. The P/E ratio divides the share price by the EPS of the last four quarters. For example, if a company is currently trading at Rs 15 per share with a EPS of Rs 2 per share, it would have a P/E of 7.5.

The P/E ratio or multiplier has been used most often to make an investment decision. A high P/E multiplier implies that the market has overvalued the security and a low P/E multiplier gives the impression that the market has undervalued the security. When the P/E multiple is low, it implies that the earnings per share is comparatively higher than the prevailing market price. Hence, the conclusion that the company has been “undervalued” by the market. Assume a P/E multiplier of 1.0. The implication is that the earnings per share is equal to the prevalent market price. While market price is an expectation of the future worth of the firm, the earnings per share is the current results of the firm. Hence, the notion that the firm has been “undervalued” by the market. On the other hand, a high P/E ratio would imply that the market is “overvaluing” the security for a given level of earnings.

Glaxo Smith had a P/E ratio of 47.2 on January 23,2003. The market price as on that date was Rs 297.15 and the earnings per share was Rs 6.3. On December 5,2002, the company had a market price of Rs 329.80 with a high P/E multiplier of 52.3. Zee Telefilms, had a consistent P/E multiplier 53. The interpretation of “overvaluation” will hold good when the market is expected to adjust towards the real worth of the company. A consistent high ratio, on the other hand, implies that the future returns expectations from the company is consistently good and that the high P/E ratio need not necessarily indicate a “overvalued” position for the company.

Arvind Mills in December 3,2002 traded at Rs 23.30 with a P/E multiplier of 9.5. In January 3,2003, it announced a positive quarterly report of Rs 36.66 crore, compared to the negative earnings report in the previous quarter to the tune of Rs 21.63 crores. In January 30,2003, Arvind Mills had a P/E multiplier of 9.4, with a market price of Rs 60.23. By evaluating the P/E multiplier alone, it will be impossible to conclude that the Arvind Mills shares had been “undervalued” in December 2002.

The forward P/E valuation is another technique that is based on the assumption that prices adjust to future P/E multipliers. The assumption is that shares typically trade at a constant P/E and therefore the ‘future’ value of a share can be calculated by comparing the current P/E with the future P/E (as predicated using analysts’ estimated earnings for that year).

The forecasted market price is calculated as [Price* (P/E, current)/(P/E, future)]. For example, if current market price is Rs 20, current P/E is 4 and forecasted P/E is 2.5, the forecast price is Rs 32 . This valuation technique cannot be applied to shares with negative current or future earnings.

The forward P/E ratio is most often used in comparison with the current rate of growth in earnings per share. This is based on the assumption that for a growth company, in a fairly valued situation, the price/ earnings ratio ought to be equal to the rate of EPS growth. When the growth rate is not in tune with P/E multiplier, then P/E multiplier can be modified to include the growth ratio.

Assume, for example, that a company’s P/E ratio is 15; earnings growth rate of 13 per cent-14 per cent would substantiate the fair valuation of the share in the market price. This can be incorporated in the P/E growth ratio (PEG). The PEG considers the annualised rate of growth and compares this with the current share price. Since it is future growth that makes a company valuable to the investors in the market, the earnings growth is expected to depict the valuation of a company better than the historical earnings per share. If a company is expected to grow at 10 per cent a year over the next two years and has a current P/ E multiple of 15, the PEG will be computed as 15/10 = 1.5. The interpretation of PEG is that the market price is worth 0.5 times more than what it really is worth, since the assumption is that the P/E multiplier ought to be equal to the earnings growth rate.

A PEG of 1.0 suggests that a company is fairly valued. That is, in the previous example, if the P/E multiplier is 15 and the earnings growth rate is also 15, then PEG is equal to (15/15) 1.0. Here the company is evaluated as priced correctly by the market. If the company in the above example had a P/E of 15 but was expected to grow at 20 per cent a year, it would have a PEG of (15/20), 0.75. This means the shares are selling for 75 per cent of their real value. This leads to the conclusion that the shares are “underpriced” in the market.

The PEG measure is useful only for positive growth companies. When the companies are not experiencing a growth opportunity or there is a short spell of negative performance due to various factors, the PEG will not be the right measure to use to assess the valuation of shares.

The forward P/E and growth ratio (FPEG) can be used for valuing companies with an expected long-term performance. Rather than looking at the current historical price earning multiplier, the measure considers the price earnings multiplier forecast by analysts. This is compared with the expected earnings growth rate to evaluate the fair price of the shares. Assuming the analysts’ expectation of the P/E multiplier of a company is 20 and the earnings growth is expected to be 25 per cent over the next five years, the FPEG is computed as (20/25) = 0.8. The interpretation of this number is similar to the interpretation of PEG, that is, the company is evaluated in the market at only 80 per cent of its realistic price. This will be an indicator of “underpricing” of shares in the market. Similarly, a company that has an expected P/E multiplier of 20 and the growth in earnings in the next five years of 10 per cent will have a FPEG of (20/10)2.0. This indicates an “overpricing” of the share by the market by double its fair value.

Although the PEG and FPEG are helpful, they both operate on the assumption that the P/E should equal the EPS rate of growth. In the real market, the assumptions behind the earnings valuation methods need not necessarily hold good. A modification to the P/E multiplier approach is to determine the relationship between the company’s P/E and the average P/E of the stock index. This is called as the price-earnings relative. Price-earnings relative is given by the following formula:

This formula estimates the shares’ P/E movement along with the index P/E. A P/E relative of 1.5 implies that the share is sold in the market 1.5 times that of the index price/earnings.

Bharat Earth Movers has shown a P/E relative of 1.5 of the BSE Sensex as of December 20,2002 (that is the stock P/E is 25.8 while the BSE Sensex average P/E is 17.1). The BSE Sensex index was expected to show a P/E of 10. It can then be presumed that Bharat Earth Movers should have a P/E of 15, assuming that nothing changes. The P/E multiplier of Bharat Earth Movers eventually reached 16.1 in January 10,2003. This method requires the tracking of P/E ratios of all companies included in the index. A simple average may not be the right substitute; hence, weighted average of P/E for the index is computed.

However, all these earnings multipliers become inapplicable when the earnings are negative. Negative earnings cannot be used for valuation of shares. However, when negative earnings occur, appropriate alternative estimates may be used for valuation. The substitute measures would depend on the cause for negative earnings.

There are a number of reasons for a company to have negative earnings. Some of the reasons for negative earnings can be listed as follows:

• Cyclical nature of industry
• Unforeseeable circumstances
• Poor management
• Persistent negative earnings
• Early growth stage
• High leverage cost

Negative Earnings Due to Cyclical Nature of Industry

Companies might belong to the cyclical industry. In such instances, when there is a recession in the economy, the company will post negative earnings. However, once the economic variables change, the companies in these cyclical industries also recover and show a positive growth rate. Take, for instance, companies belonging to the automobile sector. Whenever there is recession, these companies operate at below the break-even capacity and post negative growth rates.

If the earnings of a cyclical company are negative due to recession, the substitute earnings that have to be applied in the valuation process are the normalised earnings. Taking the average earnings over an entire business cycle can normalise earnings. Normalised earnings can be computed on the basis of net income or on the after-tax operating income. The formula for the computation of normalised earnings under these methods are:

Normalised Net Income = Average ROE * Current Book Value of Equity

Normalised after-tax Operating Income = Average ROC * Current Book Value of Assets

The choice of net income or after-tax operating income will depend on the use of debt in the company’s capital structure. When the company has relatively low debt capital, after-tax operating income would be the best choice. Net income can be used for companies with relatively high debt in its capital structure.

Negative Earnings due to Unforeseeable Circumstances

The earnings of a company may show a negative result due to a one-time unforeseen event. The extent of downtrend could depend on both external and internal factors relating to the company.

In such instances, the valuation can be done on the basis of the estimates without considering the abnormality. The substitute for the current negative earnings is the average earnings of the company. The computation is similar to that of negative earnings due to cyclical nature of industry. The average earnings of the company can be computed from the historical records to replace the present abnormal negative earnings. The time duration for considering the average earnings would depend on the nature of the industry and that of the specific company.

Negative Earnings due to Poor Management

The earnings of a company could be negative due to poor management. The company might have a team at the top which is responsible for the wrong business decisions or the company could have been affected by fraud or mismanagement issues. The negative performance could be in spite of a positive earnings record in the industry/sector to which it belongs. However, if it is felt that the negative earnings due to this mismanagement has been identified and corrective action by the company is on the agenda of the board, the valuation of such companies has to be done considering the industry earnings record.

The average return on equity or capital for the industry can be used to estimate the normalised earnings for the company. The implicit assumption is that the company will return to industry averages once the management has taken corrective measures. In this instance, the following formula can be used to compute the earnings of the company.

Normalised Net Income = Industry average ROE * Current Book Value of Equity

Normalised after-tax Operating Income = Industry average ROC * Current Book Value of Assets

Persistent Negative Earnings

The negative earnings recorded by a company could have continued over several years and the management actions may not have resulted in any improvement in the performance of the company. This persistent negative earnings significantly reduces the book value of the company over a time duration. The erosion of profits and assets of the company could be despite the good profits recorded by similar companies operating in the same industry.

To assess the value of such companies, an investor can use the average operating or profit margins for the industry along with revenues to arrive at normalised earnings. When the management has not taken any corrective action or the implications of the decisions are to be felt over a longer duration, the profit margin for the company could rise over a longer duration. The following formula can be used by investors to arrive at the value of the company using the earnings approach:

Normalised Net Income = Industry average net profit margin * Current Company Revenue

Normalised after-tax Operating Income = Industry average after-tax operating profit margin * Current Company Revenue.

Negative Earnings Due to Early Growth Stage

The earnings of a company could be negative because it operates in a sector that is in the early stages of its life cycle. This situation could also arise for a new company in an existing profit making industry. The gestation period for posting a positive return from business operations in most of these cases could involve a longer time duration.

The valuation of such companies will depend on the perceived margins and return on equity when the industry matures. In this instance, the formula for computation of company earnings is

Normalised Net Income = Expected ROE * Current Book Value of Equity

Normalised after Tax Operating Income = Expected ROC * Current Book Value of Assets

Negative Earnings Due to High Leverage Cost

The equity earnings are negative not due to operational mismanagement but may be due to high leverage or the interest burden of the company. The increased long-term obligations of the company along with increase in the interest rates may result in negative earnings to the company despite a positive result from the industry.

The valuation of such companies must be from the viewpoint of the company rather than that of equity valuation. Hence, valuation could depend on after-tax operational income rather than on the income to equity shareholders. The formula is:

Normalised after-tax operating Income = Average ROC * Current Book Value of Assets

Earnings Forecast

Earnings can be forecast through the forecasts of the rates resulting in the earnings. The variables that can be considered for forecasting earnings can be the future return on assets, expected financial cost (interest cost), the forecasted leverage position (debt equity ratio), and the future tax obligation of the company. The formula for forecasting the earnings could be stated as follows:

Where,

ROA = Forecasted Return on assets

I = Future Interest rate

D = Total Expected long term debt

E = Expected Equity capital

t = Expected tax rate

Alternatively, a forecast of sales and projected profit margin can be made to compute the forecasted earnings. The sales forecast would depend on the market share of the estimated industry sales forecast. The profit margin forecast will depend on the operational and financial expenses of the company. From this information earnings can be forecast using the following formula:

            Forecasted sales = Industry sales target * company’s expected share in industry sales

        Forecasted earnings = Forecasted sales * projected profit margin

The third method of forecasting earnings is to identify the individual variables constituting the earnings determination and forecast each of these variables separately. This will involve the forecast of the fixed and variable components of the operational expenses and the financial expense. This method is most applicable when the fixed and variable components of the cost structure of a company do not vary drastically with that of the average industry cost figures.

Consider a company with a high fixed cost relative to that of the industry average. The company will be able to make a positive return only when the projected sales dramatically exceeds this high cost. This is illustrated in Figure 7.1.

The company’s total cost far exceeds the industry total cost. Given a sales level and variable cost level, a company whose fixed costs are above the industry average will be able to reach a profit figure at a comparatively higher level of activity. Similarly, any company that is able to minimise its fixed costs will have a better position in terms of profitability than the industry average. Hence the need to forecast the individual variables that constitute profit rather than the overall return on assets.

Forecasting Earnings Using Statistical Tools

Statistical analysis can be applied in forecasting specific variables such as that of sales. Simple statistical models are the ordinary least square (OLS) estimates that draw a linear relationship between time and historical sales. Extending the linearity relationship further then helps in computing the forecasts. When the growth of variables is expected to be constant, the linearity model fits the data well. They are simple and can be tested for fitness and reliability. The graphical presentation of this method of forecast is shown in Figure 7.2.

When the variable growth is not a constant rate, the simple regression equation may not be the best estimate. For companies that expect a higher growth in later years, the linearity fit might not work very well, though for the initial years the fit might be perfect. In such circumstances, the company has to use a non-linear statistical tool such as the parabolic equation. The parabolic forecast is shown in Figure 7.3.

Other models of forecast equations for non-linearity in growth rates such as the log-linear functions, hyperbolic functions, and so on can be used. Figure 7.4 illustrates some hyperbolic functions that are typically identified with business sales estimates.

Forecast of Annual Versus Quarterly Results

The investor also has to use different criteria while forecasting quarterly earnings. Quarterly result forecasts have to be adjusted for seasonality variations. Besides using autoregressive models such as ARCH, GARCH, to predict quarterly earnings, a simple model is to forecast the growth in earnings for the following quarter similar to the previous quarter actuals a year ago. For example, the first quarter growth in sales can be forecast by relating it to the prior one year first quarter growth. Thus the following linear equation can be built to predict the quarterly forecasts:

where,

Q₂e_t = 2^nd quarter earnings in year t

Q₁e_t = 1^st quarter earnings in year t

Q₂e_t−1 = 2^nd quarter earnings in year (t−1)

Q₁e_t−1 = 1^st quarter earnings in year (t−1)

Forecasts can also be based on the analyst’s prediction in the media. Financial analysts and fund managers, while analysing their investment decisions, publish financial estimates of forecast data. The company also similarly projects its next quarter estimates and communicates it to investors. The investor can also rely on these sources though they have been found to have significant errors in their computations.

REVENUES VALUATION

Revenues are income generated by a company for undertaking business activities. A company might not have generated profits in a specific time duration, but the company would have generated positive revenues at any time unless otherwise the company has not yet established its business fully. The instances when the company does not have any revenue could also be due to plant shutdown owing to unforeseen economic situations or strike and similar situations. Even companies that may be temporarily losing money, or those that have negative earnings due to short-term circumstances (such as product development or higher taxes), or are relatively new in a high-growth industry are often valued based on their revenues and not on their earnings. Revenue-based valuations are achieved using the price/sales ratio (PSR).

The price/sales ratio considers the current market capitalisation of a company and divides it by the historical revenues of the previous 12 months. Market capitalisation is the current market value of a company, arrived at by multiplying the current share price times the shares outstanding. This is the current price at which the market is valuing the company. For instance, if a company has Rs 10 crore shares outstanding, priced at Rs 12 a share, then the market capitalisation is Rs 120 crore. If the total sales revenue for a year is Rs 50 crore, the PSR will be (120/50) 2.4. The formula for the computation of price to sales ratio is as follows:

        Price to Sales Ratio = Market capitalisation/One year total revenue

        Market capitalisation = Outstanding shares * current market price

The PSR can also be computed by adding, the total long-term debt obligations of the company to the market capitalisation to arrive at the total investible income. This is a conservative estimate of the price/ sales ratio. The logic here is that the sales revenue is earned from the total investible amount, that is, equity along with debt contribute towards the revenue generation by the company. This also is based on the assumption that when an investor buys shares in a company, he is also involved in the debt component of the company. This is because profits for equity holders are arrived at only after deducting the finance expenditure (interest). Hence, when an investor buys equity, the price of the equity instrument will include the risk of the debtholders. This method overcomes the limitation of the earlier computation that will not enable comparison of two companies with different debt positions. The formula for computation of PSR is as follows:

        Price to Sales Ratio (PSR) = Market capitalisation/Total revenue for a year.

                Market Capitalisation = (Shares Outstanding * Current Market Price) + Current Long-term Debt

Examples Mastek has recorded a sales of Rs 155.44 crores for the past year. The market capitalisation of the company is Rs 811.4 crores. Compute the PSR.

Indian Hotels has a market capitalisation of Rs 821.2 crores. The book value of the long-term debt is Rs 432.5 crores. The Indian Hotels has recorded revenue of Rs 686 crores during the previous four quarters. Compute the price/sales ratio.

        PSR = (market capitalisation + long-term debt)/revenue for four quarters

        PSR = (821.2 + 432.5)/686 = 1253.7/686 = 1.83

PSR is also used when there is a proposal of merger acquisition in the management decisions. This is also termed as a “multiple of sales” measure. PSR is the multiplier that is historically derived and given the current/estimated sales, the market capitalisation of the stock is worked out. Market capitalisation divided by the number of outstanding shares gives the forecasted value per share.

The interpretation of PSR is similar to that of price to earnings growth and forward price to earnings growth ratios. As with the PEG and the FPEG, lower PSR ratios imply an undervaluation of the shares in the market and are best buys for investors. On the other hand, a high PSR indicates that the market has already overpriced the shares. Hence, it is an indication of a sell decision for investors. This is the most common application of PSR, that is, to estimate if the market has priced the share correctly or not.

The PSR is a valuable tool to use when a company has not made profit in the preceding few years but is expected to overcome the problems in the near future. Unless the company is about to be liquidated or is foreseeing a closure of its production function, the investor can use the PSR to estimate the real value of the company’s traded share. A company has posted negative earnings in the last year but its PSR is a positive 0.80, whereas other similar companies have recorded a PSR of around 2.50. The equity value for the company should be based on PSR rather than earnings. There are some years during recessions, for example, when none of the companies in a specific industry make money. In such instances, an investor has to use PSR instead of P/E to measure how much they are paying for a rupee of sales instead of a rupee of earnings.

Another common use of PSR is to compare companies in the same line of business with each other, using the PSR in conjunction with the P/E to confirm market value. If a company has a low P/E but a high PSR, it could indicate the potential changes of a few one-time gains in the last four quarters that had resulted in a high PSR.

CASH FLOWS VALUATION

Cash flows are different from the book profits reported by companies. Cash flows indicate the net of inflows less outflows from operations. Cash flows differ from book profits since accounting profits identify expenses that are non-cash items such as depreciation. Cash flows can also be used in the valuation of shares. It is used for valuing public and private companies by investment bankers. Cash flow is normally defined as earnings before depreciation, interest, taxes, and other amortisation expenses (EBDIT). There are also valuation methods that use free cash flows. Free cash flows is the money earned from operations that a business can use without any constraints. Free cash flows are computed as cash from operations less capital expenditures, which are invested in property, plant and machinery and so on.

        FCF (Free Cash Flow) = Operational Cash Flow - Capital expenditure

EBDIT is relevant since interest income and expense, as well as taxes, are all ignored because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the legal rules and regulation of a given year and hence can cause dramatic fluctuations in earning power. The company makes tax provisions in the year in which the profits accrue while the real tax payments will be made the following year. This is likely to overstate/understate the profit of the current year.

Depreciation and amortisation, are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting allocation for tax purposes that allows companies to save on capital expenditures as plant and equipment age by the year or their use deteriorates in value as time goes by. Amortisation is writing off of capital expenses from current year profit. Such amortised expenses are also the setting aside of profit rather than involving real cash outflows. Considering that they are not actual cash expenditures, rather than accounting profits, cash profits will indicate the real strength of the company while evaluating its worth in the market.

Cash flow is most commonly used to value industries that involve tremendous initial project (capital) expenditures and hence have large amortisation burdens. These companies take a longer time to recoup their initial investments and hence tend to report negative earnings for years due to the huge capital expense, even though their cash flow has actually grown in these years.

The most common valuation application of EBDIT is the discounted cash flow method, where the forecast of cash flows over a period of time are made and these are discounted for their present worth.

The formula for computing the value of the firm will be

where C i = cash flows forecast for year i

d = expected rate of return

n = number of years for which forecasts have been made.

 

This can be easily computed using software applications such as the spreadsheet. The following table illustrates the computation of the value of firm based on cash flow expectations.

Buying a company with good cash flows can yield a lot of benefits to an investor. Cash can fund product development and strategic acquisitions and can be used to meet operational and financial expenditures.

Cash forecasts are made for a limited time duration. However, the shares are valued for their ability to produce an indefinite stream of cash flows. This is referred to as the terminal value of shares. Terminal value usually refers to the value of the company (or equity) at the end of a high growth period. When an indefinite duration of growth is considered, it is normal to assume that a stable growth will follow the high growth. This stable growth rate is expected to remain constant. With this assumption, the terminal value computation can be given by the following formula:

where,

d is the discount rate of the cash flows

‘g’ is the stable growth rate

This approach also requires the assumption that growth is constant forever, and that the cost of capital (discount rate) will not change over time.

A stable growth rate is one that can be sustained forever. Since no company, in the long term, can grow faster than the economy that it operates in, a stable growth rate cannot be greater than the growth rate of the economy.

This stable growth rate cannot be greater than the discount rate either because of the risk-free rate that is implied in the discount rate. This invariably means that the discount rate has to be fixed after considering the inflation rate, economic growth rate, time value, and so on.

Price to cash flow ratio can also be used as a valuation model. Cash flow multiplier is computed as: market price/cash flow per share. For example, if the current market price is Rs. 60 and cash flow per share is Rs. 20, the cash flow multiplier would be 3. If the forecasted cash flow per share is Rs. 23, then the market value can be estimated as (23 × 3) Rs. 69.

Economic value added (EVA) is another modification of cash flow that considers the cost of capital and the incremental return above that cost.

Assuming the after tax return from operations is 18% and the cost of capital is 10%, the incremental return for the company would be 8% (18–10). If the face value of the investment in the company is Rs. 100 per share, the economic value added per share will be Rs. 8. If the current market price of the share is Rs. 200, then the EVA multiplier will be (200/8) 25. EVA multiple can then be used to identify the under pricing or over pricing of a share in the market.

ASSET VALUATION

Expectation of earnings, sales or cash flows alone may not be able to identify the correct value of a company. This is because the intangibles such as brand names give credentials for a business. In view of this, investors have begun to consider the valuation of equity through the company’s assets.

Asset valuation is an accounting convention that includes a company’s liquid assets such as cash, immovable assets such as real estate, as well as intangible assets. This is an overall measure of how much liquidation value a company has if all of its assets were sold off. All types of assets, irrespective of whether those assets are office buildings, desks, inventory in the form of products for sale or raw materials and so on are considered for valuation.

Asset valuation gives the exact book value of the company. Book value is the value of a company that can be found on the Balance sheet. A company’s total asset value is divided by the current number of shares outstanding to calculate the book value per share. This can also be found through the following method—the value of the total assets of a company less the long-term debt obligations divided by the current number of shares outstanding.

The formulas for computing the book value of the share are given below:

        Book value = Equity worth (capital including reserves belonging to shareholders)/Number of outstanding shares

        Book value = (Total assets−Long-term debt)/Number of outstanding shares

Book value is a simple valuation model. If the investor can buy the shares from the market at a value closer to the book value, it is most valuable to the investor since it is like gaining the assets of the company at cost. However, the extent of revaluation reserve that has been created in the books of the company may distract the true value of assets. The revaluation reserve need not necessarily reflect the true book value of the company; on the other hand, it might be depicting the market price of the assets better.

Book value, however, may not correctly depict the company value, since most companies use different accounting methods. Further, the adjustment to the historical figures in terms of economic inflation or deflation of the asset book values are not incorporated in these value estimations. The book values are also subject to adjustments depending on the tax framework within which the company falls and the consequences relating to the company’s tax planning measures. But, with increased corporate governance practices, the book value concept is becoming more relevant to the investor for valuation purposes.

Another useful measure of asset valuation is the price to book ratio. This ratio is arrived at by relating the current market price of the share to the book value per share. The intention is to compare the prevailing market price with the book value per share and identify if the shares are undervalued or overvalued in the market. The computation of price to book ratio is computed as follows:

The undervaluation of shares will be established when the price to book ratio is relatively low. A high price to book ratio, on the other hand, implies that the shares are sold at a price not supported by its asset value in the market.

For example, if a company has total assets less long-term liabilities as Rs. 43950 crores and the number of outstanding shares at 2,000 crores, the book value per share will be (43950/2000) Rs. 21.975. If the market price is quoted at Rs. 84, the Price to Book multiplier will be (84/21.975) 3.82.

Another use of asset valuation is through the return on equity, (ROE). Return on equity is a measure of how much earnings a company generates in four quarters compared to its shareholder’s equity. For instance, if a company earned Rs 2 crores in the preceding year and has a shareholder’s equity of Rs 10 crores, then the ROE is 20 per cent. Investors might use ROE as a filter to slect companies that can generate large profits with a relatively small amount as capital investment. The nature of ROE, however, depends on the type of industry the company belongs to. The ROE figures of trading companies are expected to be comparatively higher than that of heavy manufacturing concerns since trading companies need not necessarily require constant capital expenditure.

The book value computation that includes within its fold the valuation of intangible assets such as brands and patents, are viewed positively by investors. Investors view brands as valuable and they are assumed to increase the expected future profits of the company. Brands also tend to have a strong market potential since customers prefer a brand exclusively for its name and sometimes, brands convey more meaning than the product quality. Specific value is given to brands that have recently established unshakable credentials. Companies also spend a lot of money on building brands in their product portfolios. Some companies build the brand name around their company name; this has a direct impact on the valuation by investors. Companies such as Colgate, Intel, Nestle, and Bata have built their company names into brands that give them an incredible edge over their competitors in the market.

Intangibles can also sometimes mean that a company’s shares can trade at a premium to its historical growth rate. Thus, a company with large profit margins, a dominant market share, consistent performance can trade at a slightly higher multiple than its growth rate would otherwise suggest.

A company can sometimes be worth more in reality than when viewed individually in terms of all the assets in its Balance Sheet. Many times, human resource strength is an intangible that is built inside the organisation and neither the company nor the shareholders give a uniform quantification to such strengths. The book valuation process of a company is hence the exercise of a few investment bankers and consultants who get to know the intricate details of the company. Rather than attempting to make a book valuation of the company individually, investors can rely on such sources to assess the undervaluation or overvaluation of shares in the market.

YIELD VALUATION

A dividend yield is the percentage of a company’s share price that it pays out as dividends over the course of a year. For example, if a company pays Rs. 4.00 in dividends during a year and its shares are trading at Rs 100, it has a dividend yield of 4 per cent.

Dividend Discount Models

The basic idea behind the dividend discount models is that the value of any asset, is simply the discounted value of all the future cash flows associated with the asset:

In general,

where,

V is the current value of a security

D1 denotes the (estimated) dividend to be paid for the share one year ahead

k is the discount rate

The calculated value of the share is compared with the current market price to determine if the share is selling at an overvalued or undervalued rate. Accordingly, investors take an investment decision of buying and holding the share or disposing it to gain profits from the market. The important assumption behind the formula is that a constant dividend of D1 is expected to flow indefinitely from the company to the investors.

There are some basic assumptions that are made when dividend valuation is used. These can be categorised into zero-growth, constant growth, abnormal growth, and multi-period growth models.

The Zero-growth Model

In this case, dividends are assumed to remain the same forever. Hence, the cash flows paid for the share are assumed to be the same over an indefinite period of time. However, the earnings growth is estimated to be internally applied in projects which pay an end value to the investor that is apart from the cash flow of dividends. Since the company discounts future constant cash flows in addition to the market price of the share, the formula is revised as:

where, P1 is the market price of the company in future.

This formula can be modified if the investor is aware of the time duration for which the shares are likely to be held. For example, if the shares are presumed to be held for a five-year duration, the value of the shares will be computed using the following equation:

Mostly, zero-growth shares are the preference shares issued by companies which carry a constant dividend payment not subject to any variation over a period of time.

Example There are about 10 crore shares outstanding of a company’s 8 per cent preferred capital. The par value is Rs 100 and the dividend is paid every quarter. Assuming that the discount rate is 10 per cent, compute the value of the share.

Dividend payment every quarter will be 100 * .08/4 = Rs 2. The annual dividend can be computed using the real rate of dividend. Nominal rate is 8 per cent per annum. The real rate of dividend payment every year will be:

The annual dividend to be paid on the preference shares is Rs 8.24.

Using the zero-growth model, dividend payment will be divided by the discount rate, assuming an indefinite flow of Rs 8.24. The value of the preference shares will be:

For the same illustration, if we assume that the discount rate is 6 per cent. The value of the preference share in the revised expectation will be:

Higher the expected discount rate, lower will be the value of the company; and lower the expectations, given the same cash flows from the company, higher will be the valuation.

Alternatively, given the market price of the company’s traded preferred share, the investor can also compute the dividend yield and compare it with the expected returns. Investment decisions can be made accordingly as to whether the dividend yield is higher or lower than the expected returns of the investor. For computing the dividend yield the future expected dividend is divided by the market price of the share. The following formula is applied.

where,

Po is the current market price/traded price of the share.

Assuming the current market price of the preference share is Rs 107, the dividend yield is computed as (8.24/107)*100 = 7.70%.

The Constant-growth Model

This model assumes that dividends grow forever at a fixed growth rate ‘g’. The growth in dividends imply that payment to shareholders from the company keeps increasing at the rate of g.

In this model, the formula for the value of a share is

When ‘g’ is 0, the constant growth model becomes a zero-growth model.

A constant growth is difficult to achieve in the real world. However, the model could be used as an approximation for companies that experience normal growth over an indefinite period. For the valuation of shares over a long duration, this model would measure the market price better than the zero-growth model.

Example In January 2003, an investor bought a share (Face Value Rs 100) with an expected annual return of 12 per cent. The dividends for the year are as follows: 1st quarter: Rs.1.5,2nd quarter: Rs 1.52,3rd quarter: Rs 1.55,4th quarter: Rs 1.57. Assuming a dividend growth rate of 6 per cent per annum, estimate the value of the share in January 2003.

Since the current year dividend payments are given, the first step is to identify the expected dividend payment which will be D0 * (1 + g). The quarterly dividend rates have been growing at an annualised rate of 6.1 per cent. Hence, ‘g’, the growth rate for the dividend payment is 6.1 per cent per annum.

For the same problem, given the current market price the yield can be identified. The formula for computing the yield is as follows:

For the illustration, dividend yield for the assumed current price of Rs 98 will be:

For example, if the closing price happens to be Rs 102, the dividend yield will be computed as follows:

The implied discount rate for the share is 12.2 per cent.

The Abnormal-growth Model

Abnormal-growth rates occur when a company faces super normal growth pattern or negative growth pattern. The company may not experience such abnormal-growth rates for an indefinite duration. Such abnormal-growth rates compel valuation of companies in stages. The computation is similar to that of multiple-growth model.

The Multiple-growth Model

The multiple-growth model assumes that in specific time periods, dividends could vary at different growth rates. The constant-growth model had the disadvantage of assuming a steady growth rate over an infinite time duration. In the multiple-growth model, this impracticality is reduced to stage-wise growth rates. Here companies are expected to go through phases/stages of ups and downs and each stage witnesses a unique growth rate. There could be abnormal growth rates in certain stages in the sense that growth rates can exceed the discount rates or capitalisation rates. A simple, two-stage growth model is given by the following formula:

The valuation is done in two stages. Stage one assumes a growth rate of g₁ and stage 2 assumes a growth rate of g₂. The shares first grow at rate ‘g₁’ for ‘n’ years and later at ‘g₂’ for an indefinite time. Even though in the initial stages, the dividends grow at a rate greater than the discount factor ‘d’, the formula considers the individual cash flows by computing the dividend received for each year under the abnormal growth situation. In the second stage, the shares are expected to have reached a stable position; hence, the assumptions of normal growth rate over an indefinite time. The second stage is similar to valuation in terms of a constant-growth model. However, the time duration in which this occurs is taken into account by the discount factor (1/(1+d)^ʌn), where ‘d’ is the expected rate or the discount factor.

Example A company is expecting to pay annual dividend of Rs 3 per share and this dividend is expected to grow at a rate of 8 per cent for the next four years. Thereafter, the dividend growth rate is expected to slow down to a constant rate of 5 per cent per annum. Assuming the expected rate from the share to be 7 per cent compute the value of the share.

Stage one involves valuing the cash flows for years 1 to 5. Stage two will value the share from the sixth year onwards. The individual cash flows for the first five years can be worked out as follows:

Stage 1

These dividend flows are then discounted at the expected rate of 7 per cent. The results are:

The total value of the firm in the first stage is the summation of all these discounted cash flows, that is, Rs 14.29.

Stage 2 discounts the sixth year’s dividend by the factor (d-g₂). The sixth year’s dividend is found by multiplying the fifth year’s dividend by the growth factor in stage 2, that is, 5 per cent. The sixth year dividend hence is computed as follows:

The stage 2 valuation is 4.28/(.07 − .5) = 4.28/.02 = 214

The stage 2 valuation is further discounted to the present by multiplying the amount by (1/(1+.07)^ʌ5)=0.713

The stage 2 current valuation is Rs 152.58

The value of the share is stage 1 valuation + stage 2 valuation.

This two-stage process can be extended into any number of multiple-stages by an investor. Multiple-stage growth models are more relevant and practical to investors. However, the investor has to forecast accurately the various stages of growth as well as the rates of growth in each stage.

The dividend models or yield models will not hold good when companies fail to declare dividend despite profits reported in their income statements. Companies may plough back the entire profit for its own project requirements and may not pay any dividend on the share. Despite zero dividend payments, such companies’ shares tend to rise in the market due to the internally generated profits of the companies.

The dividend-discount model or yield method of valuation could be still used by the investor if he is able to estimate the following variables for the company:

1. when dividends will start to be paid;
2. how much they will be; and
3. how they will grow over time.

Many income-oriented investors choose a company’s share when the yield reaches a very high rate. The dividend-yield method is a simple tool to assess the right market price of the share. Assuming a company had shown a consistent growth rate of 5 per cent in the past ten years and is expected to do the same in the future, if the dividends are expected to be Rs 3 per share, an investor (expected rate 10%) can easily work out the price of the share or its worth in the market at Rs 60 (3/0.05). If the actual price of the share in the market is Rs 40 (below Rs 60), the investor has a good bargain and buys the share, expecting the market to correct the price imperfection in the near future. When the share reaches the Rs 60 price level, the investor can sell the share to claim a capital gain from the market.

MEMBER VALUATION

Sometimes a company can be valued based on its subscribers or its customer accounts. Subscriber-based valuations are most common in media and communication companies that generate regular, monthly income such as cellular and cable TV companies. In a subscriber-based valuation, analysts calculate the average revenue per subscriber over their lifetime and then compute the value for the entire company. If Airtel has 80,000 members and each uses the service, on average, for 30 months, spending an average of Rs 1,000 a month, the company is valued at 80000 * 30 * 1000 = Rs 240 crores.

Member based valuations are done by investment consultants or merchant bankers. Not all investors would be able to avail the information needed for such valuation.

Multi-factor Share Valuation

Quantitative approaches convert a hypothetical relationship between numbers into a unique set of equations. These equations mostly consider company-level data such as market capitalisation, P/E ratio, book-to-price ratio, expectations in earnings, and so on. Quantitative methods assume that these factors are associated with shares returns, and that certain combinations of these factors can help in assessing the value and, further, predict future values. When several factors are expected to influence share price, a multi-factor model is applied in share valuation.

The choice of the right combination of factors, and how to weigh their relative importance (that is, predicting factor returns) may be achieved through quantitative multivariate statistical tools. Many factors that have been considered individually can be combined to arrive at a best-fit model for valuing equity shares. Value factors such as price to book, price to sales, and P/E or growth factors such as earnings estimates or earnings per share growth rates, can be used to develop the quantitative model. These quantitative models help to determine what factors best determine valuation during certain market periods. These multifactor share valuation models can also be used to forecast future share values.

VALUATION OF PRIVATE COMPANIES

Unlike the valuation of share in a publicly traded-company, the valuation of a private company has to consider the following:

1. The information available on private companies are scarce.
2. Past financial statements, even when available, might not reflect the true earnings potential of the company. Many private businesses could understate earnings to reduce their tax liabilities.

The limited availability of information does make the estimation of cash flows much more difficult. Past financial statements also have to be restated to make them reflect the true earnings of the company. Once the cash flows are estimated, however, the choice of an appropriate discount rate has to be made to value the business.

SUMMARY

Equity shares carry with them ownership rights. They give voting rights to the holders. They have a face value (in monetary terms) at the time of issue and are evaluated at their market value when they are listed on a stock exchange.

Equity valuation is a complex procedure since there is no consistent definition regarding what constitutes the intrinsic value of a share. Different valuation approaches and models with different assumptions and implications are available to investors to assess the true worth of a share. These include earnings approach, revenue approach, cash flow approach, yield approach, and members approach.

An investor can choose the appropriate procedure of valuation for shares and make profits from the stock market.

CONCEPTS

• Equity	• Stock dividend
• Non-linear growth rates	• Stock split
• FPEG	• Normalised earnings
• Book value	• P/E growth ratio
• Yield	• P/E relative
• P/E multiple	• PSR
• Member valuation	• Multi-factor model

SHORT QUESTIONS

1. What priority rights are available to preference shares?
2. What is P/E multiplier?
3. What is PS Ratio?
4. What are normalised earnings?
5. What is stock dividend?
6. What method of equity valuation is appropriate for media and communication companies?

ESSAY QUESTIONS

1. Discuss the assumptions and implications of earnings approach to equity valuation.
2. What are the quantitative models of equity valuation? What are their limitations?
3. What factors determine the choice of an equity valuation approach?
4. Discuss the merits and limitations of the yield approach to valuation.
5. Briefly discuss the various equity valuation approaches. Which do you think is a more practical application for investors?

PROBLEMS

1. Following are the financial forecasts of a company for three years. Compute the value of its share.
   
2. GTB has the following figures as historical data. Compute the value of its share under various valuation models.
   
3. Philips India Ltd. had a dividend payout of Rs 126.4 million in 1999 and zero dividend payout in 2000. The profit after tax figures is Rs 281.4 million in 1999 and a loss of Rs 341.5 million in 2000. The total income for 1999 is Rs 16,870.3 million and Rs 14,674.6 million in 2000. The market price of its shares at the Bombay Stock Exchange at the end of the year was Rs 95.55 in 1999 and Rs 76.24 in 2000. The number of outstanding shares was 45.53 million. Compute the value of its share.
4. Mahindra & Mahindra had the following historical earnings report. Compute the market price of its shares.
   
5. Ranbaxy Laboratories has the following historical information. Establish the price of its share for the respective years using yield valuation. Make suitable assumptions.
   
6. India Glycols Ltd. has the following historical data. Compute the yield.
   
7. Siyaram Silk Mills has the following historical figures. Compute the under/overvaluation of its shares.
   
8. Tata Chemicals has the following data. Establish the intrinsic value of its share.
   
9. ITC Ltd. has the following historical financial data. Identify if its share is a good investment.
   
10. Compute the growth ratio from the following data.