This topic focuses on share and firm valuation because when we talk about firm valuation, the most important element is the determination of a share’s price. Valuation is closely linked to capital budgeting, risk, returns and the cost of capital because a return model is a transformation of the valuation model, and the discount rate used in valuation and capital budgeting is either a part or wholly the cost of capital.
? Valuation of critical:
• Maximise the firm’s value/ordinary shares
• Estimating the cost of capita
? Three models:
Dividend Growth Valuation Models – Link to value shares
• Theorises that Dividend payments constitutes value- Dividend may be increased or decreased depending on earnings
• Represents equity or ownership
• Includes voting rights
• Priority: lower than debt and preferred
We can simplify the pattern for dividend payment as follows:
• The dividend has a zero growth rate, and
r is also known as the market capitalisation rate
(MCR) or the hurdle rate because the investor expects his “true” rate to be higher than the market rate or the hurdle rate. r is also called the holding period return, the HPR assumes that investors in securities would expect to get some of cash dividends and capital gains from the eventual sale of the shares.
Dividends-Discounting Model (DDM)
Where :?= sum of the series
E [Dt] = Expected dividends in period t
This formula is equivalent to valuing the market value of the firm’s equity at the present value since buying stocks is in fact buying a part of a firm
Since future cash flows are constant, the value of a zero growth stock is the present value of perpetuity: zero growth CDVM
D= Constant dividend
r= Required rate of return
This formula is useful for investors who want to know the historical rate of return for a company’s stock, and also when the investor wished to determine the expected required rate of return for the future value of a firm’s stock
• The dividend growths as a constant rate
Since future cash flows grow at a constant rate forever, the value of a constant growth stock is the present value of growing perpetuity:
However, discounting the above successively depends on r and g:
? if r=g, the share would be infinite
? if r
The DDM models and rate of return it can changeable
Free-Cash Flow Valuation models – Link to value firm
FCF is defined as the cash flow left over after deducting the costs of operations (purchases and expenses) and new investments from revenues (sales)
FCF= Net Income (NI) + Depreciation-Cost-Investment
Where: Vo =Value of firm at time t
FCFt = CFOt – Invt or FCFt = Nit + Dept – ?WC – Invt
Since FCF measures the cash flow from the entire firm and hence enterprise cash flow or entity cash flow is more appropriate, which is based on the comprehensive basis, the discount rate used in the FCF context must be the cost of capital for the entire firm, which is the weighted average cost of capital.
Since FCF is firm level, the growth rate relates to the cash flows of the entire firm.
Growth rate (g) = Plough back ratio x ROA = k where ROA=return on asset
Residual Income Valuation Models – Link to value shares
The alterative to the dividend-discounting model is the residual earnings or abnormal earnings valuation models. This model no need to use dividends or cash, it based on value add book value of equity as fundamental value and forecasts if residual earnings.
The Ohlson (1995) model is concerned with a single firm’s market value as it relates to contemporaneous accounting information –future earnings, book values and dividends, and other relevant information. The valuation model is set on an efficient market with risk neutrality (risk free), no arbitrage, no information asymmetry, non-stochastic interest rates and a constant term structure.
This equation is formulated by substituting RI for dividend into the DDM (equation Po = Div/r)
the RIVM is restatement of the DDM. Though using the RIVM, we can value the firm’s equity using fundamental accounting data and there is no need to use DDM to value equity. Thus the only relevance of the DDM is just to provide theoretical support for using the RIVM
Similar to the DDM and FCF models, the RIVM of equation can also be expressed in terms of constant growth model
? The advantage of the RIVM is that it emphasizes the important of fundamental economic performance to equity valuation in particular:
• The difference between ROE or and the cost of equity capital r
• The expected rate of growth in the book value of equity
RIVM can help explain prices better than the DDM or FCF for two reasons:
? By definition, any increase in RI implies value creation
? By comparing the value of the firm and MWE, we can determine whether the share price is over valued or under value
? Advantages of DDM
(1) Very intuitive-it is easy to understand the DDM in that dividends are cash flows paid directly to shareholders.
(2) The model is parsimonious.
(3) Operationalization of the DDM is straightforward and easy to apply.
(1) Obviously, the DDM only works for firms which pay dividends.
(2) The DDM does not explicitly account for risk.
(3) We need to make an estimate of the firm’s growth rate, g, but this can be difficult to do in practice.
(4) As seen in point (2) above, we are not able to explicitly account for risk.
(5) Estimates of the shares’ value are very sensitive to our estimates of g and r.
(6) The DDM only works for firms which pay dividends.
The dividends and residual income approach attempts to maximize shareholders’ wealth while the FCF approach attempts to maximize the wealth of the enterprise.