Chapter 5.

Principles of Valuation

LO1. Difference between stock price and stock value

LO 2. Free cash flow valuation

LO 3. Residual income Valuation

5.1Difference between Stock price and Stock value

Stock price is significantly different stock value. Stock price is a reflection of public sentiment about
the company. Stock value on the other hand is a stock’s inherent value which depends on company’s
earnings, sales volume over time, potential and current competitors etc. Analysts usually utilize free
cash flow valuation and residual income valuation technique to estimate stock value.

Why valuation is required

In financial markets, stock valuation is used to predict potential market prices in the future and thus
to profit from price movements. Stocks that are rated undervalued (with respect to their calculated
theoretical value) are bought, while stocks that are rated overvalued are sold, with the expectation
that undervalued stocks will rise in value, while overvalued stocks will generally decline in value.

5.2 Free cash flow valuation

Free cash flow to the firm (FCFF) is the cash flow available to the company’s suppliers of capital after
all operating expenses (including taxes) have been paid and necessary investments in working capital
(eg. Inventory) and fixed assets (eg. Equipment) have been made. FCFF is the cash flow from
operations minus capital expenditures. The company’s suppliers of capital include common
stockholders, bondholders and sometimes preferred stockholders.

FCFF = Net Income available to common shareholders (NI)

Plus: Net non-cash charges (NCC)

Plus: Interest expense X (1- Tax Rate)

Less: Investment in fixed capital (FCInv)

Less: Investment in working capital (WCInv)

FCFE = Free cash flow to Equity shareholders

FCFE = NI + NCC – FCInv – WCInv + Net borrowing, where

NI = Net income or Profit After Tax

NCC = Non cash charges ( Depreciation/ Amortization)

FCInv = Investment in fixed assets only to the extent of maintaining its current operating capacity.
This should not include expenses on new operating capacity (or expansion)

WCInv= Investment in working capital (changes in current assets and changes in current liabilities.
A +ve change in current assets means cash is invested in current assets and this should lead to a
reduction in FCFE. A +ve change in current liabilities means cash is freed up by accruing more current
liabilities and this should lead to an increase in FCFE)

Net borrowing = Repayment of long term debt + Fresh issue of long term debt

Net borrowing will be +ve if the fresh issue of long term debt is more than the repayment of long
term debt

When a company purchases fixed asset, such as equipment, the balance sheet reflects a cash
outflow at the time of purchase. In subsequent periods, the company records depreciation expense
as the asset gets used up. The depreciation expense reduces net income but is not a cash outflow.
Depreciation expense is thus the most common non-cash charge which must be added back while
computing FCFF.

After-tax interest expense must be added back to net income to arrive at FCFF. This step is required
because interest expense net of related tax savings was deducted in arriving at net income and also
because interest is a cash flow available to one of the company’s capital providers.

Investments in fixed assets represent outflows of cash to purchase fixed assets necessary to support
the company’s current and future operations. This should not include investments in new fixed
assets required for expanding production capacities.

Current assets are funded in part by current liabilities. The gap (current assets – current liabilities) is
carried by the company for the foreseeable future. This gap needs to be funded by long-term
sources of capital (equity is the most preferred method of financing).

5.2.1Constant –growth FCFF Valuation model

Here there is an assumption that FCFF grows at a constant rate, g, such that FCFF in any period is
equal to FCFF in the previous period multiplied by (1+g), where g is the constant growth rate of FCFF.
Hence, if FCFF grows at a constant rate,

FCFF 1 FCFF 0
Firm value = = X(1+g)
(WACC −g) (WACC −g)
If we subtract the market value of debt from the firm value, we get the value of equity for the firm.

Example 1: Capital Enterprises has FCFF of Rs. 700 million. The company’s before-tax cost of debt is
5.7% and required rate of return for equity is 11.8%. The company expects a target capital structure
consisting of 20% debt financing and 80% equity financing. The tax rate is 33.33% and FCFF is
expected to grow forever at 5% per annum. The company has outstanding debt of market value
Rs.2.2 billion and has 200 million outstanding common shares.

1. What is the company’s weighted average cost of capital?

2. What is the value of the company’s equity using FCFF valuation approach?
 3. What is the value per share using this FCFF approach?

Answer 1:

WACC = Weightage of debt capital X cost of debt X (1-tax rate) + Weightage of equity capital X cost
of equity

Therefore, WACC = 0.2 (5.7%) (1-0.3333) + 0.8 (11.8%)

= 10.2%

Answer 2:

The firm value of Capital Enterprises is the present value of FCFF discounted by using WACC.

FCFF 0 700 735

Firm value = X (1+g) = X (1+0.5) = = Rs. 14134.6 million.
(WACC −g) (0.102−0.05) 0.052

The value of equity = value of the firm – value of debt

Equity value = 14134.6 – 2200 = Rs.11934.6 million

Answer 3:

There are 200 million shares outstanding.

Therefore, value per share = Value of equity / No. of shares outstanding

= 11934.6 / 200

= Rs. 59.67.

Free cash flow to equity (FCFE)is the cash flow available to equity holders only. To find FCFE we must
reduce FCFF by the after-tax value of interest paid to debt holders and add net borrowing (debt
issued less debt repaid over the period for which free cash flow is calculated).

Free cash flow to equity (FCFE) =

Free cash flow to the firm (FCFF)

Less: Interest expense X (1-Tax rate)

Plus: Net borrowing

FCFE = FCFF – Int (1-Tax rate) + Net borrowing

If we expand the above formula we get,

FCFE = NI + NCC – FCInv – WCInv + Net borrowing

Now, NI + NCC – WCInv = Cash flow from operations (CFO)

Therefore, we can express FCFE in terms of CFO as follows:

FCFE = CFO – FCInv + Net borrowing

Example 2: Hi-Tech Corporation has bonds, preferred stock and common equity in its capital
structure. The market value of each of these sources of financing and the before-tax required rates
of return for each of these are given below:

Market Value (Rs. Required return

Million) (%)

Bonds 400 8
Preferred stock 100 8
Common stock 500 12
Total 1000

Other financial information (in Rs. Million):

Net income available to common shareholders = 110

Interest expense = 32

Preferred dividends = 8

Investment in fixed assets = 70

Investment in working capital = 20

Net borrowing = 25

Tax rate = 30%

Stable growth rate of FCFF= 4%

Stable growth rate of FCFE= 5.4%

1. Calculate WACC for the company

2. Calculate the current value of FCFF
3. Based on forecasted year 1 FCFF, find out the total value of the firm and the value of its
equity
4. Calculate the current value of FCFE
5. Based on forecasted year 1 FCFE, what is the value of equity?

Answer 1:
WACC = Weightage of debt capital X cost of debt X (1-tax rate) + Weightage of preference capital X
cost of preferred stock + Weightage of equity capital X cost of equity

400 100 500

WACC = X 8% X (1-0.30) + X 8% + X 12%
1000 1000 1000
WACC = 9.04%

Answer 2:

Since preferred dividends have been paid by the company, we must add back preferred dividends as
well as tax-adjusted interest payments when calculating FCFF.

Therefore, FCFF = NI + NCC + Int (1-tax rate) + Preferred dividends – FCInv – WCInv

FCFF = 110 +40 +32 (1-0.3) +8 -70-20 = 90.4

FCFF = Rs. 90.4 million.

Answer 3:

The total value of the firm is

FCFF 1 FCFF 0 90.4 94.016

Firm value = = X (1+g) = X (1+0.04) = = 1865.4
(WACC −g) ( WACC−g ) (0.0904−0.04 ) 0.0504
million.

Value of common equity is given by the difference of the total value of the firm minus the market
values of debt and preferred stock

Common Equity = 1865.4-400-100 = 1365.50 million.

The value of equity is Rs. 1365.50 million.

Answer 4:

FCFE = NI + NCC – WCInv - FCInv +Net borrowing

Here, net borrowing includes the sum of net new debt issued and net issuance of new preferred
stock.

FCFE = 110+ 40 -70 – 20 +25

FCFE = 85 million

Hence, FCFE = Rs. 85 million

Answer 5:

FCFE is assumed to grow at a constant rate of 5.4% per annum

FCFE 1 FCFE 0 85 89.59

Value of equity = = X (1+g) = X (1+0.054) = = 1357.42 million
( r−g ) ( r−g ) (0.12−0.054) 0.066

(Here, r = cost of equity capital and g= constant growth rate of FCFE)

Value of equity = Rs. 1357.42 million

5.2.2Two-stage free cash flow model

In two-stage free cash flow models, the growth rate in the second stage is a long-run sustainable
growth rate. For a declining industry, the second-stage growth rate could be slightly below the GDP
growth rate. For an industry that is expected to grow in the future faster than the overall economy,
the second-stage growth rate could be slightly greater than the GDP growth rate.

In general, the growth rate is taken to be constant in stage 1 before dropping to a long-run
sustainable rate in stage 2.

The general expression for a two-stage FCFE valuation model is as follows:

n1
FCFEt FCFE (n 1+ 1) 1
Equity value = ∑ t + X n1
0 (1+ r) (r−g) (1+r )

The summation gives the present value of the first n1 years of FCFE.

The last term in the above equation is the terminal value of FCFE from the year n1 +1 forward and is
given by FCFE(n 1+1)/ (r-g) discounted at the required rate of return on equity for n1 years. The
terminal value of FCFE is calculated at year n1 in lieu all future FCFEs from the year n1 +1 when the
growth rate of FCFE becomes constant indefinitely.

The terminal value estimation is critical for a simple reason. The present value of the terminal value
is often a substantial portion of the total value of the stock.

We will illustrate calculation of value of equity,given a 2-stage FCFE model,with examples:

Example 3:Advanced Dynamics Ltd, a manufacturing company, has a competitive advantage that is
expected to deteriorate over time. In order to value the company, the following information has
been gathered.

Current sales are Rs.600 million. Over the next six years, annual sales growth rate and net profit
margin as under:

Year 1 (%) Year 2 (%) Year 3 (%) Year 4 (%) Year 5 (%) Year 6 (%)
 Sales growth 20 16 12 10 8 7

Netprofit margin 14 13 12 11 10.5 10

Commencing from year 6, the 7% sales growth rate and 10% net profit margin should persist
indefinitely.

Capital expenditures (net of depreciation) in a year will equal 60% of increase in sales from the
previous year.

Investments in working capital are equal to 25% of sales increase every year.

Debt financing will be used to fund 40% of the total investments in working capital and net fixed
assets.

The beta for the company is 1.10. the risk-free rate of return is 6% and equity risk premium is 4.5%.

The company has 70 million outstanding shares.

1. What is the total market value of equity?

2. What is the estimated value per share?

Answer 1:

The required rate of return for the company’s equity is

r = r f + β (r m - r f ) = 6% + 1.1 (4.5%) = 10.95%

FCFE estimates for Advanced Dynamics Limited (Rs. Million)

Year
1 2 3 4 5 6

Sales growth rate

(%) 20 16 12 10 8 7
Net profit margin
(%) 14 13 12 11 10.5 10
Sales 720 835.2 935.4 1028.9 1111.3 1189.1
Net profit 100.8 108.5 112.2 113.1 116.7 118.9
Net FCInv 72 69.1 60.1 56.1 49.4 46.6
WCInv 30 28.8 25.1 23.3 20.6 19.4
Debt financing 40.8 39.1 34.1 31.8 27.9 26.5

FCFE (= Net profit - 39.6 49.7 61.1 65.5 74.6 79.4

Net FCInv-WCInv +
Debt financing)
 PV of FCFE @
10.95% 35.69 40.47 44.76 43.21 44.43

We have calculated the above parameters by following the specifications given in the problem
statement.

FCFE is discounted at the cost of equity of the company which has already been calculated and is
equal to 10.95%.

For example, for Year 2, the Present value of FCFE = 49.7/ (1+0.1095)2 = 40.47. Likewise, we can
calculate the present values of all other FCFEs.

In year 6 and beyond, sales are expected to increase at 7% perpetually. Net profit will also grow at
7% annually. All other items which are pegged to sales will also grow at 7% annually from year 6
onwards.

These conditions are perfect for applying the concept of terminal value of FCFE in year 6.

Therefore, the terminal value of FCFE in year 6 and beyond is

FCFE 6 79.4
TV 5 = = = 2010.12 million
(r−g) (0.1095−0.07)
Here, r is the cost of equity = 10.95% and g is the constant growth rate of FCFE = 7%

The present value of the terminal value is

2010.12
PV of TV 5 = 5 = 1195.59 million
(1.1095)
The estimated total market value of the firm is the sum of the present values of FCFEs for years 1 to
5 plus the present value of the terminal value

Market value = 35.69 + 40.47+ 44.76 + 43.21+ 44.43 +1195.59

= 1404.15 million.

The market value of equity of the company is Rs.1404.15 million.

Answer 2:

If we divide the market value of the firm by the number of shares outstanding, we get the estimated
value per share.

1404.15
Value per share = = 20
70
The estimated value per share is Rs.20.

Example 4:
For Eastern Plastics, the following information is collected.

EPS for 2012 is Rs. 2.40

For the next five years, the growth rate in EPS is given in the following table. After 2017, the growth
rate will be 7%.

2013 2014 2015 2016 2017

Growth rate of EPS 30% 18% 12% 9% 7%

Net investment in fixed assets (net of depreciation) for the next five years are given below. After
2017, capital expenditures are expected to grow at 7% annually.

2013 2014 2015 2016 2017

Net capex per share 3.00 2.50 2.00 1.50 1.00

The investment in working capital each year will be 50% of the net investment in fixed assets.

Thirty percent of total investment in net fixed assets and working capital is financed by debt capital.

Current market conditions dictate a risk-free rate of 6%, an equity risk premium of 4% and a beta of
1.10 for the company.

1. What is the per-share value of the company?

2. What should be the trailing P/E on the first day of 2013 and the first day of 2017?

Answer 1:

The required rate of return for the company is

r = r f + β (r m - r f ) = 6% + 1.1 (4%) = 10.4%

The FCFEs for the company for the years 2013 through 2017 are given in the table below.

2013 2014 2015 2016 2017

Growth rate for EPS 30% 18% 12% 9% 7%

EPS 3.12 3.68 4.12 4.49 4.80
Net FCInv per share 3.00 2.50 2.00 1.50 1.00
WCInv per share 1.50 1.25 1.00 0.75 0.50
Debt financing per share 1.35 1.13 0.90 0.68 0.45
FCFE per share -0.03 1.06 2.02 2.92 3.75
PV of FCFE discounted at 10.4% -0.027 0.866 1.501 1.962 2.287
Starting from 2017, FCFE will grow by a constant 7% annually, so the constant growth FCFE valuation
model can be used to value this cash flow stream.

At the end of 2016, the future value of FCFE is

 FCFE 2017 3.75
V 2016= = = 110.29
(r −g) (0.104−0.07)

The present value of V 2016 at the end of 2012 is found out as follows:

PV = 110.29/ (1.104)4 = 74.24

The total value of the company at the end of 2012 = sum of present values of present values of
FCFEs up to 2016 + the present value of the terminal value

V 2012 = -0.027 + 0.866 + 1.501 +1.962 +74.24 = 78.596

The value of the share of the company at the beginning of 2013 = Rs. 78.59.

Answer 2:

On the first day of 2013, the value of the stock is Rs.78.59 and the trailing twelve month EPS is
Rs.2.40 (The EPS of 2012)

Therefore, the trailing P/E at the beginning of 2013 = 78.59/ 2.40 = 32.74

The value of the stock at the beginning of 2017 = value of the stock at the end of 2016= Rs.110.29 (as
per the calculation above)

The trailing twelve month EPS at the beginning of 2017 = EPS of 2016 = Rs. 4.49 (as shown in the
table above)

Therefore, the trailing P/E at the beginning of 2017 = 110.29/ 4.49 = 24.56

5.3Residual Income Valuation

The income statement shows net income after deducting an expense for the cost of debt capital, i.e.
interest expense. The income statement does not, however, deduct dividends or other charges for
equity capital. The income statement does not, however, deduct dividends or other charges for
equity capital.

Residual income explicitly deducts the estimated cost of equity capital. One approach to calculating
residual income is to deduct an equity charge (the estimated cost of equity capital) from net income.
If this result is negative, this means that the company did not earn enough to cover the cost of
equity capital. We will illustrate this with an example:

Example 5: Alpha Manufacturing Company has total assets of Rs. 2 million, financed with 50% debt
and 50% equity. The cost of debt is 7% before taxes. The cost of equity capital is 12%. The company’s
EBIT is Rs. 200,000. Tax rate is 30%. Calculate residual income and interpret the result.

EBIT Rs. 200,000

Less: Interest expense Rs.70,000 (50% of Rs. 2 million X 7%)

Pretax income Rs. 130,000

Less: Tax Rs. 39,000 (30% X Rs.130,000)

Net income Rs. 91,000

The company is profitable in an accounting sense. But is the company’s profitability enough for
providing adequate return for its owners?

To determine this we have to deduct an equity charge (the estimated cost of equity capital in
monetary terms) from net income.

Equity charge = Equity capital X cost of equity capital

= 1,000,000 X 12% (50% of Rs. 2 million X 12%)

= Rs.120,000

Residual income is equal to net income minus the equity charge:

Net income: Rs.91,000

Less: Equity charge Rs. 120,000

Residual Income - Rs. 29,000

From the above calculation, we find that the company did not earn enough to cover the cost of
equity capital. As a result, it has negative residual income.

The company is profitable in an accounting sense but is not profitable in economic sense.

5.3.1The Residual Income Model

Continuing from the previous discussion, we can say that in the long run, companies that earn more
than the cost of capital trade at prices higher than book values. Conversely, companies that earn less
than the cost of capital are expected to trade at prices which are lower than book values.

The residual income model of valuation hypothesizes that the intrinsic value of equity as the sum of
two components:

The current book value of equity, and

The present value of all expected future residual income

According to the model, intrinsic value of common stock can be expressed as follows:
∞
RI t
V 0 = B0 + ∑ , or
1 (1+ r)t
 ∞
Et −rB t−1
V 0 = B0 + ∑
1 (1+ r)t
Where,

V 0 = Value of a stock today at t=0

B0 = current per share book value of equity

r = required rate of return on equity investment (or, cost of equity)

Et =expected EPS for period t

Bt = per share book value at any time t

RI t = expected per share residual income, equal to Et -rB t−1

The per share residual income in period t, RI t , is equal to the EPS for the period, Et , minus the per-
share equity charge for the period, which is the required rate of return on equity times the book
value of share at the beginning of the period, or r Bt−1.

Example 6:

Matt Plastics’s expected EPS is Rs.2, Rs.2.50 and Rs.4 for the next three years. It is expected that the
company will pay dividends of Rs.1, Rs.1.25 and Rs.12.25 for the three years. The last dividend is
anticipated to be a liquidating dividend and will cease operations after year 3. The company’s
current book value is Rs.6per share and required rate of return on equity is 10%.

1. Calculate per-share book value and residual income for the next three years.
2. Estimate the stock price using residual income model.
3. Confirm valuation obtained in question 2 using discounted dividend approach

Answer 1

The book value and residual income for the next three years are calculated below:

Year 1 2 3

Beginning book value per share (Bt-1) 6 7 8.25

Net income per share (EPS) 2 2.5 4

Less: dividends per share (D) 1 1.25 12.25
Change in retained earnings (EPS - D) 1 1.25 -8.25
Ending book value per share (Bt-1 +EPS -D) 7 8.25 0

Net income per share (EPS) 2 2.5 4

Less: Per share equity charge (rBt-1) 0.6 0.7 0.825
Residual Income (EPS - Equity Charge) 1.4 1.8 3.175
Answer 2

The stock value using the residual income model is

1.4 1.80 3.175

V0 = 6 + + 2 +
(1+0.1) (1+0.1) (1+0.1)3

Or, V 0 = 6 + 1.2727 + 1.4876 + 2.3854

Or, V 0 = 11.15

The value of the share calculated by the residual income model is Rs. 11.15

Answer 3

The value of the share using a discontinued dividend approach is

1 1.25 12.25
V0 = + 2 +
(1+0.1) (1+0.1) (1+0.1)3

Or, V 0 = 0.9091 +1.0331 +9.2036

Or, V 0 = 11.15.

The value of the share calculated by discounted dividend model is Rs. 11.15

5.3.2Single-Stage Residual Income Model

The stock’s intrinsic value under residual income model, assuming constant growth, can be
ROE−r
expressed as V 0 = B0+ X B0
( r −g )
Where,

r = required rate of return on equity investment (or, cost of equity)

B0 = current per share book value of equity

g = constant growth rate of residual income

ROE−r
In the above equation, X B0 is the present value of the expected stream of residual
r −g
income.

We can illustrate the application of the above relation with an example:

Example 7: The current book value of XYZ, Inc is Rs.26.24 per share. Current market price is Rs.34.68
per share. An analyst expects long-term ROE to be 11% and long-term growth to be 5.5%. Assume
that the cost of equity is 9.5%. Calculate the intrinsic value of the stock using a single-stage residual
income model.

Solution

ROE−r
V 0 = B 0+ X B0
( r −g )
0.11−0.095
Or, V 0 = 26.24 + X 26.24
0.095−0.055
Or, V 0 = 36.08

The intrinsic value of the stock using single-stage residual income model is Rs. 36.08

If we want to find out the market-perceived growth rate of residual income, given all data about XYZ
Inc, except growth rate, we can proceed as follows:

ROE−r
V 0 = B 0+ X B0
( r −g )
0.11−0.095
Or, 34.68 = 26.24 + X 26.24
0.095−g
Here, g is unknown.

g= 0.0484 or, the perceived constant growth rate of residual income = 4.84%.