We began the equities section with a discussion on how securities markets are organized, how efficient markets are, the different types of equity securities, and how to analyze an industry and a company. The focus of this reading is on determining the intrinsic value of the security.
The intrinsic value of a security is based on its fundamentals and characteristics. It is also called the fundamental value or estimated value as it is based on the fundamentals such as earnings, sales, and dividends. If the intrinsic value is different from the market price, then you are implicitly questioning the market’s estimate of value.
Assume, Caterpillar Inc. is trading on NYSE at $84.53. An analyst estimates its intrinsic value as $88.21. Is it overvalued, fairly valued, or undervalued? Going by the relationships given above, the security is undervalued. In reality, making this decision is not that straightforward. It depends on an analyst’s input values and assumptions in the model. Some factors to consider when market value intrinsic value:
Three major categories of equity valuation model are:
Present value models
Asset-based valuation models
The choice of model depends on availability of information and the analyst’s confidence in the appropriateness of the model. Generally, analysts will try to use more than one model.
A dividend is a distribution made to shareholders based on the number of shares owned.
Cash dividends are payments made to shareholders in cash. The three types of cash dividends are:
Stock dividend: Company distributes additional shares instead of cash. A stock dividend simply divides the ‘pie’ (the market value of equity) into smaller pieces without affecting the value of the pie. Since the market value of equity is unaffected, stock dividends are not relevant for valuation purposes.
Stock split: Increases the number of shares outstanding. For example, in a 2 for 1 split, each shareholder is issued an additional share for each share currently owned.
Reverse stock split: Reduces the number of shares outstanding. For example, in a 1 for two reverse stock split, each shareholder would receive one share for every two old shares.
Stock splits and reverse stock split are similar to stock dividends. They do not change the market value of equity hence they are not relevant for valuation purposes.
Share repurchase: This is an alternative to cash dividends. Here the company uses cash to buy back its own shares. An important point to note is that, as compared to stock dividends and stock splits, share repurchases affect the market value of equity. The effect on shareholders’ wealth is equivalent to a cash dividend. Some key reasons why companies engage in share repurchases instead of cash dividends are:
Dividend payment chronology
A dividend payment schedule is as follows:
This model is based on the principle that the value of an asset should be equal to the present value of the expected future benefits. The simplest present value model is the dividend discount model (DDM). According to DDM, the intrinsic value of a stock is the present value of future dividends plus the present value of terminal value.
Intrinsic value = PV of future dividends + PV of terminal value
For the next three years, the annual dividends of stock X are expected to be 1.0, 1.1, and 1.2. The expected stock price at the end of year 3 is expected to be $20.00. The required rate of return on the shares is 10%. What is the estimated value?
Calculate the present value of each of the future dividends at the reqd. rate of return of 10%.
Estimated value = 0.909 + 0.909 + 15.92 = 17.74
In the exam, use a financial calculator with the following keystrokes:
CF0 = 0; CF1 = 1; CF2 = 1.1; CF3 = 21.2; I = 10%, CPT NPV
NPV = 17.7
Free cash flow to equity (FCFE) is the residual cash flow available to be distributed as dividends to common shareholders. In practice, FCFE model is often used because:
FCFE = CFO – FCInv + Net borrowing
where: FCInv = fixed capital investment
Net borrowing = borrowings – repayments
Required Rate of Return on a share
Analysts generally use CAPM (capital asset pricing model) to calculate the required return on a share.
Required rate of return on share = current expected risk free rate + Betai [market risk premium]
In addition to CAPM, there are other methods to calculate the required return like the bond yield plus risk premium method which we will see later.