Lecture 4
Fundamental analysis
Fundamental analysts attempt to use information regarding current and expected
future
profitability of a company to infer its intrinsic value, in the hope of finding some
discrepancy with the company’s observable value
identify mispriced stocks relative to some measure of “true” value derived from
financial data.
Measures of observable value available in financial data
1. Book value
Represents the net worth of a company based on its accounting records. It is
the value of a company’s total assets minus its total liabilities, as recorded on
the balance sheet. Essentially, it shows what shareholders would theoretically
receive if the company were liquidated at its recorded asset values.
Limitations
Ignores Market Value & Growth Potential – Does not reflect investor
sentiment or future earnings potential.
Excludes Intangible Assets – Brand value, patents, and goodwill are not
included.
2. Market Value
Current price at which an asset, security, or company can be bought or sold in
the financial markets. For a publicly traded company, market value is the total
worth of its shares as determined by investors, based on factors such as
earnings, growth potential, industry trends, and economic conditions
3. Floor value
The floor value of a company refers to the minimum estimated worth of the
company, usually based on its tangible assets and liquidation value. It represents
the lowest price at which the company’s value should reasonably fall
Measures:
○ Liquidation Value - net amount that can be realised by selling the assets of a
firm and paying off all its debt, which is a popular measure used to identify
takeover/acquisition opportunities.
○ Replacement Cost - the cost to replace a company’s assets, less its liabilities,
which provides an indicative cost of replicating a company’s operations. Tobin’s q
for a specific company is defined as the ratio of its market value to replacement
cost.
Validation by Comparable
As a first resort, it is common to attempt to infer relative value by comparing
important
statistics, such as Price-to-Earnings, Price-to-Book Value, Price-to-Sales,
PE-to-Growth, Return-on-Equity, Return-on-Assets, Operating Profit Margin and Net
Profit Margin, across companies within a specific sector.
Intrinsic value vs Market price
There are two components that contribute to the return on an equity investment:
(i) cash dividends (Di) – Cash payments made by the company to shareholders.
(ii) capital gains/losses (Pi - Pi−1) – The increase or decrease in share price over
time.
1. Holding period return
The HPR for year iii is calculated as:
This measures the total return from holding the stock for one year
2. Rearranging for Intrinsic Valuation
which provides us with a structure for an intrinsic valuation model based on present
valuation, if we see that
3. Intrinsic valuation model
Valuation Inference & Market Capitalisation Rate
1. Compare Return (ri or HPR) with Required Rate (k)
Trading Rule:
Buy if ri >k (expected return is higher than required return).
Sell otherwise (expected return is too low to justify holding the asset)
2. Compare Intrinsic Value (Vi−1) with Market Price (Pi−1)
Trading Rule:
Buy if Vi−1>Pi-1 (stock is undervalued).
Sell otherwise (stock is overvalued).
If a stock’s intrinsic value is higher than the current market price, it's a good
investment. Otherwise, it’s overpriced, and selling would be wise.
3. Market capitalisation rate (k)
The market capitalisation rate (𝑘) is the rate of return implied by the market's
consensus on stock valuation.
The market capitalisation rate reflects the market’s required return for holding a
stock. It helps compare actual returns with what investors demand.
Market Cap Rate < Expected Rate of Return when the security is under-priced.
Dividend Discount models
The DDM says the stock price should equal the present value of all expected future
dividends into perpetuity.
It assumes that dividends grow at a constant rate or are expected to follow a
predictable pattern over time
The Dividend Discount Model values a company based on its ability to pay
dividends.
It is most useful for valuing companies with stable, predictable dividend
payments.
It is highly sensitive to the assumptions about dividend growth and required
return.
Constant-Growth DDM
valuing a stock based on the assumption that dividends grow at a constant rate
indefinitely. It is useful for valuing mature companies with stable dividend growth.
Assumptions
1. Dividends Grow at a Constant Rate: The model assumes that dividends
grow at a constant rate g forever.
2. Discount Rate is Greater than the Growth Rate: The required return r must
be greater than the growth rate g (r > g) to avoid negative or infinite
valuations.
3. Company Pays Dividends: The model is only applicable to companies that
regularly pay dividends
IF dividends remains FIXED g = 0
EXAMPLE: r needs to be calculated
Sam plans to buy Yach Ltd shares, which just paid a dividend of R3, and expects to
grow at 7% pa. Risk free rate is 6% and market risk premium is 5%, beta is 1.2.
r (k)= 6% + 1.2 ( 5% - 6%) = 12% (CAMP)
P0 = 3 ( 1 + 0.07) / 0.12 = 0.07
The constant-growth rate DDM implies that a stock’s value will be greater:
1. The larger its expected dividend per share(D).
2. The lower the market capitalization rate, k.
3. The higher the expected growth rate of dividends(g).
Discounted Cash Flow Formula
method to estimates the markets capitalisation rate of a company
Prices and Investment opportunities
The main feature here is the split between dividends paid and earnings retained from
net income:
Dividend Payout Ratio - the percentage of net income/earnings paid out as
dividends
It indicates how much of the company's profit is being returned to investors versus
how much is being retained for growth.
high growth companies (start-ups) usually have lower pay-out ratios as they are
investing for growth while mature companies have the opposite
Earnings Retention Ratio - the percentage of net income/earnings that is
reinvested into the
business:
A high ERR means the company is reinvesting most of its profits into growth
(common in tech and startup firms).
Growth rate of book/equity value
also called the sustainable growth rate
Corresponding growth in net income/earnings due to retained earnings is:
Assuming that ROE remains fixed. Accordingly, the growth in dividends is
Present Value of Growth opportunities
comparing two companies, one which is no growth ( pays out all earnings as
dividends) and one with growth (retains some for reinvestment)
No- growth scenario
The company pays out all its earnings as dividends, meaning there is no
reinvestment for future growth.
Since earnings do not grow, the company’s stock behaves like a perpetuity
(a financial instrument that pays a fixed amount forever).
The intrinsic value of the stock in this scenario is given by:
Introducing Growth (Retaining Earnings for Investment)
Instead of paying out all earnings, management reduces dividends from D to
d (where d<D).
The retained earnings are reinvested in projects that generate returns above
k, leading to growth in earnings and dividends.
This creates a sustainable growth rate, g, which enhances the company's
value beyond the no-growth scenario.
New intrinsic value
The present value of growth opportunities (PVGO) is then:
interpreted as the net present value of the firm’s future investment opportunities.
Life Cycles and Multi-Stage Growth Models
Constant-growth DDMs are unrealistic since firm’s will experience different growth
rates in net income and dividends, depending on both the firm’s maturity and the
state of the business cycle, through time. To account for such variability and to build
a model that is closer to reality, it is possible to devise 2-, 3- or multi-stage DDMs.
split the period according to certain growth levels
STEPS
1. Grow the dividend for the years of rapid growth with the ‘big’ growth rate
2. Calculate market price for final year of high growth = P using second growth rate
3. Discount all the future cash flows using the required rate of return to find the present value
4. add up the discounted cash flow
P/E Ratios and PVGO
Assuming the same setup as for the PVGO, and that the current price P0 = V g
0 , i.e., the intrinsic growth prospect value, then:
Since earnings is equal to dividends per share, D, currently, the P/E ratio becomes
which reveals how growth opportunities can impact the P/E ratio.
P/E Ratios Using the Constant-Growth DDM
Free Cash Flow Valuation Approaches
An alternative approach to DDMs are discount models that make use of free cash
flows
due to:
Free Cash Flows to the Firm (FCFF) - the after-tax cash flow generated by the
firm’s
operations, net of investments in fixed as well as working capital:
Purpose of FCFF:
Valuation: FCFF is often used in discounted cash flow (DCF) models when
calculating the value of the entire firm, as it reflects the cash flow available to
both debt and equity holders.
Debt Neutral: Since FCFF is before interest payments, it provides a view of a
company's operational cash flow without considering the impact of its capital
structure (debt vs. equity)
Free Cash Flows to Equity Holders (FCFE) - differs from FCFF by after-tax
interest
expenses and the net change in long-term debt:
Purpose of FCFE:
Valuation: FCFE is used in equity-focused DCF models, where the focus is
on valuing the equity portion of the company. It provides an estimate of the
cash flow available for equity holders after the company has taken care of its
operating and financing needs.
Equity-specific: Unlike FCFF, which is relevant to both debt and equity
holders, FCFE focuses on the cash flow available to the shareholders of the
firm, making it particularly useful for equity investors.
CoE and WACC
Represents the minimum return a company must earn on its existing assets to
satisfy its creditors, owners, and other capital providers, given their respective costs
of capital.
WACC is commonly used to discount future cash flows when valuing a business
or its assets, as it reflects the opportunity cost of using capital.
Free Cash Flow Discount Models (FCFDMs)
Example
Utica Manufacturing Company is expected to have before tax cash flow from
operations of 500 000 in the coming year The firm's corporate tax rate is 30. It is
expected that 200 000 of operating cash flow will be invested in new fixed assets
Depreciation for the year will be 100 000. After the coming year, cash flows are
expected to grow at 6% per year The appropriate market capitalization rate for
unleveraged cash flow is 15% per year The firm has no outstanding debt
V0= 180,000/(.15 -.06) = $2,000,000
