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Equity Valuation Dividend Discount Method with constant earnings growth rate

Equity Valuation Dividend Discount Method with constant earnings growth rate. Balance Sheet. Balance Sheet. Equity Value. For a simple firm Liabilities + Equities = Debt Capital + Equity Capital + “Non-Capital” Capital = Debt Capital + Equity Capital C = DB + EB

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Equity Valuation Dividend Discount Method with constant earnings growth rate

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  1. Equity ValuationDividend Discount Method with constant earnings growth rate

  2. Balance Sheet

  3. Balance Sheet

  4. Equity Value • For a simple firm • Liabilities + Equities = Debt Capital + Equity Capital + “Non-Capital” • Capital = Debt Capital + Equity Capital • C = DB + EB • Fair value of firm = Fair value of firm’s capital • V = D + E • Fair value of equity, E, is computed from the discounted cash flow to the equity holdersdiscounted at the rate cost of equity capital • Assume that the cash flow to equity holders is only dividends

  5. Firm Value

  6. Constant Growth Rate Equity Value • The value of an financial entity is the present value of future cash flows discounted at the rate cost of the cash flows • Now assume that the dividend is growing at a constant rate, gDIV • Write as a infinite sum as follow

  7. Constant Growth Value • As the spread between the rate cost, k, and cash flow growth, g, narrows, the convergence slows considerably • As cash flow growth rate approaches the rate cost, the series does not converge k=10%

  8. Equity Value Management • Explore the relationships between • Earnings growth • Dividend payouts • Cost of equity (rate) • Fair value of equity • Based on the Dividend Discount Method with dividends growing at a constant rate) • Gordon Growth Formula

  9. Equity Value Per Share

  10. Share price v. Dividend Growth Rate d1 = $0.50, kE = 10% p0 = pvcy + pvgo

  11. Price/Earnings Ratio: pe i=-1 Previousperiod i=0 Nextperiodi=1 DC = DEB + DDB = DRE + DPAR + DAPC + DDB DC = additional capital DDB = additional debt DEB = additional equity DRE = additional retained earnings (=NP1 – DIV1) DPAR = additional common equity at par DAPC = additional paid in common equity

  12. i=-1i=0i=1 e0 e1 d0 d1 eb-1eb0 eb1 Price/Earnings Ratio, pe b = plowback ratio (assume constant) thus ge = gd (1-b) = dividend payout ratio DRE = NP – DIV = NP∙ b RE DRE DIV NP

  13. Price/Earnings Ratio: pe • In the case of no additional (external) investor financing • DDB = 0, DAPC = DPAR = 0 • DC = DEB = DRE • And a scalable firm with a constant plowback, b b = plowback ratio reinvestment of earnings (1-b) = dividend payout ratio eb = equity book value per share Long run assumption ge=geb

  14. Price/Earnings Ratio: pe Note: With this input, after ~40 years geb -> ge

  15. Source

  16. PEG Ratio • The peg is a price measure normalized for earnings (e1) and earnings growth rate (ge) • 3 to 5 years estimated growth rate • Typical heuristic • > 2 relatively high valuation • = 1 pe ratio = earnings growth (converting ratio to percent) • < 1 relatively low valuation • Morningstar Table

  17. Valuation Ratios

  18. Forward PE Ratio

  19. Critical Growth Rates • Internal growth rate, gint: the maximum growth rate that does not require additional external financing • Sustainable growth rate, gsus: the maximum growth rate that maintains the current capital structure, , with additional investor contributed debt • Critical growth rate derivations for core business operations • So use • NA not TA and • IC not C or LE • NAIC • roa is return on net book assets • roe is return on book equity NA-1 NA0 NA1 IC-1 IC0 IC1 i=-1 i=0 i=1 DIV0 = NP0∙(1-b) DIV1= NP0∙(1-b)∙(1+g) DRE0 = NP0∙bDRE1=NP0∙b∙(1+g)

  20. Critical Growth Rates DNA = DIC = IC1 – IC0 = DDB + DEB = DDB + DAPC + DPAR + DRE DNA = g∙NA0DNA = DRE + DDB = NP0∙b∙(1+g) + DDB NA-1 NA0 NA1 i=-1 i=0 i=1 • DRE0 = NP0∙bDRE=NP0∙b∙(1+g) • DNA = DRE + DDB

  21. NA-1 NA0 NA1 i=-1 i=0 i=1 • DRE0 = NP0∙bDRE1=NP0∙b∙(1+g) • DNA1 = DRE1 + DDB1 Internal Growth Rate, gint

  22. NA-1 NA0 NA1 i=-1 i=0 i=1 • DRE0 = NP0∙bDRE1=NP0∙b∙(1+g) • DNA1 = DRE1 + DDB1 Sustainable Growth Rate, gsus

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