Share Valuation

Topics: Balance sheet, Net present value, Stock market Pages: 5 (1303 words) Published: December 3, 2013
Share Valuation
Valuation Situations
1. Initial Public Offerings (IPOs)
An initial public offering is the first sale of shares by a company to the public. The shares then become publicly traded.

2. Management Buy-outs (MBOs)
A management buy-out is a form of acquisition in which the existing managers of a company acquire a large part or all of the shares of the company.

3. Management Buy-ins (MBIs)
A management buy-in is a form of acquisition in which a manager or management team from outside the company raises finance, buys the company and becomes its new management.

4. Spin-offs
A spin-off is a situation in which a company sells stock in a wholly-owned subsidiary or dependent division, so the subsidiary or division becomes an independent company. The parent company may or may not maintain ownership in the new company, and may have many reasons for spinning it off. For example, it may wish to exit one industry to expand in another, or it may simply wish to profit from the sale.

5. Equity Carve Outs
An equity carve-out is a reorganization in which a company creates a new subsidiary, takes it public, and retains a majority share. An equity carve-out increases access to capital markets, enabling the carve-out subsidiary to finance its growth without issuing parent equity. It gives the subsidiary a degree of autonomy and retains its access to parent company resources.

Share Valuation Models
1. Dividend Valuation Models
Discounted Dividend Model (DDM)
Constant Growth DDM
Differential Growth DDM

2. Earning-based Models
Earnings Capitalisation without growth
Earnings Capitalisation with growth
Price-Earning Multiple Model

3. Free Cash Flow Models
Discounted Free Cash Flow to Equity (FCFE) model
Discounted Free Cash Flow to the Firm (FCFF) model

4. Book Valuation (Net Asset Value) Model

Discounted Dividend Model
The dividend discount model (DDM) is a method of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to value stocks based on the net present value of the future dividends. If we define Po as today’s theoretical price, and d1 as next period’s dividend, then the value of an ordinary share is: Po = d1/(1+ke)1 + d2/(1+ke)2 + d3/(1+ke)3 + ……… + d∞/(1+ke)∞ = ∑dt/(1+ke)t Where t = 1 to ∞, and ke is the appropriate discount rate or the rate of return required by investors to hold the shares. (Recall that this can be estimated using CAPM as:

ke = Rf + βe {E(Rm) - Rf}
where Rf = Risk free rate; βe = Beta of the security; E(Rm) = Expected market return) Essentially, therefore, the DDM asserts that share prices are determined by the cash flows accruing to shareholders, and these are the dividends. One limitation of the DDM is that it can be difficult or impractical to estimate dividends far into the future.

Constant Growth DDM
Myron Gordon constant growth DDM overcomes the limitation of the basic DDM by assuming dividend will grow at a constant rate, g, into the infinite future, as follows: Po = do(1+g)/(1+ke)1 + do(1+g)2/(1+ke)2 + do(1+g)3/(1+ke)3 + ……… + d∞/(1+ke)∞ This equation can be simplified to:

Po = do(1+g)/(ke-g) = d1/(ke-g)
If dividends are expected not to grow, then the valuation formula reduces to:
Po = do/ke
which is the valuation model for preference shares.
Implications of the constant growth model are:
1. The value of an ordinary share will be greater:
the greater the expected dividend per share
the lower the required rate of return ke and
the higher the expected growth rate of dividend
2. It also implies that share price is expected to grow at the same rate g as the dividends.

Determinants of Growth
1. The quantity of funds retained and reinvested within the business 2. The rate of return earned on those retained funds
3. The rate of return earned on existing assets

Estimating the Growth Rate
If it is assumed that growth is dependent on the...
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