SAIRATAJ (15121005)

Question no 1:
Write a detailed report on methods of equity valuation for stocks and corporations?
Dividend Discount Valuation:
The dividend discount model (DDM) is a method for assessing the present value of
a stock based on the growth rate of dividends.
This model can be used to determine the amount an investor can expect to pay for a stock if it
pays consistently increasing dividends each year. If the value from the DDM is higher than the
current price of the stock, then the stock is undervalued and can be considered a smart
investment. If this model yields a present value that is lower than the current stock price, it may
be overvalued and could fail to generate sufficient returns.
Dividends are appropriate as a measure of cash flows in the following cases:

Company has a history of dividends payments.

Dividend policy is clear and related to the earnings of the firm.
The perspective is that of a minority shareholder.

One-Period DDM:
The purpose to solve for the value today of the stock given the expected dividend, the expected
price in year one and the required return.
V0 = D (1) / (1+R) ^1 +P (1) / (1+R) ^ 1
Where:
V0 = fundamental value
D (1) = dividends expected to be received at end of year 1
P (1) = price expected at the end of year 1
R = required return of equity
Two-Period DDM:
V0 = D (1) / (1+R) ^ 1 + D (2) / (1+R) ^ 2 + P (2) / (1+R) ^2
Multi-Stage DDM:
V0 = D(1) / ( 1+R)^1 + D(2) / ( 1+R)^2 +. Dn +pn / (1+ r) ^ n

Gordon growth model:

1. Dividends grow at a constant rate.
2. Dividend policy is related to earnings.
3. Required rate of return is greater than the long term growth rate g.
Formula
V0= D0 * (1+G) / R-G
Implied growth rate:
If P0 is fairly priced:
P0 = V0 = D (1) / (R-G)
G = R- (D1 / P0)
Present value of growth opportunities (PVGO):
A firm has additional opportunities to earn returns in excess of the required rate of return would
benefit from return earnings and investing in those growth opportunities rather than paying out
dividends.
V0 = E/ R + PVGO
Where:
E= no-growth earnings level
R= required return on equity.
Justified leading and trailing P/E:
Price to earnings ratio is the most commonly used relative valuation model. Leading P/E which
is based on the earnings forecast for the next year. The trailing P/E which is based on the
earnings for the previous year.
Justified leading P/E = P0 / E1 = 1-B/ R-G
Justified trailing P/E= P0/ E0 = ( 1-B) * ( 1+G)/ R-G
Fixed- rate perpetual preferred stock:
A firm has no additional opportunities to earn returns in excess of the required rate of return
should distribute all of its earnings to shareholders in the form of dividends.
Value of perpetual preferred shares= Dp/ Rp

Where:
Dp= preferred dividend
Rp= cost of preferred equity
Sustainable growth rate ( SGR):
The rate at which earnings can continue to grow indefinitely and assume the firms debt to equity
ratio is unchanged and it does not issue new equity.
SGR = B * ROE
Where
B= earnings retention rate= 1- payout rate
ROE= return on equity
DuPont Analysis:
ROE can be estimated with the DuPont formula, which represents the relationship between
margin, sales and leverage.
G = net income dividends / net income * net income / sales * sales / total assets * total assets /
stock holder equity
Free cash flow valuation:
Free cash flow valuation is an approach to business valuation in which the business value equals
the present value of its free cash flow.
There are two approaches to valuation using free cash flow.
The first involves discounting projected free cash flow to firm (FCFF) at the weighted average
cost of the capital (WACC) to find the total firm value.
The second involves discounting future free cash flow to equity (FCFE) at the required return of
equity to find the value of the firm equity.
The following formulas are using to calculate firm value and firm equity value respectively:
Total firm Value (under FCFF model) =

FCFF Next Year

WACC g

Equity value = firm value - market value of debt

Business Equity Value (under FCFE model) = FCFE Next Year /r g
Single stage FCFF Model:
The single-stage FCFF model is useful for stable firms in mature industries. The Gordon growth
model assumes that
1. FCFF grows at a constant rate g forever.
2. Growth rate is less than WACC.
Formula:
Value of the firm = FCFF (1) / WACC G
= FCFF (0) * (1+G) / WACC-G
Two-stage FCFF Model:
Value of the firm = FCFF (1) / (1+WACC) ^1 + FCFF (2) / (1+WACC) ^2 + FCFF (2)/ WACC-G
Terminal value= FCFF (2) / WACC -G
Three- stage FCFF Model:
Value of the firm = FCFF (1) / (1+WACC) ^1 + FCFF (2) / (1+WACC) ^2 + FCFF (3) /
(1+WACC) ^3 + FCFF (3) / WACC G
Or
Terminal value= FCFF (3) / WACC G
Multi-Stage FCFF Model:
There are two basic approaches for calculating the terminal value
1. In which we forecasted and FCFF or FCFE at the point in which cash flows begin to
grow at long-term stable growth rate.
2. Use valuation multiples (like P/E ratio) to estimate the terminal value.
Formula:
Terminal value in year n = (trailing P/E)* (Earnings in year n)
Terminal value in year n = (leading P/E)* (forecasted Earnings in year n+1)
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