Equity Valuation

BY SISI ZHANG, M.SC.

Learning Objectives

1. Equity Market

2. Absolute Valuation: Dividend Discount Model (DDM)

 Constant Dividend
 Dividend growing at a constant rate
 Changing growth rates

3. Relative Valuation: P/E Multiple

4. Different Types of Equity
 Global equity market reached $109.0 trillion in 2023.

 The U.S. equity markets are the largest in the world representing
44.9% ($49.0 trillion) of the Global equity market cap in 2023.

 Canada Equity Market Capitalization reached $3.15 Trillion in 2023

representing 3% of the global equity market cap in 2023.

 Biggest crashes in the history of the stock market: 1929 stock market
crash, Black Monday crash of 1987, Dot-com bubble of 1999-2000,
Financial crisis of 2008, Coronavirus crash of 2020
 Absolute Valuation: DDM
 Absolute valuation models focus on finding the intrinsic or
true value of an investment based on fundamentals.
 Four types of absolute valuation models:
 Dividend discount model
 Discounted cash flow model
 Residual income model
 Asset-based model.
 The DDM calculates the intrinsic value of a company by
valuing the present value of the dividends the company pays
its shareholders.
DDM: Constant Dividend (Zero Growth Model)
Model Assumptions:
 No growth in the dividend paid by the company
 100% Dividend payout ratio
 Perpetuity Annuity

𝐷𝐷
Valuation: P =
𝑅𝑅
P: Price
D: Dividend
R: Discount rate
Example of Constant Dividend

Company A has a 100% dividend payout ratio, and its income

has been steady for a long time. Therefore, dividends are
expected to remain at current levels indefinitely. Company A
pays an annual dividend of $10 per share. The current market
interest rate for investments of similar risk is 5.0%. How much
should you pay for one share of company A?

𝐷𝐷 $10
Perpetuity Annuity: P = $200 =
𝑅𝑅 5.0%
DDM: Constant Growth Rate (Gordon Growth Model)

Model Assumptions:
 Constant dividend growth rate over the long term
 100% Dividend payout ratio

𝐷𝐷1
Valuation: P =
𝑅𝑅 −𝐺𝐺
P: Price
D1: Dividend one period from now
R: Discount rate
G: Growth rate
Example of Constant Dividend Growth Rate

Company B is a blue-chip company. Analysts believe its

earnings will grow at a constant rate of 2% per year forever.
Therefore, they expect Company B’s dividends will also grow
at the same rate. Today, the company declared an annual
dividend of $5 per share. Currently, the market demands an
annual return of 5% for investments of similar risk. What is a
fair price for Company B?

𝐷𝐷1 $5 𝑋𝑋 (1+2.0%)
P= = = $170 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑅𝑅 −𝐺𝐺 (5.0% −2.0%)
Example of Constant Dividend Growth Rate

DataSet has reached a matured stage. Analysts believe its

earnings will grow at a constant rate of 2.5% per year forever.
Therefore, they expect DataSet’s dividends will be growing at
the same rate. Today, the company declared an annual
dividend of $1 per share. Currently, the market demands an
annual return of 4.75% for investments of similar risk. What is
a fair price for DateSet?

𝑫𝑫𝟏𝟏 $𝟏𝟏 𝑿𝑿 (𝟏𝟏+𝟐𝟐.𝟓𝟓𝟓)

PV = = = $45.56 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑹𝑹 −𝑮𝑮 (𝟒𝟒.𝟕𝟕𝟕𝟕𝟕 −𝟐𝟐.𝟓𝟓𝟓)
DDM: Changing Dividend Growth Rate Model

Companies go through these main stages:

 Cash burning stage (infant)

 Fast growing stage (youth)

 Maturity stage (adult)

Dividend distributions and growth rates are significantly

different in each of the stages.
DDM: Changing Dividend Growth Rate Model
Company C pays an annual dividend of $2 per share today. It is expecting to grow its
dividend by 2% per year year until the launch of a new product which will boost the
growth rate indefinitely. This product is expected to be launched in 3 years and the
growth rate will be increased to 3%. The market is expecting a return of 6% for this
type of business.

D1= D0 X (1+2%) D2= D0X (1+2%)2 D3= D0 X (1+2%)3 D4 = D3 X (1+3%) D5 = D3 X (1+3%)2

0 1 2 3 4 5
D0 =$2
Example of Changing Dividend Growth Rate (Cont.)
1. Growth Annuity
𝐷𝐷 1+𝐺𝐺 N 2𝑋𝑋(1+2%) 1+2% 3
P0 = 𝑅𝑅 −𝐺𝐺
1
[1-( ) ] = X[1-( ) ]=$5.56
1+𝑅𝑅 6%−2% 1+6%

2. Growth Perpetuity at Year 3

𝐷𝐷4 2𝑋𝑋 1+2% 3𝑋𝑋 (1+3%)
P3 = = = $72.87
𝑅𝑅 −𝐺𝐺 6%−3%

$72.87
Present Value of P3 at time 0: P0’ = = $61.18
(1+6 %)3
3. Add together at t = 0
P0 + P0’ = $5.56 + $61.18 = $66.74
Relative Valuation: Price Earning Multiple (P/E)

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

EPS: Earning per share =
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜

𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

P/E =
𝐸𝐸𝐸𝐸𝐸𝐸

We assume market is rational and efficient on average, therefore,

the market average P/E is fair.

Company’s stock may trade above or below its market fair value.

Target Share Price = Benchmark P/E ratio x EPS

Example of Price Earning Multiple (P/E)

Zoey, a diligent investor, has researched Company C which just

reported an annual EPS number of $9.5. She has determined that
the average P/E of the 5 companies most comparable to Company
C is 17.5. Assuming Company C currently trades at $150, should
Zoey buy it?

$9.5 x $17.5 = $166.25 (Fair Market Value)

Current Market Price = $150 < Fair Market Value

Buy!
Preferred and Common Shares

Common shares

 Voting rights = have a say (Major issues, board of

directors)

 They have a claim on the residual value of the

company (Residual income of the company)

 Dividend growth
Preferred and Common Shares
Preferred shares
 1. Rank above common shareholders and below creditors during
liquidation
 2. Upside is capped compared to common shareholders
 3. Preferred shares’ dividend per period is often fixed, theoretically, all
residual income beyond this belongs to common shareholders
 4. Unlike bondholders, the “fixed amount of dividend payment” is not
guaranteed. Companies can opt not to pay any dividends.
 5. There are two types of preferred in general (Cumulative VS Non-
Cumulative)
 6. For a given period, a company cannot pay common dividends if it
opts to not pay preferred dividends
Preferred and Common Shares

Cumulative Vs. Non-cumulative preferred shares

If a company opts not to declare cumulative dividends, it must accrue
the dividends. This means that in the next period, if the company
resumes dividends, the accrued dividends must be paid out to its
cumulative preferred shareholders first before non-Cumulative
preferred shares and common shareholders.
Preferred and Common Shares

Zoey Co., with 50,000 common shares and 10,000 non-cumulative

preferred shares outstanding, has declared dividends for the first time
ever. It wishes to pay $1.50 per common share. Assuming the preferred
shares were sold for $100 each and state an 8% dividend rate, how much
cash will Scott Co. pay for dividends?

1. Common dividends = numbers of common shares x Dividend per

share = 50,000 x $1.5 = $75,000
2. Preferred dividends = $100 x 10,000 x 8% = $80,000

Therefore, $75,000 + $80,000 = $155,000

Preferred and Common Shares
Tim & Co. has always paid dividends except for last year. It has the following
shares outstanding:

1) Tim & Co. has $9,000 to pay out as dividends this year. How much does each
share type get?
2) What if Tim & Co. had $600,000 to distribute?
Preferred and Common Shares

1) Available cash for distribution $9,000

Pay preferred first

Last year, its cumulative preferred accrued $2000
This year, it has to pay dividends to its cumulative preferred shareholders
as well, so another $2,000
In addition, it also has to pay non-cumulative preferred shares after
cumulative preferred shareholders and before common $5,000
After paying for all its preferred shareholders, the entire $9,000 is
exhausted so nothing left for common $0
Preferred and Common Shares

2) Available cash for distribution $600,000

First, satisfy preferred shareholders $9000 from previous

question

The leftover balance goes to common shares, $600,000 -

$9,000 = $591,000
Preferred and Common Shares

Year Preferred Cum Preferred Non-Cum Common Total

Last Year $2,000 $0 $0 $2,000

Current $2,000 $5,000 $591,000 $598,000

Year

Total $4,000 $5,000 $591,000 $600,000

Preferred and Common Shares
Zoey’s Solutions Inc. is at the end of its first year of business. It has
$200,000 debt which requires 5% interest to be paid each year. Then
it has 1,000 at $30 per share preferred shares outstanding with a
stated annual dividend of $2.50. Finally, it has 2,000 common shares
outstanding. If Scott’s Solutions Inc. has $20,000 cash and is planning
on paying all of it out, how much will be paid to an investor with a
single common share?
1. Pay interest first, $200,000 x 5% = $10,000, of the $20,000 only $10,000 is left
to pay dividends

2. Pay Preferred second, 1,000 x $2.5 = $2,500, So $10,000 - $2,500 = $7,500 left
for common

3. $7,500 / 2,000 common shares = $3.75/ Common share

Thank you!