Question

1.1?A trainee analyst makes the following statement: “The terminal value element in the Residual Income Valuation Model typically accounts for a much larger proportion of the estimated intrinsic value of equity than the terminal value element in the Discounted Free Cash Flow and Dividend Discount Models. This makes the Residual Income Valuation Model inferior to the other two models”. Critically assess the statement.

1.2?sing the Residual Income Valuation Model please demonstrate what determines a company’s price-to-book (P/B) multiple. Explain why the P/B multiple of information technology companies is usually higher than the P/B of banks, and discuss which of these types of companies is likely to be more reliably valued by the P/B multiple.

Answer 1

Ans.

1.1

Terminal or continuing value (CV) is a key element in calculating the value of firm capital in any income-based valuation model. This paper focuses on calculating CV in the context of a firm operating as a going concern, highlighting some of the problems associated with the treatment of growth and inflation, which, although investigated in the literature, are not generally dealt with using sufficiently in-depth analysis. The effect of inflation on forecasted income and cash flows is examined, emphasizing issues that can have a significant impact on value, even in presence of a low inflation rate, such as that employed in CV estimation. Situations are introduced where the impact of inflation can be distinguished, and which therefore require different measures, followed by a discussion of their degree of realism. Simplified procedures within these situations are indicated that properly consider inflation and therefore lead to an internally consistent calculation of CV.

Dividend Discount Model – It is a way 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 evaluate stocks based on the net present value of the future dividends.

Financial theory states that the value of a stock is the worth all of the future cash flows expected to be generated by the firm discounted by an appropriate risk-adjusted rate. We can use dividends as a measure of the cash flows returned to the shareholder.

Here the CF = Dividends.

Dividend discount model prices a stock by adding its future cash flows discounted by the required rate of return that an investor demands for the risk of owning the stock.

However, this situation is a bit theoretical, as investors normally invest in stocks for dividends as well as capital appreciation. Capital appreciation is when you sell the stock at a higher price then you buy for. In such a case, there are two cash flows –

1. Future Dividend Payments
2. Future Selling Price

Find the present values of these cash flows and add them together :

Intrinsic Value = Sum of Present Value of Dividends + Present Value of Stock Sale Price

This Dividend Discount Model or DDM price is the intrinsic value of the stock.

If the stock pays no dividend, then the expected future cash flow will be the sale price of the stock.

TYPES OF DIVIDEND DISCOUNT MODELS

Dividend Discount Model, let us move forward and learn about three types of Dividend Discount Models.

1. Zero Growth Dividend Discount Model – This model assumes that all the dividends that are paid by the stock remain one and same forever until infinite.
2. Constant Growth Dividend Discount Model – This dividend discount model assumes that dividends grow at a fixed percentage annually. They are not variable and are constant throughout.
3. Variable Growth Dividend Discount Model or Non Constant Growth – This model may divide the growth into two or three phases. The first one will be a fast initial phase, then a slower transition phase an then ultimately ends with a lower rate for the infinite period.

VARIABLE-GROWTH RATE DDM (MULTI-STAGE DIVIDEND DISCOUNT MODEL)

Variable Growth rate Dividend Discount Model or DDM is much closer to reality as compared to the other two types of dividend dicount model. This model solves the problems related to unsteady dividends by assuming that the company will experience different growth phases.

Variable growth rates can take different forms, you can even assume that the growth rates are different for each year.  However, the most common form is one that assumes 3 different rates of growth:

1. an initial high rate of growth,
2. a transition to slower growth, and
3. lastly, a sustainable, steady rate of growth.

Primarily, the constant-growth rate model is extended, with each phase of growth calculated using the constant-growth method, but using different growth rates for the different phases. The present values of each stage are added together to derive the intrinsic value of the stock.

the term residual income, they think of excess cash or disposable income. Although that definition is correct in the scope of personal finance, in terms of equity valuation residual income is the income generated by a firm after accounting for the true cost of its capital. You might be asking, "but don't companies already account for their cost of capital in their interest expense?" Yes and no. Interest expense on the income statement only accounts for a firm's cost of its debt, ignoring its cost of equity, such as dividends payouts and other equity costs. Looking at the cost of equity another way, think of it as the shareholders' opportunity cost, or the required rate of return. The residual income model attempts to adjust a firm's future earnings estimates, to compensate for the equity cost and place a more accurate value to a firm. Although the return to equity holders is not a legal requirement like the return to bondholders, in order to attract investors firms must compensate them for the investment risk exposure.

In calculating a firm's residual income the key calculation is to determine its equity charge. Equity charge is simply a firm's total equity capital multiplied by the required rate of return of that equity, can be estimated using the capital asset pricing model. The formula below shows the equity charge equation.

Ans.

1.2Price-To-Book Ratio - P/B Ratio

The price-to-book ratio (P/B Ratio) is a ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share.

Also known as the "price-equity ratio".

Calculated as:

P/B Ratio = Market Price per Share / Book Value per Share

Where Book Value per Share = (Total Assets - Total Liabilities) / Number of shares outstanding

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that this varies by industry.

This ratio also gives some idea of whether you're paying too much for what would be left if the company went bankrupt immediately.

The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market price to the book value. It is also sometimes known as a market-to-book ratio. The idea behind "value investing" in the long-term is to find the market sleepers that other investors have passed by and hold on to them as the companies go about their business without gaining any attention from the market. Then, suddenly without warning or fanfare, the sleeper stock pops up on the screen of some analyst who “discovers” them and bids up the stock. Meanwhile, as a value investor, you pocket a hefty profit, sometimes even becoming quite wealthy.

Two Ways to Calculate the P/B Ratio

If you choose to calculate the ratio the first way, the company's market capitalization is divided by the company's total book value from its balance sheet. But, if you choose to calculate the ratio the second way (i.e., using per-share values) you must divide the company's current share price by the book value pers share.

In other words, the value is divided by the number of outstanding shares.

Most of the ratios, there's a fair amount of variation by industry. Industries that require more infrastructure capital (for each dollar of profit) will usually trade at P/B ratios much lower than, for instance, consulting firms.

Price-to-book ratios are commonly used to compare banks because most assets and liabilities of banks are constantly valued at market values. A higher P/B ratio implies that investors expect management to create more value from a given set of assets. It's important to note that P/B ratios do not, however, directly provide any information on the ability of the company to generate profits or cash for shareholders.

The accounting standards applied by firms vary, P/B ratios may not be comparable, especially for companies from different countries. Additionally, P/B ratios can be less useful for services and information technology companies with little tangible assets on their balance sheets.

The P/B ratio also gives some idea of whether or not an investor is paying too much for what would be left if a company went bankrupt immediately. For companies in distress, the book value is usually calculated without the intangible assets that would have no resale value. In such cases, the P/B ratio should be calculated on a "diluted" basis, because stock options may vest upon the sale of the company or upon the firing of management.