Equities S7

Alexei Alvarez Drobush, CFA, FRM

Review: Equity
❖ Main sources of total return: (i) Dividends, (ii) Capital gain/loss.

❖ One method to determine the value of stocks is to calculate the

present value of future expected dividend:
Review: DDM
❖ The first Dividend Discount Model is the Gordon Growth model,
which assumes a single future rate of growth for dividends:

❖ It can be extedended to a multi-stage model by assuming different

growth rates for different periods of time
DDM
❖ Advantages:
❖ Based on fundamental concept of discounted PV

❖ Widely accepted.

❖ Disadvantages:

❖ Inputs must be estimated

❖ Value estimates are very sensitive to input values

Valuation using Cash Flows
❖ What about firms that don’t pay any dividends?

❖ Total cash flow from the business can also be used to value the
company. Generally speaking, we use cash flows after paying for
all investments necessary for growt:
Valuation using Cash Flows
❖ How much is this company worth, assuming its long-term growth
rate is 6%?

❖ How important is the assumption of the long-term growth rate?

Valuation using Cash Flows
❖ Advantages:
❖ Applicable to any firm. (no need to have stable dividends)

❖ Useful for a firm with shareholders that have control over the
cash flows.
❖ Disadvantages:

❖ Need to forecast the Financial Statements of the firm

❖ Firm’s capital structure matters
Valuation using Comparables
❖ Compare a stock’s Price multiple to a benchmark value based on
another firm, an index or an industry group of firms.

❖ Intuition: I should pay aproximately the same for a unit of

earnings/sales/value that the market, for the rest of the companies
in an industry. (Law of one Price)

❖ Common Price multiples:

 Price-to-Earnings (P/E)
 Price-to-Book Value (P/B)

 Price-to-Sales (P/S)
Valuation using Comparables
Price-Earnings (P/E)
❖ Firm’s stock Price divided by earnings per share.
❖ Pros: Widely used, earnings are important.
❖ Cons: Earnings can be negative, are exposed to cyclicality and
can be manipulated (accounting principles).
Price-Book value (P/B)
❖ Firm’s stock Price divided by book value of equity per share.
❖ Pros: positive, book value is stable.
❖ Cons: Doesn’t reflect market value of assets (e.g Intangibles).
Valuation using Comparables
Price-Sales (P/S)
❖ Firm’s stock Price divided by sales per share.
❖ Pros: Sales are difficult to manipulate, less volatile than P/E.
❖ Cons: Growth in sales doesn’t necesarily mean growth in
earnings, doesn’t incorporate costs.
Dividend Yield
❖ Dividends paid divided by the firm’s stock price.
❖ Pros: Component of total return, useful for mature and stable
companies.
❖ Cons: Doesn’t take into account potential capital gains.
Valuation using Comparables
Enterprise Value / EBITDA (EV/EBITDA)
❖ EV can be viewed as what it would cost to acquire the firm

❖ Total company value divided by EBITDA.

❖ Pros: Captures the total value of a firm, proxy of cash flows

generated by firm’s operations, EBITDA is usually positive even
when earnings are not.

❖ Cons: Can be negative, market value of a firm’s debt is often not

available.
Valuation using Comparables