Security Analysis and Portfolio

Management
Second Edition
M. Ranganatham | R. Madhumathi

Chapter 7

Equity Instruments
and their Valuation

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 Equity Valuation Methods

 Earnings Valuation
 Revenues Valuation
 Cash Flow Valuation
 Economic Value Added
 Accounting Value
 Yield Valuations
 Member’sValuation

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 Earnings Valuation
Price-Earnings
– P/E multiplier
– P/E Growth rate = P/E Multiplier / Growth Rate
– P/E relative = (share P/E ) / (Index P/E)

Expected growth rate in Earnings

– Expected growth rate in Earnings = Reinvestment rate *
ROI

Negative Earnings

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 Negative Earnings
 Companies might belong to the cyclical industry. In such instances, in all
economic situations, when there is a recession, the company will post
negative earnings. However, once the economic variables change, the
companies in these cyclical industries also recover and show a positive
growth rate.

– If the earnings of a cyclical firm are depressed due to a recession, the

substitute earnings that have to be applied in the valuation process is the
normalized earnings. Illustrations are the companies belonging to the
automobile sector. Whenever there is recession, these companies
operate at below the break-even capacity and post negative growth
rates. Taking the average earnings over an entire business cycle can
normalize earnings.
– Normalized earnings can be computed on the basis of net income or on
the after-tax operating income. The formula for the computation of
normalized earnings under these methods are:

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 Normalized Net Income = Average ROE * Current Book Value
of Equity.

Normalized after-tax Operating Income = Average ROC *

Current Book Value of Assets.

– Once earnings are normalized, the growth rate used should be

consistent with the normalized earnings, and should reflect the
real growth potential of the firm rather than the cyclical effects.

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 Negative Earnings

The earnings of a firm may show a negative result due to a

one-time unforeseeable charge. The extent of depression could
depend on both external and internal factors relating to the
company.

– In such instances, the valuation can be done based on the

estimates without considering the abnormality. Average
earnings of the company can be used from the historical
records to replace the present abnormal negative earnings.
The time duration for considering the average earnings
would depend on the nature of industry and that of the
specific company.

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 Negative Earnings
 The earnings of a company could be negative due to poor management. The
company might have a team at the top which made wrong business decisions or the
company could have been affected by fraud or mismanagement issues. The negative
performance could be in spite of positive earnings record in the industry / sector to
which it belongs. However, if it is felt that the negative earnings due to this
mismanagement has been deducted and corrective action by the company is on the
agenda of the Board, valuation of such companies have to be done considering the
industry earnings record.

– The average return on equity or capital for the industry can be used to estimate
normalized earnings for the firm. The implicit assumption is that the firm will
recover back to industry averages, once management has taken the corrective
measures. In this instance, the following formula can be used to compute the
earnings of the company.

Normalized Net Income = Industry average ROE * Current Book Value of Equity

Normalized after-tax Operating Income = Industry average ROC * Current Book

Value of Assets

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 Negative Earnings
 The negative earnings recorded by the company had continued over several years and the
management actions have not resulted in any improvement in the performance of the company. The
result of this could be a significant reduction in the book value of the company over the time
duration. The erosion of profits and assets of the company could be despite the good profits recorded
by similar companies operating in the same industry / sector group.

– To assess the value of these types of companies, the investor can use the average operating or
profit margins for the industry in conjunction with revenues to arrive at normalized earnings.
When the management has not taken any corrective action or the implications of the decisions
are to be felt over a longer duration, the profit margin for the company could arise over a longer
duration. The following formula can be used by the investors to arrive at the value of the firm
using the earnings approach:

Normalized Net Income = Industry average net profit margin * Current Revenue.

Normalized after-tax Operating Income = Industry average operating profit margin * Current
Revenue.

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 Negative Earnings

The earnings of a firm are depressed or negative because it

operates in a sector that is in its early stages of its life cycle.
This situation could also arise to a new establishment in an
existing profit making industry. Mostly in these cases, the
gestation period for posting a positive return from business
operations could involve longer time duration.

– The valuation of such companies will depend on what the

perceived margins and return on equity will be when the
industry matures or the average returns of companies in the
existing sector.

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 Negative Earnings

The equity earnings are negative not due to operational

mismanagement but due to high leverage or the interest burden
of the company. The increased long-term obligations of the
company coupled with increase in the interest rates may make
the company to post negative earnings despite a positive result
from the industry/sector.

– The valuation of such companies must be from the

viewpoint of the firm rather than that of equity valuation.
Hence, valuation could depend on operational income /
earnings rather than on the income to equity shareholders.

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 Earnings forecast
Earnings (value) = (1-t) * [ROA+(ROA-I)*(D/E)] * E

ROA = Return on assets

I = Interest rate
D = Total long term debt
E = Equity capital
t = tax rate

Forecasted sales = Industry sales target * company's share in industry

sales

Forecasted earnings = Forecasted sales * profit margin

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Earnings Forecast Method

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Forecast using Fixed Cost

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Forecast using Variable Cost

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Forecast of annual versus quarterly results

(Q2et - Q1et) = a + b (Q2e t-1 - Q1e t-1) + e

Q2et = 2nd quarter earnings at year t

Q1et = 1st quarter earnings at year t
Q2e t-1 = 2nd quarter earnings at year (t-1)
Q1e t-1 = 1st quarter earnings at year (t-1)

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Forecast using Statistical Tools

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Forecast using Statistical Tools

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Forecast using Statistical Tools

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Forecast using Statistical Tools

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Forecast using Statistical Tools

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Forecast using Statistical Tools

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 Revenues Valuation
Price to Sales Ratio = Market capitalization / One year total
revenue.

Market capitalization = outstanding shares * current market price

Price to Sales Ratio (PSR) = Market capitalization / Total revenue

for a year.

Market Capitalization = (Shares Outstanding * Current Share Price) +

Current Long-term Debt 0

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Cash Flows Valuation

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 Economic Value Added (EVA)

Economic Value Added (EVA) is another modification of cash

flow that looks at the cost of capital and the incremental return
above that cost as a way of separating businesses that truly
generate cash from ones that just use it.
Economic Return =
Return on Assets – Weighted Average Cost of Capital
Economic Value Added =
Economic Return x Equity Value

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 Accounting Valuation

Book value = Equity worth (capital including reserves belonging

to shareholders) / number of outstanding shares

Book value = (Total assets - Long-term debt) / number of

outstanding shares.

Price to book value ratio = Market price / Book value per share

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 Yield Valuation

Dividend Discount Models 

The Zero-Growth Model
The Constant-Growth Model
The Multiple-Growth Model

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 Dividend Discount Models 

 V = D1 / k

Dividend yield = D1 / Po

Po is the current market price / traded price of the share

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 The Zero-Growth Model

V = (D1 + P1 / (1+k))
P1 is the market price of the company in future.

V = (d1 / (1+k)) + (d2 / (1+k)^2) + (d3 / (1+k)^3) + (d4/(1+k)^4) +

((d5 + P5) / (1+k)^5)

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The Constant-Growth Model

V = D1 / (k-g)

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The Multiple-Growth Model

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 Single Index Valuation

rs  rf   s   rm  rf 
MPt  MPt 1   1  rs 
where rs  Security expected return; rf  Risk-free return; rm  Market return;
 s  Security beta; MP  Market price

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 Members’ Valuation

Subscription value multiplier

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 Investor Valuation of Shares

Methods to Calculate

– Equity multiples: P/E, PEG, P/S, and P/BV

– Whole firm multiples: EVA/EBIT, EVA/EBDIT, EVA/R&D,
and EVA/SG&A
– Estimate growth rate in residual earnings

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 Valuation of Private Companies

Accounting Value
Economic Value Added

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