Abstract :
I will calculate the intrinsic values of the companies (MCB, MEI, MLC, MUA, SBM, SWAN) i.e the companies listed on SEM under the Insurance and Banking sector for the last 5 years. Then these intrinsic values will be compared with the respective quoted market values for each firm individually. Afterwards comparisons will be made among the valuation models themselves for any significant differences. In my dissertation I will test whether different valuation models would yield different share values. And whether the values computed will converge to the same value. The aim is to prove that applying different techniques to arrive at the equity value which should give the same value since a firm normally has only one true value, i.e its intrinsic value.
Dividend Discount Model
Financial theory holds that the value of a share of stock is equal to the sum of the discounted future expected dividends. Dividend Discount (DD) requires two inputs: a forecast of future dividends and a rate at which these benefits are to be discounted to their present value. The appropriate discount rate is the rate of return available on risk-free investments plus a risk premium. One of the most widely used models for calculating discount rates is the Capital Asset Pricing Model.
Once the discount rate is estimated, all future dividends must be discounted to their present value. Although near term dividends may be estimated with some confidence, an assumption regarding long term dividends is necessary to make the DD model operational. Two common assumptions regarding dividend growth and their associated valuation models are:
(i) earnings growth and therefore dividend growth will be constant with the Gordon Model, and
(ii) multiple stages of growth can be approximated.
Clearly the forecasts and the assumptions necessary for operating DD models introduce the possibility of significant errors into this theoretically correct approach.
Common Stock Valuation Concepts
The value of a bond at a given time can be defined as the present value of the stream of coupon payments plus the present value of the principal payment to be received at maturity, both discounted at the prevailing rate of interest for that maturity. Following analogous reasoning, the value of a common stock can be defined as the present value of the future dividend stream in perpetuity. This concept is consistent with the assumption that the corporation will indeed have a perpetual life, in accordance with its charter.
If the value of a stock is equivalent to the value for a perpetual annuity with a constant level of payments, this may be expressed mathematically as:
(1)
where V = value,
D = dividends per share
k = percentage discount rate
If the dividends are assumed to grow at a certain constant rate, the formula becomes:
(2)
where g represents annual constant percentage growth in dividends per share and D next year's dividends.
This model assumes that the growth rate for the corporation being analyzed is constant. It is thus most suitable for use in estimating the value of stable, mature companies (or, in the context of a more complex model, the residual value representing the mature phase of a currently more dynamic company). Companies with a more erratic or cyclical earnings pattern, or rapidly growing companies, require a more complex dividend capitalization model frame-work that can accommodate differing dividend growth patterns.
Although practical applications may require elaborate variations of the dividend capitalisation model, the simplified form nevertheless provides a convenient means of analysing the determinants of stock value. To begin with, the value of the stock should be greater, the greater the earning power and capacity of the corporation to pay out current dividends, D. Correspondingly, the higher the growth rate of the dividends, g, the greater the value of the corporation's stock. Finally, the greater the risk of the corporation (the higher the discount rate, k) the lower will be the value of the stock.
The discount rate is alternatively referred to as a required return. It is composed of two elements-a risk-free return and a risk premium. The risk-free return is, in turn, generally considered to consist of a real return component and an inflation premium. The real return is the basic investment compensation that investors demand for forgoing current consumption or, alternatively, the compensation for saving. Investors also require a premium to compensate for inflation; this premium will be high when the inflation rate is expected to be high and low when the inflation rate is expected to be low. Because the real return and the inflation premium comprise a basic return demanded by all investors, the risk-free return is a component of all securities. The risk premium is made up of the following elements-interest rate risk, purchasing power risk, business risk and financial risk. The risk premium might be considered to be a function of the stock's systematic risk (beta), which is determined by these four fundamental risk factors. As securities differ in their exposure to these risk elements, the premium or return that investors require to compensate for risk will differ across securities.
The constant dividend growth model reveals that the following three factors affect stock prices, ceteris paribus: 1) the higher the dividend, the higher the stock price; 2) the higher the dividend growth rate, the higher the stock price; 3) the lower the required rate of return r, the higher the stock price.
Issues of dividend policy range from its puzzle by Black (1976) to its irrelevance by Miller and Modigliani (1961), to its relevance by DeAngelo et al. (1996). Other issues include theories on dividend payment, such as stakeholders' theory, pecking order theory, agency cost, signalling theory, bird-in-hand fallacy and clientele effect. The information asymmetry between managers and shareholders, along with the separation of ownership and control, formed the base for another explanation of why dividend policy has been so popular.
Dividend irrelevance theory
Miller and Modigliani (1961) proposed that dividend policy is irrelevant to the shareholder and that stockholder wealth is unchanged when all aspects of investment policy are fixed and any increase in the current payout is financed by fairly priced stock sales. The main assumption is that there is 100 per cent payout by management in every period. Other assumptions are:
that there exist perfect capital markets; that is, no taxes or transactional cost, the market price cannot be influenced by a single buyer or seller, and free and costless access to information about the market;
that investors are rational and that they value securities based on the value of discounted future cash flow to investors;
that managers act as the best agents of shareholders; and
that there is certainty about the investment policy of the firm, with full knowledge of future cash flows.
In light of the foregoing, they concluded that the issue of dividend policy is irrelevant.
Bird-in-hand theory
Al-Malkawi (2007) asserts that in a world of uncertainty and information asymmetry, dividends are valued differently from retained earnings (capital gains): "A bird in hand (dividend) is worth more than two in the bush (capital gains)". Owing to the uncertainty of future cash flow, investors will often tend to prefer dividends to retained earnings. Though this argument has been widely criticised and has not received strong empirical support, it has been supported by Gordon and Shapiro (1956), Lintner (1962) and Walter (1963). The main assumptions are:
that investors have imperfect information about the profitability of a firm;
that cash dividends are taxed at a higher rate than when capital gain is realized on the sale of a share; and
that dividends function as a signal of expected cash flows.
Signalling hypothesis
Though Miller and Modigliani (1961) assumed that investors and management have perfect knowledge about a firm, this has been countered by many researchers, as management who look after the firm tend to have more precise and timely information about the firm than outside investors. This, therefore, creates a gap between managers and investors; to bridge this gap, management use dividends as a tool to convey private information to shareholders (Al-Malkawi, 2007). Petit (1972) observed that the amount of dividends paid seems to carry great information about the prospects of a firm; this can be evidenced by the movement of share price. An increase in dividends may be interpreted as good news and brighter prospects, and vice versa. But Lintner (1956) observed that management are reluctant to reduce dividends even when there is a need to do so, and only increase dividends when it is believed that earnings have permanently increased.
Clientele effects of dividends theories.
Investors tend to prefer stocks of companies that satisfy a particular need. This is because investors face different tax treatments for dividends and capital gains and also face some transaction costs when they trade securities. Miller and Modigliani (1961) argued that for these costs to be minimised, investors tend towards firms that would give them those desired benefits. Likewise, firms would attract different clientele based on their dividend policies. Though they argued that even though clientele effect may change a firm's dividend policy, one clientele is as good as another, therefore dividend policy remains irrelevant. Al-Malkawi (2007) affirms that firms in their growth stage, which tend to pay lower dividends, would attract clientele that desire capital appreciation, while firms in their maturity stage, which pay higher dividends, attract clientele that require immediate income in the form of dividends. Al-Malkawi (2007) grouped the clientele effect into two groups, those that are driven by tax effects and those driven by transaction cost. He argued that investors in higher tax brackets would prefer firms that pay little or no dividends, to get reward in the form of share price appreciation, and vice versa. Transaction cost-induced clientele, on the other hand, arises when small investors depend on dividend payments for their needs; this clientele prefers companies who satisfy this need because they cannot afford the high transaction cost of selling securities.
Empirical Studies on the DDM
Dividends form the hard core of stock values. As Justice Holmes remarked, "the commercial value of property consists in the expectation of income from it." (In Galveston, H. & S. A. Ry. Co. v. Texas, 210 U. S. 217, 226.) Black (1976) observed, 'The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don't fit together'
Williams applied Fisher's work on stock valuation and developed the famous dividend discount model (DDM) (Fewings, 1979, p. 12). Williams defines ''the investment value of stock as the present worth of all the dividends to be paid upon it (Williams, 1956, p. 55).'' He further makes it clear that ''the investment value of a common stock is the present worth of its net dividend to perpetuity (Williams, 1956, p. 63).'' Amid this theoretical research, the academic world was divided and a fierce debate erupted concerning the irrelevance of dividend policy in the determination of the valuation of firms or their stocks. The inconsequence of dividend policy in the stock valuation contemplates the equivalence of the valuation using earning approach and the valuation using discounted dividend approach.
Fisher's inter-temporal investment and consumption model predicted that ''earnings which are reinvested at the going rate of capital instead of being released for consumption neither adds nor subtracts from the value of the overall stream of benefits (Fewings, 1979, p. 17).'' Thus, according to Fisher, dividend policy is irrelevant in the valuation of stocks. One must remember that Fisher's theory is applicable under perfect capital markets with certain futures. At the same time, Graham and Dodd (1934) developed their valuation methodologies based on the assumption that the firm's main objective is to pay dividends to shareholders.
Empirical evidence in the market suggested a positive correlation between stock prices and dividend payout (Harkavy, 1953), suggesting the relevance of dividends in the valuation of stocks. Gordon and Shapiro (1956), Walter (1956) and Solomon (1963) supported this hypothesis. In accordance with the relevance of the dividend policy on the valuation of stocks, Gordon extended Williams' model of stock valuation to include retained earnings. He further developed the model to include continuous equity financing. These dividend dependent models are called the ''bird-in-the-hand'' models by authors like Frankfurter et al. (2003), as they are based on the assumption that there are two opportunity rates - one for the firm and the other for the investor. The firm should retain 100 per cent of its earnings if the opportunity rate of a firm is greater than the opportunity rate of the investor.
The seminal paper of Miller and Modigliani (1961) argued the irrelevance of dividend policy and the equivalence of the valuation of stocks using four approaches, namely the discounted cash flow (DCF) approach, the current earnings plus future investment opportunities approach, the discounted dividend approach and the stream of earnings approach. This equivalence was proven under assumptions of perfect capital markets, rational behavior and perfect certainty. In addition, Miller and Modigliani (1961) point out that the dividend policy may be relevant when a revision in the dividend policy points to some information that the investors do not know. This information content of dividends argument led to the development of dividend signaling models. The irrelevance of dividends is not resolved. Academics are still divided into two, if not more, schools of thought on the subject.
Price Earning Ratio
A firm's profitability, risk, quality of management, and many other factors are reflected in its stock and security prices. Hence, market value ratios indicate the market's assessment of the value of the firm's securities. The price/earnings (P/E) ratio is simply the market price of the firm's common stock divided by its annual earnings per share. Sometimes called the earnings multiple, the P/E ratio shows how much investors are willing to pay for each dollar of the firm's earnings per share. Earnings per share comes from the income statement, so it is sensitive to the many factors that affect the construction of an income statement, from the choice of GAAP to management decisions regarding the use of debt to finance assets. The price/earnings ratio is stated as:
Stock prices are determined from the actions of informed buyers and sellers in an impersonal market. Stock prices reflect much of the known information about a company and are fairly good indicators of a company's true value. Although earnings per share cannot reflect the value of patents or assets, the quality of the firm's management, or its risk, stock prices can and do reflect all of these factors. Comparing a firm's P/E to that of the stock market as a whole, or with the firm's competitors, indicates the market's perception of the true value of the company. While the P/E ratio measures the market's valuation of the firm relative to the income statement value for per-share earnings, the price-to-book value ratio measures the market's valuation relative to balance sheet equity. The book value of equity is simply the difference between the book values of assets and liabilities appearing on the balance sheet. The price-to-book-value ratio is the market price per share divided by the book value of equity per share. A higher ratio suggests that investors are more optimistic about the market value of a firm's assets, its intangible assets, and the ability of its managers. The price-to-book value ratio is stated as:
Market value indicators reflect the market's perception of the true worth of a firm's future prospects. As such, market perceptions of a firm's value are important to the financial analyst. However, the market may not be perfect; investors may become overly optimistic or pessimistic about a firm. The fact that a firm presently has a higher P/E or price-to-book-value ratio than its competition does not automatically imply that the firm is better managed or really deserves its higher valuation. Some firms may have low market value ratios because they truly deserve them; other firms may suffer from extreme and undeserved pessimism on the part of the market. High market value ratios can be similarly deceptive. The analyst must determine whether a firm deserves its market value ratios or not.
Empirical Studies on the P/E model
Nicholson (1960), McWilliams (1966), Latane et al. (1969), Dowen and Bauman (1986), Keim (1990), and Fama and French (1992) provide evidence that stock returns are linked to P/E ratios. Generally, in the long run, portfolios comprised of firms with low P/E ratios outperform portfolios containing companies with high P/E ratios. It is speculated that this phenomenon occurs because with high P/E ratio stocks investors have bid the prices up too sharply in relation to the growth potential in earnings. When the expected growth in earnings does not materialize, share price suffers.
Penman (1996), however, notes that the P/E ratio acts not as a predictor of share price or returns but of future earnings levels. Allen et al. (1998) conclude similarly as their results indicate that firms with high E/P stocks have relatively low earnings growth while companies with low E/P shares experience high earnings growth. Furthermore, Fuller et al.(1992) conclude that accounting earnings changes are not randomly distributed; their findings indicate that stocks sell at widely diverging P/E ratios because these ratios reflect consensus earnings growth forecasts. They show that low P/E ratio stocks generate low future earnings growth while high P/E ratio shares result in high earnings growth. Likewise, Ou and Penman (1989) note that P/E ratios are good predictors of future earnings while changes in share price are poor predictors of future earnings.
Thus, significant research exists supporting the notion that P/E ratios represent good indicators of future earnings levels. Another line of research (e.g., Beaver, 1989; Mande, 1994) provides strong evidence that earnings aids investors in evaluating a firm's dividend paying ability. As Larcker (1989) notes, share price is determined in the market through capitalization (i.e., discounting) of the future cash flows or dividends expected to accrue to stockholders. Since earnings provide an information signal about future cash flows, stock price is affected by expectations concerning earnings. Because P/E ratios act as predictors of future earnings, these ratios are also linked to share price or returns.
Nicholson (1960), McWilliams (1966), Latane et al. (1969), Dowen and Bauman (1986), Keim (1990), and Fama and French (1992) provide evidence that stock returns are linked to P/E ratios. Generally, in the long run, portfolios comprised of firms with low P/E ratios outperform portfolios containing companies with high P/E ratios. It is speculated that this phenomenon occurs because with high P/E ratio stocks investors have bid the prices up too sharply in relation to the growth potential in earnings. When the expected growth in earnings does not materialize, share price suffers.
