Introduction
Dividend discount model helps in valuing the equity of the company. The value of the shares is the present value of the expected dividend. If the value obtained using DDM is higher than the price at which the current shares are trading, than the shares are undervalued.
There are several methods to value the shares of the company using the dividend valuation among those the one which has been widely used is Gordon Growth Model
Gordon Growth Model (GGM):
GGM model helps to value the firm which is has dividends growing at a steady rate.
Valuation of Shares = DPS/(Ke-G)
DPS = Expected dividend per share one year from now
Ke = required rate of return for equity investors
G = Growth rate in dividend
The Gordon growth model is a simple approach to valuing equity; it cannot be used in a situation where the firm has stable growth rate. Two things must be kept in mind when estimating a stable growth rate it has to be assumed that the growth rate of the firm's dividends is expected to infinite, the firm's other performance measures (including earnings) has also be expected to grow at the same rate.
For Example if a firm whose earnings grow 8% a year forever, while its dividends grow at 10% at the same time, the dividends will exceed earnings. On the other hand, if a firm's earnings grow at a faster rate than dividends in the long term, the payout ratio, in the long term, will converge towards zero, which is also not a steady state. Though the model's requirement is for the expected growth rate in dividends, analysts should be able to substitute in the expected growth rate in earnings and get precisely the
same result, if the firm is truly in steady state.
The second issue relates to what growth rate which is considered to be a stable growth rate. This growth rate has to be less than or equal to the growth rate of the economy in which the firm operates. This does not, however, imply that analysts will always agree about what this rate should be even if they agree that a firm is a stable growth firm for three reasons.
Exceptions to Gordon Growth Model
The Gordon growth model is a straightforward and easy way to value stocks but it is extremely based on the input of data .If it is used incorrectly, it can lead to misleading or incorrect results, since, as the growth rate converges on the discount rate, the value goes to infinity.
Consider a stock, with an expected dividend per share next period of $2.50, a cost of equity of 15%, and an expected growth rate of 5% forever. The value of this stock is:
As the growth rate approaches the cost of equity, the value per share approaches infinity. If the growth rate exceeds the cost of equity, the value per share becomes negative. This issue is tied to the question of what comprises a stable growth rate.
Applications of Gordon Growth model:
The Gordon growth model is best suited for firms growing at a rate comparable to or lower than the nominal growth in the economy and which have well established dividend payout policies that they intend to continue in to the future. The dividend payout of the firm has to be consistent with the assumption of stability, since stable.
Calculation of Share Valuation
Years
2001
2002
2003
2004
2005
2006
2007
2008
Dividend (p)
39
40
41
42
44
48
53
57
Growth rate(g)
2.56%
2.50%
2.44%
4.76%
9.09%
10.42%
7.55%
Growth rate (g) is obtained by subtracting current year from last year and dividing it by last year
Ke
13%
Expected growth rate - g
8.00%
Expected dividend(D)
62
V=D/KE-g)
1231.2
Value of shares using dividend discount model is 1231.2P
Analysis of share price
Analysis of share price
Share price of GSK has been gone down by 5% in 2007 and gone by .5% in 2008.This is due to heavy investment in Research and Expenditure. Increase in share price is due to the introduction of new product into the market and also reduction in cost. The company also announces the buyback of major number of shares which also has a major impact in the change in the share price of the company.
Free Cash Flow to Firm
Cash inflows are revenues which are created by selling their products, and cash outflows are which are paid for operating expenses such as wages and taxes and the cash which is left over after cash inflow and outflows are used to invest in working capital and long term investment in working capital. The cash remaining will be used to pay to firm's investors, Bondholders and common share holders and it is called free cash flow to firm.
Free cash flow to firm helps the management in planning and reporting purposes and also helps to increase the rating of the company. Free cash flow to firm helps to identify the cash flows available to investors
Free cash flow to firm helps to identify the value of stock of a company by obtaining the free cash flow of a firm and discounting these cash flows back to present value at the appropriate required rate of return. In order to bring the cash flow to present value WACC (Weighted average cost of capital) has to be calculated.
Firm Value = FCFF discounted at WACC
FCFF can be calculated by using four different financial statement items such as
Net Income
EBIT ( Earnings before interest and taxes)
EBITDA (Earnings before interest and taxes, depreciation and amortization)
Cash flow from operation (CFO)
FCFF using Net income method:
FCFF from net income method is calculated using the following formula
FCFF=NI+NCC+(Int x (1-Tax rate ))-FCInv-WCInv
Where
NI = Net income
NCC = Noncash charges
FCInv = Fixed capital investment
WCInv = Working capital investment
Int = Interest Expenses
Non cash charges are added back to net income as they did not represent actual outflow of cash. Examples of non cash charges are Depreciation, Amortization etc.
Fixed capital investment does not appear in the income statement but they represent actual cash leaving the firm. Fixed capital investment is the difference between cash paid to acquire the asset and proceeds from the sale of long term assets.
When there is no long term asset sold during the period then the FCinv will be the changes in the gross property plant and equipment account in the balance sheet for the period.
Working capital investment represents the change in the working capital; a reduction in working capital would be added back as it represents the cash inflow.
Interest expense represents the interest charges in the income statement but interest charges do not represent operating cash flow it represents the financing cash flow.
So interest has to be added back to net income and only interest expenses after the marginal tax rate has to be added back. For Example if the tax rate is 25% then only 75% of the amount of interest is added back since this 75% represent the cash flow.
Reconciliation of free cash flow (FCFF)
2008
2007
Net cash inflow from operating activities
7,205
6,161
Purchase of non-current tangible assets
-1,437
-1,516
Purchase of non-current intangible assets
-632
-627
Disposal of non-current tangible fixed assets
20
35
Interest paid
-730
-378
Interest received
320
247
Dividends received from joint ventures and
associated undertaking
12
12
Dividends paid to minority interests
-79
-77
Free cash flow
4,679
3,857
%Increase in FCFF
21%
Valuation Of GSk Using FCFF
WACC - Weighted Average Cost Of Capital
8%
Gfcff
2%
Firm Value
77,983.33
Millions
FCFF in relation to GSK
FCFF has been increased by 21% in 2008 when compared to 2007.This is due to the higher operating profit before non-cash charges,
Primarily from the major restructuring programmes, and working capital
Improvements, partly offset by higher levels of interest paid as a result of
The significant debt issuances during the year of US $9 billion under the
US shelf registration and £0.7 billion under the EMTN programme.
Value of Equity using the FCFF is 66842.86million.
Free cash Flow to Equity :( FCFE)
Free cash flow to Equity helps to identify the cash flows available to shareholders.
FCFE is calculated by taking into account net income and convert it to a cash flow by subtracting out a firm's reinvestment needs.
Any capital expenditures, defined broadly to include acquisitions, are subtracted from the net income, since they represent cash outflows. Non cash charges such as depreciation and amortization are added back to net income. The difference between capital expenditures and depreciation is referred to as net capital expenditures and is usually a function of the growth characteristics of the firm.
High growth firms tend to have high net capital expenditures relative to earnings, whereas low-growth firms may have low and sometimes even negative, net capital expenditures
Repaying the principal on existing debt represents a cash outflow; but the debt repayment may be fully or partially financed by the issue of new debt, which is a cash inflow. Again, netting the repayment of old debt against the new debt issues provides a measure of the cash flow effects of changes in debt.
Allowing for the cash flow effects of net capital expenditures, changes in working
capital and net changes in debt on equity investors and the cash flows left over
after these changes as the free cash flow to equity (FCFE)
Free cash flow to Equity can be calculated as follows
= Net Income- (Capital Expenditures - Depreciation) - (Change in Non-cash Working
Capital) + (New Debt Issued - Debt Repayments)
Free Cash Flow to Equity Valuation Models:
The Constant growth FCFE model:
The constant growth model aims to value firms which are developing at a stable growth rate. And hence value of the equity under constant growth model is the expected FCFE in the next period the stable growth and the required rate of return.
Formula for Calculating FCFE is
The growth rate used should not be more than the growth rate of the economy.
Two Stage FCFE Model
Two stage FCFE model helps to determine the value of the firm which is expected to grow at much faster than the stable firm in the initial period and at a stable rate after that.
Value of the stocks can be computed by obtaining the present value of the FCFE for the extraordinary growth period plus the present value of the terminal price at the end of the period.
Formula to compute:
Three Stage FCFE Model
Three stage models is designed to value firms that are expected to go through three stages of growth
an initial phase of high growth rates,
a transitional period where the growth rate declines and
a steady state period where growth is stable
Three stage models calculate the present value of expected free cash flow to equity over all three stages of growth.
Net Income
4,602.00
Depreciation
1,602.00
ADD
Capital Expenditures
2,069.00
Decrease in Working Capital
450.00
New Debt Issued
5,523.00
Less:Debt Repayment
3,059.00
Free cash flow to equity
7,049.00
Residual Income Approach:
Residual income is net income less a charge (deduction) for common shareholders' opportunity cost in generating net income.
The concept of residual income considers the cost of equity capital leaves to the owners the determination as to whether the resulting earnings are sufficient to meet the cost of equity capital.
Traditional method Versus Residual income approach:
Traditional financial statements are prepared in order to ascertain the earnings available to owners. Net income includes only the interest expense which represents the cost of debt capital, dividends or other charges for equity capital are not included. Traditional accounting helps to determine whether the resulting earnings are sufficient to meet the cost of equity capital.
The economic concept of residual income explicitly considers the cost of equity capital.
It is used in the Measurement of internal corporate performance of an organization
And in the estimation of the intrinsic value of common shares
Residual income has also been called economic profit since it represents the economic profit of the firm after deducting the cost of all capital, debt and equity.
The term abnormal earnings is also used. Assuming that over the long term the firm is expected to earn its cost of capital (from all sources) any earnings in excess of the cost of capital can be termed as abnormal earnings.
Residual income can be used in situation where
A firm is not paying dividends or it has an unpredictable dividend pattern.
A firm which has a negative cash flow in the past, but is expected to generate positive cash flow at some point in the future
When there is a great deal of uncertainty in forecasting a stable growth rate of future cash flows.
In the Residual Income Model (RIM) of valuation, the intrinsic value of the firm has two components:
The current book value of equity, plus
The present value of future residual income
This can be expressed algebraically as
Years
2008
2009
2010
2011
2012
2013
2014
E=Net income(£m)
4602
5292.30
5821.53
6403.68
6980.01
7468.62
7991.42
g E
0.15
0.10
0.10
0.09
0.07
0.07
B=Share holder's equity(£m)
7931
8724.10
9596.51
10364.23
11089.73
11422.42
11765.09
g B
0.10
0.10
0.08
0.07
0.03
0.03
RIt=E-Ke*Bt-1
3354
4261.27
4687.40
5156.14
5632.66
6026.95
6506.50
DF(Ke=13%)
0.88
0.78
0.69
0.61
0.54
0.48
PV of RI
3771.04
3670.92
3573.46
3454.62
3271.19
3125.19
Value of GSK(£M)
28797.42
Residual Income:
Economic Value Added:
Economic Value Added (EVA) measures the financial performance based on the concept that all capital has a cost. It is obtained by calculating Net operating profit after tax (NOPAT) less a capital charge. It shows the true profit earned as it consist of all costs including the cost of capital. If a company makes a return more than cost of capital then it is creating a true value for its share holders.
EVA is a technique useful in changing organizational behaviour and in driving the decision-making process in a manner that maximizes value to the business
Economic Value Added (EVA) and its uses:
It is used in most companies for corporate performance measure and evaluating performance, it is also used for determining incentive pay.
EVA helps to identify investors how well the company is doing and how it is producing value to its share holders.
EVA is based on accounting figures and hence it able provide more immediate and accurate results.
Advantages of EVA:
EVA can be calculated for divisions and even projects.
EVA measure's the performance over a period of time rather than a point of time.EVA is a flow variable and depends on the ongoing and future operations of the firm or divisions.
EVA is a measure of the firm's economic profit. Hence, it shows the true picture of the firm's value.
Calculating EVA:
NOPAT is profits derived from a company's operations after taxes but before financing costs and non cash entries. It is the total profits available to provide cash return to those who provide capital to the firm.
Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less no interest-bearing current liabilities.
Capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested.
The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk. Another perspective on EVA can be gained by looking at a firm's Return on Net Assets (RONA).
RONA is a ratio that is calculated by dividing a firm's
NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system
NOPAT=
4712
TOTAL CAPITAL
15230
WACC
8%
EVA=
3493.6
REFERENCES USED
ACCA TEXT BOOKS
CIMA TEXT BOOKS
INTERNET - ESPECIALLY WEBSITES
LECTURE HANDOUTS
POUNDS2DOLLARS WEBSITE
INVESTOPEDIA,WICKEDPEDIA
CFA - FINANCIAL ANALYSIST BOOKS
LIBRARY RESEARCH INCLUDES GOING THROUGH VARIOUS BOOKS WRITTEN BY VARIOUS AUTHORS
PRESS RELEASES AND JOURNAL RELEASES
WEBSITES USED
WWW.SCRIBD.COM
http://en.allexperts.com/q/Management-Consulting-2802/2009/10/International-Financial-Management.htm
