Equity Analysis and

Valuation
JSC «Kazakh-British Technical University»
Business School
Course 1 Overview of Equity Securities
Introduction to Industry and
agenda 2 Company Analysis
Equity Valuation: Concepts and Basic
3
Tools
4 Equity Valuation: Applications and
Processes
5 Discounted Dividend Valuation

6 Free Cash Flow Valuation

7
Market-Based Valuation: Price and
Enterprise Value Multiples
8 Residual Income Valuation

9 Private Company Valuation

MODULE 1
Overview of Equity
Securities
LO 1 Describe characteristics of types of equity securities

CHARACTERISTICS OF EQUITY SECURITIES

EQUITY DEBT

o shareholders have a o is a liability of the

claim on the company’s issuing company
assets o issuer obligated to
o owners of the company repay the amount it
o total return (capital or borrows
price appreciation and o cost of using these
dividend income) funds is called interest

Common Preference
Shares shares
LO 2 Describe differences in voting rights and other ownership characteristics among different equity
classes

CHARACTERISTICS OF EQUITY SECURITIES

COMMON SHARES VOTING RIGHTS
o share in the operating performance o corporate governance decisions:
• the election of its board of directors,
o participate in the governance process • the decision to merge with or take over
through voting rights • the selection of outside auditors
o claim on the company’s net assets in the o vote by proxy (having someone else vote as
case of liquidation they direct them, on their behalf)
o no obligation to pay dividends o Statutory voting system
• each share held is assigned one vote in the
election of each member of the board of directors
• shareholder can vote 100 shares for his director
choice in each election
o Cumulative voting
• shareholders can allocate their votes to one or
more candidates as they choose.
• the shareholder has 300 votes, which can be
cast for a single candidate or spread across
multiple candidates.
• makes it possible for a minority shareholder
LO 1 Describe characteristics of types of equity securities

CHARACTERISTICS OF EQUITY SECURITIES

PREFERENCE SHARES
o have features of both common stock and debt
• preferred stock dividends are not a • typically make fixed periodic
contractual obligation payments to investors
• the shares usually do not mature • do not usually have voting rights
• may be callable or puttable

o Preferred shares have a stated par value and pay a percentage dividend based on
the par.
o An $80 par value preferred with a 10% dividend pays a dividend of $8 per year.

Cumulative preference shares

o are usually promised fixed dividends; any dividends that are not paid must be made up
before common shareholders can receive dividends.

Non-cumulative preference shares

o The dividends do not accumulate over time when they are not paid, but dividends for
any period must be paid before common shareholders can receive dividends.
LO 1 Describe characteristics of types of equity securities

CHARACTERISTICS OF EQUITY SECURITIES

PREFERENCE SHARES
Participating preference shares
o receive extra dividends if firm profits exceed a predetermined level
o may receive a value greater than the par of the preferred stock if the firm is
liquidated.
Non-participating preference shares
o have a claim equal to par value in the event of liquidation and do not share in firm
profits.
Convertible preference shares
o can be exchanged for common stock at a conversion ratio (when originally issued)
o It has the following advantages:
• The preferred dividend is higher than a common dividend.
• If the firm is profitable, the investor can share in the profits by converting his
shares into common stock.
• conversion is more valuable when the common stock price increases.
• often used to finance risky venture capital and private equity firms
➢ compensates investors for the additional risk they take
LO 3 Compare and contrast public and private equity securities

PRIVATE EQUITY SECURITIES

Private equity is usually issued to institutional investors via private placements.

Less liquidity because no Potentially weaker corporate

public market for the shares governance because of reduced
exists. reporting requirements and less public
scrutiny.

Share price is negotiated between Greater ability to focus on long-term

the firm and its investors, not prospects because there is no public
determined in a market. pressure for short-term results.

Lower reporting costs because Potentially greater return for

of less onerous reporting investors once the firm goes public.
requirements.
LO 3 Compare and contrast public and private equity securities

PRIVATE EQUITY SECURITIES

TYPES OF PRIVATE EQUITY INVESTMENTS

1. VENTURE CAPITAL
✓ refers to the capital provided to 2. LEVERAGED BUYOUTS
firms early in their life cycles
to fund their development and ✓ In a LBO, investors buy all of a 3. PRIVATE INVESTMENTS
growth. firm’s equity using debt IN PUBLIC EQUITY
✓ financing is referred to as seed financing (leverage).
✓ In a PIPE, a public firm that
or start-up, early stage, or ✓ If the buyers are the firm’s
needs capital quickly sells
mezzanine financing. current management, the LBO
private equity to investors.
✓ Investors can be family, is referred to as a
✓ The firm may have growth
friends, wealthy individuals, or management buyout (MBO).
opportunities, be in distress,
private equity funds. ✓ Firms in LBOs usually have
or have large amounts of
✓ investments are illiquid cash flow that is adequate to
debt.
✓ Lock up period: three to ten service the issued debt or
✓ The investors can often buy the
years before they can cash out have undervalued assets that
stock at a sizeable discount to
✓ Investors hope to profit when can be sold to pay down the
its market price.
they can sell their shares after debt over time.
(or as part of) an IPO or to an
established firm.
LO 4 Describe methods for investing in non-domestic equity securities.

NON-DOMESTIC EQUITY SECURITIES

o The world’s financial markets have become more DIRECT INVESTING

integrated over time (capital flows freely across o in the securities of foreign companies simply refers
borders), especially as a result of improved to buying a foreign firm’s securities in foreign
communications and trading technologies. markets.

o Barriers to global capital flows still exist: o Some obstacles to direct foreign investment are:
• some countries restrict foreign ownership of • The investment and return are denominated
their domestic stocks - to prevent foreign in a foreign currency.
control • The foreign stock exchange may be illiquid.
• The reporting requirements of foreign stock
o Reducing capital barriers improves equity exchanges may be less strict, impeding
market performance: analysis.
• listing on foreign stock exchanges increases • Investors must be familiar with the
publicity for the firm’s products and the regulations and procedures of each market in
liquidity of the firm’s shares. which they invest.
• Foreign listing also increases firm
transparency due to the stricter disclosure
requirements of many foreign markets.
LO 4 Describe methods for investing in non-domestic equity securities.

NON-DOMESTIC EQUITY SECURITIES

DEPOSITORY RECEIPTS (DRS)

o represent ownership in a foreign firm and are traded in the markets of other countries in
local market currencies.
o A bank deposits shares of the foreign firm and then issues receipts representing
ownership of a specific number of the foreign shares.
o The depository bank acts as a custodian and manages dividends, stock splits, and other
events.
o Although the investor does not have to convert to the foreign currency, the value of the DR is
affected by exchange rate changes, as well as firm fundamentals, economic events, and any
other factors that affect the value of any stock.

o If the firm is involved with the issue, the depository receipt is a sponsored DR; otherwise, it is
an unsponsored DR.
o A sponsored DR provides the investor voting rights and is usually subject to greater
disclosure requirements.
o In an unsponsored DR, the depository bank retain the voting rights.
LO 4 Describe methods for investing in non-domestic equity securities.

NON-DOMESTIC EQUITY SECURITIES

Global depository American depository
receipts (GDRs)
Types of ADRs
receipts (ADRs)
✓are issued outside the ✓are denominated in U.S.
United States and the dollars and trade in the
issuer’s home country. United States.
✓Most GDRs are traded on ✓The security on which the
the London and ADR is based is the
Luxembourg exchanges. American depository
✓are usually denominated share (ADS), which
in U.S. dollars and can be trades in the firm’s
sold to U.S. institutional domestic market.
✓Global registered shares (GRS) are traded in
investors. ✓Some ADRs allow firms to
✓GDRs are not subject to different currencies on stock exchanges around the
raise capital in the United
the capital flow world.
States
✓A basket of listed depository receipts (BLDR) is an
restrictions imposed by ✓Most require U.S. (SEC)
governments exchange-traded fund (ETF) that is a collection of
registration, but some are
✓has greater opportunities DRs.
privately placed (Rule
for foreign investment. • ETF shares trade in markets just like common
144A or Regulation S
stocks.
receipts).
LO 5 Compare the risk and return characteristics of different types of equity securities.

RISK AND RETURN CHARACTERISTICS

RETURNS RISK
o on equity investments consist of: o of equity securities is measured as the
1. price changes standard deviation of returns.
2. dividend payments o Preferred stock is less risky than common
3. in the case of equities denominated in a stock
foreign currency, gains or losses from • fixed dividend to investors
changes in exchange rates. • distributions before
• in case of liquidation has priority over the
𝑷𝒕 – 𝑷𝒕–𝟏 + 𝑫𝒕 claims of common stock owners.
𝑻𝒐𝒕𝒂𝒍 𝒓𝒆𝒕𝒖𝒓𝒏, 𝑹𝒕 = • lower average return than common stock.
𝑷𝒕–𝟏
o Cumulative preferred shares have less risk
than non-cumulative preferred shares
o Gains from dividends and the o For both common and preferred shares,
reinvestment of dividends have been an puttable shares are less risky and callable
important part of equity investors’ long-term shares are more risky compared to option-free
returns. shares
• Puttable shares - lower dividend yield
• Callable shares - higher dividend yields
LO 6 Distinguish between the market value and book value of equity securities.

MARKET VALUE AND BOOK VALUE OF EQUITY SECURITIES

The primary goal of firm management is to increase the book value of the firm’s equity and thereby
increase the market value of its equity.

MARKET VALUE BOOK VALUE

o is the total value of a firm’s outstanding o is the value of the firm’s assets on the
equity shares based on market prices balance sheet minus its liabilities.
o reflects the expectations of investors o It increases when the firm has positive net
about the firm’s future performance. income and retained earnings that flow
o Investors use their perceptions of the firm’s into the equity account.
risk and the amounts and timing of future o When management makes decisions that
cash flows to determine the market value increase income and retained earnings,
of equity. they increase the book value of equity.

o The market value and book value of equity are seldom equal.
o Although management may be maximizing the book value of equity, this may not be reflected in the
market value of equity because book value does not reflect investor expectations about future firm
performance.
LO 6 Distinguish between the market value and book value of equity securities.

MARKET VALUE AND BOOK VALUE OF EQUITY SECURITIES

THE PRICE-TO-BOOK RATIO (THE MARKET-TO-BOOK RATIO)

o is the market value of a firm’s equity divided by the book value of its equity.

o The more optimistic investors are about the firm’s future growth, the greater its price-to-
book ratio.

o Firms with low price-to-book ratios are considered value stocks

o Firms with high price-to-book ratios are considered growth stocks.

LO 7 Compare a company’s cost of equity, its (accounting) return on equity, and investors’ required
rates of return.

ACCOUNTING RETURN ON EQUITY

RETURN ON EQUITY (ROE)
o a key ratio used to determine management efficiency
o is calculated as net income available to common (net income minus preferred dividends) divided by the
average book value of common equity over the period:
𝑵𝑰𝒕 𝑵𝑰𝒕
𝑹𝑶𝑬𝒕 = =
𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝑩𝑽𝒕 𝑩𝑽𝒕 + 𝑩𝑽𝒕−𝟏
𝟐
• more appropriate when it is the industry convention or when book value is volatile

o ROE is often calculated using only beginning-of-year book value of equity (end of year t − 1):
𝑵𝑰𝒕
𝑹𝑶𝑬𝒕 =
𝑩𝑽𝒕−𝟏
• is more appropriate when examining ROE for a number of years or when book value is stable.

o Higher ROE is generally viewed as a positive for a firm

• But the reason for an increase should be examined – decreasing book value or debt issue to
repurchase equity; make the firm’s shares riskier due to the increased financial leverage (debt).
LO 7 Compare a company’s cost of equity, its (accounting) return on equity, and investors’ required
rates of return.

ACCOUNTING RETURN ON EQUITY

EXAMPLE: ROE, market, and book value of equity calculations
Given the following data for O’Grady Industries, calculate the return on average equity for 20X9 and the
total market value of equity, the book value per share, and the price-to-book ratio at the end of 20X9.

Fiscal Year-End Dec. 31 20X9 20X8

Total stockholder’s equity 18,503 17,143
Net income available to common 3,526 3,056
Stock price $16.80 $15.30
Shares outstanding 3,710 2,790
Answer:
The return on average equity for 20X9 is:
𝑵𝑰𝒕 $𝟑, 𝟓𝟐𝟔
𝑵𝑰𝒕 𝑩𝑽𝒕 + 𝑩𝑽𝒕−𝟏 ($𝟏𝟖, 𝟓𝟎𝟑 + $𝟏𝟕, 𝟏𝟒𝟑)
𝑹𝑶𝑬𝒕 = = = = 𝟏𝟗. 𝟕𝟖%
𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝑩𝑽𝒕 𝟐 𝟐
The total market value of the firm’s equity at the end of 20X9 is: $16.80 × 3,710 = $62,328
The book value per share at the end of 20X9 is: = $18,503 / 3,710= $4.99
The price-to-book ratio at the end of 20X9 is: =$16.80 / $4.99 = 3.37
LO 7 Compare a company’s cost of equity, its (accounting) return on equity, and investors’ required
rates of return.

INVESTORS’ REQUIRED RETURN AND THE COST OF EQUITY

A FIRM’S COST OF EQUITY
o is the expected equilibrium total return (including dividends) on its shares in the market.
o It is usually estimated in practice using a dividend discount model or the capital asset
pricing model.

o A decrease in share price will increase the expected return on the shares
o An increase in share price will decrease expected returns on the shares

INTRINSIC VALUE OF A FIRM’S SHARES

o is the discounted present value of its future cash flows, an increase (decrease) in the
required return used to discount future cash flows will decrease (increase) intrinsic value.
o Investors also estimate the expected market returns on equity shares and compare this to
the minimum return they will accept for bearing the risk inherent in a particular stock.
• expected return > minimum required rate => shares are an attractive investment.

o A firm’s cost of equity can be interpreted as the minimum rate of return required by
investors (in the aggregate) to compensate them for the risk of the firm’s equity shares.
 PRACTICE TEST
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