Appreciating investment valuation models (Pt VI)
As noted in the previous publication, valuation models play an influential role in meaningful and productive investment decisions of governments and their agencies, managements of corporate bodies and investors.
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Discussions in the previous write-up ended on coupon payments in bond transactions and their impact on investment valuation and decisions.
Equity valuation model
The underlying objective of an equity valuation model is to assess the value of a security or share. Equity or share is valued by determining the present value of its future pay-offs discounted at an appropriate rate.
This is similar to debt valuation. However, unlike bond valuation, the investor has no predetermined pay-offs under equity valuation; the investor has two main uncertain payoffs. These include dividend payments and capital appreciation. These two pay-offs are explained later in this section.
The value of an equity security at time t, or Vt, is the sum of the present values of all future expected dividends, computed as follows:
Vt = [E(Dt + 1)/(1 +k)¹ + E(Dt + 2)/(1 +k)² + E(Dt + 3)/(1+k)³ +…]
Where:
EDt + n = Expected Dividend in period t + n
k = Cost of capital
The above is known as the dividend discount model. The formula is based on expected, not actual dividend. Basically, expected dividend refers to the portion of corporate earnings estimated to be paid as dividend to shareholders.
The estimate is made prior to the end of the accounting year. Actual dividend relates to the portion of corporate earnings that is paid out to shareholders as dividend.
This amount is often determined at the end of the accounting period when the real or actual corporate profit is computed; and decision made on various payments and portion of the profit to be retained for current or future investment in the organisation.
Dividend payments refer to the portion of corporate earnings that is distributed to shareholders. Portions of corporate earnings that are not distributed to shareholders are known as retained earnings.
An increase in the value of shares of an organisation held by investors is called capital appreciation. It is worth emphasising capital appreciation is not restricted to shares; it is extended to other securities such as bonds and assets such as land.
However, capital gains are recorded when investors sell their shares at a price in excess of the original cost. To illustrate, in January 2010, an investor purchased 500 shares in Company A at GH¢2.00 per share.
In July 2014, the shares of Company A traded at GH¢5.00 per share on the stock exchange. The total cost of investment (shares) to the investor was GH¢1,000.00 (500 shares x GH¢2.00 = GH¢1,000.00).
Total earnings from the sale of investment (shares) was GH¢2,500.00 (500 shares x GH¢5.00 = GH¢2,500.00). The investor’s earnings (GH¢2,500.00) exceeded the initial investment (GH¢1,000.00) by GH¢1,500.00 (GH¢2,500.00 – GH¢1,000.00 = GH¢1,500.00). The excess amount of GH¢1,500.00 is known as capital gains. In some jurisdictions, capital gains are taxable.
Free cash flow to equity valuation model
This model computes the value of an equity security at time t, or Vt, by replacing expected dividends with expected free cash flow to equity. The free cash flow to equity (FCFE) refers to the free cash flow available to equity holders at a given period; it refers to the amount available to shareholders after operational cost (expenses), debt and reinvestment have been paid by the organisation.
The organisation may decide to reinvest in property, plant and equipment (PP&E), inventory and bonds; it may decide to reinvest in shares for ownership in another organisation, among others. The free cash flow to equity model is expressed by the following formula:
Vt = [E(FCFEt + 1)/(1 +k)¹ + E(FCFEt + 2)/(1 +k)² + E(FCFEt + 3)/(1 +k)³ +…]
Where:
EFCFEt + n = Expected free cash flow to equity in period t + n
k = Cost of capital
The free cash flow to equity model is an alternative to the dividend discount model; it is discounted at the cost of equity. The FCFE model helps us to determine the amount available to shareholders.
However, it does not, necessarily, represent the actual payout by management to shareholders; the value of dividend distributed to shareholders may be less than the free cash flow to equity value.
Key financial statement components used in the derivation of the free cash flow to equity value include debt, working capital, capital expenditures and net income. Debt can be traced to the balance sheet; it can also be traced to the financing activities section on the statement of cash flows.
The latter serves as a reliable source of obtaining accurate data on cash-basis net borrowing (debt); the former may provide information on both cash-basis and non-cash-basis borrowing. Working capital represents the difference between current assets and current liabilities.
Cash and non-cash-related working capital transactions can be located on the balance sheet; only cash-related working capital transactions can be found in the operating activities section on the statement of cash flows.
Capital expenditures include investment in property, plant and equipment, and others. Cash and non-cash values of these expenditures can be located on the balance sheet.
Values of cash
However, values of cash-related capital expenditures can be obtained in the investing activities section on the statement of cash flows. Information on net income can be extracted from the profit and loss statement or the income statement.
The net income value obtained from this source often includes cash and non-cash transactions. The operating activities section on the statement of cash flows provides cash-basis net income value.
The FCFE model lays emphasis on free cash flow available to shareholders. This makes the statement of cash flows an important and a reliable source of financial information for deriving the free cash flow to equity model.
Ideally, investors expect dividend payments to shareholders; and repurchasing or retiring of shares to be financed with free cash flow to equity. Fulfilling this condition enhances considerably, investors’ confidence in the given organisation.