Valuing Equity:
Just like bonds, we value equity using the discounted cash flow method. The cash flow provided by equity is dividends. Therefore we may value equity by discounting all the expected future dividends.
We will begin the valuation of equity with some important formulas:
1. Div Yield: Grossed up dividend/Current share price
2. Growth: ROE from reinvested earnings x retention rate
Retention rate = reinvestment or plowback ratio
3. Retention Rate: 1- dividend payout ratio
4. Dividend Payout Ratio: Dividend/Earnings per Share
5. DPS: Dividend Payout Ratio x EPS
DPS = Dividend Per Share
EPS = Earnings Per Share
We can break down equity valuation into three categories:
- Equity with zero growth
- Equity with constant growth
- Equity with non-constant growth
Valuing Equity with zero growth:
For a company generating zero growth we assume that all profit is paid out in dividends. i.e dividend payout ratio = 1. The share price of a zero growth firm would therefore be:
Share Price = DPS/re = EPS / re (re = return on equity)
Valuing Equity with constant growth
For a company generating constant growth:
Share Price = Div(yr1) / (re-g) (g = growth)
The valuation of equity with constant growth requires the use of the following two formulas:
Growth = ROE from reinvested earnings x retention rate
Dividend payout ratio = Dividend / Earnings per share
- The first formula allows us to determine the growth
- The second formula allows us to calculate the dividend in year one
Example:
- ROE of ABC ltd is 12.5%
- Current dividend is 14 cents
- Current earnings per share is 46 cents
- Re = 10.6%
What is the share price?
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