9. Valuing Public Equity

Stock markets trade public equity, but equity can be private as well. In fact, most equity in most companies starts as private and remains private (see Chap. 10). Only larger companies scale up to become public, because only then the benefits of listing (in terms of risk sharing) start to outweigh the relatively high costs of listing (due to information disclosure requirements). In some ways, private equity investing is instructive for public equity investing. Precisely because private equity lacks standardised data, ratings, and daily pricing, it has not become the victim of benchmark thinking, and reducing companies and portfolios to a few market metrics. Private equity needs to do fundamental analysis of investee companies, which is a good starting point for integrating sustainability into equity valuation.

The way one invests in public equity can be classified as active versus passive investing. Passive investing refers to investments in indices or ETFs (Exchange-Traded Funds, which mimics an index), whereas active approaches tend to be either fundamental (i.e. based on analysis of financial statements, business models, etc.) or quant (i.e. based on factors in a model or algorithm). The attraction of passive investing is that it limits the costs of both trading and analysis. However, it also means there is a very limited scope for the societal allocation role of finance (French, 2008). In fact, as passive investing relies on efficient markets, it is dependent on the presence of sufficient fundamental and quant investors to keep markets efficient. Figure 9.2 provides a classification of public and private equities investing approaches.

A block diagram classifies private and public equity investing approaches. The public approaches include the choice of business fundamentals, the choice of quant factors, and the passive choice of index.

Fundamental equity strategies are rooted in absolute valuation methods from corporate finance and are best suited for sustainability integration. Fundamental investors assess a company, which enables them to identify material sustainability issues and to estimate the impact on the company’s valuation. Fundamental equity strategies are thus the ones with the most potential to integrate sustainability into company valuation. Traditional asset pricing theory has paid limited attention to fundamental equity investing, as it does not align with efficient markets and portfolio theory very well (see Chaps. 12 and 14) and is hard to capture in econometric analysis. That is unfortunate, since fundamental analysis of a company (and its value drivers) is needed to assess the preparedness of companies for the transition to a more sustainable economy. The rise of machine learning can complement fundamental analysis, allowing for the upscaling of fundamental analysis.

A distinction can be made between primary and secondary stock markets. In the primary market, new issues of a stock are sold to investors. In a secondary market, equities that have been previously issued are traded. When issuing public equity, a firm may obtain a listing on a stock exchange for the first time, the initial public offering (IPO). If a firm is already listed and issues additional shares, this is called seasoned equity offering (SEO) or secondary public offering (SPO).

There are various motives for IPOs. One of the main reasons, of course, is to obtain funds to finance investment. Moreover, the listing of a firm’s shares on a stock exchange increases its financial autonomy, as the firm becomes less dependent on a single financial provider (like a bank). Further, by issuing equity the firm’s owners can diversify their investment risk by selling stakes in the company in a liquid market. Another advantage of public issuance is increased recognition of the company name. In addition, from the moment of the IPO, investors receive better information due to improved transparency and the disclosure requirements that are part of the listing conditions. At the same time, the price of a company’s stock acts as a measure of the company’s value and as a disciplining mechanism for managers.

However, there are a number of inherent disadvantages for a company in listing its shares on a stock exchange. To start with, equity issuance is an expensive procedure, incurring costs such as underwriters’ commission, legal fees, and other charges resulting primarily from the need to satisfy the additional disclosure requirements. From the perspective of investors, going public implies that the ownership of the company is likely to be shared more widely, resulting in a larger gap between external investors and managers. This separation of ownership and control could cause agency problems, where company insiders hold more accurate information on the prospects of the firm than external equity investors, resulting in a divergence of interests between managers and outside investors (see Chap. 3). Lastly, by going public, a company exposes itself to the scrutiny of shareholders, who may be focused too much on short-term results.

There are several methods for determining (or better, estimating) the value of equity. One can distinguish two types of valuation methods:

Absolute valuation methods are based on the company’s cash flows. These cash flows are forecasted and then discounted at the company’s discount rate. The dividend-discount model is a basic model that discounts future dividends. An important factor is the expected growth rate of dividends. The discounted cash flow model is more elaborate. It estimates the free cash flows available to equity and bondholders. The equity valuation can be split into three value drivers:

Relative valuation methods derive a company’s value from the value of comparable companies. The idea is to find ‘identical’ companies, which in practice is very difficult, so more or less comparable companies are used. A frequently applied metric is the price-earnings (P/E) ratio, which is the stock prices divided by the earnings. You then multiply your company’s earnings with the P/E ratio of comparable companies. Relative valuation methods are typically used for market transactions (e.g. M&A), as the value is derived from prevailing market prices.

We can link debt valuation in Chap. 8 and equity valuation in this chapter. To do so, we introduce the concept of enterprise value V₀, which is the total value of the company:

The enterprise value is the market value of the company’s underlying business before financing by equity and debt, and separate from any cash. It provides a comprehensive overview of the company’s business activities, which helps to focus on a company’s long-term value, as discussed in Chap. 2. Which activities contribute to the company’s future value and which activities may have a negative impact on the company’s future value? This holistic approach can aid the company in its strategy-setting.

The dividend-discount model looks at cash flows to equity investors. A first cash flow is the dividend that an investor receives. A second cash flow is the cash received when selling the stock at some future date. Taking the perspective of a 1-year investor, we get the following equation for today stock price P₀:

Today, stock price P₀ is the net present value of the dividends received during the year Div₁ and the stock price at the end of the year P₁. These cash flows are discounted at the cost of equity r_E, which is the expected return of other investments available in the market with similar risks. We can rewrite Eq. (9.2) as follows:

The total return of the stock for the equity investor can thus be split in the stock’s dividend yield and the stock’s capital gain. Example 9.1 shows how the stock price and return of a company can be calculated.

Up till now we use 1 year’s dividend and the stock price at the end of the year (at which you can sell the stock in the market) to calculate today’s stock price. Instead of referring to future stock prices, we can expand the dividend-discount model to a multiyear perspective:

We can now use Eq. (4.​6) from Chap. 4 for valuing a perpetuity. This is the present value of a continuous stream of constant cash flows: \( PV=\frac{CF}{r} \). In this case, we have growing dividends (instead of constant dividends). The equation is then as follows:

This is the famous constant dividend growth model. Dividends cannot keep on growing beyond the discount rate forever, as this would imply an infinite stock price (i.e. value) of the company. So, this formula requires that the constant growth rate of dividend is below the discount rate. Example 9.2 shows how we can value a company with constant dividend growth.

Dividend has to come out of a company’s earnings. The actual dividend depends on the payout ratio:

The earnings per share EPS is the company’s earnings divided by the number of outstanding shares. The dividend is thus the EPS multiplied by the payout ratio, which is defined as payouts divided by earnings or net income (see Chap. 16). Equation (9.7) shows that dividends are ultimately based on a company’s earnings. So, there is natural limit to dividend growth, as the underlying earnings matter. Next, there are dangers in constant growth formulas. As circumstances change, the growth of dividends (and underlying earnings) will change. High-growth companies, for example, are not likely to keep these growth rates forever. This is the fallacy of extrapolating current numbers, without thinking about whether these numbers can be sustained in the future.

An update of the original dividend growth model includes share repurchases. Companies complement dividend payouts with share repurchases, because share repurchases are exempt from dividend tax. Share repurchases are therefore a more tax-efficient way of rewarding shareholders. The economic effect is the same. This is because shareholders are still entitled to future earnings, which are now assigned to the remaining shares (the originally outstanding shares minus the repurchased shares), so that each shareholder’s claim on future earnings remains the same. The total payout model includes both dividends and share repurchases:

Multiplying both sides by the number of shares outstanding provides the company’s equity value:

So, the equity value is the present value of total dividends and share repurchases.

Another absolute valuation method is the Discounted Cash Flow (DCF) model. It goes several steps further than the Dividend-Discount Model, which only estimates the resulting cash flows from the business operations paid as dividends to shareholders. The Dividend-Discount model thus measures the company’s equity value. The DCF model values a company’s assets on the basis of their discounted future cash flows. It covers the enterprise value, which is the sum of a company’s equity and debt (see Eq. 9.1).

To value the enterprise, we start with estimating the free cash flows that the company has available for all investors: equity and debt holders. Company cash flows can be estimated in the same way as project cash flows in Chap. 7. The starting point is the earnings before interest and taxes EBIT. The company has to pay corporate tax τ on these earnings. These items are based on accounting. The next step to arrive at cash flows is to deduct net investment and increases in net working capital NWC (see Chap. 7 for a definition of NWC). Net investment and increases in NWC support the company’s future operations and growth. A company’s net investment is defined as the company’s capital expenditures CAPEX minus depreciation:

The free cash flow FCF of the company is then calculated as follows:

FCF is the cash flow left to be distributed to financiers after all positive NPV investments have been done. It is calculated as cash from operations minus cash into investments. It is important to use FCF rather than earnings which is much more easily manipulated, as is visible in accruals. Accruals are differences between net earnings and operational cash flow, driven, for example, by revenues or expenses that have been earned or incurred (in other words ‘accrued’ to the accounts), but cash related to the transactions has not yet changed hands. Another factor which can be manipulated is depreciation. A company can increase depreciation to reduce (taxable) profits or decrease depreciation to show higher book profits to investors. In that way, companies can smooth profits over time, which is also referred to as ‘cooking the books’. Cash flow statements can overcome these accounting gimmicks. Deprecation is, for example, deducted as a cost item in EBIT, but subsequently added to CAPEX to derive net investment. Depreciation is thus eliminated from the cash flow analysis.

The free cash flow FCF can be discounted to obtain the enterprise or company value V₀ at t = 0:

where WACC represents the weighted average cost of capital and TV_N the terminal value at t = N, which may in turn be valued with a DCF (see below Eq. 9.14). Note that V₀ in the DCF formula is the enterprise value of the company to all financiers, i.e. the value of debt and equity together. Equity holders are residual claimholders, who receive income only after the debt holders have been paid. In effect, equity is a call option on the company (Merton, 1974; see Chap. 19 on options).

WACC is the weighted average cost of capital, which is the rate of return demanded by the company’s financiers (of both equity and debt) and is derived from the expected return on an asset with similar risk (see Chap. 13 on WACC).

In the case of a constant growth g of the company’s FCF from t = 0, we can simplify Eq. (9.12). Just like in the dividend-discount model (Eq. 9.6), the value V₀ of the constant stream of growing free cash flows can be summarised as follows:

In a similar way, we can calculate the terminal value TV_N in Eq. (9.12) as follows:

A constant growth rate of the company’s cash flows FCF is a simplifying assumption. A DCF valuation crucially relies on assumptions to be made on future FCF and on the cost of capital WACC, as well as on their elements. This opens the door to a behavioural problem, because analysts often simply extrapolate recent historical numbers or short-term forecasts into infinity (while the company is exposed to internal and external changes which impact it).

The DCF example in Table 9.1 illustrates how that works. The top part lists the inputs (e.g. a sales growth of 6 per cent until 2030, a long-term sales growth of 2%, and an EBIT margin of 11–12%) and the components (sales, EBIT, and taxes) to calculate the FCF. The note at Table 9.1 explains the abbreviations. First, taxes are deducted from EBIT to obtain the net operation profit less adjusted taxes (NOPLAT). Next, depreciation is added (no cash outflow) and investment in the form of CAPEX and NWC is deducted (cash outflow) to obtain the FCF. The rows represent the years: the shaded area from 2023 to 2031 are the assumptions made by the analyst to arrive at the forecasted cash flows (all other data in Table 9.1 is given or calculated). The middle part contains the discount factor (based on a WACC of 8%) to discount the FCF to the present value.

The enterprise value V₀ is the sum of the present values of the free cash flows from 2023 to 2030 and the terminal value. Next, net debt is deducted and cash added to obtain the equity value (Eq. 9.1). Dividing the equity value by the number of shares outstanding provides the stock price:

Finally, the bottom part outlines the capital side: net working capital NWC, invested capital, and return on invested capital (ROIC). The invested capital is net investment (from Eq. 9.10) and NWC. The return on invested capital is the net operation profit less taxes divided by invested capital:

Some argue that short-termism is not an issue, as stocks incorporate more than a decade of cash flows in their pricing. That is true, but cash flow forecasts can be a mere extrapolation of the short term—not reflecting change or the relevance of sustainability. Multiples (relative) valuation in Sect. 9.3 faces this problem as well, and to an even larger extent, as it implicitly makes the same assumptions while giving the analyst a false sense of being objective.

In a DCF valuation, one can make explicit assumptions and choose to be very clear on which point one disagrees with the market. In a DCF valuation of the same company as in Table 9.1, an analyst uses, for example, exactly the same assumptions with one crucial difference: since they have a stronger belief in the company’s competitive position, their margin assumptions are 4% higher (an EBIT margin of 16 instead of 12%), resulting in a 35% higher fair value of the stock.

The full DCF valuation model in Table 9.1 is the bread and butter of a seasoned equity analyst, but it is also quite elaborate. To provide more practice and the ability to develop a more intuitive understanding, we give a simpler valuation example. Example 9.3 calculates the value of Adidas’ stock price at €301.2. Since the calculation of the value depends on several assumptions on sales, EBIT margins, investment needs, and cost of capital, Example 9.4 provides a sensitivity analysis of Adidas’ stock valuation. The sensitivity analysis shows that ‘under reasonable assumptions’ the stock price can fluctuate from –24% (€227.6) to +28% (€385.5) in comparison with the midpoint estimate of €301.2.

We can compare the different absolute stock valuation methods. Table 9.2 summarises the various discounting methods with increasing information needs. The dividend-discount model estimates the dividend payments per share to derive a company’s stock price. As share repurchases are becoming more important, the total payout model includes total dividends and share repurchases to calculate a company’s equity value. These are relatively easy to establish.

The most cumbersome, but insightful method is applying the full discounted cash flow model to establish a company’s enterprise value. One needs to estimate a company’s free cash flows and then its weighted average cost of capital. As Table 9.1 shows, this is quite an exercise. The benefit is a fundamental valuation of the company. The discounted cash flow model is also the basis for calculating a company’s integrated value in Sect. 9.5.

In the case of relative valuation, often called multiples valuation, a stock value P₀ (or more generally, an asset’s value) is derived from the given (market) value of another comparable stock. For example, a fast moving consumer goods company like Unilever might be valued by taking its earnings per share EPS₀ and multiplying that number with the average price-earnings P/E ratio of its peer group:

So, in this method, when Unilever’s EPS is €2.2 and its peers trade at a P/E of 24.0 at year-end 2021, then Unilever’s fair stock value P is 24.0 × €2.2 = €52.8. Table 9.3 shows the average P/E of Unilever’s direct peers from the consumer goods industry. Unilever’s stock price is €46.8 at year-end 2021. So, Unilever’s P/E ratio is slightly lower at 21.3 than the industry average at 24.0. Example 9.5 shows how Apple’s stock price can be derived using the technology’s industry’s P/E ratio.

The P/E ratio can be used to derive a company’s equity value by multiplying the stock value from Eq. (9.17) with the number of outstanding shares. The P/E ratio is thus an equity value multiple.

Companies differ also in leverage, making more leveraged companies riskier. That makes a precise comparison between companies difficult. To correct for leverage, multiples can be based on a company’s enterprise value V. As enterprise value is the company’s value before financing, the earnings should also be adapted to an earnings number before payment to financiers. A common earnings indicator is earnings before interest and taxes EBIT. In case one wants to correct for investments as well, earnings before interest, taxes, depreciation, and amortisation EBITDA can be used. The multiples formula for enterprise value V₀ is as follows:

Whereby V/EBITDA is the enterprise value multiple.

To get a company’s stock price P₀, we need to deduct net debt from enterprise value to get a company’s equity value and subsequently divide that by the number of shares outstanding (see Eq. 9.15).

While academic corporate finance is very much concerned with risk and discount rates (see Chaps. 4 and 12), it tends to take a company’s free cash flow as a given and it does not analyse where that free cash flow comes from. Fundamental equity valuation methods, like the DCF model in Sect. 9.2, analyse both cash flows and discount rates. Schramade (2016) introduces the Value Driver Adjustment (VDA) approach to integrate sustainability into the DCF model. The starting point is to split the enterprise valuation into value drivers (Koller et al., 2020):

While the first two value drivers (sales and margins) affect cash flows, only the third value driver (capital) affects the discount rate. Making these splits in value drivers can yield useful insights into how efficiently and successfully a company is run. Moreover, one can also analyse what is driving the value drivers. That is, what are the sources of competitive advantage that determine how fast a company grows and how profitable it can sell its goods and services (see Chap. 2). This is also where the link to sustainability comes in, as intangible assets on material social and environmental issues (such as intellectual capital, social capital, or environmental capital) tend to be the underlying value drivers.

Think of a mining company that has much lower costs than its peers because it is much better at managing local stakeholders (and hence experiences less delays and production losses) and has a better safety record (and more efficient production). Then consider a mining company that currently enjoys lower costs than its peers because it is ignoring lots of safety regulations and is paying its employees poorly, without pension or social security arrangements. That cost advantage is likely to be temporary and entails a high risk of costly disruptions, which should be factored into its cost of capital.

Applying the VDA approach, Schramade (2016) proposes a three-step approach to integrating sustainability into fundamental enterprise valuation:

The VDA approach is very practical. Box 9.3 provides a case study of a medtech company (based on a list of questions summarised in the Appendix to this chapter). The combined insights from sustainability analysis and traditional fundamental analysis allow one to make better financial valuations. Schramade (2017) argues that the impact can be substantial and reports valuation impacts ranging from –23% to +71% for a sample of 127 investment cases. Value driver adjustments can be made on any sustainability issue, but some are more frequent than others. Innovation, corporate governance, environmental management, and supply chain management are frequently used. The way value driver adjustments are made also differs: while value driver adjustments on innovation tend to be made to sales growth and margins (reflecting competitive position), the value driver adjustments on corporate governance are mostly about adjusting the cost of capital (reflecting risk).

The above illustrations of the VDA approach do not include a transition perspective. But the transition perspective can be included by building transition scenarios with distinctive value driver assumptions. Please see the Inditex case study in Chap. 11 (Sect. 11.​3) for an illustration of how that works.