Analysis of Equity Valuation Models and Target Price Accuracy Assignment

Assignment Task

PART A - Equity Valuation

This individual assignment is designed to apply the techniques that you learned in class on the equity valuation of companies in today’s stock markets.

1. Pick the companies and intrinsic valuation

Using Yahoo Finance or NZX Research for company search. Pick two companies, making sure at least you have:

• (Company 1, the main Company that you analyse) One Company that has growth potential . Look for companies whose earnings or revenues have grown in recent financial years.
• (Company 2) The other Company should be the competitor of Company 1, which means that Company 2 has a similar capitalisation and business line to Company 1 or is in competition with the business of Company 1 for market share.

Provide a narrative regarding the purpose of this report and introduce/brief necessary details of Company 1 you choose (e.g., how your Company was evolving; describing the product/service markets, industries, and the competition it faces; discussing the past three- year financial performance evident in some key financial ratios). Also, you must: 1) justify the validity of your companies’ comparison; 2) tie your narrative to key numbers and conclusion in your valuation . 

2. Discounted Cashflow Valuation

• Value the stock in Company 1 using a Free Cash Flows to Equity model (you need to decide the specifications of FCFE model that best fit your companies, e.g., 2-stage, 3-stage, or n- stage…etc.) and provide your responses to the requirements as follows.
• Justify the specifications of the FCFE model for your companies (i.e. what pattern (2- stage, 3-stage, or n-stage) will you assume the Company’s growth to follow and why?).
• Conduct firm valuation using the FCFE Model for Company 1 (besides descriptions, please provide all your calculations/workings in tables and graphs as possible). See the Steps
• Identify at least two assumptions used in your discounted cash flow valuation and describe their economic
• Provide additional analyses and explain how the assumptions identified in (c) affect the results of your
• Conduct Discounted Cashflow Valuation for Company 2 and compare the results in valuation for Company 1 with those for Company 2.

3. Final Value Estimate and Recommendation

Consider the results obtained from the discounted cash flow and the comparable.

Provide the economic implications of your comparisons from Step 2. Make final recommendations on the stocks of your Companies 1 and 2 (Strong Buy, Buy, Hold, Sell, or Strong Sell), justify your recommendations, and summarise all your analyses and the results with a conclusion.

PART B - Cost of Equity

Required (please show all your workings of OLS regression analysis and simulations)

The Capital Asset Pricing Model (CAPM) is one of the most tested models in Finance. When beta is estimated in practice, a variation of CAPM called the market model is often used. To derive the market model, we start with the CAPM:

E(E i ) = R _f + β[E(Rm  ) − R F ]

Since CAPM is an equation, we can subtract the risk-free rate from both sides, which gives us:

E(Ri ) − R f = β[E(Rm ) − R F ]

This equation is deterministic, that is, exact. In regression, we know that there is some indeterminate error. We need to formally recognise this in the equation by adding epsilon (ε), which represents this error:

E(Ri ) − Rf = β [E(Rm  ) − Rf ] + ε

Finally, think of the above equation in a regression. Since there is no intercept in the equation, the intercept is zero. However, when we estimate the regression equation, we can add an intercept term, which we will call alpha:

E(Ri) − Rf= ai+ β[E(RM) − RF] + ε

This equation, known as the market model , is generally the model used for estimating beta (β). The intercept term is known as Jensen’s alpha and represents the excess return. If CAPM holds exactly, this intercept should be zero. If you think of alpha in terms of the SML, if the alpha is positive, the stock plots above the SML and if the alpha is negative, the stock plots below the SML.

You want to estimate the market model for the individual stock of a company you choose. First, go to finance.yahoo.com, or use Datastream (Eikon) database to download the adjusted prices for the last 61 months for the stock of the Company and the S&P 500. ¹ You may access NZX Company Research from the Library website for NZ companies. Next, go to the St. Louis Federal Reserve website at www.stlouisfed.org . You should find the database on this website  Look for the 1-Month Treasury Constant Maturity Rate and download this data. ² This will be the proxy for the risk-free rate. This interest rate is the annual interest rate (EAR), while we are using monthly stock returns, so you will need to adjust the 1-month T-bill rate. For the stock that you select, estimate the beta and alpha of the stock using the market model. When you estimate the regression model, find the box that says Residuals and check this box when you do each regression. Because you are saving the residuals, you may want to keep the regression output in a new worksheet.

1. Draw characteristic lines for the companies i and provide interpretation and implications based on the estimated beta and 

2. Calculate the average cost of equity for the companiesover the period by using the estimated 

Compare your companies based on the estimates obtained from (a) and (b). Provide the corresponding implication.

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