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Equity Valuation Models. Chapter 18. Models of Equity Valuation. Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios Estimating Growth Rates and Opportunities. Intrinsic Value and Market Price. Intrinsic Value Self assigned Value

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Models of equity valuation
Models of Equity Valuation

  • Basic Types of Models

    • Balance Sheet Models

    • Dividend Discount Models

    • Price/Earning Ratios

  • Estimating Growth Rates and Opportunities


Intrinsic value and market price
Intrinsic Value and Market Price

  • Intrinsic Value

    • Self assigned Value

    • Variety of models are used for estimation

  • Market Price

    • Consensus value of all potential traders

  • Trading Signal

    • IV > MP Buy

    • IV < MP Sell or Short Sell

    • IV = MP Hold or Fairly Priced


Dividend discount models general model
Dividend Discount Models: General Model

V0 = Value of Stock

Dt = Dividend

k = required return


No growth model
No Growth Model

Stocks that have earnings and dividends that are expected to remain constant.

Preferred Stock


No growth model example
No Growth Model: Example

E1 = D1 = $5.00

k = .15

V0 = $5.00 / .15 = $33.33


Constant growth model
Constant Growth Model

g = constant perpetual growth rate


Constant growth model example
Constant Growth Model: Example

E1 = $5.00 b = 40% k = 15%

(1-b) = 60% D1 = $3.00 g = 8%

V0 = 3.00 / (.15 - .08) = $42.86


Estimating dividend growth rates
Estimating Dividend Growth Rates

g = growth rate in dividends

ROE = Return on Equity for the firm

b = plowback or retention percentage rate

(1- dividend payout percentage rate)


Specified holding period model
Specified Holding Period Model

PN = the expected sales price for the stock at time N

N = the specified number of years the stock is expected to be held


Growth no growth components of value
Growth & No Growth Components of Value

PVGO = Present Value of Growth Opportunities

E1 = Earnings Per Share for period 1


Partitioning value example
Partitioning Value: Example

ROE = 20% d = 60% b = 40%

E1 = $5.00 D1 = $3.00 k = 15%

g = .20 x .40 = .08 or 8%


Partitioning Value: Example

Vo = value with growth

NGVo = no growth component value

PVGO = Present Value of Growth Opportunities


Price earnings ratios
Price Earnings Ratios

  • P/E Ratios are a function of two factors

    • Required Rates of Return (k)

    • Expected growth in Dividends

  • Uses

    • Relative valuation

    • Extensive Use in industry


P e ratio no expected growth
P/E Ratio: No Expected Growth

  • E1 - expected earnings for next year

    • E1 is equal to D1 under no growth

  • k - required rate of return


P e ratio with constant growth
P/E Ratio with Constant Growth

b = retention ratio

ROE = Return on Equity


Numerical example no growth
Numerical Example: No Growth

E0 = $2.50 g = 0 k = 12.5%

P0 = D/k = $2.50/.125 = $20.00

PE = 1/k = 1/.125 = 8


Numerical example with growth
Numerical Example with Growth

b = 60% ROE = 15% (1-b) = 40%

E1 = $2.50 (1 + (.6)(.15)) = $2.73

D1 = $2.73 (1-.6) = $1.09

k = 12.5% g = 9%

P0 = 1.09/(.125-.09) = $31.14

PE = 31.14/2.73 = 11.4

PE = (1 - .60) / (.125 - .09) = 11.4


Pitfalls in p e analysis
Pitfalls in P/E Analysis

  • Use of accounting earnings

    • Historical costs

    • May not reflect economic earnings

  • Reported earnings fluctuate around the business cycle.


Other valuation ratios
Other Valuation Ratios

  • Price-to-Book

  • Price-to-Cash Flow

  • Price-to-Sales


Inflation and equity valuation
Inflation and Equity Valuation

  • Inflation has an impact on equity valuations.

  • Historical costs underestimate economic costs.

  • Empirical research shows that inflation has an adverse effect on equity values.

    • Research shows that real rates of return are lower with high rates of inflation.


Lower equity values with inflation
Lower Equity Values with Inflation

  • Shocks cause expectation of lower earnings by market participants.

  • Returns are viewed as being riskier with higher rates of inflation.

  • Real dividends are lower because of taxes.


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