CHAPTER 18. Equity Valuation. Fundamental analysis. Identify stocks that are mispriced relative to true value Compare the actual market price and the true price estimated from various models using publicly available information The true price estimated from models is the intrinsic value (IV)
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CHAPTER 18
Equity Valuation
estimated E(R) = (52+448)/48 = 16.7%
Intrinsic value The present value of a firm’s expected future net cash flows discounted by the required rate of return.
Dividend discount model (infinite horizon):
the intrinsic value is the present value of all futures dividends discounted by the required return
Dividend
Yield
Capital
Gains Yield
Fraction of earnings retained and reinvested in the firm
Where:
ROE = Return on Equityb = Plowback Ratio
(or Earning Retention Ratio)
Example: g = 15% (0.6) = 9%
E
1
+
V
PVGO
=
o
k
+
D
(
1
g
)
E
1
o
=

PVGO

(
k
g
)
k
Example: Takeover Target has a dividend payout ratio of 60% and an ROE of 20%. If it expects earnings to be $ 5 per share, the appropriate capitalization rate is 15%? What is the intrinsic value, what is PVGO, what is NGVo?
Partitioning Value: Example
3
=
=
V
$42
.
86
o

(.
15
.
08
)
5
=
=
NGV
$33
.
33
o
.
15
=

=
PVGO
$42
.
86
$33
.
33
$9
.
52
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities
Changing growth rates:
temporary high
(or low) growth
permanent
constant growth
Example: Whitewater Rapids Company is expected to have dividends grow at a rate of 20% for the next three years. In three years, the dividends will settle down to a more sustainable growth rate of 5% which is expected to last “forever.” If Whitewater just paid a dividend of $2.00 and its level of risk requires a discount rate of 15%, what is the intrinsic value of Whitewater stock?
+ (36.3) / (1.15)3 = 30.40

D
E
(
1
b
)
1
1
=
=
P
0


´
k
g
k
(
b
ROE
)

P
1
b
0
=

´
E
k
(
b
ROE
)
1
BUT
Holding everything equal:
High risk (k), Low P/E.
The P/E ratio of any company that is fairly priced will equal its growth rate. I am talking here about growth rate of earnings.... If the P/E ratio of CocaCola is 15, you’d expect the company to be growing at 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.
Current price and current earnings
Future expected earnings is more appropriate
Discount the free cash flow for the firm
Discount rate is the firm’s cost of capital
Components of free cash flow
After tax EBIT
Depreciation
Capital expenditures
Increase in net working capital
Present value of expected future dividends
growth opportunities