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CHAPTER 13

CHAPTER 13. Equity Valuation. 13.1 VALUATION BY COMPARABLES. Fundamental Stock Analysis: Models of Equity Valuation. Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earnings Ratios Estimating Growth Rates and Opportunities. Models of Equity Valuation.

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CHAPTER 13

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  1. CHAPTER 13 Equity Valuation

  2. 13.1 VALUATION BY COMPARABLES

  3. Fundamental Stock Analysis: Models of Equity Valuation • Basic Types of Models • Balance Sheet Models • Dividend Discount Models • Price/Earnings Ratios • Estimating Growth Rates and Opportunities

  4. Models of Equity Valuation • Valuation models use comparables • Look at the relationship between price and various determinants of value for similar firms • The internet provides a convenient way to access firm data. Some examples are: • EDGAR • Finance.yahoo.com

  5. Table 13.1 Microsoft Corporation Financial Highlights

  6. Valuation Methods • Book value: an accounting measure that values a firm at the (adjusted) cost of acquiring the assets of a firm. • Market value: current value of firm. • Liquidation value: a measure of the value that could be realized by breaking up a firm, selling all its assets, repaying all its debts, and returning the rest to shareholders. • Replacement cost: Cost of replacing all a firm’s assets. • Tobin’s Q: ratio of market price to replacement cost. Idea: in long run this ratio tends to 1, so departures from this ratio will be corrected over time in market price.

  7. 13.2 INTRINSIC VALUE VERSUS MARKET PRICE

  8. Expected Holding Period Return • The return on a stock investment comprises cash dividends and capital gains or losses • Assuming a one-year holding period

  9. Required Return • CAPM gave us required return: • If the stock is priced correctly • Required return should equal expected return

  10. Intrinsic Value and Market Price • Market Price • Consensus value of all potential traders • Current market price will reflect intrinsic value estimates • This consensus value of the required rate of return, k, is the market capitalization rate • Trading Signal (IV = Intrinsic Value, the present value of all cash payments, discounted at rate k; MP = Market Price) • IV > MP Buy • IV < MP Sell or Short Sell • IV = MP Hold or Fairly Priced

  11. 13.3 DIVIDEND DISCOUNT MODELS

  12. General Model ¥ D å t = V o + t ( 1 k ) = 1 t • V0 = Value of Stock at time 0 • Dt = Dividend at time t, t = 1, 2,3,…. • k = required return

  13. No Growth Model D = V o k • Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock • A perpetuity…

  14. No Growth Model: Example D = V o k E1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33

  15. Constant Growth Model + D ( 1 g ) o = Vo - k g • g = constant perpetual growth rate

  16. Constant Growth Model: Example + D ( 1 g ) o = Vo - k g E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86

  17. Stock Prices and Investment Opportunities = ´ g ROE b • g = growth rate in dividends • ROE = Return on Equity for the firm • b = plowback or retention percentage rate • (1- dividend payout percentage rate)

  18. Figure 13.1 Dividend Growth for Two Earnings Reinvestment Policies

  19. Present Value of Growth Opportunities • If the stock price equals its IV, growth rate is sustained, the stock should sell at: • If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist)

  20. Present Value of Growth Opportunities (cont.) • Price = No-growth value per share + PVGO (present value of growth opportunities) • Where: E1 = Earnings Per Share for period 1 and

  21. Partitioning Value: Example • ROE = 20% d = 60% b = 40% • E1 = $5.00 D1 = $3.00 k = 15% • g = .20 x .40 = .08 or 8%

  22. Partitioning Value: Example (cont.) 3 = = P $42 . 86 o - (. 15 . 08 ) 5 = = NGV $33 . 33 o . 15 = - = PVGO $42 . 86 $33 . 33 $9 . 52 Po = price with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities

  23. Life Cycles and Multistage Growth Models + + t T ( 1 g ) D ( 1 g ) å T = + 2 P D 1 o o + - + t T ( 1 k ) ( k g ) ( 1 k ) = 1 t 2 • g1 = first growth rate • g2 = second growth rate • T = number of periods of growth at g1

  24. Multistage Growth Rate Model: Example D0 = $2.00 g1 = 20% g2 = 5% k = 15% T = 3 D1 = 2.40 D2 = 2.88 D3 = 3.46 D4 = 3.63 V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 + D4 / (.15 - .05) ( (1.15)3 V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

  25. 13.4 PRICE-EARNINGS RATIOS

  26. P/E Ratio and Growth Opportunities • 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

  27. P/E Ratio: No expected growth E 1 = P 0 k P 1 0 = E k 1 • E1 - expected earnings for next year • E1 is equal to D1 under no growth • k - required rate of return

  28. P/E Ratio: Constant Growth - D E ( 1 b ) 1 1 = = P 0 - - ´ k g k ( b ROE ) - P 1 b 0 = - ´ E k b ROE ) ( 1 • b = retention ration • ROE = Return on Equity

  29. Numerical Example: No Growth E0 = $2.50 g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 P/E = 1/k = 1/.125 = 8

  30. 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 P/E = 31.14/2.73 = 11.4 P/E = (1 - .60) / (.125 - .09) = 11.4

  31. P/E Ratios and Stock Risk • Riskier stocks will have lower P/E multiples • Riskier firms will have higher required rates of return (higher values of k)

  32. Pitfalls in Using P/E Ratios • Flexibility in reporting makes choice of earnings difficult • Pro forma earnings may give a better measure of operating earnings • Problem of too much flexibility

  33. Figure 13.3 P/E Ratios and Inflation

  34. Figure 13.4 Earnings Growth for Two Companies

  35. Figure 13.5 Price-Earnings Ratios

  36. Figure 13.6 P/E Ratios

  37. Other Comparative Valuation Ratios • Price-to-book • Price-to-cash flow • Price-to-sales • Be creative

  38. Figure 13.7 Valuation Ratios for the S&P 500

  39. 13.5 FREE CASH FLOW VALUATION APPROACHES

  40. Free Cash Flow • One approach is to discount the free cash flow for the firm (FCFF) at the weighted-average cost of capital • Subtract existing value of debt • FCFF = EBIT (1- tc) + Depreciation – Capital expenditures – Increase in NWC where: EBIT = earnings before interest and taxes tc = the corporate tax rate NWC = net working capital

  41. Free Cash Flow (cont.) • Another approach focuses on the free cash flow to the equity holders (FCFE) and discounts the cash flows directly at the cost of equity • FCFE = FCFF – Interest expense (1- tc) + Increases in net debt

  42. Comparing the Valuation Models • Free cash flow approach should provide same estimate of IV as the dividend growth model • In practice the two approaches may differ substantially • Simplifying assumptions are used

  43. 13.6 THE AGGREGATE STOCK MARKET

  44. Earnings Multiplier Approach • Forecast corporate profits for the coming period • Derive an estimate for the aggregate P/E ratio using long-term interest rates • Product of the two forecasts is the estimate of the end-of-period level of the market

  45. Figure 13.8 Earnings Yield of the S&P 500 Versus 10-year Treasury Bond Yield

  46. Table 13.4 S&P 500 Index Forecasts

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