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Security Valuation Learning Objectives. 1. Top-down and Bottom-up Approaches to Security Valuation 2. Discounted Cash Flow Valuation Approach 3. Dividend Discount Model (DDM) and its Logic 4. Application of DDM to Value Supernormal Growth Firms. 5. Application of Relative Valuation Models.

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Security valuation learning objectives
Security ValuationLearning Objectives

1. Top-down and Bottom-up Approaches to Security Valuation

2. Discounted Cash Flow Valuation Approach

3. Dividend Discount Model (DDM) and its Logic

4. Application of DDM to Value Supernormal Growth Firms.

5. Application of Relative Valuation Models


The investment decision process
The Investment Decision Process

  • Determine the required rate of return

  • Evaluate the investment to determine if its market price is consistent with your required rate of return

    • Estimate the value based on expected cash flows and your required rate of return

    • Compare this intrinsic value to the market price

  • If Intrinsic Value > Market Price, Buy

  • If Intrinsic Value < Market Price, Don’t Buy


Valuation process
Valuation Process

  • Two approaches

    • 1. Top-down, three-step approach

    • 2. Bottom-up, stock valuation, stock picking approach

  • The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks


Top-down overview of the valuation process

Industry Analysis

Structure, supply-demand relationships, quality and cost elements, gov't. regulation, financial norms

and standards, et. cetera

Economic Analysis

Business cycles, government policy, indicators, trade, public

attitudes, legislation, inflation, GDP growth, ect.

Company Analysis

Forecasts, balance sheet--income statement

analysis, flow-of-funds analysis,

accounting policy and footnotes,

management,research,

return, risk`

GE

Other stocks

GM, Xerox, Caterpillar, 3M,

Merck, Motorola, Delta, Intel.

Portfolio

management

Portfolio Assets


Does the three step process work
Does the Three-Step Process Work?

  • An analysis of the relationship between rates of return for the aggregate stock market, alternative industries, and individual stocks showed that most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry


Theory of valuation
Theory of Valuation

  • The value of an asset is the present value of its expected returns

  • To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return

  • This requires estimates of:

    • The stream of expected returns, and

    • The required rate of return on the investment


Stream of expected returns
Stream of Expected Returns

  • Form of returns

    • Earnings

    • Cash flows

    • Dividends

    • Interest payments

    • Capital gains (increases in value)

  • Time pattern and growth rate of returns


Required rate of return
Required Rate of Return

  • Determined by

    • 1. Economy’s risk-free rate of return, plus

    • 2. Expected rate of inflation during the holding period, plus

    • 3. Risk premium determined by the uncertainty of returns


Valuation approaches
Valuation Approaches

Two Approaches to Equity Valuation

Discounted Cash Flow Techniques

Relative Valuation Techniques

  • Price/Earnings Ratio (P/E)

  • Price/Cash flow ratio (P/CF)

  • Price/Book Value Ratio (P/BV)

  • Price/Sales Ratio (P/S)

  • Present Value of Dividends (DDM)

  • Present Value of Operating Cash Flow

  • Present Value of Free Cash Flow


Why and when to use the discounted cash flow valuation approach
Why and When to Use the Discounted Cash Flow Valuation Approach

  • The measure of cash flow used

    • Dividends

      • Cost of equity as the discount rate

    • Operating cash flow

      • Weighted Average Cost of Capital (WACC)

    • Free cash flow to equity

      • Cost of equity

  • Dependent on growth rates and discount rate


Why and when to use the relative valuation techniques
Why and When to Use the Relative Valuation Techniques Approach

  • Provides information about how the market is currently valuing stocks

    • aggregate market

    • alternative industries

    • individual stocks within industries

  • No guidance as to whether valuations are appropriate

    • best used when have comparable entities

    • aggregate market is not at a valuation extreme


Discounted cash flow valuation techniques
Discounted Cash-Flow ApproachValuation Techniques

Where:

Vj = value of stock j

n = life of the asset

CFt = cash flow in period t

k = the discount rate that is equal to the investor’s required rate of return for asset j, which is determined by the uncertainty (risk) of the stock’s cash flows


The dividend discount model ddm infinite holding period
The Dividend Discount Model (DDM)-Infinite Holding Period Approach

The value of a share of common stock is the present value of all future dividends

Where:

Vj = value of common stock j

Dt = dividend during time period t

k = required rate of return on stock j


The dividend discount model ddm finite holding period
The Dividend Discount Model (DDM)-Finite Holding Period Approach

If the stock is not held for an infinite period, a sale at the end of year 2 would imply:

Selling price at the end of year two is the value of all remaining dividend payments, which is simply an extension of the original equation


The dividend discount model ddm constant growth rate
The Dividend Discount Model (DDM)-Constant Growth Rate Approach

Infinite period model assumes a constant

growth rate for estimating future dividends

Where:

Vj = value of stock j

D0 = dividend payment in the current period

g = the constant growth rate of dividends

k = required rate of return on stock j

n = the number of periods, which we assume to be infinite


The dividend discount model ddm constant growth rate1
The Dividend Discount Model (DDM)-Constant Growth Rate Approach

Infinite period model can be reduced to:

Where D1 is the expected dividend, defined as

D1= D0 (1+g)

1. Estimate the required rate of return (k)

2. Estimate the dividend growth rate (g)


The dividend discount model ddm constant growth rate2
The Dividend Discount Model (DDM)-Constant Growth Rate Approach

Assumptions of DDM:

1. Dividends grow at a constant rate

2. The constant growth rate will continue for an infinite period

3. The required rate of return (k) is greater than the infinite growth rate (g)


Required rate of return k
Required Rate of Return ( Approachk)

Three factors influence an investor’s required rate of return:

  • The economy’s real risk-free rate (RRFR)

  • The expected rate of inflation (I)

  • A risk premium (RP)

  • How to estimate k:

    K= Rf +  (Rm – Rf)

    K= Bond yield+ERP


Expected growth rate of dividends roe based
Expected Growth Rate of Dividends ApproachROE Based

  • Determined by

    • the growth of earnings

    • the proportion of earnings paid in dividends

  • In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio

  • Earnings growth is also affected by compounding of earnings retention

    g = (Retention Rate) x (Return on Equity)

    = RR x ROE


Estimating growth based on history
Estimating Growth Based on History Approach

  • Historical growth rates of sales, earnings, cash flow, and dividends

  • Three techniques

    1. arithmetic or geometric average of annual percentage changes

    2. linear regression models

    3. long-linear regression models

  • All three use time-series plot of data


How to calculate g
How to Calculate g Approach

Historical ROE and Payout

Year Dividend g = (1-Payout) x ROE

  • $1.38 = (1 - .50) x .16 = 8%

  • 1.49

  • 1.67 Average of two methods = 8%

  • 1.75

    g = 8%


Infinite period ddm and growth companies
Infinite Period DDM Approachand Growth Companies

Growth companies have opportunities to earn return on investments greater than their required rates of return

To exploit these opportunities, these firms generally retain a high percentage of earnings for reinvestment, and their earnings grow faster than those of a typical firm

This is inconsistent with the infinite period DDM assumptions


Valuation with supernormal growth
Valuation with Supernormal Growth Approach

Example: The last dividend paid (D0) was $2.00. The required rate of return is 14 percent. The dividends are expected to grow at the following rates. What is the value of this stock?

Year dividend

1-3: 25%

4-6: 20%

7-9: 15%

10 on: 9%



Operating cash flow model
Operating Cash Flow Model Growth

  • Derive the value of the total firm by discounting the total operating cash flows prior to the payment of interest to the debt-holders

  • Then subtract the value of debt to arrive at an estimate of the value of the equity


Operating cash flow model1
Operating Cash Flow Model Growth

Where:

Vj = value of firm j

n = number of periods assumed to be infinite

OCFt = the firms operating cash flow in period t

WACC = firm j’s weighted average cost of capital


Operating cash flow model2
Operating Cash Flow Model Growth

Similar to DDM, this model can be used to estimate an infinite period

Where growth has matured to a stable rate, the adaptation is

Where:

OCF1=operating cash flow in period 1

gOCF = long-term constant growth of operating free cash flow


Operating cash flow model3
Operating Cash Flow Model Growth

  • Assuming several different rates of growth for OCF, these estimates can be divided into stages as with the supernormal dividend growth model

  • Estimate the rate of growth and the duration of growth for each period


Present value of free cash flows to equity
Present Value of GrowthFree Cash Flows to Equity

  • “Free” cash flows to equity are derived after operating cash flows have been adjusted for debt payments (interest and principle)

  • The discount rate used is the firm’s cost of equity (k) rather than WACC


Present value of free cash flows to equity1
Present Value of GrowthFree Cash Flows to Equity

Where:

Vj = Value of the stock of firm j

n = number of periods assumed to be infinite

FCFt = the firm’s free cash flow in period t

K j =the cost of equity


Free cash flow to equity model
Free Cash Flow to Equity Model Growth

FCFE = NI + Depreciation – Capital Expenditure - Working Capital – Principal Repayment + New Debt Issues.

If capital expenditures and working capital is expected to be financed at the target debt ratio () and principal repayment are made from new debt issues, FCFE can be written as:

FCFE = NI + (1- ) (Capital Expenditure - Depreciation) + (1- )Working Capital.


Free cash flow to equity model1
Free Cash Flow to Equity Model Growth

FCF is a measure of what firm can payout as dividend. Dividend can be greater than or less than FCF and is influenced by:

• Desire for stability

• Future Investment Needs

• Signaling Affect.

P0 = EFCE ; All assumptions about dividend

(K – g) valuation model apply.


Relative valuation techniques
Relative Valuation Techniques Growth

  • Value can be determined by comparing to similar stocks based on relative ratios

  • Relevant variables include:

    • Price/earnings

    • Cash flow

    • Book value

    • Sales

  • The most popular relative valuation technique is based on price to earnings


  • Earnings multiplier model
    Earnings Multiplier Model Growth

    The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio

    Dividing both sides by expected earnings during the next 12 months (E1)


    Earnings multiplier model1
    Earnings Multiplier Model Growth

    As an example, assume:

    • Dividend payout = 50%

    • Required return = 12%

    • Expected growth = 8%

    • D/E = .50; k = .12; g=.08


    Earnings multiplier model2
    Earnings Multiplier Model Growth

    A small change in either or both k or g will have a large impact on the multiplier

    D/E = .50; k=.13; g=.08 P/E = 10

    D/E = .50; k=.12; g=.09 P/E = 16.7

    D/E = .50; k=.11; g=.09 P/E = 25


    How to estimate eps
    How to Estimate EPS Growth

    Estimated EPS = Net Income

    # Shares Outstanding

    • EPS can also be derived:

    • EPS = ROE * Book value per share

    • EPS = NI * E = NI

      E Shares Shares

      Where ROE= Profit Margin * Total Asset Turnover * Equity Multiplier


    Earnings multiplier model3
    Earnings Multiplier Model Growth

    Given current earnings of $2.00 and growth of 9%

    You would expect E1 to be $2.18

    D/E = .50; k=.12; g=.09 P/E = 16.7

    V = 16.7 x $2.18 = $36.41

    Compare this estimated value to market price to decide if you should invest in it


    The price sales ratio
    The Price-Sales Ratio Growth

    • Strong, consistent growth rate is a requirement of a growth company

    • Sales is subject to less manipulation than other financial data


    The price sales ratio1
    The Price-Sales Ratio Growth

    • Match the stock price with recent annual sales, or future sales per share

    • This ratio varies dramatically by industry

    • Profit margins also vary by industry

    • Relative comparisons using P/S ratio should be between firms in similar industries

    • Average stock price should encompass a long lime period


    The price sales model
    The Price-Sales Model Growth

    • Price-to-Sales Model (10 year Average Price Ratios are assumed)

      • Average Price/Average Sales Per Share

      • $19.41/14.55=1.33 Price to sales ratio

      • Vt = P/S ratio*Estimated SPS(t+1)

        =1.33*$24.65=$32.78


    The price cash flow ratio
    The Price-Cash Flow Ratio Growth

    • Companies can manipulate earnings

    • Cash-flow is less prone to manipulation

    • Cash-flow is important for fundamental valuation and in credit analysis

      • Price-to-Cash Flow Model

        • Average Price/Average Cash Flow Per Share

        • $19.41/1.37=14.17 Cash flow per share ratio

        • Vt = P/CF*Estimated CFPS (t+1)

        • Vt = 14.17 * $2.41 = $34.15


    The price book value ratio
    The Price-Book Value Ratio Growth

    Price-to-Book Value Model

    • Average Price/Average book value per share

    • $19.41/6.01=3.23 price to book value ratio

    • Vt = P/BV*Estimated BVPS(t+1)

    • Vt = 3.23* $10.5 = $33.91


    The price book value ratio1
    The Price-Book Value Ratio Growth

    Widely used to measure bank values (most bank assets are liquid (bonds and commercial loans)

    Fama and French study indicated inverse relationship between P/BV ratios and excess return for a cross section of stocks


    The price book value model
    The Price-Book Value Growth Model

    • Price to Book Value Ratio

    • 1. Po= DPS1

      (K-g) *where DPS1=EPS(1+g)*payout ratio

    • 2. Po= EPSo * Payout * (1+g)

      (K-g)

      - where EPS=equity/#shares * NI/equity=BV*ROE

    • 3. Po= BVo * ROE * Payout * (1+g)

      (K-g)


    Investment valuation models
    Investment Valuation Models Growth

    • 4. Po = PBV= ROE * Payout * (1+g)

      BVo (K-g)

      - i. if ROE depends on expected earnings, or

      - ii. If payout ratio remains constant 4 becomes 5

    • 5. P0 = PBV = ROE * Payout

      BVo (K-g)

      -The relationship of:

      - PBV increase ROE increase

      - PBV increase  Payout increase

      - PBV increase g increase

      - PBV decrease K increase


    Investment valuation models1
    Investment Valuation Models Growth

    • Formula can be simplified

      g = ROE (1-payout)

      ROE*Payout = ROE - g

      PBV=(ROE-g) / (k-g)

      Implications:

      • A) ROE>kP>BV; ROE<kP<BV; ROE=kP=BV

      • B) PBV decreases if k increases.

      • C) Larger (R-k) greater PBV


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