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Fin2808: Investments Spring, 2010 Dragon Tang

Lectures 13 & 14 Equity Valuation Models March 9&11 ， 2010 Readings: Chapter 18 Practice Problem Sets: 1,5,7,14, 16,17. Fin2808: Investments Spring, 2010 Dragon Tang. How to make money in stocks?. Capital gains: buy low/sell high Growth companies Dividend yields: income stream

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Fin2808: Investments Spring, 2010 Dragon Tang

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  1. Lectures 13 & 14 Equity Valuation Models March 9&11， 2010 Readings: Chapter 18 Practice Problem Sets: 1,5,7,14, 16,17 Fin2808: InvestmentsSpring, 2010Dragon Tang Chapter 18: Equity Valuation

  2. How to make money in stocks? Chapter 18: Equity Valuation

  3. Capital gains: buy low/sell high Growth companies Dividend yields: income stream Matured (value) companies How to make money in stocks? Chapter 18: Equity Valuation

  4. Equity Valuation • Objectives: • Calculate the intrinsic value of a firm using either a constant growth or multistage dividend discount model. • Calculate the intrinsic value of a stock using a dividend discount model in conjunction with a price/earnings ratio. • Assess the growth prospects of a firm from it P/E ratio. Chapter 18: Equity Valuation

  5. Book Value Liquidation Value Replacement Cost Balance Sheet Valuation Methods Chapter 18: Equity Valuation

  6. Expected Holding Period Return • If E(HPR) > Required Rate of Return(RRR), the stock • is a good deal. • RRR is from a pricing model, e.g. CAPM: • In market equilibrium, E(HPR) = RRR. Chapter 18: Equity Valuation

  7. Intrinsic Value versus Market Price Intrinsic value --The present value of a firm’s expected future net cash flows discounted by the required rate of return. • V0 (intrinsic value) > P0 (market price) Þ buy • V0 (intrinsic value) < P0 (market price) Þ sell or sellshort • In market equilibrium, V0 = P0 • k is the market capitalization rate which equates V0 and P0 • If V0¹ P0, then EMH implies the estimate of k is wrong Chapter 18: Equity Valuation

  8. Dividend Discount Models One Period Case: Multi-period Case: Where D1,…, DH and PH are expected values Chapter 18: Equity Valuation

  9. Dividend Discount Models Example: Whitewater Rapids Company is expected to have dividends grow at a rate of 12% for the next three years. In three years, the price of the stock is expected to be $ 74.46. If Whitewater just paid a dividend of $2.00 and its level of risk requires a discount rate of 10%, what is the intrinsic value of Whitewater stock? Chapter 18: Equity Valuation

  10. Dividend Discount Models Dividend discount model (infinite horizon): Chapter 18: Equity Valuation

  11. Constant Growth DDM (Gordon’s Model) Chapter 18: Equity Valuation

  12. Constant Growth DDM Example: Whitewater Rapids Company is expected to have dividends grow at a constant rate of 6% for the foreseeable future. If Whitewater just paid a dividend of $2.81 and its level of risk requires a discount rate of 10%, what is the intrinsic value of Whitewater stock? Chapter 18: Equity Valuation

  13. Market Capitalization Rate Gordon’s Model: If V0 = P0 : Dividend Yield Capital Gains Yield If g = 0: Perpetuity Chapter 18: Equity Valuation

  14. Implications of this Model • If D1increases, then V0increases. • If kdecreases, then V0increases. • If gincreases, then V0increases. • If D1increases X%, then V0will • increase X%. • g = the capital gains yield Chapter 18: Equity Valuation

  15. Dividend Payout Ratio: Percentage of earnings paid out as dividends Plowback (or Earning Retention) Ratio: Fraction of earnings retained and reinvested in the firm Dividend Payout RatioandPlowback Ratio Chapter 18: Equity Valuation

  16. If a firm retains earnings and reinvest them in a profitable investment opportunity, dividend may grow “faster”. If a firm pays out all dividends nothing gets re-invested, nothing growths. Stock Prices and Investment Opportunities Chapter 18: Equity Valuation

  17. Figure 12.1 Dividend Growth for Two Earnings Reinvestment Policies Chapter 18: Equity Valuation

  18. Plowback Ratio and Growth Where: ROE = Return on Equityb = Plowback Ratio (or Earning Retention Ratio) Chapter 18: Equity Valuation

  19. Stock Prices and Investment Opportunities Present value no-growth (b=0 or ROE=k) Present value of growth Opportunities PVGO > 0 if ROE>k PVGO <0 if ROE<k Chapter 18: Equity Valuation

  20. Estimating Growth Example: Takeover Target has a plowback ratio of 60% and an ROE of 10%. If it expects earnings to be $ 5 per share, what is the present value of Takeover’s growth opportunities if the appropriate capitalization rate is 15%? What is the PVGO? Chapter 18: Equity Valuation

  21. Life Cycles and the Constant Growth Model Changing growth rates: temporary high (or low) growth permanent constant growth Chapter 18: Equity Valuation

  22. Changing Growth Rate Example: Whitewater Rapids Company is expected to have dividends grow at a rate of 12% for the next three years. In three years, the dividends will settle down to a more sustainable growth rate of 6% 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 10%, what is the intrinsic value of Whitewater stock? Chapter 18: Equity Valuation

  23. Ratio of Stock price to its earnings per share Useful for firm valuation: Problems: Forecasts of E Forecasts of P/E Price-Earning (P/E) Ratios Chapter 18: Equity Valuation

  24. P/E Ratios and Growth If PVGO = 0: Chapter 18: Equity Valuation

  25. E0 = $2.50 g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 P/E = 1/k = 1/.125 = 8 Numerical Example: No Growth Chapter 18: Equity Valuation

  26. P/E Ratios and ROE P/E ratio rises with ROE but not necessarily with b P/E ROE>k 1/k b ROE<k Chapter 18: Equity Valuation

  27. 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 Numerical Example with Growth Chapter 18: Equity Valuation

  28. Figure 12-3 P/E Ratio of the S&P 500 Index and Inflation Chapter 18: Equity Valuation

  29. High plowback ratio (b) High Growth Rate (g) (g = ROE*b) BUT High g (if due to high b) High P/E ratio Practitioners: high P/E as proxy of high dividend growth (g) Caveat with P/E Ratios Chapter 18: Equity Valuation

  30. Holding everything equal: High risk (k), Low P/E. Why do small-risky firm have high P/E? P/E ratio and Risk Chapter 18: Equity Valuation

  31. Pitfalls in P/E Analysis • Earnings are based on accounting data • Current price and current earnings • Future expected earnings is more appropriate • In P/E formula, E is an expected trend • In financial pages, E is the actual past period's earnings Chapter 18: Equity Valuation

  32. Figure 12-6 P/E Ratios Chapter 18: Equity Valuation

  33. Combining P/E and DDM Chapter 18: Equity Valuation

  34. The Aggregate Stock Market:Earning Multiplier Approach Chapter 18: Equity Valuation

  35. Price-to-book Price-to-cash flow Price-to-sales Present Value of Free Cash Flow Other Valuation Ratios & Approaches Chapter 18: Equity Valuation

  36. Summary • Valuation approaches: • Balance sheet values • -Present value of expected future dividends • DDM states that the price of a share of stock is equal to the present value of all future dividends discounted at the appropriate required rate of return • Constant growth model DDM: • P/E ratio is an indication of the firm's future • growth opportunities • Models used for the firm can be used to forecast the • behavior of the aggregate stock market Chapter 18: Equity Valuation

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