Chapter 13

1. Chapter 13 COMMON STOCK VALUATION

2. Fundamental Analysis • analysts (or investors) try to determine the intrinsic value of a stock • If: • intrinsic value < current market value • overpriced sell stock • intrinsic value < current market value • underpriced  buy stock

3. Determining Intrinsic Value • various methods • we will look at several • all are based on estimates of what will happen in the future • no method is perfect as based on estimates of certain (unknown) parameters • cannot predict the future exactly, can only make best guess • therefore, can never true intrinsic value, only your best estimate

4. two analysts may come up with different estimates of intrinsic value if: • They use different valuation models or • They use the same model but have different parameter estimates

5. If fundamental analysis of intrinsic values is based on • estimates, is it useful? • Yes! • Investors need to make buy/sell decisions based on what the stock is priced at and what they feel it should be worth • Need way to determine what it “should” be worth • Different investors can have different estimates •  this is what creates trading

6. Two Common Valuation Methods • Present Value Approach • dividend discount model (DDM) • Free Cash Flow Valuation • Value stock based on value of cashflows it generates for the investor • 2) Relative Valuation Approach • (a) Price-earnings ratio • (b) other ratios (price to book, price to sales etc.) • Value stock by looking at how similar stocks are valued by the market

7. Present Value Approach- Dividend Discount Model • the value of any stock (or other security) is the present value of future cashflows coming from the stock • for a stock, cashflows received by investors are the dividends • intrinsic value of share = PV of all future dividends

8. to implement, need estimates of two things: • 1) required return on the stock • 2) all future dividends

9. required return on stock depends on: • general level of interest rates in economy • risk level of stock • estimating future dividends: • impossible to predict exactly what all future • dividends will be • typically, simplifying assumptions are used • Three cases: • 1) Zero Growth • 2) Constant Growth • 3) Multiple Growth

10. Zero Growth Model • Assume that firm does not reinvest anything in itself, • pays out all earnings as dividends • it should experience no growth over time: • D0 = EPS0 • and D0 = D1 = D2 = ... • DDM becomes a perpetuity: This simple model would generally never apply to common stocks (applies to straight convertible shares)

11. Constant Growth Model • dividends are expected to grow at a constant rate, g, forever • DDM becomes a growing perpetuity where D1 = D0(1+g)

12. The constant growth model shows the basic factors which affect stock prices: Firm Profitability (via dividends) • Level of interest rates • Risk level of stock Future profitability (via dividends)

13. in constant growth model, g is growth rate in dividends and is also expected appreciation in stock price • the expected (required) return to the investor can be broken down in to a dividend yield and a capital gain yield (=g) • in practice, this simple model would only apply to a stock with very stable (in terms of growth) dividends – typically in a fully mature and non-cyclical industry

14. Multiple Growth Model • dividends are expected to grow at different rates over different periods • eventually, dividends enter a period of stable, long term growth which goes on forever • common to use 2 or 3 different growth rates in practice, or to estimate first few dividends directly and then assume growth rate(s)

15. Where: • the dividends (D1 to Dn+1) have to be estimated directly • using the estimated growth rates

16. Problems with Present Value Approach • in theory, DDM is correct but implementation can be hard • parameters (next dividends, growth rate(s), required return) must be estimated and this is the hard part • we will look at methods to estimate required return, earnings, dividends and growth rates a little later in course • the intrinsic value calculated can be very sensitive to assumptions made

17. DDM best suited to firms which maintain stable payout ratios • DDM best suited for firms which have reasonably stable growth rates • does not work well for cyclical firms or firms with erratic earnings • DDM may work reasonably well for firms in mature industries with stable profits (or growing at stable rate) and an established dividend policy

18. Another Present Value Approach- Free Cash Flow Valuation • Many firms do not currently pay dividends • Theoretically, DDM will work, but extremely difficult to estimate when dividends will begin and what growth rate will be • Alternative to DDM is calculating present value of Free Cash Flow

19. Two approaches: • Free Cash Flow to Equity (FCFE) • Free Cash Flow to the Firm (FCFF) Free Cash Flow to Equity: • Estimate how much cash the firm could pay out as dividends if it wanted to = FCFE • Think of this as “potential” dividends • Calculate present value of future FCFE to get value of equity

20. Free Cash Flow to Equity FCFE = Net Income + Depreciation – Capital Expenditures – Change in non-cash Working Capital + Net New Debt Issued

21. Free Cash Flow to Equity • Similar to DDM, estimate a growth rate and then discount at the required return on equity: Total value of Equity = • Divide this number by number of shares outstanding to get estimate of intrinsic value of one share

22. Free Cash Flow to Firm • FCFF represents the cashflow available each that could be distributed to all security holders (i.e. shareholders and debt holders) FCFF = FCFE – Net New debt + Interest(1-tax)

23. Free Cash Flow to Firm FCFF = Net Income + Depreciation - Capital Expenditures - Change in non-cash Working Capital + Interest (1 – tax rate)

24. Free Cash Flow to Firm • Estimate growth rate for FCFF • Discount future FCFF at the weighted average cost of capital (WACC) Value of Firm = • This is value of overall firm, to get share value subtract value of debt and divide by number of shares

25. Estimating Intrinsic Value- Relative Valuation Approach • value a stock by comparing it to other stocks • usually done by comparing the level of some accounting variable such as earnings, sales or book value • in some industries non-accounting numbers might be used (e.g. # of subscribers in the cable industry, amount of oil reserves in oil industry)

26. whatever the basis of comparison, the process is essentially the same • determine what the relationship between the variable and the stock price “should” be • use this and the level of the variable for the • firm to value the stock

27. by far the most common relative valuation approach is based on the price-earnings ratio (P\E ratio)

28. P/E Ratios • Price of a stock alone does not tell you if it is “expensive” or “cheap” • price must be measured relative so something • most common is earnings • how much does the stock cost per dollar of earnings the firm generates?

29. Using P\E ratios in valuation: determine what P\E “should” be “justified P/E ratio” EPS times justified P\E ratio estimated intrinsic value

30. newspapers often report current P\E ratios for stocks • usually based on “trailing” earnings (EPS for previous year = EPS0) • stock valuation generally done using “forward” earnings • estimate of EPS for next year (EPS1 = the future)

31. Estimating Justified P\E Ratio • Four basic methods: • 1) based on fundamentals of firm (using DDM model) • 2) industry average • 3) historic average for the firm (or the industry) • 4) relative to market overall

32. Justified P\E from Fundamentals • if assume the constant growth DDM holds, can be shown that: • gives justified P\E based on payout ratio and estimates of kcs and g to calculate justified P\E • multiply by estimate of EPS1 to get intrinsic value

33. the P\E ratio justified by fundamentals also shows the factors that determine the P\E ratio: • 1) a higher payout ratio means a higher P\E ratio, all else being equal • 2) a higher required return (risk) means a lower P\E ratio, all else being equal • 3) a higher growth rate means a higher P\E ratio, all else being equal • “all else being equal” never really holds since all three variables are related to each other

34. The formula for P/E from fundamentals (and the formulae for other ratios that follow) is derived from a simple DDM with a single, stable growth rate (D/(k-g)) • As such, it is only applicable in cases where that formula would apply (mature, stable companies) • Generally, these formulae are not actually used to generate estimates of P/E (or the other ratios), but rather to understand the factors that make a ratio higher or lower.

35. e.g. if a stock has a lower P/E than industry average but is considered lower risk, then the lower P/E may be appropriate. Similarly, a stock with higher growth will have a higher P/E. • These ideas are sometimes utilized in a regression framework: e.g. for many firms you have growth rates and P/E ratios. Regress P/E on growth to determine the relationship. Based on another firm’s growth rate you can then use the regression parameters to estimate what an appropriate P/E should be.

36. Comparison to Industry Average: • average P\E ratio of comparable firms • may have to make adjustments for differences • e.g. differences in growth potential, risk level etc. • Comparison to Historic P\E Ratio for Firm: • average P\E ratio for the firm in the past • or, average P\E ratio for industry in the past • have to adjust for changes in the firm/industry

37. Average Industry P\E Ratios Averages over 1999-2004 in Canada: Autos and Auto Parts 16.93 Banks 13.19 Biotechnology 34.11 Metals and Mining 24.58 Steel 14.48 Food and Staples Retailing 17.52 Utilities 17.58 Retailing 12.61 Source: FPinfomart.ca

38. Comparison to Market Overall • company or industry’s P\E ratio relative to ratio for market • e.g. if firm has P\E ratio that is historically 1.5 times as big as average market ratio, use that fact and current market P\E to estimate firm’s P\E • Average P/E on TSX approximately 16 to 18 on average

39. Problems with Using P\E Ratio for Valuation • if other firms are over- or under-valued in the market than estimating P\E ratio by looking at industry or market can simply repeat the error • if earnings are negative, P\E ratio meaningless • earnings can be very volatile, makes P\E ratios very volatile

40. P/E Ratios over time • average P/E since 1999 for Steel sector: Source: FPinfomart.ca

41. Market-to-Book Ratio • price divided by book value of equity per share • determine justified market-to-book and multiply by book value to estimate intrinsic value • Advantages: • - Book value of equity (BV) less volatile than EPS • - BV rarely negative • Disadvantages: • - BV based on accounting numbers, may have little • meaning for some types of firms • - comparison of firms difficult if accounting standards different

42. justified market to book ratio estimated in same ways as P\E • from fundamentals, assuming constant growth DDM:

43. Price-Sales Ratio • price divided by sales per share • determine justified price-sales ratio and multiply by sales per share to estimate intrinsic value • Advantages: • - sales not as volatile as earnings • - sales do not depend on accounting standards very much • - sales never negative • Disadvantages: • - sales do not reflect cost structure of the firm

44. justified sales-price ratio can be estimated in same four ways as the other ratios • from fundamentals, assuming constant growth DDM: