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Chapter 18

Chapter 18. Equity Valuation Models. Fundamental Stock Analysis: Models of Equity Valuation. Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios Estimating Growth Rates and Opportunities. Intrinsic Value and Market Price. Intrinsic Value

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Chapter 18

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  1. Chapter 18 Equity ValuationModels 18-1

  2. Fundamental Stock Analysis: Models of Equity Valuation • Basic Types of Models • Balance Sheet Models • Dividend Discount Models • Price/Earning Ratios • Estimating Growth Rates and Opportunities 18-2

  3. 18-3

  4. Intrinsic Value and Market Price • Intrinsic Value • Self assigned Value • Eddie: IV = $10, Elin: IV = $12, Myron: IV = $14 • Variety of models are used for estimation • Market Price • Consensus value of all potential traders • Trading Signal • IV > MP Buy • IV < MP Sell or Short Sell • IV = MP Hold or Fairly Priced 18-4

  5. 18-5

  6. Dividend Discount Models:General Model V0 = Value of Stock Dt = Dividend k = required return 18-6

  7. No Growth Model Stocks that have earnings and dividends that are expected to remain constant Preferred Stock 18-7

  8. No Growth Model: Example E1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33 18-8

  9. Constant Growth Model g = constant perpetual growth rate 18-9

  10. Constant Growth Model: Example E1 = $5.00 b = retention =40% k = 15% (1-b) = payout = 60% g = 8% D1 = E1*(1-b) = $5*.60 V0 = 3.00 / (.15 - .08) = $42.86 18-10

  11. Estimating Dividend Growth Rates g = growth rate in earnings (& dividends if g and ROE are constant) ROE = Return on Equity for the firm b = plowback or retention percentage rate (1- dividend payout percentage rate) 18-11

  12. Constant Growth Model: Example E0 = $4.63 b = 40% k = 15% (1-b) = 60% g = 8% E1 = $4.63*(1.08) = $5 and D1 = E1*(1-b) = $5*.60 = $3 D0 = 4.63*.60 = $2.78 D1 = 2.78*1.08 = $3 18-12

  13. 18-13

  14. Constant growth example • Example: • last year's EPS = $4.00 • required return = 15% • constant return on new equity investment (ROE) = 20% • constant dividend payout = 40% • Growth in earnings = ROE*retention ratio = ROE*b 18-14

  15. Specified Holding Period Model PN = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held 18-15

  16. Multistage Growth Models • Two period model • Calculate the present value of the expected dividends over the first (or nonconstant) stage • Estimate the stock price at the end of the first stage and discount this value back to time 0 • Add these two together to estimate the value at time 0 18-16

  17. last year's EPS = $3.75 & required return = 12% ROE years 1 & 2 = 24% year 3 = 20% year 4 and beyond = 16% dividend payout years 1 & 2 = 30% year 3 = 40% year 4 and beyond = 50% growth in earnings years 1 & 2 = year 3 = year 4 and beyond = Multistage example 18-17

  18. Partitioning Value: Growth and No Growth Components PVGO = Present Value of Growth Opportunities E1 = Earnings Per Share for period 1 18-18

  19. Partitioning Value: Example ROE = 20% d = 60% b = 40% E1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8% 18-19

  20. Partitioning Value: Example Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities 18-20

  21. Price Earnings Ratios • 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 18-21

  22. 18-22

  23. P/E Ratio: No Expected Growth • E1 - expected earnings for next year • E1 is equal to D1 under no growth • k - required rate of return 18-23

  24. P/E Ratio with Constant Growth b = retention ratio ROE = Return on Equity 18-24

  25. Numerical Example: No Growth E0 = $2.50 g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 18-25

  26. 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 PE = 31.14/2.73 = 11.4 PE = (1 - .60) / (.125 - .09) = 11.4 18-26

  27. Pitfalls in P/E Analysis • Use of accounting earnings • Historical costs • May not reflect economic earnings • Reported earnings fluctuate around the business cycle 18-27

  28. 18-28

  29. Inflation and Equity Valuation • Inflation has an impact on equity valuations • Historical costs underestimate economic costs • Empirical research shows that inflation has an adverse effect on equity values • Research shows that real rates of return are lower with high rates of inflation 18-29

  30. Potential Causes of Lower Equity Values with Inflation • Shocks cause expectation of lower earnings by market participants • Returns are viewed as being riskier with higher rates of inflation • Real dividends are lower because of taxes 18-30

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