Chapter 13

1. Chapter 13 Equity Valuation

2. Good Company= Good stock?

3. Fundamental Stock Analysis: Models of Equity Valuation • Outline • Balance sheet appoach • Dividend Discount Models • Constant dividend growth model • Non-constant dividend growth model • Price/Earning Ratio models • Free Cash Flow(FCF) models

4. Intrinsic Value and Market Price • Intrinsic Value • The present value of all future cash flows • The true intrinsic value is not observable • Variety of models are used for estimation • Market Price • Consensus value of current market participants (buyers and sellers) • Price of last stock market transaction • Trading Signal • IV > MP(discount, on sale) Buy • IV < MP(too expensive) Sell or Short Sell • IV = MP(fair) Hold

5. Intrinsic Value and Market Price • In the long-run, market price should converge to intrinsic value • Remember: value(intrinsic) is what you get, price(market) is what you pay. Pay less, get more!

6. Balance Sheet Valuation • A share of stock represents a slice of the ownership( F assets are claims on real assets) • Claims of Equity (on balance sheet) • Book Value: net worth of a company as reported on balance sheet • However, BV and MV could be significantly different • BV represents past, while MV represents future • Stocks are also Claims of future Earnings and Dividends.

7. Balance Sheet Valuation • BV is still relevant in stock valuation • Is BV a floor of stock price? • BV(Equity)=Asset-Liability • When MV is much lower than BV, the whole company can be sold at a higher price than MV • However, Asset can be overvalued (Goodwill). Net tangible assets might be more useful. • Examples: BBI • Should I be concerned if MV/BV is too high? • Rich evaluation invites competition • Competition and Tobin’s Q (MV/replacement cost)

8. Book value and stock price: reality check • Most stocks are sold at a price higher than book value • Researches show that, on average and over long term, lower Price/Book stock has higher return • Higher Risk of low P/B stock • Investors chasing glamour stock(high P/B) stock

9. Dividend Discount Models:General Model • V0 = Value of Stock • Dt = Dividend • k = required return

10. No Growth Model • Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock

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

12. Constant growth stock • A stock whose dividends are expected to grow forever at a constant rate, g. D1 = D0 (1+g)1 D2 = D0 (1+g)2 Dt = D0 (1+g)t

13. Constant Growth Model • g = constant perpetual growth rate

14. What happens if g > ks? • If g > ks, the constant growth formula leads to a negative stock price, which does not make sense. • The constant growth model can only be used if: • ks > g • g is expected to be constant forever

15. What is the stock’s market value? • K=13% • D0 = $2 and g is a constant 6%, • Using the constant growth model:

16. 0 1 2 3 ks = 13% ... 2.00 2.00 2.00 What would the expected price today be, if g = -5%?, if g=0? • When g=-5% D1=1.9, P=1.9/(13%+5%)=10.56 • When g=0, The dividend stream would be a perpetuity.

17. Supernormal growth:What if g = 30% for 3 years before achieving long-run growth of 6%? • Can no longer use just the constant growth model to find stock value. • However, the growth does become constant after 3 years.

18. 0 1 2 3 4 rs = 13% ... g = 30% g = 30% g = 30% g = 6% D0 = 2.00 2.600 3.380 4.394 4.658 2.301 2.647 3.045 4.658 = = $66.54 46.114 3 - 0.13 0.06 54.107 = P0 Valuing common stock with nonconstant growth $ P ^

19. 0 1 2 3 4 ks = 13% ... g = 0% g = 0% g = 0% g = 6% D0 = 2.00 2.00 2.00 2.00 2.12 1.77 1.57 1.39 2.12 $ P = = $30.29 20.99 3 - 0.13 0.06 ^ 25.72 = P0 Nonconstant growth:What if g = 0% for 3 years before long-run growth of 6%?

20. Practical problem with dividend model • How to estimate g • Using historical average • When ROE and dividend payout ratio are constant: • Dividend growth rate=Return on Equity*plowback ratio • g=ROE* b • Derive the relationship • Dividend will grow the same rate as Earning (constant dividend payout ratio) • Earning will grow at the same rate as Equity (constant ROE) • Equity will grow at ROE*b • How to estimate k

21. Practical problem with dividend model • Dividend model is forward looking. Inputs are future dividends, which are not observable • Historical dividends and dividend growth rate are not an accurate estimates of future dividend growth rate • Many companies are not paying dividends • For those who pay, dividend growth rate can change dramatically overtime

22. Price Earnings Ratios • What is P/E • P/E=current stock price/annual earning per share • It measures how much investors are willing to pay for $1 of current earnings • If earning is constant, P/E measures the number of years for investor to breakeven • Earning yield, (E/P, the reverse/reciprocal of P/E) measures your current return on investment • From 1920-1990, P/E average is about 15 • Uses • Relative valuation • Extensive Use in industry

23. The simple P/E approach • Current(trailing) PE approach: • Find E • Assign a reasonable P/E ratio • P=E*assigned P/E • Forward PE approach • Find forward E • Assign a reasonable forward P/E ratio • Price target in the future=forward E*assigned forward P/E

24. P/E=? • P/E Ratios are a function of two factors • Required Rates of Return (k) • Expected growth in Dividends

25. Pitfalls in Using PE Ratios • Investors make fatal mistakes when: • PE with abnormal once-only Es. • PE with skewed E due to GAAP (AAPL subscription treatment of iPhone revenue) • Inflated PE: When earning is close to 0 • Negative PE • Solution • Normalized PE • Forward PE (option vs. facts)

26. Free Cash Flow (FCF): • Def: Cash available to the firm (or equity holder) net of capital expenditures. • Idea: FCF is the cash shareholder (investor) can withdraw from the company without affecting its normal operation and expansion

27. FCF: Calculating • FCFE=NI+Dep-Capital Expenditure-Increase in NWC • Practically: Cash Flow from Operating Activity-Capital expenditure • MV=PV of all Future FCF