Valuing Stocks and Bonds

1. Valuing Stocks and Bonds

2. Multiplier Methods • Price-to-earnings (P/E) • Price-to-earnings-before-interest-tax-depreciation and amortization (P/EBITDA). • Price-to-book (P/B) • Price-to-sales (P/S) • Price-to-cash flow (P/CF).

3. Determining Value • Value = Item x Multiplier • We illustrate this approach using the P/E method: • Value = EPS forecast x Predicted P/E multiple

4. Choosing the Level of the Multiplier • 1)Examine historic P/E’s for the company. Pay special attention to trends. • 2)Examine P/E’s and trends for several comparable companies. • 3)Determine if the company has historically traded at a premium, at the same level, or a discount to its competitors. If at a premium, can it maintain that premium? Why? If a discount, can it move to the industry level? How? • 4)Repeat (3) relative to the S&P index.

5. Example • We want to value an unlisted company in the automobile manufacturing sector. • Our pro forma estimates suggest earnings next year of $25 million. • Data on four comparables are given on the next slide (the comparables are chosen from the same industry and are about the same size as our company)

6. Example Data • Comparable P/E • Arvin Industries 12.75 • Detroit Diesel 15.72 • Donnely 16.86 • Excel 10.76 • Lear Corp. 16.16 • Average 14.45

7. P/E Example • We believe our company has better growth prospects than the typical firm in the industry. • Therefore we assign it a P/E multiple of 17. • Using this gives the following valuation: • Value = $25m x 17 = $425m

8. Dividend Discount Models • (a)No Growth Model • Assumes dividends will remain at a constant level of D, forever. • Value = D/r • where r is the return demanded from equity (Note: not the WACC). • This model rarely applies to common equity. • It is used to value preferred stock.

9. Dividend Discount Models • (b) Constant Growth model • Dividends are assumed to grow at a rate of “g” per year, forever. • Value = D1/(r-g) • where D1 = next year’s dividend [this year’s dividend (D0) times (1+g)]

10. Dividend Discount Models • (b) Constant Growth model (cont’d) • This model is easy to apply and is widely used. • D0 (this year’s dividend) is known • only “r” and “g” must be estimated. • The growth rate “g” is the most difficult to estimate. • “g” is the growth rate in divs, in earnings, cash flow and the stock price. • In determining “g”, examine the historic growth rate in all of these items.

11. Constant Growth Example • The 1996 annual financial statements for Kellogg’s indicate a dividend of $1.62. • We estimate that equity holders require a return of 11%. • No Growth Model: V = 1.62/0.11 = 14.73 per share. • Constant Growth Model: Estimating “g” is difficult.

12. Constant Growth Example • Historical Growth Rate for Kellogg (from Kellogg Annual Report) • 1 year 3 years 5 years 10 years • DPS 8.0% 4.9% 9.5% 12.5% • EPS 11.6% (7.4%) 8.5% 11.0% • CF/Share 13.4% (1.1%) 8.5% 11.5% • Sales (4.7%) 1.0% 7.5% 10.0% • Sales/Share (1.6%) 2.5% 22.0% 8.2% • Stock Price 8.5% 9.0% N/A N/A

13. Constant Growth Example

14. Constant Growth Example • Considering all of the above we decide that 8% is a reasonable estimate of g. Using this g as the constant growth rate we obtain the following value: • V = 1.62 x (1 + .08) / (.11 - .08) = 1.75/0.03 = $58.32

15. Dividend Discount Models • (c) Abnormal Growth Model • Use the pro forma approach to predict annual dividends for the next N years (the explicit forecast period). Assume a constant growth rate in dividends thereafter. • The explicit forecast period is often 3 to 5 years, although in some cases you may be comfortable doing pro formas for 10 to 25 years.

16. Abnormal Growth Example • Using proforma analysis on Kellogg’s we estimate dividends of 1.75 next year and 1.95 in the following year. Thereafter we assume constant growth at 8%.

17. Note on Present Value of Growth Opportunities (PVGO) • If the company chooses not to grow and therefore pays out all of its earnings as dividends, then:

18. PVGO • If the market value (VMKT) is different from VNG, the difference represents the value of the growth opportunities. • VMKT = VNG + PVGO = E/r + PVGO

19. PVGO Example • It is sometimes interesting to see how much of a company’s value is due to existing earnings and how much is from anticipated growth.

20. PVGO Example

21. Free Cash Flow Models • Many companies do not pay dividends. This precludes the use of the DDMs. • Also, many firms are choosing to repurchase stock rather than increase current dividends. • For these reasons free cash flow models have become increasingly popular. • Free cash flow represents the cash flow generated by the company that is available for dividends and interest payments (but may also be used to grow the business or repurchase stock).

22. Free Cash Flow Models • Free cash flow = Gross Cash Flow - Investment • = (NOPAT + Depreciation) – Investment • NOPAT = EBIT – Adjusted Taxes • or N/Inc + After Tax Interest [Interest Expense x (I-T)] • or EBIT x (I-T) • Adj Taxes = [Taxes + (Tax rate x Net Int. Expense)] • Investment = [NPPE + Dep] + Op W Cap

23. Free Cash Flow Models • (a) No Growth Model • (Note: Denominator is the WACC, not • the return on equity)

24. Free Cash Flow Models • (b) Constant Growth Model

25. Free Cash Flow Models • (c) Abnormal Growth Model

26. Free Cash Flow Models • CV is known as the continuing value and is the value of the company at the end of the explicit forecast period (i.e. at the end of year N). • There are two common ways to estimate CV: • 1) Constant Growth Method • 2) Multiplier Method

27. Free Cash Flow Models • (i) Constant Growth Method • g is the constant growth rate per year in perpetuity after year N. • In general, g consists of three components: • g = Expected Infl + Real Growth in Econ + Fran Growth Rate • The first two can be obtained from many economic forecasting services. • The last is the rate at which you believe the company can grow above that of the economy as a whole.

28. Free Cash Flow Models • (ii) Multiplier Method • Because it is difficult to estimate g and because g often has a very large impact on value, many analysts prefer to estimate the CV using a simple multiplier method.

29. Free Cash Flow Models This approach is uses the final year’s pro formas to determine either N/Inc, EBITDA, or book value at the end of the explicit forecast period. The model then assumes that the company will trade at an industry average multiplier after year N. CV = Net Inc of year N x (Industry Avg. P/E)

30. Free Cash Flow Models