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Equity Valuation

Equity Valuation. Basic Types of Models Balance sheet models Dividend discount models EPS (cashflow) discount models Modeling Framework Deterministicdynamics Stochastic dynamics. Fair Value vs Market Price. Fair Value Self assigned Value Variety of models are used for estimation

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Equity Valuation

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  1. Equity Valuation • Basic Types of Models • Balance sheet models • Dividend discount models • EPS (cashflow) discount models • Modeling Framework • Deterministicdynamics • Stochastic dynamics

  2. Fair Value vs Market Price • Fair Value • Self assigned Value • Variety of models are used for estimation • Market Price • Consensus value assessment by all market participants • Trading Signal • FV > MP: Buy • FV < MP: Sell or Short Sell • FV = MP: Hold or Fairly Priced

  3. Dividend Discount Models V0 = Value of Stock Dt = Dividend k = required return

  4. No Growth Model Where the stock has earnings and dividends that are expected to remain constant foreever. Example: Preferred Stock

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

  6. Constant Growth Model g = constant perpetual growth rate

  7. Constant Growth Model: Example E1 = $5.00 b = 40% (1-b) = 60% k = 15% D1 = $3.00 g = 8% (b: EPS retention ratio) V0 = 3.00 / (.15 - .08) = $42.86

  8. Estimating Dividend Growth Rates • g = growth rate in dividends • ROE = Return on Equity for the firm • b = EPS retention rate (1- dividend payout ratio)

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

  10. Partitioning Value: Example ROE = 20% b = 40% E1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8%

  11. Partitioning Value: Example • Vo = value with growth • NGVo = no growth component value • PVGO = Present Value of Growth Opportunities

  12. Multi-Period Dividend-Discount Model PN = expected sales price of stock at time N N = number of years the stock is to be held

  13. Practical Difficulties with DDM • Some firms do not pay dividends • Can you forecast future dividends? • Can you predict the terminal liquidation value Pn ? • What about the discount rate k? (perhaps, the CAPM? The APT?)

  14. Multi-Period Earnings-Discount Model PN = expected sales price of stock at time N N = number of years the stock is to be held

  15. Practical Concerns with EDM • EPS forecasts are available from I/B/E/S, First Call, Zacks, …. • Dividend payout ratio (1-b) can be estimated, either based on cash dividend or dividend-in-kind • But, what about Pn and k?

  16. P/E Ratios d: dividend payout ratio k: cost-of-capital (or, risk-adjusted discount rate) g: EPS growth rate

  17. P/E Example k = 12.5% g = 9% d = 40% Thus, P/E = (1 - .60) / (.125 - .09) = 11.4 If E = $2.73, we have P = 11.4 X 2.73 =$31.14

  18. Problems with P/E Ratios • What is E ? • E = trailing 12-month EPS? • E = 12-month-forward EPS? • What is g ? • g = average historical EPS growth? • g = expected next-yr EPS growth? • g = long-run EPS growth?

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