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CHAPTER 13

CHAPTER 13. Equity Valuation. 13.1 VALUATION BY COMPARABLES. Fundamental Stock Analysis: Models of Equity Valuation. Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earnings Ratios Estimating Growth Rates and Opportunities. Models of Equity Valuation.

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CHAPTER 13

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  1. CHAPTER 13 Equity Valuation

  2. 13.1 VALUATION BY COMPARABLES

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

  4. Models of Equity Valuation • Valuation models use comparables • Look at the relationship between price and various determinants of value for similar firms • The internet provides a convenient way to access firm data. Some examples are: • EDGAR • Finance.yahoo.com

  5. Table 13.1 Microsoft Corporation Financial Highlights

  6. Valuation Methods • Book value • Market value • Liquidation value • Replacement cost

  7. 13.2 INTRINSIC VALUE VERSUS MARKET PRICE

  8. Expected Holding Period Return • The return on a stock investment comprises cash dividends and capital gains or losses • Assuming a one-year holding period

  9. Required Return • CAPM gave us required return: • If the stock is priced correctly • Required return should equal expected return

  10. Intrinsic Value and Market Price • Market Price • Consensus value of all potential traders • Current market price will reflect intrinsic value estimates • This consensus value of the required rate of return, k, is the market capitalization rate • Trading Signal • IV > MP Buy • IV < MP Sell or Short Sell • IV = MP Hold or Fairly Priced

  11. 13.3 DIVIDEND DISCOUNT MODELS

  12. General Model ¥ D å t = V o + t ( 1 k ) = 1 t • V0 = Value of Stock • Dt = Dividend • k = required return

  13. No Growth Model D = V o k • Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock

  14. No Growth Model: Example D = V o k E1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33

  15. Constant Growth Model + D ( 1 g ) o = Vo - k g • g = constant perpetual growth rate

  16. Constant Growth Model: Example + D ( 1 g ) o = Vo - k g E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86

  17. Stock Prices and Investment Opportunities = ´ g ROE b • g = growth rate in dividends • ROE = Return on Equity for the firm • b = plowback or retention percentage rate • (1- dividend payout percentage rate)

  18. Figure 13.1 Dividend Growth for Two Earnings Reinvestment Policies

  19. Present Value of Growth Opportunities • If the stock price equals its IV, growth rate is sustained, the stock should sell at: • If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist)

  20. Present Value of Growth Opportunities (cont.) • Price = No-growth value per share + PVGO (present value of growth opportunities) • Where: E1 = Earnings Per Share for period 1 and

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

  22. Partitioning Value: Example (cont.) 3 = = P $42 . 86 o - (. 15 . 08 ) 5 = = NGV $33 . 33 o . 15 = - = PVGO $42 . 86 $33 . 33 $9 . 52 Po = price with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities

  23. Life Cycles and Multistage Growth Models + + t T ( 1 g ) D ( 1 g ) å T = + 2 P D 1 o o + - + t T ( 1 k ) ( k g ) ( 1 k ) = 1 t 2 • g1 = first growth rate • g2 = second growth rate • T = number of periods of growth at g1

  24. Multistage Growth Rate Model: Example D0 = $2.00 g1 = 20% g2 = 5% k = 15% T = 3 D1 = 2.40 D2 = 2.88 D3 = 3.46 D4 = 3.63 V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 + D4 / (.15 - .05) ( (1.15)3 V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

  25. 13.4 PRICE-EARNINGS RATIOS

  26. P/E Ratio and Growth Opportunities • 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

  27. P/E Ratio: No expected growth E 1 = P 0 k P 1 0 = E k 1 • E1 - expected earnings for next year • E1 is equal to D1 under no growth • k - required rate of return

  28. P/E Ratio: Constant Growth - D E ( 1 b ) 1 1 = = P 0 - - ´ k g k ( b ROE ) - P 1 b 0 = - ´ E k b ROE ) ( 1 • b = retention ration • ROE = Return on Equity

  29. Numerical Example: No Growth E0 = $2.50 g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 P/E = 1/k = 1/.125 = 8

  30. 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 P/E = 31.14/2.73 = 11.4 P/E = (1 - .60) / (.125 - .09) = 11.4

  31. P/E Ratios and Stock Risk • Riskier stocks will have lower P/E multiples • Riskier firms will have higher required rates of return (higher values of k)

  32. Pitfalls in Using P/E Ratios • Flexibility in reporting makes choice of earnings difficult • Pro forma earnings may give a better measure of operating earnings • Problem of too much flexibility

  33. Figure 13.3 P/E Ratios and Inflation

  34. Figure 13.4 Earnings Growth for Two Companies

  35. Figure 13.5 Price-Earnings Ratios

  36. Figure 13.6 P/E Ratios

  37. Other Comparative Valuation Ratios • Price-to-book • Price-to-cash flow • Price-to-sales • Be creative

  38. Figure 13.7 Valuation Ratios for the S&P 500

  39. 13.5 FREE CASH FLOW VALUATION APPROACHES

  40. Free Cash Flow • One approach is to discount the free cash flow for the firm (FCFF) at the weighted-average cost of capital • Subtract existing value of debt • FCFF = EBIT (1- tc) + Depreciation – Capital expenditures – Increase in NWC where: EBIT = earnings before interest and taxes tc = the corporate tax rate NWC = net working capital

  41. Free Cash Flow (cont.) • Another approach focuses on the free cash flow to the equity holders (FCFE) and discounts the cash flows directly at the cost of equity • FCFE = FCFF – Interest expense (1- tc) + Increases in net debt

  42. Comparing the Valuation Models • Free cash flow approach should provide same estimate of IV as the dividend growth model • In practice the two approaches may differ substantially • Simplifying assumptions are used

  43. 13.6 THE AGGREGATE STOCK MARKET

  44. Earnings Multiplier Approach • Forecast corporate profits for the coming period • Derive an estimate for the aggregate P/E ratio using long-term interest rates • Product of the two forecasts is the estimate of the end-of-period level of the market

  45. Figure 13.8 Earnings Yield of the S&P 500 Versus 10-year Treasury Bond Yield

  46. Table 13.4 S&P 500 Index Forecasts

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