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Security Analysis Part I

Security Analysis Part I. Fundamental 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 Self assigned Value

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Security Analysis Part I

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  1. Security Analysis Part I

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

  3. Intrinsic Value and Market Price • Intrinsic Value • Self assigned Value • 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

  4. Dividend Discount Models (DDM):General Model V0 = Value of Stock Dt = Dividend k = required return

  5. Special Cases • No growth: Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock • Example EPS1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33

  6. Constant Growth Model g = constant perpetual growth rate

  7. Constant Growth Model: Example EPS1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86

  8. Model-Building Assumptions • k > g (otherwise denominator would be negative, leading to a negative stock price) • Both k and g represent long-run averages • Ignores taxes, external financing and options • Allowing for taxes and debt financing is relatively easy • Allowing for executive stock options and warrants is more difficult

  9. Structural Changes in Cash Dividend Payments • Corporate earnings will be used for • Cash dividends paid to owners (shareholders) • Retained earnings reinvested in firm • Share buybacks to repurchase outstanding shares • Recently firms have decreased cash dividend growth rates and begun buying back stock • Examples: IBM, American Express, Coca-Cola

  10. Restating Present Value Models in Terms of Earnings • The retention ratio, or plowback ratio, b represents the portion of earnings not paid as dividends • Therefore, it is retained earnings • The payout ratio is (1 –b) • Thus, a firm’s dividend can be rewritten as • Dt = (1 – b)*EPSt • A firm can use retained earnings to either repurchase shares or to reinvest and earn the firm’s ROE • Reinvested earnings can finance internal growth at a periodic rate of g = b*ROE • Therefore, EPSt = EPS0 * (1+g)t = EPS0 [1 + b*(ROE)]t

  11. Restating Present Value Models in Terms of Earnings • Profitable firms can earn ROE > 0 by reinvesting RE in profitable projects or repurchasing shares • Share repurchases can increase EPS because the firm’s earnings are now spread out over fewer shares (called reverse dilution) • If the b>0, then the following equations are equivalent • Dt = (1 – b) EPSt • Dt = (1 – b) (1 + g)t EPS0 • Dt = (1 – b) [1 + b*(ROE)]t EPS0

  12. Reformulated Present Value Model • Substituting the basic discounted dividend model • If D1 is replaced with EPS1 (1 – b) in the constant DDM, we obtain: • This allows us the ability to examine how dividend policy impacts share value • Dividend policy is reflected in the retention rate b

  13. Dividend Policy Irrelevance • Since g = b*(ROE) • If a firm has an ROE on new investments equal to the risk-adjusted discount rate then • Thus, regardless of a firm’s initial EPS or riskiness, the firm’s value is unaffected by dividend policy, as RR is no longer in the equation • So, when ROE = k dividend policy is irrelevant

  14. Dividend Policy and Growth Firms • The relationship between a firm’s ROE and its discount rate determine the impact of dividend policy on firm value • A firm earning an ROE > discount rate is considered a growth firm • Declining firms have ROE below the discount rate, or ROE < k • When ROE = k dividend policy is irrelevant

  15. Example • Assume a firm has • An ROE of 15% • A discount rate, k, of 15% • A retention rate b of 66.67% • Leads to a growth rate of 0.6667 x .15 = 10% • Cash dividends growth rate of 10% • If these assumptions hold, the firm’s value will remain a constant $50 (in present value terms)

  16. Example

  17. 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. Partitioning Value: Growth and No Growth Components PVGO = Present Value of Growth Opportunities E1 = Earnings per share for period 1

  19. Partitioning Value: Example ROE = 20% d = 60% b = 40% EPS1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8%

  20. Partitioning Value: Example (cont’d) Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities

  21. Two Stages of Growth DDM • A firm’s common stock may have one of the following growth patters in dividends • Two stages of positive growth (g1 and g2) • One constant positive growth rate • Zero growth • One constant negative growth rate

  22. Example • Battel Corporation has the following attributes: • Paid an annual dividend of $2 per share • Cost of equity capital is 10% • Cash dividends are growing at 2% annually • What is Battel’s stock worth?

  23. Example • Battel is now considering international expansion with the following adjustments • Same dividend as above, but now the expected growth rate is 4%, not 2%, and the increased risk is expected to increase the cost of equity to 11% • Battel’s value should increase to:

  24. Example • Example • Initial stock price: $25.50 • With international expansion: $29.71 • What if the international expansion caused Battel's growth rate to rise to 4% for only four years and then the growth rate dropped to the original estimate of 2% forever? • If the exposure to international risks increases Battel’s cost of equity to 11% permanently

  25. DDM Criticism • Critics argue that it is too difficult to accurately forecast future cash dividends • This criticism is true for some firms but not others • Example: Coca-Cola’s dividend payment is relatively easy to forecast even though its operations cover over 200 different countries • Critics then argue that, even if earlier dividends are relatively easy to forecast, longer-term dividends (say 50 to 100 years from now) are more difficult to determine • These long-range forecasts are unimportant

  26. DDM Criticism • Because the present value of these amounts are very low

  27. Implications • It is only essential to accurately forecast cash dividends for 10 years in order to use the DDM • Cash dividends in years 11-30 only need to be forecasted within  40% of their actual values • All cash dividends received from years 31 to infinity have a present value of only $1 or $2 • When a higher discount rate is used (as with smaller, riskier firms) it is only necessary to forecast dividends for a few years

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