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Chapter 13

Chapter 13. Equity Valuation. Fundamental Stock 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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Chapter 13

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  1. Chapter 13 Equity Valuation

  2. Fundamental Stock 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 • Jason: $14, Jamie: $16, Katie: $18 • Variety of models are used for estimation • Market Price • Consensus value of all potential traders ($16) • Trading Signal • IV > MP Buy • IV < MP Sell or Short Sell • IV = MP Hold or Fairly Priced

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

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

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

  7. Constant Growth Model • g = constant perpetual growth rate Note: D1 = D0(1+g)

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

  9. Estimating Dividend Growth Rates • g = growth rate in earnings • ROE = Return on Equity for the firm • b = plowback or retention percentage rate • (1- dividend payout percentage rate) • d = dividend payout = 1 - b

  10. Constant growth • Rankin Corporation earns a constant 20% on new equity investment (ROE) and pays out a constant 60% of earnings as dividends. EPS for the year just ended = $3.00. • The beta of the stock is .90, the expected return on the market is 13 percent and Rf = 4 percent. • Calculate earnings and dividends for the next 4 years.

  11. Rankin

  12. Rankin continued • Calculate the growth (percentage change) in earnings and dividends. • Calculate the required return • R = Rf + Beta*(Rm-Rf) • R = .04 + .9*(.13-.04) = .121 • Calculate the price (or value) • Pt = Dt+1/(k-g)

  13. Rankin continued Calculate the percentage change in the stock price. Calculate your HPR if you buy today and hold for one period.

  14. Shifting Growth Rate Model • g1 = first growth rate • g2 = second growth rate • T = number of periods of growth at g1

  15. Shifting growth Value at time T Value at t = 0 D1 D2 D3 ……... DT Note: value at T = D T+1/(k-g)

  16. Lang Company • The Lang Company just paid a dividend of $2 • Dividends are expected to grow at a rate of 20% for 3 years and then at a constant rate of 5 percent. • If your required return is 15%, how much would you pay for a share of Lang Company stock?

  17. Shifting 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

  18. Multistage or nonconstant growth • The Wade Company just paid a dividend of $1.20 per share. Dividends are expected to grow at a rate of 10% for 2 years, 9 percent for the next 2 years and a constant 8 percent thereafter. If the required return is 13 percent, find value of a share of Wade.

  19. 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

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

  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 Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities

  23. Price Earnings Ratios • 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

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

  25. P/E Ratio with Constant Growth • b = retention ration • ROE = Return on Equity

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

  27. 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 PE = 31.14/2.73 = 11.4 PE = (1 - .60) / (.125 - .09) = 11.4

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