FINC4101 Investment Analysis

1. 1 FINC4101 Investment Analysis Instructor: Dr. Leng Ling Topic: Equity Valuation

2. 2 Learning objectives Distinguish between the intrinsic value and price of a share of common stock. Calculate the intrinsic value of a firm using dividend discount models Constant dividend growth model Multistage dividend growth model Use the constant growth model to relate growth opportunities to stock value. Calculate the P/E ratio for a constant growth firm. Discuss the free cash flow valuation methods.

3. 3 Concept Map

4. 4 Why equity valuation? Identify mispriced equity securities. How? By calculating “intrinsic” or “true” value of a stock using valuation models. These valuation models make use of information concerning current & future profitability. This approach of identifying mispriced stocks is called fundamental analysis. In this chapter, the information concerning current and future profitability will be information like dividends, earnings, dividend growth rate (g), required rate of return, ROE, retention rate/dividend payout ratio, etc. Next slide explains “intrinsic” value. In this chapter, the information concerning current and future profitability will be information like dividends, earnings, dividend growth rate (g), required rate of return, ROE, retention rate/dividend payout ratio, etc. Next slide explains “intrinsic” value.

5. 5 Intrinsic value vs. market price (1) Intrinsic value, V0 Present value of all expected future cash flows to the stock investor. The cash flows are discounted at the appropriate required rate of return, k. Expected future cash flows consist of: cash dividends sale price: proceeds from the ultimate sale of the stock

6. 6 Intrinsic value vs. market price (2) Intrinsic value is your (the analyst’s) estimate of what a stock is really worth. Intrinsic value (V0) can differ from the current market price (P0). If V0 > P0: stock is underpriced => buy If V0 < P0: stock is overpriced => sell or don’t buy. When V0 differs from P0, then investor must disagree with some or all of the market consensus estimates of future cash flows (dividends or sale price) or k. When V0 differs from P0, then investor must disagree with some or all of the market consensus estimates of future cash flows (dividends or sale price) or k.

7. 7 Market equilibrium In market equilibrium, Everyone has the same intrinsic value. So, intrinsic value equals market price, i.e., V0 = P0. Everyone also demands the same required rate of return from the stock. So everyone has the same k. In addition, expected HPR = k. This common required rate of return is called the market capitalization rate. Market capitalization rate: required rate of return which the market (i.e., everyone) uses to discount future cash flows. Bring in the powerful concept of market equilibrium. From asset pricing topic, we know that in market equilibrium (and assuming everyone agrees on the expected future cash flows and riskiness), required rate of return must equal expected HPR. Otherwise, people will continue to trade and prices will continue to change. This slide is saying that there is a special name for the required rate of return in equilibrium. That name is “market capitalization rate”. Tell class that the market capitalization rate is the discount rate that gives rise to the observed market price. So later we see how we can use valuation models to infer or ‘back out’ the market capitalization rate. Bring in the powerful concept of market equilibrium. From asset pricing topic, we know that in market equilibrium (and assuming everyone agrees on the expected future cash flows and riskiness), required rate of return must equal expected HPR. Otherwise, people will continue to trade and prices will continue to change. This slide is saying that there is a special name for the required rate of return in equilibrium. That name is “market capitalization rate”. Tell class that the market capitalization rate is the discount rate that gives rise to the observed market price. So later we see how we can use valuation models to infer or ‘back out’ the market capitalization rate.

8. 8 Equity valuation models Dividend discount models Constant dividend growth model Multistage (non-constant) dividend growth model Price-earnings ratio (P/E) Free cash flow models

9. 9 Dividend discount models (DDMs) Dividend discount models say that the intrinsic value of a stock is equal to the present value of all expected future dividends. What about cash flow from the ultimate sale of the stock? Is that included? Yes, because stock price at time of sale is again determined by expected dividends at the time of sale. Show that price is ultimately determined by dividends, so intrinsic value is ultimately determined by dividends. V0 = D1/(1+k) What is P1? Assuming that P1=V1, we know that V1 = (D2 + P2)/(1 + k). Substitute this for P1, and we get V0 = D1/(1+k) + (D2 + P2)/(1 + k)2 This says that the intrinsic value of the stock is the PV of dividends plus sales price for a two-year holding period. So both dividends and sales price appear in the valuation of the stock. If we plan to hold the stock for H years, we can continue with this type of substitution and write the stock price as the PV of dividends over the H years, plus the ultimate sales price, PH , V0 = D1/(1+k) + (D2 + P2)/(1 + k)2 + ….. + (DH + PH)/(1 + k)H We can continue to substitute for price indefinitely to conclude: V0 = D1/(1+k) + (D2 + P2)/(1 + k)2 + (D3 + P3)/(1 + k)3 ….. This states that the stock price should equal the PV of all expected future dividends into perpetuity. This is the dividend discount model (DDM) of stock prices. Show that price is ultimately determined by dividends, so intrinsic value is ultimately determined by dividends. V0 = D1/(1+k) What is P1? Assuming that P1=V1, we know that V1 = (D2 + P2)/(1 + k). Substitute this for P1, and we get V0 = D1/(1+k) + (D2 + P2)/(1 + k)2 This says that the intrinsic value of the stock is the PV of dividends plus sales price for a two-year holding period. So both dividends and sales price appear in the valuation of the stock. If we plan to hold the stock for H years, we can continue with this type of substitution and write the stock price as the PV of dividends over the H years, plus the ultimate sales price, PH , V0 = D1/(1+k) + (D2 + P2)/(1 + k)2 + ….. + (DH + PH)/(1 + k)H We can continue to substitute for price indefinitely to conclude: V0 = D1/(1+k) + (D2 + P2)/(1 + k)2 + (D3 + P3)/(1 + k)3 ….. This states that the stock price should equal the PV of all expected future dividends into perpetuity. This is the dividend discount model (DDM) of stock prices.

10. 10 Dividend discount model: General formula