07a. security evaluation

8/2/2019 07A. Security Evaluation

1/85

Valuation Process Two approaches

1. Top-down, three-step approach 2. Bottom-up, stock valuation, stock picking

approach

The difference between the two

approaches is the perceived importanceof economic and industry influence onindividual firms and stocks


2/85

Top-Down, Three-Step Approach

1. General economic influences Decide how to allocate investment funds among

countries, and within countries to bonds, stocks,

and cash2. Industry influences

Determine which industries will prosper and whichindustries will suffer on a global basis and within

countries

3. Company analysis Determine which companies in the selected

industries will prosper and which stocks are

undervalued


3/85

Does the Three-Step Process Work? Studies indicate that most changes in

an individual firms earnings can be

attributed to changes in aggregatecorporate earnings and changes in thefirms industry


4/85

Does the Three-Step Process Work? Studies have found a relationship

between aggregate stock prices and

various economic series such asemployment, income, or production


5/85

Does the Three-Step Process Work?An analysis of the relationship between

rates of return for the aggregate stock

market, alternative industries, andindividual stocks showed that most ofthe changes in rates of return for

individual stock could be explained bychanges in the rates of return for theaggregate stock market and the stocks

industry


6/85

Theory of Valuation The value of an asset is the present

value of its expected returns

You expect an asset to provide astream of returns while you own it


7/85

Theory of Valuation To convert this stream of returns to a

value for the security, you must

discount this stream at your requiredrate of return


8/85

Stream of Expected Returns Form of returns

Earnings Cash flows Dividends Interest payments Capital gains (increases in value)

Time pattern and growth rate of returns


9/85

Required Rate of Return Determined by

1. Economys risk-free rate of return, plus 2. Expected rate of inflation during the

holding period, plus 3. Risk premium determined by the

uncertainty of returns


10/85

Uncertainty of Returns Internal characteristics of assets Business risk (BR)

Financial risk (FR) Liquidity risk (LR) Exchange rate risk (ERR) Country risk (CR)

Market determined factors Systematic risk (beta) or Multiple APT factors


11/85

Investment Decision Process: AComparison of Estimated Values and

Market Prices

If Estimated Value > Market Price, Buy

If Estimated Value < Market Price, Dont Buy


12/85

Valuation of Alternative

InvestmentsValuation of Bonds is relatively easy

because the size and time pattern of

cash flows from the bond over its lifeare known 1. Interest payments usually every six

months equal to one-half the coupon ratetimes the face value of the bond

2. Payment of principal on the bondsmaturity date


13/85

Valuation of Bonds Example: in 2000, a $10,000 bond due

in 2015 with 10% coupon

Discount these payments at theinvestors required rate of return (if therisk-free rate is 9% and the investor

requires a risk premium of 1%, thenthe required rate of return would be10%)


14/85

Valuation of BondsPresent value of the interest payments is anannuity for thirty periods at one-half therequired rate of return:

$500 x 15.3725 = $7,686

The present value of the principal is similarlydiscounted:

$10,000 x .2314 = $2,314

Total value of bond at 10 percent = $10,000


15/85

Valuation of BondsThe $10,000 valuation is the amount that

an investor should be willing to pay for

this bond, assuming that the requiredrate of return on a bond of this riskclass is 10 percent


16/85


17/85


18/85

Valuation of Preferred Stock

Owner of preferred stock receives apromise to pay a stated dividend,

usually quarterly, for perpetuity Since payments are only made after the

firm meets its bond interest payments,

there is more uncertainty of returns Tax treatment of dividends paid to

corporations (80% tax-exempt) offsets

the risk premium


19/85


pR

Dividend=V

The value is simply the stated annualdividend divided by the required rate of

return on preferred stock (Rp)

Assume a preferred stock has a $100 par valueand a dividend of $8 a year and a required rate ofreturn of 9 percent


20/85


pR

Dividend=V

The value is simply the stated annualdividend divided by the required rate of

return on preferred stock (Rp)

Assume a preferred stock has a $100 par valueand a dividend of $8 a year and a required rate ofreturn of 9 percent

.09

$8=V 89.88$=


21/85


Given a market price, you can derive itspromised yield


22/85



Price

DividendpR =


23/85



At a market price of $85, this preferredstock yield would be

Price

DividendpR =

0941.$85.00

$8pR ==


24/85

Approaches to theValuation of Common Stock

Two approaches have developed 1. Discounted cash-flow valuation

Present value of some measure of cash flow,including dividends, operating cash flow, andfree cash flow

2. Relative valuation techniqueValue estimated based on its price relative to

significant variables, such as earnings, cashflow, book value, or sales


25/85

Approaches to theValuation of Common Stock

These two approaches have some factorsin common Investors required rate of return Estimated growth rate of the variable used


26/85

Discounted Cash Flow Valuation Approach

The measure of cash flow used Dividends

Cost of equity as the discount rate

Operating cash flow Weighted Average Cost of Capital (WACC)

Free cash flow to equity Cost of equity

Dependent on growth rates and

discount rate


27/85

Discounted Cash-Flow ValuationTechniques

=

= +

=nt

ttR

tCFjV

1 )1(Where:

Vj = value of stock j

n= life of the asset

CFt = cash flow in period tR= the discount rate that is equal to the investors

required rate of return for asset j, which is determinedby the uncertainty (risk) of the stocks cash flows


28/85

Valuation Approachesand Specific Techniques

Approaches to Equity Valuation

Discounted Cash FlowTechniques

Relative ValuationTechniques

Present Value of Dividends (DDM)

Present Value of Operating Cash Flow

Present Value of Free Cash Flow

Price/Earnings Ratio (PE)Price/Cash flow ratio (P/CF)

Price/Book Value Ratio (P/BV)

Price/Sales Ratio (P/S)


29/85

The Dividend Discount Model (DDM)

The value of a share of common stock is thepresent value of all future dividends

= +

=

+++

++

+++=

n

t tR

tD

R

D

R

D

R

D

R

DjV

1 )1(

)1(...3)1(

32)1(2)1( 1

Where:

Vj = value of common stock j

Dt = dividend during time period t

R= required rate of return on stock j


30/85

The Dividend Discount Model(DDM)

If the stock is not held for an infiniteperiod, a sale at the end of year 2

would imply:

2)1(

2

2)1(

2

)1(

1

R

jSP

R

D

R

DjV

+

+

+

++

=


31/85


If the stock is not held for an infiniteperiod, a sale at the end of year 2

would imply:

Selling price at the end of year two is thevalue of all remaining dividendpayments, which is simply an extension

of the original equation

2)1(

2

2)1(

2

)1(

1

R

jSP

R

D

R

DjV

+

+

+

++

=


32/85


Stocks with no dividends are expected tostart paying dividends at some point


33/85


Stocks with no dividends are expected tostart paying dividends at some point,

say year three...

+++

++

++

+=

)1(...

)1()1()1( 33

2

21

k

D

k

D

k

D

k

DVj


34/85


Stocks with no dividends are expected tostart paying dividends at some point,

say year three...

Where:

D1 = 0

D2 = 0

+++

++

++

+=

)1(...

)1()1()1( 33

2

21

k

D

k

D

k

D

k

DVj


35/85


Infinite period model assumes a constantgrowth rate for estimating future

dividends


36/85


Infinite period model assumes a constantgrowth rate for estimating future dividends

Where:

Vj = value of stock j

D0 = dividend payment in the current period

g = the constant growth rate of dividends

k= required rate of return on stock j

n = the number of periods, which we assume to be infinite

nR

ngD

R

gD

R

gD

jV)1(

)1(0...2)1(

2)1(0

)1(

)1(0

+

+

+++

+

++

+

=


37/85


Infinite period model assumes a constantgrowth rate for estimating future dividends

nR

ngD

R

gD

R

gDjV

)1(

)1(0...2)1(

2)1(0

)1(

)1(0

+

+++

+

++

+

+=

gR

DjV

= 1This can be reduced to:1. Estimate the required rate of return (R)

2. Estimate the dividend growth rate (g)


38/85

Infinite Period DDMand Growth Companies

Assumptions of DDM:

1. Dividends grow at a constant rate

2. The constant growth rate will continuefor an infinite period

3. The required rate of return (R) isgreater than the infinite growth rate (g)


39/85


Growth companies have opportunities to earn returnon investments greater than their required rates ofreturn

To exploit these opportunities, these firms generallyretain a high percentage of earnings forreinvestment, and their earnings grow faster than

those of a typical firmThis is inconsistent with the infinite period DDM

assumptions


40/85


The infinite period DDM assumesconstant growth for an infinite period,

but abnormally high growth usuallycannot be maintained indefinitely

Risk and growth are not necessarily

relatedTemporary conditions of high growth

cannot be valued using DDM


41/85

Valuation with TemporarySupernormal Growth

Combine the models to evaluate theyears of supernormal growth and then

use DDM to compute the remainingyears at a sustainable rate


42/85


Combine the models to evaluate theyears of supernormal growth and then

use DDM to compute the remainingyears at a sustainable rate

For example:

With a 14 percent required rate ofreturn and dividend growth of:


43/85


Dividend

Year Growth Rate

1-3: 25%

4-6: 20%

7-9: 15%

10 on: 9%


44/85


The value equation becomes

9

333

9

333

8

233

7

33

6

33

5

23

4

3

3

3

2

2

)14.1(

)09.14(.

)09.1()15.1()20.1()25.1(00.2

14.1

)15.1()20.1()25.1(00.2

14.1

)15.1()20.1()25.1(00.2

14.1

)15.1()20.1()25.1(00.2

14.1

)20.1()25.1(00.2

14.1

)20.1()25.1(00.2

14.1

)20.1()25.1(00.2

14.1

)25.1(00.2

14.1

)25.1(00.2

14.1

)25.1(00.2

+

++

++

++

++=iV

C f l f S k f C


45/85

Computation of Value for Stock of Companywith Temporary Supernormal Growth

Discount Present Growth

Year Dividend Factor Value Rate

1 2.50$ 0.8772 2.193$ 25%

2 3.13 0.7695 2.408$ 25%

3 3.91 0.6750 2.639$ 25%

4 4.69 0.5921 2.777$ 20%

5 5.63 0.5194 2.924$ 20%6 6.76 0.4556 3.080$ 20%

7 7.77 0.3996 3.105$ 15%

8 8.94 0.3506 3.134$ 15%

9 10.28 0.3075 3.161$ 15%

10 11.21 9%

224.20$a

0.3075b

68.943$

94.365$

aValue of dividend stream for year 10 and all future dividends, that is

$11.21/(0.14 - 0.09) = $224.20bThe discount factor is the ninth-year factor because the valuation of the

remaining stream is made at the end of Year 9 to reflect the dividend in

Year 10 and all future dividends.


46/85

Present Value ofOperating Cash Flows

Derive the value of the total firm bydiscounting the total operating cash

flows prior to the payment of interest tothe debt-holders

Then subtract the value of debt to arrive

at an estimate of the value of theequity


47/85


=

= +=

nt

tt

j

t

j WACC

OCFV

1 )1(


48/85


=

= +

=nt

t tjWACC

tOCFjV

1 )1(Where:Vj=value of firm j

n =number of periods assumed to be infinite

OCFt =the firms operating cash flow in period t

WACC =firm js weighted average cost of capital

(OCF and WACC to be discussed in Chapter 20)


49/85


50/85


Assuming several different rates ofgrowth for OCF, these estimates can be

divided into stages as with thesupernormal dividend growth model

Estimate the rate of growth and the

duration of growth for each period This will be demonstrated in chapter 20


51/85

Present Value ofFree Cash Flows to Equity

Free cash flows to equity are derivedafter operating cash flows have been

adjusted for debt payments (interestand principle)

The discount rate used is the firms cost

of equity (k) rather than WACC


52/85

Present Value ofFree Cash Flows to Equity

Where:

Vj= Value of the stock of firmj

n= number of periods assumed to beinfinite

FCFt = the firms free cash flow in period t

= +

=n

t tjR

tFCFjV

1 )1(


53/85

Relative Valuation Techniques

Value can be determined by comparingto similar stocks based on relative ratios

Relevant variables include earnings,cash flow, book value, and sales

The most popular relative valuation

technique is based on price to earnings


54/85

Earnings Multiplier Model

This values the stock based onexpected annual earnings

The price earnings (P/E) ratio, or

Earnings Multiplier

EarningsMonth-TwelveExpected

PriceMarketCurrent=


55/85


The infinite-period dividend discountmodel indicates the variables that

should determine the value of the P/Eratio


56/85




gR

DiP

= 1


57/85




Dividing both sides by expected earningsduring the next 12 months (E1)

gR

DiP

= 1


58/85

Earnings Multiplier ModelThe infinite-period dividend discount

model indicates the variables thatshould determine the value of the P/E

ratio

Dividing both sides by expected earnings

during the next 12 months (E1)

gRDiP

= 1

gR

ED

E

iP

= 1

/1

1


59/85


Thus, the P/E ratio is determined by 1. Expected dividend payout ratio

2. Required rate of return on the stock (R) 3. Expected growth rate of dividends (g)

gR

ED

E

iP

=

1/1

1


60/85


As an example, assume: Dividend payout = 50% Required return = 12% Expected growth = 8% D/E = .50; R= .12; g=.08


61/85


As an example, assume: Dividend payout = 50%

Required return = 12% Expected growth = 8% D/E = .50; R= .12; g=.08

12.5

.50/.04

.08-.12

.50

P/E

=

=

=


62/85


A small change in either or both Ror gwill have a large impact on the

multiplier

gR

ED

E

iP

= 1

/1

1


63/85



multiplierD/E = .50; R=.13; g=.08

P/E = .50/(.13-/.08) = .50/.05 = 10

gR

ED

E

iP

= 1

/1

1


64/85

Earnings Multiplier ModelA small change in either or both Ror g

will have a large impact on themultiplier

D/E = .50; R=.13; g=.08 P/E = 10

D/E = .50; R=.12; g=.09

P/E = .50/(.12-/.09) = .50/.03 = 16.7

gR

ED

E

iP

= 1

/1

1


65/85



multiplierD/E = .50; R=.13; g=.08 P/E = 10

D/E = .50; R=.12; g=.09 P/E = 16.7

gR

ED

E

Pi

= 11

1

/


66/85

Earnings Multiplier ModelA small change in either or both kor gwillhave a large impact on the multiplier

D/E = .50; R=.13; g=.08 P/E = 10

D/E = .50; R=.12; g=.09 P/E = 16.7D/E = .50; R=.11; g=.09

P/E = .50/(.11-/.09) = .50/.02 = 25

gR

ED

E

iP

= 1/1

1


67/85


Given current earnings of $2.00 andgrowth of 9%

You would expect E1 to be $2.18

D/E = .50; R=.12; g=.09 P/E =16.7

V= 16.7 x $2.18 = $36.41


68/85


Given current earnings of $2.00 andgrowth of 9%

You would expect E1 to be $2.18

D/E = .50; R=.12; g=.09 P/E =16.7

V= 16.7 x $2.18 = $36.41

Compare this estimated value to marketprice to decide if you should invest in it


69/85

The Price-Cash Flow Ratio

Companies can manipulate earnings

Cash-flow is less prone to manipulation

Cash-flow is important for fundamentalvaluation and in credit analysis


70/85





1

/+

=t

t

i

CF

PCFP


71/85





1

/+

=t

t

i

CF

PCFP

Where:P/CFj = the price/cash flow ratio for firm j

Pt = the price of the stock in period t

CFt+1

= expected cash low per share for firm j


72/85

The Price-Book Value Ratio

Widely used to measure bank values(most bank assets are liquid (bonds and

commercial loans)Fama and French study indicated inverse

relationship between P/BV ratios and

excess return for a cross section ofstocks


73/85


1

/+

=t

tj

BV

PBVP


74/85


Where:

P/BVj= the price/book value for firmj

Pt = the end of year stock price for firmjBVt+1 = the estimated end of year book

value per share for firmj

1

/+

=t

tj

BV

PBVP


75/85


Be sure to match the price with either arecent book value number, or estimate

the book value for the subsequent year Can derive an estimate based upon

historical growth rate for the series or

use the growth rate implied by the(ROE) X (Ret. Rate) analysis


76/85

The Price-Sales Ratio

Strong, consistent growth rate is arequirement of a growth company

Sales is subject to less manipulationthan other financial data


77/85


1+=

t

t

S

P

S

P


78/85


Where:

1+

=t

t

S

P

S

P

tjSjP

jS

P

t

t

j

j

Yearduringfirmforsharepersalesannualfirmforpricestockyearofend

firmforratiosalestoprice

1 ==

=

+


79/85


Match the stock price with recent annualsales, or future sales per share

This ratio varies dramatically by industryProfit margins also vary by industry

Relative comparisons using P/S ratioshould be between firms in similarindustries


80/85

Expected Growth Rate of Dividends

Determined by the growth of earnings the proportion of earnings paid in dividends

In the short run, dividends can grow at a differentrate than earnings due to changes in the payout ratio

Earnings growth is also affected by compounding ofearnings retention

g = (Retention Rate) x (Return on Equity)

= RR x ROE


81/85

Breakdown of ROE

EquityCommon

AssetsTotal

AssetsTotal

Sales

Sales

IncomeNet

ROE

=

=

Profit Total Asset Financial

Margin Turnover Leverage= xx


82/85

Estimating Growth Based on History

Historical growth rates of sales, earnings,cash flow, and dividends

Three techniques1. arithmetic or geometric average of

annual percentage changes

2. linear regression models

3. long-linear regression modelsAll three use time-series plot of data

Estimating Dividend Growth


83/85

Estimating Dividend Growthfor Foreign Stocks

Differences in accounting practicesaffect the components of ROE

Retention Rate Net Profit Margin

Total Asset Turnover

Total Asset/Equity Ratio


84/85

Some Analytical Factors

Caveats about the DDM: The DDM is at most a useful tool in security

analysis - it requires certain assumptions and it has

shortcomings.

False growth: False growth occurs when a firm acquires another

firm with a lower price-earnings ratio - historicaldata should always be scrutinized carefully whenused to determine a growth rate.


85/85

Some Analytical Factors

A firms cash flow: The statement of cash flows is a useful analytical

tool - the cash flow from operations figures are

widely used as a check on a firms earnings quality. Small-cap, mid-cap, and large-cap stocks:

Another consideration in fundamental stockanalysis relates to the size of the firm - forexample, the small firm effect.

The fundamental analyst is necessarily interested inthe firms accounting statements and in the prevailinggeneral economic conditions.

07a. security evaluation

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