equity valuation. 15.1 valuation by comparables basic types of models ◦ balance sheet models ◦...
TRANSCRIPT
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Equity Valuation
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15.1 VALUATION BY COMPARABLES
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Basic Types of Models◦ Balance Sheet Models◦ Dividend Discount Models◦ Price/Earnings Ratios
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Valuation models use comparables◦ Look at the relationship between price and
various determinants of value for similar firms
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Book value ◦ Based on historical values◦ Not the floor
Can book value represent a floor value? Better approaches
◦Liquidation value If below, attractive
◦Replacement cost Tobin’s q (ratio of market price to replacement cost)
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14.2 INTRINSIC VALUE VERSUS MARKET PRICE
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• Example (1-year horizon), whether the price today is attractively priced given your forecast of next year’s price and dividend
• Rf=6%, beta=1.2 Rm=11%
0 1 148, 52, 4P E P E D
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compare expected HPR and required return expected HPR
◦ The return on a stock investment comprises cash dividends and capital gains or losses Assuming a one-year holding period 1 1 0
0
( ) ( )Expected HPR= ( )
E D E P PE r
P
16.7%E r
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required return CAPM gave us required return:
If the stock is priced correctly◦ Required return should equal expected
return
( )f M fk r E r r
6% 1.2*5% 12%k
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Intrinsic value ◦ The present value of all cash payments
to the investor, including dividends and proceeds from the ultimate sale of the stock, discounted at the appropriate risk-adjusted interest rate, k
Example:
50>48, undervalued
0V
1 10
52 450
1 1 12%
E D E PV
k
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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
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14.3 DIVIDEND DISCOUNT MODELS
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1 10 1
D PV
k
2 21 1
D PP
k
1 2 20 2
1 2 20 2
1 1
1 1 1H H
H
D D PV
k k
D D P D PV
k k k
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DDM◦ Stock price should equal the present value
of all expected future dividends into perpetuity
VDk
ot
tt
( )11
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VDk
ot
tt
( )11
V0 = Value of StockDt = Dividendk = required return
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Constant Growth Model ◦Assuming dividends are trending upward at a stable growth rate g
g = constant perpetual growth rate
VoD g
k g
o
( )1
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Constant growth DDM
A Stock’s price will be greater ◦Larger its expected dividend per share
◦Lower k◦Higher g
0 10
1D g DP
k g k g
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Stock price is expected to grow at the same rate as dividends
If market price equals its intrinsic value, expected HPR will be equal to required return
121 0
11
D gDP P g
k g k g
1 01 1
0 0 0
P PD DE r g k
P P P
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VoD g
k g
o
( )1
E1 = $5.00 b = 40% k = 15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
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VD
ko
g=0
Stocks that have earnings and dividends that are expected to remain constant◦ Preferred Stock
VoD g
k g
o
( )1
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E1 = D1 = $5.00
k = 12.5%V0 = $5.00 / .125 = $40
VD
ko
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Consider two companies◦ Cash Cow, Inc◦ Growth Prospects
k=12.5% IF pay out all as dividends (payout ratio =100%),
perpetual dividend=5 Both valued at 5/12.5%=40, neither firm will grow in
value GP, project’s ROE=15%, what should be GP’s dividend
policy ? investment=$100 million, 3 million shares outstanding,
expected earnings in coming year (EPS)=$100*15%/3= $5
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Suppose, Growth Prospects lower payout ratio (40%) Earnings retention ratio b=1-40%=60% Total earning=$100*15%=$15 million Reinvestment=$15*60%=$9 million (capital increase
9/100=9%) 9% more capital, 9% more income, 9% higher dividend
Low-reinvestment-rate plan, pay higher initial dividends, but result in a lower dividend growth rate
High-reinvestment-rate, lower initial dividends, but result in higher dividend growth
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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)
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g=15%*60%=9%
The project’s ROE >required rate (the project has positive NPV), reduce dividend payout ratio and reinvest in the positive NPV project.
The firm’s value rises by the NPV of the project PVGO: net present value of growth opportunities
10
5*40%57.14
12.5% 9%
DP
k g
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Value of the firm rises by the NPV of the investment opportunities
Price = No-growth value per share (NGV) +present value of growth opportunities (PVGO)
PVGO=57.14-40=17.14 Where: E1 = Earnings Per Share for period 1
and
10
EP PVGO
k
0 1(1 )
( )
D g EPVGO
k g k
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Growth enhance company value only if it is achieved by investment in projects with attractive profit opportunities (ROE>k)
If the project’s ROE=12.5%=k, lower the dividend payout ratio (40%)
Then stock price=?
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g= ROE*b=12.5%*60%=7.5%
No different from no-growth strategy To justify reinvestment, the firm must
engage in projects with better prospective returns than those shareholders can find elsewhere
If ROE=k, no advantage to reinvestment
10
5*40%40
12.5% 7.5%
DP
k g
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ROE = 20% d = 60% b = 40%
E1 = $5.00 D1 = $3.00 k = 15%
g = .20 x .40 = .08 or 8%
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P
NGV
PVGO
o
o
3
15 0886
5
1533
86 33 52
(. . )$42.
.$33.
$42. $33. $9.
Partitioning Value: ExamplePartitioning Value: Example
PPoo = price with growth = price with growth
NGVNGVoo = no growth component value = no growth component value
PVGO = Present Value of Growth OpportunitiesPVGO = Present Value of Growth Opportunities
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Constant-growth DDM◦ Assume dividend growth rate be constant
In fact, different dividend profiles in different phases◦ In early years, high return, high reinvestment,
high growth◦ In later years, low return, low reinvestment, low
growth, as mature companies Multistage version of DDM
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P Dg
k
D g
k g ko o
t
tt
TT
T
( )
( )
( )
( )( )
1
1
1
11
1
2
2
g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1
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D0 = $2.00 g1 = 20% g2 = 5% k = 15% T = 3 D1 =2*1.2= 2.40 D2 = 2.4*1.2=2.88 D3 =2.88*1.2= 3.46 D4 =3.46*1.05= 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
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14.4 PRICE-EARNINGS RATIOS
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Used to assess the valuation of one firm versus another based on a fundamental indicator such as earnings.
Price-to-earnings multiple Price-to-book ratio Price-to-cash-flow ratio Price-to-sales ratio
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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
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Useful indicator of expectations of growth opportunities
Ratio of PVGO/(E/k), component of firm value due to growth opportunities to the component of value due to assets already in place
High P/E ratio indicates ample growth opportunities◦ GROWTH PROSPECT, 57.14/5=11.4◦ CASH COW, 40/5=8
0
1
11
P PVGOEE kk
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Investor may well pay a higher price per dollar of current earnings if he or she expects that earnings stream to grow more rapidly
P/E ratio a reflection of the market’s optimism concerning a firm’s growth prospects, but whether they are more of less optimistic than the market ?
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PE
kP
E k
01
0
1
1
E1 - expected earnings for next year◦ E1 is equal to D1 under no growth
k - required rate of return
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PD
k g
E b
k b ROE
P
E
b
k b ROE
01 1
0
1
1
1
( )
( )
( )
b = retention rationROE = Return on Equity
Higher ROE, higher P/E Higher b, higher P/E, only if ROE>k
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E0 = $2.50 k = 12.5%, ROE=15%,
No growth: g=0 P/E=?With growth: payout ratio=40%,
P/E=?
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E0 = $2.50 g = 0 k = 12.5%
P0 = D/k = $2.50/.125 = $20.00
P/E = 1/k = 1/.125 = 8
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b = 60% ROE = 15% (1-b) = 40%g = (.6)(.15)= 9%E1 = $2.50 (1 +9%) = $2.73D1 = $2.73 (1-.6) = $1.09k = 12.5% g = 9%P0 = 1.09/(.125-.09) = $31.14P/E = 31.14/2.73 = 11.4P/E = (1 - .60) / (.125 - .09) = 11.4
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Holding all else equal◦Riskier stocks will have lower P/E multiples
◦Higher values of k; therefore, the P/E multiple will be lower
1P b
E k g
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Use of accounting earnings◦ Influenced by somewhat arbitrary accounting rules , use
of historical cost in depreciation and inventory valuation (earnings management)
Inflation◦ P/E ratio have tended to be lower when inflation has been
higher ◦ Market’s assessment that earnings in these periods are of
lower quality Reported earnings fluctuate around the business cycle No way to say P/E is overly high or low without referring to
the company’s long-run growth and current EPS relative to the long-run trend line
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Price-to-book ratio Price-to-cash-flow ratio Price-to-sales ratio Creative: price-to-hits ratio for retail
internet firms
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14.5 FREE CASH FLOW VALUATION APPROACHES
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Discount the free cash flow for the firm
Discount rate is the firm’s cost of capital
Components of free cash flow◦After tax EBIT◦Depreciation◦Capital expenditures◦Increase in net working capital
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discount FCFF at the weighted-average cost of capital , Subtract existing value of debtFCFF = EBIT (1- tc) + Depreciation – Capital
expenditures – Increase in NWC where:
EBIT = earnings before interest and taxestc = the corporate tax rate
NWC = net working capital
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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
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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