finance chapter 13 (suited)

7/25/2019 Finance Chapter 13 (Suited)

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Chapter 13

EquityValuation

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

13-2

Fundamental Stock Analysis:Models of Equity Valuation

Basic Types of Models

Balance Sheet Models

Dividend Discount Models

Price/Earnings Ratios

Free Cash Flow Models

13-3

Models of Equity Valuation

Valuation models using comparables

Look at the relationship between price andvarious determinants of value for similar firms

The internet provides a convenient way toaccess firm data. Some examples are:

EDGAR Electronic Data-Gathering, Analysis, and Retrieval system

Finance.yahoo.com

Factset, Reuters (Thompson), Bloomberg, etc

Aside) 10-K, 10-Q 13-4

Table 13.1 Microsoft CorporationFinancial Highlights 2009


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13-5

Valuation Methods

Book value

Value of common equity on the balance sheet

Based on historical values of assets and

liabilities, which may not reflect current values

Some assets such as brand name orspecialized skills are not on a balance sheet

13-6

Valuation Methods

Market value

Current market value of assets minus currentmarket value of liabilities

Market value of assets may be difficult to ascertain

Market value based on stock price =>basically, price rather than value

Better measure than book value of the worthof the stock to the investor.

13-7

Valuation Methods (Other Measures)

Liquidation value

Net amount realized from sale of assets andpaying off all debt

Firm becomes a takeover target if marketvalue stock falls below this amount, soliquidation value may serve as floor to value

13-8

Valuation Methods (Other Measures)

Replacement cost

Replacement cost of the assets less theliabilities

May put a ceiling on market value in the longrun because values above replacement costwill attract new entrants into the market.

Cost; should tend toward 1 over time.


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13-9

13.2 Intrinsic Value VersusMarket Price

13-10

Expected Holding Period Return

1 1 0

0

( ) ( )Expected HPR= ( )

E D E P PE r

P

The return on a stock investmentcomprises cash dividends and capitalgains or losses

Assuming a one-year holding period

13-11

Required ReturnCAPM gave us requiredreturn, call it k:

k = market capitalizationrate

If the stock is pricedcorrectly (EMH)

Required return shouldequal expected return

1 1 0

0

( ) ( )Expected HPR= ( )

E D E P PE r

P=

( )f M f

k r E r r

13-12

Intrinsic Value

Intrinsic Value

The present value

required rate of return (e.g., CAPM).

The cash flows on a stock are?Dividends (Dt)

Sale price (Pt)

Intrinsic Value today (time 0) is denoted V0 and for a oneyear holding period may be found as:

k1

)P(E)D(EV 110


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13-13

Intrinsic Value and Market Price

Market Price

Consensus value of all traders

Given to small investors like you and me

In equilibrium, the current market price willequal intrinsic value (EMH)

Trading Signals

If V0 > P0If V0 < P0If V0 = P0

Buy for me. But then what happens?

Sell or Short Sell for me. But then?

Indifferent at it is fairly priced

13-14

Basic Dividend Discount Model

Intrinsic value of a stock can be found from thefollowing:

What happened to the expected sale price in thisformula?

Why is this an infinite sum?

holding period?

1tt

t

0 )k1(

D

V

V0 = Intrinsic Value of Stock

Dt = Dividend in time tk = required return

13-15

Basic Dividend Discount Model

Intrinsic value of a stock can be found from thefollowing:

This equation is not useable because it is aninfinite sum of variable cash flows.

Therefore we have to make assumptions aboutthe dividends to make the model tractable.

1t

tt

0

)k1(

DV

13-16

No Growth ModelUse: Stocks that have earnings anddividends that are expected to remainconstant over time (zero growth)

Preferred Stock

A preferred stock pays a $2.00 per share dividendand the stock has a required return of 10%. Whatis the most you should be willing to pay for thestock?

k

D

V0

00.20$0.10

$2.00V0


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13-17

Constant Growth Model

Use: Stocks that have earnings and dividendsthat are expected to grow at a constant rateforever

A common stock share just paid a $2.00 pershare dividend and the stock has a requiredreturn of 10%. Dividends are expected to growat 6% per year forever. What is the most youshould be willing to pay for the stock?

dividendsinrategrowthperpetual;g-k

D

V

1

0 g

00.53$0.06-0.10

1.06$2.00V0

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Comparing Value and ReturnsWhy do you have to pay more for theconstant growth stock?

Must pay for expected growth

What is the one year rate of return foreach stock?

No Growth Stock

V0 = $20.00; D = $2.00

E(V1)=

%1020$

2$20$20$)(ROIE

Constant Growth Stock

V0 = $53.00; D0 = $2.00

18.56$0.06-0.10

1.06$2.00)E(V

2

1

%1053$

12.2$53$18.56$)(ROIE

$2.00 / 0.10 = $20.00

13-19

Comparing Value and Returns

Both stocks give an investor a pre-taxreturn of 10%.

Is one stock a better buy than the other?Not if both are actually priced at their intrinsicvalue (ignoring taxes).

13-20

Stock Prices and InvestmentOpportunities

g = growth rate in dividends is a function oftwo variables:

ROE = Return on Equity for the firm

b = plowback or retention percentage rate

= (1- dividend payout percentage rate)

g increases if a firm increases its retentionratio and/or its ROE

bROEg


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13-21

Value of Growth Opportunities

Cash Cow, Inc.(CC)

E1 = $5, ROE=12.5%

D1 = $5

b = ; therefore g =

k = 12.5% ; Find VCC

Growth Prospects(GP)

E1 = $5, ROE=15%

D1 = $5

b =0; therefore g = 0

k = 12.5%, Find VGP

00

40$0.125

$5.00VCC 40$

0.125

$5.00VGP

Should either or both firms retain some earnings?

bROEgValue with 100% dividend payout

13-22


Cash Cow, Inc.(CC)

E1 = $5, ROE=12.5%

b = 60%; therefore g =

D1 = 0.40 x $5 = $2.00

k = 12.5%; Find VCCCC value is the same, why?

Growth Prospects (GP)

E1 = $5, ROE=15%

b = 60%; therefore g = 9%

D1 = 0.40 x $5 = $2.00

k = 12.5%; Find VGPGP Value has increased,

why?

7.5%

40$0.075-0.125

$2.00VCC 14.57$

0.09-0.125

$2.00V

GP

bROEgValue with 40% dividend payout

13-23


Value of assets in place for GP = $40.00 (value with alldividends paid out, with ROE = 12.5%)

Value of growth opportunities with ROE = 15% may beinferred from the difference between the new VGP =

$57.14 and the no growth value of $40.00Thus the present value of growth opportunities

(PVGO) = $57.14 - $40.00 = $17.14

0 1(1 )

( )

D g EPVGO

k g kIn general:

13-24

Figure 13.1 Dividend Growth forTwo Earnings Reinvestment

Policies

(for a given ROE)

High reinvestment increases stockprice only if ROE > k


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13-25

Multistage Growth Models

As firms progress through their industry life cycle,earnings and dividend growth rates (ROE) are likely tochange.

A two stage growth model:

g1 = first growth rate

g2 = second growth rate

T = number of periods of growth at g1

T

2

2TT

1tt

t

100

k))(1g(k

)g(1D

k)(1

)g(1DV

13-26

Multistage Growth RateModel: 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 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

3320 )15.1)(05.015.0(

63.3$

15.1

46.3$

15.1

88.2$

15.1

40.2$V

13-27

Two Stage DDM for Honda

Dividends:

Assume the dividend growth rate will besteady beyond 2012. Value Line forecastsb = 70% and ROE of 11%. What shouldbe the long term growth rate?

Year Dividend

2009 0.90

2010 0.98

2011 1.06

2012 1.15

bROEg %7.77.0%11g

From Value Line

13-28


The required rate of return:

Honda = 1.05

Rf in 2008 = 3.5%

Market risk premium=historical average of 8%

HondafMfHonda )RR(Rk

%9.1105.1%8%5.3Hondak

From Value Line


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13-29


k = 11.90%

g = 7.70%

Find the intrinsic value

Value Line reported the actual price = $21.37, soHonda was undervalued by $0.51 or about 2.4%.

44320 )119.1)(077.0119.0(

077.115.1$

119.1

15.1$

119.1

06.1$

119.1

98.0$

119.1

90.0$V

Year Dividend

2009 0.90

2010 0.98

2011 1.06

2012 1.15

88.21$V0

13-30

Two Stage DDM for HondaShould we trust the valuation result?

What if the beta is slightly incorrect,suppose it is 1.10 (< 5% error) rather than 1.05?

Now k = 12.3% and the intrinsic value estimate V0=$19.98, reversing our conclusion that Honda isundervalued

Recall that the actual price = $21.37

13-31

13.4 Price-Earnings (P/E) Ratios

13-32

P/E Ratio and GrowthOpportunities

P/E Ratios are a function of two factors

Required Rates of Return (k) (inverse relationship)

Expected Growth in Dividends (direct relationship)

Uses

Estimate intrinsic value of stocksConceptually equivalent to the constant growthDDM

Extensively used by analysts and investors

Aside) k = required r/r, discount rate, opportunity, canbe given, or needs to be estimated. As k increases,the (present) value decreases.


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13-33

P/E, ROE and Growth

With positive growth:

With zero growth:

If b = 0 then g should = 0 and the ratiosimplifies to:

bROEg

gk

b

E

P )1(

1

0

k

1

E

P

1

0

The P/E here is not the actual P/Eyou get with P0 and trailing EPS.The elements of the V0/E1 ratiohere (theoretical P/E) are similar tothe constant growth DDM.

13-34

Numerical Example: No GrowthE(E1)= $2.50 g = 0 k = 12.5%; Find P/Eand V0

P/E = 1/k = 1/.125 = 8

V0

= P/E x E(E1

)= 8 x $2.50 = $20.00 or= $2.50/(.125-0)= $20.00Then, the theoretical P/E= $20/$2.5= 8

V0 = P/E x E(E1) is called P/E multiple.Typically, we use current industry P/E andprojected E(EPS1) of the firm instead ofthis hypothetcal situation.

13-35

Numerical Example with Growthb = 60% ROE = 15%; k = 12.5% (1-b) = 40%, E0 = $2.50

Find the P/E and V0:

g = ROE x b = 15% x 60% = 9%

E(E1)= $2.50 (1.09) = $2.725, E(D1)=$2.725 (0.4) = $1.09

P/E = (1 - 0.60) / (0.125 - 0.09) = 11.4

V0 = P/E x E(E1)= 11.4 x $2.73 = $31.14 or

= $1.09/(.125 - .09) = $31.14

Then => the theoretical P/E = 31.14/2.725 = 11.4

Again, V0 = P/E x E(E1) Is using data (current industry P/Efrom Yahoo Finance! and the projected E(E1) from I/B/E/Sor pro forma I/S)

13-36

ROE and b and growth and P/E


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13-37

P/E Ratios and Stock Risk

Riskier firms will have higher requiredrates of return (higher values of k)

Riskier stocks will have lower P/Emultiples

gk

b

E

P )1(

1

0

13-38

Pitfalls in Using Actual P/E1 RatiosNot often, but E(EPS1) can be negative,

Earnings management is a serious problem,

E(EPS1) should be calculated using pro formaearnings, or obtained from data services which

A high P/E implies high expected growth, but notnecessarily high stock returns,

It assumes that the future P/E will be steady. If theexpected growth in earnings fails to materialize, theP/E will fall and investors may incur (large) losses.

13-39

Figure 13.3 Actual P/E Ratiosand Inflation

13-40

Figure 13.4 Earnings Growthfor Two Companies


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13-41

Figure 13.5 Price-Earnings Ratios

13-42

Figure 13.6 P/E Ratios

13-43

Other Comparative ValuationRatios

Price-to-book

High ratio indicates a large premium over book value,

Price-to-cash flow

P/Cash Flow instead of P/E; less subject toaccounting manipulation

Price-to-sales

Useful for firms with low or negative earnings in earlygrowth stage

Be creative

13-44

Figure 13.7 Valuation Ratios for theS&P 500


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13-45

Free Cash Flow Valuation Approach

Capitalize or discount the free cash flow for the firm(FCFF) at the weighted-average cost of capital and thensubtract the existing (market) value of debt

Helpful to understand sources and uses of cash

where:

EBIT = earnings before interest and taxes

Tc = the corporate tax rate

NWC = net working capital

NWCinIncreaseesExpenditurCapitalonDepreciati)TEBIT(1FCFF C

13-46

FCFF, Firm Value & Equity ValueThe free cash flow methods discount year to year cash flowsplus some estimate of the terminal value PT where

WACC = Weighted average cost of capital

g = estimate of long run growth in free cash flow

T = time period when the firm approaches constant growth

Equity value =

gWACC

FCFFP 1TT

T

TT

tt

t

WACC

P

WACC

FCFFValueFirm

)1()1(

1

Firm Value Market Value of Debt

13-47

Free Cash Flow (cont.)

Another approach calculates the free cash flowto the equity holders (FCFE) and discounts thecash flows directly at the cost of equity, kE.

Equity value can then be estimated as:

DebtNetinIncrease)TExpense(1InterestFCFFFCFE C

gk

FCFEP

E

1TT T

E

TT

1tt

E

t

)k1(

P

)k1(

FCFEValuequityE

13-48

FCF Valuation Example


13/14

13-49

Comparing the Valuation Models

In theory free cash flow approaches should provide the sameestimate of intrinsic value as the dividend growth model

In practice the various approaches often differ substantially

Simplifying assumptions are used in all models

The models establish ranges of likely intrinsic value

Using multiple models forces rigorous thinking about theinputs

13-50

13.6 The Aggregate StockMarket

13-51

Earnings Multiplier Approach

1. Forecast corporate profits for the coming period for anindex such as the S&P 500.

2. Derive an estimate for the aggregate P/E ratio using

long-term interest rates

10 year Treasuries

3. Product of the two forecasts is the estimate of the end-of-period level of the market

13-52

Figure 13.8 Earnings Yield of the S&P500 Versus 10-year Treasury Bond Yield


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13-53

Earnings Multiplier Approach2009 Data: Starting S&P500 level = 900

Treasury yield = 3.2%

Implied Earnings Yield = 2.5% + 3.2% = 5.7%

If E/P = 5.7% then P/E = 1 / 0.057 = 17.54

If forecast EPS = $55 what is the expected forecast forthe S&P500 one year later and the % gain or loss?

2.5%spreadTreasuryyr10?P500&SyieldEarningsExpected

7.2%900

900965turnExpectedRe

9655517.54P500&S 1

13-54

Table 13.4 S&P 500 IndexForecasts

finance chapter 13 (suited)

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