Equity Valuation
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Transcript Equity Valuation
Equity Valuation
Basic Types of Models
• Balance sheet models
• Dividend discount models
• EPS (cashflow) discount models
Modeling Framework
• Deterministicdynamics
• Stochastic dynamics
Fair Value vs Market Price
Fair Value
• Self assigned Value
• Variety of models are used for estimation
Market Price
• Consensus value assessment by all market participants
Trading Signal
• FV > MP:
• FV < MP:
• FV = MP:
Buy
Sell or Short Sell
Hold or Fairly Priced
Dividend Discount Models
Dt
Vo
t
t 1 (1 k )
V0 = Value of Stock
Dt = Dividend
k = required return
No Growth Model
D
Vo
k
Where the stock has earnings and dividends that are
expected to remain constant foreever.
Example: Preferred Stock
No Growth Model: Example
D
Vo
k
E1 = D1 = $5.00
k = .15
Then, V0 = $5.00 / .15 = $33.33
Constant Growth Model
Do (1 g )
Vo
kg
g = constant perpetual growth rate
Constant Growth Model: Example
Do (1 g )
Vo
kg
E1 = $5.00
b = 40%
(1-b) = 60%
k = 15%
D1 = $3.00
g = 8%
(b: EPS retention ratio)
V0 = 3.00 / (.15 - .08) = $42.86
Estimating Dividend Growth Rates
g ROE b
g = growth rate in dividends
ROE = Return on Equity for the firm
b = EPS retention rate (1- dividend payout ratio)
Partitioning Value: Growth and No Growth Components
E1
Vo
PVGO
k
Do (1 g )
E1
PVGO
(k g)
k
PVGO = Present Value of Growth Opportunities
E1 = Earnings Per Share for period 1
Partitioning Value: Example
ROE = 20%
b = 40%
E1 = $5.00
D1 = $3.00
g = .20 x .40 = .08
or 8%
k = 15%
Partitioning Value: Example
3
Vo
$42.86
(.15.08)
5
NGVo
$33.33
.15
PVGO $42.86 $33.33 $9.52
• Vo = value with growth
• NGVo = no growth component value
• PVGO = Present Value of Growth Opportunities
Multi-Period Dividend-Discount Model
P
D
D
D
...
V
(1 k ) (1 k )
(1 k )
1
0
N
2
1
2
PN = expected sales price of stock at time N
N = number of years the stock is to be held
N
N
Practical Difficulties with DDM
Some firms do not pay dividends
Can you forecast future dividends?
Can you predict the terminal liquidation
value Pn ?
What about the discount rate k?
(perhaps, the CAPM? The APT?)
Multi-Period Earnings-Discount Model
(1 b) E N P N
(1 b) E1 (1 b) E 2
...
V0
(1 k )1
(1 k ) 2
(1 k ) N
PN = expected sales price of stock at time N
N = number of years the stock is to be held
Practical Concerns with EDM
EPS forecasts are available from I/B/E/S,
First Call, Zacks, ….
Dividend payout ratio (1-b) can be
estimated, either based on cash dividend or dividendin-kind
But, what about Pn
and k?
P/E Ratios
P0
d
E
k g
d: dividend payout ratio
k: cost-of-capital (or, risk-adjusted discount rate)
g: EPS growth rate
P/E Example
k = 12.5%
Thus,
g = 9%
d = 40%
P/E = (1 - .60) / (.125 - .09) = 11.4
If E = $2.73, we have
P = 11.4 X 2.73 =$31.14
Problems with P/E Ratios
What is
E?
• E = trailing 12-month EPS?
• E = 12-month-forward EPS?
What is
g?
• g = average historical EPS growth?
• g = expected next-yr EPS growth?
• g = long-run EPS growth?