Transcript Fundamentals of Investment Management

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Fundamentals of Investment Management
Hirt • Block
Basic Valuation Concepts
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Dividend valuation models
Constant growth
Non-constant growth
Finite/infinite holding period
Earnings valuation models
P/E Ratio based model
Dividend and Earnings model
Other Valuation models
Price to Sales
Price to Dividends
Price to Earnings
Price to Cash flow
Price to Book Value
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1. General Dividend Models
The value of a share of stock is equal to
the present value of an expected stream
of future dividends.
D1
D2
D3
Dn
+
P0 (1+K )1 (1+K )2 +
+.
.
+
3
(1+Ke)
(1+Ke)n
e
e
=
Where P0= Present value of the stock price
Di = Dividend for each year
Ke = Required rate of return (discount rate)
Model assumes that the investor can determine the
dividend for each period and the required rate of return.
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Constant Growth Model
D0(1+g)1 D0 (1+g)2 D0 (1+g)3
D0 (1+g)n
P0= (1+K )1 + (1+K )2 + (1+K )3 + ... + (1+K )n
e
e
e
e
For extremely long time (infinite holding
period) periods, this formula reduces to
P0=
D1
(Ke - g)
if following conditions are met.
1. g is constant
2. Ke > g
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Required Return
K e  R F  b( K m  R F )
( 7  2)
Ke
RF
b
KM
= Required rate of return
= Risk-free rate
= Beta Coefficient
= Expected return for common
stocks in the market
(KM - RF) = Equity risk premium (ERP)
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Table 7-1. Present Value Analysis of ABC Corporation
Present Value
Expected
Factor
Dividend
Year
ke = 12%
g = 8%
2002
3.38
0.893
2003
3.65
0.797
2004
3.94
0.712
2005
4.26
0.636
2006
4.60
0.567
2007
4.97
0.507
2008
5.36
0.452
2009
5.79
0.404
2010
6.26
0.361
2011
6.76
0.322
2012
7.30
0.287
2013
7.88
0.257
2014
8.51
0.229
2015
9.19
0.205
2016
9.93
0.183
2017
10.72
0.163
2018
11.58
0.146
2019
12.51
0.130
2020
13.51
0.116
2021
14.59
0.104
PV of dividends for years 2002-2021
PV of dividends for 2002- infinity
Total Present Value of ABC common stock.
Present Value
of Dividends
3.02
2.91
2.81
2.71
2.61
2.52
2.43
2.34
2.26
2.18
2.10
2.03
1.95
1.87
1.81
1.75
1.69
1.63
1.57
1.52
43.71
40.79
84.50
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A Nonconstant Growth Model
1. Divide time period into intervals of constant dividend
growth
2. Calculate the dividend at the beginning of each
period
3. Calculate the Present Value of each interval of
constant growth
4. Price = Sum of the PVs
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Fundamentals of Investment Management
Figure 7-1. JAYCAR Growth Pattern.
Dividends per share
8%
(years 11 to infinity)
20%
(years 1-10)
1
5
10
15
20
25
30
35
40
45
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Fundamentals of Investment Management
Non-constant growth illustration
Year
Dividend
(20% growth)
PV Factor
(12%)
Present
Value of
Dividends
1
2
1.00
1.20
0.893
0.797
0.89
0.96
:
:
:
:
9
10
4.29
5.15
0.361
0.322
1.55
1.66
12.42
JAYCAR's
Growth
pattern
first
ten
years
P10 = D11 / (Ke - g)
Dividend Year 11 = Div 10 x (1+ growth rate)
= 5.15 ( 1.08) = 5.56
P10 = 5.56 / (12% - 8% ) = 5.56 / .04 = $139
Discount to Present: $139 / .322 = $44.76
P0 = $12.42 + $44.76 = $57.18
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2. Combined Earnings and
Dividend Model
The value of common stock can be viewed as
a dividend stream plus a market price at the
end of the dividend stream.
Earnings-per-share and dividends-per-share
are estimated for some period.
Ending stock price estimated by using longterm PE ratio.
Stock Price = (Present value of dividend flow)
+ Present value of stock price
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Price Earnings Ratio
It indicates the price that investors are willing
to pay for a firm’s earnings.
Published P/E ratios based on today’s price
divided by the latest 12-month earnings.
P/E ratios can be a proxy for risk. The
higher the P/E ratio relative to the market
P/E ratio, the higher the risk.
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Price Earnings Ratio
P/E ratios vary across industries.
P/E ratios are also influenced by the political and
economic conditions, management abilities and
quality of earnings.
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Table 7-2 Johnson & Johnson Combined Dividend and Earnings
Present Value Analysis
Part A: Present Value of Dividends for 5 years
(1)
Estimated
EPS
Growth =
13.61%
Year
2002
2003
2004
2005
2006
$2.20
$2.50
$2.84
$3.23
$3.67
(2)
(3)
Estimated Estimated
Payout
Dividends
ratio
Per Share
36%
36%
36%
36%
36%
$0.79
$0.90
$1.02
$1.16
$1.32
(4)
(5)
Present Value
Factor at
Ke = 10.0%
Present
Value of
Cash Flows
1.000
1.000
1.000
1.000
1.000
0.79
0.90
1.02
1.16
1.32
PV dividends
$3.84
Part B: Present Value of Johnson & Johnson"s 2006 Common Stock Price
2006
EPS
P/E
Price 2006
PV Factor
3.67
22.56
82.8
0.62
51.42
A + B = Present Value of Johnson & Johnson at beginning of 2002$55.20
*Ke = RF + b(KM - RF )
RF = 3.62
b = .85
(KM - RF ) = .75
*Ke = 10.00%
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13 Fundamentals of Investment Management
Table 7-3. P/E and Growth in EPS
(1)
(2)
(3)
(4)
Expected 5-Yr.
Growth in EPS P/E July
Industry
Company
2001-2006
2001
Electric Utility
First Energy
6.5%
11.1
Auto Parts
Genuine Parts
7.5%
13.6
Telecom Services
Bell South
13.5%
16.7
Paper/Forest Products Weyerhouser
13.5%
20.9
Pharmacy Services
Walgreens
17.5%
39.4
Telecom Equipment
Qualcomm
29.0%
52.4
Semiconductors
Intel *
9.0%
51.0
*Intel's P/E is inflated because earnings declined faster than the stock price
and the market expects this high quality technology company to eventually
recover but grow at a slow er rate.
Source: Value Line Investment Survey, selected issues (Value Line Inc.)
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14 Fundamentals of Investment Management
Calculating Value based on relative P/E
Table 7-5
Projected Earnings and Relative
P/E Valuation Model
Johnson &
Johnson's
Expected
P/E
Johnson &
Jonnson's
Estimated
EPS 2000
Johnson &
Johnson's
Value in
2002 Based
on Relative
P/E
Relative
P/E
S&P 500
Current
P/E
Average high P/E
1.09
26.65
29.05
$2.20
$63.91
Average low P/E
0.93
26.65
24.78
2.20
54.52
Average P/E
1.01
26.65
26.92
2.20
59.22
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15 Fundamentals of Investment Management
3 Other Valuation
Models Using Average
A. PRICE to SALES per SHARE
Average
Price
Average
Sales Per
$ 28.11
$
Average
Price
Average
Dividends
Per Share
$ 28.11
$
Average
Price
Average
Earnings
Per Share
$ 28.11
$
8.12
Price to
SPS
Estimated Projected
2002 SPS 2002 Price
3.46 $ 12.55
$ 43.42
B. PRICE to DIVIDENDS per SHARE
0.42
Price to
DPS
Ratio
Estimated Projected
2002
2002
DPS
Price
66.93 $ 0.80
$ 53.54
C. PRICE to EARNINGS per SHARE
1.18
Price to
EPS
Ratio
Estimated Projected
2002
2002
EPS
Price
23.82 $ 2.20
$ 52.40
B. PRICE to CASH FLOW per SHARE
Average
Price
Average
Cash Flow
Per Share
$ 28.11
$
1.59
Price to
Projected
CFPS
Estimated
2002
Ratio 2002 CFPS
Price
17.68 $ 2.90
$ 51.27
E. PRICE to BOOK VALUE per SHARE
Average
Price to
Average Book Value BVPS
Price
Per Share
Ratio
$ 28.11
$
4.44
Estimated Projected
2002
2002
BVPS
Price
6.33 $ 8.55
$ 54.12
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