Transcript Lecture Presentation to accompany Investment Analysis

Security Valuation
Learning Objectives
1. Top-down and Bottom-up Approaches to
Security Valuation
2. Discounted Cash Flow Valuation Approach
3. Dividend Discount Model (DDM) and its
Logic
4. Application of DDM to Value Supernormal
Growth Firms.
5. Application of Relative Valuation Models
1
The Investment Decision Process
• Determine the required rate of return
• Evaluate the investment to determine if its
market price is consistent with your required
rate of return
– Estimate the value based on expected cash flows
and your required rate of return
– Compare this intrinsic value to the market price
• If Intrinsic Value > Market Price, Buy
• If Intrinsic Value < Market Price, Don’t Buy
2
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 importance of economic
and industry influence on individual firms
and stocks
3
Top-down overview of the valuation process
Economic Analysis
Business cycles, government policy, indicators, trade, public
attitudes, legislation, inflation, GDP growth, ect.
Industry Analysis
Structure, supply-demand relationships, quality and cost
elements, gov't. regulation, financial norms
and standards, et. cetera
Company Analysis
Forecasts, balance sheet--income statement
analysis, flow-of-funds analysis,
accounting policy and footnotes,
management,research,
return, risk`
GE
Other stocks
GM, Xerox, Caterpillar, 3M,
Merck, Motorola, Delta, Intel.
Portfolio
management
Portfolio Assets
4
Does the Three-Step Process
Work?
• An analysis of the relationship between
rates of return for the aggregate stock
market, alternative industries, and
individual stocks showed that most of the
changes in rates of return for individual
stock could be explained by changes in the
rates of return for the aggregate stock
market and the stock’s industry
5
Theory of Valuation
• The value of an asset is the present value of
its expected returns
• To convert this stream of returns to a value
for the security, you must discount this
stream at your required rate of return
• This requires estimates of:
– The stream of expected returns, and
– The required rate of return on the
investment
6
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
7
Required Rate of Return
• Determined by
– 1. Economy’s 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
8
Valuation Approaches
Two Approaches to Equity Valuation
Discounted Cash Flow
Techniques
Relative Valuation
Techniques
•Present Value of Dividends (DDM)
•Price/Earnings Ratio (P/E)
•Present Value of Operating Cash Flow
•Price/Cash flow ratio (P/CF)
•Present Value of Free Cash Flow
•Price/Book Value Ratio (P/BV)
•Price/Sales Ratio (P/S)
9
Why and When to Use the 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
10
Why and When to Use the
Relative Valuation Techniques
• Provides information about how the market
is currently valuing stocks
– aggregate market
– alternative industries
– individual stocks within industries
• No guidance as to whether valuations are
appropriate
– best used when have comparable entities
– aggregate market is not at a valuation extreme
11
Discounted Cash-Flow
Valuation Techniques
t n
CFt
Vj  
t
t 1 (1  k )
Where:
Vj = value of stock j
n = life of the asset
CFt = cash flow in period t
k = the discount rate that is equal to the investor’s required rate
of return for asset j, which is determined by the uncertainty
(risk) of the stock’s cash flows
12
The Dividend Discount Model
(DDM)-Infinite Holding Period
The value of a share of common stock is the
present value of all future dividends
D3
D1
D2
D
Vj 


 ... 
2
3
(1  k ) (1  k )
(1  k )
(1  k ) 
n
Dt

t
(
1

k
)
t 1
Where:
Vj = value of common stock j
Dt = dividend during time period t
k = required rate of return on stock j
13
The Dividend Discount Model
(DDM)-Finite Holding Period
If the stock is not held for an infinite period, a
sale at the end of year 2 would imply:
SPj 2
D1
D2
Vj 


2
(1  k ) (1  k )
(1  k ) 2
Selling price at the end of year two is the
value of all remaining dividend payments,
which is simply an extension of the original
equation
14
The Dividend Discount Model
(DDM)-Constant Growth Rate
Infinite period model assumes a constant
growth rate for estimating future
dividends
2
D0 (1  g ) D0 (1  g )
D0 (1  g )
Vj 

 ... 
2
(1  k )
(1  k )
(1  k ) n
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
15
n
The Dividend Discount Model
(DDM)-Constant Growth Rate
Infinite period model can be reduced to:
D1
Vj 
kg
Where D1 is the expected dividend, defined as
D1= D0 (1+g)
1. Estimate the required rate of return (k)
2. Estimate the dividend growth rate (g)
16
The Dividend Discount Model
(DDM)-Constant Growth Rate
Assumptions of DDM:
1. Dividends grow at a constant rate
2. The constant growth rate will continue for
an infinite period
3. The required rate of return (k) is greater
than the infinite growth rate (g)
17
Required Rate of Return (k)
•
•
•
•
Three factors influence an investor’s required
rate of return:
The economy’s real risk-free rate (RRFR)
The expected rate of inflation (I)
A risk premium (RP)
How to estimate k:
K= Rf +  (Rm – Rf)
K= Bond yield+ERP
18
Expected Growth Rate of Dividends
ROE Based
• Determined by
– the growth of earnings
– the proportion of earnings paid in dividends
• In the short run, dividends can grow at a different
rate than earnings due to changes in the payout
ratio
• Earnings growth is also affected by compounding
of earnings retention
g = (Retention Rate) x (Return on Equity)
= RR x ROE
19
Estimating Growth Based on History
• Historical growth rates of sales, earnings, cash
flow, and dividends
• Three techniques
1. arithmetic or geometric average of annual
percentage changes
2. linear regression models
3. long-linear regression models
• All three use time-series plot of data
20
How to Calculate g
Year
1
2
3
4
g
Historical
ROE and Payout
Dividend
g = (1-Payout) x ROE
$1.38
= (1 - .50) x .16 = 8%
1.49
1.67
Average of two methods = 8%
1.75
= 8%
21
Infinite Period DDM
and Growth Companies
Growth companies have opportunities to earn
return on investments greater than their
required rates of return
To exploit these opportunities, these firms
generally retain a high percentage of earnings
for reinvestment, and their earnings grow
faster than those of a typical firm
This is inconsistent with the infinite period
DDM assumptions
22
Valuation with Supernormal Growth
Example: The last dividend paid (D0) was
$2.00. The required rate of return is 14
percent. The dividends are expected to grow
at the following rates. What is the value of
this stock?
Year
1-3:
4-6:
7-9:
10 on:
dividend
25%
20%
15%
9%
23
Computation of Value for Stock of Company
with Supernormal Growth
Year
Dividend
1
2
3
4
5
6
7
8
9
10
$
2.50
3.13
3.91
4.69
5.63
6.76
7.77
8.94
10.28
11.21
$ 224.20
Discount
Present
Growth
Factor
Value
Rate
0.8772
0.7695
0.6750
0.5921
0.5194
0.4556
0.3996
0.3506
0.3075
a
0.3075
$
$
$
$
$
$
$
$
$
b
2.193
2.408
2.639
2.777
2.924
3.080
3.105
3.134
3.161
25%
25%
25%
20%
20%
20%
15%
15%
15%
9%
$ 68.943
$ 94.365
a
Value of dividend stream for year 10 and all future dividends, that is
$11.21/(0.14 - 0.09) = $224.20
b
The 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.
24
Operating Cash Flow Model
• Derive the value of the total firm by
discounting the total operating cash flows
prior to the payment of interest to the debtholders
• Then subtract the value of debt to arrive at
an estimate of the value of the equity
25
Operating Cash Flow Model
t n
OCFt
Vj  
t
t 1 (1  WACC j )
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 j’s weighted average cost of capital
26
Operating Cash Flow Model
Similar to DDM, this model can be used to
estimate an infinite period
Where growth has matured to a stable rate, the
adaptation is
Where:
OCF1
Vj 
WACC j  g OCF
OCF1=operating cash flow in period 1
gOCF = long-term constant growth of operating free cash
flow
27
Operating Cash Flow Model
• Assuming several different rates of growth
for OCF, these estimates can be divided into
stages as with the supernormal dividend
growth model
• Estimate the rate of growth and the duration
of growth for each period
28
Present Value of
Free Cash Flows to Equity
• “Free” cash flows to equity are derived after
operating cash flows have been adjusted for
debt payments (interest and principle)
• The discount rate used is the firm’s cost of
equity (k) rather than WACC
29
Present Value of
Free Cash Flows to Equity
n
FCFt
Vj  
t
(
1

k
)
t

1
j
Where:
Vj = Value of the stock of firm j
n = number of periods assumed to be infinite
FCFt = the firm’s free cash flow in period t
K j = the cost of equity
30
Free Cash Flow to Equity Model
FCFE = NI + Depreciation – Capital Expenditure
- Working Capital – Principal Repayment +
New Debt Issues.
If capital expenditures and working capital is
expected to be financed at the target debt ratio
() and principal repayment are made from new
debt issues, FCFE can be written as:
FCFE = NI + (1- ) (Capital Expenditure Depreciation) + (1- ) Working Capital.
31
Free Cash Flow to Equity Model
FCF is a measure of what firm can payout as
dividend. Dividend can be greater than or less than
FCF and is influenced by:
• Desire for stability
• Future Investment Needs
• Signaling Affect.
P0 = EFCE ; All assumptions about dividend
(K – g) valuation model apply.
32
Relative Valuation Techniques
• Value can be determined by comparing to similar
stocks based on relative ratios
• Relevant variables include:
•
•
•
•
Price/earnings
Cash flow
Book value
Sales
• The most popular relative valuation technique is
based on price to earnings
33
Earnings Multiplier Model
The infinite-period dividend discount model
indicates the variables that should determine the
value of the P/E ratio
D1
Pi 
kg
Dividing both sides by expected earnings during
the next 12 months (E1)
Pi
D1 / E1

E1
kg
34
Earnings Multiplier Model
As an example, assume:
–
–
–
–
Dividend payout = 50%
Required return = 12%
Expected growth = 8%
D/E = .50; k = .12; g=.08
.50
P/E 
 12.5
.12 - .08
35
Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
D/E = .50; k=.13; g=.08
P/E = 10
D/E = .50; k=.12; g=.09
P/E = 16.7
D/E = .50; k=.11; g=.09
P/E = 25
Pi
D1 / E1

E1
kg
36
How to Estimate EPS
Estimated EPS = Net Income
# Shares Outstanding
• EPS can also be derived:
• EPS = ROE * Book value per share
• EPS = NI * E
=
NI
E
Shares
Shares
Where ROE= Profit Margin * Total
Asset Turnover * Equity Multiplier
37
Earnings Multiplier Model
Given current earnings of $2.00 and growth of
9%
You would expect E1 to be $2.18
D/E = .50; k=.12; g=.09
P/E = 16.7
V = 16.7 x $2.18 = $36.41
Compare this estimated value to market price
to decide if you should invest in it
38
The Price-Sales Ratio
• Strong, consistent growth rate is a
requirement of a growth company
• Sales is subject to less manipulation than
other financial data
39
The Price-Sales Ratio
• Match the stock price with recent annual
sales, or future sales per share
• This ratio varies dramatically by industry
• Profit margins also vary by industry
• Relative comparisons using P/S ratio should
be between firms in similar industries
• Average stock price should encompass a
long lime period
40
The Price-Sales Model
• Price-to-Sales Model (10 year Average Price
Ratios are assumed)
• Average Price/Average Sales Per Share
• $19.41/14.55=1.33 Price to sales ratio
• Vt = P/S ratio*Estimated SPS(t+1)
=1.33*$24.65=$32.78
41
The Price-Cash Flow Ratio
• Companies can manipulate earnings
• Cash-flow is less prone to manipulation
• Cash-flow is important for fundamental valuation
and in credit analysis
– Price-to-Cash Flow Model
• Average Price/Average Cash Flow Per
Share
• $19.41/1.37=14.17 Cash flow per share
ratio
• Vt = P/CF*Estimated CFPS (t+1)
• Vt = 14.17 * $2.41 = $34.15
42
The Price-Book Value Ratio
Price-to-Book Value Model
• Average Price/Average book value per
share
• $19.41/6.01=3.23 price to book value
ratio
• Vt = P/BV*Estimated BVPS(t+1)
• Vt = 3.23* $10.5 = $33.91
43
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 of stocks
44
The Price-Book Value Model
• Price to Book Value Ratio
• 1. Po= DPS1
(K-g) *where DPS1=EPS(1+g)*payout ratio
• 2. Po= EPSo * Payout * (1+g)
(K-g)
- where EPS=equity/#shares *
NI/equity=BV*ROE
• 3. Po= BVo * ROE * Payout * (1+g)
(K-g)
45
Investment Valuation Models
• 4. Po = PBV=
BVo
ROE * Payout * (1+g)
(K-g)
- i. if ROE depends on expected earnings, or
- ii. If payout ratio remains constant 4 becomes 5
• 5. P0 = PBV =
BVo
ROE * Payout
(K-g)
- The relationship of:
- PBV increase ROE increase
- PBV increase  Payout increase
- PBV increase g increase
- PBV decrease K increase
46
Investment Valuation Models
• Formula can be simplified
g = ROE (1-payout)
ROE*Payout = ROE - g
PBV=(ROE-g) / (k-g)
Implications:
• A) ROE>kP>BV; ROE<kP<BV;
ROE=kP=BV
• B) PBV decreases if k increases.
• C) Larger (R-k) greater PBV
47