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Equity Valuation 13 Bodie, Kane and Marcus Essentials of Investments 9th Global Edition 13.1 EQUITY VALUATION Book Value Net worth of common equity according to a firm’s balance sheet Limitations of Book Value Liquidation value: Net amount realized by selling assets of firm and paying off debt Replacement cost: Cost to replace firm’s assets Tobin’s q: Ratio of firm’s market value to replacement cost TABLE 13.1 MICROSOFT FINANCIAL HIGHLIGHTS, JAN 2012 Price per share Common shares outstanding (billion) Market capitalization ($ billion) Latest 12 Months Sales ($ billion) EBITDA ($ billion) Net income ($ billion) Earnings per share Valuation P/E ratio Price/Book Price/Sales Price/Cash flow PEG Profitability ROE (%) ROA (%) Operating profit margin (%) Net profit margin (%) $28.25 8.41 237.6 71.12 30.15 23.48 $2.75 Microsoft 10.3 4.0 3.3 13.9 1.1 44.16 17.33 38.78 33.01 Industry Avg 17.5 10.5 2.7 20.5 1.2 24.9 8.58 23.2 13.2 INTRINSIC VALUE VERSUS MARKET PRICE = expected dividend per share = current share price = expected end-of-year price 13.2 INTRINSIC VALUE VERSUS MARKET PRICE Intrinsic Value Present value of firm’s expected future net cash flows discounted by required RoR Market Capitalization Rate Market-consensus estimate of appropriate discount rate for firm’s cash flows 13.2 INTRINSIC VALUE VERSUS MARKET PRICE • 13.3 DIVIDEND DISCOUNT MODELS • 13.3 DIVIDEND DISCOUNT MODELS • 13.3 DIVIDEND DISCOUNT MODELS • 13.3 DIVIDEND DISCOUNT MODELS 13.3 DIVIDEND DISCOUNT MODELS Life Cycles and Multistage Growth Models Two-stage DDM DDM in which dividend growth assumed to level off only at future date Multistage Growth Models Allow dividends per share to grow at several different rates as firm matures 13.4 PRICE-EARNINGS RATIOS • 13.4 PRICE-EARNINGS RATIOS P/E Ratios 25 20 15 NBK KFH 10 Zain 5 0 1998 2000 2002 2004 2006 2008 13.4 PRICE-EARNINGS RATIOS Growth Rate 40% 35% 30% 25% 20% NBK 15% KFH 10% Zain 5% 0% 2000 -5% -10% -15% 2001 2002 2003 2004 2005 2006 2007 13.4 PRICE-EARNINGS RATIOS • TABLE 13.3 EFFECT OF ROE AND PLOWBACK ON GROWTH AND P/E RATIO 13.4 PRICE-EARNINGS RATIOS The P/E ratio of any company that’s fairly priced will equal its growth rate. I’m talking here about growth rate of earnings…if the the P/E ratio of Coca-Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain. 13.4 PRICE-EARNINGS RATIOS • FIGURE 13.3 P/E RATIO OF S&P 500 AND INFLATION 60 P/E ratio Inflation rate 50 40 30 20 10 0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 13.4 PRICE-EARNINGS RATIOS Pitfalls in P/E Analysis Earnings Management Practice of using flexibility in accounting rules to improve apparent profitability of firm Large amount of discretion in managing earnings FIGURE 13.6 P/E RATIOS Aerospace/defense Integrated oil & gas Money center banks Health care plans Computer systems Telecom services Industrial metals Electric utilities Home improvement Pharmaceuticals Chemical products Application software Asset management Food products Restaurants Auto manufacturers Trucking Heavy construction Business software Biotech 8.5 10.2 11.0 11.8 13.2 14.7 14.9 15.6 16.5 17.2 17.4 17.5 17.5 21.1 21.4 25.3 28.0 32.4 34.7 57.8 0 10 20 30 P/E ratio 40 50 60 P/E as of end of 2012 30 25 20 15 10 5 0 13.4 PRICE-EARNINGS RATIOS Combining P/E Analysis and the DDM Estimates stock price at horizon date Other Comparative Valuation Ratios Price-to-book: Indicates how aggressively market values firm Price-to-cash-flow: Cash flow less affected by accounting decisions than earnings Price-to-sales: For start-ups with no earnings Creative ratios FIGURE 13.7 VALUATION RATIOS FOR S&P 500 13.5 FREE CASH FLOW VALUATION APPROACHES • 13.5 FREE CASH FLOW VALUATION APPROACHES • 13.5 FREE CASH FLOW VALUATION APPROACHES • 13.5 FREE CASH FLOW VALUATION APPROACHES • 13.5 FREE CASH FLOW VALUATION APPROACHES Comparing Valuation Models Model values differ in practice Differences stem from simplifying assumptions Problems with DCF Models DCF estimates are always somewhat imprecise Investors employ hierarchy of valuation Real estate, plant, equipment Economic profit on assets in place Growth opportunities 13.6 THE AGGREGATE STOCK MARKET Forecasting Aggregate Stock Market Earnings multiplier applied at aggregate level Forecast corporate profits for period Derive estimate of aggregate P/E ratio based on long-term interest rates Some analysts use aggregate DDM FIGURE 13.8 EARNINGS YIELD OF S&P 500 VERSUS 10-YEAR TREASURY BOND YIELD 16% Treasury yield Earnings yield 14% 12% 10% 8% 6% 4% 2% 0% 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 TABLE 13.4 S&P 500 FORECASTS Pessimistic Most Likely Scenario Scenario Optimistic Scenario Treasury bond yield 3.6% 3.1% 2.6% Earnings yield 6.5% 6.0% 5.5% Resulting P/E ratio 15.4 16.7 18.2 93 93 93 1431 1550 1691 EPS forecast Forecast for S&P 500