Transcript Slide 1

Management 183
Financial Markets
Equity Valuation
The Valuation Model
• Approach
a) Cost
b) Income
c) Market
• Method
a) De Novo or M&A
b) Revenues, Earnings, Cash flows
c) Comparables
Concepts of Value
• Book Value
• Market value
• Liquidation Value
• Fair Market Value, Intrinsic Value
a) Market Value - given a thorough appreciation of
the Company, its prospects, and the market
b) Look for mispricing
c) Alpha = E(HPR) less Market RRR
The Valuation Process
Some similarities w/ Bond Valuation but several
challenging differences
• Similarity:
Intrinsic value - the PV of its expected CFs
discounted at the appropriate RADR
• Differences:
Market value – a comparables approach.
Intrinsic Valuation
• Forecast Earnings and Cash Flows
a) Growth rates
b) Dividend payout rate
• Model Selection
• Discount Rate
a) Exogenous or endogenous considerations
• Conclusion & Recommendation
a) Under or over Valued: Buy, Sell, Hold
Intrinsic Valuation Models
• Intrinsic Value: the present value of a the
future cash flows that will accrue to the owner
of the asset.
– Return on a stock investment is comprised of
cash dividends and capital gains or losses.
– Factors in valuing equities
• Magnitude of the cash flows
• Timing of those future cash flows
• Proper discount rate
Intrinsic Valuation Methods
• Dividend Discount Models (DDM): General
Model

V0  
t 1
Dt
t
(1  k )
• V0 = Intrinsic value of Stock
• Dt = Dividend
• k = required return
Intrinsic Valuation Methods
• Simplified versions of the DDM:
– Assume a resale price criterion:
D
D


V
(1 k ) (1 k )
1
0
1
P
D
... 
(1 k )
N
2
2
N
N
• PN = the expected sales price for the stock at time N
• N = the specified number of years the stock is
expected to be held
Intrinsic Valuation Methods
• Gordon’s constant growth model
D0  1  g 
D
 1
kg
kg
where D0 is thecurrentdividend
V0 
D1 is thedividend to be paid next year
g is theexpecteddividend growth rate
k is thediscount factoraccordingto
theriskinessof thestock
• The model assumes that the dividend stream is
perpetual and that the long-term growth rate is
constant.
Intrinsic Valuation Methods
– Example:
If a common stock is expected to pay a dividend
of $3.00 next year, has a long term growth rate
of 5%, and should be priced to provide a return
of 15%, it is worth:
D1
V0 

kg
$3
0 .1 5  0 .0 5
 $ 30
Intrinsic Valuation Methods
• The Gordon growth model can also be used to
get an idea of how risky the market thinks a
particular stock is at that moment or
shareholders’ required rate of return.
– Use the current price as the P0 and solve for k.
D0  1  g 
k
g
P0
Intrinsic Valuation Methods
– Shifting Growth Rate Model or Multistage DDM
T
V0  D0 
t 1
• g1
• g2
•T
(1  g 1 ) t
D T (1  g 2 )

t
(1  k )
( k  g 2 )(1  k ) T
= first growth rate
= second growth rate
= number of periods of growth at g1
Intrinsic Valuation Methods
• Advantages of DDM
– Simplicity
• Disadvantages of DDM
– Apply only to dividend paying stocks.
– Risk is not an explicit variable.
– Estimates of discount rate and growth rate may be
in error.
– Small changes in discount rate and growth rate
produce large differences in valuation.
– Models do not reflect the value of underutilized
assets.
Models
• Dividend Discount Model
• D.C.F.
• C.A.P.M.
Discount Rates
• Build-up Method
a) Risk-free Rate +
b) Equity risk premium +
c) Company risk premium
• P/E implied
• C.A.P.M.
a) Risk-free Rate +
b) Non-systematic risk premium
Market Value
• TOP DOWN: Economy, Sector, Industry
• Inherent sector and industry profitability
• Industry structure:
a) Market share, Cost leadership, Pricing power
b) Product differentiation versus product focus
• Ratio Analysis and Valuation Multiples
• Conclusion & Recommendation
a) Under or over Valued: Buy, Sell, Hold
Economy, Sector, Market, Company
• Inherent sector and industry profitability
• Industry structure
• Company’s relative competitive position
a) Market share
b) Cost leadership
c) Pricing power
d) Product differentiation versus product focus
DJIA annual Returns since 2003
2003
8341.63
10453.92
2112.29
25.32%
2004
10453.92
10783.01
329.09
3.15%
2005
10783.01
10717.50
-65.51
-0.61%
2006
10717.50
12463.15
1745.65
16.29%
2007
12463.15
13264.82
801.67
6.43%
2008
13264.82
8776.39
-4488.43
-33.84%
2009
8776.39
10428.05
1651.66
18.82%
2010
10428.05
11577.51
1149.46
11.02%
2011
11577.51
12217.56
640.05
5.53%
2012
12217.56
13104.14
886.58
7.26%
Average
Standard Deviation
5.95%
16.02%
Forecasting
• Top-down forecast
a) Economy-Sector-Industry-Company
b) Financial forecast
c) Financial Statement Analysis: revenues &
expenses
d) From profits to cash flows, esp. Free Cash Flows
e) Costs, prices, and the Product life cycle
• Value Stocks and Growth Stocks: How to Tell by
Looking.
– No precise definition exists.
– Low Price-to-Book for Value
– High Price-to-Earnings for Growth
Price to Book Ratio
• The price-to-book ratio is computed by dividing
the current stock price by the firm’s book value
per share.
– Book value per share is an accounting concept
synonymous with equity per share or net asset
value.
– Share price is not normally equal to book value
because of
• depreciation, uncollectible debts, goodwill, etc.
• economic obsolescence
• intangible assets
Price to Earning Ratio
• The price-earnings ratio (PE) is computed by
dividing the current stock price by the firm’s
earnings per share.
– Trailing PE
– Forward PE
– Growth stocks tend to have higher PE ratios than
average
Price to Earning Ratio
• The price-earnings ratio (PE) is computed by
dividing the current stock price by the firm’s
earnings per share.
– Trailing PE
– Forward PE
– Growth stocks tend to have higher PE ratios than
average
Price to Earning’s Growth
– The P/E ratio divided by the company’s growth
rate of its earnings for a specified time period.
P/E ratio ÷ Annual EPS Growth
– The PEG ratio brings the earnings growth rate
into the valuation process.
– A more complete picture than the P/E ratio
because, while a high P/E ratio may make
indicate the attractiveness of a stock, by
factoring in the company's growth rate can tell a
different story.
– The lower the PEG ratio, the more the stock may
be undervalued given its earnings performance.
Price to Earning’s Growth
– A broad rule of thumb is that a PEG ratio below
one is desirable.
– Why?
– Interpretive value is sensitive to inputs used.
Using historical growth rates, for example, may
provide an inaccurate PEG ratio if future growth
rates are expected to deviate from historical
growth rates.
Distinguish between future growth and
historical growth by using "forward PEG" and
"trailing PEG" are sometimes used.
Price to Earning’s Growth
Example - Calculating the PEG
Let\'s look at two hypothetical stocks to see how the PEG
ratio is calculated:
ABC Industries has a P/E of 20 times earnings. The
consensus of all the analysts covering the stock is that ABC
has an anticipated earnings growth of 12% over the next five
years.
20 (x times earnings) / 12 (n % anticipated earnings
growth) = 20/12 = 1.66
XYZ Micro is a young company with a P/E of 30 times
earnings. Analysts conclude that the company has an
anticipated earnings growth of 40% over the next five years.
30 (x times earnings) / 40 (n % anticipated earnings
growth) = 30/40 = 0.75
Insert Figure 7-3 here.
Analytical Factors: Growth Rates
• Choosing a Growth Rate
– Financial analysts typically calculate a number of
growth rates using different ways to determine a
likely range for the statistic.
– Recent data may be more reliable than data from
the more distant past.
– Company statements regarding company targets
may be considered too.
– Other analysts – Zacks, First Call and I/B/E/S
– Whisper Number -- thewhispernumber.com
Other Valuation Methods
• Price Earnings Ratio: The ratio of a firm’s stock
price to its earnings per share.
• Price-to-book value ratios
• Price-to-Cash Flow Ratios
• Price-to-Sales
Beta
• Beta is the volatility, or risk, of a particular stock
relative to the volatility of the entire stock
market.
• Beta is an indicator of how risky a particular
stock is and it is used to evaluate its expected
rate of return.
• Beta is one of the fundamentals that stock
analysts consider when choosing stocks for their
portfolios, along with price-to-earnings ratio,
shareholder's equity, debt-to-equity ratio, and
other factors.
Beta
• The beta of the market is by definition 1.0.
• A beta of less than 1 means that the stock is less
volatile than the market as a whole, while
• A beta greater than 1 means the stock is more
volatile than the market as a whole.
• The beta value can be less than zero, meaning
either that the stock is losing money while the
market as a whole is gaining (more likely) or
that the stock is gaining while the market as a
whole is losing money (less likely).
Beta
• Look at the time frame chosen for calculating
beta.
• Provided betas are calculated with time frames
unknown to their consumers.
• Long-term investors will certainly want to gauge
the risk over a longer time period than a
position trader who turns over his or her
portfolio every few months.
Beta
• Another problem may be the index used to
calculate beta.
• Most provided betas use the American standard
of the S&P 500 Index.
• If your portfolio contains equities that extend
beyond U.S. borders, like a company that is
based and operated in China, the S&P 500 may
not be the best measure of the market.
• By calculating your own beta you can adjust for
these differences and create a more
encompassing view of risk.
Adjusted Closing Price
• Adjusted Closing Price The adjusted closing
price is a useful tool when examining historical
returns because it gives analysts an accurate
representation of the firm's equity value beyond
the simple market price. It accounts for all
corporate actions such as stock splits,
dividends/distributions and rights