Transcript No Slide Title

Chapter 13
Equity Valuation
13-1
Fundamental Stock Analysis:
Models of Equity Valuation
• Basic Types of Models
– Balance Sheet Models
– Dividend Discount Models
– Price/Earnings Ratios
– Free Cash Flow Models
13-2
Models of Equity Valuation
• Valuation models using comparables
– Look at the relationship between price and
various determinants of value for similar firms
• The internet provides a convenient way to
access firm data. Some examples are:
– EDGAR
– Finance.yahoo.com
13-3
Table 13.1 Microsoft Corporation
Financial Highlights 2009
13-4
Valuation Methods
• Book value
– Value of common equity on the balance sheet
– Based on historical values of assets and
liabilities, which may not reflect current values
– Some assets such as brand name or
specialized skills are not on a balance sheet
– Is book value a floor value for market value of
equity?
13-5
Valuation Methods
• Market value
– Current market value of assets minus current
market value of liabilities
• Market value of assets may be difficult to ascertain
– Market value based on stock price
– Better measure than book value of the worth
of the stock to the investor.
13-6
Valuation Methods (Other
Measures)
• Liquidation value
– Net amount realized from sale of assets and
paying off all debt
– Firm becomes a takeover target if market
value stock falls below this amount, so
liquidation value may serve as floor to value
13-7
Valuation Methods (Other
Measures)
• Replacement cost
– Replacement cost of the assets less the
liabilities
– May put a ceiling on market value in the long
run because values above replacement cost
will attract new entrants into the market.
– Tobin’s Q = Market Value / Replacement
Cost; should tend toward 1 over time.
13-8
13.2 Intrinsic Value Versus Market
Price
13-9
Required Return
• CAPM gave us required
return, call it k:
• k = market capitalization
rate
• If the stock is priced
correctly
– Required return should
=
equal expected return
k  rf    E (rM )  rf 
k  rf    E (rM )  rf 
Expected HPR= E (r ) 
E ( D1 )   E ( P1 )  P0

P0
13-10
Intrinsic Value
Intrinsic Value
• The present value of a firm’s expected future net cash
flows discounted by a risk adjusted required rate of
return.
• The cash flows on a stock are?
E(D1 )  E(P1 )
– Dividends (Dt)
V0 
1 k
– Sale price (Pt)
• Intrinsic Value today (time 0) is denoted V0 and for a one
year holding period may be found as:
13-11
Intrinsic Value and Market Price
• Market Price
– Consensus value of all traders
– In equilibrium the current market price will
equal intrinsic value
•
Buy
Trading Signals
Sell or Short Sell
– If V0 > P0
Hold as it is Fairly Priced
– If V0 < P0
– If V0 = P0
13-12
No Growth Model
• Use: Stocks that have earnings and
dividends that are expected to remain
constant over time (zero growth)
D
V0 
k
– Preferred Stock
• A preferred stock pays a $2.00 per share dividend
and the stock has a required return of 10%. What
is the most you should be willing to pay for the
stock?
$2.00
V0 
0.10
 $20.00
13-13
Constant Growth Model
• Use: Stocks that have earnings and dividends
that are expected to grow at a constant rate
forever
D0  (1  g )
V0 
; g  pe rpe tualgrowthratein divide nds
k -g
• A common stock share just paid a $2.00 per
share dividend and the stock has a required
return of 10%. Dividends are expected to grow
at 6% per year forever. What is the most you
should be willing to pay for the stock?
$2.00  1.06
V0 
 $53.00
0.10 - 0.06
13-14
Comparing Value and Returns
• Why do you have to pay more for the
constant growth stock?
– Must pay for expected growth
• What is the one year rate of return for
each stock?
No Growth Stock
V0 = $20.00
D = $2.00
V1 = $2.00 / 0.10 = $20.00
k
$20  $20  $2
 10%
$20
Constant Growth Stock
V0 = $53.00; D0 = $2.00
$2.00  1.062
V1 
 $56.18
0.10 - 0.06
k
$56.18  $53  $2.12
 10%
$53
13-15
Comparing Value and Returns
• Both stocks given an investor a pre-tax
return of 10%.
• Is one stock a better buy than the other?
– Not if both are actually priced at their intrinsic
value (ignoring taxes).
13-16
Stock Prices and Investment
Opportunities
• g = growth rate in dividends is a function of
two variables:
– ROE = Return on Equity for the firm
– b = plowback or retention percentage rate
• (1- dividend payout percentage rate)
g  ROE  b
• g increases if a firm increases its retention
ratio and/or its ROE
13-17
Value of Growth Opportunities
Value with 100% dividend payout
Cash Cow, Inc. (CC)
E1 = $5
D1 = $5
b = 0 ; therefore g = 0
k = 12.5% ; Find VCC
VCC 
$5.00
 $40
0.125
ROE = 12.5%
g  ROE  b
Growth Prospects
$5.00
(GP)
V 
 $40
0.125
E1 = $5
D1 = $5
b = 0; therefore g = 0
k = 12.5%, Find VGP
ROE = 15%
GP
Should either or both firms retain some earnings?
13-18
Value of Growth Opportunities
Value with 40% dividend payout
Cash Cow, Inc. (CC)
E1 = $5
7.5%
b = 60%; therefore g
D1 = 0.40 x $5 = $2.00
k = 12.5%; Find VCC
ROE = 12.5%
CC value is the same,
why?
VCC 
2.00
 $40
0.125 - 0.075
g  ROE  b
Growth Prospects (GP)
E1 = $5
b = 60%; therefore g = 9%
D1 = 0.40 x $5 = $2.00
k = 12.5%; Find VGP
ROE = 15%
GP Value has increased,
why?
VGP 
$2.00
 $57.14
0.125 - 0.09
13-19
Value of Growth Opportunities
Value of assets in place for GP = $40.00 (value with all
dividends paid out, with ROE = 12.5%)
Value of growth opportunities with ROE = 15% may be
inferred from the difference between the new VGP =
$57.14 and the no growth value of $40.00
Thus the present value of growth opportunities
(PVGO) = $57.14 - $40.00 = $17.14
D0 (1  g ) E1
In general: PVGO 

(k  g )
k
13-20
P/E Ratio and Growth
Opportunities
• P/E Ratios are a function of two factors
– Required Rates of Return (k) (inverse relationship)
– Expected Growth in Dividends (direct relationship)
• Uses
– Estimate intrinsic value of stocks
• Conceptually equivalent to the constant growth
DDM
– Extensively used by analysts and investors
13-21
P/E, ROE and Growth
With positive growth:
P0 (1  b)

E1 k  g
g  ROE  b
Are the elements of the P/E
ratio similar to the constant
growth DDM?
P0 1

E1 k
With zero growth:
If g = 0 then b should = 0 and the ratio
simplifies to:
13-22
Numerical Example: No Growth
• E1 = $2.50
and V0
g=0
k = 12.5%; Find P/E
• P/E = 1/k = 1/.125 = 8
• V0 = P/E x E1 = 8 x $2.50 = $20.00
13-23
Numerical Example with Growth
• b = 60% ROE = 15%; k = 12.5% (1-b) = 40%,
E0 = $2.50
• Find the P/E and V0:
• g = ROE x b = 15% x 60% = 9%
• E1 = $2.50 (1.09) = $2.725
• P/E = (1 - .60) / (.125 - .09) = 11.4
• V0 = P/E x E1 = 11.4 x $2.73 = $31.14
13-24
P/E Ratios and Stock Risk
P0 (1  b)

E1 k  g
• Riskier firms will have higher required
rates of return (higher values of k)
• Riskier stocks will have lower P/E
multiples
13-25
Pitfalls in Using P/E Ratios
• Earnings management is a serious problem,
• P/E should be calculated using pro forma
earnings,
• A high P/E implies high expected growth, but not
necessarily high stock returns,
• Simplistic, assumes the future P/E will not be
lower than the current P/E. If expected growth in
earnings fails to materialize the P/E will fall and
investors may incur large losses.
13-26
Figure 13.3-7
13-27
Other Comparative Valuation
Ratios
• Price-to-book
– High ratio indicates a large premium over book value,
and a ‘floor’ value that is often far below market price
• Price-to-cash flow
– P/Cash Flow instead of P/E; less subject to
accounting manipulation
• Price-to-sales
– Useful for firms with low or negative earnings in early
growth stage
• Be creative
13-28
13.5 Free Cash Flow Valuation
Approaches

13-29
Free Cash Flow
• Capitalize or discount the free cash flow for the firm
(FCFF) at the weighted-average cost of capital and then
subtract the existing (market) value of debt
– Useful for firms that don’t pay dividends,
– Helpful to understand sources and uses of cash
FCFF  EBIT(1  TC )  Depreciation  Capital Expenditures  Increase in NWC
– where:
• EBIT = earnings before interest and taxes
• Tc = the corporate tax rate
• NWC = net working capital
13-30
FCFF, Firm Value & Equity
Value
The free cash flow methods discount year to year cash
flows plus some estimate of the terminal value PT where
PT 
FCFF T 1
WACC  g
WACC = Weighted average cost of capital
g = estimate of long run growth in free cash flow
T = time period when the firm approaches constant
growth
Firm Value
T

FCFFt
PT
Firm Value  

t
T
(
1

WACC
)
(
1

WACC
)
t

1


Equity value = Firm Value – Market Value of Debt
13-31
Free Cash Flow (cont.)
• Another approach calculates the free cash flow
to the equity holders (FCFE) and discounts the
cash flows directly at the cost of equity, kE.
FCFE  FCFF  Interest Expense(1 TC )  Increase in Net Debt
FCFE T 1
PT 
kE  g
 T FCFE t 
PT
Equity Value  

t
T
 t 1 (1  k E )  (1  k E )
• Equity value can then be estimated as:

13-32
Comparing the Valuation
Models
• In theory free cash flow approaches should provide the
same estimate of intrinsic value as the dividend growth
model
• In practice the various approaches often differ
substantially
– Simplifying assumptions are used in all models
– The models establish ranges of likely intrinsic value
– Using multiple models forces rigorous thinking about
the inputs
13-33
Earnings Multiplier Approach
1. Forecast corporate profits for the coming period for an
index such as the S&P 500.
2. Derive an estimate for the aggregate P/E ratio using
long-term interest rates
– Based on the relationship between the ‘earnings
yield’ or E/P ratio for the S&P 500 and the yield on
10 year Treasuries
3. Product of the two forecasts is the estimate of the endof-period level of the market
13-34
Earnings Multiplier Approach
2009 Data: Starting S&P500 level = 900
Expected Earnings yield S & P500 – 10 yr Treasury spread  2.5%
Treasury yield = 3.2%
Implied Earnings Yield = 2.5% + 3.2% = 5.7%
If E/P = 5.7% then P/E = 1 / 0.057 = 17.54
If forecast EPS = $55 what is the expected
forecast for the S&P500 one year later and the
S & P500  17.54  55  965
% gain or loss?
965  900
1
ExpectedReturn 
900
 7.2%
13-35