Transcript No Slide Title

Chapter 13
Equity
Valuation
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
13.1 Valuation by
Comparables
13-2
Fundamental Stock Analysis:
Models of Equity Valuation
• Basic Types of Models
– Balance Sheet Models
– Dividend Discount Models
– Price/Earnings Ratios
– Free Cash Flow Models
13-3
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
13-4
Table 13.1 Microsoft Corporation
Financial Highlights 2009
13-5
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?
13-6
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.
13-7
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
13-8
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.
13-9
13.2 Intrinsic Value Versus
Market Price
13-10
Expected Holding Period Return
• The return on a stock investment
comprises cash dividends and capital
gains or losses
– Assuming a one-year holding period
Expected HPR= E (r ) 
E ( D1 )   E ( P1 )  P0

P0
13-11
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
13-12
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:
13-13
Intrinsic Value and Market Price
• Market Price
– Consensus value of all traders
– In equilibrium the current market price will
equal intrinsic value
• Trading Signals
– If V0 > P0
– If V0 < P0
– If V0 = P0
Buy
Sell or Short Sell
Hold as it is Fairly Priced
13-14
13.3 Dividend Discount
Models
For now assume price = intrinsic value
13-15
Basic Dividend Discount Model
Intrinsic value of a stock can be found from the
following:

Dt
V0  
t
t 1 (1  k )
V0 = Intrinsic Value of Stock
Dt = Dividend in time t
k = required return
What happened to the expected sale price in this
formula?
• Why is this an infinite sum?
• Is stock price independent of the investor’s
holding period?
13-16
Basic Dividend Discount Model
Intrinsic value of a stock can be found from the
V0 = Intrinsic Value of Stock
following:

Dt
V0  
t
(
1

k
)
t 1
Dt = Dividend in time t
k = required return
• This equation is not useable because it is an
infinite sum of variable cash flows.
• Therefore we have to make assumptions about
the dividends to make the model tractable.
13-17
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
13-18
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
13-19
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
13-20
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).
13-21
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
13-22
Value of Growth Opportunities
Value with 100% dividend payout
Cash Cow, Inc. (CC)
E1 = $5
D1 = $5
0
0
b = ; therefore g =
k = 12.5% ; Find VCC
VCC 
$5.00
 $40
0.125
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
GP
ROE = 12.5%
Should either or both firms retain some earnings?
ROE = 15%
13-23
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
13-24
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
13-25
Figure 13.1 Dividend Growth for
Two Earnings Reinvestment
Policies
(for a given ROE)
High reinvestment increases stock
price only if ROE > k
13-26
Multistage Growth Models
• As firms progress through their industry life cycle,
earnings and dividend growth rates (ROE) are likely to
change.
• A two stage growth model:
 T (1 g1 )t 
DT (1 g2 )
V0  D0 

t 
T
(1

k)
(k

g
)(1

k)
2
 t 1

• g1 = first growth rate
• g2 = second growth rate
• T = number of periods of growth at g1
13-27
Multistage Growth Rate
Model: Example
• D0 = $2.00 g1 = 20% g2 = 5%
• k = 15% T = 3
• D1 = 2.40 D2 = 2.88 D3 = 3.46
D4 = 3.63
$2.40 $2.88 $3.46
$3.63
V0 



2
3
1.15 1.15
1.15
(0.15  0.05)(1.15)3
• V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40
13-28
Table 13.2 Financial Ratios
13-29
Figure 13.2 Honda Motor
13-30
Two Stage DDM for Honda
Year
Dividends:
2009
2010
2011
Dividen
d
0.90
0.98
1.06
From Value Line
.0%  70%  7.70%
g  ROE  b2012g  11
1.15
Assume the dividend growth rate will be
steady beyond 2012. Value Line forecasts
b = 70% and ROE of 11.0%. What should
be the long term growth rate?
13-31
Two Stage DDM for Honda
The required rate of return:
From Value Line
Honda = 1.05
Rf in 2008 = 3.5%
Market risk premium = historical average of
8%
kHonda  Rf  (RM  Rf )Honda
kHonda  3.5%  (8%  1.05)  11.90%
13-32
Two Stage DDM for Honda
k = 11.90%
g = 7.70%
Find the intrinsic value
V0  $21.88
Year
Divid
end
2009
2010
2011
0.90
0.98
1.06
2012
1.15
$0.90 $0.98 $1.06 $1.15
$1.15  1.077
V0 




2
3
4
1.119 1.119 1.119 1.119
(0.119  0.077)(1.119)4
Value Line reported the actual price = $21.37, so
Honda was undervalued by $0.51 or about 2.4%.
13-33
Two Stage DDM for Honda
Should we trust the valuation result?
Year
Dividen
d
2009
2010
2011
0.90
0.98
1.06
What if the beta is slightly incorrect,
suppose it is 1.10 (< 5% error) rather
than 1.05?
2012
Actual price =
1.15
$21.37
Now k = 12.3% and the intrinsic value
estimate V0= $19.98, reversing our
conclusion that Honda is undervalued
13-34
13.4 Price-Earnings (P/E)
Ratios
13-35
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
13-36
P/E, ROE and Growth
g  ROE  b
With positive growth:
Are the elements of the P/E
ratio similar to the constant
growth DDM?
P0 (1  b)

E1 k  g
With zero growth:
If g = 0 then b should = 0 and the ratio
simplifies to:
P0 1
E1

k
13-37
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
13-38
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
13-39
ROE and b and growth and P/E
13-40
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
13-41
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.
13-42
Figure 13.3 P/E Ratios and
Inflation
13-43
Figure 13.4 Earnings Growth
for Two Companies

13-44
Figure 13.5 Price-Earnings
Ratios

13-45
Figure 13.6 P/E Ratios

13-46
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
13-47
Figure 13.7 Valuation Ratios for the
S&P 500
13-48
13.5 Free Cash Flow
Valuation Approaches

13-49
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
13-50
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
T


FCFFt
PT
Firm Value  

t
T
 t 1 (1 WACC)  (1 WACC)
Equity value =
Firm Value
Firm Value – Market Value of Debt
13-51
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:
13-52
FCF Valuation Example
13-53
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
13-54
13.6 The Aggregate Stock
Market
13-55
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
13-56
Figure 13.8 Earnings Yield of the
S&P 500 Versus 10-year Treasury
Bond Yield
13-57
Earnings Multiplier Approach
2009
Data: Starting S&P500 level = 900
Expected Earnings yield S & P500 – 10 yr Treasury spread  2.5%
S & P500 1  17.54  55  965
Treasury yield = 3.2%
ExpectedReturn 
965  900
 7.2%
900
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
% gain or loss?
13-58
Table 13.4 S&P 500 Index
Forecasts
13-59