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Chapter 10

Equity Valuation Tools

Portfolio Construction, Management, & Protection, 5e, Robert A. StrongCopyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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“Things are different now.”

(The four most dangerous words in finance.)

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Introduction More than 10,000 different listed stocks By simply buying a diversified portfolio

you could earn an average rate of return Who wants to be average? This chapter provides insight to:

• The source of stock value• Why value changes

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Stock as a Present Value Investors price stock on the basis of

anticipated inflows Since dividends are the only cash reward

for investing, a popular valuation model is the dividend discount model

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Relationship of World Exchanges (cont’d)

International capital markets continue to show independent price behavior• International diversification offers potential

advantages

• Repeating the Evans and Archer methodology for international securities should result in a lower level of systematic risk

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Valuation of Apple ComputerExample

Microsoft pays a $0.50 dividend. This is expected to grow at a rate of 7%. The required rate of return is 10%.

Based on the dividend discount model, what is the value of Microsoft’s common stock?

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Valuation of Apple Computer (con’d)

Example

Stock price =

Next dividend / Required return in Excess of anticipated dividend growth rate

Stock price = $0.50 (1.07) / [0.10 – 0.07]

= $0.535 / 0.03

= $18

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Valuation of Apple Computer (con’d)

Example

Small errors in estimation result in huge changes in estimated stock price value!

Increase dividend growth rate by ten percent (to 7.7%)

Stock price = $0.50 (1.077) / [0.10 – 0.077]

= $0.5385 / 0.023

= $23.41

That is a 30% increase!

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Accounting Versus Finance Perspectives

Account looks at past and present to determine:

• Where firm is (balance sheet)• How it got there (income statement)

Finance looks at the future

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Present Value of Growth Opportunities

Present value equals• Valuation of current earnings

– Assuming earnings and required return stay constant

• Present value of growth opportunities (PVGO) This technique essentially identifies PVGO PVGO is estimated and less certain Hence, investors tend to prefer stocks with lower

PVGO values

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Present Value of Growth Opportunities

Example

Abell Machines is priced at $34, had earning of $1.45 over the past year, and a required return of 9.5 percent.

Bell Retailers is priced at $45, had earnings of $2.20 over the past year, and a required return of 12.3 percent.

Which company has the lower PVGO value?

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Present Value of Growth Opportunities (con’d)

PV = E/K + PVGO

Hence, PV – E/K = PVGO

PVGO of Abell Machines:

$34 - $1.45 / 0.095 = $34 - $15.26 = $18.74

PVGO of Bell Retail:

$45 - $2.2/0.123 = $45 – 17.89 = $27.11

Since PVGO is uncertain, most investors would prefer Abell Machines, despite its lower level of earnings

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EBITDA Earnings Before Interest, Taxes,

Depreciation and Amortization Tool: Stock price / EBITDA Seek firms with lower stock price/EBITDA

ratios Not as popular as others because firms may

claim expenses as investments in assets, reducing EBITDA

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Cash Flows Changes in cash arising from business operations Tool: Stock Price/Operating cash flow Generally seek firms with lower ratios Modification: Use Free Cash Flow

• Operating cash flow less required investment in plant and equipment

• Excess is money available to investors

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PEG Ratios Price/earnings ratio dividend by dividend

growth rate Investors seek PEG ratios less than 1.0 Problems:

• Identifying earnings (Past? Forecast?)• Identifying growth rate (1-year forecast?, 5-

year forecast?)

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The Required Return Real Portion:

• Return for saving instead of spending money• Relatively stable in the 3-4 percent range

Inflation Adjustment:• Reflects changes in general price level• Relatively stable in the 3 percent range

Risk Premium:Depends on– Firm conditions– Overall economic conditions

Note: Small changes in any of these can result in large changes in firm valuation

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Changes in Stock Price Primary Long-Term Driver of Change

• Earnings – or lack thereof Primary Short-term Driver of Price Change

• Changes in investor sentiment• Relatively stable in the 3 percent range

Note: Both are difficult to predict

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Equity Risk Premium Extra return on equity

• 8.4% higher than Treasury bills• 6.7% higher than Treasury bonds• In any year stocks could be lower

– After all, this is an equity “risk” premium

Note: Beta is multiplied by the equity risk premium in the capital asset pricing model

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Anticipated Equity Risk Premium Changes

Forecasts suggest a diminishing equity risk premium• One reason is the anticipated higher costs for raw

materials Note: The market sets these, not individual

investors• Though investors could sell shares not providing

sufficient returns• The sale increases supply, reducing price, and

increasing returns to the buyer!

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Greenspan Model General indicator of whether the stock market is

over- or undervalued Mentioned in 1997 Federal Reserve Board

publication Alan Greenspan was Chairman of the Federal

Reserve Board at that time Model: YieldU.S. Treasury note less P/ES&P 500

Positive Result: Stock market overvalued Negative Result: Stock market undervalued

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Changing PE Multiples The amount individuals are willing to pay for a dollar of

earnings varies Long-run average is 16 Varies over time Returns will come from higher earnings and higher

price/earnings ratios A companies earnings cannot be manipulated by investors However, investors can buy firms with lower P/E ratios

• Yet, such firms are not expected to have as high a rate of earnings growth

• Hence, the lower price/earning ratio