Investment Management © 2008
Equity Valuation ModelsEquity Valuation Models
Lectured byChandra Wijaya
Lectured byChandra Wijaya
22
Basic Types of ModelsBalance Sheet Models
Dividend Discount Models
Price/Earning Ratios
Estimating Growth Rates and Opportunities
Models of Equity Valuation
33
Limitations of Book Value
Book value is an application of arbitrary accounting rules
Can book value represent a floor value?
Better approachesLiquidation value
Replacement cost
44
Intrinsic ValueSelf assigned ValueVariety of models are used for estimation
Market PriceConsensus value of all potential traders
Trading SignalIV > MP BuyIV < MP Sell or Short SellIV = MP Hold or Fairly Priced
Intrinsic Value and Market Price
55
VD
ko
t
tt
( )11
VD
ko
t
tt
( )11
V0 = Value of Stock
Dt = Dividendk = required return
Dividend Discount Models: General Model
66
VD
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Stocks that have earnings and dividends that are expected to remain constant.
Preferred Stock
No Growth Model
77
E1 = D1 = $5.00k = .15
V0 = $5.00 / .15 = $33.33
VD
ko
No Growth Model: Example
88
VoD g
k g
o
( )1
VoD g
k g
o
( )1
g = constant perpetual growth rate
Constant Growth Model
99
VoD g
k g
o
( )1
VoD g
k g
o
( )1
E1 = $5.00b = 40% k = 15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
Constant Growth Model: Example
1010
g ROE b g ROE b
g = growth rate in dividendsROE = Return on Equity for the firmb = plowback or retention percentage rate
(1- dividend payout percentage rate)
Estimating Dividend Growth Rates
1111
)1()1()1(...2
21
10
kPD
kD
kDV N
NN
PN = the expected sales price for the stock at time N
N = the specified number of years the stock is expected to be held
Specified Holding Period Model
1212
Dividend Growth for Two Earnings Reinvestment Policies
1313
VE
kPVGO
PVGOD g
k g
E
k
o
o
1
11( )
( )
VE
kPVGO
PVGOD g
k g
E
k
o
o
1
11( )
( )
PVGO = Present Value of Growth Opportunities
E1 = Earnings Per Share for period 1
Growth & No Growth Components of Value
1414
ROE = 20% d = 60% b = 40%
E1 = $5.00 D1 = $3.00 k = 15%
g = .20 x .40 = .08 or 8%
Partitioning Value: Example
1515
V
NGV
PVGO
o
o
3
15 0886
5
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86 33 52
(. . )$42.
.$33.
$42. $33. $9.
V
NGV
PVGO
o
o
3
15 0886
5
1533
86 33 52
(. . )$42.
.$33.
$42. $33. $9.
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities
Partitioning Value: Example
1616
P/E Ratios are a function of two factorsRequired Rates of Return (k)
Expected growth in Dividends
UsesRelative valuation
Extensive Use in industry
Price Earnings Ratios
1717
PE
kP
E k
01
0
1
1
PE
kP
E k
01
0
1
1
E1 - expected earnings for next year
E1 is equal to D1 under no growth
k - required rate of return
P/E Ratio: No Expected Growth
1818
)(
1
)(
)1(
1
0
110
ROEbk
b
E
P
ROEbk
bE
gk
DP
)(
1
)(
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1
0
110
ROEbk
b
E
P
ROEbk
bE
gk
DP
b = retention ratio
ROE = Return on Equity
P/E Ratio with Constant Growth
1919
E0 = $2.50 g = 0 k = 12.5%
P0 = D/k = $2.50/.125 = $20.00
PE = 1/k = 1/.125 = 8
Numerical Example: No Growth
2020
b = 60% ROE = 15% (1-b) = 40%
E1 = $2.50 (1 + (.6)(.15)) = $2.73
D1 = $2.73 (1-.6) = $1.09k = 12.5% g = 9%
P0 = 1.09/(.125-.09) = $31.14PE = 31.14/2.73 = 11.4PE = (1 - .60) / (.125 - .09) = 11.4
Numerical Example with Growth
2121
Effect of ROE and Plowback on Growth and the P/E Ratio
2222
Pitfalls in P/E Analysis
Use of accounting earningsHistorical costs
May not reflect economic earnings
Inflation
Reported earnings fluctuate around the business cycle.
2323
P/E Ratios and Inflation
2424
Earnings Growth for Two Companies
2525
Price-Earnings Ratios
2626
Other Valuation Ratios
Price-to-Book
Price-to-Cash Flow
Price-to-Sales
2727
Market Valuation Statistics
2828
Inflation and Equity Valuation
Inflation has an impact on equity valuations.
Historical costs underestimate economic costs.
Empirical research shows that inflation has an adverse effect on equity values.
Research shows that real rates of return are lower with high rates of inflation.
2929
Lower Equity Values with Inflation
Shocks cause expectation of lower earnings by market participants.
Returns are viewed as being riskier with higher rates of inflation.
Real dividends are lower because of taxes.
3030
Free Cash Flow Approach
Discount the free cash flow for the firm
Discount rate is the firm’s cost of capital
Components of free cash flowAfter tax EBIT
Depreciation
Capital expenditures
Increase in net working capital
3131
Categories of Stock
Blue chip stock
Income stocks
Cyclical stocks
Defensive stocks
Growth stocks
Speculative stocks
Penny stocks
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Categories of Stock
Blue Chip Stock
Blue chip has become a colloquial term meaning “high quality”
Some define blue chips as firms with a long, uninterrupted history of dividend paymentsThe term blue chip lacks precise meaning, but some examples are:
Coca-ColaUnion PacificGeneral Mills
3333
Categories of Stock
Income Stocks
Income stocks are those that historically have paid a larger-than-average percentage of their net income as dividends
The proportion of net income paid out as dividends is the payout ratioThe proportion of net income retained is the retention ratio
3434
Categories of Stock
Cyclical Stocks
Cyclical stocks are stocks whose fortunes are directly tied to the state of the overall national economy
Examples include steel companies, industrial chemical firms, and automobile producers
3535
Categories of Stock
Defensive Stocks
Defensive stocks are the opposite of cyclical stocks
They are largely immune to changes in the macroeconomy and have low betas
Examples include retail food chains, tobacco and alcohol firms, and utilities
3636
Growth Stocks
Categories of Stock
Growth stocks do not pay out a high percentage of their earnings as dividends and may be good candidates for above-average returns.
They reinvest most of their earnings into investment opportunities
Many growth stocks do pay dividends
3737
Categories of Stock
A speculative stock has a high probability of a loss and a small probability of a large profit.Most speculative stocks are relatively new companies with representation in the technology, bioresearch, and pharmaceutical industries
Penny stocks refer to unusually risky, especially inexpensive shares.Penny stocks sell for $1 per share or less
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Categories of Stock
Categories Are Not Mutually Exclusive
An income stock or a growth stock can also be a blue chip
E.g., Potomac Electric Power
Defensive or cyclical stocks can be growth stocks
E.g., Dow Chemical is a cyclical growth stock