Chapter Eighteen: Equity Valuation Models

I. This chapter describes the valuation models that stock market analysts use to uncover
mispriced securities. The models are those used by fundamental analysts, those analysts
who use information concerning the current and prospective profitability of a company
to assess its fair market value.

II. Valuation by comparables:

1. Compare valuation ratios of the firm with those of comparable firms or industry average. E.g. P/E
ratio, Price/book value per share, price/sales per share and price/cash flow per share.
2. a “floor” for the stock’s price:
a. Book value: is the net worth of a company as reported on its balance sheet. Book value reflects
“history”, while market price reflects the present value of its expected future cash flows.
b. A better measure of a floor for the stock price is the liquidation value per share of the firm. This
represents the amount of money that could be realized by breaking up the firm, selling its assets,
repaying its debt, and distributing the remainder to the shareholders. The reasoning behind this
concept is that if the market price of equity drops below the liquidation value of the firm, the firm
becomes attractive as a takeover target.
3. Another measure relative to valuing a firm is the replacement cost of its assets less its liabilities.
Some believe that the market value of the firm cannot remain for long too far above its
replacement cost because if it did, competitors would try to replicate the firm. The competitive
pressure of other similar firms entering the same industry would drive down the market value of
all firms until they came into equality with replacement cost.

Tobin’s Q: the market value of all of the firm’s debt plus equity divided by the replacement value of
the firm’s assets.
III. Intrinsic value versus market price:
• The return on a stock is composed of dividends and capital gains or losses.
E ( D1 )   E ( P1 )  P0 
Expected HPR= E (r ) 
P0
• The expected HPR may be more or less than the required rate of return, based on the stock’s
risk.
• Required return: CAPM gives the required return, k:

k  rf    E (rM )  rf 
• If the stock is priced correctly, k should equal expected return.
• k is the market capitalization rate.

The intrinsic value of a share is defined as the present value of all cash payments to the investor
in the stock, including dividends as well as the proceeds from the ultimate sale of the stock,
discounted at the appropriate risk-adjusted interest rate, r.
Whenever the intrinsic value of the investor’s own estimate of what the stock is really worth,
exceeds (bellows) the market price, the stock is considered undervalued (overvalued) and the
investor should long (short) the stock. However, it is usually very dangerous to try to “beat market”.

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If your estimate of the value is different from that of the market, it is probably because you have used
poor dividend forecasts (not because the market mispriced the stock, though it is possible).
Therefore, the advice is “Do not use DCF valuation formulas to test whether the market is
correct in its assessment of a stock’s value”.
In market equilibrium, the current market price will reflect the intrinsic value estimates of all market
participants. This means that individual investor whose estimate differs from the market price in
effect must disagree with some or all of the market consensus estimate of expected dividends,
expected sale price or required rate of return.
A common term for the market consensus value of the required rate of return, r, is the market
capitalization rate.

4. Dividend discount model:

D1 D2 D3
V0     ...
1  k  1  k  2 1  k  3
Constant growth DDM:

D0 1  g  D
V0   1
kg kg
Here dividend growth rate is:
g  ROE x b
Present value of Growth Opportunities:

E1
P0   PVGO
k
IV. Price-earnings ratio:

P0 1  PVGO 
 1
E1 k  E 
 k 

The ratio of PVGO to E/k is the ratio of the component of firm value due to growth opportunities to
the component of value due to assets already in place (i.e. the no-growth value of the firm, E/k).
When future growth opportunities dominate the estimate of total value, the firm will command a high
price relative to current earnings. Thus, a high P/E ratio indicates that a firm enjoys ample growth
opportunities.
2.
P0 1 b

E1 k  ROE x b
P 1 b

E kg

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a. P/E ratio increases with ROE
b. The higher the plowback rate, the higher the growth rate, but a higher plowback rate does not
necessarily mean a higher P/E ratio. A higher plowback rate increases P/E only if investments
undertaken by the firm offer an expected rate of return higher than the market capitalization rate.
Otherwise, higher plowback hurts investors because it means more money is sunk into projects with
inadequate rates of return.
3. A common Wall Street rule of thumb is that the growth rate ought to be roughly equal to the P/E
ratio. In other words, the ratio of P/E to g, often called the PEG ratio, should be around 1.
4. It is the case that high P/E ratio stocks are almost invariably expected to show rapid earnings
growth, even if the expected growth rate does not equal the P/E ratio.
5. Pitfalls in P/E analysis:
a. earnings is accounting earnings, which are influenced by somewhat arbitrary accounting rules such
as the use of historical cost in depreciation and inventory valuation.
b. Earnings management is the practice of using flexibility in accounting rules to improve the
apparent profitability of the firm.
c. The use of P/E ratios is related to the business cycle: we assume in our models that earnings rise at
a constant rate, or, on a smooth trend line. In contrast, reported earnings can fluctuate dramatically
around a trend line over the course of the business cycle. Another way to make this point is to note
that in our models, P/E ratio is the ratio of today’s price to the trend value of future earnings,
EPS1. The P/E ratio reported in the financial pages of the newspaper, by contrast, is the ratio
of price to the most recent past accounting earnings. Current accounting earnings can differ
considerably from future economic earnings. Therefore, the ratio of price to most recent earnings can
vary substantially over the business cycle, as accounting earnings and the trend value of economic
earnings diverge by greater and lesser amount.
d. In sum, analysts must be careful in using P/E ratios. There is no way to say P/E ratio is overly high
or low without referring to the company’s long-run growth prospects, as well as to current earnings
per share relative to the long-run trend line.

6. Free Cash flow Approach:

1. Value the firm by discounting free cash flow at WACC.
• Free cash flow to the firm, FCFF, equals: After tax EBIT, Plus depreciation, Minus capital
expenditures, Minus increase in net working capital.
2. Free cash flows are not published and readily available and needs to be computed.
3. Analysts needs to understand a company’s financial; statements, its operations and financing
and its industry and role in the economy in order to able to forecast free cash flows.
4. Appropriate when one of the following applies
• The company is not dividend paying.
• Company’s dividend payments do not reflect its capacity to pay dividends.
• Free cash flows align with profitability within a reasonable forecast period with
which the analyst is comfortable.
• The investor takes a control perspective.

Thank you