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Equity Valuation

 Basic Types of Models

• Balance sheet models


• Dividend discount models
• EPS (cashflow) discount models
 Modeling Framework

• Deterministicdynamics
• Stochastic dynamics
Fair Value vs Market Price
 Fair Value
• Self assigned Value
• Variety of models are used for estimation

 Market Price
• Consensus value assessment by all market participants

 Trading Signal

• FV > MP: Buy


• FV < MP: Sell or Short Sell
• FV = MP: Hold or Fairly Priced
Dividend Discount Models
 
Dt
Vo  
t  1 (1  k )
t

V0 = Value of Stock
Dt = Dividend
k = required return
No Growth Model
 D
Vo 
k
Where the stock has earnings and dividends that are
expected to remain constant foreever.

Example: Preferred Stock


No Growth Model: Example

D
Vo 
k
E1 = D1 = $5.00
k = .15

Then, V0 = $5.00 / .15 = $33.33


Constant Growth Model

Do (1  g )
Vo 
kg

g = constant perpetual growth rate


Constant Growth Model: Example

Do (1  g )
Vo 
kg

E1 = $5.00 b = 40% (1-b) = 60%


k = 15% D1 = $3.00 g = 8%
(b: EPS retention ratio)

V0 = 3.00 / (.15 - .08) = $42.86


Estimating Dividend Growth Rates

 g  ROE  b

 g = growth rate in dividends

 ROE = Return on Equity for the firm

 b = EPS retention rate (1- dividend payout ratio)


Partitioning Value: Growth and No Growth Components

E1

Vo   PVGO
k
Do (1  g ) E1
PVGO  
(k  g) k

 PVGO = Present Value of Growth Opportunities

 E1 = Earnings Per Share for period 1


Partitioning Value: Example

ROE = 20% b = 40%

E1 = $5.00 D1 = $3.00 k = 15%

g = .20 x .40 = .08 or 8%


Partitioning Value: Example
 3
Vo   $42.86
(.15.08)
5
NGVo   $33.33
.15
PVGO  $42.86  $33.33  $9.52

• Vo = value with growth


• NGVo = no growth component value
• PVGO = Present Value of Growth Opportunities
Multi-Period Dividend-Discount Model

D D D P
V   1
...  2 N N

(1 k ) (1 k ) (1 k )


0 1 2 N

PN = expected sales price of stock at time N


N = number of years the stock is to be held
Practical Difficulties with DDM

 Some firms do not pay dividends

 Can you forecast future dividends?

 Can you predict the terminal liquidation

value Pn ?

 What about the discount rate k?


(perhaps, the CAPM? The APT?)
Multi-Period Earnings-Discount Model


(1  b) E1 (1  b) E 2 (1  b) E N  P N
V0   ... 
(1  k )1 (1  k ) 2 (1  k ) N

PN = expected sales price of stock at time N


N = number of years the stock is to be held
Practical Concerns with EDM

 EPS forecasts are available from I/B/E/S,


First Call, Zacks, ….
 Dividend payout ratio (1-b) can be

estimated, either based on cash dividend or dividend-


in-kind

 But, what about Pn and k?


P/E Ratios

P0 d

E k  g

d: dividend payout ratio


k: cost-of-capital (or, risk-adjusted discount rate)
g: EPS growth rate
P/E Example
k = 12.5% g = 9% d = 40%

Thus, P/E = (1 - .60) / (.125 - .09) = 11.4

If E = $2.73, we have

P = 11.4 X 2.73 =$31.14


Problems with P/E Ratios

 What is E?
• E = trailing 12-month EPS?

• E = 12-month-forward EPS?

 What is g?
• g = average historical EPS growth?

• g = expected next-yr EPS growth?

• g = long-run EPS growth?