Equity Valuation

Lecture 12
13.1 VALUATION BY COMPARABLES
Fundamental Stock Analysis:
Models of Equity Valuation
Basic Types of Models
Balance Sheet Models
Dividend Discount Models
Price/Earnings Ratios
Estimating Growth Rates and
Opportunities - the most difficult
component of valuation
Models of Equity Valuation
Valuation models use 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

Table 13.1 Microsoft Corporation
Financial Highlights
Valuation Methods
Book value
net worth of common equity according to a
firms balance sheet
Market value
present value of its expected future cash
flow
Liquidation value
net amount that can be realized by selling
the assets of a firm and paying off the debt
Replacement cost
cost to replace a firms assets
13.2 INTRINSIC VALUE VERSUS
MARKET PRICE
Expected Holding Period
Return
The return on a stock investment comprises cash
dividends and capital gains or losses
Assuming a one-year holding period
| |
1 1 0
0
( ) ( )
Expected HPR= ( )
E D E P P
E r
P
+
=
Required Return
CAPM gave us required return:



If the stock is priced correctly
Required return should equal expected
return

( )
f M f
k r E r r |
(
= +

Intrinsic Value and Market
Price
Market Price
Consensus value of all potential traders
Current market price will reflect intrinsic value
estimates
This consensus value of the required rate of
return, k, is the market capitalization rate
Trading Signal
IV > MP Buy
IV < MP Sell or Short Sell
IV = MP Hold or Fairly Priced

Discussion
You expect the price of ABC stock to be
$59.77 per share a year from now Its
current market price is $50 and you
expect it to pay a dividend one year from
now of $2.15 per share.
If the required rate of return on ABC stock
is 15.2%, what is the intrinsic value of
ABC stock, and how does it compare to
the current market price?
13.3 DIVIDEND DISCOUNT MODELS
General Model
V
D
k
o
t
t
t
=
+
=


( ) 1
1
V
0
= Value of Stock
D
t
= Dividend
k = required return
No Growth Model
V
D
k
o
=
Stocks that have earnings and
dividends that are expected to
remain constant
Preferred Stock
No Growth Model: Example
E
1
= D
1
= $5.00
k = .15
V
0
= $5.00 / .15 = $33.33
V
D
k
o
=
Constant Growth Model
Vo
D g
k g
o
=
+

( ) 1
g = constant perpetual growth
rate
Constant Growth Model:
Example
Vo
D g
k g
o
=
+

( ) 1
E
1
= $5.00 b = 40% k = 15%
(1-b) = 60% D
1
= $3.00 g = 8%
V
0
= 3.00 / (.15 - .08) = $42.86

Stock Prices and Investment
Opportunities
g ROE b
=
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention
percentage rate
(1- dividend payout percentage rate)
Figure 13.1 Dividend Growth for
Two Earnings Reinvestment Policies
Stock Prices and Investment
Opportunities
g ROE b
=
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention
percentage rate
(1- dividend payout percentage rate)
Discussion
Calculate the price of the firm wit ha
plowback ratio of 0.6 if its ROE is
20%. Current earning, E1, will be $5
per share, and k=12.5%
Present Value of Growth
Opportunities

If the stock price equals its IV, growth
rate is sustained, the stock should sell at:



If all earnings paid out as dividends, price
should be lower (assuming growth
opportunities exist)
1
0
D
P
k g
=

Present Value of Growth

Opportunities
(cont.)
Price = No-growth value per share + PVGO
(present value of growth opportunities)


Where:
E
1
= Earnings Per Share for period 1 and


1
0
E
P PVGO
k
= +
0 1
(1 )
( )
D g E
PVGO
k g k
+
=

Partitioning Value: Example

ROE = 20% d = 60% b = 40%

E
1
= $5.00 D
1
= $3.00 k = 15%

g = .20 x .40 = .08 or 8%
P
NGV
PVGO
o
o
=

=
= =
= =
3
15 08
86
5
15
33
86 33 52
(. . )
$42 .
.
$33 .
$42 . $33 . $9 .
Partitioning Value: Example (cont.)
P
o
= price with growth
NGV
o
= no growth component value
PVGO = Present Value of Growth Opportunities
Life Cycles and Multistage
Growth Models
P D
g
k
D g
k g k
o o
t
t
t
T
T
T
=
+
+
+
+
+
=

( )
( )
( )
( ) ( )
1
1
1
1
1
1
2
2
g
1
= first growth rate
g
2
= second growth rate
T = number of periods of growth at
g
1
Multistage Growth Rate Model:
Example
D
0
= $2.00 g
1
= 20% g
2
= 5%
k = 15% T = 3 D
1
= 2.40
D
2
= 2.88 D
3
= 3.46 D
4
= 3.63

V
0
= D
1
/(1.15) + D
2
/(1.15)
2
+ D
3
/(1.15)
3

+ D
4
/ (.15 - .05) (1.15)
3

V
0
= 2.09 + 2.18 + 2.27 + 23.86 =
$30.40
13.4 PRICE-EARNINGS RATIOS
P/E Ratio and Growth
Opportunities
P/E Ratios are a function of two
factors
Required Rates of Return (k)
Expected growth in Dividends
Uses
Relative valuation
Extensive use in industry
P/E Ratio: No expected
growth
P
E
k
P
E k
0
1
0
1
1
=
=
E
1
- expected earnings for next year
E
1
is equal to D
1
under no growth
k - required rate of return
P/E Ratio: Constant Growth
P
D
k g
E b
k b ROE
P
E
b
k b ROE
0
1 1
0
1
1
1
=

=


=


( )
( )
( )
b = retention ration
ROE = Return on Equity
Numerical Example: No
Growth
E
0
= $2.50 g = 0 k = 12.5%

P
0
= D/k = $2.50/.125 = $20.00

P/E = 1/k = 1/.125 = 8
Numerical Example with
Growth
b = 60% ROE = 15% (1-b) = 40%
E
1
= $2.50 (1 + (.6)(.15)) = $2.73
D
1
= $2.73 (1-.6) = $1.09
k = 12.5% g = 9%
P
0
= 1.09/(.125-.09) = $31.14
P/E = 31.14/2.73 = 11.4
P/E = (1 - .60) / (.125 - .09) = 11.4
P/E Ratios and Stock Risk
Riskier stocks will have lower P/E
multiples
Riskier firms will have higher required
rates of return (higher values of k)
1 P b
E k g

A firm has an earnings retention

ratio of 40%. The stock has a
market capitalization rate of 15%
and an ROE 18%. What is the
stock's P/E ratio?

a. 12.82
b. 7.69
c. 8.33
d. 9.46
Pitfalls in Using P/E Ratios
Flexibility in reporting makes
choice of earnings difficult
Pro forma earnings may give a
better measure of operating
earnings
Problem of too much flexibility
Figure 13.3 P/E Ratios and
Inflation
Figure 13.4 Earnings Growth
for Two Companies
Figure 13.5 Price-Earnings
Ratios
Figure 13.6 P/E Ratios
Other Comparative Valuation
Ratios
Price-to-book
Price-to-cash flow
Price-to-sales
Be creative
Figure 13.7 Valuation Ratios for
the S&P 500
13.5 FREE CASH FLOW VALUATION
APPROACHES
Free Cash Flow
One approach is to discount the free
cash flow for the firm (FCFF) at the
weighted-average cost of capital,
then subtract existing value of debt
FCFF = EBIT (1- t
c
) + Depreciation
Capital expenditures Increase in NWC
where:
EBIT = earnings before interest and taxes
t
c
= the corporate tax rate
NWC = net working capital

Free Cash Flow (cont.)
Another approach focuses on the free
cash flow to the equity holders (FCFE)
and discounts the cash flows directly
at the cost of equity
FCFE = FCFF Interest expense (1-
t
c
) + Increases in net debt
P
g
T
t
=

FCFE
(
)
T+1
k
If a firm has a free cash flow equal
to $50 million and that cash flow
is expected to grow at 3% forever,
what is the total firm value given a
WACC of 9.5%?

a. $679 million
b. $715 million
c. $769 million
d. $803 million
Comparing the Valuation
Models
Free cash flow approach should
provide same estimate of IV as the
dividend growth model
In practice the two approaches may
differ substantially
Simplifying assumptions are used
References
Bodie, Kane, and Marcus, Essentials
of Investments, 7
th
Edition, McGraw-
Hill, pp 2-23