Investments

FINA-3720

Ligang Zhong

Lectures 12 & 13 (Chapter 18)

Equity Evaluation Models
Chapter Summary

• Objective: To introduce fundamental stock analysis by

describing different types of valuation models.
– Valuation by Comparables
– Intrinsic Value Versus Market Price
– Dividend Discount Models
– Earnings, Growth and Price-Earnings Ratios
– Free-Cash Flow Valuation
Fundamental Analysis: Models of Equity Valuation

• Basic Types of Models

– Balance Sheet Models
– Dividend Discount Models
– Price/Earning Ratios
• Estimating Growth Rates and Opportunities
Financial Ratios from Statements

 Balance Sheet:
– Financial condition at a point in time
• Income Statement:
– Profitability over time
• Statement of Cash Flows:
– Tracks the cash implications of transactions.
• Ratios:
– Book value
– Revenue and income (growth)
– Valuation ratios (P/E, P/B, P/S, P/CF, PEG)
– Profitability measures
Balance Sheet Relationships

• Accounting Equation
– B.V. (Equity) = B.V. (Assets) – B.V. (Debt)
– B.V. (Assets) = Liquidation value or Replacement value (Tobin’s q)
• Market Value
– M.V. (Equity) = M.V. (Assets) – M.V. (Debt)
– M.V. (Assets) = P.V. (Operating Income)
Limitations of Book Value

• Book value is an application of arbitrary accounting

rules
• Can book value represent a floor value?
• Better approaches
– Liquidation value
– Replacement cost
Intrinsic Value and Market Price

• Intrinsic Value
– Self assigned Value
– Variety of models are used for estimation
• Market Price
– Consensus value of all potential traders
• Trading Signal
– IV > MP Buy
– IV < MP Sell or Short Sell
– IV = MP Hold or Fairly Priced
Intrinsic and Market Valuation

• Intrinsic Value = Exp. (future dividends and price of sale)

discounted at a corresponding discount rate

• Single period V0 = [E(D1)+E(P1)] / (1+k)

k = market capitalization rate or
required return or
cost of equity capital
Dividend Discount Models: General Model


Dt
Vo   t
t  1 (1  k )

V0 = Value of Stock
Dt = Dividend
k = required return
Constant Growth Model

D o(1  g)
Vo 
k  g
g = constant perpetual growth rate
Where does g come from?

Example: $100 Million Equity Finance, ROE = 15%, #

Shares = 3 Million. Total Earnings = 15% * $100 Million =
$15 Million. EPS = $15 Million / 3 Million= $5 Per Share.
60% was reinvested and 40 % paid out as dividend.
Then the growth of Capital Stock: 60% * $15 Million = 9
Million, or by 9%.
Estimating Dividend Growth Rates

g  RO E  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 18.1 Dividend Growth for Two Earnings
Reinvestment Policies
Constant Growth Model: Example

D o(1  g) D1
Vo  
k g kg

E1 = $5.00 b = 40% k = 15%

ROE = 20%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
Preferred Stock and the DDM

• No growth case (fixed dividends)

• Value a preferred stock paying a fixed dividend of $2
per share when the discount rate is 8%:

$2
V0   $25
0.08  0

© 2019 McGraw-Hill Education Limited 18-14

DDM Implications

• The constant-growth rate DDM implies that a

stock’s value will be greater:
• The larger its expected dividend per share.
• The lower the market capitalization rate, k.
• The higher the expected growth rate of dividends.
• The stock price is expected to grow at the
same rate as dividends.
Specified Holding Period Model

D D D P
V  1
1
 2
2
...  N N
N
(1  k ) (1  k ) (1  k )
0

PN = the expected sales price for the stock

at time N
N = the specified number of years the
stock is expected to be held
Partitioning Value: Growth and No Growth
Components

E1
Vo   PVGO
k
D o(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% d = 60% b = 40%

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

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

Partitioning Value: Example (cont’d)

3
Vo   $ 42 .86
(.15  .08)
5
NGV o   $ 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
Life Cycle & Multistage Model
 Life Cycles and Multistage Growth Models
Firms typically pass through life cycles
Early Years
• Ample opportunities for profitable
reinvestment in the company
• Competitors may have not entered
the market.
• Payout ratios are low
• Growth is correspondingly rapid.
© 2019 McGraw-Hill Education Limited.
Later Years
• Attractive opportunities for
reinvestment may become harder to
find.
• Competitors enter the market
• Payout ratios are high
• Dividend growth slows because the
company has fewer investment
opportunities.
18-21
Estimating Honda’s Value

• Expected dividends for Honda:

Year 1: $.78 Year 3: $ .92
Year 2: $.85 Year 4: $1.00
• g = ROE x b
• Steady constant growth after year 4: the
dividend payout ratio is 25% and ROE is
10%, the “steady-state” growth rate is 7.5%.
Estimating Honda’s Value (cont’d)

• Honda’s beta is 0.95 and the risk-free rate is 2%.

If the market risk premium is 8%, then k is given
by:
k = 2% + 0.95(8%) = 9.6%
• Therefore:

D5 D 1  g  $11.075
P4   4   $51.19
kg kg 0.096  0.075
Estimating Honda’s Value (cont’d)

• Finally,

$0.78 $0.85 $0.92 $1  $51.19

V0   2
 3
 4
1.096 1.096 1.096 1.096

• Estimated value = $38.29

• If currently, one share of Honda Motor Company
Stock sold for $32.88, over- or undervalued?
Price-Earnings Ratios and Growth

• 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
Price-Earnings Ratio and Growth

• The ratio of PVGO to E / k is the ratio of firm value

due to growth opportunities to value due to assets
already in place (i.e., the no-growth value of the firm,
E / k ).

 
P0 1  PVGO 
 1  
E1 k  E1 
 k 
P/E Ratio: No Expected Growth

• When PVGO = 0

E1 P0 1
P0  or 
k E1 k

• E1 - expected earnings for next year

– E1 is equal to D1 under no growth
• P/E rises dramatically with PVGO.
• High P/E indicates that the firm has ample growth
opportunities.
P/E Ratio with Constant Growth

P/E increases:
As ROE increases
As plowback increases, if ROE > k
As plowback decreases, if ROE < k
As k decreases

D1 E1(1  b)
P0  
k g k  (b  ROE)
P0 1b

E1 k  (b  ROE)

b = retention ratio ROE = Return on Equity

ROE & Plowback vs. Growth & P/E

Plowback Ratio (b)

0 0.25 0.50 0.75

ROE A. Growth Rate (g)
10% 0% 2.5% 5.0% 7.5%
12 0 3.0 6.0 9.0

14 0 3.5 7.0 10.5

ROE B. P/E Ratio

10% 8.33 7.89 7.14 5.56
12 8.33 8.33 8.33 8.33
14 8.33 8.82 10.00 16.67

Table 18.3
Effect of ROE and plowback on growth and the P/E ratio
Assumption: k = 12% per year
P/E and Growth Rate

• Wall Street rule of thumb: The growth rate is roughly

equal to the P/E ratio.

• “If the P/E ratio of Coca Cola is 15, you’d expect the
company to be growing at about 15% per year, etc.
But if the P/E ratio is less than the growth rate, you
may have found yourself a bargain.”
P/E Ratios and Stock Risk

• When risk is higher, k is higher; therefore, P/E is

lower.

P 1 b

E kg
Pitfalls in P/E Analysis

• Use of accounting earnings

– Historical costs
– May not reflect economic earnings
– Earnings Management
– Choices of GAAP
• Inflation
• Reported earnings fluctuate around the business cycle
P/E Ratios of the S&P 500 Index and Inflation
Earnings Growth for Two Companies
P/E Ratios for Two Companies
P/E Ratios for Different Industries
Other Valuation Ratios

• Price-to-Book
• Price-to-Cash-Flow
• Price-to-Sales
Market Valuation Statistics
The Free Cash-Flow Approach

• Basis: the intrinsic value of a firm is the present value of all

its net cash-flows to shareholders
• Estimate the value of the firm as a whole
– PV of cash-flows, with all-equity financing
– plus NPV of tax shields from using debt
• Value of equity = value of firm less market value of all non-
equity claims
Free Cash Flow to the Firm

• Discount rate is the firm’s cost of capital

• Components of free cash flow
– After tax EBIT
– Depreciation
– Capital expenditures
– Increase in net working capital

• FCFF = EBIT (1-tc)+Depreciation-Capital Expenditures –

Increases in NWC
Free Cash Flow to Equity

• FCFE =FCFF  Interest expense  (1 tc) + Increase in net debt

• Firm value = (FCFF + terminal value) capitalized at the WACC

• Equity value = (FCFE + terminal value) capitalized at the cost

of equity

• Both terminal values are found from the constant growth

model for equilibrium free- cash flows (V = CF / (k-g))
Value of Firm and Equity

WACC = Weighted Average Cost of Capital

KE = the Cost of Equity

Comparing the Valuation Models

• In practice
– Values from these models may differ
– Analysts are always forced to make simplifying
assumptions
• Problems with DCF
– Calculations are sensitive to small changes in inputs
– Growth opportunities and growth rates are hard to pin down
The Aggregate Stock Market

• Use of earnings multiplier approach at

aggregate level
• Some analysts use aggregate version of DDM
• S&P 500 taken as leading economic indicator

© 2019 McGraw-Hill Education Limited 18-44

Earnings Yield, S&P 500 vs. 10-Year Treasury
Bond

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S&P 500 Price Forecasts Under Various
Scenarios

Pessimistic Most Likely Optimistic

Scenario Scenario Scenario

Treasury bond
3.0% 2.5% 2.0%
yield
Earnings yield 5.6% 5.1% 4.6%
Resulting P/E
ratio 17.86 19.61 21.74

EPS forecast 118 118 118

Forecast for
S&P 500 2,107 2,314 2,565

Table 18.4
S&P 500 index forecasts under various interest-rate scenarios
Forecast for the earnings yield on the S&P 500 equals Treasury bond yield
plus 2.6%. The P/E ratio is the reciprocal of the forecast earnings yield.

© 2019 McGraw-Hill Education Limited. 18-46