Chapter

13 Equity Valuation

Bodie, Kane, and Marcus

Essentials of Investments
12th Edition

© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 13.1 Equity Valuation
Book Value:
• Net worth of common equity according to a firm’s balance
sheet.

Alternatives to Book Value:

• Liquidation value:
• Net amount realized by selling assets of firm and paying off debt.
• Replacement coast:
• Cost to replace firm’s assets.
• Tobin’s q:
• Ratio of firm’s market value to replacement cost.

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 Table 13.1 Financial Highlights for Microsoft 2019
Microsoft Industry
Price per share 137.41
Common shares outstanding (billion) 7.64
Market capitalization ($ billion) 1,050
Latest 12 Months
Sales ($ billion) 118.48
EBITDA ($ billion) 49.58
Net income ($ billion) 33.54
Earnings per share 4.31
Valuation
Price/Earnings 26.16 39.94
Price/Book 10.26 8.03
Price/Sales 8.34 6.42
P EG 1.84 1.99
Profitability
ROE (%) 42.41 13.47
ROA (%) 9.85
Operating profit margin (%) 34.14 21.35
Net profit margin(%) 31.18 10.45

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 13.2 Intrinsic Value versus Market Price 1

E ( D1 )  [ E ( P1 )  P0 ]
Expected HPR  E (r ) 
P0

• E(D1) = expected dividend per share.

• P0 = current share price.
• E(P1) = expected end-of-year price.
Example: Suppose you purchased a share of DAR Inc. for $40 in
January. You expect to sell it for $42 in December and expect to receive
a dividend of $2.42 during that year. What is your expected RHP?

E ( D1 )  [ E ( P1 )  P0 ] $2.42  $42  40
HPR  E (r )    .1105  11.05%
P0 40

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 13.2 Intrinsic Value versus Market Price 2

Intrinsic Value:
• Present value of firm’s expected future net cash flows
discounted by required Rate of Return (RoR).

Market Capitalization Rate:

• Market-consensus estimate of appropriate discount rate
for firm’s cash flows.
• Denoted k.

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 13.2 Intrinsic Value versus Market Price 3

Intrinsic Value:
• For one period:

D1  P1
V0 
1 k
• For holding period H:

D1 D2 DH  PH
V0     
1  k (1  k ) 2 (1  k ) H

Dividend Discount Model (DDM):

• Value equals present value of all expected future dividends.

D1 D2 D3
V0    
1  k (1  k ) 2 (1  k )3

Note: All future dividends and prices are expected values; notation removed to avoid clutter.

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 13.3 Dividend Discount Models 1

Constant-Growth DDM.

D1
V0 
kg

• Form of DDM that assumes dividends will grow at

constant rate.
• Implies stock’s value greater if:
• Larger dividend per share.
• Lower market capitalization rate, k.
• Higher expected growth rate of dividends.

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 13.3 Dividend Discount Models 2

• For stock with market price = intrinsic value,

expected holding period return.

E(r) = Dividend Yield + Capital Gains Yield

D1 P1  P0
 
P0 P0
D1
 g
P0

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 13.3 Dividend Discount Models 3

Stock Prices and Investment Opportunities:

• Dividend payout ratio.
• Percentage of earnings paid as dividends.
• Plowback ratio/earnings retention ratio.
• Proportion of firm’s earnings reinvested in business.
• Present value of growth opportunities (PVGO).

P0 = No-Growth Value per Share + PVGO

E1
  PVGO
k

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 13.3 Dividend Discount Models 4

Life Cycles and Multistage Growth Models:

• Two-stage DDM:
• DDM in which dividend growth assumed to level off only at future
date.
• Multistage Growth Models:
• Allow dividends per share to grow at several different rates as firm
matures.

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 13.3 Dividend Discount Models: Two Stage Example

Consider the following information:

• The firm’s dividends are expected to grow at g = 20% until t = 3 yrs.
• At the start of year four, growth slows to gs= 5%.
• The stock just paid a dividend Div0 = $1.00.
• Assume a market capitalization rate of k = 12%.

What is the price, P0, of this stock?

D0  (1  g ) D0  (1  g )t D0  (1  g ) t  (1  g s )
P0   ...  
(1  k ) (1  k )t (1  k )t  ( k  g s )

$1  (1  .2) $1  (1  .2) 2 $1  (1  .2) 3 D0  (1  .2)3  (1  .05)

   
(1  .12) (1  .12) 2 (1  .12)3 (1  .12) 3  (.12  .05)
 $1.07  $1.15  $1.23  $18.45  $21.90

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 13.3 Dividend Discount Models: Stock Value
The Constant Growth Model states that a stocks
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.

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 Figure 13.1 Dividend Growth and Reinvestment

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 13.4 Price-Earnings Ratios 1

Price Earnings Ratio and Growth Opportunities:

• Price-earnings multiple.
• Ratio of stock’s price to earnings per share.
• Determinant of P/E ratio.

 
P0 1  PVGO 
 
E1 k  E1 
 k 

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 13.4 Price-Earnings Ratios 2

P/E Ratio for Firm Growing at Long-Run

Sustainable Pace.

P0 1  b 1 b
 
E1 k  g k  ROE  b

PEG Ratio.
• Ratio of P/E multiple to earnings growth rate.

P0 E1
g

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 Table 13.3 Effect of ROE and Plowback on Growth and
P/E Ratio

Plowback Ratio (b)

0 0.25 0.50 0.75
A. Growth rate, g
ROE
10% 0% 2.5% 5.0% 7.5%
12 0 3.0 6.0 9.0
14 0 3.5 7.0 10.5
B. P/E ratio
ROE
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

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 13.4 Price-Earnings Ratios 3

P/E Ratios and Stock.

P0 1  b

E1 k  g

• All else equal, riskier stocks have:

• Lower P/E multiples.
• Higher required RoR.
• Higher k.

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 13.4 Price-Earnings Ratios 4

Pitfalls in P/E Analysis:

• Earnings Management.
• Practice of using flexibility in accounting rules to improve apparent
profitability of firm.
• Large amount of discretion in managing earnings.

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 Figure 13.3 P/E Ratio and Inflation

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 Figure 13.4 Earnings Growth for Two Companies

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 Figure 13.5 Price-Earnings Ratios

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 13.4 Price-Earnings Ratios 5

Cyclically adjusted P/E ratio (CAPE):

• Divide stock price by estimate of sustainable long-term
earnings.
• Proposes using average inflation-adjusted earnings over
extended period (that is, 10 years).
• Shiller argues CAPE is a better gauge of potential market
mispricing.

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 13.4 Price-Earnings Ratios 6

Combining P/E Analysis and the DDM.

• Estimates stock price at horizon date.

Other Comparative Valuation Ratios:

• Price-to-book: Indicates how aggressively market values
firm.
• Price-to-cash-flow: Cash flow less affected by accounting
decisions than earnings.
• Price-to-sales: For start-ups with no earnings.

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 Figure 13.6 Valuation Ratios for S&P 500

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 13.5 Free Cash Flow Valuation Approaches 1

Free Cash Flow for Firm (FCFF):

FCFF  EBIT  (1  tc )  Dep  CapEx  NWC

• EBIT = Earnings before interest and taxes.
• tc = Corporate tax rate.
• Dep = Depreciation.
• CapEx = Capital Expenditures.
• NWC = Net working capital.

Free Cash Flow to Equity Holders (FCFE):

FCFE  FCFF  Interest Expense  (1  tc )  Net Debt

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 13.5 Free Cash Flow Valuation Approaches 2

• Estimating Terminal Value using Constant Growth

Model.
T
FCFFt PT
Firm Value   t

t 1 (1  WACC ) (1  WACC )T

where

FCFFT 1
PT 
WACC  g

WACC = Weighted Average Cost of Capital

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 13.5 FCF Valuation Approaches: FCFF Example 1

• Suppose FCFF = $1 mil for years 1 to 4 and then is

expected to grow at a rate of 3%. Assume WACC = 15%.
T
FCFFt PT
Firm Value   
t 1 (1  WACC )t (1  WACC )T

$1, 000, 000 1.03

4
$1, 000, 000 .15  .03
 t

t 1 (1  .15) (1  .15) 4

  $ 7, 762,527

• If 500,000 shares are outstanding, what is the predicted

price of this stock if the firm has $5,000,000 of debt?
 $7, 762, 527  $5, 000, 000
P0     $5.53
500, 000
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 13.5 Free Cash Flow Valuation Approaches 3

• Market Value of Equity.

FCFEt
T
PT
Market Value of Equity   t

t 1 (1  k E ) (1  k E )T

where

FCFET 1
PT 
kE  g

KE = Cost of Equity Capital

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 13.5 FCF Valuation Approaches: FCFF Example 2

• Suppose FCFE = $900,000 for years 1 to 4 and then is

expected to grow at a rate of 3%. Assume ke = 18%.
T
FCFE PT
Market Value of Equity   
t 1 (1  ke )t (1  ke )t
$900, 000  1.03
4
$900, 000 .18  .03
 t

t 1 (1  .18) (1  .18) 4
  $ 2,500,851

• If there are 500,000 shares outstanding, what is the

predicted price of this stock? Why can debt be ignored?
 $ 2,500,851
P0     $5.00
500, 000
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 Spreadsheet 13.2: Free Cash Flow of Chevron

*2019 P/E ratio is from Yahoo! Finance. Final input is from Value Line, and intermediate values are interpolated.

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 13.5 Free Cash Flow Valuation Approaches 4

Comparing Valuation Models:

• Model values differ in practice.
• Differences stem from simplifying assumptions.

Problems with DCF Models:

• DCF estimates are always somewhat imprecise.
• Investors employ hierarchy of valuation.
• Real estate, plant, equipment.
• Economic profit on assets in place.
• Growth opportunities.

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 13.6 The Aggregate Stock Market
Forecasting Aggregate Stock Market:
• Earnings multiplier applied at aggregate level.
• Forecast corporate profits for period.
• Derive estimate of aggregate P/E ratio based on long-term interest
rates.
• Some analysts use aggregate DDM.

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 Figure 13.7 Earnings Yield of S&P 500 versus 10-Year
Treasury Bond Yield

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 Table 13.4 S&P 500 Forecasts

Pessimistic Most Likely Optimistic

Scenario Scenario Scenario
Treasury bond yield 2.50% 2.00% 1.50%
Earnings yield 5.25% 4.75% 4.25%
Resulting P/E ratio 19.05 21.05 23.53
EPS forecast $162.00 $162.00 $162.00
Forecast for S&P 500 3,086 3,411 3,812

Note: The forecast for the earnings yield on the S&P 500 equals the
Treasury-bond yield plus 2.75%. The P/E ratio is the reciprocal of the
forecast earnings yield.

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© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill. 35