Investment Management © 2008

Equity Valuation ModelsEquity Valuation Models

Lectured byChandra Wijaya

Lectured byChandra Wijaya

22

Basic Types of ModelsBalance Sheet Models

Dividend Discount Models

Price/Earning Ratios

Estimating Growth Rates and Opportunities

Models of Equity Valuation

33

Limitations of Book Value

Book value is an application of arbitrary accounting rules

Can book value represent a floor value?

Better approachesLiquidation value

Replacement cost

44

Intrinsic ValueSelf assigned ValueVariety of models are used for estimation

Market PriceConsensus value of all potential traders

Trading SignalIV > MP BuyIV < MP Sell or Short SellIV = MP Hold or Fairly Priced

Intrinsic Value and Market Price

55

VD

ko

t

tt

( )11

VD

ko

t

tt

( )11

V0 = Value of Stock

Dt = Dividendk = required return

Dividend Discount Models: General Model

66

VD

ko

Stocks that have earnings and dividends that are expected to remain constant.

Preferred Stock

No Growth Model

77

E1 = D1 = $5.00k = .15

V0 = $5.00 / .15 = $33.33

VD

ko

No Growth Model: Example

88

VoD g

k g

o

( )1

VoD g

k g

o

( )1

g = constant perpetual growth rate

Constant Growth Model

99

VoD g

k g

o

( )1

VoD g

k g

o

( )1

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

(1-b) = 60% D1 = $3.00 g = 8%

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

Constant Growth Model: Example

1010

g ROE b g ROE b

g = growth rate in dividendsROE = Return on Equity for the firmb = plowback or retention percentage rate

(1- dividend payout percentage rate)

Estimating Dividend Growth Rates

1111

)1()1()1(...2

21

10

kPD

kD

kDV N

NN

PN = the expected sales price for the stock at time N

N = the specified number of years the stock is expected to be held

Specified Holding Period Model

1212

Dividend Growth for Two Earnings Reinvestment Policies

1313

VE

kPVGO

PVGOD g

k g

E

k

o

o

1

11( )

( )

VE

kPVGO

PVGOD g

k g

E

k

o

o

1

11( )

( )

PVGO = Present Value of Growth Opportunities

E1 = Earnings Per Share for period 1

Growth & No Growth Components of Value

1414

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

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

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

Partitioning Value: Example

1515

V

NGV

PVGO

o

o

3

15 0886

5

1533

86 33 52

(. . )$42.

.$33.

$42. $33. $9.

V

NGV

PVGO

o

o

3

15 0886

5

1533

86 33 52

(. . )$42.

.$33.

$42. $33. $9.

Vo = value with growth

NGVo = no growth component value

PVGO = Present Value of Growth Opportunities

Partitioning Value: Example

1616

P/E Ratios are a function of two factorsRequired Rates of Return (k)

Expected growth in Dividends

UsesRelative valuation

Extensive Use in industry

Price Earnings Ratios

1717

PE

kP

E k

01

0

1

1

PE

kP

E k

01

0

1

1

E1 - expected earnings for next year

E1 is equal to D1 under no growth

k - required rate of return

P/E Ratio: No Expected Growth

1818

)(

1

)(

)1(

1

0

110

ROEbk

b

E

P

ROEbk

bE

gk

DP

)(

1

)(

)1(

1

0

110

ROEbk

b

E

P

ROEbk

bE

gk

DP

b = retention ratio

ROE = Return on Equity

P/E Ratio with Constant Growth

1919

E0 = $2.50 g = 0 k = 12.5%

P0 = D/k = $2.50/.125 = $20.00

PE = 1/k = 1/.125 = 8

Numerical Example: No Growth

2020

b = 60% ROE = 15% (1-b) = 40%

E1 = $2.50 (1 + (.6)(.15)) = $2.73

D1 = $2.73 (1-.6) = $1.09k = 12.5% g = 9%

P0 = 1.09/(.125-.09) = $31.14PE = 31.14/2.73 = 11.4PE = (1 - .60) / (.125 - .09) = 11.4

Numerical Example with Growth

2121

Effect of ROE and Plowback on Growth and the P/E Ratio

2222

Pitfalls in P/E Analysis

Use of accounting earningsHistorical costs

May not reflect economic earnings

Inflation

Reported earnings fluctuate around the business cycle.

2323

P/E Ratios and Inflation

2424

Earnings Growth for Two Companies

2525

Price-Earnings Ratios

2626

Other Valuation Ratios

Price-to-Book

Price-to-Cash Flow

Price-to-Sales

2727

Market Valuation Statistics

2828

Inflation and Equity Valuation

Inflation has an impact on equity valuations.

Historical costs underestimate economic costs.

Empirical research shows that inflation has an adverse effect on equity values.

Research shows that real rates of return are lower with high rates of inflation.

2929

Lower Equity Values with Inflation

Shocks cause expectation of lower earnings by market participants.

Returns are viewed as being riskier with higher rates of inflation.

Real dividends are lower because of taxes.

3030

Free Cash Flow Approach

Discount the free cash flow for the firm

Discount rate is the firm’s cost of capital

Components of free cash flowAfter tax EBIT

Depreciation

Capital expenditures

Increase in net working capital

3131

Categories of Stock

Blue chip stock

Income stocks

Cyclical stocks

Defensive stocks

Growth stocks

Speculative stocks

Penny stocks

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Categories of Stock

Blue Chip Stock

Blue chip has become a colloquial term meaning “high quality”

Some define blue chips as firms with a long, uninterrupted history of dividend paymentsThe term blue chip lacks precise meaning, but some examples are:

Coca-ColaUnion PacificGeneral Mills

3333

Categories of Stock

Income Stocks

Income stocks are those that historically have paid a larger-than-average percentage of their net income as dividends

The proportion of net income paid out as dividends is the payout ratioThe proportion of net income retained is the retention ratio

3434

Categories of Stock

Cyclical Stocks

Cyclical stocks are stocks whose fortunes are directly tied to the state of the overall national economy

Examples include steel companies, industrial chemical firms, and automobile producers

3535

Categories of Stock

Defensive Stocks

Defensive stocks are the opposite of cyclical stocks

They are largely immune to changes in the macroeconomy and have low betas

Examples include retail food chains, tobacco and alcohol firms, and utilities

3636

Growth Stocks

Categories of Stock

Growth stocks do not pay out a high percentage of their earnings as dividends and may be good candidates for above-average returns.

They reinvest most of their earnings into investment opportunities

Many growth stocks do pay dividends

3737

Categories of Stock

A speculative stock has a high probability of a loss and a small probability of a large profit.Most speculative stocks are relatively new companies with representation in the technology, bioresearch, and pharmaceutical industries

Penny stocks refer to unusually risky, especially inexpensive shares.Penny stocks sell for $1 per share or less

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Categories of Stock

Categories Are Not Mutually Exclusive

An income stock or a growth stock can also be a blue chip

E.g., Potomac Electric Power

Defensive or cyclical stocks can be growth stocks

E.g., Dow Chemical is a cyclical growth stock