M12 - Valuation of Equity

8/6/2019 M12 - Valuation of Equity

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Chapter 15

COMPANY ANALYSIS AND

STOCK VALUATION


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Chapter 15 QuestionsWhy is it important to differentiate betweencompany analysis and stock analysis?

What is the difference between a growthcompany and a growth stock?

When valuing an asset, what are the requiredinputs?

After an investorhas valued an asset, what isthe investment decision process?

How is the value of bonds determined?


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Chapter 15 QuestionsWhat are the two primary approaches to thevaluation of common stock?

How do we apply the discounted cash flowvaluation approach, and what are the majordiscounted cash flow valuation techniques?

What is the dividend discount model (DDM),

and what is its logic?What is the effect of the assumptions of theDDM when valuing a growth company?


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Chapter 15 QuestionsHow do we apply the DDM to the valuation ofa firm that is expected to experience

temporary supernormal growth?How do we apply the relative valuationapproach to valuation, and what are themajor relative valuation techniques (ratios)?

How can the DDM be used to develop anearnings multiplier model?

What does the DDM model imply are thefactors that determine a stocks P/E ratio?


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Chapter 15 QuestionsWhat are some economic, industry, andstructural links that should be considered in

company analysis?What insights regarding a firm can be derivedfrom analyzing its competitive strategy andfrom a SWOT analysis?

What techniques can be used to estimate theinputs to alternative valuation models?

What techniques aid estimating companysales?


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Chapter 15 QuestionsHow do we estimate the profit margins andearnings per share for a company?

What procedures and factors do we considerwhen estimating the earnings multiplier for afirm?

What two specific competitive strategies can

a firm use to cope with the competitiveenvironment in its industry?

When should we consider selling a stock?


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Company Analysis and

Stock SelectionGood companies are not necessarilygood investments

In the end, we want to compare theintrinsic value of a stock to its marketvalue

Stock of a great company may beoverpriced

Stock of a lesser company may be asuperior investment since it is undervalued


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Companies that consistently experience

above-average increases in sales and

earnings have traditionally been thought of asgrowth companies

Limitations to this definition

Financial theorists define a growth company

as one with management and opportunitiesthat yield rates of return greater than the

firms required rate of return

Growth Companies and

Growth Stocks


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Growth Companies and

Growth StocksGrowth stocks are not necessarilyshares in growth companies

A growth stock has a higher rate of returnthan other stocks with similar risk

Superior risk-adjusted rate of return occursbecause of market under-valuation

compared to other stocksStudies indicate that growth companieshave generally not been growth stocks


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Defensive Companies

and StocksDefensive companies future earningsare more likely to withstand an

economic downturn Low business risk

Not excessive financial risk

Defensive stocks returns are not assusceptible to changes in the market

Stocks with low systematic risk


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Cyclical Companies and

StocksSales and earnings heavily influencedby aggregate business activity

High business risk Sometimes high financial risk as well

Cyclical stocks experience high returns

is up markets, low returns in downmarkets

Stocks withhigh betas


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Speculative Companies

and StocksSpeculative companies invest in sssets

involving great risk, but with the

possibility of great gain

Veryhigh business risk

Speculative stocks have the potential

for great percentage gains and losses May be firms whose current price-earnings

ratios are veryhigh


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Value versus Growth

InvestingGrowth stocks will have positiveearnings surprises and above-average

risk adjusted rates of return because thestocks are undervalued

Value stocks appear to be undervaluedfor reasons besides earnings growthpotential

Value stocks usuallyhave low P/E ratio orlow ratios of price to book value


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The Search forTrue

Growth StocksTo find undervalued

stocks, we must

understand thetheory of valuation

itself


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Theory of

Valuation

The value of a financial asset is the

present value of its expected future

cash flows

Required inputs:

The stream of expected future returns, or

cash flows The required rate of return on the

investment


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Stream of Expected

Returns (Cash Flows)From of returns

Depending on the investment, returns can be

in the form of: Earnings

Dividends

Interest payments

Capital gainsTime period and growth rate of returns

When will the cash flows be received from theinvestment?


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Required Rate of ReturnDetermined by the risk of an investment and

available returns in the market

Determined by:1. The real risk-free rate of return, plus

2. The expected rate of inflation, plus

3. A risk premium to compensate for the

uncertainty of returns Sources of uncertainty, and therefore risk premiums,

vary by the type of investment


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Investment Decision

ProcessOnce expected (intrinsic) value is

calculated, the investment decision is

rather straightforward and intuitive:

If Estimated Value > Market Price, buy

If Estimated Value < Market Price, do not

buyThe particulars of the valuation process

vary by type of investment


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Valuation of Alternative

InvestmentsWe will consider the valuation of two

important types of investments:

The valuation of bonds

The valuation of common stock


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Valuation of Bonds

What are the cash flows?

Bond cash flows (typically fixed)

Interest payments every six months equal to one-half of: (Coupon rate x Face value)

The payment of principal (Face or par value) atmaturity

Discount at the required rate of return to findthe bonds value

Process made relatively easy with a financialcalculator or spreadsheet software


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Approaches to Common

Stock ValuationDiscounted Cash Flow Techniques

Present value of Dividends (DDM)

Present value of Operating Cash Flow Present value of Free Cash Flow

Relative valuation techniques

Price-earnings ratio (P/E)

Price-cash flow ratios (P/CF)

Price-book value ratios (P/BV)

Price-sales ratio (P/S)


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Discounted Cash Flow

TechniquesBased on the basic valuation model: thevalue of a financial asset is the present

value of its expected future cash flowsVj = 7CFt/(1+k)

t

The different discounted cash flow

techniques consider different cash flowsand also different appropriate discountrates


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Dividend Discount

ModelsSimplifying assumptions help in estimating

present value of future dividends

Vj = 7Dt/(1+k)t

Can also assume various dividends for a

finite period of time with a reselling price, and

simply calculate the combined present value

of the dividends


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Dividend Discount

ModelsAlternative dividend assumptions

Constant Growth Model:

Assumes dividends started at D0 (last yearsdividend) and will grow at a constant growth rate

Growth will continue for an infinite period of time

The required return (k) is greater than the constant

rate of growth (g)

V = D1/(k-g)

where D1= D0(I+g)


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Dividend Discount

ModelsConstant Growth Model

Growth rate Can be estimated from past growth in earnings

and dividends

Can be estimated using the sustainable growthmodel

Discount rateWould consider the systematic risk of the

investment (beta)

Capital Asset Pricing Model


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Dividend Discount

ModelsValuation with Temporary SupernormalGrowth

Ifyou expect a company to experience rapidgrowth for some period of time

1. Find the present value of each dividend duringthe supernormal growth period separately

2. Find the present value of the remaining dividends

when constant growth can be assumed.3. Find the present value of the remaining dividends

by finding the present value of the estimateobtained in step 2.


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Present Value of

Operating Cash FlowsAnother discounted cash flow approach

is to discount operating cash flows

Operating cash flows are pre-interest cash

flows, so the required rate of return would

be adjusted to incorporate the required

returns of all investors (use the WACC)

VFj = 7OCFt/(1+WACCj)t


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Present Value of

Operating Cash FlowsIf we further assume a growth rate of

gOCF for operating cash flows, we can

value the firm as:

VFj = OCFt/(WACCj gOCF)


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Present Value of Free

Cash Flow to EquityA third discounted cash flow techniqueis to consider the free cash flows of a

firm available to equity as the cash flowstream to be discounted.

Since this is an equity stream, theappropriate discount rate is the requiredreturn on equity

VSj = 7FCFt/(1+kj)t


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Present Value of Free

Cash Flow to EquityOnce again, if we constant growth in

free cash flows, this expression reduces

to the following

VSj = FCFt/(kj gFCF)


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Relative Valuation

TechniquesThese techniques assume that prices

should have stable and consistent

relationships to various firm variablesacross groups of firms

Price-Earnings Ratio

Price-Cash Flow RatioPrice-Book Value Ratio

Price-Sales Ratio


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Relative Valuation

TechniquesPrice Earnings Ratio

Affected by two variables:

1. Required rate of return on its equity (k)

2. Expected growth rate of dividends (g)

gk

EDEP

!

11

1

//


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Relative Valuation

TechniquesPrice Earnings Ratio

Affected by two variables:

1. Required rate of return on its equity (k)

2. Expected growth rate of dividends (g)

Price/Cash Flow Ratio

gk

EDEP

!

11

1

//


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Price-Earnings RatioLook at the relationship between the current

market price and expected earnings per

share over the next year The ratio is the earnings multiplier, and is a

measure of the prevailing attitude of investors

regarding a stocks value

P/E factors Expected growth in dividends and earnings

Required rate of return on the stock


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Price-Earnings RatioUsing the P/E approach to valuation:

1. Estimate earnings for next year

2. Estimate the P/E ratio (EarningsMultiplier)

3. Multiply expected earnings by the

expected P/E ratio to get expectedprice

V =E1x(P/E)


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Price-Cash Flow RatioCash flows can also be used in this

approach, and are often considered less

susceptible to manipulation bymanagement.

The steps are similar to using the P/E

ratioV =CF1x(P/CF)


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Price-BookV

alue RatioBook values can also be used as a

measure of relative value

The steps to obtaining valuation

estimates are again similar to using the

P/E ratio

V =BV1x(P/BV)


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Price-Sales RatioFinally, sales can be used in relation to stock

price.

Some drawbacks, in that sales do not necessarilyproduce profit and positive cash flows

Advantage is that sales are also less susceptible

to manipulation

The steps are similar to using the P/E ratioV =S1x(P/S)


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Company Analysis:

Examining InfluencesCompany analysis is the final step in the top-

down approach to investing

Macroeconomic analysis identifies industriesexpected to offer attractive returns in the

expected future environment

Analysis of firms in selected industries

concentrates on a stocks intrinsic valuebased on growth and risk


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Economic and Industry

InfluencesIf trends are favorable for an industry, the

company analysis should focus on firms in

that industry that are positioned to benefitfrom the economic trends

Firms with sales or earnings particularly

sensitive to macroeconomic variables should

also be consideredResearch analysts need to be familiar with

the cash flow and risk of the firms


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Structural Influences

Social trends, technology, political, and

regulatory influences can have significant

influence on firmsEarly stages in an industrys life cycle see

changes in technology which followers may

imitate and benefit from

Politics and regulatory events can createopportunities even when economic influences

are weak


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Company Analysis

Competitive forces necessitate competitive

strategies.

Competitive Forces:1. Current rivalry

2. Threat of new entrants

3. Potential substitutes

4. Bargaining power of suppliers

5. Bargaining power of buyers

SWOT analysis is another useful tool


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Firm Competitive

StrategiesDefensive or offensive

Defensive strategy deflects competitive

forces in the industryOffensive competitive strategy affectscompetitive force in the industry toimprove the firms relative position

Porter suggests two major strategies:low-cost leadership and differentiation


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Low-Cost Strategy

Seeks to be the low cost leader in its

industry

Must still command prices near industry

average, so still must differentiate

Discounting too much erodes superior

rates of return


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Differentiation Strategy

Seeks to beidentified as uniquein its industry in anarea that isimportant to buyers

Above average rateof return only comesif the price premiumexceeds the extracost of being unique


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Focusing a Strategy

Firms with focused strategies:

Select segments in the industry

Tailor the strategy to serve those specific

groups

Determine which strategy a firm is pursuing

and its success Evaluate the firms competitive strategy

over time


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SWOT Analysis

Examination of a firms:

Strengths

Competitive advantages in the marketplace

Weaknesses Competitors have exploitable advantages of some kind

Opportunities

External factors that make favor firm growth over time

Threats External factors that hinder the firms success


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Favorable Attributes of

FirmsPeter Lynchs list of favorable attributes:

1. Firms product is not faddish

2. Companyhas competitive advantage over rivals3. Industry or product has potential for market

stability

4. Firm can benefit from cost reductions

5. Firm is buying back its own shares or managers(insiders) are buying


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Categorizing Companies

Lynch further recommends thefollowing categorization of firms:

1. Slow growers2. Stalwart

3. Fast growers

4. Cyclicals

5. Turnarounds

6. Asset plays


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Specific Valuation with

the P/E RatioEarnings per share estimates Time series use statistical analysis

Sales - profit margin approach EPS = (Sales Forecast x Profit Margin)/ Number of

Shares Outstanding

Judgmental approaches to estimating earnings Last years income plus judgmental evaluations

Using the consensus of analysts earnings estimates Once annual estimates are obtained, do quarterly

estimates and interpret announcementsaccordingly


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Site Visits, Interviews,

and FairDisclosureFair Disclosure (FD) requires that alldisclosure of material information be madepublic to all interested parties at the sametime Many firms will not allow interviews with

individuals, only provide information during largepublic presentations

Analysts now talk to people other than topmanagers Customers, suppliers


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Making the Investment

DecisionIf the estimate of the stocks intrinsic value isgreater than or equal to the current marketprice, buy the stock

Ifyour estimate of the stocks future intrinsicvalue would yield a return greater than yourrequired rate of return (based on currentinvestment price), then buy the stock

If the value is less than its current price, or itsreturn would be less than your required rateof return, do not buy the stock


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When to Sell

Hold on or move on?

If stocks decline right after purchase, is that a

further buying opportunity or a signal of amistaken investment?

Continuously monitor key assumptions thatled to the purchase of the investment

Know whyyou bought, and see if conditions havechanged

Evaluate when market value approachesestimated intrinsic value


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Influences on Analysts

Several factors make it difficult for analysts tooutperform the market

Efficient Markets Markets tend to price securities correctly, so

opportunities are rare

Most opportunities are likely in small, less followedcompanies

Paralysis of Analysis Must see the forest (the appropriate

recommendation) despite all of the trees (data)that complicate the decision


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Influences on Analysts

Investment bankers may push forfavorable evaluations of securities when

the same firm does (or wants to do)underwriting business with the firm inquestion

Are analysts independent and unbiased in

their recommendations? Ideally, analysts will remain independent

and show confidence in their analyses

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M12 - Valuation of Equity