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Security Analysis Part I. Fundamental Analysis: Models of Equity Valuation. Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios Estimating Growth Rates and Opportunities. Intrinsic Value and Market Price. Intrinsic Value Self assigned Value - PowerPoint PPT Presentation
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comm 324 --- W. SuoSlide 1Slide 1
Security AnalysisSecurity AnalysisPart IPart I
comm 324 --- W. SuoSlide 2Slide 2
Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios
Estimating Growth Rates and Opportunities
Fundamental Analysis: Models of Equity Valuation
comm 324 --- W. SuoSlide 3Slide 3
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 Value and Market Price
comm 324 --- W. SuoSlide 4Slide 4
1 (1 )
to
tt
DV
k
1 (1 )
to
tt
DV
k
V0 = Value of Stock
Dt = Dividendk = required return
Dividend Discount Models (DDM):General Model
comm 324 --- W. SuoSlide 5Slide 5
No growth: Stocks that have earnings and dividends that are expected to remain constant Preferred Stock
Example
EPS1 = D1 = $5.00 k = .15
V0 = $5.00 / .15 = $33.33
Special Cases
comm 324 --- W. SuoSlide 6Slide 6
00
(1 )D gV
k g
0
0
(1 )D gV
k g
g = constant perpetual growth rate
Constant Growth Model
comm 324 --- W. SuoSlide 7Slide 7
0 10
(1 )D g DV
k g k g
0 1
0
(1 )D g DV
k g k g
EPS1 = $5.00 b = 40% k = 15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
Constant Growth Model: Example
comm 324 --- W. SuoSlide 8Slide 8
Model-Building Assumptions
k > g (otherwise denominator would be negative, leading to a negative stock price)
Both k and g represent long-run averages
Ignores taxes, external financing and options Allowing for taxes and debt financing is relatively easy Allowing for executive stock options and warrants is more difficult
comm 324 --- W. SuoSlide 9Slide 9
Structural Changes in Cash Dividend Payments
Corporate earnings will be used for Cash dividends paid to owners (shareholders) Retained earnings reinvested in firm Share buybacks to repurchase outstanding shares
Recently firms have decreased cash dividend growth rates and begun buying back stock
Examples: IBM, American Express, Coca-Cola
comm 324 --- W. SuoSlide 10Slide 10
Restating Present Value Models in Terms of Earnings
The retention ratio, or plowback ratio, b represents the portion of earnings not paid as dividends
Therefore, it is retained earnings The payout ratio is (1 –b) Thus, a firm’s dividend can be rewritten as
Dt = (1 – b)*EPSt
A firm can use retained earnings to either repurchase shares or to reinvest and earn the firm’s ROE
Reinvested earnings can finance internal growth at a periodic rate of g = b*ROE
Therefore, EPSt = EPS0 * (1+g)t = EPS0 [1 + b*(ROE)]t
comm 324 --- W. SuoSlide 11Slide 11
Restating Present Value Models in Terms of Earnings
Profitable firms can earn ROE > 0 by reinvesting RE in profitable projects or repurchasing shares
Share repurchases can increase EPS because the firm’s earnings are now spread out over fewer shares (called reverse dilution)
If the b>0, then the following equations are equivalent Dt = (1 – b) EPSt
Dt = (1 – b) (1 + g)t EPS0
Dt = (1 – b) [1 + b*(ROE)]t EPS0
comm 324 --- W. SuoSlide 12Slide 12
Reformulated Present Value Model
Substituting the basic discounted dividend model
If D1 is replaced with EPS1 (1 – b) in the constant DDM, we obtain:
This allows us the ability to examine how dividend policy impacts share value
Dividend policy is reflected in the retention rate b
¥
0
01
(1 – ) [1 ( )]
1
t
tt
b b ROE EPSP
k
1
0
1 -
-
bEPSk gP
comm 324 --- W. SuoSlide 13Slide 13
Dividend Policy Irrelevance
Since g = b*(ROE) 1
0
1
bEPSk b ROEP
If a firm has an ROE on new investments equal to the risk-adjusted discount rate then
1 1
0
1
(1- )
bEPS EPSk b kP
Thus, regardless of a firm’s initial EPS or riskiness, the firm’s value is unaffected by dividend policy, as RR is no longer in the equation So, when ROE = k dividend policy is irrelevant
comm 324 --- W. SuoSlide 14Slide 14
Dividend Policy and Growth Firms
The relationship between a firm’s ROE and its discount rate determine the impact of dividend policy on firm value A firm earning an ROE > discount rate is considered a
growth firm Declining firms have ROE below the discount rate, or
ROE < k When ROE = k dividend policy is irrelevant
comm 324 --- W. SuoSlide 15Slide 15
Example
Assume a firm has An ROE of 15% A discount rate, k, of 15% A retention rate b of 66.67%
Leads to a growth rate of 0.6667 x .15 = 10% Cash dividends growth rate of 10%
If these assumptions hold, the firm’s value will remain a constant $50 (in present value terms)
comm 324 --- W. SuoSlide 16Slide 16
Example
Future Value at g = 10% Present Value at k = 15%
Time Period Divt Stock Price
PV of cumulative dividend
PV of future price Total
T=0 NA $50 NA $50 $50
T=1 $2.50 55 $2.18 $47.82 50
T=2 $2.75 60.50 4.26 45.74 50
T=3 3.03 66.55 6.25 43.76 50
T=4 3.33 73.20 8.15 41.85 50
T=5 3.66 80.53 9.97 40.03 50
T=10 5.89 129.68 17.94 32.06 50
T=20 15.29 336.37 29.44 20.56 50
T=50 266.80 5869.55 44.58 5.42 50
T=100 31,319.57 689,030.62 49.41 0.59 50
T= 50 0.0 50
comm 324 --- W. SuoSlide 17Slide 17
1 20 1 2 ...
(1 ) (1 ) (1 )N N
NV D PD Dk k k
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
comm 324 --- W. SuoSlide 18Slide 18
0
1
1(1 )
( )
V
o
EPSPVGO
kD g EPS
PVGOk g k
0
1
1(1 )
( )
V
o
EPSPVGO
kD g EPS
PVGOk g k
PVGO = Present Value of Growth Opportunities
E1 = Earnings per share for period 1
Partitioning Value: Growth and No Growth Components
comm 324 --- W. SuoSlide 19Slide 19
ROE = 20% d = 60% b = 40%
EPS1 = $5.00 D1 = $3.00 k = 15%
Partitioning Value: Example
g = .20 x .40 = .08 or 8%
comm 324 --- W. SuoSlide 20Slide 20
52.9$33.33$86.42$
33.33$15.
5
86.42$)08.15(.
3
PVGO
NGV
V
o
o
52.9$33.33$86.42$
33.33$15.
5
86.42$)08.15(.
3
PVGO
NGV
V
o
o
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth
Opportunities
Partitioning Value: Example (cont’d)
comm 324 --- W. SuoSlide 21Slide 21
Two Stages of Growth DDM
A firm’s common stock may have one of the following growth patters in dividends
Two stages of positive growth (g1 and g2) One constant positive growth rate Zero growth One constant negative growth rate
comm 324 --- W. SuoSlide 22Slide 22
Example
Battel Corporation has the following attributes: Paid an annual dividend of $2 per share Cost of equity capital is 10% Cash dividends are growing at 2% annually
What is Battel’s stock worth?
0
0
1 $2 1.02 $2.04 $25.50 per share
- 0.10 - 0.02
0.08
D g
k gP
comm 324 --- W. SuoSlide 23Slide 23
Example
Battel is now considering international expansion with the following adjustments
Same dividend as above, but now the expected growth rate is 4%, not 2%, and the increased risk is expected to increase the cost of equity to 11%
Battel’s value should increase to:
00
1 $2 1.04 $29.71
0.11 0.02
g
k gDP
comm 324 --- W. SuoSlide 24Slide 24
Example
Example Initial stock price: $25.50 With international expansion: $29.71
What if the international expansion caused Battel's growth rate to rise to 4% for only four years and then the growth rate dropped to the original estimate of 2% forever?
If the exposure to international risks increases Battel’s cost of equity to 11% permanently
40
$26.516 $6.81576
1.11 $6.81576 $17.4669
$24.282
P
24
52
1 $2.3397 1.02 $26.516
- 0.11- 0.0
2
g
k gDP
comm 324 --- W. SuoSlide 25Slide 25
DDM Criticism
Critics argue that it is too difficult to accurately forecast future cash dividends This criticism is true for some firms but not others
Example: Coca-Cola’s dividend payment is relatively easy to forecast even though its operations cover over 200 different countries
Critics then argue that, even if earlier dividends are relatively easy to forecast, longer-term dividends (say 50 to 100 years from now) are more difficult to determine These long-range forecasts are unimportant
comm 324 --- W. SuoSlide 26Slide 26
DDM Criticism
• Because the present value of these amounts are very low
Time
Present Value
Of $1
(i=10%)
Present Value
Of $1
(i=16%)
10 39¢ 23¢
25 9.2¢ 2.5¢
50 < 1¢ 6/100 of 1¢
100 < 1/100 of 1¢ 3/100,000 of 1¢
comm 324 --- W. SuoSlide 27Slide 27
Implications
It is only essential to accurately forecast cash dividends for 10 years in order to use the DDM
Cash dividends in years 11-30 only need to be forecasted within 40% of their actual values
All cash dividends received from years 31 to infinity have a present value of only $1 or $2
When a higher discount rate is used (as with smaller, riskier firms) it is only necessary to forecast dividends for a few years