# Equity Valuation Models

## Presentation on theme: "Equity Valuation Models"— Presentation transcript:

Equity Valuation Models
CHAPTER 18

Valuation Methods Valuation by comparables
Price/Earning Ratios Balance Sheet Models Book Value Expected Returns vs. Required Return CAPM Intrinsic Value vs. Market price Dividend Discount Models

Table 18.1 Financial Highlights for Microsoft Corporation, October 25, 2007

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 Tobin’s q ratio

Expected Holding Period Return
The return on a stock investment comprises cash dividends and capital gains or losses Assuming a one-year holding period

Required Return CAPM gave us required return:
If the stock is priced correctly Required return should equal expected return

Intrinsic Value and Market Price
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

Specified Holding Period
PH = the expected sales price for the stock at time H H = the specified number of years the stock is expected to be held

Dividend Discount Models: General Model
V0 = Value of Stock Dt = Dividend k = required return

No Growth Model Stocks that have earnings and dividends that are expected to remain constant Preferred Stock

No Growth Model: Example
E1 = D1 = \$5.00 k = .15 V0 = \$5.00 /.15 = \$33.33

Constant Growth Model g = constant perpetual growth rate

Constant Growth Model: Example
E1 = \$5.00 b = 40% k = 15% (1-b) = 60% D1 = \$3.00 g = 8% V0 = 3.00 / ( ) = \$42.86

Estimating Dividend Growth Rates
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

Present Value of Growth Opportunities
If the stock price equals its IV, growth rate is sustained, the stock should sell at: If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist)

Present Value of Growth Opportunities Continued
Price = No-growth value per share + PVGO (present value of growth opportunities)

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 Continued
Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities

Life Cycles and Multistage Growth Models
g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1

Multistage Growth Rate Model: Example
D0 = \$ g1 = 20% g2 = 5% k = 15% T = 3 D1 = 2.40 D2 = D3 = D4 = 3.63 V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 + D4 / ( ) ( (1.15)3 V0 = = \$30.40

Table 18.2 Financial Ratios in Two Industries

Figure 18.2 Value Line Investment Survey Report on Honda Motor Co.

Price Earnings Ratios 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

P/E Ratio: No Expected Growth
E1 - expected earnings for next year E1 is equal to D1 under no growth k - required rate of return

P/E Ratio: Constant Growth
b = retention ratio ROE = Return on Equity

Numerical Example: No Growth
E0 = \$ g = 0 k = 12.5% P0 = D/k = \$2.50/.125 = \$20.00 PE = 1/k = 1/.125 = 8

Numerical Example: Growth
b = 60% ROE = 15% (1-b) = 40% E1 = \$2.50 (1 + (.6)(.15)) = \$2.73 D1 = \$2.73 (1-.6) = \$1.09 k = 12.5% g = 9% P0 = 1.09/( ) = \$31.14 PE = 31.14/2.73 = 11.4 PE = ( ) / ( ) = 11.4

Table 18.3 Effect of ROE and Plowback on Growth and the P/E Ratio

P/E Ratios and Stock Risk
Holding all else equal Riskier stocks will have lower P/E multiples Higher values of k; therefore, the P/E multiple will be lower

Pitfalls in P/E Analysis
Use of accounting earnings Earnings Management Choices on GAAP Inflation Reported earnings fluctuate around the business cycle

Figure 18.3 P/E Ratios of the S&P 500 Index and Inflation

Figure 18.4 Earnings Growth for Two Companies

Figure 18.5 Price-Earnings Ratios

Figure 18.6 P/E Ratios for Different Industries, 2007

Other Comparative Value Approaches
Price-to-book ratio Price-to-cash-flow ratio Price-to-sales ratio

Figure 18.7 Market Valuation Statistics

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 flow After tax EBIT Depreciation Capital expenditures Increase in net working capital

Comparing the Valuation Models
In practice Values from these models may differ Analysts are always forced to make simplifying assumptions

The Aggregate Stock Market
Explaining Past Behavior Forecasting the Stock Market

Figure 18.8 Earnings Yield of S&P 500 versus 10-Year Treasury-Bond Yield

Table 18.4 S&P 500 Price Forecasts Under Various Scenarios