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CHAPTER 18 Equity Valuation Models. Valuation Methods  Valuation by comparables  Price/Earning Ratios  Balance Sheet Models Book Value

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Presentation on theme: "CHAPTER 18 Equity Valuation Models. Valuation Methods  Valuation by comparables  Price/Earning Ratios  Balance Sheet Models Book Value"— Presentation transcript:

1 CHAPTER 18 Equity Valuation Models

2 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

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

4 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

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

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

7 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

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

9 V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model

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

11 E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 No Growth Model: Example

12 g = constant perpetual growth rate Constant Growth Model

13 E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / ( ) = $42.86 Constant Growth Model: Example

14 g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1- dividend payout percentage rate) Estimating Dividend Growth Rates

15 Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies

16 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)

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

18 ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% g =.20 x.40 =.08 or 8% Partitioning Value: Example

19 V o = value with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example Continued

20 Life Cycles and Multistage Growth Models g 1 = first growth rate g 2 = second growth rate T = number of periods of growth at g 1

21 Multistage Growth Rate Model: Example D 0 = $2.00 g 1 = 20% g 2 = 5% k = 15% T = 3 D 1 = 2.40 D 2 = 2.88 D 3 = 3.46 D 4 = 3.63 V 0 = D 1 /(1.15) + D 2 /(1.15) 2 + D 3 /(1.15) 3 + D 4 / ( ) ( (1.15) 3 V 0 = = $30.40

22 Table 18.2 Financial Ratios in Two Industries

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

24 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 Price Earnings Ratios

25 E 1 - expected earnings for next year – E 1 is equal to D 1 under no growth k - required rate of return P/E Ratio: No Expected Growth

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

27 E 0 = $2.50 g = 0 k = 12.5% P 0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 Numerical Example: No Growth

28 b = 60% ROE = 15% (1-b) = 40% E 1 = $2.50 (1 + (.6)(.15)) = $2.73 D 1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P 0 = 1.09/( ) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 -.60) / ( ) = 11.4 Numerical Example: Growth

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

30 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

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

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

33 Figure 18.4 Earnings Growth for Two Companies

34 Figure 18.5 Price-Earnings Ratios

35 Figure 18.6 P/E Ratios for Different Industries, 2007

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

37 Figure 18.7 Market Valuation Statistics

38 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

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

40 The Aggregate Stock Market Explaining Past Behavior Forecasting the Stock Market

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

42 Table 18.4 S&P 500 Price Forecasts Under Various Scenarios


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