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Equity Valuation Models

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

1 Equity Valuation Models
CHAPTER 18

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 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

8 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

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

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

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

12 Constant Growth Model g = constant perpetual growth rate

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

14 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)

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 Partitioning Value: Example
ROE = 20% d = 60% b = 40% E1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8%

19 Partitioning Value: Example Continued
Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities

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

21 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

22 Table 18.2 Financial Ratios in Two Industries

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

24 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

25 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

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

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

28 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

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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