Equity Valuation

Methods Balance Sheet Models Discounted Cash Flow Models Multiplier Models

Balance Sheet Models Book Value Liquidation Value Replacement Cost Tobin’s q Ratio

Book Value Book Value of Common Equity –Assets – Liabilities Divide by Common Shares Outstanding gives Book Value per Share Sensitive to accounting methods used Inventory accounting Leasing v. purchasing of long-term assets

Liquidation Value MV assets - MV liabilities –where MV = market value Value kept by shareholders if the firm is broken up and sold off.

Replacement Cost & Tobin’s q New Cost of Assets – MV liabilities Tobin’s q = SP / RC –where SP = stock price, RC = replacement cost RC v. SPTobin’s qIntrinsic ValueAction >< 1UndervaluedLiquidate (sell) <> 1OvervaluedReplicate (buy)

Tobin’s q & the Market Tobin's q for the US market from 1900 to Shows when the market was overvalued or undervalued. When Tobin's q spiked upward in 1929 and 1999 the market was expensive.

Discounted Cash Flow Methods Discounted Dividend Model Discounted Free Cash Flow Model

Discounted Dividend Model Assume constant growth rate in –Dividends –Earnings –Stock price

Example Expected Net Income = $2,000,000 1 million shares common Half of income paid as dividends –EPS = $2 mil / 1 mil = $2.00 per share –D = $2.00 x 50% = $1.00 per share Discount Rate = 15% Growth Rate = 5%

Example VoSPValueAction $10$12ovevaluedsell 10 fairly valuedhold 108undervaluedbuy

Discount Rate (k) Required Rate of Return Typically estimated from CAPM –K i = TBill Rate + beta i x Market Risk Premium

CaseTBill Rate MRPKV0V0 16%8%14%$ % 16%$ %12%20%$6.67 D 1 = $1.00 g = 5% beta = 1.0

Growth Rate Sustainable growth rate = ROE x b ROE = Return on Equity –Net Income / Common Equity b = Plowback (retention) ratio –(net income – dividends) / net income

K = 15% E 1 = $5.00 ROE = 20% b = 40% D 1 = E 1 x (1-b)= $3.00 g = ROE x b = 8%

Plowback & Reinvestment Rates High Rates of return on investment encourage the firm to retain earnings for reinvestment (plowback). Low Rates of return encourage the payment of dividends.

Growth Rates and Earnings E 0 NIb  E E 1  E ROEg $10$11.00$ % %10%4% Where: E 0 = Current Equity E 1 = Expected end-of-period equity

K = 15% E 1 = $5.00 ROE = 20% b = 40% D 1 = E 1 x (1-b)= $3.00 g = ROE x b = 8% Partitioning Intrinsic Value

NGV –Value of assets in place Firm without any further future investment PVGO –Value of future investment Investment which will generate future cash flow –Positive if earnings reinvested at rates of return higher than what investors require on the company’s stock (ROE > k)

ROE = ROA x m M = 1 / (1 – DR) DR = debt ratio