McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Equity Valuation CHAPTER 13

VALUATION BY COMPARABLES

13-3 Fundamental Stock Analysis: Models of Equity Valuation Basic Types of Models –Balance Sheet Models –Dividend Discount Models –Price/Earnings Ratios Estimating Growth Rates and Opportunities

13-4 Models of Equity Valuation Valuation models use comparables –Look at the relationship between price and various determinants of value for similar firms The internet provides a convenient way to access firm data. Some examples are: –EDGAR –Finance.yahoo.com

13-5 Table 13.1 Microsoft Corporation Financial Highlights

13-6 Valuation Methods Book value: an accounting measure that values a firm at the (adjusted) cost of acquiring the assets of a firm. Market value: current value of firm. Liquidation value: a measure of the value that could be realized by breaking up a firm, selling all its assets, repaying all its debts, and returning the rest to shareholders. Replacement cost: Cost of replacing all a firm’s assets. Tobin’s Q: ratio of market price to replacement cost. Idea: in long run this ratio tends to 1, so departures from this ratio will be corrected over time in market price.

INTRINSIC VALUE VERSUS MARKET PRICE

13-8 Expected Holding Period Return The return on a stock investment comprises cash dividends and capital gains or losses –Assuming a one-year holding period

13-9 Required Return CAPM gave us required return: If the stock is priced correctly –Required return should equal expected return

13-10 Intrinsic Value and Market Price Market Price –Consensus value of all potential traders –Current market price will reflect intrinsic value estimates –This consensus value of the required rate of return, k, is the market capitalization rate Trading Signal (IV = Intrinsic Value, the present value of all cash payments, discounted at rate k; MP = Market Price) –IV > MP  Buy –IV < MP  Sell or Short Sell –IV = MP  Hold or Fairly Priced

DIVIDEND DISCOUNT MODELS

13-12 General Model V D k o t t t      ()1 1 V 0 = Value of Stock at time 0 D t = Dividend at time t, t = 1, 2,3,…. k = required return

13-13 No Growth Model V D k o  Stocks that have earnings and dividends that are expected to remain constant –Preferred Stock –A perpetuity…

13-14 No Growth Model: Example E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 V D k o 

13-15 Constant Growth Model Vo Dg kg o    ()1 g = constant perpetual growth rate

13-16 Constant Growth Model: Example Vo Dg kg o    ()1 E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / ( ) = $42.86

13-17 Stock Prices and Investment Opportunities gROEb  g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate – (1- dividend payout percentage rate)

13-18 Figure 13.1 Dividend Growth for Two Earnings Reinvestment Policies

13-19 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)

13-20 Present Value of Growth Opportunities (cont.) Price = No-growth value per share + PVGO (present value of growth opportunities) Where: E 1 = Earnings Per Share for period 1 and

13-21 Partitioning Value: Example ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% g =.20 x.40 =.08 or 8%

13-22 P NGV PVGO o o      (..) $42.. $33. $42.$33.$9. Partitioning Value: Example (cont.) P o = price with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities

13-23 Life Cycles and Multistage Growth Models PD g k Dg kgk oo t t t T T T         () () () ()() g 1 = first growth rate g 2 = second growth rate T = number of periods of growth at g 1

13-24 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 D 4 / ( ) ( (1.15) 3 V 0 = = $30.40

PRICE-EARNINGS RATIOS

13-26 P/E Ratio and Growth Opportunities 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

13-27 P/E Ratio: No expected growth P E k P Ek   E 1 - expected earnings for next year –E 1 is equal to D 1 under no growth k - required rate of return

13-28 P/E Ratio: Constant Growth P D kg Eb kbROE P E b kb         () () ( ) b = retention ration b = retention ration ROE = Return on Equity ROE = Return on Equity

13-29 Numerical Example: No Growth E 0 = $2.50 g = 0 k = 12.5% P 0 = D/k = $2.50/.125 = $20.00 P/E = 1/k = 1/.125 = 8

13-30 Numerical Example with Growth 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 P/E = 31.14/2.73 = 11.4 P/E = (1 -.60) / ( ) = 11.4

13-31 P/E Ratios and Stock Risk Riskier stocks will have lower P/E multiples Riskier firms will have higher required rates of return (higher values of k)

13-32 Pitfalls in Using P/E Ratios Flexibility in reporting makes choice of earnings difficult Pro forma earnings may give a better measure of operating earnings Problem of too much flexibility

13-33 Figure 13.3 P/E Ratios and Inflation

13-34 Figure 13.4 Earnings Growth for Two Companies

13-35 Figure 13.5 Price-Earnings Ratios

13-36 Figure 13.6 P/E Ratios

13-37 Other Comparative Valuation Ratios Price-to-book Price-to-cash flow Price-to-sales Be creative

13-38 Figure 13.7 Valuation Ratios for the S&P 500

FREE CASH FLOW VALUATION APPROACHES

13-40 Free Cash Flow One approach is to discount the free cash flow for the firm (FCFF) at the weighted- average cost of capital –Subtract existing value of debt –FCFF = EBIT (1- t c ) + Depreciation – Capital expenditures – Increase in NWC where: where: EBIT = earnings before interest and taxes t c = the corporate tax rate NWC = net working capital

13-41 Free Cash Flow (cont.) Another approach focuses on the free cash flow to the equity holders (FCFE) and discounts the cash flows directly at the cost of equity FCFE = FCFF – Interest expense (1- t c ) + Increases in net debt

13-42 Comparing the Valuation Models Free cash flow approach should provide same estimate of IV as the dividend growth model In practice the two approaches may differ substantially –Simplifying assumptions are used

THE AGGREGATE STOCK MARKET

13-44 Earnings Multiplier Approach Forecast corporate profits for the coming period Derive an estimate for the aggregate P/E ratio using long-term interest rates Product of the two forecasts is the estimate of the end-of-period level of the market

13-45 Figure 13.8 Earnings Yield of the S&P 500 Versus 10-year Treasury Bond Yield

13-46 Table 13.4 S&P 500 Index Forecasts