COMMON STOCK VALUATION Chapter 13 COMMON STOCK VALUATION

Fundamental Analysis If: intrinsic value < current market value analysts (or investors) try to determine the intrinsic value of a stock If: intrinsic value < current market value overpriced  sell stock underpriced  buy stock

Determining Intrinsic Value various methods we will look at several all are based on estimates of what will happen in the future no method is perfect as based on estimates of certain (unknown) parameters cannot predict the future exactly, can only make best guess therefore, can never true intrinsic value, only your best estimate

two analysts may come up with different estimates of intrinsic value if: They use different valuation models or They use the same model but have different parameter estimates

Need way to determine what it “should” be worth If fundamental analysis of intrinsic values is based on estimates, is it useful? Yes! Investors need to make buy/sell decisions based on what the stock is priced at and what they feel it should be worth Need way to determine what it “should” be worth Different investors can have different estimates  this is what creates trading

Two Common Valuation Methods Present Value Approach dividend discount model (DDM) Free Cash Flow Valuation Value stock based on value of cashflows it generates for the investor 2) Relative Valuation Approach (a) Price-earnings ratio (b) other ratios (price to book, price to sales etc.) Value stock by looking at how similar stocks are valued by the market

Present Value Approach - Dividend Discount Model the value of any stock (or other security) is the present value of future cashflows coming from the stock for a stock, cashflows received by investors are the dividends intrinsic value of share = PV of all future dividends

1) required return on the stock to implement, need estimates of two things: 1) required return on the stock 2) all future dividends

general level of interest rates in economy risk level of stock required return on stock depends on: general level of interest rates in economy risk level of stock estimating future dividends: impossible to predict exactly what all future dividends will be typically, simplifying assumptions are used Three cases: 1) Zero Growth 2) Constant Growth 3) Multiple Growth

Zero Growth Model pays out all earnings as dividends Assume that firm does not reinvest anything in itself, pays out all earnings as dividends it should experience no growth over time: D0 = EPS0 and D0 = D1 = D2 = ... DDM becomes a perpetuity: This simple model would generally never apply to common stocks (applies to straight convertible shares)

Constant Growth Model DDM becomes a growing perpetuity dividends are expected to grow at a constant rate, g, forever DDM becomes a growing perpetuity where D1 = D0(1+g)

Level of interest rates The constant growth model shows the basic factors which affect stock prices: Firm Profitability (via dividends) Level of interest rates Risk level of stock Future profitability (via dividends)

in constant growth model, g is growth rate in dividends and is also expected appreciation in stock price the expected (required) return to the investor can be broken down in to a dividend yield and a capital gain yield (=g) in practice, this simple model would only apply to a stock with very stable (in terms of growth) dividends – typically in a fully mature and non-cyclical industry

Multiple Growth Model dividends are expected to grow at different rates over different periods eventually, dividends enter a period of stable, long term growth which goes on forever common to use 2 or 3 different growth rates in practice, or to estimate first few dividends directly and then assume growth rate(s)

using the estimated growth rates Where: the dividends (D1 to Dn+1) have to be estimated directly using the estimated growth rates

Problems with Present Value Approach in theory, DDM is correct but implementation can be hard parameters (next dividends, growth rate(s), required return) must be estimated and this is the hard part we will look at methods to estimate required return, earnings, dividends and growth rates a little later in course the intrinsic value calculated can be very sensitive to assumptions made

DDM best suited to firms which maintain stable payout ratios DDM best suited for firms which have reasonably stable growth rates does not work well for cyclical firms or firms with erratic earnings DDM may work reasonably well for firms in mature industries with stable profits (or growing at stable rate) and an established dividend policy

Another Present Value Approach - Free Cash Flow Valuation Many firms do not currently pay dividends Theoretically, DDM will work, but extremely difficult to estimate when dividends will begin and what growth rate will be Alternative to DDM is calculating present value of Free Cash Flow

Two approaches: Free Cash Flow to Equity (FCFE) Free Cash Flow to the Firm (FCFF) Free Cash Flow to Equity: Estimate how much cash the firm could pay out as dividends if it wanted to = FCFE Think of this as “potential” dividends Calculate present value of future FCFE to get value of equity

Free Cash Flow to Equity FCFE = Net Income + Depreciation – Capital Expenditures – Change in non-cash Working Capital + Net New Debt Issued

Free Cash Flow to Equity Similar to DDM, estimate a growth rate and then discount at the required return on equity: Total value of Equity = Divide this number by number of shares outstanding to get estimate of intrinsic value of one share

Free Cash Flow to Firm FCFF represents the cashflow available each that could be distributed to all security holders (i.e. shareholders and debt holders) FCFF = FCFE – Net New debt + Interest(1-tax)

Free Cash Flow to Firm FCFF = Net Income + Depreciation - Capital Expenditures - Change in non-cash Working Capital + Interest (1 – tax rate)

Free Cash Flow to Firm Estimate growth rate for FCFF Discount future FCFF at the weighted average cost of capital (WACC) Value of Firm = This is value of overall firm, to get share value subtract value of debt and divide by number of shares

Estimating Intrinsic Value - Relative Valuation Approach value a stock by comparing it to other stocks usually done by comparing the level of some accounting variable such as earnings, sales or book value in some industries non-accounting numbers might be used (e.g. # of subscribers in the cable industry, amount of oil reserves in oil industry)

use this and the level of the variable for the firm to value the stock whatever the basis of comparison, the process is essentially the same determine what the relationship between the variable and the stock price “should” be use this and the level of the variable for the firm to value the stock

by far the most common relative valuation approach is based on the price-earnings ratio (P\E ratio)

P/E Ratios price must be measured relative so something Price of a stock alone does not tell you if it is “expensive” or “cheap” price must be measured relative so something most common is earnings how much does the stock cost per dollar of earnings the firm generates?

estimated intrinsic value Using P\E ratios in valuation: determine what P\E “should” be “justified P/E ratio” EPS times justified P\E ratio estimated intrinsic value

usually based on “trailing” earnings (EPS for previous year = EPS0) newspapers often report current P\E ratios for stocks usually based on “trailing” earnings (EPS for previous year = EPS0) stock valuation generally done using “forward” earnings estimate of EPS for next year (EPS1 = the future)

Estimating Justified P\E Ratio Four basic methods: 1) based on fundamentals of firm (using DDM model) 2) industry average 3) historic average for the firm (or the industry) 4) relative to market overall

Justified P\E from Fundamentals if assume the constant growth DDM holds, can be shown that: gives justified P\E based on payout ratio and estimates of kcs and g to calculate justified P\E multiply by estimate of EPS1 to get intrinsic value

3) a higher growth rate means a higher P\E ratio, all else being equal the P\E ratio justified by fundamentals also shows the factors that determine the P\E ratio: 1) a higher payout ratio means a higher P\E ratio, all else being equal 2) a higher required return (risk) means a lower P\E ratio, all else being equal 3) a higher growth rate means a higher P\E ratio, all else being equal “all else being equal” never really holds since all three variables are related to each other

The formula for P/E from fundamentals (and the formulae for other ratios that follow) is derived from a simple DDM with a single, stable growth rate (D/(k-g)) As such, it is only applicable in cases where that formula would apply (mature, stable companies) Generally, these formulae are not actually used to generate estimates of P/E (or the other ratios), but rather to understand the factors that make a ratio higher or lower.

e.g. if a stock has a lower P/E than industry average but is considered lower risk, then the lower P/E may be appropriate. Similarly, a stock with higher growth will have a higher P/E. These ideas are sometimes utilized in a regression framework: e.g. for many firms you have growth rates and P/E ratios. Regress P/E on growth to determine the relationship. Based on another firm’s growth rate you can then use the regression parameters to estimate what an appropriate P/E should be.

Comparison to Industry Average: average P\E ratio of comparable firms may have to make adjustments for differences e.g. differences in growth potential, risk level etc. Comparison to Historic P\E Ratio for Firm: average P\E ratio for the firm in the past or, average P\E ratio for industry in the past have to adjust for changes in the firm/industry

Average Industry P\E Ratios Averages over 1999-2004 in Canada: Autos and Auto Parts 16.93 Banks 13.19 Biotechnology 34.11 Metals and Mining 24.58 Steel 14.48 Food and Staples Retailing 17.52 Utilities 17.58 Retailing 12.61 Source: FPinfomart.ca

Comparison to Market Overall company or industry’s P\E ratio relative to ratio for market e.g. if firm has P\E ratio that is historically 1.5 times as big as average market ratio, use that fact and current market P\E to estimate firm’s P\E Average P/E on TSX approximately 16 to 18 on average

Problems with Using P\E Ratio for Valuation if other firms are over- or under-valued in the market than estimating P\E ratio by looking at industry or market can simply repeat the error if earnings are negative, P\E ratio meaningless earnings can be very volatile, makes P\E ratios very volatile

P/E Ratios over time average P/E since 1999 for Steel sector: Source: FPinfomart.ca

Market-to-Book Ratio price divided by book value of equity per share determine justified market-to-book and multiply by book value to estimate intrinsic value Advantages: - Book value of equity (BV) less volatile than EPS - BV rarely negative Disadvantages: - BV based on accounting numbers, may have little meaning for some types of firms - comparison of firms difficult if accounting standards different

from fundamentals, assuming constant growth DDM: justified market to book ratio estimated in same ways as P\E from fundamentals, assuming constant growth DDM:

Price-Sales Ratio price divided by sales per share determine justified price-sales ratio and multiply by sales per share to estimate intrinsic value Advantages: - sales not as volatile as earnings - sales do not depend on accounting standards very much - sales never negative Disadvantages: - sales do not reflect cost structure of the firm

from fundamentals, assuming constant growth DDM: justified sales-price ratio can be estimated in same four ways as the other ratios from fundamentals, assuming constant growth DDM: