1 Chapter 13 Equity Valuation

2 Good Company= Good stock? Good CompanyBad Company Cheap stockBuyAvoid Expensive stockAvoidSell

3 Fundamental Stock Analysis: Models of Equity Valuation Outline –Balance sheet appoach –Dividend Discount Models Constant dividend growth model Non-constant dividend growth model –Price/Earning Ratio models –Free Cash Flow(FCF) models

4 Intrinsic Value and Market Price Intrinsic Value –The present value of all future cash flows –The true intrinsic value is not observable –Variety of models are used for estimation Market Price –Consensus value of current market participants (buyers and sellers) –Price of last stock market transaction Trading Signal –IV > MP(discount, on sale) Buy –IV < MP(too expensive) Sell or Short Sell –IV = MP(fair) Hold

5 Intrinsic Value and Market Price In the long-run, market price should converge to intrinsic value Remember: value(intrinsic) is what you get, price(market) is what you pay. Pay less, get more!

6 Balance Sheet Valuation A share of stock represents a slice of the ownership( F assets are claims on real assets ) –Claims of Equity (on balance sheet) Book Value: net worth of a company as reported on balance sheet However, BV and MV could be significantly different –BV represents past, while MV represents future –Stocks are also Claims of future Earnings and Dividends.

7 Balance Sheet Valuation BV is still relevant in stock valuation Is BV a floor of stock price? –BV(Equity)=Asset-Liability –When MV is much lower than BV, the whole company can be sold at a higher price than MV –However, Asset can be overvalued (Goodwill). Net tangible assets might be more useful. –Examples: BBI Should I be concerned if MV/BV is too high? –Rich evaluation invites competition –Competition and Tobin’s Q (MV/replacement cost)

8 Book value and stock price: reality check Most stocks are sold at a price higher than book value Researches show that, on average and over long term, lower Price/Book stock has higher return –Higher Risk of low P/B stock –Investors chasing glamour stock(high P/B) stock

9 Dividend Discount Models: General Model V 0 = Value of Stock D t = 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 E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33

12 Constant growth stock A stock whose dividends are expected to grow forever at a constant rate, g. D 1 = D 0 (1+g) 1 D 2 = D 0 (1+g) 2 D t = D 0 (1+g) t

13 Constant Growth Model g = constant perpetual growth rate

14 What happens if g > k s ? If g > k s, the constant growth formula leads to a negative stock price, which does not make sense. The constant growth model can only be used if: –k s > g –g is expected to be constant forever

15 What is the stock’s market value? K=13% D 0 = $2 and g is a constant 6%, Using the constant growth model:

16 What would the expected price today be, if g = -5%?, if g=0? When g=-5% D1=1.9, P=1.9/(13%+5%)=10.56 When g=0, The dividend stream would be a perpetuity k s = 13%...

17 Supernormal growth: What if g = 30% for 3 years before achieving long-run growth of 6%? Can no longer use just the constant growth model to find stock value. However, the growth does become constant after 3 years.

18 Valuing common stock with nonconstant growth r s = 13% g = 30% g = 6%  P  0.06 $   = P 0 ^ D 0 =

19 Nonconstant growth: What if g = 0% for 3 years before long- run growth of 6%? k s = 13% g = 0% g = 6% 0.06  $30.29P    = P 0 ^ D 0 =

20 Practical problem with dividend model How to estimate g –Using historical average –When ROE and dividend payout ratio are constant: –Dividend growth rate=Return on Equity*plowback ratio –g=ROE* b –Derive the relationship »Dividend will grow the same rate as Earning (constant dividend payout ratio) »Earning will grow at the same rate as Equity (constant ROE) »Equity will grow at ROE*b How to estimate k

21 Practical problem with dividend model Dividend model is forward looking. Inputs are future dividends, which are not observable Historical dividends and dividend growth rate are not an accurate estimates of future dividend growth rate Many companies are not paying dividends For those who pay, dividend growth rate can change dramatically overtime

22 Price Earnings Ratios What is P/E –P/E=current stock price/annual earning per share –It measures how much investors are willing to pay for $1 of current earnings –If earning is constant, P/E measures the number of years for investor to breakeven –Earning yield, (E/P, the reverse/reciprocal of P/E) measures your current return on investment –From , P/E average is about 15 Uses –Relative valuation –Extensive Use in industry

23 The simple P/E approach Current(trailing) PE approach: –Find E –Assign a reasonable P/E ratio –P=E*assigned P/E Forward PE approach –Find forward E –Assign a reasonable forward P/E ratio –Price target in the future=forward E*assigned forward P/E

24 P/E=? P/E Ratios are a function of two factors –Required Rates of Return (k) –Expected growth in Dividends

25 Pitfalls in Using PE Ratios Investors make fatal mistakes when: –PE with abnormal once-only Es. –PE with skewed E due to GAAP (AAPL subscription treatment of iPhone revenue) –Inflated PE: When earning is close to 0 –Negative PE Solution –Normalized PE –Forward PE (option vs. facts)

26 Free Cash Flow (FCF): Def: Cash available to the firm (or equity holder) net of capital expenditures. Idea: FCF is the cash shareholder (investor) can withdraw from the company without affecting its normal operation and expansion

27 FCF: Calculating FCFE=NI+Dep-Capital Expenditure- Increase in NWC Practically: Cash Flow from Operating Activity-Capital expenditure MV=PV of all Future FCF