1. CHAPTER 18 Equity Valuation Models

2. Topics Security analysis –Fundamental analysis –Technical analysis Intrinsic value versus market price Equity valuation models –Valuation by comparable Limitation of book value –Dividend discount model –Price ratio analysis –Free cash flow analysis 2

3. SECURITY ANALYSIS 3

4. Top Down Analysis 4

5. What is Security Analysis? “The process of gathering information, organizing it into a logical framework, and then using it to determine the intrinsic value of a share of common stock.” Two different approaches –Fundamental analysis –Technical analysis 5

6. Security Analysis Fundamental analysis is a term for studying a company’s accounting statements and other financial and economic information to estimate the economic value of a company’s stock. –The basic idea: to identify both “undervalued” or “cheap” stocks to buy and “overvalued” or “rich” stocks to sell. Technical Analysis (“Chartists”): Many investors try to predict future stock price movements based on investor sentiment, errors in judgment, and/or historical prices. –Technical analysis differs significantly from fundamental analysis. –Unlike fundamental analysis, technical analysis does not rely on traditional stock valuation techniques. –Technical analysis attempts to exploit recurring and predictable patterns in stock prices and search for bullish (positive) and bearish (negative) signals about stock prices or market direction. 6

7. Security Analysis: Be Careful Out There Fundamental analysis is a term for studying a company’s accounting statements and other financial and economic information to estimate the economic value of a company’s stock. Fundamental analysis models a company’s value by assessing its current and future profitability. The purpose of fundamental analysis is to identify mispriced stocks relative to some measure of “true” value derived from financial data. –The basic idea: to identify both “undervalued” or “cheap” stocks to buy and “overvalued” or “rich” stocks to sell. In practice, however, such stocks may in fact be correctly priced for reasons not immediately apparent to the analyst. The pure form of these models may return the unrealistic prices in the real world. More “applied” version of these models are recommended. 7

8. INTRINSIC VALUE 8

9. Intrinsic Value vs. Market Price The return on a stock is composed of dividends and capital gains or losses. The expected HPR may be more or less than the required rate of return, based on the stock’s risk. 9

10. 10 Required Return CAPM gives the required return, k: If the stock is priced correctly, k should equal expected return. k is the market capitalization rate.

11. Intrinsic Value and Market Price The intrinsic value (IV) is the “true” value, according to a model. The market value (MV) is the consensus value of all market participants Trading Signal: IV > MV Buy IV < MV Sell or Short Sell IV = MV Hold or Fairly Priced 11

12. A Numerical Example: A Conceptual View 12

13. Equation Valuation Models Valuation by comparable Dividend discount model Price ratio analysis Free cash flow analysis 13

14. VALUATION BY COMPARABLE 14

15. 15 Valuation by Comparables Compare valuation ratios of firm to industry averages. Ratios like price/sales are useful for valuing start-ups that have yet to generate positive earnings.

16. Example 16

17. 17 Limitations of Book Value In theory, the stock price is the difference between the current market values of all assets and liabilities, or the shareholder’s equity (i.e., the residual claim). Book values from financial statements are based on historical cost, not actual market values, so they are inferior measures. In addition, brand name and specialized expertise are not reflected in book value. Need to turn to expected future cash flows for a better estimate of the firm’s value as a going concern.

18. DIVIDEND DISCOUNT MODEL 18

19. 19 V 0 =current value; D t =dividend at time t; k = required rate of return The DDM says the stock price should equal the present value of all expected future dividends into perpetuity. Dividend Discount Models (DDM)

20. 20 The Dividend Discount Model Assuming that the dividends will grow forever at a constant growth rate g. DDM with an infinite series of dividends with constantly growing dividends For constant perpetual dividend growth, the DDM formula becomes: g is the growth rate. Note that this is the Growing Perpetuity formula.

21. 21 No growth case Value a preferred stock paying a fixed dividend of $2 per share when the discount rate is 8%: Preferred Stock and the DDM

22. 22 Constant Growth DDM A stock just paid an annual dividend of $3/share. The dividend is expected to grow at 8% indefinitely, and the market capitalization rate (from CAPM) is 14%.

23. DDM Implications The constant-growth rate DDM implies that a stock’s value will be greater: 1.The larger its expected dividend per share. 2.The lower the market capitalization rate, k. 3.The higher the expected growth rate of dividends. 23

24. Dividend Discount Model The stock price is expected to grow at the same rate as dividends. 24

25. The Constant Growth Model 25

26. 26 g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate = (1- dividend payout percentage rate) Estimating Dividend Growth Rates

27. Deriving the Growth Rate, g Given ROE and equity, –Earnings = ROE * Equity –Suppose the firm reinvest a fraction of Earnings to acquire more assets. Let’s call this fraction plowback ratio or denoted as b. –Then, the asset will increase by ROE * b. The percentage increase in assets is the rate at which income was generated (ROE) times the plowback ratio (the fraction of earnings reinvested in the firm). –If the asset increase by ROE * b, then the firm earns ROE*b more income, and pay out ROE * b higher dividends. –Dividend growth rate, g = ROE * b 27

28. 28 Dividend Growth for Two Earnings Reinvestment Policies

29. Stock Prices and Reinvestment Policy Suppose –D 1 = $5, b = 0% (then g = ROE * b = 0), k = 12.5%. Then P 0 = D 1 / k = $5 / 12.5% = $40. With b = 0, the firm would not grow. Now, assume that ROE = 15% which is bigger than k. Then the firm should reinvest some portion of earnings because ROE > k. –With b = 60% & ROE = 15%, –g = 15% * 60% = 9%. –New D 1 = $5 * (1 - 60%) = $2 –Then, P 0 = $2 / (12.5% - 9%) = $57.14 –That is, the stock price rises if you reinvest some earnings on highly profitable projects (i.e., the project with ROE greater than k). 29

30. Present Value of Growth Opportunities The value of the firm equals the value of the assets already in place, the no-growth value of the firm, Plus the NPV of its future investments, which is called the present value of growth opportunities or PVGO. Price = No-growth value per share + PVGO In the earlier example, P 0 = $54.17 = $40 + $17.14. 30

31. Stock Price and Growth Opportunities, I. It is important to recognize that growth per se is not what investors desire. Growth enhances the firm value only if it accompanies profitable investments (i.e., with ROE > k). To see why, suppose ROE is only 12.5%, which is equal to k. –g= ROE * b= 12.5% * 60% = 7.5% –P 0 = $2 / (12.5% - 7.5%) = $40 –$40 = E 1 / k + PVGO = $40 + $0 –No increase in stock price! –Which is no different from the no-growth strategy. –If the project yields only what investors can achieve (k) on their own, shareholders cannot be made better offer by a high- reinvestment-rate policy. 31

32. Stock Price and Growth Opportunities, II. Firm reinvests 60% of its earnings in projects with ROE of 10%, capitalization rate is 15%. Expected year-end dividend is $2/share, paid out of earnings of $5/share. g = ROE x b = 10% x.6 = 6% PVGO = Price per share – no-growth value per share 32

33. Life Cycle of the Firm and Growth Rates DDM formula is based on a simplifying assumption that the dividend growth rate is constant forever. In fact, firms typically pass through life cycles with very different dividend profiles in different phases. 33

34. Growth Rates: Computer Software vs. Electric Utilities 34

35. Value Line Survey 35

36. Value Line Survey The beta appears at the circle A. Its recent stock price is at the B. The per-share dividend payments is at the C. The ROE is at the D. The dividend payout ratio (referred to as “all dividends to net profits”) is at the E. 36

37. Life Cycles and Multistage Growth Models Expected dividends for Honda: 2010 $.50 2012 $.83 2011 $.66 2013 $1.00 Since the dividend payout ratio is 30% and ROE is 11%, the “steady-state” growth rate is 7.7%. –ROE * b = 11% * (1 – 30%) = 7.7% 37

38. 38 Honda Example Honda’s beta is 0.95 and the risk-free rate is 3.5%. If the market risk premium is 8%, then k is: k = 3.5% + 0.95(8%) = 11.1% Therefore:

39. Honda Example Finally, In 2009, one share of Honda Motor Company Stock was worth $23.04. In the Value Line Survey, the stock price was $32.06 at the circle B. The stock is overpriced! Does not mean that you must short sell though. 39

40. PRICE-EARNINGS RATIO MODEL 40

41. Price-Earnings Ratio and Growth From Rearranging this formula, 41

42. Price-Earnings Ratio and Growth When PVGO = 0, P 0 = E 1 / k. The stock is valued like a non-growing perpetuity. P/E rises dramatically with PVGO. The ratio of PVGO to E/K is the ratio of firm value due to growth opportunities to value due to assets already in place (i.e., the no- growth value of the firm, E/k). Since this ratio is positively related to P/R ratio, high P/E indicates that the firm has ample growth opportunities. –P/E ratio is a reflection of the market’s optimism concerning a firm’s growth prospects. In their use of a P/E ratio, analysts must decide whether they are more or less optimistic than the market. If they are more optimistic, they will recommend buying the stock. 42

43. Price-Earnings Ratio and Growth We know P 0 = D 1 / (k - g). Recall that dividends equal the earnings that are reinvested in the firm : D 1 = E 1 (1 - b), And g = ROE * b. Substituting for D 1 and g, we will get, P/E increases: –As ROE increases –As plowback increases, as long as ROE > k 43

44. Effect of ROE and Plowback on Growth and the P/E Ratio, I 44

45. Effect of ROE and Plowback on Growth and the P/E Ratio, II Growth is not desirable for its own sake. –Although growth always increases with the plowback rate, the P/E falls as the plowback rate increases. For ROE lower than k, the value of the firm falls as plowback increases. –When the expected ROE is less than the required return, k, investors prefer that the firm pay out earnings as dividends rather than reinvest earnings in the firm as an inadequate rate of return. –Conversely, when ROE exceeds k, the firm offers attractive investment opportunities, so the value of the firm is enhanced as those opportunities are more fully exploited by increasing the plowback rate. –Where ROE just equals k, the firm offers “break-even” investment opportunities with a fair rate of return. 45

46. Effect of ROE and Plowback on Growth and the P/E Ratio, III The higher the plowback rate, the higher the growth rate, but a higher plowback rate does not necessarily mean a higher P/E ratio. –Higher plowback increases P/E only if investments undertaken by the firm offer an expected rate of return greater than the market capitalization rate. –Otherwise, increasing plowback hurts investors because more money is sunk into projects with inadequate rates of return. –Notwithstanding these fine points, P/E ratios frequently are taken as proxies for the expected growth in dividends or earnings. 46

47. P/E and Growth Rate Wall Street rule of thumb: The growth rate is roughly equal to the P/E ratio. In other words, the ratio of P/E to g, often called the PEG ratio, should be about 1.0 “If the P/E ratio of Coca Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.” Quote from Peter Lynch in One Up on Wall Street. When company valuation is determined primarily by growth opportunities, those values can be very sensitive to reassessments of such prospects. –The dot.com bubble 47

48. P/E Ratios and Stock Risk When risk is higher, k is higher; therefore, P/E is lower. For any expected earnings and dividend stream, the present value of those cash flows will be lower when the steam is perceived to be riskier. 48

49. Pitfalls in P/E Analysis Use of accounting earnings –Denominator is accounting earnings. Choices on GAAP matters! –Earnings Management: the practice of using flexibility in accounting rules to improve the profitability of earnings. Inflation –In high inflationary environment, historic cost depreciation and inventory costs will tend to underrepresent true economic values, because the replacement cost of both goods and capital equipment will rise with the general level of prices. Reported earnings fluctuate around the business cycle –Accounting earnings do not necessarily correspond to economic earnings. –The P/E ratios reported in the financial press is based on the past earnings, but current earnings can differ considerably from future economic earnings. The P/E ratios should vary across industries. –Industries with attractive investment opportunities and relatively high growth rates should have the high multiples. 49

50. P/E Ratios of the S&P 500 Index and Inflation 50 An inverse relationship between inflation and P/E ratio

51. Earnings Growth for Two Companies 51

52. P/E Ratios for Different Industries 2010 52

53. P/E Ratios for Different Industries, 2012

54. Other Comparative Value Approaches: Price Ratio Analysis Price-cash flow ratio (P/CF ratio) –Current stock price divided by current cash flow per share –In this context, cash flow is usually taken to be net income plus depreciation. Price-sales ratio (P/S ratio) –Current stock price divided by annual sales per share –A high P/S ratio suggests high sales growth, while a low P/S ratio suggests sluggish sales growth. Price-book ratio (P/B ratio) –Market value of a company’s common stock divided by its book (accounting) value of equity –A ratio bigger than 1.0 indicates that the firm is creating value for its stockholders 54

55. Price/Earnings Analysis, Intel Corp. 55 Intel Corp (INTC) - Earnings (P/E) Analysis 5-year average P/E ratio27.30 Current EPS $.86 EPS growth rate 8.5% Expected stock price = historical P/E ratio  projected EPS $25.47 = 27.30  ($.86  1.085) Mid-2011 stock price = $24.27

56. 56 Price/Cash Flow Analysis, Intel Corp. Intel Corp (INTC) - Cash Flow (P/CF) Analysis 5-year average P/CF ratio14.04 Current CFPS$1.68 CFPS growth rate 7.5% Expected stock price = historical P/CF ratio  projected CFPS $25.36 = 14.04  ($1.68  1.075) Mid-2011 stock price = $24.27

57. 57 Price/Sales Analysis, Intel Corp. Intel Corp (INTC) - Sales (P/S) Analysis 5-year average P/S ratio 4.51 Current SPS$6.14 SPS growth rate 7% Expected stock price = historical P/S ratio  projected SPS $29.63 = 4.51  ($6.14  1.07) Mid-2011 stock price = $24.27

58. Market Valuation Statistics 58

59. FREE CASH FLOW ANALYSIS 59

60. Free Cash Flow Approach, I Value the firm by discounting free cash flow at WACC. Free cash flow to the firm, FCFF, 60

61. Free Cash Flow Approach, II Free cash flow to the equityholder, FCFE, 61

62. DDMs Versus FCF The DDMs calculate a value of the equity only. –DDMs use dividends, a cash flow only to equity holders –DDMs use the CAPM to estimate required return –DDMs use an equity beta to account for risk Using the FCF model, we calculate a value for the firm. –Free cash flow can be paid to debt holders and to stockholders. –We can still calculate the value of equity using FCF Calculate the value of the entire firm Subtract out the value of debt –We need a beta for assets, not the equity, to account for risk. 62

63. Asset Betas Asset betas measure the risk of the company’s industry. –Firms in an industry should have about the same asset betas. –Their equity betas can be quite different. Investors can increase portfolio risk by borrowing money. A business can increase risk by using debt. So, to value the company, we must “convert” reported equity betas into asset betas by adjusting for leverage. The following conversion formula is widely used: What happens when a firm has no debt? 63 tax rate.

64. The FCF Approach, Example Inputs –An estimate of FCF: Net Income Depreciation Capital Expenditures –The growth rate of FCF –The proper discount rate –Tax rate –Debt/Equity ratio –Equity beta Calculate value using a “DDM” formula “DDM” because we are using FCF, not dividends. 64

65. Example: Valuing Landon Air An estimate of FCF: –EBIT: $45 million –Depreciation: $10 million –Capital Expenditures: $3 million –Growth rate of FCF: 3% –10 million shares –Tax rate: 35% –Debt/Equity ratio:.40 –Equity beta: 1.2 Asset Beta: 1.2 = B Asset x [1+.4 x (1-.35)] 1.2 = B Asset x 1.26 B Asset = 0.95 The proper discount rate: k = 4.00 + (7.00 × 0.95) = 10.65% Assume: No dividends Risk-free rate = 4% Market risk premium = 7% 65

66. Spreadsheet Example 66

67. COMPARING THE VALUATION MODELS 67

68. Comparing the Valuation Models In principle, –The free cash flow approach is fully consistent with the dividend discount model and should provide the same estimate of intrinsic value if one can extrapolate to a period in which the firm begins to pay dividends growing at a constant rate. In practice, –Values from these models may differ –Analysts are always forced to make simplifying assumptions 68

69. A Honda Example 69

70. AGGREGATE STOCK MARKET 70

71. Aggregate Stock Market Earnings Yield vs. Treasury Yield 71

72. Earnings Yield Investors often compare the earnings yield of a broad market index (such as the S&P 500) to prevailing interest rates, such as the current 10- year Treasury yield. If the earnings yield is less than the rate of the 10- year Treasury yield, –stocks as a whole may be considered overvalued relative to bonds. If the earnings yield is higher, –stocks may considered undervalued relative to bonds. 72