1. Equity Valuation Models
Investments
Cover image
CHAPTER 18
Equity Valuation Models
Slides by
Richard D. Johnson
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

2. Models of Equity Valuation
Balance Sheet Models
Book Value
Dividend Discount Models
Price/Earning Ratios

3. Table 18.1Financial Highlights for Microsoft Corporation, March 8, 2006

4. Limitations of Book Value
Book value is an application of arbitrary accounting rules
Can book value represent a floor value?
Better approaches
Liquidation value
Replacement cost

5. Intrinsic Value and Market Price
Self assigned Value
Variety of models are used for estimation
Market Price
Consensus value of all potential traders
Trading Signal
IV > MP Buy
IV < MP Sell or Short Sell
IV = MP Hold or Fairly Priced

6. Dividend Discount Models: General Model
V0 = Value of Stock
Dt = Dividend
k = required return

7. No Growth Model
Stocks that have earnings and dividends that are expected to remain constant.
Preferred Stock

8. No Growth Model: Example
E1 = D1 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33

9. g = constant perpetual growth rate
Constant Growth Model
g = constant perpetual growth rate

10. Constant Growth Model: Example
E1 = $5.00 b = 40% k = 15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / ( ) = $42.86

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

12. Specified Holding Period Model
PN = the expected sales price for the stock at time N
N = the specified number of years the stock is expected to be held

13. Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies

14. Partitioning Value: Example
ROE = 20% d = 60% b = 40%
E1 = $5.00 D1 = $3.00 k = 15%
g = .20 x .40 = .08 or 8%

15. Partitioning Value: Example
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities

16. Table 18.2 Financial Ratios in Two Industries

17. Figure 18.2 Value Line Investment Survey Report on Hewlett Packard

18. P/E Ratios are a function of two factors
Price Earnings Ratios
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

19. P/E Ratio: No Expected Growth
E1 - expected earnings for next year
E1 is equal to D1 under no growth
k - required rate of return

20. P/E Ratio with Constant Growth
b = retention ratio
ROE = Return on Equity

21. Numerical Example: No Growth
E0 = $ g = 0 k = 12.5%
P0 = D/k = $2.50/.125 = $20.00
PE = 1/k = 1/.125 = 8

22. Numerical Example with Growth
b = 60% ROE = 15% (1-b) = 40%
E1 = $2.50 (1 + (.6)(.15)) = $2.73
D1 = $2.73 (1-.6) = $1.09
k = 12.5% g = 9%
P0 = 1.09/( ) = $31.14
PE = 31.14/2.73 = 11.4
PE = ( ) / ( ) = 11.4

23. Table 18.3 Effect of ROE and Plowback on Growth and the P/E Ratio

24. Pitfalls in P/E Analysis
Use of accounting earnings
Earnings Management
Choices on GAAP
Inflation
Reported earnings fluctuate around the business cycle.

25. Figure 18.3 P/E Ratios and Inflation

26. Figure 18.4 Earnings Growth for Two Companies

27. Figure 18.5 Price-Earnings Ratios

28. Figure 18.6 P/E Ratios for Different Industries, 2006

29. Other Comparative Value Approaches
Price-to-book ratio
Price-to-sales ratio
Price-to-cash-flow ratio

30. Figure 18.7 Market Valuation Statistics

31. Free Cash Flow Approach
Discount the free cash flow for the firm
Discount rate is the firm’s cost of capital
Components of free cash flow
After tax EBIT
Depreciation
Capital expenditures
Increase in net working capital

32. Steps to Forecasting the Aggregate Market
Step 1: Forecast corporate profits
Step 2: Estimate the earnings multiple using long-term interest rates
Step 3: Product is the estimate for aggregate level

33. Figure 18.8 Earnings Yield of S&P 500 versus 10-Year Treasury-Bond Yield

34. Table 18.4 S&P 500 Forecasts Under Various Scenarios