1. COMMON STOCK VALUATION
Chapter 13
COMMON STOCK VALUATION

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

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

9. 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

10. 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)

11. 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)

12. 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)

13. 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

14. 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)

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

16. 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

17. 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

18. 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

19. 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

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

21. 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

22. 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)

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

24. 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

25. 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)

26. 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

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

28. 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?

29. 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

30. 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)

31. 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

32. 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

33. 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

34. 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.

35. 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.

36. 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

37. Average Industry P\E Ratios
Averages over in Canada:
Autos and Auto Parts
Banks
Biotechnology
Metals and Mining
Steel
Food and Staples Retailing
Utilities
Retailing
Source: FPinfomart.ca

38. 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

39. 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

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

41. 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

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

43. 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

44. 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: