1. Fall-02 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html Investments Zvi Wiener tel: 02-588-3049 mswiener@mscc.huji.ac.il Equity Valuation Methods BKM Ch 18

2. Zvi WienerBKM Ch 18 slide 2 Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios Estimating Growth Rates and Opportunities Fundamental Stock Analysis: Models of Equity Valuation Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Zvi WienerBKM Ch 18 slide 3 Intrinsic Value 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 Intrinsic Value and Market Price Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

4. Zvi WienerBKM Ch 18 slide 4 V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5. Zvi WienerBKM Ch 18 slide 5 Stocks that have earnings and dividends that are expected to remain constant. Preferred Stock No Growth Model Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

6. Zvi WienerBKM Ch 18 slide 6 E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 No Growth Model: Example Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

7. Zvi WienerBKM Ch 18 slide 7 g = constant perpetual growth rate Constant Growth Model Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

8. Zvi WienerBKM Ch 18 slide 8 E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / (.15 -.08) = $42.86 Constant Growth Model: Example Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

9. Zvi WienerBKM Ch 18 slide 9 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 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

10. Zvi WienerBKM Ch 18 slide 10 P N = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held Specified Holding Period Model Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

11. Zvi WienerBKM Ch 18 slide 11 PVGO = Present Value of Growth Opportunities E 1 = Earnings Per Share for period 1 Partitioning Value: Growth and No Growth Components Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

12. Zvi WienerBKM Ch 18 slide 12 ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% g =.20 x.40 =.08 or 8% Partitioning Value: Example Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

13. Zvi WienerBKM Ch 18 slide 13 V o = value with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities »Partitioning Value: Example Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14. Zvi WienerBKM Ch 18 slide 14 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 Price Earnings Ratios Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

15. Zvi WienerBKM Ch 18 slide 15 E 1 - expected earnings for next year E 1 is equal to D 1 under no growth k - required rate of return P/E Ratio: No Expected Growth Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

16. Zvi WienerBKM Ch 18 slide 16 b = retention ratio ROE = Return on Equity P/E Ratio with Constant Growth Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

17. Zvi WienerBKM Ch 18 slide 17 E 0 = $2.50 g = 0 k = 12.5% P 0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 Numerical Example: No Growth Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

18. Zvi WienerBKM Ch 18 slide 18 b = 60% ROE = 15% (1-b) = 40% E 1 = $2.50 (1 + (.6)(.15)) = $2.73 D 1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P 0 = 1.09/(.125-.09) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 -.60) / (.125 -.09) = 11.4 Numerical Example with Growth Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

19. Zvi WienerBKM Ch 18 slide 19 Pitfalls in P/E Analysis Use of accounting earnings Historical costs May not reflect economic earnings Reported earnings fluctuate around the business cycle. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

20. Zvi WienerBKM Ch 18 slide 20 Other Valuation Ratios Price-to-Book Price-to-Cashflow Price-to-Sales Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

21. Zvi WienerBKM Ch 18 slide 21 Inflation and Equity Valuation Inflation has an impact on equity valuations. Historical costs underestimate economic costs. Empirical research shows that inflation has an adverse effect on equity values. Research shows that real rates of return are lower with high rates of inflation. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

22. Zvi WienerBKM Ch 18 slide 22 Potential Causes of Lower Equity Values with Inflation Shocks cause expectation of lower earnings by market participants. Returns are viewed as being riskier with higher rates of inflation. Real dividends are lower because of taxes. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

23. Zvi WienerBKM Ch 18 slide 23 Home Assignment Required: Read chapter 18 in BKM problems 2, 5, 8, 14 (3 rd ed). problems 4, 7, 10, 16 (5 th ed). closely follow financial news!