1. Security Valuation Learning Objectives
1. Top-down and Bottom-up Approaches to Security Valuation
2. Discounted Cash Flow Valuation Approach
3. Dividend Discount Model (DDM) and its Logic
4. Application of DDM to Value Supernormal Growth Firms.
5. Application of Relative Valuation Models

2. The Investment Decision Process
Determine the required rate of return
Evaluate the investment to determine if its market price is consistent with your required rate of return
Estimate the value based on expected cash flows and your required rate of return
Compare this intrinsic value to the market price
If Intrinsic Value > Market Price, Buy
If Intrinsic Value < Market Price, Don’t Buy

3. Valuation Process Two approaches
1. Top-down, three-step approach
2. Bottom-up, stock valuation, stock picking approach
The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks

4. Top-down overview of the valuation process
Economic Analysis
Business cycles, government policy, indicators, trade, public
attitudes, legislation, inflation, GDP growth, ect.
Industry Analysis
Structure, supply-demand relationships, quality and cost elements, gov't. regulation, financial norms
and standards, et. cetera
Company Analysis
Forecasts, balance sheet--income statement
analysis, flow-of-funds analysis,
accounting policy and footnotes,
management,research,
return, risk` GE
Other stocks
GM, Xerox, Caterpillar, 3M,
Merck, Motorola, Delta, Intel.
Portfolio
management
Portfolio Assets

5. Does the Three-Step Process Work?
An analysis of the relationship between rates of return for the aggregate stock market, alternative industries, and individual stocks showed that most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry

6. Theory of Valuation
The value of an asset is the present value of its expected returns
To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return
This requires estimates of:
The stream of expected returns, and
The required rate of return on the investment

7. Stream of Expected Returns
Form of returns
Earnings
Cash flows
Dividends
Interest payments
Capital gains (increases in value)
Time pattern and growth rate of returns

8. Required Rate of Return
Determined by
1. Economy’s risk-free rate of return, plus
2. Expected rate of inflation during the holding period, plus
3. Risk premium determined by the uncertainty of returns

9. Valuation Approaches Two Approaches to Equity Valuation
Discounted Cash Flow Techniques
Relative Valuation Techniques
Present Value of Dividends (DDM)
Present Value of Operating Cash Flow
Present Value of Free Cash Flow
Price/Earnings Ratio (P/E)
Price/Cash flow ratio (P/CF)
Price/Book Value Ratio (P/BV)
Price/Sales Ratio (P/S)

10. Why and When to Use the Discounted Cash Flow Valuation Approach
The measure of cash flow used
Dividends
Cost of equity as the discount rate
Operating cash flow
Weighted Average Cost of Capital (WACC)
Free cash flow to equity
Cost of equity
Dependent on growth rates and discount rate

11. Why and When to Use the Relative Valuation Techniques
Provides information about how the market is currently valuing stocks
aggregate market
alternative industries
individual stocks within industries
No guidance as to whether valuations are appropriate
best used when have comparable entities
aggregate market is not at a valuation extreme

12. Discounted Cash-Flow Valuation Techniques
Where:
Vj = value of stock j
n = life of the asset
CFt = cash flow in period t
k = the discount rate that is equal to the investor’s required rate of return for asset j, which is determined by the uncertainty (risk) of the stock’s cash flows

13. The Dividend Discount Model (DDM)-Infinite Holding Period
The value of a share of common stock is the present value of all future dividends
Where:
Vj = value of common stock j
Dt = dividend during time period t
k = required rate of return on stock j

14. The Dividend Discount Model (DDM)-Finite Holding Period
If the stock is not held for an infinite period, a sale at the end of year 2 would imply:
Selling price at the end of year two is the value of all remaining dividend payments, which is simply an extension of the original equation

15. The Dividend Discount Model (DDM)-Constant Growth Rate
Infinite period model assumes a constant
growth rate for estimating future dividends
Where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k = required rate of return on stock j
n = the number of periods, which we assume to be infinite

16. The Dividend Discount Model (DDM)-Constant Growth Rate
Infinite period model can be reduced to:
Where D1 is the expected dividend, defined as
D1= D0 (1+g)
1. Estimate the required rate of return (k)
2. Estimate the dividend growth rate (g)

17. The Dividend Discount Model (DDM)-Constant Growth Rate
Assumptions of DDM:
1. Dividends grow at a constant rate
2. The constant growth rate will continue for an infinite period
3. The required rate of return (k) is greater than the infinite growth rate (g)

18. Required Rate of Return (k)
Three factors influence an investor’s required rate of return:
The economy’s real risk-free rate (RRFR)
The expected rate of inflation (I)
A risk premium (RP)
How to estimate k:
K= Rf +  (Rm – Rf)
K= Bond yield+ERP

19. Expected Growth Rate of Dividends ROE Based
Determined by
the growth of earnings
the proportion of earnings paid in dividends
In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio
Earnings growth is also affected by compounding of earnings retention
g = (Retention Rate) x (Return on Equity)
= RR x ROE

20. Estimating Growth Based on History
Historical growth rates of sales, earnings, cash flow, and dividends
Three techniques
1. arithmetic or geometric average of annual percentage changes
2. linear regression models
3. long-linear regression models
All three use time-series plot of data

21. How to Calculate g Historical ROE and Payout
Year Dividend g = (1-Payout) x ROE
$ = ( ) x .16 = 8%
1.49
1.67 Average of two methods = 8%
1.75
g = 8%

22. Infinite Period DDM and Growth Companies
Growth companies have opportunities to earn return on investments greater than their required rates of return
To exploit these opportunities, these firms generally retain a high percentage of earnings for reinvestment, and their earnings grow faster than those of a typical firm
This is inconsistent with the infinite period DDM assumptions

23. Valuation with Supernormal Growth
Example: The last dividend paid (D0) was $2.00. The required rate of return is 14 percent. The dividends are expected to grow at the following rates. What is the value of this stock?
Year dividend
1-3: %
4-6: %
7-9: %
10 on: %

24. Computation of Value for Stock of Company with Supernormal Growth

25. Operating Cash Flow Model
Derive the value of the total firm by discounting the total operating cash flows prior to the payment of interest to the debt-holders
Then subtract the value of debt to arrive at an estimate of the value of the equity

26. Operating Cash Flow Model
Where:
Vj = value of firm j
n = number of periods assumed to be infinite
OCFt = the firms operating cash flow in period t
WACC = firm j’s weighted average cost of capital

27. Operating Cash Flow Model
Similar to DDM, this model can be used to estimate an infinite period
Where growth has matured to a stable rate, the adaptation is
Where:
OCF1=operating cash flow in period 1
gOCF = long-term constant growth of operating free cash flow

28. Operating Cash Flow Model
Assuming several different rates of growth for OCF, these estimates can be divided into stages as with the supernormal dividend growth model
Estimate the rate of growth and the duration of growth for each period

29. Present Value of Free Cash Flows to Equity
“Free” cash flows to equity are derived after operating cash flows have been adjusted for debt payments (interest and principle)
The discount rate used is the firm’s cost of equity (k) rather than WACC

30. Present Value of Free Cash Flows to Equity
Where:
Vj = Value of the stock of firm j
n = number of periods assumed to be infinite
FCFt = the firm’s free cash flow in period t
K j = the cost of equity

31. Free Cash Flow to Equity Model
FCFE = NI + Depreciation – Capital Expenditure - Working Capital – Principal Repayment + New Debt Issues.
If capital expenditures and working capital is expected to be financed at the target debt ratio () and principal repayment are made from new debt issues, FCFE can be written as:
FCFE = NI + (1- ) (Capital Expenditure - Depreciation) + (1- ) Working Capital.

32. Free Cash Flow to Equity Model
FCF is a measure of what firm can payout as dividend. Dividend can be greater than or less than FCF and is influenced by:
• Desire for stability
• Future Investment Needs
• Signaling Affect.
P0 = EFCE ; All assumptions about dividend
(K – g) valuation model apply.

33. Relative Valuation Techniques
Value can be determined by comparing to similar stocks based on relative ratios
Relevant variables include:
Price/earnings
Cash flow
Book value
Sales
The most popular relative valuation technique is based on price to earnings

34. Earnings Multiplier Model
The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio
Dividing both sides by expected earnings during the next 12 months (E1)

35. Earnings Multiplier Model
As an example, assume:
Dividend payout = 50%
Required return = 12%
Expected growth = 8%
D/E = .50; k = .12; g=.08

36. Earnings Multiplier Model
A small change in either or both k or g will have a large impact on the multiplier
D/E = .50; k=.13; g= P/E = 10
D/E = .50; k=.12; g= P/E = 16.7
D/E = .50; k=.11; g= P/E = 25

37. How to Estimate EPS Estimated EPS = Net Income # Shares Outstanding
• EPS can also be derived:
EPS = ROE * Book value per share
EPS = NI * E = NI
E Shares Shares
Where ROE= Profit Margin * Total Asset Turnover * Equity Multiplier

38. Earnings Multiplier Model
Given current earnings of $2.00 and growth of 9%
You would expect E1 to be $2.18
D/E = .50; k=.12; g= P/E = 16.7
V = 16.7 x $2.18 = $36.41
Compare this estimated value to market price to decide if you should invest in it

39. The Price-Sales Ratio
Strong, consistent growth rate is a requirement of a growth company
Sales is subject to less manipulation than other financial data

40. The Price-Sales Ratio
Match the stock price with recent annual sales, or future sales per share
This ratio varies dramatically by industry
Profit margins also vary by industry
Relative comparisons using P/S ratio should be between firms in similar industries
Average stock price should encompass a long lime period

41. The Price-Sales Model
Price-to-Sales Model (10 year Average Price Ratios are assumed)
Average Price/Average Sales Per Share
$19.41/14.55=1.33 Price to sales ratio
Vt = P/S ratio*Estimated SPS(t+1)
=1.33*$24.65=$32.78

42. The Price-Cash Flow Ratio
Companies can manipulate earnings
Cash-flow is less prone to manipulation
Cash-flow is important for fundamental valuation and in credit analysis
Price-to-Cash Flow Model
Average Price/Average Cash Flow Per Share
$19.41/1.37=14.17 Cash flow per share ratio
Vt = P/CF*Estimated CFPS (t+1)
Vt = * $2.41 = $34.15

43. The Price-Book Value Ratio
Price-to-Book Value Model
Average Price/Average book value per share
$19.41/6.01=3.23 price to book value ratio
Vt = P/BV*Estimated BVPS(t+1)
Vt = 3.23* $10.5 = $33.91

44. The Price-Book Value Ratio
Widely used to measure bank values (most bank assets are liquid (bonds and commercial loans)
Fama and French study indicated inverse relationship between P/BV ratios and excess return for a cross section of stocks

45. The Price-Book Value Model
Price to Book Value Ratio
1. Po= DPS1
(K-g) *where DPS1=EPS(1+g)*payout ratio
2. Po= EPSo * Payout * (1+g)
(K-g)
- where EPS=equity/#shares * NI/equity=BV*ROE
3. Po= BVo * ROE * Payout * (1+g)

46. Investment Valuation Models
4. Po = PBV= ROE * Payout * (1+g)
BVo (K-g)
- i. if ROE depends on expected earnings, or
- ii. If payout ratio remains constant 4 becomes 5
5. P0 = PBV = ROE * Payout
BVo (K-g)
- The relationship of:
- PBV increase ROE increase
- PBV increase  Payout increase
- PBV increase g increase
- PBV decrease K increase

47. Investment Valuation Models
Formula can be simplified
g = ROE (1-payout)
ROE*Payout = ROE - g
PBV=(ROE-g) / (k-g)
Implications:
A) ROE>kP>BV; ROE<kP<BV; ROE=kP=BV
B) PBV decreases if k increases.
C) Larger (R-k) greater PBV