BM410: Investments Equity Valuation. Objectives A. Understand the relationship between intrinsic...

BM410: Investments

Equity Valuation

Objectives

A. Understand the relationship between intrinsic value and market valueB. Understand the various types of valuation models, including balance sheet, dividend discount models, and PE ratiosC. Understand other key metrics used in valuing securities

A. The Relationship between Intrinsic Value and Market Value

• What is intrinsic value?• The present value of a firm’s cash flows discounted

by the firm’s required rate of return• What is the firm’s market value (or price)?

• The total value of a firm’s outstanding shares times its market price

• In an efficient market, what should this relationship be?

• In a truly efficient market, the intrinsic value should equal its market value

• What happens if it doesn’t?

Intrinsic Value (continued)

How do you identify mis-priced securities?• Determine the intrinsic or fair value of the security.

This can be done by many methods:

• Models, i.e. CAPM, APT (E(rs) = rf + s [E(rM) - rf ])

• Fundamental analysis

• Balance sheet methods

• Dividend Discount Models (DDMs)

• Then you compare the fair value to the current price


Do all analysts look at companies the same way?

• No. If you have 30 analysts, you will generally have more than 60 sets of intrinsic values.

How much is intrinsic value used in the real world?

• It is used much in terms of equity valuation and financial analysis. These have a more solid foundation and are not as affected by key assumptions

• It is not used as much with DDM’s and PV models, as slight changes in assumptions can have large changes in a company’s intrinsic value. Also these models assume a longer time frame generally.


If DD and PV models is not used as much in the real world, why are we learning them?• The concepts are critical to understanding finance

• It can add value in specific cases and companies

• It can be used to support your recommendations from other models if assumptions are stated clearly


How do you determine Intrinsic Value?• It is a value assigned by the analyst

• It is based on specific theories and assumptions

• Analysts use specific models for estimation

• Lots of models exist

• Remember, these models/assumptions are proxies for reality – not reality


What happens if the intrinsic value is greater than the market price?• Intrinsic Value > Market Price

• Buy• Intrinsic Value < Market Price

• Sell or Short Sell• Intrinsic Value = Market Price

• Hold or Fairly Priced or valued• These models are not as accurate as investors (or

students) would like. • They are more indicators than directors• It is more an art than a science!

Questions

Do you understand the relationship between intrinsic value and market value or price?

B. Understand Various Types of Equity Valuation Models

Fundamental Stock Analysis: Models of Equity Valuation

• Basic Types of Models• 1. Balance Sheet Models

• Book Value• Liquidation Value• Replacement Value

• 2. Discounting Models• Free Cash Flow to the Firm (FCFF)• Free Cash Flow to Equity (FCFE)

• 3. Dividend Discount Models• 4. Price/Earning Ratios

1. Balance Sheet Models

• Balance sheet models assume that the intrinsic value of the firm is the value of its assets.• What is the value of the firms assets?

• Is it the value on the books?

• Is it the value we could really get for the assets (liquidation value)?

• Is it the value we could get to replace the assets?

Balance Sheet Models (continued)

1.A. Book Value (per share)Look at the book value: Equity / shares outstandingExample: Ford

Assets 243,283 millionLiabilities 219,736 “Owners Equity 23,547 “Shares Outstanding 1,169 “

What is the Book Value per share?$23,547/1,169 = Book value of $20.14 per share

Logic: the value of the assets should be equal to their value on the books.

Be careful as book value does not tell you depreciation methods or the true value of the assets (they may be worthless)


1.B. Liquidation value (per share)The amount of money realized by breaking up the firm,

selling assets and repaying its debt

• Company A has a market value of $250 million (mn) with $50 mn in debt, cash of $150 mn and other assets likely worth $200 mn if sold today.

• What is the liquidation value?

• Liquidation value is the cash on hand and what they could liquidate the other assets for, I.e. 150+200-50 = $300 mn

• Logic: if market price falls below liquidation value, the firm becomes a takeover target as investors buy the company and sell it in pieces


1.C. Replacement Cost (per share)

The amount of money it would take to replace the tangible and intangible assets of a company

• Company B is a trucking company valued at $25 mn. Since Company C takes 60% of the company’s business and is planning to expand, you know that its CEO could replicate the trucking company for $20 million and build her own trucking division.

• What is the replacement cost for the trucking company? $20 million

• Logic: If the market value gets too high above the replacement cost, competitors would try to replicate the firm and entering competition would drive down the market value of all trucking firms.


1.D. Tobin’s qIt is the ratio of a firm’s market price to its replacement cost

In the long run, the market price to replacement cost will tend toward 1 as investors correctly value the replacement cost of the assets

- But differences will remain over periods of time

- Logic: Investors will be willing to purchase the company as long as the company’s market price is below the replacement cost. As soon as its price is greater than the replacement cost, competition will come in, dropping the price to close to its replacement cost.

2. Discounting Models

Discounting models assume the intrinsic value of the company is the present value of the firms’ expected future cash flows. It is useful when:• The company does not pay dividends

• Dividends paid differs from what the firm could pay

• Free cash flows align with profitability within a specific forecast period

• The investor takes a control perspective

Discounting Models (continued)

2.A. Free Cash Flow to the Firm (FCFF)• FCFF is the cash flow available to the company’s

suppliers of capital after all operating expenses (including taxes) are paid and working and fixed capital investments are made.

• FCFF = cash prior to the payment of interest to the debt holders

FCFF = EBIT - taxes + depreciation (non-cash costs) – capital spending – increase in net working capital – change in other assets + terminal value

Discount this at the firm’s WACC Firm Value = Operating free cash flow

WACC – growth OFCF


2.B. Free Cash Flows to Equity (FCFE)- FCFE is the cash flow available to the company’s

equity shareholders after all operating expenses, interest, and principle repayments have been made and necessary investments in working capital and fixed capital have been made

- FCFE = Adjusts cash flows for debt repayments

- FCFE = EBIT – interest - taxes + depreciation (non-cash costs) – capital expenditures – increase in net working capital – principal debt repayments + new debt issues + terminal value. Discount at k = required return on equity

Firm Value = Free Cash Flows to Equity/(k – growth FCFE)


Calculation Note for Discounting Models:• Determine the appropriate discount rate

• Set up each of the individual cash flows

• Discount each of the individual cash flows

• Discount the final cash flow assuming a constant growth rate = cash flow / (k – g)

• The question remains whether the final cash flow representative of all future cash flows

• Sum all the discounted cash flows

• Make adjustments as required

3. Dividend Discount Models

Models which take into account discounting expected future cash flows to gain a reference for the value of a company• Dividend Discount Models

General ModelConstant Growth Model

Dividend Discount Models (continued)

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3.a. General Model Vo= Sum [Dt/(1+k)t ]

V0 = Value of Stock

Dt = Dividend k = Required return


3.b. Constant Growth Rate Model

Vo = Do (1+g)/(k-g)

This is for stocks that are growing at a constant growth rate (assumed for perpetuity)

g = constant perpetual growth rate

b = plowback or retention ratio (rr)

Note: take out the g and the formula becomes the no growth model

E1 = $5.00 b = 40% k = 15%

(1-b) = 60% D1 = $3.00 g = 8%

V0 = 3.00 / (.15 - .08) = $42.86


Estimating Dividend Growth Rates

g = ROE x b• g = growth rate in dividends

• ROE = Return on Equity for the firm

• b = plowback or retention percentage rate

• (1- dividend payout percentage rate)

• Internal Growth Rate (ROE x (1-payout)

• This is the rate that the company can continue to grow without any additional external financing

• Note: if the firm distributes all its earnings, there is nothing to allow the firm to continue to grow


More Changes to the DDM• What about growth opportunities?

• Do those impact the value of the company?

• Does the DDM only look at dividends?

• What about earnings on specific projects?

• Can we fix the DDM to look at the value of new projects?

• There are a number of different DDM models that can handle each of these situations


The constant growth dividend discount model can be used for both for the valuation of companies and for the estimation of long-term total return of a stock. Assume:

$20.00 = the price of a stock today, 8% = expected growth rate of dividends, and $0.60 = Annual dividend one year forward

A. Using only the data above, compute the expected long-term total return on the stock using the constant growth dividend discount model. Show calculations.

B. Briefly discuss two disadvantages of the constant growth dividend discount model in its application to investment analysis.

C. Identify two alternative methods to the dividend discount model for the valuation of companies.

Answer

A. Expected Return = k = D1/Po + g = .60/20 +.08 = 11%

B. The model assumes that the dividend growth rate is forever constant. Therefore, the model cannot be applied to firms that currently do not pay dividends. Second, the model is inappropriate when g > k (which presumably cannot persist indefinitely). Third, the model cannot handle firms with variable dividend growth paths.

C. One can use either P/E multiples or market-to-book multiples exhibited by other firms in the same industry.

4. Valuing Companies using PE Ratios

M & A Departments often use PE’s as one way of valuing companies. They find similar public companies to the ones they want to make public, they estimate their fair trading PE range, and then they apply the PE range to the new company.• The fair trading PE range times the EPS gives the

price per share.

PE Ratio Example

In 1996 Montgomery Asset Management of San Francisco California, a non-public company, was looking to be sold as its owner, Montgomery Securities, needed cash to build up its other operations. Assume it had $10 billion in assets and earns $20 million in revenues per year. Assuming similar asset management companies were being sold at 8-10 times earnings, what is MAM worth?

Answer

Assuming an 8-10 range for PE, MAM would be worth between $160-200 million.

Price Earnings Ratios (continued)

P/E Ratios are a function of two factors• Required Rates of Return (k)

• Expected growth in Dividends

Uses• Valuation of new companies

• Relative valuation versus market and industry

• Note: this is used extensively in the industry. Research has found that low PE stocks have given a higher return to Investors than high PE stocks over the last 70 years


Price Earnings Key Terms• Price Earnings = Price per share/Average Common

diluted Earnings Per Share

• Forward or Prospective PE = Current Price / Forward EPS

• Historic PE = Year-end Price/Year-end EPS

• Normalized PE = Current Price/normalized earnings (earnings adjusted to take into account the cycles in the economy)

• Earnings Yield (E/P) = 1 / Price Earnings


Benefits and Pitfalls of P/Es Benefits

• Used extensively in the industry

• Generally low PE firms outperform high PE firms Pitfalls

• Earnings are accounting earnings, which can be manipulated through depreciation, inventory, etc.

• Earnings can fluctuate widely around a trend

• You cannot know if the PE is high or low unless you compare it to a trend, to long-run growth prospects, to an industry, or to the market


P/E Ratio with no expected growth

P0 = E1 / k

P0 / E1 = 1 / k

where:

• E1 - expected earnings for next year

• E1 is equal to D1 under no growth (100% payout)

• k - required rate of return


P/E Ratio with Constant GrowthP0 = D1 / (k –g) = E1 (1-b) / [ k – (b x ROE)

P0 / E1 = (1 – b ) / [ k – (b x ROE)]

where:

• b = earnings retention ratio

• ROE = Return on Equity

• Note: since we do not know what P1 will be, the EMH states that the best estimate of tomorrow’s price is today’s price, hence we use P0 or today’s price

PE Example: No Growth

Company XYZ has earnings per share this year of E0 = $2.50, growth of 0%, and a discount rate from the CAPM of k = 12.5%. What should its PE be?

Answer:

• With no growth (and 100% payout), the price of XYZ would be P0 = D/k = $2.50/.125 = $20.00.

• Its PE would be PE = 1/k = 1/.125 = 8.0x or PE = P0 /EPS1 = 20/2.50 = 8.0x

Note: PE is independent of currency, so there is no dollar sign in front of it. It is a ratio.

PE Example: Growth

Company XYZ now is under new management, and they no longer distribute all their earnings as dividends, with b (or rr) = 60% ROE = 15% (1-b) = 40%. With EPS0 this year of $2.50, k = 12.5%, calculate E1, D1, g, and their new PE ratio be?

Answer:

E1 = $2.50 (1 + (.6)(.15)) = $2.73

D1 = $2.73 (1-.6) = $1.09

g = 9% or .6 * 15%

P0 = 1.09/(.125-.09) = $31.14

PE = 31.14/2.73 = 11.4x or

PE = (1 - .60) / (.125 - .09) = 11.4x (generally format PE to

one decimal point and place an “x” behind it)

Problem

Explain why the following statements are true / false / uncertain.

• a. Holding all else constant, a firm will have a higher P/E if its beta is higher.

• b. P/E will tend to be higher when ROE is higher (assuming plowback is positive).

• c. P/E will tend to be higher when the plowback rate is higher.

Answer

a. False. Higher beta means that the risk of the firm is higher and the discount rate applied to value the cash flows is higher. For any expected path of earnings and cash flows the present value of the cash flows, and therefore, the price of the firm will be lower when risk is higher. Thus the ratio of price to earnings will be lower.

b. True. Higher ROE means more valuable growth opportunities.

c. Uncertain. The answer will depend on a comparison of the expected rate of return on reinvested earnings versus the market capitalization rate. If the expected rate of return on the firm’s projects is higher than the market capitalization rate, the P/E ratio will increase as the plowback ratio increases.

Problem

Even Better Products has come out with a new and improved product. As a result, the firm projects an ROE of 20%, and it will maintain a plowback ratio of 0.30 or 30%. Its earnings this year will be $2 per share. Investors expect a 12% rate of return on the stock.

At what price and P/E ratio would you expect the firm to sell?

What is the present value of growth opportunities? (Remember V0 = E1/k + PVGO so PVGO = D0(1+g)/(k-g) – E1/k)

What would be the P/E ratio and the present value of growth opportunities if the firm planned to reinvest only 20% of its earnings?

Answer

a. Price and P/E ratio?g = ROE x b = 20% x .30 = 6%

D1 = $2(1-b) = $2(1 - .30) = $1.40

P0 = D1/(k – g) = $1.40/(.12 - .06) = $23.33 so P/E = 23.33/2 =11.7x

b. Present value of growth opportunities?

PVGO = P0 – EPS0/k = 23.33 – 2.00/.12 = $6.67c. B = 20%

G = ROE x b = 20% x .20 = 4%D1 = $2(1 – b) = $2(1 - .20) = $1.60

Po = D1/(k-g) = $1.60/(.12 - .04) = $20 P/E = 20/2 = 10

PVGO = P0 – EPS0/K = 20 – 2.00/ .12 = $3.33

Questions

Any questions on methods of equity valuation?

C. Understand the Key Valuation Metrics in Valuing Securities

What are the key valuation metrics?PE, PBV, PS, DY, POCF, PEBIT, PEVITDA,

P/IGR, and P/EGR Why are they important?

They relate the current market price to key profitability variables

They relate the company’s PE ratio to certain types of growth

1. Price/Earnings (PE=P/EPS)

PE Ratio• The most common measures of a firm’s stock price

relative to its earnings--what you are paying for $1 of earnings.

How is it analyzed?• Versus its historical average

• If lower that than its history, it may indicate it is moving into more attractive territory, i.e., growth is increasing

• Versus the market. • Gives a historical view. If it is trading at a lower

relative PE, it may be becoming more attractive. • Versus the industry

• If the relative PE versus the Industry is declining, it may indicate the stock is becoming more attractive.

2. Price/Book (PB=P/BVS)

P/BV or PB or Market to Book Gives the relationship between the stock price and

the book value of the firm (i.e. owners equity). How it is analyzed?

If the PB ratio is high when compared to peer firms, the stock may be overvalued, all else being equal.

If the PB is negative, the firm is in serious trouble.Remember that owners’ equity is based on

accounting depreciation and may not have relevance to the actual value of the assets of the company.

Generally, the higher the P/BV (or the lower its inverse, Book to Price) the more expensive the company.

3. Price/Sales (PS=P/SPS)

Price to Sales Sales multiples are sometimes an indicator of

growth in sales and hence future profits. How it is analyzed?

Can be positive or negativeNote that growth in sales translates into growth

in profits only if the other drivers of profits are sustained, i.e. profit margins, turnover, etc.

New companies New companies like PS ratios when they don’t

have any earnings. But if earnings fail to materialize, then PS ratios are irrelevant.

Generally, the lower the PS ratio, the more attractive the company, all else being equal

4. Dividend Yield (DY=DPS/P)

Dividend Yield Certain companies are known for their high

dividend payouts Historically we have seen an overall decline in the

market’s dividend yield as firms decided that they could use dividend payouts more effectively in their own firms

How is it analyzed? DY assesses the amount of dividend an investor

will receive for his dollar if invested at the current share price.

A high dividend yield can be perceived as both positive and negative. Positively, as you have a return of capital; negatively, as the company has no better use for the funds

5. Price/Operating Cash Flow (POCF=P/OCFS)

Price to Operating Cash Flow P/OCF is an important measure of a firm’s health It gives an assessment of the firm’s power to

generate operating cash flow on a price per share basis

How is it analyzed? Firms that are generating a high amount of cash are

perceived to be more attractive than firms which are not generating cash

Generally, the lower the P/OCF the more attractive the firm

6. Price/EBIT (PEBIT=P/EBITS)

Price to Earnings before Interest and Taxes In evaluating firms which are potential takeover

targets or which are not making earnings, analysts often use Price/EBIT, which they would use instead of Price Earnings (as there are not earnings).

This gives the relevant ratio assuming the firm had no other expenses, i.e. debts, taxes, etc. This was used in valuing the high-flying tech firms

How is it analyzed? Generally the lower the ratio, the more attractive the

company Be careful as this ratio says nothing about overall

profits, but only operating earnings.

7. Price/EBITDA (PEBITDA=P/EBITDAS)

Price to Earnings Before Interest and Taxes and Depreciation and Amortization Used to put a price on firms which have no

earnings but are generating cash and which may be attractive as acquisition candidates

P/EBITDA is similar to the Price/EBIT, except that it includes depreciation and amortization, which are non-cash charges

How is it analyzed? Takeover firms are concerned with the amount of

cash firms are generating assuming no other charges and taxes. Generally the lower the ratio, the more attractive the company

8. PE to IGR (PE/Internal Growth Rate or g)

PE to Internal Growth Rate (which is a proxy for a firm’s sustainable growth rate) Used to relate a company’s PE to its sustainable

growth rate How is it analyzed?

A low PE stock with a high internal growth rate will have a low ratio, while a high PE stock with a low IGR will have a high ratio.

Generally the lower the ratio, the more attractive the company.

9. PE to Earnings Growth (PE/EPS Growth)

Price Earnings to Earnings Growth Another takeoff on the PE to growth ratio

Sometimes used this as a screening device, only looking at companies whose PE divided by Earnings growth rates are 1 or less

How is it analyzed? Generally, companies are more attractive when this

ratio is lower, as they have not only higher earnings, but those earnings are expected to growth in the near future.

Can be very volatile due to the volatility of earnings per share growthDue to volatility, some investors prefer the PE to

IGR above

Questions

Do you have any questions on the various types of metrics used in valuing companies?

Problem

Portfolio managers and analysts often compare a company’s Price Earnings ratio to measures of growth as indicators of value. Which of the two measures, PE to IGR or PE to EPS growth, will be more stable and why?

Answer

The PE to IGR will be more stable as ROE is generally in the 5-35% range, and earnings per share growth can be anywhere from –100% to +200% depending on the company.

Review of Objectives

A. Do you understand the relationship between intrinsic value and market value?

B. Are you familiar with the various types of valuation models, including balance sheet, dividend discount models, and PE ratios?

C. Do you understand other key metrics used in valuing securities?

BM410: Investments Equity Valuation. Objectives A. Understand the relationship between intrinsic...

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