Chap 22 Equity Valuation Models

5/26/2018 Chap 22 Equity Valuation Models

1/38

INVESTMENTS|BODIE, KANE, MARCUS

INVESTMENTS|BODIE, KANE, MARCUSCopyri ght 2011 by The McGraw-Hi ll Companies, Inc. A ll r ight s reserved.McGraw-Hil l / Irwin

CHAPTER 18

Equity Valuation Models


2/38


18-2

Valuation: Fundamental Analysis

Fundamental analysis models acompanys value by assessing its currentand future profitability.

The purpose of fundamental analysis is toidentify mispriced stocks relative to somemeasure of truevalue derived from

financial data.


3/38


18-3

Balance Sheet Models

Dividend Discount Models (DDM)

Price/Earnings Ratios Free Cash Flow Models

Models of Equity Valuation


4/38


18-4

Valuation by Comparables

Compare valuation ratios of firm toindustry averages.

Ratios like price/sales are useful forvaluing start-ups that have yet togenerate positive earnings.


5/38


18-5

Limitations of Book Value

Book values are based on historical cost,not actual market values.

It is possible, but uncommon, for marketvalue to be less than book value.

Flooror minimum value is the liquidationvalue per share.

Tobins q is the ratio of market price toreplacement cost.


6/38


18-6

Intrinsic Value vs. Market Price

The return on a stock is composed ofdividends and capital gains or losses.

The expected HPR may be more or lessthan the required rate of return, based onthe stocks risk.

1 1 00

( ) ( )Expected HPR= ( ) E D E P PE rP


7/38INVESTMENTS|BODIE, KANE, MARCUS

18-7

Required Return

CAPM gives the required return, k:

If the stock is priced correctly, k

should equal expected return. k is the market capitalization rate.

( )f M fk r E r r



18-8

The intrinsic value (IV) is the truevalue,according to a model.

The market value (MV) is the consensus

value of all market participants

Trading Signal:

IV > MV BuyIV < MV Sell or Short SellIV = MV Hold or Fairly Priced

Intrinsic Value and Market Price



18-9

V0=current value; Dt=dividend attime t; k = required rate of return

The DDM says the stock priceshould equal the present value of allexpected future dividends intoperpetuity.

Dividend Discount Models (DDM)

...

111 3

3

2

210

kD

kD

kDV



18-10

Constant Growth DDM

gk

D

gk

gDV

100

1

g=dividend growth rate


11/38


18-11

25$008.0

2$

oV

No growth case

Value a preferred stock paying a

fixed dividend of $2 per share whenthe discount rate is 8%:

Example 18.1 Preferred Stock and theDDM


12/38


18-12

Example 18.2 Constant Growth DDM

A stock just paid an annual dividend of$3/share. The dividend is expected togrow at 8% indefinitely, and the market

capitalization rate (from CAPM) is 14%.

54$08.14.

24.3$10

gk

DV


13/38


18-13

DDM Implications

The constant-growth rate DDM implies that astocks value will be greater:

1. The larger its expected dividend per share.

2. The lower the market capitalization rate, k.

3. The higher the expected growth rate ofdividends.

The stock price is expected to grow at thesame rate as dividends.


14/38


18-14

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

bROEg x


15/38


18-15

Figure 18.1 Dividend Growth for TwoEarnings Reinvestment Policies


16/38


18-16

Present Value of Growth Opportunities

The value of the firm equals the valueof the assets already in place, the no-growth value of the firm,

Plusthe NPV of its future investments,

Which is called the present value ofgrowth opportunities or PVGO.


17/38


18-17

Present Value of Growth Opportunities

Price = No-growth value per share +PVGO

10

EP PVGOk

18 18


18/38


18-18

Firm reinvests 60% of its earnings inprojects with ROE of 10%,capitalization rate is 15%. Expected

year-end dividend is $2/share, paid outof earnings of $5/share.

g=ROE x b = 10% x .6 = 6%

Example 18.4 Growth Opportunities

22.22$06.15.

2$0

P

18 19


19/38


18-19

Example 18.4 Growth Opportunities

PVGO =Price per share no-growth value pershare

22.22$06.15.

2$0

P

11.11$15.

5$22.22$ PVGO

18 20


20/38


18-20

Life Cycles and Multistage Growth Models Expected dividends for Honda:

2010 $.50 2012 $ .83

2011 $.66 2013 $1.00

Since the dividend payout ratio is

30% and ROE is 11%, thesteady-

stategrowth rate is 7.7%.

18 21


21/38


18-21

Honda Example

Hondas beta is 0.95 and the risk-free rateis 3.5%. If the market risk premium is 8%,then k is:

k=3.5% + 0.95(8%) = 11.1%

Therefore:

68.31$077.0111.0077.11$1

201320142013

gk

gD

gk

DP

18 22


22/38


18-22

Honda Example

Finally,

In 2009, one share of Honda MotorCompany Stock was worth $23.04.

4322009 111.1

68.31$1$

111.1

83.0$

111.1

66.0$

111.1

50.0$

V

18 23


23/38


18-23

Price-Earnings Ratio and Growth

The ratio of PVGO to E / k is the ratio offirm value due to growth opportunities tovalue due to assets already in place (i.e.,

the no-growth value of the firm, E / k ).

k

E

PVGO

kE

P

1

1

1

0

18 24


24/38


18-24


When PVGO=0, P0=E1/ k. The stock isvalued like a nongrowing perpetuity.

P/E rises dramatically with PVGO.

High P/E indicates that the firm has amplegrowth opportunities.

18 25


25/38


18-25


P/E increases:

As ROE increases

As plowback increases, as long as ROE>k

bROEk

b

E

P

x

1

1

0

18-26


26/38


18-26

Table 18.3 Effect of ROE and Plowback onGrowth and the P/E Ratio

18-27


27/38


18-27

P/E and Growth Rate

Wall Street rule of thumb: The growth rateis roughly equal to the P/E ratio.

If the P/E ratio of Coca Cola is 15, youdexpect the company to be growing at about 15%per year, etc. But if the P/E ratio is less than the

growth rate, you may have found yourself abargain.

Quote from Peter Lynch in One Up on Wall Street.

18-28


28/38


18-28

P/E Ratios and Stock Risk

When risk is higher, k is higher;therefore, P/E is lower.

1P b

E k g

18-29


29/38


18 29

Pitfalls in P/E Analysis

Use of accounting earnings

Earnings Management

Choices on GAAP Inflation

Reported earnings fluctuate around the

business cycle

18-30


30/38


18 30

Figure 18.3 P/E Ratios of the S&P 500 Indexand Inflation

18-31


31/38


18 31

Figure 18.4 Earnings Growth for TwoCompanies

18-32


32/38


18 32

Figure 18.6 P/E Ratios for DifferentIndustries, 2007

18-33


33/38


Other Comparative Value Approaches

Price-to-book ratio

Price-to-cash-flow ratio

Price-to-sales ratio

18-34


34/38


Figure 18.7 Market Valuation Statistics

18-35


35/38


Free Cash Flow Approach

Value the firm by discounting free cashflow at WACC.

Free cash flow to the firm, FCFF,

equals:After tax EBIT

Plus depreciation

Minus capital expendituresMinus increase in net working capital

18-36


36/38


Comparing the Valuation Models

In practice

Values from these models may differ

Analysts are always forced to makesimplifying assumptions

18-37


37/38


The Aggregate Stock Market

Explaining Past Behavior

Forecasting the Stock Market

18-38


38/38

INVESTMENTS | BODIE KANE MARCUS

Table 18.4 S&P 500 Price Forecasts UnderVarious Scenarios

Chap 22 Equity Valuation Models

Documents

Transcript of Chap 22 Equity Valuation Models