Chapter 13 Equity Valuation
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Chapter 13
Equity Valuation
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Good Company= Good stock?
Good Company Bad Company
Cheap stock Buy Avoid
Expensive stock Avoid Sell
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Fundamental Stock Analysis: Models of Equity Valuation
• Outline– Balance sheet appoach– Dividend Discount Models
• Constant dividend growth model• Non-constant dividend growth model
– Price/Earning Ratio models– Free Cash Flow(FCF) models
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Intrinsic Value and Market Price• Intrinsic Value
– The present value of all future cash flows– The true intrinsic value is not observable – Variety of models are used for estimation
• Market Price– Consensus value of current market participants
(buyers and sellers)– Price of last stock market transaction
• Trading Signal– IV > MP(discount, on sale) Buy– IV < MP(too expensive) Sell or Short Sell– IV = MP(fair) Hold
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Intrinsic Value and Market Price
• In the long-run, market price should converge to intrinsic value
• Remember: value(intrinsic) is what you get, price(market) is what you pay. Pay less, get more!
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Balance Sheet Valuation• A share of stock represents a slice of the
ownership( F assets are claims on real assets)– Claims of Equity (on balance sheet)
• Book Value: net worth of a company as reported on balance sheet
• However, BV and MV could be significantly different– BV represents past, while MV represents future– Stocks are also Claims of future Earnings and
Dividends.
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Balance Sheet Valuation
• BV is still relevant in stock valuation• Is BV a floor of stock price?
– BV(Equity)=Asset-Liability– When MV is much lower than BV, the whole
company can be sold at a higher price than MV– However, Asset can be overvalued (Goodwill). Net
tangible assets might be more useful.– Examples: BBI
• Should I be concerned if MV/BV is too high?– Rich evaluation invites competition– Competition and Tobin’s Q (MV/replacement cost)
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Book value and stock price: reality check
• Most stocks are sold at a price higher than book value
• Researches show that, on average and over long term, lower Price/Book stock has higher return – Higher Risk of low P/B stock– Investors chasing glamour stock(high P/B)
stock
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Dividend Discount Models:General Model
VD
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t
tt
( )11
VD
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t
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• V0 = Value of Stock• Dt = Dividend• k = required return
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No Growth Model
k
DVo
• Stocks that have earnings and dividends that are expected to remain constant
• Preferred Stock
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No Growth Model: Example
E1 = D1 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33
VD
ko
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Constant growth stock
• A stock whose dividends are expected to grow forever at a constant rate, g.
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t
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Constant Growth Model
VoD g
k g
o
( )1Vo
D g
k g
o
( )1
• g = constant perpetual growth rate
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What happens if g > ks?
• If g > ks, the constant growth formula leads to a negative stock price, which does not make sense.
• The constant growth model can only be used if:– ks > g
– g is expected to be constant forever
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What is the stock’s market value?
• K=13%
• D0 = $2 and g is a constant 6%,
• Using the constant growth model:
$30.29
0.07
$2.12
0.06 - 0.13
$2.12
g - k
D P
s
10
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What would the expected price today be, if g = -5%?, if g=0?
• When g=-5% D1=1.9, P=1.9/(13%+5%)=10.56• When g=0, The dividend stream would be a
perpetuity.
2.00 2.002.00
0 1 2 3ks = 13% ...
$15.38 0.13
$2.00
k
PMT P
^
0
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Supernormal growth:What if g = 30% for 3 years before achieving long-run growth of 6%?
• Can no longer use just the constant growth model to find stock value.
• However, the growth does become constant after 3 years.
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Valuing common stock with nonconstant growth
rs = 13%
g = 30% g = 30% g = 30% g = 6%
P 0.06
$66.543
4.658
0.13
2.301
2.647
3.045
46.114
54.107 = P0
^
0 1 2 3 4
D0 = 2.00 2.600 3.380 4.394
...
4.658
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Nonconstant growth:What if g = 0% for 3 years before long-run growth of 6%?
ks = 13%
g = 0% g = 0% g = 0% g = 6%
0.06 $30.29P3
2.12
0.13
1.77
1.57
1.39
20.99
25.72 = P0
^
0 1 2 3 4
D0 = 2.00 2.00 2.00 2.00
...
2.12
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Practical problem with dividend model• How to estimate g
– Using historical average– When ROE and dividend payout ratio are
constant:– Dividend growth rate=Return on Equity*plowback ratio
– g=ROE* b
– Derive the relationship
» Dividend will grow the same rate as Earning (constant dividend payout ratio)
» Earning will grow at the same rate as Equity (constant ROE)
» Equity will grow at ROE*b
• How to estimate k
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Practical problem with dividend model
• Dividend model is forward looking. Inputs are future dividends, which are not observable
• Historical dividends and dividend growth rate are not an accurate estimates of future dividend growth rate
• Many companies are not paying dividends
• For those who pay, dividend growth rate can change dramatically overtime
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Price Earnings Ratios• What is P/E
– P/E=current stock price/annual earning per share– It measures how much investors are willing to pay
for $1 of current earnings– If earning is constant, P/E measures the number
of years for investor to breakeven– Earning yield, (E/P, the reverse/reciprocal of P/E)
measures your current return on investment– From 1920-1990, P/E average is about 15
• Uses– Relative valuation– Extensive Use in industry
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The simple P/E approach
• Current(trailing) PE approach:– Find E– Assign a reasonable P/E ratio– P=E*assigned P/E
• Forward PE approach– Find forward E– Assign a reasonable forward P/E ratio– Price target in the future=forward
E*assigned forward P/E
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P/E=?
• P/E Ratios are a function of two factors– Required Rates of Return (k)– Expected growth in Dividends
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Pitfalls in Using PE Ratios
• Investors make fatal mistakes when:– PE with abnormal once-only Es.– PE with skewed E due to GAAP (AAPL
subscription treatment of iPhone revenue)– Inflated PE: When earning is close to 0 – Negative PE
• Solution– Normalized PE– Forward PE (option vs. facts)
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Free Cash Flow (FCF):
• Def: Cash available to the firm (or equity holder) net of capital expenditures.
• Idea: FCF is the cash shareholder (investor) can withdraw from the company without affecting its normal operation and expansion
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FCF: Calculating
• FCFE=NI+Dep-Capital Expenditure-Increase in NWC
• Practically: Cash Flow from Operating Activity-Capital expenditure
• MV=PV of all Future FCF