Ch 10 ppt ipm

Chapter 10Charles P. Jones, Investments: Principles and Concepts,

Twelfth Edition, John Wiley & Sons

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Discounted Cash Flow Techniques◦ Intrinsic value based on the discounted value of

the expected stream of cash flows◦ Dividend Discount Model often emphasized in

textbooks Often not used by practitioners

Earnings Multiplier Approach Relative Valuation Metrics

◦ Emphasizes selecting stocks to buy rather than valuation

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Intrinsic value of a security is

K = appropriate discount rate Estimated intrinsic value compared to the

current market price Can value equity of firm or entire firm

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n

tt k) (

Cash Flows urity secValue of 1 1

Special case of valuing equity Current value of a share of stock is the

discounted value of all future dividends Required rate of return is minimum return

that induces investor to buy stock

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V0 D1

(1 k )1

D2

(1 k )2...

D

(1 k )

Dt

(1 k )tt1

Dividends must be valued for infinitely long time period◦ Not as large a practical problem as it may seem

Dividend stream is uncertain Dividends expected to grow over time

◦ Estimated growth in dividends can be included in DDM

◦ Three growth cases: zero, constant, multiple

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Implementing the DDM

Zero-Growth Rate Model Fixed dollar amount of dividends reduces

the security to a perpetuity

◦ Similar to preferred stock because dividend remains unchanged

◦ Values future stream of dividends from now to infinity

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V0 D0

k

Constant Growth Rate Model◦ Dividends expected to grow at a constant rate, g,

over time

◦ D1 is the expected dividend at end of the first period

◦ D1 = D0 (1+g) D0 is current dividend

◦ Accounts for all future cash flows from now to infinity

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V0 D1

k g

Implications of constant growth◦ Stock prices grow at the same rate as the

dividends◦ Stock total returns grow at the required rate of

return Growth rate in price plus growth rate in dividends

equals k, the required rate of return◦ A lower required return or a higher expected

growth in dividends raises prices Model is very sensitive to small variations in

inputs

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Multiple-Growth Rate Model◦ Two or more expected growth rates in dividends

One could be zero◦ Two-stage model assumes growth at a rapid rate

for n periods followed by steady growth

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V0 D0(1 g1)

t

(1 k)t

t1

n

Dn(1 gc)

k-g

1

(1 k)n

Multiple growth rates◦ First present value covers the period of abnormal

growth◦ Second present value covers the period of stable

growth Limitations

◦ Very sensitive to inputs◦ Difficult to determine how long abnormal growth

will last◦ Assumes immediate transition to constant growth

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Investors very interested in capital gains DDM does account for capital gains

◦ Price received in future reflects expectations of dividends from that point forward

◦ Discounting dividends or a combination of dividends and price produces same results

Can use DDM to select stocks

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k D1 /P0 g

Free Cash Flow to Equity (FCFE): What could firm pay in dividends?◦ FCFE = Net Inc. + Deprec. – Debt Repayments –

Capital Expend. – Change in Working Cap. + Debt Issuance

Free Cash Flow to the Firm (FCFF): What cash is available before any financing considerations?◦ FCFF = FCFE + Interest Exp. (1-tax rate) + Principal

Repayments – Debt Issuance – Preferred Dividends10

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V0 Expected FCFE

k-g

Estimated value of stock today◦ Derived from estimating and discounting future

cash flows If intrinsic value >(<) current market price,

hold or purchase (avoid or sell) because the asset is undervalued (overvalued)◦ Decision will always involve estimates, be subject

to error◦ Some analysts use 15% rule

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Alternative approach often used by security analysts

P/E ratio is the strength with which investors value earnings as expressed in stock price◦ Divide the current market price of the stock by

the latest 12-month earnings◦ Price paid for each $1 of earnings◦ One of the most widely discussed variable of a

stock

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By definition◦ Current stock price is P0, EPS is E0

To value stock, must forecast EPS and P/E ratio◦ Can compound current earnings to forecast

expected earnings

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Po E0(P0 /E0)

PE E1 PE /E1

Compare company relative to peers, the market

P/E ratios◦ High P/E ratios can result from several factors, not

all equally desirable for investor◦ Best used to make specific comparisons

Price/Book value◦ Price/Stockholders’ Equity◦ Best suited for companies with hard assets

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Relative Valuation

Price/Sales Ratio (PSR)◦ Can be used to value companies without earnings◦ Price/Revenues per share over four most recent

quarters◦ Important to interpret within industry norms

Economic Value Added (EVA)◦ Difference between operating profits and

company’s capital cost◦ Emphasizes return on capital

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Relative Valuation

Discounted cash flow theoretically best◦ May be unrealistic because accurate estimates

difficult P/E multiplier serves dual role

◦ Estimating intrinsic value of stock◦ Relative valuation

All methods subject to estimation error Traditional methods do apply to “new

economy” stocks: revenues and profits matter

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