chapter 13 common stock valuation. fundamental analysis analysts (or investors) try to determine the...
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![Page 1: Chapter 13 COMMON STOCK VALUATION. Fundamental Analysis analysts (or investors) try to determine the intrinsic value of a stock If: intrinsic value](https://reader035.vdocuments.net/reader035/viewer/2022081504/56649d405503460f94a1a4cd/html5/thumbnails/1.jpg)
Chapter 13
COMMON STOCK VALUATION
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Fundamental Analysis
• analysts (or investors) try to determine the intrinsic value of a stock
• If:• intrinsic value < current market value
• overpriced sell stock
• intrinsic value < current market value• underpriced buy stock
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Determining Intrinsic Value
• various methods• we will look at several
• all are based on estimates of what will happen in the future
• no method is perfect as based on estimates of certain (unknown) parameters
• cannot predict the future exactly, can only make best guess• therefore, can never true intrinsic value, only your best estimate
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• two analysts may come up with different estimates of intrinsic value if:
– They use different valuation models
or– They use the same model but have
different parameter estimates
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• If fundamental analysis of intrinsic values is based on estimates, is it useful?
• Yes!• Investors need to make buy/sell decisions based on what the stock is priced at and what they feel it should be worth• Need way to determine what it “should” be worth
• Different investors can have different estimates this is what creates trading
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Two Common Valuation Methods
1) Present Value Approach(a) dividend discount model (DDM)(b)Free Cash Flow Valuation
• Value stock based on value of cashflows it generates for the investor
2) Relative Valuation Approach(a) Price-earnings ratio(b) other ratios (price to book, price to sales
etc.)• Value stock by looking at how similar stocks are
valued by the market
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Present Value Approach- Dividend Discount Model
• the value of any stock (or other security) is the present value of future cashflows coming from the stock
• for a stock, cashflows received by investors are the dividends
intrinsic value of share = PV of all future dividends
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1tt
cs
tcs )k1(
DP
• to implement, need estimates of two things:
1) required return on the stock
2) all future dividends
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• required return on stock depends on:• general level of interest rates in economy• risk level of stock
• estimating future dividends:• impossible to predict exactly what all future dividends will be• typically, simplifying assumptions are used • Three cases:
1) Zero Growth2) Constant Growth3) Multiple Growth
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Zero Growth Model• Assume that firm does not reinvest anything in itself, pays out all earnings as dividends• it should experience no growth over time:
D0 = EPS0
and D0 = D1 = D2 = ...
• DDM becomes a perpetuity:
cs
00 k
DP
This simple model would generally never apply to common stocks(applies to straight convertible shares)
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Constant Growth Model
• dividends are expected to grow at a constant rate, g, forever
• DDM becomes a growing perpetuity
gk
DP
cs
10
where D1 = D0(1+g)
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• The constant growth model shows the basic factors which affect stock prices:
gk
DP
cs
10
Future profitability
(via dividends)
Firm Profitability(via dividends)
-Level of interest rates-Risk level of stock
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• in constant growth model, g is growth rate in dividends and is also expected appreciation in stock price
• the expected (required) return to the investor can be broken down in to a dividend yield and a capital gain yield (=g)
• in practice, this simple model would only apply to a stock with very stable (in terms of growth) dividends – typically in a fully mature and non-cyclical industry
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Multiple Growth Model
• dividends are expected to grow at different rates over different periods
• eventually, dividends enter a period of stable, long term growth which goes on forever
• common to use 2 or 3 different growth rates in practice, or to estimate first few dividends directly and then assume growth rate(s)
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ncs
nn
cs
n3
cs
32
cs
2
cs
10 )k1(
P
)k1(
D
)k1(
D
)k1(
D
)k1(
DP
Where:
gk
DP
cs
1nn
• the dividends (D1 to Dn+1) have to be estimated directly using the estimated growth rates
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Problems with Present Value Approach
• in theory, DDM is correct but implementation can be hard
• parameters (next dividends, growth rate(s), required return) must be estimated and this is the hard part• we will look at methods to estimate required return, earnings, dividends and growth rates a little later in course
• the intrinsic value calculated can be very sensitive to assumptions made
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• DDM best suited to firms which maintain stable payout ratios
• DDM best suited for firms which have reasonably stable growth rates
• does not work well for cyclical firms or firms with erratic earnings
• DDM may work reasonably well for firms in mature industries with stable profits (or growing at stable rate) and an established dividend policy
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Another Present Value Approach- Free Cash Flow Valuation
• Many firms do not currently pay dividends• Theoretically, DDM will work, but
extremely difficult to estimate when dividends will begin and what growth rate will be
• Alternative to DDM is calculating present value of Free Cash Flow
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Two approaches:1. Free Cash Flow to Equity (FCFE)2. Free Cash Flow to the Firm (FCFF)
Free Cash Flow to Equity:– Estimate how much cash the firm could pay out as
dividends if it wanted to = FCFE– Think of this as “potential” dividends– Calculate present value of future FCFE to get
value of equity
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Free Cash Flow to Equity
FCFE = Net Income
+ Depreciation
– Capital Expenditures
– Change in non-cash Working Capital
+ Net New Debt Issued
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Free Cash Flow to Equity
• Similar to DDM, estimate a growth rate and then discount at the required return on equity:
Total value of Equity =
• Divide this number by number of shares outstanding to get estimate of intrinsic value of one share
gk
FCFE
CS
1
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Free Cash Flow to Firm
• FCFF represents the cashflow available each that could be distributed to all security holders (i.e. shareholders and debt holders)
FCFF = FCFE – Net New debt + Interest(1-tax)
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Free Cash Flow to Firm
FCFF = Net Income
+ Depreciation
- Capital Expenditures
- Change in non-cash Working Capital
+ Interest (1 – tax rate)
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Free Cash Flow to Firm• Estimate growth rate for FCFF• Discount future FCFF at the weighted average cost of
capital (WACC)
Value of Firm =
• This is value of overall firm, to get share value subtract value of debt and divide by number of shares
gWACC
FCFF1
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Estimating Intrinsic Value- Relative Valuation Approach
• value a stock by comparing it to other stocks
• usually done by comparing the level of some accounting variable such as earnings, sales or book value
• in some industries non-accounting numbers might be used (e.g. # of subscribers in the cable industry, amount of oil reserves in oil industry)
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• whatever the basis of comparison, the process is essentially the same
• determine what the relationship between the variable and the stock price “should” be
• use this and the level of the variable for the firm to value the stock
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• by far the most common relative valuation approach is based on the price-earnings ratio (P\E ratio)
EPS
P
shareperearnings
pricestockratioE\P
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P/E Ratios
• Price of a stock alone does not tell you if it is “expensive” or “cheap”
• price must be measured relative so something
• most common is earnings• how much does the stock cost per dollar of earnings the firm generates?
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Using P\E ratios in valuation:
determine what P\E “should” be
“justified P/E ratio”
EPS times justified P\E ratio
estimated intrinsic value
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• newspapers often report current P\E ratios for stocks
• usually based on “trailing” earnings (EPS for previous year = EPS0)
• stock valuation generally done using “forward” earnings
• estimate of EPS for next year (EPS1 = the future)
10 EPSE\PjustifiedP
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Estimating Justified P\E Ratio
Four basic methods:
1) based on fundamentals of firm (using DDM model)
2) industry average
3) historic average for the firm (or the industry)
4) relative to market overall
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Justified P\E from Fundamentals
• if assume the constant growth DDM holds, can be shown that:
gk
ratiopayout
EPS
P
CS1
0
• gives justified P\E based on payout ratio and estimates of kcs and g to calculate justified P\E
• multiply by estimate of EPS1 to get intrinsic value
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• the P\E ratio justified by fundamentals also shows the factors that determine the P\E ratio:
1) a higher payout ratio means a higher P\E ratio, all else being equal
2) a higher required return (risk) means a lower P\E ratio, all else being equal
3) a higher growth rate means a higher P\E ratio, all else being equal
• “all else being equal” never really holds since all three variables are related to each other
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• The formula for P/E from fundamentals (and the formulae for other ratios that follow) is derived from a simple DDM with a single, stable growth rate (D/(k-g))
• As such, it is only applicable in cases where that formula would apply (mature, stable companies)
• Generally, these formulae are not actually used to generate estimates of P/E (or the other ratios), but rather to understand the factors that make a ratio higher or lower.
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• e.g. if a stock has a lower P/E than industry average but is considered lower risk, then the lower P/E may be appropriate. Similarly, a stock with higher growth will have a higher P/E.
• These ideas are sometimes utilized in a regression framework: e.g. for many firms you have growth rates and P/E ratios. Regress P/E on growth to determine the relationship. Based on another firm’s growth rate you can then use the regression parameters to estimate what an appropriate P/E should be.
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Comparison to Industry Average:
• average P\E ratio of comparable firms
• may have to make adjustments for differences• e.g. differences in growth potential, risk level etc.
Comparison to Historic P\E Ratio for Firm:
• average P\E ratio for the firm in the past
• or, average P\E ratio for industry in the past
• have to adjust for changes in the firm/industry
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Average Industry P\E RatiosAverages over 1999-2004 in Canada:
Autos and Auto Parts 16.93Banks 13.19Biotechnology 34.11Metals and Mining 24.58Steel 14.48Food and Staples Retailing 17.52Utilities 17.58Retailing 12.61
Source: FPinfomart.ca
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Comparison to Market Overall
– company or industry’s P\E ratio relative to ratio for market
• e.g. if firm has P\E ratio that is historically 1.5 times as big as average market ratio, use that fact and current market P\E to estimate firm’s P\E
– Average P/E on TSX approximately 16 to 18 on average
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Problems with Using P\E Ratio for Valuation
• if other firms are over- or under-valued in the market than estimating P\E ratio by looking at industry or market can simply repeat the error
• if earnings are negative, P\E ratio meaningless
• earnings can be very volatile, makes P\E ratios very volatile
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P/E Ratios over time
• average P/E since 1999 for Steel sector:
Source: FPinfomart.ca
1999 7.75 2000 8.53 2001 25.20 2002 20.93 2003 20.03 2004 4.45
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Market-to-Book Ratio
• price divided by book value of equity per share• determine justified market-to-book and multiply by book value to estimate intrinsic value
• Advantages: - Book value of equity (BV) less volatile than EPS- BV rarely negative
• Disadvantages:- BV based on accounting numbers, may have little meaning for some types of firms - comparison of firms difficult if accounting standards different
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• justified market to book ratio estimated in same ways as P\E
• from fundamentals, assuming constant growth DDM:
gk
)g1(ratiopayoutROE
BV
P
CS
0
0
0
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Price-Sales Ratio
• price divided by sales per share• determine justified price-sales ratio and multiply by sales per share to estimate intrinsic value
Advantages:- sales not as volatile as earnings- sales do not depend on accounting standards very much- sales never negative
Disadvantages:- sales do not reflect cost structure of the firm
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• justified sales-price ratio can be estimated in same four ways as the other ratios
• from fundamentals, assuming constant growth DDM:
gk
)g1(ratiopayoutinargmincomenet
Sales
P
CS0
0