chapter 13 equity valuation 13-1. fundamental stock analysis: models of equity valuation basic types...
TRANSCRIPT
Chapter 13
Equity Valuation
13-1
Fundamental Stock Analysis: Models of Equity Valuation
• Basic Types of Models– Balance Sheet Models– Dividend Discount Models– Price/Earnings Ratios– Free Cash Flow Models
13-2
Models of Equity Valuation
• Valuation models using comparables– Look at the relationship between price and
various determinants of value for similar firms
• The internet provides a convenient way to access firm data. Some examples are:– EDGAR – Finance.yahoo.com
13-3
Table 13.1 Microsoft Corporation Financial Highlights 2009
13-4
Valuation Methods
• Book value – Value of common equity on the balance sheet– Based on historical values of assets and
liabilities, which may not reflect current values– Some assets such as brand name or
specialized skills are not on a balance sheet
– Is book value a floor value for market value of equity?
13-5
Valuation Methods
• Market value– Current market value of assets minus current
market value of liabilities• Market value of assets may be difficult to ascertain
– Market value based on stock price
– Better measure than book value of the worth of the stock to the investor.
13-6
Valuation Methods (Other Measures)
• Liquidation value – Net amount realized from sale of assets and
paying off all debt
– Firm becomes a takeover target if market value stock falls below this amount, so liquidation value may serve as floor to value
13-7
Valuation Methods (Other Measures)
• Replacement cost – Replacement cost of the assets less the
liabilities
– May put a ceiling on market value in the long run because values above replacement cost will attract new entrants into the market.
– Tobin’s Q = Market Value / Replacement Cost; should tend toward 1 over time.
13-8
13.2 Intrinsic Value Versus Market Price
13-9
Required Return
( )f M fk r E r r
• CAPM gave us required return, call it k:
• k = market capitalization rate
• If the stock is priced correctly– Required return should
equal expected return
1 1 0
0
( ) ( )Expected HPR= ( )
E D E P PE r
P
=
( )f M fk r E r r
13-10
Intrinsic Value
Intrinsic Value• The present value of a firm’s expected future net cash
flows discounted by a risk adjusted required rate of return.
• The cash flows on a stock are?– Dividends (Dt)
– Sale price (Pt)
• Intrinsic Value today (time 0) is denoted V0 and for a one year holding period may be found as:
k1
)P(E)D(EV 11
0
13-11
Intrinsic Value and Market Price
• Market Price– Consensus value of all traders– In equilibrium the current market price will
equal intrinsic value
• Trading Signals– If V0 > P0
– If V0 < P0
– If V0 = P0
Buy
Sell or Short Sell
Hold as it is Fairly Priced
13-12
No Growth Model• Use: Stocks that have earnings and
dividends that are expected to remain constant over time (zero growth)
– Preferred Stock• A preferred stock pays a $2.00 per share dividend
and the stock has a required return of 10%. What is the most you should be willing to pay for the stock?
k
DV0
00.20$0.10
$2.00V0
13-13
Constant Growth Model• Use: Stocks that have earnings and dividends
that are expected to grow at a constant rate forever
• A common stock share just paid a $2.00 per share dividend and the stock has a required return of 10%. Dividends are expected to grow at 6% per year forever. What is the most you should be willing to pay for the stock?
dividends in rate growth perpetual;g-k
)1(DV 0
0
gg
00.53$0.06-0.10
1.06$2.00V0
13-14
Comparing Value and Returns• Why do you have to pay more for the
constant growth stock?– Must pay for expected growth
• What is the one year rate of return for each stock?
No Growth Stock
V0 = $20.00
D = $2.00
V1 =
%1020$
2$20$20$k
Constant Growth Stock
V0 = $53.00; D0 = $2.00
18.56$0.06-0.10
1.06$2.00V
2
1
%1053$
12.2$53$18.56$k
$2.00 / 0.10 = $20.00
13-15
Comparing Value and Returns
• Both stocks given an investor a pre-tax return of 10%.
• Is one stock a better buy than the other?– Not if both are actually priced at their intrinsic
value (ignoring taxes).
13-16
Stock Prices and Investment Opportunities
• g = growth rate in dividends is a function of two variables:– ROE = Return on Equity for the firm
– b = plowback or retention percentage rate• (1- dividend payout percentage rate)
• g increases if a firm increases its retention ratio and/or its ROE
bROEg
13-17
Value of Growth Opportunities
Cash Cow, Inc. (CC)
E1 = $5
D1 = $5
b = ; therefore g =
k = 12.5% ; Find VCC
ROE = 12.5%
Growth Prospects (GP)
E1 = $5
D1 = $5
b = 0; therefore g = 0
k = 12.5%, Find VGP
ROE = 15%
00
40$0.125
$5.00VCC
40$0.125
$5.00VGP
Should either or both firms retain some earnings?
bROEg Value with 100% dividend payout
13-18
Value of Growth Opportunities
Cash Cow, Inc. (CC)
E1 = $5
b = 60%; therefore g
D1 = 0.40 x $5 = $2.00
k = 12.5%; Find VCC
ROE = 12.5%
CC value is the same, why?
Growth Prospects (GP)
E1 = $5
b = 60%; therefore g = 9%
D1 = 0.40 x $5 = $2.00
k = 12.5%; Find VGP
ROE = 15%
GP Value has increased, why?
7.5%
40$0.075-0.125
2.00VCC 14.57$
0.09 - 0.125
$2.00VGP
bROEg Value with 40% dividend payout
13-19
Value of Growth Opportunities
Value of assets in place for GP = $40.00 (value with all dividends paid out, with ROE = 12.5%)
Value of growth opportunities with ROE = 15% may be inferred from the difference between the new VGP = $57.14 and the no growth value of $40.00
Thus the present value of growth opportunities (PVGO) = $57.14 - $40.00 = $17.14
0 1(1 )
( )
D g EPVGO
k g k
In general:
13-20
P/E Ratio and Growth Opportunities
• P/E Ratios are a function of two factors– Required Rates of Return (k) (inverse relationship)– Expected Growth in Dividends (direct relationship)
• Uses– Estimate intrinsic value of stocks
• Conceptually equivalent to the constant growth DDM
– Extensively used by analysts and investors
13-21
P/E, ROE and Growth
With positive growth:
With zero growth:
If g = 0 then b should = 0 and the ratio simplifies to:
bROEg
gk
)b1(
E
P
1
0
k
1
E
P
1
0
Are the elements of the P/E ratio similar to the constant growth DDM?
13-22
Numerical Example: No Growth
• E1 = $2.50 g = 0 k = 12.5%; Find P/E and V0
• P/E = 1/k = 1/.125 = 8
• V0 = P/E x E1 = 8 x $2.50 = $20.00
13-23
Numerical Example with Growth
• b = 60% ROE = 15%; k = 12.5% (1-b) = 40%, E0 = $2.50
• Find the P/E and V0:
• g = ROE x b = 15% x 60% = 9%• E1 = $2.50 (1.09) = $2.725
• P/E = (1 - .60) / (.125 - .09) = 11.4
• V0 = P/E x E1 = 11.4 x $2.73 = $31.14
13-24
P/E Ratios and Stock Risk
• Riskier firms will have higher required rates of return (higher values of k)
• Riskier stocks will have lower P/E multiples
gk
)b1(
E
P
1
0
13-25
Pitfalls in Using P/E Ratios
• Earnings management is a serious problem,• P/E should be calculated using pro forma
earnings,• A high P/E implies high expected growth, but not
necessarily high stock returns,• Simplistic, assumes the future P/E will not be
lower than the current P/E. If expected growth in earnings fails to materialize the P/E will fall and investors may incur large losses.
13-26
Figure 13.3-7
13-27
Other Comparative Valuation Ratios
• Price-to-book– High ratio indicates a large premium over book value,
and a ‘floor’ value that is often far below market price• Price-to-cash flow
– P/Cash Flow instead of P/E; less subject to accounting manipulation
• Price-to-sales– Useful for firms with low or negative earnings in early
growth stage• Be creative
13-28
13.5 Free Cash Flow Valuation Approaches
13-29
Free Cash Flow
• Capitalize or discount the free cash flow for the firm (FCFF) at the weighted-average cost of capital and then subtract the existing (market) value of debt– Useful for firms that don’t pay dividends, – Helpful to understand sources and uses of cash
– where:• EBIT = earnings before interest and taxes• Tc = the corporate tax rate
• NWC = net working capital
NWC in IncreaseesExpenditur CapitalonDepreciati)TEBIT(1FCFF C
13-30
FCFF, Firm Value & Equity ValueThe free cash flow methods discount year to year cash flows plus some estimate of the terminal value PT where
WACC = Weighted average cost of capital
g = estimate of long run growth in free cash flow
T = time period when the firm approaches constant growth
Equity value =
gWACC
FCFFP 1T
T
TT
T
1tt
t
)WACC1(
P
)WACC1(
FCFFValue Firm
Firm Value
Firm Value – Market Value of Debt
13-31
Free Cash Flow (cont.)• Another approach calculates the free cash flow
to the equity holders (FCFE) and discounts the cash flows directly at the cost of equity, kE.
• Equity value can then be estimated as:
Debt Net in Increase)TExpense(1 InterestFCFFFCFE C
gk
FCFEP
E
1TT
T
E
TT
1tt
E
t
)k1(
P
)k1(
FCFEValuequity E
13-32
Comparing the Valuation Models
• In theory free cash flow approaches should provide the same estimate of intrinsic value as the dividend growth model
• In practice the various approaches often differ substantially– Simplifying assumptions are used in all models– The models establish ranges of likely intrinsic value– Using multiple models forces rigorous thinking about
the inputs
13-33
Earnings Multiplier Approach
1. Forecast corporate profits for the coming period for an index such as the S&P 500.
2. Derive an estimate for the aggregate P/E ratio using long-term interest rates– Based on the relationship between the ‘earnings
yield’ or E/P ratio for the S&P 500 and the yield on 10 year Treasuries
3. Product of the two forecasts is the estimate of the end-of-period level of the market
13-34
Earnings Multiplier Approach
2009 Data: Starting S&P500 level = 900
Treasury yield = 3.2%
Implied Earnings Yield = 2.5% + 3.2% = 5.7%
If E/P = 5.7% then P/E = 1 / 0.057 = 17.54
If forecast EPS = $55 what is the expected forecast for the S&P500 one year later and the % gain or loss?
2.5% spreadTreasury yr10 – P500&S yieldEarnings Expected
7.2%900
900965turnExpectedRe
9655517.54P500&S 1
13-35