Chapter 13 Fundamental Stock Analysis:

Models of Equity Valuation

Basic Types of Models

Equity
Balance Sheet Models
Dividend Discount Models

Valuation
Price/Earnings Ratios
Free Cash Flow Models

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 13-2

Table 13.1 Microsoft Corporation

Models of Equity Valuation Financial Highlights 2009
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 Electronic Data-Gathering, Analysis, and Retrieval system
Finance.yahoo.com
Factset, Reuters (Thompson), Bloomberg, etc
Aside) 10-K, 10-Q 13-3 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
13-5
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
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 =>
basically, price rather than value
Better measure than book value of the worth
of the stock to the investor.
13-6
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.
Cost; should tend toward 1 over time.
13-8
 Expected Holding Period Return
The return on a stock investment
13.2 Intrinsic Value Versus comprises cash dividends and capital
Market Price gains or losses

Assuming a one-year holding period

E ( D1 ) E ( P1 ) P0
Expected HPR= E ( r )
P0

13-9 13-10

Required Return Intrinsic Value

CAPM gave us required
return, call it k: Intrinsic Value
k = market capitalization k rf E (rM ) rf The present value
rate
required rate of return (e.g., CAPM).
The cash flows on a stock are?
If the stock is priced
Dividends (Dt) E(D1 ) E(P1 )
correctly (EMH) V0
Sale price (Pt) 1 k
Required return should E ( D1 ) E ( P1 ) P0
= Expected HPR= E ( r )
Intrinsic Value today (time 0) is denoted V0 and for a one
equal expected return P0
year holding period may be found as:

13-11 13-12
 Intrinsic Value and Market Price Basic Dividend Discount Model
Market Price Intrinsic value of a stock can be found from the
Consensus value of all traders following:
Given to small investors like you and me Dt V0 = Intrinsic Value of Stock
V0 Dt = Dividend in time t
In equilibrium, the current market price will 1 (1 k )
t
t k = required return
equal intrinsic value (EMH) What happened to the expected sale price in this
Trading Signals formula?
If V0 > P0 Buy for me. But then what happens?
Why is this an infinite sum?
If V0 < P0 Sell or Short Sell for me. But then?
holding period?
If V0 = P0 Indifferent at it is fairly priced
13-13 13-14

Basic Dividend Discount Model No Growth Model

Use: Stocks that have earnings and
Intrinsic value of a stock can be found from the dividends that are expected to remain
following:
constant over time (zero growth)
Dt
V0 D
1 (1 k )
t
t V0
This equation is not useable because it is an k
infinite sum of variable cash flows.
Preferred Stock
Therefore we have to make assumptions about
A preferred stock pays a $2.00 per share dividend
the dividends to make the model tractable.
and the stock has a required return of 10%. What
is the most you should be willing to pay for the
stock? $2.00
V0 $20.00
13-15
0.10 13-16
 Comparing Value and Returns
Constant Growth Model Why do you have to pay more for the
constant growth stock?
Use: Stocks that have earnings and dividends
Must pay for expected growth
that are expected to grow at a constant rate
forever What is the one year rate of return for
V0
D1
; g perpetual growth rate in dividends each stock?
k -g
No Growth Stock Constant Growth Stock
A common stock share just paid a $2.00 per V0 = $20.00; D = $2.00 V0 = $53.00; D0 = $2.00
share dividend and the stock has a required
$2.00 1.062
return of 10%. Dividends are expected to grow E(V1)= $2.00 / 0.10 = $20.00 E(V1 ) $56.18
0.10 - 0.06
at 6% per year forever. What is the most you
should be willing to pay for the stock? E (ROI )
$20 $20 $2
10% E (ROI )
$56.18 $53 $2.12
10%
$2.00 1.06 $20 $53
V0 $53.00
0.10 - 0.06 13-17 13-18

Stock Prices and Investment

Comparing Value and Returns
Opportunities
Both stocks give an investor a pre-tax g = growth rate in dividends is a function of
return of 10%. two variables:
ROE = Return on Equity for the firm
Is one stock a better buy than the other?
Not if both are actually priced at their intrinsic b = plowback or retention percentage rate
value (ignoring taxes). = (1- dividend payout percentage rate)

g ROE b
g increases if a firm increases its retention
ratio and/or its ROE
13-19 13-20
Value of Growth Opportunities Value of Growth Opportunities
Value with 100% dividend payout g ROE b Value with 40% dividend payout g ROE b
Cash Cow, Inc.(CC) Growth Prospects(GP)
Cash Cow, Inc.(CC) Growth Prospects (GP)
E1 = $5, ROE=12.5% E1 = $5, ROE=15% E1 = $5, ROE=12.5% E1 = $5, ROE=15%
D1 = $5 D1 = $5 b = 60%; therefore g = 7.5% b = 60%; therefore g = 9%
b =0 ; therefore g = 0 b =0; therefore g = 0 D1 = 0.40 x $5 = $2.00 D1 = 0.40 x $5 = $2.00
k = 12.5% ; Find VCC k = 12.5%, Find VGP k = 12.5%; Find VCC k = 12.5%; Find VGP
CC value is the same, why? GP Value has increased,
$5.00 why?
VCC $40 $5.00
0.125 VGP $40 $2.00 $2.00
0.125 VCC $40 VGP $57.14
0.125 - 0.075 0.125 - 0.09
Should either or both firms retain some earnings?
13-21 13-22

Figure 13.1 Dividend Growth for

Value of Growth Opportunities
Two Earnings Reinvestment
Value of assets in place for GP = $40.00 (value with all Policies
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

D0 (1 g ) E1
In general: PVGO
(k g ) k (for a given ROE)
High reinvestment increases stock
price only if ROE > k
13-23 13-24
 Multistage Growth Rate
Multistage Growth Models
Model: Example
As firms progress through their industry life cycle, D0 = $2.00 g1 = 20% g2 = 5%
earnings and dividend growth rates (ROE) are likely to k = 15% T = 3
change. D1 = 2.40 D2 = 2.88 D3 = 3.46 D4 = 3.63
A two stage growth model:
T
(1 g1 ) t DT (1 g 2 ) $2.40 $2.88 $3.46 $3.63
V0 D0 V0
1 (1 k) (k g 2 )(1 k)T 1.15 1.152 1.153 (0.15 0.05)(1.15)3
t
t
g1 = first growth rate
g2 = second growth rate V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40
T = number of periods of growth at g1

13-25 13-26

Two Stage DDM for Honda Two Stage DDM for Honda
From Value Line
Dividends: Year Dividend The required rate of return:
2009 0.90
Honda = 1.05
From Value Line
2010 0.98
2011 1.06 Rf in 2008 = 3.5%
2012 1.15 Market risk premium=historical average of 8%
Assume the dividend growth rate will be
steady beyond 2012. Value Line forecasts kHonda Rf (RM Rf ) Honda
b = 70% and ROE of 11%. What should k Honda 3.5% 8% 1.05 11.9%
be the long term growth rate?
g ROE b g 11% 0.7 7. 7%
13-27 13-28
 Two Stage DDM for Honda Two Stage DDM for Honda
Year Divid
end Should we trust the valuation result?
k = 11.90% 2009 0.90
g = 7.70% 2010 0.98
What if the beta is slightly incorrect,
Find the intrinsic value 2011 1.06
suppose it is 1.10 (< 5% error) rather than 1.05?
2012 1.15
Recall that the actual price = $21.37
$0.90 $0.98 $1.06 $1.15 $1.15 1.077
V0
1.119 1.119 2 1.1193 1.119 4 (0.119 0.077)(1.119)4
V0 $21.88 Now k = 12.3% and the intrinsic value estimate V0=
$19.98, reversing our conclusion that Honda is
Value Line reported the actual price = $21.37, so
undervalued
Honda was undervalued by $0.51 or about 2.4%.

13-29 13-30

P/E Ratio and Growth

Opportunities
13.4 Price-Earnings (P/E) Ratios 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

Aside) k = required r/r, discount rate, opportunity, can

be given, or needs to be estimated. As k increases,
13-31
the (present) value decreases. 13-32
 P/E, ROE and Growth Numerical Example: No Growth
g ROE b E(E1)= $2.50 g = 0 k = 12.5%; Find P/E
With positive growth: and V0
The P/E here is not the actual P/E
P0 (1 b)
you get with P0 and trailing EPS.
P/E = 1/k = 1/.125 = 8
E1 k g
The elements of the V0/E1 ratio V0 = P/E x E(E1)= 8 x $2.50 = $20.00 or
here (theoretical P/E) are similar to = $2.50/(.125-0)= $20.00
the constant growth DDM.
Then, the theoretical P/E= $20/$2.5= 8

With zero growth: V0 = P/E x E(E1) is called P/E multiple.

Typically, we use current industry P/E and
If b = 0 then g should = 0 and the ratio
projected E(EPS1) of the firm instead of
simplifies to: P0 1
E1 k
this hypothetcal situation.
13-33 13-34

Numerical Example with Growth ROE and b and growth and P/E
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%
E(E1)= $2.50 (1.09) = $2.725, E(D1)=$2.725 (0.4) = $1.09
P/E = (1 - 0.60) / (0.125 - 0.09) = 11.4
V0 = P/E x E(E1)= 11.4 x $2.73 = $31.14 or
= $1.09/(.125 - .09) = $31.14
Then => the theoretical P/E = 31.14/2.725 = 11.4
Again, V0 = P/E x E(E1) Is using data (current industry P/E
from Yahoo Finance! and the projected E(E1) from I/B/E/S
or pro forma I/S)

13-35 13-36
 P/E Ratios and Stock Risk Pitfalls in Using Actual P/E1 Ratios
P0 (1 b) Not often, but E(EPS1) can be negative,
E1 k g Earnings management is a serious problem,
E(EPS1) should be calculated using pro forma
Riskier firms will have higher required earnings, or obtained from data services which
rates of return (higher values of k)
A high P/E implies high expected growth, but not
necessarily high stock returns,
Riskier stocks will have lower P/E It assumes that the future P/E will be steady. If the
multiples expected growth in earnings fails to materialize, the
P/E will fall and investors may incur (large) losses.

13-37 13-38

Figure 13.3 Actual P/E Ratios Figure 13.4 Earnings Growth

and Inflation for Two Companies

13-39 13-40
Figure 13.5 Price-Earnings Ratios Figure 13.6 P/E Ratios

13-41 13-42

Other Comparative Valuation Figure 13.7 Valuation Ratios for the

Ratios S&P 500
Price-to-book
High ratio indicates a large premium over book value,

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

13-43 13-44
Free Cash Flow Valuation Approach FCFF, Firm Value & Equity Value
The free cash flow methods discount year to year cash flows
Capitalize or discount the free cash flow for the firm plus some estimate of the terminal value PT where
(FCFF) at the weighted-average cost of capital and then FCFFT 1
PT
subtract the existing (market) value of debt WACC g
WACC = Weighted average cost of capital
Helpful to understand sources and uses of cash g = estimate of long run growth in free cash flow
FCFF EBIT(1 TC ) Depreciati on Capital Expenditur es Increase in NWC T = time period when the firm approaches constant growth
where: T
FCFFt PT
Firm Value
EBIT = earnings before interest and taxes t 1 (1 WACC)t (1 WACC)T

Tc = the corporate tax rate Equity value = Firm Value Market Value of Debt
NWC = net working capital

13-45 13-46

Free Cash Flow (cont.) FCF Valuation Example

Another approach calculates the free cash flow
to the equity holders (FCFE) and discounts the
cash flows directly at the cost of equity, kE.

FCFE FCFF Interest Expense(1 TC ) Increase in Net Debt

FCFET 1 T
FCFEt PT
PT Equity Value
kE g t 1 (1 k E )
t
(1 kE )T

Equity value can then be estimated as:

13-47 13-48
Comparing the Valuation Models
In theory free cash flow approaches should provide the same
estimate of intrinsic value as the dividend growth model 13.6 The Aggregate Stock
In practice the various approaches often differ substantially
Market
Simplifying assumptions are used in all models
The models establish ranges of likely intrinsic value
Using multiple models forces rigorous thinking about the
inputs

13-49 13-50

Figure 13.8 Earnings Yield of the S&P

Earnings Multiplier Approach 500 Versus 10-year Treasury Bond Yield
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

10 year Treasuries

3. Product of the two forecasts is the estimate of the end-

of-period level of the market

13-51 13-52
 Table 13.4 S&P 500 Index
Earnings Multiplier Approach
Forecasts
2009 Data: Starting S&P500 level = 900
Expected Earnings yield S & P500 ? 10 yr Treasury spread 2.5%
Treasury yield = 3.2% S & P5001 17.54 55 965
965 900
ExpectedRe turn 7.2%
900

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?

13-53 13-54