Equity Valuation and

Financial Analysis
 Models of Equity Valuation

• Balance Sheet Models

• Book Value
• Dividend Discount Models
• Price/Earning Ratios
 Limitations of Book Value

• Book value is an application of arbitrary accounting rules

• Can book value represent a floor value?
• Better approaches
• Liquidation value
• Replacement cost
 Intrinsic Value and Market Price
• Intrinsic Value
• Self assigned Value
• Variety of models are used for estimation
• Market Price
• Consensus value of all potential traders
• Trading Signal
• IV > MP Buy
• IV < MP Sell or Short Sell
• IV = MP Hold or Fairly Priced
Dividend Discount Models: General Model


Dt
Vo  
t  1 (1  k )
t

V0 = Value of Stock
Dt = Dividend
k = required return
 No Growth Model

D
Vo 
k
• Stocks that have earnings and dividends that are
expected to remain constant
• Preferred Stock
No Growth Model: Example

D
Vo 
k
E1 = D1 = $5.00
k = .15
V0 = $5.00 /.15 = $33.33
 Constant Growth Model

Do(1  g )
Vo 
kg
g = constant perpetual growth rate
Constant Growth Model: Example

Do (1  g )
Vo 
kg
E1 = $5.00 b = 40% k = 15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
 Estimating Dividend Growth Rates

g  ROE  b
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
 Specified Holding Period

D D D P
V   1 2
 ...  H H

(1 k ) (1 k ) (1 k )

0 1 2 H

PH = the expected sales price for the stock at time H

H = the specified number of years the stock is
expected to be held
Figure 18.1 Dividend Growth for Two
Earnings Reinvestment Policies
 Present Value of Growth Opportunities Continued

• Price = No-growth value per share + PVGO (present value of

growth opportunities)

E1
P0   PVGO
k
 Partitioning Value: Example

ROE = 20% d = 60% b = 40%

E1 = $5.00 D1 = $3.00 k = 15%

g = .20 x .40 = .08 or 8%

Partitioning Value: Example Continued
3
Vo   $42.86
(.15.08)
5
NGVo   $33.33
.15
PVGO  $42.86  $33.33  $9.52
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities
Table 18.2 Financial Ratios in Two Industries
 Price Earnings Ratios

• P/E Ratios are a function of two factors

• Required Rates of Return (k)
• Expected growth in Dividends
• Uses
• Relative valuation
• Extensive Use in industry
P/E Ratio: No Expected Growth

E1
P0 
k
P0 1

E1 k
• E1 - expected earnings for next year
• E1 is equal to D1 under no growth
• k - required rate of return
 P/E Ratio: Constant Growth

D1 E1 (1  b)
P0  
k g k  (b  ROE )
P0 1 b

E1 k  (b  ROE )

b = retention ratio
ROE = Return on Equity
 Numerical Example: No Growth

E0 = $2.50 g = 0 k = 12.5%

P0 = D/k = $2.50/.125 = $20.00

PE = 1/k = 1/.125 = 8
 Numerical Example: Growth

b = 60% ROE = 15% (1-b) = 40%

E1 = $2.50 (1 + (.6)(.15)) = $2.73
D1 = $2.73 (1-.6) = $1.09
k = 12.5% g = 9%
P0 = 1.09/(.125-.09) = $31.14
PE = 31.14/2.73 = 11.4
PE = (1 - .60) / (.125 - .09) = 11.4
Table 18.3 Effect of ROE and Plowback on
Growth and the P/E Ratio
 P/E Ratios and Stock Risk

• Holding all else equal

• Riskier stocks will have lower P/E multiples
• Higher values of k; therefore, the P/E
multiple will be lower

P 1 b

E kg
 Pitfalls in P/E Analysis

• Use of accounting earnings

• Earnings Management
• Choices on GAAP
• Inflation
• Reported earnings fluctuate around the business cycle
Figure 18.3 P/E Ratios of the S&P 500 Index
and Inflation
Figure 18.4 Earnings Growth for Two Companies
Figure 18.5 Price-Earnings Ratios
Figure 18.6 P/E Ratios for Different
Industries, 2007
 Other Comparative Value Approaches

• Price-to-book ratio
• Price-to-cash-flow ratio
• Price-to-sales ratio
Figure 18.7 Market Valuation Statistics
 Free Cash Flow Approach

• Discount the free cash flow for the firm

• Discount rate is the firm’s cost of capital
• Components of free cash flow
• After tax EBIT
• Depreciation
• Capital expenditures
• Increase in net working capital
 Comparing the Valuation Models

• In practice
• Values from these models may differ
• Analysts are always forced to make simplifying assumptions
Figure 18.8 Earnings Yield of S&P 500 versus 10-
Year Treasury-Bond Yield
Table 18.4 S&P 500 Price Forecasts Under Various
Scenarios
Two Stage DDM
Financial Statement Analysis

36
 Financial Statement Analysis
• Financial statement analysis can be used to
discover mispriced securities.
• Financial accounting data are widely available,
but
• Accounting earnings and economic earnings are not
always the same thing!

37
 Financial Statements
• Income Statement:
• Profitability over time
• Balance Sheet:
• Financial condition at a point in time
• Statement of Cash Flows:
• Tracks the cash implications of
transactions.

23-38 38
Table 23.1 Consolidated Statement of Income for Hewlett-
Packard, 2009

39
Table 23.2 Consolidated Balance Sheet for Hewlett-Packard,
2009

40
 Table 23.3 Statement of Cash Flows for Hewlett-Packard,
2009

23-41 41
Accounting Versus Economic Earnings
• Economic earnings
• Sustainable cash flow that can be paid to
stockholders without impairing productive
capacity of the firm
• Accounting earnings
• Affected by conventions regarding the
valuation of assets

42
 Profitability Measures
• ROE measures profitability for contributors of
equity capital.
• After-tax profit/book value of equity

• ROA measures profitability for all contributors

of capital.
• EBIT/total assets

23-43 43
 Past vs. Future ROE

• ROE is a key determinant of earnings growth.

• Past profitability does not guarantee future profitability.
• Security values are based on future profits.
• Expectations of future dividends determine today’s stock value.

23-44 44
 Financial Leverage and ROE

• ROE can differ from ROA because of leverage.

• Leverage makes ROE more volatile.
• Let t=tax rate and r=interest rate, then:

 Debt 
ROE  1  t ROA  ROA  r  
 Equity 

23-45 45
 ROE, ROA and Leverage
 Debt 
ROE = (1 - Tax rate)  ROA + (ROA - Interest rate) 
 Equity 

Net profit EBIT - Interest - Taxes (1 - Tax rate)(EBIT- Interest)

ROE   
Equity Equity Equity
 (ROA x Assets) - (Interest rate x Debt) 
 (1 - Tax rate)  
 Equity 
 Equity + Debt Debt 
 (1 - Tax rate)  ROA x  Interest rate x
 Equity Equity 
 Debt 
 (1 - Tax rate)  ROA + (ROA - Interest rate)
 Equity 
 Financial Leverage and ROE
 Debt 
ROE  1  t ROA  ROA  r  
 Equity 
• If there is no debt or ROA = r, ROE will simply
equal ROA(1 - t).
• If ROA > r, the firm earns more than it pays out
to creditors and ROE increases.
• If ROA < r, ROE will decline as a function of the
debt-to-equity ratio.

23-47 47
Table 23.5 Impact of Financial Leverage on
ROE

48
 Decomposition of ROE
DuPont Method

Net Profit Pretax Profit EBIT Sales Assets

ROE = x x x x
Pretax Profit EBIT Sales Assets Equity

(1) x (2) x (3) x (4) x (5)

Tax Interest
x x Margin x Turnover x Leverage
Burden Burden

23-49 49
 Decomposition of ROE

ROA = EBIT/Sales X Sales/Assets

= margin X turnover

• Margin and turnover are unaffected by leverage.

• ROA reflects soundness of firm’s operations, regardless of how they
are financed.

50
 Decomposition of ROE

ROE=Tax burden X ROA X Compound leverage factor

• Tax burden is not affected by leverage.

• Compound leverage factor = Interest burden X Leverage

23-51 51
Table 23.6 Ratio Decomposition Analysis for Nodett and
Somdett

52
 Choosing a Benchmark

• Compare the company’s ratios across time.

• Compare ratios of firms in the same industry.

• Cross-industry comparisons can be misleading.

23-53 53
 Table 23.7 Differences between Profit Margin and Asset
Turnover across Industries

23-54 54
 Table 23.9 Summary of Key Financial Ratios

23-55 55
 Table 23.9 Summary of Key Financial Ratios

23-56 56
 Table 23.9 Summary of Key Financial Ratios

23-57 57
 Table 23.9 Summary of Key Financial Ratios

23-58 58
 Table 23.9 Summary of Key Financial Ratios

23-59 59
 Figure 23.1 DuPont Decomposition for Hewlett-Packard

23-60 60
 Economic Value Added

• EVA is the difference between return on assets

(ROA) and the opportunity cost of capital (k),
multiplied by the capital invested in the firm.
• EVA is also called residual income
• If ROA > k, value is added to the firm.

23-61 61
 Example 23.4 Wal-Mart

• In 2009, Wal-Mart’s cost of capital was 5.9%. Its ROA was 9.6% and its
capital base was $115 billion.

• Wal-Mart’s EVA =
(0.096-0.059) x $115 billion = $4.25 billion

23-62 62
 Comparability Problems
• Accounting Differences
• Inventory Valuation
• Depreciation
• Inflation and Interest Expense
• Fair Value Accounting
• Quality of Earnings
• International Accounting Conventions

23-63 63
 International Accounting Differences

• Reserves – many other countries allow more flexibility in use

of reserves
• Depreciation – US allows separate tax and reporting
presentations
• Intangibles – treatment varies widely

23-64 64
 Figure 23.2 Adjusted Versus Reported Price-Earnings Ratios

23-65 65
 The Graham Technique
• Rules for stock selection:
• Purchase common stocks at less than their working-capital value.
• Give no weight to plant or other fixed assets.
• Deduct all liabilities in full from assets.

23-66 66