Equity Valuation: Bodie, Kane, and Marcus Eleventh Edition

Chapter
13 Equity Valuation
Bodie, Kane, and Marcus

Essentials of Investments
Eleventh Edition
13.1 Equity Valuation
• Book Value
• Net worth of common equity according to a
firm’s balance sheet
• Limitations of Book Value
• Liquidation value: Net amount realized by selling
assets of firm and paying off debt
• Replacement cost: Cost to replace firm’s assets
• Tobin’s q: Ratio of firm’s market value to
replacement cost
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2
Table 13.1 Apple and Alphabet Financial Highlights, April 2017
13.2 Intrinsic Value versus Market Price
• = expected dividend per share

• = current share price
• = expected end-of-year price
Example: Suppose you purchased a share of DAR Inc. for $40 in January. You
expect to sell it for $42 in December and expect to receive a dividend of $2.42
during that year. What is your expected HPR?
E ( D1 ) + [ E ( P1 ) - P0 ] $2.42 + $42 - 40
HPR = E (r ) = = = .1105 = 11.05%
P0 40
• Intrinsic Value
• Present value of firm’s expected future net cash
flows discounted by required RoR
• Market Capitalization Rate
• Market-consensus estimate of appropriate
discount rate for firm’s cash flows
• Intrinsic Value
" #! $"(&! )
• 𝑉! =
($)
• For holding period H
#! #" ## $&#
• 𝑉! = + + ⋯+
($) (($))" (($))#
• Dividend Discount Model (DDM)

• Formula for intrinsic value of firm equal to
present value of all expected future dividends
13.3 Dividend Discount Models
• Constant-Growth DDM
• Form of DDM that assumes dividends will grow
at constant rate
#!
• 𝑉! =
)*+
• Implies stock’s value greater if:

• Larger dividend per share
• Lower market capitalization rate, k
• Higher expected growth rate of dividends
• For stock with market price = intrinsic value,
expected holding period return
• 𝐸 𝑟 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑
#! &! *&% #!
• + = +𝑔
&$ &% &%
• Stock Prices and Investment Opportunities
• Dividend payout ratio
• Percentage of earnings paid as dividends
• Plowback ratio/earnings retention ratio
• Proportion of firm’s earnings reinvested in
business
• Present value of growth opportunities (PVGO)
• Price = No-growth value per share + PVGO
"!
• 𝑃! = + 𝑃𝑉𝐺𝑂
)
• Life Cycles and Multistage Growth Models
• Two-stage DDM
• DDM in which dividend growth assumed to
level off only at future date
• Multistage Growth Models
• Allow dividends per share to grow at several different
rates as firm matures
13.3 Dividend Discount Models: Two Stage Example
• Consider the following information:
• The firm’s dividends are expected to grow at g = 20% until t = 3 yrs.
• At the start of year four, growth slows to gs= 5%.
• The stock just paid a dividend Div0 = $1.00
• Assume a market capitalization rate of k = 12%
• What is the price, P0, of this stock?
D0 ´ (1 + g ) D0 ´ (1 + g )t D0 ´ (1 + g )t ´ (1 + g s )
P0 = + ... + +
(1 + k ) (1 + k ) t
(1 + k )t ´ ( k - g s )
$1´ (1 + .2) $1´ (1 + .2) 2 $1´ (1 + .2)3 D0 ´ (1 + .2)3 ´ (1 + .05)
= + + +
(1 + .12) (1 + .12) 2
(1 + .12) 3
(1 + .12)3 ´ (.12 - .05)
= $1.07 + $1.15 + $1.23 + $18.45 = $21.90
13.3 Dividend Discount Models: Stock Value
• The Constant Growth Model states that a stocks value will

be greater
• The larger its expected dividend per share.
• The lower the market capitalization rate, k.
• The higher the expected growth rate of dividends.
13.3 Dividend Growth and Reinvestment
13.4 Price-Earnings Ratios
• Price Earnings Ratio and Growth
Opportunities
• Price-earnings multiple
• Ratio of stock’s price to earnings per share
• Determinant of P/E ratio
&% ( &,-.
• = &!
"! )
'
• P/E Ratio for Firm Growing at Long-Run
Sustainable Pace
&% (*/
• =
"! )*(0."×/)
• PEG Ratio
• Ratio of P/E multiple to earnings growth rate
Table 13.3 Effect of ROE and Plowback on Growth and P/E Ratio
• P/E Ratios and Stock

& (*/
• =
" )*+
• All else equal, riskier stocks have lower P/E

multiples, higher required RoR, k
Figure 13.3 P/E Ratio and Inflation
• Pitfalls in P/E Analysis
• Earnings Management
• Practice of using flexibility in accounting rules
to improve apparent profitability of firm
• Large amount of discretion in managing
earnings
Figure 13.4 Earnings Growth for Two Companies
Figure 13.5 Price-Earnings Ratios
• Combining P/E Analysis and the DDM
• Estimates stock price at horizon date
• Other Comparative Valuation Ratios

• Price-to-book: Indicates how aggressively
market values firm
• Price-to-cash-flow: Cash flow less affected by
accounting decisions than earnings
• Price-to-sales: For start-ups with no earnings
Figure 13.6 Valuation Ratios for S&P 500
13.5 Free Cash Flow Valuation Approaches
• Free Cash Flow for Firm (FCFF)
• 𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 1 − 𝑡2 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 −
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑁𝑊𝐶
• EBIT = Earnings before interest and taxes
• 𝑡! = Corporate tax rate
• NWC = Net working capital
• Free Cash Flow to Equity Holders (FCFE)

• 𝐹𝐶𝐹𝐸 = 𝐹𝐶𝐹𝐹 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒× 1 − 𝑡2 +
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑖𝑛 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡
• Estimating Terminal Value using Constant
Growth Model
5 ($6766( &)
• 𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = ∑34( +
(($8977)( (($8977))
#$##!"#
• 𝑃" =
%&$$'(
• WACC = Weighted average cost of capital
13.5 FCF Valuation Approaches: FCFF Example
• Suppose FCFF = $1 mil for years 1-4 and then is
expected to grow at a rate of 3%. Assume WACC = 15%
T
FCFF PT
FirmValue = å +
t =1 (1 + WACC ) (1 + WACC )T
t
$1, 000, 000 ´ 1.03

4
$1, 000, 000 .15 - .03
=å +
t =1 (1 + .15)t (1 + .15) 4
= $ 7, 762, 527
• If 500,000 shares are outstanding, what is the predicted
price of this stock if the firm has $5,000,000 of debt?
$7, 762, 527-$5,000,000
P0 = = $5.53
500, 000
• Market Value of Equity
5 676"( &)
• 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = ∑34( +
(($) )( & (($)& ))
676")*!
• 𝑃5 =
)& *+
13.5 FCF Valuation Approaches: FCFE Example
• Suppose FCFE = $900,000 for years 1-4 and then is
expected to grow at a rate of 3%. Assume ke = 18%
T
FCFE PT
Market Value of Equity = å +
t =1 (1 + k e ) t
(1 + k e ) t
$900, 000 ´ 1.03

4
$900, 000 .18 - .03
=å +
t =1 (1 + .18) (1 + .18) 4
t
= $ 2, 500,851
• If there are 500,000 shares outstanding, what is the
predicted price of this stock? Why can debt be ignored?
$ 2, 500,851
P0 = = $5.00
500, 000
Spreadsheet 13.2: FCF
• Comparing Valuation Models
• Model values differ in practice
• Differences stem from simplifying assumptions
• Problems with DCF Models

• DCF estimates are always somewhat imprecise
• Investors employ hierarchy of valuation
• Real estate, plant, equipment
• Economic profit on assets in place
• Growth opportunities
13.6 The Aggregate Stock Market
• Forecasting Aggregate Stock Market

• Earnings multiplier applied at aggregate level
• Forecast corporate profits for period
• Derive estimate of aggregate P/E ratio based
on long-term interest rates
• Some analysts use aggregate DDM
Figure 13.7 Earnings Yield of S&P 500 versus 10-Year Treasury
Bond Yield
16%
14%
Treasury yield
12%
Earnings yield
10%
8%
6%
4%
2%
0%
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
2012
Table 13.4 S&P 500 Forecasts

Equity Valuation: Bodie, Kane, and Marcus Eleventh Edition

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Chapter

Bodie, Kane, and Marcus

• = expected dividend per share

• Dividend Discount Model (DDM)

• Implies stock’s value greater if:

• What is the price, P0, of this stock?

• The Constant Growth Model states that a stocks value will

• The lower the market capitalization rate, k.

• The higher the expected growth rate of dividends.

• P/E Ratios and Stock

• All else equal, riskier stocks have lower P/E

• Other Comparative Valuation Ratios

• Free Cash Flow to Equity Holders (FCFE)

• WACC = Weighted average cost of capital

$1, 000, 000 ´ 1.03

$900, 000 ´ 1.03

• Problems with DCF Models

• Forecasting Aggregate Stock Market

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