Equity Valuation

Analysis of Investments &

Management of Portfolios
10TH EDITION

Reilly & Brown

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Valuation: Fundamental Analysis
• Fundamental analysis models a company’s value
by assessing its current and future profitability.
• The purpose of fundamental analysis is to identify
mispriced stocks relative to some measure of
“true” value derived from financial data.

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 Models of Equity Valuation

There are three main methods to value (price) an

investment
1. Asset value is equal to its total future cash flows
2. Asset value is equal to its net asset value
3. Asset value is equal to its comparable companies
Which method to use will depend on the nature of the
investment itself and the reason of the investment

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 Models of Equity Valuation

• Balance Sheet Models

• Dividend Discount Models (DDM)
• Price/Earnings Ratios
• Free Cash Flow Models

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 Models of Equity Valuation

Cash flow models Comparable Nets Asset Value

• Dividend companies model
Discount Models models (Balance sheet
(DDM) • Price/Earnings models)
ratio • Balance Sheet
• Free Cash Flow • Price/Sales ratio Models
Models (FCFF
and FCFE)

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 Valuation by Comparables

• Compare financial results and ratios of the

firm to an industry average.

• Example: P/S ratio (price/sales) is useful for

valuing start-ups that have yet to generate
positive earnings.

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 Limitations of Book Value
• Book values are based on historical cost, not actual
market values. (e.g equipment depreciation)
• Book value are based on original costs, but market
value measures the current value of assets and
liabilities.
• Thus, the market value of equity must be equal to the
difference between market value of assets and liabilities.
• Its unusual to find MV = BV
• It is possible, but uncommon, for market value to be less
than book value.

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 Limitations of Book Value
• The question here what can be used as floor
for the stock price?
• “Floor” or minimum value is the liquidation
value per share.
• Tobin’s q is the ratio of market price to
replacement cost.

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Limitations of Book Value
Tobin Q
The Q ratio, also known as Tobin's Q,
equals the market value of a company
divided by its assets' replacement cost.
Thus, equilibrium is when market value
equals replacement cost. At its most
basic level, the Q Ratio expresses the
relationship between market
valuation and intrinsic value. In other
words, it is a means of estimating
whether a given business or market
is overvalued or undervalued.
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Liquidation value
Liquidation is the difference between
some value of tangible assets and
liabilities. As an example, assume
liabilities for company A are $550,000.
Also, assume the book value of assets
found on the balance sheet is $1 million,
the salvage value is $50,000, and the
estimated value of selling all assets at
auction is $750,000, or 75 cents on the
dollar. The liquidation value is
calculated by subtracting the liabilities
from the auction value, which is
$750,000 minus $550,000, or $200,000.
 Limitations of Book Value
• Although focusing on the balance sheet and ratios
calculation is useful about firms replacement costs
and liquidation value.
• Stock market analysts focus on the expected future
cash flows as better estimates of the firm future value
“ as going concern”.
• Thus the most poplar model for assessing the value
of firm going concern option was from investor
expectation to (capital gain and dividend gain)

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 Intrinsic Value vs. Market Price
• The return on a stock is composed of
dividends and capital gains or losses.

E ( D1 ) +  E ( P1 ) − P0 
Expected HPR= E (r ) =
P0

• The expected holding period return HPR

may be more or less than the required
rate of return, based on the stock’s risk.
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 Intrinsic Value vs. Market Price

E ( D1 ) +  E ( P1 ) − P0 
Expected HPR= E (r ) =
P0

expected
dividend
yield
Rate of price
appreciation

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 Intrinsic Value vs. Market Price
EX.1:
Assume ABC expected dividends per share is $4, the
share price now is $48 and its expected to raise at the
end of the year to $52.
Use the EHPR to calculate the expected return

E ( D1 ) +  E ( P1 ) − P0 
Expected HPR= E (r ) =
P0

EHPR= 4+( 52-48) = 16.7%

48
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 Intrinsic Value vs. Market Price
Required Rate Of Return
• CAPM gives the required return, k:
k = rf +   E (rM ) − rf 

• If the stock is priced correctly, k should

equal expected return.
• k is the market capitalization rate.

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 Intrinsic Value vs. Market Price
EX.2:
Based on ABC stock , the risk free rate 6% ,
beta of ABC stock = 1.2, market return= 11%
Calculate the required rate of return

k = rf +   E (rM ) − rf 

K= 6%+ 1.2 ( 11% - 6%) = 12%

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 Intrinsic Value vs. Market Price

EHPR > RRR

16.7% > 12%

Difference 4.7%

Stock is underpriced
So investors must include more of ABC stock
in their portfolio.

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 Intrinsic Value vs. Market Price
• By comparing the market price by the
true value of an asset we can say that
this is asset is
– Overpriced in the market
– Underpriced in the market
– Fairly priced in the market
• Which case would you expect to be
an opportunity to buy the asset, the
overpriced or the underpriced asset?

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 Intrinsic Value vs. Market Price
• It is your job as an investment manager to:
– Calculate intrinsic value
– Monitor the market
– Exploiting opportunities

Buy Hold Sell the overpriced

the underpriced assets the Fairly priced assets
assets

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 Intrinsic Value vs. Market Price

EX.3:
Company Trading
name Market price Fair value Over/Undervalued decision
ABC 40 35
EFG 21 20.5
HIJ 18 26
KLM 9 12
NOP 1.5 1.25

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 Intrinsic Value vs. Market Price

Company name Market price Fair value Over/Undervalued Trading decision

ABC 40 35 overvalued sell/underweight

EFG 21 20.5 fairly valued hold

HIJ 18 26 undervalued buy/overweight

KLM 9 12 undervalued buy/overweight

NOP 1.5 1.25 overvalued sell/underweight

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 Intrinsic Value and Market Price
• The intrinsic value (IV) is the “true” value,
according to a model.
• The market value (MV) is the consensus
value of all market participants

Trading Signal:
IV > MV Buy
IV < MV Sell or Short Sell
IV = MV Hold or Fairly Priced
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 Cash flow models

1. Dividend Discount Model DDM

2. Free Cash Flow Models FCF

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 Dividend Discount Model
DDM

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 Zero Growth Models

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 No Growth Model :Preferred Stock

• Special Case 1 : No growth case

Ex. 4:
• Value a preferred stock paying a fixed
dividend of $2 per share when the discount
rate is 8%:

• V0 = Dt / k

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 No Growth Model :Preferred Stock

• Special Case 1 : No growth case

• Value a preferred stock paying a fixed
dividend of $2 per share when the discount
rate is 8%:

$2
Vo = = $25
0.08 − 0
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 Constant Growth Models

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 Constant Growth DDM

• A special case 2 : of the company has

a constant growth rate the formula will
be
D0 (1 + g ) D1
V0 = =
k−g k−g
• g=dividend growth rate

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 Constant Growth DDM
• Ex. 5:
• A stock just paid an annual dividend of $3 per
share. The dividend is expected to grow at 8%
indefinitely, and the market capitalization rate(or
required rate of return, or CAPM) is 14%.
• What is the value of the company

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 Constant Growth DDM
• Answer
• D1 = D0 x ( 1+g)
• 3.24 = 3 x (1+8%)

D1 $3.24
V0 = = = $54
k − g 14% − 8%

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 Multistage Growth Models

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 Multistage Growth Models

EX.6:
Expected dividends for Honda:
2010 $.50 2012 $ .83
2011 $.66 2013 $1.00
After 2013 the company is expected to grow
at a constant growth rate of 7.7%
Required rate of return 11.1%
Calculate the company value:
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 Solving for the terminal value
• Step 1 : find the terminal value
• Using the constant growth model

D2014 D2013 (1 + g ) $1(1.077 )

P2013 = = = = $31.68
k−g k−g 0.111 − 0.077

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 Finally: Present value of all CFs
• Step 2
• Find the total present value of all cash flows
$0.50 $0.66 $0.83 $1 + $31.68
V2009 = + 2
+ 3
+
1.111 1.111 1.111 1.1114
• In 2009, one share of Honda Motor Company
Stock was worth $23.04.

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 Estimating Dividend Growth
Rates

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 Estimating Dividend Growth Rates

g = ROE x b
• g = Dividends growth rate
• ROE = Return on Equity
• b = retention percentage rate
= (1- dividend payout ratio)

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 Estimating Dividend Growth Rates

EX.7:
The company's EPS is $ 12 and last cash
dividend per share was $4.80 and ROE is
8.34%. Calculate retention ratio.

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 Estimating Dividend Growth Rates
Ex. 7 :
the company's EPS is $ 12 and last cash dividend per share was
$4.80 and ROE is 8.34%. Calculate retention ratio and growth
rate.
Answer :
b= 1-dividend payout ratio
b= 1-40%= 60%
g = ROE
Dividend payout= D0/
x EPS=
b 4.80/ 12= 40%

g= 8.34% X 60%= 5 %

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 Estimating Dividend Growth Rates

Ex. 8:
• XYZ Company has an EPS of $ 100, and its
equity per share is $1000, dividend payout ratio
is 0.4.
• Calculate growth rate of the company

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 Estimating Dividend Growth Rates
Ex.8:
• XYZ Company has an EPS of $ 100, and its equity per
share is $1000, dividend payout ratio is 0.4.
• Calculate growth rate of the company
• Answer 5
• ROE = EPS/equity per share
• ROE = 100/1000 = 10%
• b= 1- dividend payout ratio : 1- 40% = 60%
g= b x ROE
g= 60% x 10% = 6%

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 Estimating next year Dividend
Ex.9:
Estimate the next year’s dividend, using the
following data:
• Earnings per share EPS is $12.00, Book Value
per Share BVS is $45.00, and last year dividend
was $ 3.0.calculate D1.

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 Estimating next year Dividend
• In order to estimate the next year’s dividend we
need first to calculate the sustainable growth rate
as follows
• ROE= (EPS/BVS), retention ratio = 1-(D0/EPS),
G=ROE x b, D1=D0 x (1+G)

ROE b Growth Dividend

Growth ratio = 0.267 0.75 20% 3.60

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 Ex. 10
• EFG company is expecting that in the next three
years dividends will be as follows
D1 D2 D3
$ 40 $ 50 $ 60

• Starting from year four, dividends will grow at a

constant growth rate 5%, cost of capital is 18%.
• Using the DDM model; find the value of this
company

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