FNCE3302

INVESTMENTS AND
SECURITY ANALYSIS

Liping Qiu
CHAPTER 13: EQUITY VALUATION

Apr. 1, 2020
Today’s Schedule
• Discounted Cash Flow Models
• Applications of Gordon Growth Model
• Gordon Growth Model with Historical Data
 4

After This Class, You Should Be Able To:

• Understand the applications of Gordon growth
model.
• Calculate the stock price-implied growth
opportunity
• Estimate the expected growth rate in dividends
using historical data
• Estimate cost of equity using historical data
Today’s Schedule
• Discounted Cash Flow Models
• Applications of Gordon Growth Model
• Gordon Growth Model with Historical Data
 6

Applications of Gordon Growth

Model
• Introduction to the Applications of Gordon Growth
Model
• Stock Price-Implied Growth Rate
• Stock Price-Implied Required Rate of Return
• Stock Prices and Investment Opportunities
 7

Introduction to the Applications of Gordon

Growth Model
• The Gordon growth model has a number of
characteristics that make it useful and appropriate for
many applications. The model:
• Is applicable to stable, mature, dividend-paying firms.
• Is appropriate for valuing market indices.
• Is easily communicated and explained because of its
straightforward approach.
• Can be used to determine price-implied growth rates,
required rates of return, and value of growth
opportunities.
• Can be used to supplement other, more complex
valuation methods.
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Stock Price-Implied Growth Rate

•
D2 D1
V1   (1  g )  V0 (1  g )
kg kg
• For stock with market value=intrinsic value
P1
g 1
P0
• Therefore, the DDM implies that, in the case of
constant expected growth of dividends, the
expected rate of price appreciation in any year
will equal that constant growth rate, g.
 9

Stock Price-Implied Required Rate of

Return
• For stock with market price=intrinsic value (V0  P0 )
expected holding period return
• E(r )=Dividend yield + Capital gains yield = k

D1 P1  P0 D1
k    g
P0 P0 P0

This equation is known also as the discounted cash

flow (DCF) formula.
 10

Stock Prices and Investment

Opportunities
• Present value of growth opportunities
(PVGO)
• Price=No-growth value per share + PVGO

E1
P0   PVGO
k
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Question 1
• Company has expected earnings of $4.8
per share for next year. The firm's ROE is
16%, and its earnings retention ratio is
55%. If the firm's market capitalization rate
is 12%, what is the present value of its
growth opportunities?
Today’s Schedule
• Discounted Cash Flow Models
• Applications of Gordon Growth Model
• Gordon Growth Model with Historical Data
 13

Gordon Growth Model with Historical Data

• Get Data from Internet
• Estimate the expected growth rate in
dividends
• Estimate the expected dividends in the next
period
• Estimate Cost of Equity
• Equity valuation using Gordon growth
model
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Get Data from Internet

• Go to http://finance.yahoo.com/
• Enter the name or stock symbol in the box of “Quote
Lookup”
• Click “Historical Data”
• In “Time Period”, type in start date and end date of data.
• Show “Historical Prices”; choose the frequency of your
data
• Click “Apply” and then Click “Download Data”
• Name your file properly
• You can also download the dividend for the stock by
showing “Dividends Only”.
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Estimate Dividend Growth Rate

Step 1: Download the dividend data from Yahoo.Finance
Step 2: Calculate the yearly dividend
Step 3: Calculate dividend growth rate using the following
formula or Excel function:
• A. Formula: g  ( t t ) D / D  1
2 1
t 2t 1

• B. Function:
RATE(t2  t1 ,, Dt1 ,  Dt2 )
Where
Dt1 =Divident distribution in year t1
Dt2 =Divident distribution in year t2
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SUMIF Function
• Use SUMIF function to calculate the yearly dividend
distribution
• SUMIF function: To sum the values in a range that meet
criteria that you specify.
• SUMIF(range, criteria, [sum_range])
• range Required. The range of cells that you want
evaluated by criteria.
• criteria Required. The criteria in the form of a number,
expression, a cell reference, text, or a function that
defines which cells will be added.
• sum_range Optional. The actual cells to add, if you
want to add cells other than those specified in the range
argument.
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Estimate Next Period Dividend

• If the dividend just paid D0 is given, the expected
dividend in the next period can be calculated as:
D1  D0  (1  g )
• The expected dividend in the next period can also
be estimated as:
D1  E1  (1  b)
• Where
E1 = expected earnings per share in the next period
b = plowback ratio or earnings retention ratio
= 1 - dividend payout ratio
Estimate Cost of Equity
• The analyst can use CAPM to estimate the
required rate of return required by shareholders
for investing in the stock (cost of equity)
E (ri )  rf   i [ E (rM )  rf ]
• Beta can be estimated as the slope of the linear
regression of excess return of stock on the
excess returns on market.
• Beta can also be calculated as:
Cov  RM , Ri   Mi
i   2
Var  RM  M 18
Functions and Formulas
• Excel Formulas:
• Average = average(B3:B26)
• Variance = varp(B3, B26)
• Std deviation =stdevp(B3:B26)
• Covariance =covar(B3:B26,C3:C26)
• Correlation =correl(B3:B26,C3:C26)
n
 APR 
EAR  1  Rate per period   1  1 
n
 1
 n 
n  Number of periods per year
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Homework
• Read Chapter 13.
• Assignment
• Chapter 13: 3, 4, 6, 10, 14, 11, 19, 21