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Security Analysis - Must For Portfolio Management
Security Analysis - Must For Portfolio Management
Portfolio Management
Objective
Understand the theoretical basis of a DCF
Wisdom Words: You may find all of this too easy; in reality it is a problem that can’t be solved easily
Security Analysis: Be Careful Out There
Fundamental analysis is a term for studying a company’s accounting statements and other
financial and economic information to estimate the economic value of a company’s stock.
The basic idea is to identify “undervalued” stocks to buy and “overvalued” stocks to sell.
In practice however, such stocks may in fact be correctly priced for reasons not immediately
apparent to the analyst.
What is company ultimately worth?
Cash in the investors’ pockets
Two key questions about DCF?
How much cash?
Growth rates
Operating margins
Always obtainable
Challenges of DCF
DCF results should be presented as a RANGE of estimated values not a single estimate!
Reliability
Subjective valuation
Upside potential
Downside risk
Generally speaking: As growth nears stable growth, risk and CAPX needs decline
= EBIT
Less: Taxes (at the marginal tax rate)
Projections ?
Two methods:
Exit Multiple
Assumes the business is worth (or "sold") a multiple of an operating statistic at the end of the projections
Perpetuity Growth
Exit Multiple
Inherent difficulty in estimating when the company achieves "steady state”, perpetual growth rate growth
Major considerations:
Synergies
Mature industries
Calculate Enterprise Value
Calculate Equity Value
Return commensurate with risk of the investment (i.e., target company or project, not the acquirer in an M&A
transaction)
Where:
Ke = cost of equity (from CAPM)
Kd = cost of debt (current cost of borrowing from average yield to maturity) E = market value of equity
D = market value of debt
T = marginal tax rate
Determining the cost of debt
Ideally, observable in market
Based on comparables
Ke difficult to estimate
Common source: long-term horizon equity risk premium from Ibbotson Associates' SBBI: Valuation Edition
Yearbook
Risk free rate
Rate of return on a "riskless" investment
Use the long-term rate that best matches the time frame of most investment or acquisition decisions
Limited data
The Dividend Discount Model (DDM) is a method to estimate the value of a share of stock by
discounting all expected future dividend payments. The basic DDM equation is:
D1 D2 D3 DT
P0
1 k 1 k 1 k
2 3
1 k T
In the DDM equation:
P0 = the present value of all future dividends
Dt = the dividend to be paid t years from now
k = the appropriate risk-adjusted discount rate
Example: The Dividend Discount Model
Suppose that a stock will pay three annual dividends of $200 per year, and the
appropriate risk-adjusted discount rate, k, is 8%.
D1 D2 D3
P0
1 k 1 k 1 k 3
2
Assume that the dividends will grow at a constant growth rate g. The dividend next period (t + 1)
is:
D t 1 D t 1 g
So, D 2 D1 (1 g) D 0 (1 g) (1 g)
For constant dividend growth for “T” years, the DDM formula becomes:
D1 (1 g) 1 g
T
P0 1 if k g
k g 1 k
P0 T D 0 if k g
Example: Constant Growth Rate Model
Suppose the current dividend is $10, the dividend growth rate is 10%, there will be 20 yearly
dividends, and the appropriate discount rate is 8%.
What is the value of the stock, based on the constant growth rate model?
D 0 (1 g) 1 g
T
P0 1
k g 1 k
P0 1 $243.86
.08 .10 1.08
DDM: Perpetual Growth Model
Assuming that the dividends will grow forever at a constant growth rate g.
D 0 1 g D1
P0 (Important : g k)
kg kg
Example: Perpetual Growth Model
Think about the electric utility industry.
In 2007, the dividend paid by the utility company, DTE Energy Co. (DTE), was $2.12.
Using D0 =$2.12, k = 6.7%, and g = 2%, calculate an estimated value for DTE.
$2.12 1.02
P0 $46.01
.067 .02
DDM: Estimating the Growth Rate
The spreadsheet below shows how to estimate historical average growth rates, using arithmetic
and geometric averages.
Retention rate?
What is the value of AEP stock, using the perpetual growth model, and a discount rate of 6.7%?
$1.56 1.03122
P0 $44.96
.067 .03122
In this case, using the sustainable growth rate to value the stock gives a reasonably accurate
estimate.
Two-Stage Dividend Growth Model
The two-stage dividend growth model assumes that a firm will initially grow at a rate g1 for T
years, and thereafter grow at a rate g2 < k during a perpetual second stage of growth.
D 0 (1 g1 ) 1 g1 1 g1 D 0 (1 g 2 )
T T
P0 1
k g1 1 k 1 k k g2
Two-Stage Dividend Growth Model
Although the formula looks complicated, think of it as two parts:
Part 1 is the present value of the first T dividends (it is the same formula we used for the
constant growth model).
With a discount rate of k = 10%, what is the present value of the stock?
Two-Stage Dividend Growth Model
D 0 (1 g1 ) 1 g1 1 g1 D 0 (1 g 2 )
T T
P0 1
k g1 1 k 1 k k g2
P0 1
0.10 ( 0.10) 1 0.10 1 0.10 0.10 0.04
$14.25 $31.78
$46.03.
The total value of $46.03 is the sum of a $14.25 present value of the first five dividends, plus a
$31.78 present value of all subsequent dividends.
Example: DDM “Supernormal” Growth
Chain Reaction, Inc., has been growing at a phenomenal rate of 30% per year.
You believe that this rate will last for only three more years.
Then, you think the rate will drop to 10% per year.
First, calculate the total dividends over the “supernormal” growth period:
Using the long run growth rate, g, the value of all the shares at Time 3 can be calculated as:
P3 = [D3 x (1 + g)] / (k – g)
D1 D2 D3 P3
P0
1 k 1 k 2 1 k 3 1 k 3
$87.58 million.
Discount Rates: DDM
The discount rate for a stock can be estimated using the capital asset pricing model (CAPM ).
Observations on DDM
Simple to compute
More realistic when it accounts for two stages of growth (two-stage model)
Price Ratio Analysis
Price-earnings ratio (P/E ratio)
Earnings yield
High-P/E stocks are often referred to as growth stocks, while low-P/E stocks are often referred to as
value stocks.
Price Ratio Analysis
Price-cash flow ratio (P/CF ratio)
In this context, cash flow is usually taken to be net income plus depreciation.
Most analysts agree that in examining a company’s financial performance, cash flow can be more
informative than net income.
Earnings and cash flows that are far from each other may be a signal of poor quality earnings.
Price Ratio Analysis
Price-sales ratio (P/S ratio)
Current stock price divided by annual sales per share
A high P/S ratio suggests high sales growth, while a low P/S ratio suggests sluggish sales
growth.
(Microsoft has an expected growth rate in earnings of 24% for the next five years.)
A. Estimate the cost of equity using the dividend growth model. Which, if any, of these firms may
be reasonable candidates for using this model? Why?
B. Estimate the cost of equity using the CAPM. (The thirty-year bond rate is 6.25%.)
C. Which estimate will you use in valuation and why?
Numericals…
AIG has 1.13 billion shares traded at a market value of $32 per share, and $1.918 billion in book value
of outstanding debt (with an estimated market value of $2 billion). The equity has a book value of $5.5
billion, and the stock has a beta of 1.20. The firm paid interest expenses of $160 million in the most
recent financial year, is rated AAA and paid 35% of its income as taxes. The thirty-year government
bond rate is 6.25%, and AA bonds trade at a spread of twenty basis points (0.4%) over the treasury
bond rate.
A. What are the market value and book value weights on debt and equity?
B. What is the cost of equity?
C. What is the after-tax cost of debt?
D. What is the cost of capital?
Numericals…
Ryder System is a full-service truck leasing, maintenance, and rental firm with operations in North
America and Europe. The following are selected numbers from the financial statements for 1992 and
1993 (in millions).
The firm had capital expenditures of $800 million in 1992 and $850 million in 1993. The working
capital in 1991 was $34.8 million, and the total debt outstanding in 1991 was $1.75 billion. There were
77 million shares outstanding, trading at $29 per share.
A. Estimate the arithmetic average growth rate in earnings per share from 1987 to 1992.
B. Estimate the geometric average growth rate in earnings per share from 1987 to 1992.
The firm also paid out total dividends of $660 million in 1993. The stock was trading at $63, and there
were 330 million shares outstanding. (It faced a corporate tax rate of 40%.) Eastman Kodak had a beta
of 1.10.
Analysts believe that Kodak could take the following restructuring actions to improve its financial
strength:
• It could sell its chemical division, which has a total book value of assets of $2,500 million and has
only $100 million in earnings before interest and taxes.
• It could use the cash to pay down debt and improve its bond rating (leading to a decline in the
interest rate to 7%).
• It could reduce the dividend payout ratio to 50% and reinvest more back into the business.
A. What is the expected growth rate in earnings, assuming that 1993 numbers remain unchanged?
B. What is the expected growth rate in earnings, if the restructuring plan described above is put into
effect?
C. What will the beta of the stock be, if the restructuring plan is put into effect?