FNCE 625 – Investment Analysis and Management

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 10

Common Stock Valuation

Fundamental Analysis

Discounted Cash Flow Techniques

Intrinsic value based on the discounted value of the expected stream of cash flows

Dividend discount model can be challenging to apply in many cases

Multiplier Approaches

Relative Valuation Metrics

Emphasize stock comparisons rather than valuation

Discounted Cash Flow Approach

Intrinsic value of a security is:

k = appropriate discount rate

Estimated intrinsic value is compared to current market price to make investment decision

Dividend Discount Model (D D M) 1

Special case of equity valuation model

Current value of stock is discounted value of all future dividends

Required return is minimum return that induces investor to buy stock

Implementing the D D M

Dividends must be valued for infinity

Practically is not an insurmountable problem

Dividend stream is uncertain

Dividends expected to grow over time

Estimated growth in dividends can be incorporated into D D M

Three growth cases: zero, constant, multiple

Dividend Discount Model (DDM) 2

Zero-Growth Rate Model

Fixed dollar amount of dividends - security is treated as a perpetuity

Commonly applied to preferred stock because dividend remains unchanged

Values future stream of dividends from now to infinity

Present Value Growth Opportunities (P V G O)

P V G O represents the value investors are assigning to a firm’s growth opportunities

P V G O is estimated by taking the difference between a firm’s current stock price (P) and its no-growth value

* E1 is the firm’s forecasted E P S for next year

Dividend Discount Model (D D M) 3

Constant Growth Rate D D M:

Dividends expected to grow at a constant rate, g, over time

D1 is expected dividend one period from now

D1 = D0  (1 + g), where D0 is current dividend

Model values all cash flows from now to infinity

Constant Growth Rate D D M

Constant growth model should be used to value stocks that pay a stable dividend with an expected persistent growth

Methods to obtain an estimate for g:

project from past growth in dividends

use formula  g = ROE × retention ratio

employ analysts’ estimates of g

Retention ratio = (1− dividend payout ratio)

Dividend Discount Model (D D M) 4

Implications of constant growth D D M

Stock price grows at same rate as dividends

Stock return grows at required rate of return

Growth in price plus growth in dividends equals k, the required rate of return

Lower required return or higher expected growth raises the price

Model is very sensitive to small variations in inputs

Dividend Discount Model (DDM) 5

Multiple-Growth Rate D D M

Two or more expected growth rates

Two-stage and three stage models assume unusual growth for n periods followed by steady/constant growth

H-Model

Special case of multi-stage D D M

Assumes dividends decline linearly from initial short-term growth (gs) to stable long-term constant growth (gc)

* H is the half life of the projected unusual growth period

Dividend Discount Model (D D M) 6

Multiple growth rates

First value covers the period of unusual growth

Second value covers the period of stable growth

Limitations

Very sensitive to inputs

Difficult to determine term of unusual growth

Assumes immediate transition to constant growth

What about Capital Gains?

D D M accounts for capital gains

Future price reflects expected dividends from that point forward

D D M assumes price appreciates at “g”

Valuing only dividends or a combination of dividends and price produces same result

Rearranging D D M shows two components of expected return:

Other Discounted Cash Flows

Free Cash Flow to Equity (F C F E): What firm could pay in dividends

F C F E = net inc. + deprec. − capital expend. − working cap. expend. + net borrowing

Free Cash Flow to Firm (F C F F): Cash available before any financing considerations

F C F F = F C F E + int. exp. (1 − tax rate) − net borrowing

Intrinsic Value

Estimated value of stock today

Derived from estimating and discounting future cash flows with a valuation model

If intrinsic value is:

greater than current market price, purchase (or hold) asset because it is undervalued

less than current market price, do not purchase (or sell) asset, it is overvalued

Remember that models produce value estimates

Multiplier Approach for Valuation 1

Alternative to discounted cash flow approach

Widely used approach due to ease of interpretation and calculation

Value estimate is the product of two inputs

Firm financial characteristic

Estimated price multiple (multiplier)

Multiplier Approach for Valuation 2

Used with a variety of price multiples

P/S, P/B, P/C F, E V/E B I T D A

P/E multiple (ratio) is the most commonly considered multiplier

Reflects price paid for each $1 of earnings

Approach is also used to value other asset types

Commonly applied to real estate

P/E Multiplier Approach

To estimate a stock’s value (V0), an analyst must forecast next period’s E P S (E1) and the appropriate current multiplier for next period’s estimated E P S  (P0/E1)A

Relative Valuation 1

Compare firm to peers, or the market, to assess relative valuation

Most applicable when comparison is between similar type firms

Apply the same multiples as used in the multiplier approach

P/E, P/B, P/S, P/C F and E V/E B I T D A

P/E ratios tend to be emphasized

Relative Valuation 2

Higher multiples imply greater expected growth prospects, more investor optimism

P/E – most commonly assessed multiple

P/B – most useful with firms with hard assets and liquid assets

P/S – advocated for intercountry comparisons within industry

P/CF – C F less prone to manipulation than E P S

Relative Valuation 3

Methods that combine financial measures

E V/E B I T D A – controls for debt differences across firms

Newer measure with strong empirical support

Economic Value Added (E V A)

Difference between operating profits and company’s capital cost

Emphasizes return on capital

Which Approach Is Best?

Discounted cash flow is theoretically best

Application is difficult in some cases

Price multiples serve dual role

Estimating intrinsic value of stock

Relative valuation

All methods subject to estimation error

Traditional methods apply to “new economy” stocks: revenues and profits do matter

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FNCE 625 – Investment Analysis and Management

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