equity valuation

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Understand and compare the theoretical equity valuation methods to the more commonly-used multiple valuation approach, and then apply these tools to value a company.

This supplement explores the reasoning behind and the disadvantages of the three theoretical equity valuation models—constant growth model, multi-stage growth model, and dividend discount model—by comparing them to the most frequently-used market multiple valuation approach through the lens of General Electric (GE).

Subsequently, we will do the same valuations and comparisons with The Walt Disney Company (Disney) for homework.

Materials

HOMEWORK CASE STUDY HANDOUT The Case Study reinforces the class lesson. TERMINAL TUTORIAL VIDEO A brief video explains how to gather equity data from the Bloomberg terminal. Web: https://vimeo.com/300775187/3a3918015e Terminal: PLYR VOD 332919111 <GO>

Case Study

Use the information below to guide your responses to each question.

HOW DISNEY MAKES MONEY Disney has four operating segments: parks and resorts, studio entertainment, consumer products, and media networks. The table below shows the proportion of Disney’s total revenues and operating income that come from each segment.

THINKING ABOUT VALUATION Consider purchasing a house. The fundamental valuation metric in a house purchase is square feet. A person interested in purchasing a house should look at the listing price per square foot and compare it to the price per square foot of other houses that recently sold in the area. If the current market for new homes is $112 per square foot and the target home is listed at $124 per square foot, the target home may be overvalued. Focus on the word may. It may be that the target home is superior to the properties used as comparables. Perhaps the target home is in a nicer neighborhood or is built to a higher standard or has other characteristics that warrant a premium to the comparable properties. All of these characteristics need to be considered. But the beginning point of any valuation is uncovering the fundamental valuation metric of the asset, which in the case of our real estate example, is square feet.

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28%

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Parks and Resorts

Studio Entertainment

Consumer Products

Media Networks Disney Consolidated

Disney Operating Margins by Segment and Consolidated All Data from Fiscal Year 2017 in Millions, Except Percentages

Disney Segment Revenues and Operating Income All Data from Fiscal Year 2017 in Millions, Except Percentages

Revenues % of Total

Operating Income

% of Total

Parks and Resorts 18,415 33% 3,774 26%

Studio Entertainment 8,379 15% 2,355 16%

Consumer Products 4,833 9% 1,744 12%

Media Networks 23,510 43% 6,902 47%

Total 55,137 14,755

Source: The Walt Disney Company Annual Report (10-K)

EQUITY ANALYSIS & VALUATION

CASE STUDY

Equity Analysis and Valuation Case Study Page 2

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When valuing stock, the fundamental valuation metric may be profit, cash flow, or dividends. These cash flows are made to investors as a reward for their investment. Since they are made after the asset has been purchased, appropriate valuation techniques determine the present value of these cash flows to uncover the intrinsic value of the stock. Each of the four equity valuation metrics used in this case arrive at the intrinsic value of Disney’s stock by discounting the shareholder rewards (or returns) from the dates they will be paid in the future to our decision point in the present. DISNEY’S NUMBERS Use the following information on Disney to answer the case questions.

Disney’s current stock price is $113.00 per share. The average growth rate of the company’s dividend has been 16.09% from 2002 through 2017.

Disney’s return on equity is 19.5% and the company retains approximately 75.7% of its profits while paying out the remaining 24.3% in dividends.

The company’s stock currently trades at 16.27 times its current year earnings estimate of $6.96 per share.

Analysts expect the company to earn $7.36 per share in 2019 and $8.24 in 2020.

Disney’s peers engaged in movie making trade at 19.6 times their current year earnings estimates while peers in parks and resorts trade at 19.2; media and broadcasting at 17.0 and consumer products at 19.1. THE 4 MODELS

Constant Growth Model The constant growth model, also known as the Gordon Growth Model, discounts future cash flows, or dividends, under the assumption that a company’s dividends grow at a constant rate forever. The intrinsic value of a company’s equity is calculated by dividing a company’s dividend for next year, labelled D1, by the difference between the stock’s expected return, labelled k, and its dividend growth rate, labelled g.

A primary weakness of the constant growth model is that very few, if any, companies grow their dividends at a constant growth rate. This central condition is unreasonable and unlikely to ever be met by any company. The graph below shows the dividend growth rates for The Walt Disney Company since 2002. It is clear that there is nothing constant about its dividend growth.

The constant growth model also rests on a second condition, that the denominator’s result of the expected return minus the dividend growth rate must be a positive number.

What is Disney stock’s intrinsic value using the constant growth model?

Multi-Stage Growth Model The multi-stage growth model is designed to partially remedy one of the constant growth model’s primary flaws, that is, that no company grows its dividends at a constant rate forever. The multi-stage model assumes that a company’s dividends grow in two periods. The first is a period of fast growth that lasts for a determined period of time. The second is a period characterized by slower growth that lasts forever. Technology companies exhibit fast growth during their early years, followed by slower growth.

What is Disney stock’s intrinsic value using the multi-stage growth model?

Discounted Dividend Model There are three primary steps used to calculate a stock’s intrinsic value using the discounted dividend model. First, the dividends for future years must be calculated. Second, the terminal value of the stock must be calculated. Third, dividends are placed in a timeline using a spreadsheet or calculator and the stock’s net present value is calculated.

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Disney Divident Growth Rates Annual Growth Rates in US Dollars, Including Average Source: The Walt Disney Comapny Annual Report (10-K)

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Equity Analysis and Valuation Case Study Page 3

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What is Disney stock’s intrinsic value using the dividend discount model?

Market Multiples Approach In the strictest terms, all the valuation models discussed up to this point could be considered dividend discount models since they attempt to find the present value of future cash flows and/or dividends.

What is Disney stock’s intrinsic value using the market multiple method?

Reconcile Disney stock’s intrinsic value, considering the strengths and weaknesses of each valuation approach.

While in front of the Bloomberg Terminal, watch the tutorial video below and mimic the steps. Then attach a screenshot of the GP function screen comparing Disney to the S&P 500 from January 1, 2018, to September 30, 2018. Describe in one sentence if and how the comparison has changed from what was shown in the video.

TERMINAL TUTORIAL SCRIPT The following Bloomberg instructions illustrate how to gather the equity data on Disney. Use these directions as a template or watch the accompanying video tutorial. Web: https://vimeo.com/300775187/3a3918015e Terminal: PLYR VOD 332919111 <GO> Log in to the Bloomberg terminal and type DIS, press the F8 equity sector key, and then DES. Press the Enter or <GO> key. This is the description page for The Walt Disney Company. Here we can see key data such as the P/E ratio (glow) and the estimated earnings per share (glow).

If we click on the Price Chart, we will go to the GP page which shows us a line graph of the stock price for Disney.

Disney’s stock price is most interesting in comparison to an equity benchmark, like the S&P 500 index. Let’s add a line for the S&P 500, or SPX, onto this graph by clicking the Chart Content button. In the amber field, start typing S&P and choose from the autocomplete menu S&P 500 Index. We can also adjust the date range to show data for the calendar year 2017 and press Enter once the dates are set.

The chart shows that Disney and the S&P began 2017 moving roughly in tandem, but the S&P outperformed Disney from mid-May to the end of the year.

If we wanted to build a model to value Disney’s stock we need to gather some financial information. Let’s type Financial Analysis in the command line and select FA from the dropdown. All of Disney’s financial statements are accessible in the folders of this page (glow). A company’s dividends are often used to value its stock. Click on the I/S tab to see Disney’s historical income statements. Scroll toward the bottom of the screen and find dividends per share. The numbers in amber are historical while those in white are projections.

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A company’s cost of equity, which can be used as the expected return for its stock, can be found by typing WACC in the command line for Weighted Average Cost of Capital and pressing Enter or <GO>. Disney’s cost of equity is 9.8% at the time of this recording in mid-November 2018. These data points are all useful to value stock.

Pressing the Menu key on your keyboard to explore a collection of other functions with which you can perform company analysis.

Use the instructions in this video to create a graph on the GP screen of the Terminal, plotting Disney’s stock price against that of the S&P 500 from January 1, 2018, to September 30, 2018. Include a screenshot of your work and describe in one sentence if and how the comparison has changed from what was shown in the video.

THE BOTTOM LINE By applying the constant growth model, multi-stage growth model, dividend discount model, and market multiples approach to valuing a company, we can see that the market multiples approach is most commonly used because it is usually the most accurate.