Week 3

equity valuation Models

Chapter Overview

This chapter discusses the process of valuation of common stock. It describes the relationships between intrinsic value and market and book values. Chapter 18 also presents the various fundamental valuation techniques, centered on the dividend discount model, and the strengths and weaknesses of these techniques.

Learning Objectives

After studying this chapter, the student should be familiar with the role of a security’s intrinsic value within the context of fundamental analysis. The student should be able to value a firm using the appropriate dividend discount model and the dividend discount-derived price/earnings ratio. The student should understand the limitations of each of these models.

Presentation of Material

18.1 Valuation by Comparables

There are three major types of approaches used in equity valuation. One approach is to tie value to an accounting value. An example of this approach would be to use Book Value to Market Value Relationships. A second major approach is the dividend discount model approach. The third method is to use price/earnings ratios. The most difficult component of valuation is the assessment of the firm’s growth rates and opportunities. Students should also become familiar with other valuation approaches such as free cash flow models and the approach used by researchers in forecasting aggregate levels of the stock market.

18.2 Intrinsic Value versus Market Price

Underlying the process of fundamental analysis is the concept of intrinsic value. The intrinsic value is the value that the analyst places on a stock. It establishes the basis for a trading signal. An intrinsic value can be estimated using a variety of models or approaches. The most popular model for assessing the value of a firm as a going concern starts from the observation that an investor in stock expects a return consisting of cash dividends and capital gains or losses.

18.3 Dividend Discount Models

Stress to the students that though there are several models presented in this section and the following sections, the discounted dividend concept remains unchanged. Equity’s value is based on some future payoff, discounted appropriately. If a firm’s earnings and dividends are not expected to grow in the foreseeable future, the value of the stock can be estimated using the no growth model. Preferred stock exactly fits this model.

If a firm’s earnings and dividends are expected to grow at a constant rate in the foreseeable future, the general model simplifies to the constant growth model. The growth rate that is used in the constant model is a long-term and permanent growth rate. Students often are not clear on this concept. The approach to estimating growth using return on equity and retention rates only applies if current measures are reasonable estimates for long term values. The relationship between dividend payout and growth is depicted in Figure 18.1 of the text.

Analysts often partition the value of stock into a no growth and a present value of growth opportunities component. The concept of using the PVGO approach is very useful in assessing how much of the value is being attributed to growth and growth opportunities. If a substantial portion of the value is attributed to growth, careful analysis of the growth assumptions is appropriate.

Firms typically pass through life cycles with very different dividend profiles in different phases. In early years, there are ample opportunities for profitable reinvestment in the company. Payout ratios are low, and growth is correspondingly rapid. In later years, the firm matures, production capacity is sufficient to meet market demand, competitors enter the market, and attractive opportunities for reinvestment may become harder to find. The contribution of growth to the total value is different for different industries and for firms.

18.4. Price Earnings Ratios

An alternative approach to use of the dividend growth model approach is to use the P/E approach. The P/E is used extensively in industry and is helpful in comparing relative values of firms. The appropriate P/E is a function of two factors; the required rate of return and expected growth in earnings. While the P/E appears easier to use, the same estimates that apply to the dividend discount approach apply to the P/E approach. The appropriate P/E multiple depends on growth.

The price earnings ratios that are presented in the chapter are based on next year’s expected earnings. Point out to students that the P/E ratios that are reported in the financial press are often based on historical earnings. Both measures of Price/Earnings ratios are used in industry. The impact that plowback has on growth is shown in Table 18.3.

Price/Earnings ratios use accounting values in their calculation. Accounting conventions use historical costs and because of this accounting earnings may not reflect economic earnings. Earnings also fluctuate significantly around the business cycle. The limitations in using P/E ratios are highlighted here and three additional valuation ratios are presented as alternatives/complements. In recent years the price-to-sales ratio has been used extensively.

18.5 Free Cash Flow Valuation Approaches

Another popular approach in valuing firms is the free cash flow model. Once free cash flow is estimated, the cash flow is discounted at the firm’s cost of capital. The equation here may seem daunting, but a quick refresher in cash-flow analysis (WACC, depreciation, NWC, etc) should allow the student to fully understand this equation.

18.6 The Aggregate Stock Market

The most popular approach used in forecasting the aggregate market is the earnings multiplier approach. An example of using this approach is shown in Table 18.4.

Excel Model