Week 8
mloi01
IPPTChap018.pptINVESTMENTS | BODIE, KANE, MARCUS
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter Eighteen
Equity Valuation Models
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Valuation: Fundamental Analysis
- Fundamental analysis models a company’s value by assessing its current and future profitability.
- The purpose of fundamental analysis is to identify mispriced stocks relative to some measure of “true” value derived from financial data.
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Models of Equity Valuation
- Balance Sheet Models
- Dividend Discount Models (DDM)
- Price/Earnings Ratios
- Free Cash Flow Models
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Valuation by Comparables
- Compare valuation ratios of firm to industry averages.
- Ratios like price/sales are useful for valuing start-ups that have yet to generate positive earnings.
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Limitations of Book Value
- Book values are based on historical cost, not actual market values.
- It is possible, but uncommon, for market value to be less than book value.
- “Floor” or minimum value is the liquidation value per share.
- Tobin’s q is the ratio of market price to replacement cost.
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Intrinsic Value vs. Market Price
- The return on a stock is composed of dividends and capital gains or losses.
- The expected HPR may be more or less than the required rate of return, based on the stock’s risk.
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Required Return
- CAPM gives the required return, k:
- If the stock is priced correctly, k should equal expected return.
- k is the market capitalization rate.
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Intrinsic Value and Market Price
- The intrinsic value (IV) is the “true” value, according to a model.
- The market value (MV) is the consensus value of all market participants
Trading Signal:
IV > MV Buy
IV < MV Sell or Short Sell
IV = MV Hold or Fairly Priced
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Dividend Discount Models (DDM)
- V0 =current value; Dt=dividend at time t; k = required rate of return
- The DDM says the stock price should equal the present value of all expected future dividends into perpetuity.
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Constant Growth DDM
k= appropriate risk-adjusted interest rate
g= dividend growth rate
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Example 18.1 Preferred Stock and the DDM
- No growth case
- Value a preferred stock paying a fixed dividend of $2 per share when the discount rate is 8%:
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Example 18.2 Constant Growth DDM
- A stock just paid an annual dividend of $3/share. The dividend is expected to grow at 8% indefinitely, and the market capitalization rate (from CAPM) is 14%.
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DDM Implications
- The constant-growth rate DDM implies that a stock’s value will be greater:
The larger its expected dividend per share.
The lower the market capitalization rate, k.
The higher the expected growth rate of dividends.
- The stock price is expected to grow at the same rate as dividends.
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Estimating Dividend Growth Rates
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
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Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies
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Present Value of Growth Opportunities
- The value of the firm equals the value of the assets already in place, the no-growth value of the firm,
- Plus the NPV of its future investments,
- Which is called the present value of growth opportunities or PVGO.
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Present Value of Growth Opportunities
- Price = No-growth value per share + PVGO
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Example 18.4 Growth Opportunities
- Firm reinvests 60% of its earnings in projects with ROE of 10%, capitalization rate is 15%. Expected year-end dividend is $2/share, paid out of earnings of $5/share.
- g=ROE x b = 10% x .6 = 6%
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Example 18.4 Growth Opportunities
- PVGO =Price per share – no-growth value per share
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Life Cycles and Multistage Growth Models
- Expected dividends for Honda:
2013 $.78 2015 $ .92
2014 $.85 2016 $1.00
- Since the dividend payout ratio is 25% and ROE is 10%, the “steady-state” growth rate is 7.5%.
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Honda Example
- Honda’s beta is 0.95 and the risk-free rate is 2%. If the market risk premium is 8%, then k is:
- k=2% + 0.95(8%) = 9.6%
- Therefore:
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Honda Example
- Finally,
- In 2012, one share of Honda Motor Company Stock was worth $32.88.
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Price-Earnings Ratio and Growth
- The ratio of PVGO to E / k is the ratio of firm value due to growth opportunities to value due to assets already in place (i.e., the no-growth value of the firm, E / k ).
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Price-Earnings Ratio and Growth
- When PVGO=0, P0=E1 / k. The stock is valued like a nongrowing perpetuity.
- P/E rises dramatically with PVGO.
- High P/E indicates that the firm has ample growth opportunities.
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Price-Earnings Ratio and Growth
- P/E increases:
- As ROE increases
- As plowback increases, as long as ROE>k
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Table 18.3 Effect of ROE and Plowback on Growth and the P/E Ratio
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P/E and Growth Rate
- Wall Street rule of thumb: The growth rate is roughly equal to the P/E ratio.
- “If the P/E ratio of Coca Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.”
Quote from Peter Lynch in One Up on Wall Street.
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P/E Ratios and Stock Risk
- When risk is higher, k is higher; therefore, P/E is lower.
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Pitfalls in P/E Analysis
- Use of accounting earnings
- Earnings Management
- Choices on GAAP
- Inflation
- Reported earnings fluctuate around the business cycle
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Figure 18.3 P/E Ratios of the S&P 500 Index and Inflation
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Figure 18.4 Earnings Growth for Two Companies
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Figure 18.6 P/E Ratios for Different Industries, 2012
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Other Comparative Value Approaches
- Price-to-book ratio
- Price-to-cash-flow ratio
- Price-to-sales ratio
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Figure 18.7 Market Valuation Statistics
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Free Cash Flow Approach
- Value the firm by discounting free cash flow at WACC.
- Free cash flow to the firm, FCFF, equals:
After tax EBIT
Plus depreciation
Minus capital expenditures
Minus increase in net working capital
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Comparing the Valuation Models
- In practice
- Values from these models may differ
- Analysts are always forced to make simplifying assumptions
- Problems with DCF
- Calculations are sensitive to small changes in inputs
- Growth opportunities and growth rates are hard to pin down
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The Aggregate Stock Market
- Use of earnings multiplier approach at aggregate level
- Some analysts use aggregate version of DDM
- S&P 500 taken as leading economic indicator
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Table 18.4 S&P 500 Price Forecasts Under Various Scenarios
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