Equity Valuation Models



Valuation by Comparables
•FA
–Identification of mispriced stocks
•Relative to some „true value“
–Derived from financial data
–http://www.sec.gov/edgar.shtml
•All public comapnies
–Except foreign companies and companies with less than $10 million in assets and 500 shareholders

Table 18.1Financial Highlights for Microsoft Corporation, March 8, 2006
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•Balance Sheet Models
–Book Value
•Dividend Discount Models
•Price/Earning Ratios
Models of Equity Valuation

Limitations of Book Value
•Book value is an application of arbitrary accounting rules
•Can book value represent a floor value?
•Better approaches
–Liquidation value
•Amount of money that can be realized when company breaking up
–Replacement cost
•Assets less liabilities
•Tobin’s q

•Intrinsic Value
–Self assigned Value
–Variety of models are used for estimation
•Market Price
–Consensus value of all potential traders
•Trading Signal
–IV > MP Buy
–IV < MP Sell or Short Sell
–IV = MP Hold or Fairly Priced
–
Intrinsic Value and Market Price

•Assessing value
–Return of cash dividends and capital gains or losses
–ABC company
•1-year holding period
•Exp. Dividens per share 4
•Current price per share 48
•Price at the and of year 52
•Expected holding-period return
–16.7 %
•??? Required rate of return
–E.g. CAPM model
•Compare intrinsic value with market price
–Alfa factor

Dividend Discount Models: General Model
•V0 = Value of Stock
•Dt = Dividend
•k = required return

•Stocks that have earnings and dividends that are expected to remain constant.
•Preferred Stock
No Growth Model

•E1 = D1 = $5.00
•k = .15
•V0 = $5.00 / .15 = $33.33
No Growth Model: Example

•g = constant perpetual growth rate
Constant Growth Model


•E1 = $5.00 b = 40%      k = 15%
•(1-b) = 60% D1 = $3.00  g = 8%
•V0 = 3.00 / (.15 - .08) = $42.86
Constant Growth Model: Example

•PN = the expected sales price for the stock at time N
•N = the specified number of years the stock is expected to be held
Specified Holding Period Model

Stock Prices and Investment Opportunities
-p: dividend payment ratio
-b: earning retention ratio
-Plowback ratio
-p + b = 1 or p + b = 100
-Low reinvestment plan
-High reinvestment plan
-ROE
-PVGO present value of growth opportunities
-P0 = No-growth value per share + PVGO
-ROE > k

•g = growth rate in dividends
•ROE = Return on Equity for the firm
•b = plowback or retention percentage rate
– (1- dividend payout percentage rate)
Estimating Dividend Growth Rates

Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies
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•ROE = 20%  d = 60%  b = 40%
•
•E1 = $5.00  D1 = $3.00  k = 15%
•
•g = .20 x .40 = .08 or 8%
Partitioning Value: Example

Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities
Partitioning Value: Example

Life Cycle and Multistage Growth Models
•g  - constant forever
–Different dividend profiles

Table 18.2 Financial Ratios in Two Industries
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Figure 18.2 Value Line Investment Survey Report on Hewlett Packard
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•P/E Ratios are a function of two factors
–Required Rates of Return (k)
–Expected growth in Dividends
•Uses
–Relative valuation
–Extensive Use in industry
Price Earnings Ratios

•E1 - expected earnings for next year
–E1 is equal to D1 under no growth
•k  -  required rate of return
P/E Ratio: No Expected Growth

• b = retention ratio
• ROE = Return on Equity
P/E Ratio with Constant Growth

•E0 = $2.50    g = 0    k = 12.5%
•
•P0 =  D/k  =  $2.50/.125  =  $20.00
•
•PE  =  1/k  =  1/.125  =  8
Numerical Example: No Growth

•b = 60%  ROE = 15%  (1-b) = 40%
•E1 =  $2.50 (1 + (.6)(.15))  =  $2.73
•D1 =  $2.73 (1-.6)  =  $1.09
•k = 12.5%   g = 9%
•P0 =  1.09/(.125-.09)  =  $31.14
•PE = 31.14/2.73  =  11.4
•PE = (1 - .60) / (.125 - .09)  = 11.4
Numerical Example with Growth

Table 18.3 Effect of ROE and Plowback on Growth and the P/E Ratio
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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.

Figure 18.6 P/E Ratios for Different Industries, 2006
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Other Comparative Value Approaches
•Price-to-book ratio
•Price-to-sales ratio
•Price-to-cash-flow ratio

Figure 18.7 Market Valuation Statistics
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