1 FIN 2808, Spring 10 - Tang

Chapter 18: Equity Valuation

Fin2808: Investments
Spring, 2010
Dragon Tang

Lectures 13 & 14
Equity Valuation Models
March 9&11 2010

Readings: Chapter 18
Practice Problem Sets: 1,5,7,14, 16,17

2 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
How to make money in stocks?

3 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
How to make money in stocks?
Capital gains: buy low/sell high
Growth companies
Dividend yields: income stream
Matured (value) companies
4 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Equity Valuation
Objectives:

Calculate the intrinsic value of a firm using either a
constant growth or multistage dividend discount model.

Calculate the intrinsic value of a stock using a dividend
discount model in conjunction with a price/earnings
ratio.

Assess the growth prospects of a firm from it P/E ratio.
5 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Balance Sheet Valuation Methods
Book Value

Liquidation Value

Replacement Cost

cost t replacemen
price market
Q s Tobin' =
6 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Expected Holding Period Return
( ) ( ) | |
( ) ( ) | |
yield
gain/loss capital
expected

yield
dividend
expected

P
P P E
P
D E

P
P P E D E
E(HPR)
0
0 1
0
1
0
0 1 1
+ =

+
+
=
+
=
If E(HPR) > Required Rate of Return(RRR), the stock
is a good deal.
RRR is from a pricing model, e.g. CAPM:


In market equilibrium, E(HPR) = RRR.
) ) ( ( ) (
f m XYZ f XYZ
r r E r r E + = |
7 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Intrinsic Value versus Market Price
V
0
(intrinsic value) > P
0
(market price) buy

V
0
(intrinsic value) < P
0
(market price) sell or sell short

In market equilibrium, V
0
= P
0


k is the market capitalization rate which equates V
0
and P
0

If V
0
= P
0
, then EMH implies the estimate of k is wrong

Intrinsic value --The present value of a firms expected future
net cash flows discounted by the required rate of return.

k
P E D E
V
+
+
=
1
) ( ) (
1 1
0
8 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Dividend Discount Models
One Period Case:
k
P E D E
V
+
+
=
1
) ( ) (
1 1
0
Multi-period Case:
( ) ( )
H
H H
k
P D
k
D
k
D
V
+
+
+ +
+
+
+
=
1
...
1
1
2
2 1
0
Where D
1
,, D
H
and P
H
are expected values
9 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Dividend Discount Models
Example: Whitewater Rapids Company is expected to have
dividends grow at a rate of 12% for the next three years. In
three years, the price of the stock is expected to be $ 74.46. If
Whitewater just paid a dividend of $2.00 and its level of risk
requires a discount rate of 10%, what is the intrinsic value of
Whitewater stock?
10 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Dividend Discount Models
( ) ( )
...
1 1
1
3
3
2
2 1
0
+
+
+
+
+
+
=
k
D
k
D
k
D
V
Dividend discount model (infinite horizon):
11 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Constant Growth DDM
(Gordons Model)
( )
k g
g k
D
g k
g D
V <

+
= ,
1
1 0
0
( ) ( )
( )
( )
( )
...
1
1
1
1
1
1
3
3
0
2
2
0 0
0
+
+
+
+
+
+
+
+
+
=
k
g D
k
g D
k
g D
V
12 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Constant Growth DDM
Example: Whitewater Rapids Company is expected to have
dividends grow at a constant rate of 6% for the foreseeable
future. If Whitewater just paid a dividend of $2.81 and its level
of risk requires a discount rate of 10%, what is the intrinsic value
of Whitewater stock?
13 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Market Capitalization Rate
If V
0
= P
0
:
V
D
k g
0
1
=

k
D
P
g = +
1
0
Dividend
Yield
Capital
Gains Yield
Gordons Model:
If g = 0:
( ) ( )
k
D
k
D
g k
g D
V
1 0 0
0
0
0 1 1
=

+
=

+
=
Perpetuity
14 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Implications of this Model
If D
1
increases, then V
0
increases.
If k

decreases, then V
0
increases.
If g

increases, then V
0
increases.
If D
1
increases X%, then V
0
will
increase X%.
g = the capital gains yield
V
D
k g
0
1
=

15 FIN 2808, Spring 10 - Tang

Chapter 18: Equity Valuation
Dividend Payout Ratio
and
Plowback Ratio
Dividend Payout Ratio: Percentage of earnings paid
out as dividends

Plowback (or Earning Retention) Ratio:
Fraction of earnings retained and reinvested in the firm
16 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Stock Prices and
Investment Opportunities
If a firm retains earnings and reinvest
them in a profitable investment
opportunity, dividend may grow faster.

If a firm pays out all dividends nothing
gets re-invested, nothing growths.


17 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Figure 12.1 Dividend Growth for
Two Earnings Reinvestment Policies
18 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Plowback Ratio and Growth


g b = ROE
Where:

ROE = Return on Equity
b = Plowback Ratio
(or Earning Retention Ratio)
19 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Stock Prices and
Investment Opportunities
Present value
no-growth
(b=0 or ROE=k)
Present value of growth
Opportunities
PVGO > 0 if ROE>k
PVGO <0 if ROE<k
b) k-(ROE
-b) ( E
g k
D
P

=
1
1 1
0
PVGO
1
0
+ =
k
E
P
20 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Estimating Growth
Example: Takeover Target has a plowback ratio of 60% and an
ROE of 10%. If it expects earnings to be $ 5 per share, what is
the present value of Takeovers growth opportunities if the
appropriate capitalization rate is 15%? What is the PVGO?
21 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Life Cycles and the
Constant Growth Model
Changing growth rates:
temporary high
(or low) growth
permanent
constant growth
( ) ( ) ( )
V
D
k
D
k
D
k
D
k
H
H
H
H
0
1 2
2
1
1
1
1 1 1
=
+
+
+
+ +
+
+
+
+
+
+
. . . . . .
22 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Changing Growth Rate
Example: Whitewater Rapids Company is expected to have
dividends grow at a rate of 12% for the next three years. In three
years, the dividends will settle down to a more sustainable growth
rate of 6% which is expected to last forever. If Whitewater just
paid a dividend of $2.00 and its level of risk requires a discount
rate of 10%, what is the intrinsic value of Whitewater stock?
23 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Price-Earning (P/E) Ratios
Ratio of Stock price to its earnings per share
Useful for firm valuation:



Problems:
Forecasts of E
Forecasts of P/E


E
P
E P =
24 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
P/E Ratios and Growth
PVGO
k
E
P
1
+ =
0
(
(
(

+ =
k
E
k E
P
1
1
0
PVGO
1
1
If PVGO = 0:
P
E
k
0
1
=
25 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Numerical Example: No Growth
E
0
= $2.50 g = 0 k = 12.5%

P
0
= D/k = $2.50/.125 = $20.00

P/E = 1/k = 1/.125 = 8
26 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
P/E Ratios and ROE
( ) b k
b
E
P


=
ROE
1
1
0
P/E ratio rises with ROE but not necessarily with b
1/k
ROE<k
ROE>k
b
P/E
27 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Numerical Example with Growth
b = 60% ROE = 15% (1-b) = 40%
E
1
= $2.50 (1 + (.6)(.15)) = $2.73
D
1
= $2.73 (1-.6) = $1.09
k = 12.5% g = 9%
P
0
= 1.09/(.125-.09) = $31.14
P/E = 31.14/2.73 = 11.4
P/E = (1 - .60) / (.125 - .09) = 11.4
28 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Figure 12-3 P/E Ratio of the
S&P 500 Index and Inflation
29 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Caveat with P/E Ratios
High plowback ratio (b) High Growth Rate (g)
(g = ROE*b)

BUT

High g (if due to high b) High P/E ratio

Practitioners: high P/E as proxy of high dividend
growth (g)
30 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
P/E ratio and Risk

Holding everything equal:
High risk (k), Low P/E.

Why do small-risky firm have high P/E?
g k
b
E
P

=
1
31 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Pitfalls in P/E Analysis
Earnings are based on accounting data

Current price and current earnings

Future expected earnings is more appropriate

In P/E formula, E is an expected trend

In financial pages, E is the actual past
period's earnings
32 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Figure 12-6 P/E Ratios
33 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Combining P/E and DDM
( ) ( )
( )( )
( )
V
D
k
D
k
D
k
D P E EPS
k
0
1 2
2
3
3
4
4
1
1 1 1
=
+
+
+
+
+
+
+
+
34 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
The Aggregate Stock Market:
Earning Multiplier Approach
V
P
E
E
where
P E
E P
and E P is the earnings yield
M
=
= /
1
35 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Other Valuation Ratios & Approaches
Price-to-book
Price-to-cash flow
Price-to-sales
Present Value of Free Cash Flow
36 FIN 2808, Spring 10 - Tang
Chapter 18: Equity Valuation
Summary
Valuation approaches:
-Balance sheet values
-Present value of expected future dividends

DDM states that the price of a share of stock is equal to the
present value of all future dividends discounted at the appropriate
required rate of return

Constant growth model DDM:

P/E ratio is an indication of the firm's future
growth opportunities

Models used for the firm can be used to forecast the
behavior of the aggregate stock market
g k
D
V

=
1
0