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Lecture Presentation Software

to accompany

Investment Analysis and


Portfolio Management
Seventh Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 13

Applying the DDM


Valuation Model to the Market
The stream of expected returns
The time pattern of expected returns
The required rate of return on the investment

D0 (1 g ) D0 (1 g )
D0 (1 g )
Vj

...

2
n
(1 k )
(1 k )
(1 k )
2

D1
V j Pj
kg

Pi
D1 / E1

E1
kg

Applying the DDM


Valuation Model to the Market
Pi
D1 / E1

E1
kg

Determinants of the Earnings Multiplier:


1. The expected dividend payout ratio
2. The required rate of return on the stock
3. The expected growth rate of dividends for the stock

Market Valuation Using the


Reduced Form DDM

Estimating k and g for the U.S. equity market


The nominal risk-free rate
The equity risk premium
The current estimate of Risk Premium and k
Estimating the growth rate of dividends (g)
g = f(b,ROE)

ROE = Net Income / Equity

Estimating Growth Rate


Growth rate of dividends is equal to
Retention rate - the proportion of earnings
retained and reinvested
Return on equity (ROE) rate of return earned
on investment
An increase in either or both of these variables
causes an increase in the expected growth rate
(g) and an increase in the earnings multiplier

Return on Equity (ROE)


Net Income

Common Equity
Net Income
Sales
Total Assets

Sales
Total Assets Common Equity

Profit
Margin

x Total Asset x Financial


Turnover

Leverage

Market Valuation Using the Free


Cash Flow to Equity (FCFE) Model

FCFE is:
+ Net Income
+ Depreciation Expense
- Capital Expenditures
- in Working Capital
- Principal Debt Repayments
+ New Debt issues

Market Valuation Using the Free


Cash Flow to Equity (FCFE) Model
The Constant Growth FCFE Model
The Two Stage Growth FCFE Model

D
k g
p

Market Valuation Using Relative


Valuation Approach
The price-earnings ratio (P/E)
The price-book value ratio (P/BV)
The price-cash flow ratio (P/CF)
The price-sales ratio (P/S)

Market Valuation Using Relative


Valuation Approach
Two-part valuation procedure

D1
V j Pj
kg

Pj D1 1 k g

D1 Pj k g

Market Valuation Using Relative


Valuation Approach
Importance of both components of
value
1. Estimating the future earnings per share
for the stock-market series
2. Estimating a future earnings multiplier
for the stock-market series

Estimating Expected Earnings Per


Share
Estimating expected earnings per share
Estimate sales per share for a stock-market series
Estimate the operating profit margin for the series
Estimate depreciation per share for the next year
Estimate interest expense per share for the next year
Estimate the corporate tax rate for the next year

Estimating Gross Domestic Product


Estimating sales per share for a market series

Estimating Expected Earnings Per


Share
Alternative estimates of corporate net profits
Direct estimate of the net profit margin based on recent
trends
Estimate the net before tax (NBT) profit margin
Estimate an operating profit margin to obtain EBITDA;
estimate depreciation and interest to arrive at EBT;
estimate the tax rate (T) and multiply by (1-T) to
estimate net income

Estimating Expected Earnings Per


Share
Estimating aggregate operating profit margins
Capacity utilization rate
Unit labor costs
Rate of inflation
Foreign competition

Estimating Expected Earnings Per


Share
Estimating depreciation expense
time series trends
estimate based on property, plant, and equipment
sales and turnover
depreciation

Estimating Expected Earnings Per


Share
Estimating interest expense
debt levels
total assets
expected capital structure
interest rates
subtract result from EBIT to estimate EBT

Estimating Expected Earnings Per


Share
Estimating the tax rate
depends on future political action
multiply (1-T) times the EBT per-share to estimate the
net income per share

Estimating the Earnings Multiplier


for a Stock Market Series
Determinants of the earnings multiplier
Dividend payout ratio
required rate of return on common stock
the expected growth rate of dividends for the stocks

Pi
D1 / E1

E1
kg

Estimating the Earnings Multiplier


for a Stock Market Series
Estimating the required rate of return (k)
inversely related to the earnings multiplier
determined by risk-free rate, expected inflation, and the risk
premium for the investment
Estimating the dividend payout ratio (D/E)
active decision or residual outcome?
time series plots
long-run perspective

Estimating the Earnings


Multiplier for a Stock Market
Series
Estimating an Earnings Mutiplier: An
Example
The Direction of Change Approach
Specific Estimate Approach

Calculating an Estimate of the Value for the


Market series

Other Relative Valuation Ratios


Price to book value ratio (P/BV)
Price to cash flow ratio (P/CF)
Price to sales ratio (P/S)

Analysis of World Markets


Individual country analysis
analyze economy and security markets before
analyzing alternative industries or companies
macro techniques
micro techniques
technical analysis
top down approach

The Internet
Investments Online
www.ms.com
www.yardeni.com
www.nabe.com
www.agedwards.com

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