Models of Equity Valuation

Transcription

1 CHAPTER 3 Equity Valuation 3. VALUATION BY COMPARABLES Fundamental Stoc Analysis: Models of Equity Valuation Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earnings Ratios Estimating Growth Rates and Opportunities Models of Equity Valuation Valuation models use comparables Loo at the relationship between price and various determinants of value for similar firms The internet provides a convenient way to access firm data. Some examples are: EDGAR Finance.yahoo.com Table 3. Microsoft Corporation Financial Highlights Valuation Methods Boo value Maret value Liquidation value Replacement cost

2 Expected Holding Period Return 3.2 INTRINSIC VALUE VERSUS MARKET PRICE The return on a stoc investment comprises cash dividends and capital gains or losses Assuming a one-year holding period [ ] E( D ) + E( P ) P0 Expected HPR E( r) P 0 Required Return Intrinsic Value and Maret Price CAPM gave us required return: rf + β E( rm ) r f If the stoc is priced correctly Required return should equal expected return Maret Price Consensus value of all potential traders Current maret price will reflect intrinsic value estimates This consensus value of the required rate of return,, is the maret capitalization rate Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV MP Hold or Fairly Priced General Model 3.3 DIVIDEND DISCOUNT MODELS V o Dt ( + ) t t V 0 Value of Stoc D t Dividend required return

3 No Growth Model V o D Stocs that have earnings and dividends that are expected to remain constant Preferred Stoc No Growth Model: Example V o D E D $ V 0 $5.00 /.5 $33.33 Constant Growth Model Constant Growth Model: Example Vo Do( + g) g Vo Do( + g) g g constant perpetual growth rate E $5.00 b 40% 5% (-b) 60% D $3.00 g 8% V / ( ) $42.86 Stoc Prices and Investment Opportunities g ROE b Figure 3. Dividend Growth for Two Earnings Reinvestment Policies g growth rate in dividends ROE Return on Equity for the firm b plowbac or retention percentage rate (- dividend payout percentage rate)

4 Present Value of Growth Opportunities If the stoc price equals its IV, growth rate is sustained, the stoc should sell at: D P 0 g If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist) Present Value of Growth Opportunities (cont.) Price No-growth value per share + PVGO (present value of growth E opportunities) P0 + PVGO Where: E Earnings Per Share for period and D0 ( + g) E PVGO ( g) Partitioning Value: Example ROE 20% d 60% b 40% E $5.00 D $3.00 5% g.20 x or 8% Partitioning Value: Example (cont.) 3 P o $ ( ) 5 NGVo $ PVGO $ $ $9. 52 P o price with growth NGV o no growth component value PVGO Present Value of Growth Opportunities Life Cycles and Multistage Growth Models Multistage Growth Rate Model: Example P o T t g D ( + ) o t ( + ) t DT( + g2) + ( g )( + ) 2 T D 0 $2.00 g 20% g 2 5% 5% T 3 D 2.40 D D D g first growth rate g 2 second growth rate T number of periods of growth at g V 0 D /(.5) + D 2 /(.5) 2 + D 3 /(.5) 3 + D 4 / ( ) ( (.5) 3 V $30.40

5 P/E Ratio and Growth Opportunities 3.4 PRICE-EARNINGS RATIOS P/E Ratios are a function of two factors Required Rates of Return () Expected growth in Dividends Uses Relative valuation Extensive use in industry P/E Ratio: No expected growth P P E 0 0 E E - expected earnings for next year E is equal to D under no growth - required rate of return P/E Ratio: Constant Growth D E( b) P0 g ( b ROE) P0 b E ( b ROE) b retention ration ROE Return on Equity Numerical Example: No Growth Numerical Example with Growth E 0 $2.50 g 0 2.5% P 0 D/ $2.50/.25 $20.00 P/E / /.25 8 b 60% ROE 5% (-b) 40% E $2.50 ( + (.6)(.5)) $2.73 D $2.73 (-.6) $ % g 9% P 0.09/( ).09) $3.4 P/E 3.4/ P/E ( -.60) / ( ).4

6 P/E Ratios and Stoc Ris Pitfalls in Using P/E Ratios Risier stocs will have lower P/E multiples Risier firms will have higher required rates of return (higher values of ) P b E g Flexibility in reporting maes choice of earnings difficult Pro forma earnings may give a better measure of operating earnings Problem of too much flexibility Figure 3.3 P/E Ratios and Inflation Figure 3.4 Earnings Growth for Two Companies Figure 3.5 Price-Earnings Ratios Figure 3.6 P/E Ratios

7 Other Comparative Valuation Ratios Price-to to-boo Price-to to-cash flow Price-to to-sales Be creative Figure 3.7 Valuation Ratios for the S&P 500 Free Cash Flow 3.5 FREE CASH FLOW VALUATION APPROACHES One approach is to discount the free cash flow for the firm (FCFF) at the weighted- average cost of capital Subtract existing value of debt FCFF EBIT (- t c ) + Depreciation Capital expenditures Increase in NWC where: EBIT earnings before interest and taxes t c the corporate tax rate NWC net woring capital Free Cash Flow (cont.) Comparing the Valuation Models Another approach focuses on the free cash flow to the equity holders (FCFE) and discounts the cash flows directly at the cost of equity FCFE FCFF Interest expense (- t c ) + Increases in net debt Free cash flow approach should provide same estimate of IV as the dividend growth model In practice the two approaches may differ substantially Simplifying assumptions are used

8 Earnings Multiplier Approach 3.6 THE AGGREGATE STOCK MARKET Forecast corporate profits for the coming period Derive an estimate for the aggregate P/E ratio using long-term interest rates Product of the two forecasts is the estimate of the end-of of-period level of the maret Figure 3.8 Earnings Yield of the S&P 500 Versus 0-year Treasury Bond Yield Table 3.4 S&P 500 Index Forecasts