Valuation Equity Analysis I: Valuation Models. Investment Decision or Recommendation. Why Is It Important? Valuation of Stocks.

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1 Valuation Equity Analysis I: Valuation Models Valuation is the estimation of an asset s value based either on variables perceived to be related to future investment returns or on comparisons with similar assets. Why Is It Important? Valuation is one of the most important steps in investments and portfolio management To get good return on your investment, you need to buy undervalued securities and sell overvalued securities It is therefore critical to determine the fair value (intrinsic value or fundamental value) of the security Investment Decision or Recommendation Buy When Hold When Sell When Valuation Models Absolute valuation models Relative valuation models Valuation of Stocks Discounted cash flow valuation models view the intrinsic value of common stock as the present value of its expected future cash flows. 1

2 Discounted Cash Flow Valuation Model Basic formula V 0 = CFt t= 1 + t ( 1 r) Valuation of Stocks: We expect a stock to generate cash flows of $100 in one year, $150 in two years, and $200 in three years. What is the value of this stock today? Valuation of Stocks In contrast to risk-free debt, future cash flows for equity investment are not known with certainty they are risky. The most common approach to dealing with risky cash flows involves two adjustments. Two challenges The first challenge of applying DCF models is to define what we mean by future cash flows and, forecast what they will be in the future. The second challenge is to estimate the appropriate rate of return to use for discounting cash flows back to the present, the discount rate. The definitions of discount rate and cash flow must be coordinated. Discount Rate In choosing a discount rate, we want it to reflect both the time value of money and the riskiness of the stock. Cost of Equity Two approaches to determining cost of equity CAPM Bond yield 2

3 Suppose the beta of XYZ is The riskfree rate is 4%. The market risk premium is 6%. What is the expected return or required rate of return for XYZ stock? Dividend Discount Model (DDM) DDM defines cash flows as dividends In practice, analysts usually view investment value as driven by earnings Earnings = dividends + retained earnings Payout ratio = dividends/earnings But retained earnings help generate future dividends DDM DDM is the simplest and oldest present value approach to valuing stocks. If an investor buys a stock and hold it for one year. P1 = r 1 + r If the investor holds the stock for n years Dn Pn = + + n n 1 + r (1 + r) (1 + r) You expect GM to pay $2 dividend next year and the price to be $58 in one year. The required rate of return for GM is 10%. What is your estimate of the value of GM stock? DDM If the investor holds the stock forever = Dt t = 1 + t ( 1 r) Gordon Growth Model The Gordon Growth Model assumes that the dividends grow at a constant rate g 2 = r (1 + r) = r g or r g + + n (1 + r) n + 3

4 The required rate of return for JCP is 8.8%. You believe a stable growth rate of 6% is reasonable. JCP s current dividend is $0.50. What is the value of JCP stock? If the current market price for JCP is $25, is JCP undervalued or overvalued? Gordon Growth Model The model s required rate of return and growth rate should reflect long term expectations Models values are very sensitive to both the required rate of return and the growth rate Sensitivity analysis Implied dividend growth rate Given price, the current dividend, and the required rate of return, we can infer the dividend growth rate reflected in price assuming Gordon growth model. An analysis can then judge whether the implied dividend growth rate is reasonable. Beta: 1.1; risk free rate: 5.6%; market risk premium: 6%; Current dividend: $2; What dividend growth rate would be required to justify a $40 price? = g = r r g V 0 Beta: 1.1; risk free rate: 5.6%; market risk premium: 6%; Current dividend: $2; What dividend growth rate would be required to justify a $40 price? Determinants of Growth Rates The dividend earnings ratio is called the payout ratio, denoted as b retention rate = 1- payout ratio g = b ROE 4

5 Determinants of Growth Rates g = b ROE Year 1 Year 2 Equity $10 m $11.5 m Net Income $2.5 m $2.875 m Retained Earnings $1.5 m $1.725 m Dividend $1 m $1.15 m g = ROE (1-b) = 25% 60% = 15% Determinants of Growth Rates Net Income ROE = Shareholders' Equity Net Income Sales Total Assets = Sales Total Assets Shareholders' Equity Net Income Dividends g = Net Income Net Income Sales Sales Total Assets Total Assets Shareholders' Equity P/E and Gordon Growth Model E0 (1 b)(1 + g) P0 = = = r g r g r g P0 = E 0 P0 1 b = E r g 1 ( 1 b)( 1 + g) r g The Present Value of Growth Opportunities a no growth company distributes all of its earnings as dividends E P0 or = + PVGO r PVGO = or P0 r g ( 1 b) r CTWS stock; expected earnings next year $1.27; dividend payout ratio: 70%; dividend growth rate: 3.7%; required rate of return: 6.2%; current price:$30 What is the value of CTWS stock? What is the present value of growth opportunity? CTWS stock; expected earnings next year $1.27; dividend payout ratio: 70%; dividend growth rate: 3.7%; required rate of return: 6.2%; current price:$30 5

6 Strengths of Gordon Growth Model Weaknesses Values sensitive to the assumed growth rate and required rate of return Not applicable to non-dividend-paying stock Not applicable to unstable-growth, dividendpaying stocks Multi-stage DDM When forecasting an earnings growth rate far above the economy s nominal growth rate, analysts should use a multi-stage DDM in which the final-stage growth rate reflects a growth rate that is more plausible relative to the economy s nominal growth rate, rather than using the Gordon growth model. ABC just paid a dividend of $2. The dividend is expected to grow at 20% per year for two years and then grows at 5% per year indefinitely. What is the intrinsic value of the ABC stock according to the DDM? Assuming the required rate of return is 10% $2 $2.4 $2.88 $3.024 $ Growth Perpetuity The intrinsic value of the stock is the present value of all its expected dividends DDM Dividends are not as volatile as earnings are Less sensitive to short-term fluctuations in underlying value Analysts often view DDM values as reflecting long-run intrinsic value 6

7 DDM A lot of companies do not pay dividends Not profitable Too profitable Free Cash Flow Valuation Discounted cash flow valuation views the intrinsic value of a security as the present value of its expected future cash flows. Unlike dividends, free cash flow models are based on cash flows available for distribution Free Cash Flow Free cash flow to the firm (FCFF) is cash flow from operations minus capital expenditure WACC = FCF Valuation Firm Value = = t 1 Debt Debt FCFF ( 1 + WACC) Equity Value = Firm Value Market Value of rd + Equity t T Debt Equity Debt + Equity ( 1 Tax Rate) + re FCFF FCFF=Net Income available to common shareholders + net noncash charges + interest expense (1-Tax Rate) investment in fixed capital investment in working capital Noncash charges Depreciation amortization EBITDA Dep. Int. Exp. Net Income Fixed asset WC FCFF ? ? 7

8 WACC If we use the FCFF valuation model, we are defining cash flows as cash flows available to bondholders, common stockholders, and preferred stockholders, if any. We need to use the weighted-average cost of capital the weighted average cost of equity, the after-tax cost of debt, and the cost of preferred stock. 8