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

Chapter 18: Equity Valuation

FIN 2808, Spring 10 - Tang 1
 How to make money in stocks?

Chapter 18: Equity Valuation

FIN 2808, Spring 10 - Tang 2
 How to make money in stocks?

• Capital gains: buy low/sell high

– Growth companies
• Dividend yields: income stream
– Matured (value) companies

Chapter 18: Equity Valuation

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 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.

Chapter 18: Equity Valuation

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 Balance Sheet Valuation Methods

• Book Value

• Liquidation Value

• Replacement Cost

market price
Tobin' s Q 
replacemen t cost

Chapter 18: Equity Valuation

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 Expected Holding Period Return
E D1   E P1   P0 
E(HPR) 
P0
E D1   E P1   P0 
 
P0 P0
expected expected
 dividend  capital gain/loss
yield yield
• If E(HPR) > Required Rate of Return(RRR), the stock
is a good deal.
• RRR is from a pricing model, e.g. CAPM:
E (rXYZ )  rf   XYZ ( E (rm )  rf )
•In market equilibrium, E(HPR) = RRR.
Chapter 18: Equity Valuation
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 Intrinsic Value versus Market Price
Intrinsic value --The present value of a firm’s expected future
net cash flows discounted by the required rate of return.
E ( D1 )  E ( P1 )
V0 
1 k
•V0 (intrinsic value) > P0 (market price)  buy

•V0 (intrinsic value) < P0 (market price)  sell or sell short

•In market equilibrium, V0 = P0

•k is the market capitalization rate which equates V0 and P0

•If V0 P0, then EMH implies the estimate of k is wrong

Chapter 18: Equity Valuation

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 Dividend Discount Models
One Period Case:

E ( D1 )  E ( P1 )
V0 
1 k
Multi-period Case:
D1 D2 DH  PH
V0   ...
1  k 1  k 2
1  k H

Where D1,…, DH and PH are expected values

Chapter 18: Equity Valuation

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 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?

Chapter 18: Equity Valuation

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 Dividend Discount Models

Dividend discount model (infinite horizon):

D1 D2 D3
V0    ...
1  k 1  k 2
1  k 3

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 Constant Growth DDM
(Gordon’s Model)

D0 1  g  D0 1  g  D0 1  g 
2 3
V0    ...
1 k 1  k 2
1  k 3

D0 1  g  D1
V0   , gk
kg kg

Chapter 18: Equity Valuation

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 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?

Chapter 18: Equity Valuation

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 Market Capitalization Rate
D1
Gordon’s Model: V0 
k g

D1
If V0 = P0 : k  g
P0
Dividend Capital
Yield Gains Yield

D0 1  g  D0 1  0 D1
If g = 0: V0   
kg k 0 k
Perpetuity
Chapter 18: Equity Valuation
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 Implications of this Model
D1
V0 
k g
• If D1 increases, then V0 increases.
• If k decreases, then V0 increases.
• If g increases, then V0 increases.
• If D1 increases X%, then V0 will
increase X%.
• g = the capital gains yield
Chapter 18: Equity Valuation
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 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

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 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.

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 Figure 12.1 Dividend Growth for
Two Earnings Reinvestment Policies

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 Plowback Ratio and Growth

g  ROE  b
Where:

ROE = Return on Equity

b = Plowback Ratio
(or Earning Retention Ratio)

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 Stock Prices and
Investment Opportunities

D1 E1  ( 1-b)
P0  
k  g k-(ROE  b)

E1
P0   PVGO
k
Present value Present value of growth
no-growth Opportunities
(b=0 or ROE=k) PVGO > 0 if ROE>k
PVGO <0 if ROE<k
Chapter 18: Equity Valuation
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 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 Takeover’s growth opportunities if the
appropriate capitalization rate is 15%? What is the PVGO?

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 Life Cycles and the
Constant Growth Model
Changing growth rates:
D1 D2 DH DH  1
V0    ...    ...
1  k 1  k  2
1  k  1  k 
H H 1

temporary high permanent

(or low) growth constant growth

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 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?

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 Price-Earning (P/E) Ratios

• Ratio of Stock price to its earnings per share

• Useful for firm valuation:
P
P  E
E
• Problems:
– Forecasts of E
– Forecasts of P/E

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 P/E Ratios and Growth
E1
P0   PVGO
k

 
P0 1  PVGO 
 1  
E1 k  E1 
 k 
E1
If PVGO = 0: P 0 
k
Chapter 18: Equity Valuation
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 Numerical Example: No Growth

E0 = $2.50 g=0 k = 12.5%

P0 = D/k = $2.50/.125 = $20.00

P/E = 1/k = 1/.125 = 8

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 P/E Ratios and ROE

P0 1 b

E1 k  ROE  b 
P/E ratio rises with ROE but not necessarily with b
P/E
ROE>k
1/k

ROE<k

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 Numerical Example with 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
P/E = 31.14/2.73 = 11.4
P/E = (1 - .60) / (.125 - .09) = 11.4

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 Figure 12-3 P/E Ratio of the
S&P 500 Index and Inflation

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 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)

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 P/E ratio and Risk
P 1 b

E kg
Holding everything equal:
High risk (k), Low P/E.

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

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 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

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 Figure 12-6 P/E Ratios

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 Combining P/E and DDM

D1 D2 D3 D4   P E  EPS 
V0    
1  k 1  k  2
1  k  3
1  k  4

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 The Aggregate Stock Market:
Earning Multiplier Approach

P
VM  E
E
where
1
P/ E 
E P
and E P is the earnings yield

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 Other Valuation Ratios & Approaches

• Price-to-book
• Price-to-cash flow
• Price-to-sales
• Present Value of Free Cash Flow

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 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
D1
• Constant growth model DDM: V0 
kg
• 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

Chapter 18: Equity Valuation

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