Copyright 2010 by The McGraw-Hill Companies, I nc. All rights reserved.

McGraw-Hill/I rwin
13-2
13.1 Valuation by
Comparables
13-3
Fundamental Stock Analysis:
Models of Equity Valuation
Basic Types of Models
Balance Sheet Models
Dividend Discount Models
Price/Earnings Ratios
Free Cash Flow Models
13-4
Models of Equity Valuation
Valuation models using comparables
Look 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

13-5
Table 13.1 Microsoft Corporation
Financial Highlights 2009
13-6
Valuation Methods
Book value
Value of common equity on the balance sheet
Based on historical values of assets and
liabilities, which may not reflect current values
Some assets such as brand name or
specialized skills are not on a balance sheet

Is book value a floor value for market value of
equity?
13-7
Valuation Methods
Market value
Current market value of assets minus current
market value of liabilities
Market value of assets may be difficult to ascertain
Market value based on stock price

Better measure than book value of the worth
of the stock to the investor.
13-8
Valuation Methods (Other
Measures)
Liquidation value
Net amount realized from sale of assets and
paying off all debt

Firm becomes a takeover target if market
value stock falls below this amount, so
liquidation value may serve as floor to value
13-9
Valuation Methods (Other
Measures)
Replacement cost
Replacement cost of the assets less the
liabilities

May put a ceiling on market value in the long
run because values above replacement cost
will attract new entrants into the market.

Tobins Q = Market Value / Replacement
Cost; should tend toward 1 over time.
13-10
13.2 Intrinsic Value Versus
Market Price
13-11
Expected Holding Period Return
| |
1 1 0
0
( ) ( )
Expected HPR= ( )
E D E P P
E r
P
+
=
The return on a stock investment
comprises cash dividends and capital
gains or losses

Assuming a one-year holding period
13-12
Required Return
( )
f M f
k r E r r |
(
= +

CAPM gave us required
return, call it k:
k = market capitalization
rate

If the stock is priced
correctly
Required return should
equal expected return

| |
1 1 0
0
( ) ( )
Expected HPR= ( )
E D E P P
E r
P
+
=
=
( )
f M f
k r E r r |
(
= +

13-13
Intrinsic Value
Intrinsic Value
The present value of a firms expected future net cash
flows discounted by a risk adjusted required rate of
return.
The cash flows on a stock are?
Dividends (D
t
)
Sale price (P
t
)
Intrinsic Value today (time 0) is denoted V
0
and for a one
year holding period may be found as:

k 1
) P ( E ) D ( E
V
1 1
0
+
+
=
13-14
Intrinsic Value and Market Price
Market Price
Consensus value of all traders
In equilibrium the current market price will
equal intrinsic value

Trading Signals
If V
0
> P
0

If V
0
< P
0

If V
0
= P
0


Buy
Sell or Short Sell
Hold as it is Fairly Priced
13-15
13.3 Dividend Discount
Models

For now assume price = intrinsic value
13-16
Basic Dividend Discount Model
Intrinsic value of a stock can be found from the
following:


What happened to the expected sale price in this
formula?
Why is this an infinite sum?
Is stock price independent of the investors
holding period?

=
+
=
1 t
t
t
0
) k 1 (
D
V
V
0
= Intrinsic Value of Stock
D
t
= Dividend in time t
k = required return
13-17
Basic Dividend Discount Model
Intrinsic value of a stock can be found from the
following:


This equation is not useable because it is an
infinite sum of variable cash flows.
Therefore we have to make assumptions about
the dividends to make the model tractable.

=
+
=
1 t
t
t
0
) k 1 (
D
V
V
0
= Intrinsic Value of Stock
D
t
= Dividend in time t
k = required return
13-18
No Growth Model
Use: Stocks that have earnings and
dividends that are expected to remain
constant over time (zero growth)



Preferred Stock
A preferred stock pays a $2.00 per share dividend
and the stock has a required return of 10%. What
is the most you should be willing to pay for the
stock?
k
D
V
0
=
00 . 20 $
0.10
$2.00
V
0
= =
13-19
Constant Growth Model
Use: Stocks that have earnings and dividends
that are expected to grow at a constant rate
forever


A common stock share just paid a $2.00 per
share dividend and the stock has a required
return of 10%. Dividends are expected to grow
at 6% per year forever. What is the most you
should be willing to pay for the stock?
dividends in rate growth perpetual ;
g - k
) 1 ( D
V
0
0
=
+
= g
g
00 . 53 $
0.06 - 0.10
1.06 $2.00
V
0
=

=
13-20
Comparing Value and Returns
Why do you have to pay more for the
constant growth stock?
Must pay for expected growth

What is the one year rate of return for
each stock?
No Growth Stock
V
0
= $20.00
D = $2.00
V
1
=
% 10
20 $
2 $ 20 $ 20 $
k =
+
=
Constant Growth Stock
V
0
= $53.00; D
0
= $2.00
18 . 56 $
0.06 - 0.10
1.06 $2.00
V
2
1
=

=
% 10
53 $
12 . 2 $ 53 $ 18 . 56 $
k =
+
=
$2.00 / 0.10 = $20.00
13-21
Comparing Value and Returns
Both stocks given an investor a pre-tax
return of 10%.

Is one stock a better buy than the other?
Not if both are actually priced at their intrinsic
value (ignoring taxes).
13-22
Stock Prices and Investment
Opportunities
g = growth rate in dividends is a function of
two variables:
ROE = Return on Equity for the firm

b = plowback or retention percentage rate
(1- dividend payout percentage rate)


g increases if a firm increases its retention
ratio and/or its ROE
b ROE g =
13-23
Value of Growth Opportunities
Cash Cow, Inc. (CC)
E1 = $5
D1 = $5
b = ; therefore g =
k = 12.5% ; Find V
CC



ROE = 12.5%
Growth Prospects
(GP)
E1 = $5
D1 = $5
b = 0; therefore g = 0
k = 12.5%, Find V
GP


ROE = 15%
0 0
40 $
0.125
$5.00
V
CC
= =
40 $
0.125
$5.00
V
GP
= =
Should either or both firms retain some earnings?
b ROE g = Value with 100% dividend payout
13-24
Value of Growth Opportunities
Cash Cow, Inc. (CC)
E1 = $5
b = 60%; therefore g
D1 = 0.40 x $5 = $2.00
k = 12.5%; Find V
CC
ROE = 12.5%
CC value is the same,
why?
Growth Prospects (GP)
E1 = $5
b = 60%; therefore g = 9%
D1 = 0.40 x $5 = $2.00
k = 12.5%; Find V
GP
ROE = 15%
GP Value has increased,
why?
7.5%
40 $
0.075 - 0.125
2.00
V
CC
= = 14 . 57 $
0.09 - 0.125
$2.00
V
GP
= =
b ROE g =
Value with 40% dividend payout
13-25
Value of Growth Opportunities
Value of assets in place for GP = $40.00 (value with all
dividends paid out, with ROE = 12.5%)
Value of growth opportunities with ROE = 15% may be
inferred from the difference between the new V
GP
=
$57.14 and the no growth value of $40.00
Thus the present value of growth opportunities
(PVGO) = $57.14 - $40.00 = $17.14

0 1
(1 )
( )
D g E
PVGO
k g k
+
=

In general:
13-26
Figure 13.1 Dividend Growth for
Two Earnings Reinvestment
Policies
(for a given ROE)
High reinvestment increases stock
price only if ROE > k
13-27
Multistage Growth Models
As firms progress through their industry life cycle,
earnings and dividend growth rates (ROE) are likely to
change.
A two stage growth model:


g
1
= first growth rate
g
2
= second growth rate
T = number of periods of growth at g
1

T
2
2 T
T
1 t
t
t
1
0 0
k) )(1 g (k
) g (1 D
k) (1
) g (1
D V
+
+
+
(

+
+
=

=
13-28
Multistage Growth Rate
Model: Example
D0 = $2.00 g1 = 20% g2 = 5%
k = 15% T = 3
D1 = 2.40 D2 = 2.88 D3 = 3.46 D4 = 3.63



V
0
= 2.09 + 2.18 + 2.27 + 23.86 = $30.40
3 3 2
0
) 15 . 1 )( 05 . 0 15 . 0 (
63 . 3 $
15 . 1
46 . 3 $
15 . 1
88 . 2 $
15 . 1
40 . 2 $
V

+ + + =
13-29
Table 13.2 Financial Ratios
13-30
Figure 13.2 Honda Motor
13-31
Two Stage DDM for Honda
Dividends:



Assume the dividend growth rate will be
steady beyond 2012. Value Line forecasts
b = 70% and ROE of 11.0%. What should
be the long term growth rate?
Year Dividen
d
2009 0.90
2010 0.98
2011 1.06
2012 1.15
b ROE g =
% 70 . 7 % 70 % 0 . 11 g = =
From Value Line
13-32
Two Stage DDM for Honda
The required rate of return:
|
Honda
= 1.05
R
f
in 2008 = 3.5%
Market risk premium = historical average of
8%




Honda f M f Honda
) R R ( R k | + =
% 90 . 11 ) 05 . 1 % 8 ( % 5 . 3 k
Honda
= + =
From Value Line
13-33
Two Stage DDM for Honda
k = 11.90%
g = 7.70%
Find the intrinsic value



Value Line reported the actual price = $21.37, so
Honda was undervalued by $0.51 or about 2.4%.
4 4 3 2
0
) 119 . 1 )( 077 . 0 119 . 0 (
077 . 1 15 . 1 $
119 . 1
15 . 1 $
119 . 1
06 . 1 $
119 . 1
98 . 0 $
119 . 1
90 . 0 $
V

+ + + + =
Year Divid
end
2009 0.90
2010 0.98
2011 1.06
2012 1.15
88 . 21 $ V
0
=
13-34
Two Stage DDM for Honda
Should we trust the valuation result?

What if the beta is slightly incorrect,
suppose it is 1.10 (< 5% error) rather
than 1.05?

Now k = 12.3% and the intrinsic value
estimate V
0
= $19.98, reversing our
conclusion that Honda is undervalued


Year Dividen
d
2009 0.90
2010 0.98
2011 1.06
2012 1.15
Actual price =
$21.37
13-35
13.4 Price-Earnings (P/E)
Ratios
13-36
P/E Ratio and Growth
Opportunities
P/E Ratios are a function of two factors
Required Rates of Return (k) (inverse relationship)
Expected Growth in Dividends (direct relationship)
Uses
Estimate intrinsic value of stocks
Conceptually equivalent to the constant growth
DDM
Extensively used by analysts and investors
13-37
P/E, ROE and Growth
With positive growth:




With zero growth:
If g = 0 then b should = 0 and the ratio
simplifies to:

b ROE g =
g k
) b 1 (
E
P
1
0

=
k
1
E
P
1
0
=
Are the elements of the P/E
ratio similar to the constant
growth DDM?
13-38
Numerical Example: No Growth
E
1
= $2.50 g = 0 k = 12.5%; Find P/E
and V
0


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

V
0
= P/E x E
1
= 8 x $2.50 = $20.00
13-39
Numerical Example with Growth
b = 60% ROE = 15%; k = 12.5% (1-b) = 40%,
E
0
= $2.50

Find the P/E and V
0
:
g = ROE x b = 15% x 60% = 9%
E
1
= $2.50 (1.09) = $2.725

P/E = (1 - .60) / (.125 - .09) = 11.4

V
0
= P/E x E
1
= 11.4 x $2.73 = $31.14
13-40
ROE and b and growth and P/E
13-41
P/E Ratios and Stock Risk


Riskier firms will have higher required
rates of return (higher values of k)

Riskier stocks will have lower P/E
multiples

g k
) b 1 (
E
P
1
0

=
13-42
Pitfalls in Using P/E Ratios
Earnings management is a serious problem,
P/E should be calculated using pro forma
earnings,
A high P/E implies high expected growth, but not
necessarily high stock returns,
Simplistic, assumes the future P/E will not be
lower than the current P/E. If expected growth in
earnings fails to materialize the P/E will fall and
investors may incur large losses.
13-43
Figure 13.3 P/E Ratios and
Inflation
13-44
Figure 13.4 Earnings Growth
for Two Companies

13-45
Figure 13.5 Price-Earnings
Ratios

13-46
Figure 13.6 P/E Ratios

13-47
Other Comparative Valuation
Ratios
Price-to-book
High ratio indicates a large premium over book value,
and a floor value that is often far below market price
Price-to-cash flow
P/Cash Flow instead of P/E; less subject to
accounting manipulation
Price-to-sales
Useful for firms with low or negative earnings in early
growth stage
Be creative
13-48
Figure 13.7 Valuation Ratios for the
S&P 500
13-49
13.5 Free Cash Flow
Valuation Approaches

13-50
Free Cash Flow
Capitalize or discount the free cash flow for the firm
(FCFF) at the weighted-average cost of capital and then
subtract the existing (market) value of debt
Useful for firms that dont pay dividends,
Helpful to understand sources and uses of cash

where:
EBIT = earnings before interest and taxes
T
c
= the corporate tax rate
NWC = net working capital

NWC in Increase es Expenditur Capital on Depreciati ) T EBIT(1 FCFF
C
+ =
13-51
FCFF, Firm Value & Equity
Value
The free cash flow methods discount year to year cash
flows plus some estimate of the terminal value P
T
where

WACC = Weighted average cost of capital
g = estimate of long run growth in free cash flow
T = time period when the firm approaches constant
growth

Equity value =
g WACC
FCFF
P
1 T
T

=
+
T
T
T
1 t
t
t
) WACC 1 (
P
) WACC 1 (
FCFF
Value Firm
+
+
(

+
=

=
Firm Value Firm Value Market Value of Debt
13-52
Free Cash Flow (cont.)
Another approach calculates the free cash flow
to the equity holders (FCFE) and discounts the
cash flows directly at the cost of equity, k
E
.




Equity value can then be estimated as:
Debt Net in Increase ) T Expense(1 Interest FCFF FCFE
C
+ =
g k
FCFE
P
E
1 T
T

=
+
T
E
T
T
1 t
t
E
t
) k 1 (
P
) k 1 (
FCFE
Value quity E
+
+
(

+
=

=
13-53
FCF Valuation Example
13-54
Comparing the Valuation
Models
In theory free cash flow approaches should provide the
same estimate of intrinsic value as the dividend growth
model

In practice the various approaches often differ
substantially
Simplifying assumptions are used in all models
The models establish ranges of likely intrinsic value
Using multiple models forces rigorous thinking about
the inputs
13-55
13.6 The Aggregate Stock
Market
13-56
Earnings Multiplier Approach
1. Forecast corporate profits for the coming period for an
index such as the S&P 500.

2. Derive an estimate for the aggregate P/E ratio using
long-term interest rates
Based on the relationship between the earnings
yield or E/P ratio for the S&P 500 and the yield on
10 year Treasuries

3. Product of the two forecasts is the estimate of the end-
of-period level of the market
13-57
Figure 13.8 Earnings Yield of the
S&P 500 Versus 10-year Treasury
Bond Yield
13-58
Earnings Multiplier Approach
2009 Data: Starting S&P500 level = 900

Treasury yield = 3.2%

Implied Earnings Yield = 2.5% + 3.2% = 5.7%

If E/P = 5.7% then P/E = 1 / 0.057 = 17.54

If forecast EPS = $55 what is the expected
forecast for the S&P500 one year later and the
% gain or loss?
2.5% spread Treasury yr 10 P500 & S yield Earnings Expected =
7.2%
900
900 965
turn ExpectedRe
965 55 17.54 P500 & S
1
=

=
= =
13-59
Table 13.4 S&P 500 Index
Forecasts