Chapter 11: Security

Valuation Principles
Analysis of Investments &
Management of Portfolios
10TH EDITION

Reilly & Brown

Overview of the Valuation

Process

Two General Approaches

1)

Top-down, three-step approach

2)

Bottom-up, stock valuation, stock picking

approach

The difference between the two approaches is

the perceived importance of economic and
industry influence on individual firms and stocks

Both of these approaches can be implemented

by either fundamentalists or technicians

11-2

Overview of the Valuation

Process

The Three-Step Top-Down Process

1)

First examine the influence of the general

economy on all firms and the security
markets

2)

Then analyze the prospects for various global

industries with the best outlooks in this
economic environment

3)

Finally turn to the analysis of individual firms

in the preferred industries and to the
common stock of these firms.

See Exhibit 11.1

11-3

11-4

Three-Step Valuation
Approach

Company Analysis

The purpose of company analysis to identify the best

companies in a promising industry

This involves examining a firms past performance, but

more important, its future prospects

It needs to compare the estimated intrinsic value to the

prevailing market price of the firms stock and decide
whether its stock is a good investment

The final goal is to select the best stock within a desirable

industry and include it in your portfolio based on its
relationship (correlation) with all other assets in your
portfolio
11-5

Theory of Valuation

The value of an asset is the present value of its

expected returns

To convert this stream of returns to a value for

the security, you must discount this stream at
your required rate of return

This requires estimates of:

1)

The stream of expected returns

2)

The required rate of return on the

investment
11-6

Theory of Valuation

Stream of Expected Returns

Form of returns

Earnings

Cash flows

Dividends

Interest payments

Capital gains (increases in value)

Time pattern and growth rate of returns

When the returns (Cash flows) occur

At what rate will the return grow

11-7

Theory of Valuation

Required Rate of Return

Reflect the uncertainty of return (cash flow)

Determined by economys risk-free rate of return, plus

Expected rate of inflation during the holding period,

plus

Risk premium determined by the uncertainty of

returns

business risk

financial risk

liquidity risk

exchanger rate risk and country

11-8

Theory of Valuation

Investment Decision Process: A Comparison of

Estimated Values and Market Prices

You have to estimate the intrinsic value of

the investment at your required rate of
return and then compare this estimated
intrinsic value to the prevailing market price

If Estimated Value > Market Price, Buy

If Estimated Value < Market Price, Dont Buy

11-9

Valuation of Common Stock

Two General Approaches:

1)

Discounted Cash-Flow Techniques

2)

Relative Valuation Techniques

Present value of some measure of cash flow,

including dividends, operating cash flow,
and free cash flow
Value estimated based on its price relative
to significant variables, such as earnings,
cash flow, book value, or sales

See Exhibit 11.2

11-10

11-11

Valuation of Common Stock

Both of these approaches and all of these

valuation techniques have several common
factors:
1)

All of them are significantly affected by

investors required rate of return on the stock
because this rate becomes the discount rate
or is a major component of the discount rate;

2)

All valuation approaches are affected by the

estimated growth rate of the variable used in
the valuation technique

11-12

Why Discounted Cash Flow Approach

These techniques are obvious choices for

valuation because they are the epitome of how
we describe valuethat is, the present value of
expected cash flows
1)

Dividends: Cost of equity as the discount rate

2)

Operating cash flow: Weighted Average Cost

of Capital (WACC)

3)

Free cash flow to equity: Cost of equity as

the discount rate

Dependent on growth rates and discount rate

11-13

Why Relative Valuation Techniques

Provides information about how the market is currently valuing stocks

aggregate market

alternative industries

individual stocks within industries

No guidance as to whether valuations are appropriate

best used when have comparable entities

aggregate market and companys industry are not at a valuation

extreme

11-14

Discounted Cash Flow

Valuation Techniques
The General Formula
t n

CFt
Vj
t
t 1 (1 k )
Where:
Vj =

value of stock j

life of the asset

CFt =

cash flow in period t

Discount rate that is equal to the investors

required rate of return for asset j,

11-15

The Dividend Discount

Model (DDM)

The value of a share of common stock is the present

value of all future dividends

Vj
n

t 1

D3
D1
D2
D

...

(1 k ) (1 k ) 2 (1 k ) 3
(1 k )
Dt
(1 k ) t

where:
Vj

= value of common stock j

Dt

= dividend during time period t

= required rate of return on stock j

11-16

The Dividend Discount

Model (DDM)

Infinite Period Model (Constant Growth Model)

Assumes a constant growth rate for estimating all of future dividends

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

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

where:
Vj = value of stock j
D0 = dividend payment in the current period
g
k
n

= the constant growth rate of dividends

= required rate of return on stock j
11-17
= the number of periods, which we assume to be infinite

The Dividend Discount

Model (DDM)

Given the constant growth rate, the earlier

formula can be reduced to:

D1
Vj
kg

Assumptions of DDM:
1)

Dividends grow at a constant rate

2)

The constant growth rate will continue for an

infinite period

3)

The required rate of return (k) is greater than

the infinite growth rate (g)
11-18

Infinite Period DDM

and Growth Companies

Growth companies have opportunities to earn

return on investments greater than their required
rates of return

To exploit these opportunities, these firms

generally retain a high percentage of earnings for
reinvestment, and their earnings grow faster than
those of a typical firm

During the high growth periods where g>k, this is

inconsistent with the constant growth DDM
assumptions
11-19

Valuation with Temporary

Supernormal Growth

First evaluate the years of supernormal growth and then

use the DDM to compute the remaining years at a
sustainable rate

Suppose a 14% required rate of return with the

following dividend growth pattern

Year
1-3
4-6
7-9
10 on

Dividend
Growth Rate
25%
20%
15%
9%
11-20

Valuation with Temporary

Supernormal Growth

The Value of the Stock (See Exhibit 11.3)

2.00(1.25) 2.00(1.25) 2 2.00(1.25) 3

Vi

2
1.14
1.14
1.143
2.00(1.25) 3 (1.20) 2.00(1.25) 3 (1.20) 2

4
1.14
1.145
2.00(1.25) 3 (1.20) 3 2.00(1.25) 3 (1.20) 3 (1.15)

6
1.14
1.147
2.00(1.25) 3 (1.20) 3 (1.15) 2 2.00(1.25) 3 (1.20) 3 (1.15) 3

8
1.14
1.149
2.00(1.25) 3 (1.20) 3 (1.15) 3 (1.09)
(.14 .09)

11-21
(1.14) 9

Present Value of
Operating Free Cash Flows

Derive the value of the total firm by discounting the total

operating cash flows prior to the payment of interest to the
debt-holders

Then subtract the value of debt to arrive at an estimate of

the value of the equity

Similar to the DDM, we can have

We have use a constant rate forever

We can assume several different rates of growth for OCF,

like the supernormal dividend growth model
11-22

Present Value of
Operating Free Cash Flows

11-23

Present Value of
Free Cash Flows to Equity

Free cash flows to equity are derived after

operating cash flows have been adjusted for debt
payments (interest and principle)

These cash flows precede dividend payments to the

common stockholder

The discount rate used is the firms cost of equity (k)

rather than WACC

11-24

Present Value of
Free Cash Flows to Equity

The Formula

FCFEt
Vj
t
t 1 (1 k j )
where:
Vj

= Value of the stock of firm j

= number of periods assumed to be infinite

FCFEt

= the firms free cash flow in period t

Kj

= the cost of equity

11-25

Relative Valuation
Techniques

Value can be determined by comparing to

similar stocks based on relative ratios

Relevant variables include earnings, cash flow,

book value, and sales

Relative valuation ratios include price/earning;

price/cash flow; price/book value and
price/sales

The most popular relative valuation technique is

based on price to earnings

11-26

Earnings Multiplier Model

P/E Ratio: This values the stock based on

expected annual earnings
Price/Earnings Ratio= Earnings Multiplier

Current Market Price

Expected 12 - Month Earnings

11-27

Earnings Multiplier Model

Combining the Constant DDM with the P/E ratio

approach by dividing earnings on both sides of DDM
formula to obtain

Pi
D1 / E1

E1
kg

Thus, the P/E ratio is determined by

Expected dividend payout ratio

Required rate of return on the stock (k)

Expected growth rate of dividends (g)

11-28

Earnings Multiplier Model

Assume the following information for AGE stock (1)
Dividend payout = 50% (2) Required return = 12%
(3) Expected growth = 8% (4) D/E = .50 and the
growth rate, g=.08. What is the stocks P/E ratio?
P/E

.50
.50 / .04 12.5
.12 - .08

What if the required rate of return is 13%

P/E

.50
.50 / .05 10.0
.13 - .08

What if the growth rate is 9%

.50
P/E
.50 / .03 16.7
.12 - .09

11-29

Earnings Multiplier Model

In the previous example, suppose the current

earnings of $2.00 and the growth rate of 9%.
What would be the estimated stock price?

Given D/E =0.50; k=0.12; g=0.09, P/E = 16.7

You would expect E1 to be $2.18

V = 16.7 x $2.18 = $36.41

Compare this estimated value to market price to

decide if you should invest in it

11-30

The Price-Cash Flow Ratio

Why Price/CF Ratio

Companies can manipulate earnings but Cashflow is less prone to manipulation

Cash-flow is important for fundamental valuation

and in credit analysis

The Formula:

Pt
P / CFi
CFt 1

where:
P/CFj
Pt
CFt+1
j

= the price/cash flow ratio for firm j

= the price of the stock in period t
= expected cash low per share for firm11-31

The Price-Book Value Ratio

Widely used to measure bank values

Fama and French (1992) study indicated inverse relationship

between P/BV ratios and excess return for a cross section of
stocks

The Formula:

Pt
P / BV j
BVt 1

where:
P/BVj

= the price/book value for firm j

Pt

= the end of year stock price for firm j

BVt+1

11-32
= the estimated end of year book value
per
share for firm j

The Price-Sales Ratio

Sales is subject to less manipulation than other financial data

This ratio varies dramatically by industry

Relative comparisons using P/S ratio should be between firms

in similar industries

The Formula:

Pt
P/Sj
St 1

where: P/Sj

= the price to sales ratio for Firm j

Pt

= the price of the stock in Period t

St+1

11-33
= the expected sales per share for Firm
j

Implementing the Relative Valuation

Technique

First Step: Compare the valuation ratio for a company

to the comparable ratio for the market, for stocks
industry and to other stocks in the industry

Is it similar to these other P/Es

Is it consistently at a premium or discount

Second Step: Explain the relationship

Understand what factors determine the specific

valuation ratio for the stock being valued

Compare these factors versus the same factors for

the market, industry, and other stocks

11-34

Estimating the Inputs: k and g

Valuation procedure is the same for securities around the

world

The two most important input variables are :

1)

The required rate of return (k)

2)

The expected growth rate of earnings and other valuation

variables (g) such as book value, cash flow, and dividends

These two input variables differ among countries in the world

The quality of these estimates are key

11-35

Required Rate of Return (k)

The investors required rate of return must be estimated

regardless of the approach selected or technique applied

This will be used as the discount rate and also affects

relative-valuation

Three factors influence an investors required rate of return:

1)

The economys real risk-free rate (RRFR)

2)

The expected rate of inflation (I)

3)

A risk premium (RP)

11-36

Required Rate of Return (k) - RRFR

The Economys Real Risk-Free Rate:

Minimum rate an investor should require

Depends on the real growth rate of the economy

(Capital

invested should grow as fast as the economy)

Rate is affected for short periods by tightness or ease of

credit markets

11-37

Required Rate of Return (k) - NRFR

The Expected Rate of Inflation

Investors are interested in real rates of return that will

allow them to increase their rate of consumption

The investors required nominal risk-free rate of return

(NRFR) should be increased to reflect any expected
inflation:

NRFR [1 RRFR][1 E (I)] - 1

where:
E(I)

= expected rate of inflation

11-38

Required Rate of Return (k)

Risk Premium

The Risk Premium:

Causes differences in required rates of return on

alternative investments

Explains the difference in expected returns among

securities

Changes over time, both in yield spread and ratios of

yields

11-39

Estimating the Required Return

for Foreign Securities

Foreign Real RFR

Should be determined by the real growth rate within the

particular economy. Can vary substantially among
countries

Inflation Rate

Estimate the expected rate of inflation, and adjust the

NRFR for this expectation
NRFR=(1+Real Growth)x(1+Expected Inflation)-1

See Exhibit 11.6

11-40

Exhibit 11.6

11-41

Expected Growth Rate

Estimating Growth From Fundamentals

Determined by
1)

the growth of earnings

2)

the proportion of earnings paid in dividends

In the short run, dividends can grow at a different rate

than earnings if the firm changes its dividend payout ratio

Earnings growth is also affected by earnings retention and

equity return
g

= (Retention Rate) x (Return on Equity)

= RR x ROE
= Internally generated growth rate
11-42

Expected Growth Rate

ROE

Net Income
Sales
Total Assets

Common Equity
Sales
Total Assets

Profit
Total Asset
*
Margin Turnover

Financial
Leverage
11-43

Expected Growth Rate

The first component, net profit margin, indicates the

firms profitability on sales

The second component, total asset turnover is the

indicator of operating efficiency and reflect the asset
and capital requirements of business.

The final component measure financial leverage. It

indicates how management has decided to finance the
firm

11-44

Financial Forecasting & Internally

generated growth rate
If

5 corporate policies are kept constant then internally

generated growth in OE , g OE , translates into same growth
rate in TA, TL, Sales, NI, EPS, DPS, and finally in share price
(Po);
Projecting

concise financial statements if 5 corporate

policies are kept unchanged; and double checking that it is
true that all the above stated financial variables do grow at
the same percentage growth rate.

11-45

Financial Forecasting & Internally

generated growth rate
The 5 policies that are assumed to be kept constant are:
1.NI/S

ratio, net profit margin showing profitability

2.S/TA ratio,

total assets turnover showing productivity of

total assets in generating sales
3.TA/OE

ratio, financial leverage showing capital structure

of the business
4.DPS/EPS

ratio, dividend payout ratio showing dividend

policy of the business. It is denoted with symbol d.
5.Number

of shares outstanding.

11-46

Internally Generated Growth

Rate

If a Co does not issue new shares to raise fresh cash as

equity investment by its owners then any growth in its
OE is internally generated through retention of some
portion or all of NI by not distributing all the NI of that
year as cash dividends.

Reinvesting a portion of NI of a year in the business

causes increase on the right hand side of balance
sheet (an increase in its OE); specifically within OE,
the RE (also called reserves) experience an increase.

Since balance sheet must balance therefore on the

left hand side of balance sheet total assets experience
an increase by the same amount because 2 sides of
balance sheet must always be the same amount.
11-47

Internally Generated Growth

Rate

It is internally generated growth in OE of a business

because this growth in OE is attained by retaining and
reinvesting a portion of NI; and is not generated by
issuing shares to raise external equity funds.

It is only logical that if both TA & Equity are growing

at the same rate, then, in order to maintain balance,
TL must also increase at the same rate. Therefore all
three portions of balance sheet would grow at this
growth rate.

Since growth in liabilities would entail increase in

external debt financing therefore this growth rate
cannot be called sustainable growth rate of a business
corporation.
11-48

Sustainable Growth rate

Sustainable growth rate is that growth rate in sales

which does not require raising debt or equity
financing externally to finance additional assets
needed to support growth in production and sales.

Rather the sustainable growth rate relies only on

raising equity internally by reinvesting the profits and
also relies on that increase in liabilities that takes
place spontaneously due to larger production and
selling operations, such as increase in accounts
payables and salaries payables.

Therefore when a company is growing at sustainable

growth rate then financing for the growth in assets
is not done by taking debt or by issuing shares
11-49

Financial Forecasting Example

TA = 200, TL = 100 & OE = 100

Sales = 500, NI = 10, d = 50%, Kc = 10% & number of

shares outstanding = 10 million.

Calculate Growth of OE

11-50

Financial Forecasting Example

TA = 200, TL = 100 & OE = 100

Sales = 500, NI = 10, d = 50%, Kc = 10% & number of

shares outstanding = 10 million.
gOE

= ROE(1 - d)
= (NI/OE) * (1- d)
= (10/100) * (1- 0.5)
= 10% * (1- 0.5)
= 10 % * 0.5
= 5%

11-51

Financial Forecasting Example

TA = 200, TL = 100 & OE = 100

Sales = 500, NI = 10, d = 50%, Kc = 10% & number of

shares outstanding = 10 million.

If 5 policies are kept constant, calculate Div payout

ratio, Number of shares outstanding, Net Profit
Margin, Total Asset Turnover & TA/OE ratio for the
next year?

11-52

Financial Forecasting Example

1)

Dividend payout policy remains unchanged, i.e. d = 0.5

2)

Number of shares outstanding remains unchanged at

10m shares; it means during the next year no new
shares would be issued nor repurchased.

3)

Net profit margin = 10/500 =2% and would remain the

same next year; it implies no change in profitability.

4)

Turnover of TA = S / TA ratio: 500/200=2.5 times

meaning one rupee invested in TA was helping to
generate sales of 2.5 rupees & it would be same next
year

5)

Financial leverage remains unchanged, this year TA /OE

ratio: 200/100 = 2 times, and it would be 2 next year
as well, it means capital structure would remain
unchanged; and so would be financial risk.
11-53

Financial Forecasting Example

TA = 200, TL = 100 & OE = 100

Sales = 500, NI = 10, d = 50%, Kc = 10% & number of

shares outstanding = 10 million.

If 5 policies are kept constant, Forecast balance sheet

for the next year?

11-54

Financial Forecasting
Forecasting Balance Sheet
OE1 = OE0( 1 + gOE)
= 100(1 + 0.05)

105 m

As TA/OE last year is 200 /100 = 2

Therefore, equity multiplier (financial leverage)
will be same next year , so:
TA1 /OE1 =

TA1

2*OE1

TA1

2*105

TA1

210m
11-55

Financial Forecasting
Forecasting Balance Sheet
Since balance sheet is always balanced therefore
you can work out next years TL as:
TL1

=
=

TA1 - OE1

210 105
=

105m

Now, you have projected balance sheet for the

next year:
TA1 = TL1 + OE1
210 = 105 + 105
11-56

Financial Forecasting Example

TA = 200, TL = 100 & OE = 100

Sales = 500, NI = 10, d = 50%, Kc = 10% & number of

shares outstanding = 10 million.

If 5 policies are kept constant, Forecast Income

Statement (Sales, NI, Expenses, EPS, DPS) for the next
year?

11-57

Financial Forecasting
Forecasting Income Statement
As
S / TA was last year 500/200 = 2.5 times
Therefore, next year this turnover of asset would
also be 2.5 times, so:
S1 / TA1 =

2.5

S1

2.5* TA1

S1

2.5*210

S1

525m

11-58

Financial Forecasting
Forecasting Income Statement
Since last year NI /S was 10 /500 = 2%
Therefore,
Net profit margin for the next year would
also be 2% of sales, so:
NI1 / S1

= 2%

NI1

= 2% * S1

NI1

= 0.02*525

NI1

= 10.5m
11-59

Financial Forecasting
Forecasting Income Statement
S1 - Expenses1 =

NI1

525 expenses

10.5

Expenses1

525 10.5

514.5

11-60

Financial Forecasting
Forecasting Income Statement
Last years EPS was:
EPS0

NIo / Shares

10m Rs/10m shares = 1 Re/Share

Next year EPS would be:

EPS1

NI1 / number of Shares outstanding

EPS1

10.5m Rs/10m

(note the number of shares outstanding is same 10

million as last year)
EPS1

1.05 Rs/ Share

11-61

Financial Forecasting
Forecasting Income Statement
Last year:
DPSo=

EPS0 * d

DPSo =

1*0.5

DPSo =

0.5 Rs/ Share

Next year DPS would be:

DPS1 =

EPS1*d

DPS1 =

1.05 * 0.5

(note dividend payout ratio, d, is unchanged at 50%)

DPS1 = 0.525 Rs/Sh

(next years estimated dividend per share)

11-62

Financial Forecasting Example

TA = 200, TL = 100 & OE = 100

Sales = 500, NI = 10, d = 50%, Kc = 10% & number of

shares outstanding = 10 million.

Calculate growth rate of Sales, NI, EPS, DPS, TA & TL

11-63

Financial Forecasting Example

TA = 200, TL = 100 & OE = 100

Sales = 500, NI = 10, d = 50%, Kc = 10% & number of

shares outstanding = 10 million.

Calculate growth rate of Price & Expected Rate of

Return for shareholders

11-64

Financial Forecasting Example

Po

DPS1/ (Kc g)

Po

10.5 Rs/ Sh

DPS 2

= DPS1(1 + g)
=

0.525/ (0.1 - 0 .05)

0.525(1 + 0.05)

0.55 Rs/Share

Therefore share price at the end of this year (year one) ,

P1, is estimated as:
P1 = DPS2/ (Kc g)

= 0.55/(0.1 - 0.05)

P1 =11.02

11-65

Financial Forecasting Example

Growth in share price (capital gains yield) from now till the
end of the year is estimated as:
g Po =

(P1 - Po) /Po

(11.02 - 10.5) /10.5

5%

Hence,
gOE = gTA = g TL = gS = gNI = gEPS = g

DPS

= g

Po

(P1 - Po )/Po
5% = 5%= 5% = 5% = 5% = 5% = 5% = 5%
=5%
11-66

Expected Rate of Return for

shareholders
Expected ROR next year (Kc1)
= (P1 - P0) / P0

+ DPS1 /P0

= (5%) + (0.525 /10.5)

= 5%

5%

= 10%
Please

note that expected Kc came 10% because while

doing valuation of share in year 0 &1, to estimate P 0 & P1,
the risk adjusted required rate of return used, Kc, was 10%
in the Gordons valuation formula: P0 = DPS1 / (Kc - g).
The

Price at which expected rate of return & required rate

of return equate is referred to as Fair Market price.
11-67

Investment implications

Shareholders of fast growing companies are likely to

become richer sooner than shareholders of slow
growing companies; therefore fast growing companies
are deemed as more valuable in the stock market
because their share price is expected to grow faster,
and their shareholders are likely to get richer more
quickly.

That is why when you go out looking for investing in

shares you should search for fast growing companies;
also as finance manager who is looking for target
companies for friendly mergers and acquisitions or
for hostile takeovers, you should look for companies
which have high growth potential.
11-68

Investment Implications Example

A co has paid Rs 3 per share cash dividends, its risk

adjusted required rate of return estimated using
CAPM model is 17%, and it is estimated to grow at the
constant growth rate of 3% per year for ever, this
growth rate was estimated as ROE (1 - d) under the
assumption of constancy of 5 corporate policies.

Required:
Estimate its fair value of share today?
Or in other words; at what price it should be trading
in the market?

11-69

Investment Implications Example

P0

= DPS0(1 + g) / ( Kc - g)
= 3 (1 + 0.03) / (0.17 - 0.03)
= 3.09 / 0.14
= 22.07 Rs per share.

11-70

Investment Implications Example

Suppose you do not agree that this co has a

growth potential and decide that it is a no
growth co, that means its g = 0%; what would be
your estimate of its fair value per share?

11-71

Investment Implications Example

P0

= DPS0(1 + g) / ( Kc - g)
= 3 (1 + 0) / (0.17 - 0)
= 3/0.17
= 17.64 Rs per share.

Lesson: Growing companies are more

valuable than non-growing companies.
11-72

Investment Implications Example

Suppose you, as an analyst, believe this

cos product lines are losing market
share to competitors, therefore you
think it is likely to experience negative
3% growth per year in foreseeable
future. What is your estimate of its fair
value per share?

11-73

Investment Implications Example

P0

= DPS0(1 + g) / ( Kc + g)
= 3 (1 + - 0.03) / (0.17 + 0.03)
= 2.91 / 0.2
= 14.55 Rs per share.

Lesson: Companies that are likely to

shrink in future are less valuable.
11-74

Conclusion - ROE & Valuation

11-75

Thank you for your Time &

Patience

11-76