W. Sean Cleary
Charles P. Jones
Analysis and Management
Second Canadian Edition

• Name two approaches to the valuation of common stocks used in fundamental security analysis.
• Explain the present value approach.
• Use the dividend discount model to estimate stock prices.
• Explain the P/E ratio approach.
• Outline other relative valuation approaches.

• Present value approach
 Capitalization of expected income
 Intrinsic value based on the discounted value of the expected stream of future cash flows
• Multiple of earnings approach
 Valuation relative to a financial performance measure
 Justified P/E ratio

• Intrinsic value of a security is
Value of security
 t n


1
Cash Flows
(1
 k) t
• Estimated intrinsic value compared to the current market price
 What if market price is different than estimated intrinsic value?

• Discount rate
 Required rate of return : minimum expected rate to induce purchase
 The opportunity cost of dollars used for investment
• Expected cash flows
 Stream of dividends or other cash payouts over the life of the investment

• Expected cash flows
 Dividends paid out of earnings
• Earnings important in valuing stocks
 Retained earnings enhance future earnings and ultimately dividends
• Retained earnings imply growth and future dividends
• Produces similar results as current dividends in valuation of common shares

• Current value of a share of stock is the discounted value of all future dividends
P cs

( 1

D
1 k cs
)
1

( 1

D
2 k cs
)
2

...

( 1

D
 k cs
)

 t



1
(1

D t k cs
) t

• Problems:
 Need infinite stream of dividends
 Dividend stream is uncertain
• Must estimate future dividends
 Dividends may be expected to grow over time
• Must model expected growth rate of dividends and need not be constant

• Assume no growth in dividends
 Fixed dollar amount of dividends reduces the security to a perpetuity
P
0

D
0 k cs
 Similar to preferred stock because dividend remains unchanged

• Assume constant growth rate in dividends
 Dividends expected to grow at a constant rate, g, over time
P
0
 k
D
1
 g
 D1 is the expected dividend at end of the first period
 D1 = D0 x (1+g)

• Implications of constant growth



Stock prices grow at the same rate as the dividends
Stock total returns grow at the required rate of return
• Growth rate in price plus growth rate in dividends equals k, the required rate of return
A lower required return or a higher expected growth in dividends raises prices

• Multiple growth rates : two or more expected growth rates in dividends


Ultimately, growth rate must equal that of the economy as a whole
Assume growth at a rapid rate for n periods, followed by steady growth
P
0
 t n


1
D
0
(1
(1

 g k)
1 t
) t

D n
(1
 k g g c
) 1
( 1
 k ) n

• Multiple growth rates
 First present value covers the period of supernormal (or sub-normal) growth
 Second present value covers the period of stable growth
• Expected price uses constant-growth model as of the end of super- (sub-) normal period
• Value at n must be discounted to time period zero

Valuing equity with growth of 30% for 3 years, then a long-run constant growth of 6%
0 k=16% 1 2 3 4 g = 30% g = 30% g = 30% g = 6%
D
0
= 4.00 5.20 6.76 8.788 9.315
4.48
5.02
5.63
59.68
74.81 = P
0
P
3
= 9.315
.10

• Is the dividend discount model only capable of handling dividends?
 Capital gains are also important
• Price received in future reflects expectations of dividends from that point forward
 Discounting dividends or a combination of dividends and price produces same results

• “Fair” value based on the capitalization of income process
 The objective of fundamental analysis
• If intrinsic value >(<) current market price, hold or purchase (avoid or sell) because the asset is undervalued (overvalued)
 Decision will always involve estimates
• If intrinsic value = current market price, an equilibrium because the asset is correctly valued

• Alternative approach often used by security analysts
• P/E ratio is the strength with which investors value earnings as expressed in stock price


Divide the current market price of the stock by the latest 12-month earnings
Price paid for each $1 of earnings

• To estimate share value
P o
 estimated earnings
 justified P/E ratio

E
1

P o
/E
1
• P/E ratio can be derived from
P o
 k
D
1
g or P o
/E
1

D
1
/E
1 k g
 Indicates the factors that affect the estimated
P/E ratio

• The higher the payout ratio, the higher the justified P/E
 Payout ratio is the proportion of earnings that are paid out as dividends
• The higher the expected growth rate, g, the higher the justified P/E
• The higher the required rate of return, k, the lower the justified P/E

• Can firms increase payout ratio to increase market price?
 Will future growth prospects be affected?
• Does rapid growth affect the riskiness of earnings?
 Will the required return be affected?
 Are some growth factors more desirable than others?
• P/E ratios reflect expected growth and risk

• A P/E ratio reflects investor optimism and pessimism
 Related to the required rate of return
• As interest rates increase, required rates of return on all securities generally increase
• P/E ratios and interest rates are inversely related

• Market-to-book ratio (M/B)

Ratio of share price to per share shareholder’s equity as measured on the balance sheet
 Price paid for each $1 of equity
• Price-to-sales ratio (P/S)

Ratio of company’s market value (price times number of shares) divided by sales

Market valuation of a firm’s revenues

• Economic Value Added (EVA)


Difference between operating profits and cost of capital
Technique for focusing on a firm’s return on capital in order to determine if shareholders are being rewarded
 EVA = (ROC - WACC) x Capital
 EVA = NOPAT - (WACC x Capital)

• Market Value Added (MVA)


A measure of external performance
MVA = Market value of the firm – Capital
 MVA relies on market perceptions and is more forward looking than EVA

• Best estimate is probably the present value of the (estimated) dividends
 Can future dividends be estimated with accuracy?
 Investors like to focus on capital gains not dividends
• P/E multiplier remains popular for its ease of use and the objections to the dividend discount model

• Complementary approaches?
 P/E ratio can be derived from the constantgrowth version of the dividend discount model
 Dividends are paid out of earnings
 Using both increases the likelihood of obtaining reasonable results
• Dealing with uncertain future is always subject to error

• Described as a perpetuity, and it will pay the indicated dividend forever
• Dividends are fixed when the stock is issued; these dividends are specified as an annul dollar amount or as a percentage of par value
• Less risky because the dividend is specified and must be paid before a common stock dividend can be paid

V p

C
( 1
 k p
)
1

C
( 1
 k p
)
2

...

( 1

C k p
)

V p

C k p
• When the required rate of return rises, the price of the preferred stock declines, vice versa

• FCF to the Firm Valuation Approach
 Focuses on the present value of the estimated future FCFs available to all supplies of capital after all expenses have been paid
 Using firm’s weighted average cost of capital
(WACC)
 FCF
F
= NI + D – Cap. EX. +/- ΔWC + I (1 – t) or FCF
F
= EBIT (1
– t) + D (t)
–
Cap. Ex. +/ΔWC

• FCF to Equity Valuation Approach
 Focuses on finding the present value of the estimated future FCFs available to equity holders after all expenses have been paid and all capital expenditures have been funded
 FCF
E
= FCF
F
– I (1-t) +/- Net Debt or FCF
E
= NI + D – Cap. Ex. +/- ΔWC +/-
Net Debt

• Appropriate when the company whose shares are being analyzed does not pay dividends, or if the company pays dividends, but dividends differ significantly from the company’s capacity to pay dividends

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