Chapter 10 Equity Valuation Tools

Chapter 10
Equity Valuation Tools
Portfolio Construction, Management, & Protection, 5e, Robert A. Strong
Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
“Things are different now.”
(The four most dangerous words in finance.)
 More
than 10,000 different listed stocks
 By simply buying a diversified portfolio
you could earn an average rate of return
 Who wants to be average?
 This chapter provides insight to:
• The source of stock value
• Why value changes
Stock as a Present Value
 Investors
price stock on the basis of
anticipated inflows
 Since dividends are the only cash reward for
investing, a popular valuation model is the
dividend discount model
Relationship of
World Exchanges (cont’d)
 International
capital markets continue to
show independent price behavior
• International diversification offers potential
• Repeating the Evans and Archer methodology
for international securities should result in a
lower level of systematic risk
Valuation of Apple Computer
Microsoft pays a $0.50 dividend. This is expected to grow
at a rate of 7%. The required rate of return is 10%.
Based on the dividend discount model, what is the value of
Microsoft’s common stock?
Valuation of Apple Computer (con’d)
Stock price =
Next dividend / Required return in Excess of anticipated
dividend growth rate
Stock price
= $0.50 (1.07) / [0.10 – 0.07]
= $0.535 / 0.03
= $18
Valuation of Apple Computer (con’d)
Small errors in estimation result in huge changes in
estimated stock price value!
Increase dividend growth rate by ten percent (to 7.7%)
Stock price = $0.50 (1.077) / [0.10 – 0.077]
= $0.5385 / 0.023
= $23.41
That is a 30% increase!
Accounting Versus Finance
 Account looks at past and present to
Where firm is (balance sheet)
How it got there (income statement)
 Finance looks at the future
Present Value of Growth
Present value equals
• Valuation of current earnings
– Assuming earnings and required return stay constant
• Present value of growth opportunities (PVGO)
This technique essentially identifies PVGO
 PVGO is estimated and less certain
 Hence, investors tend to prefer stocks with lower
PVGO values
Present Value of Growth
Abell Machines is priced at $34, had earning of $1.45 over
the past year, and a required return of 9.5 percent.
Bell Retailers is priced at $45, had earnings of $2.20 over
the past year, and a required return of 12.3 percent.
Which company has the lower PVGO value?
Present Value of Growth
Opportunities (con’d)
Hence, PV – E/K = PVGO
PVGO of Abell Machines:
$34 - $1.45 / 0.095 = $34 - $15.26 = $18.74
PVGO of Bell Retail:
$45 - $2.2/0.123 = $45 – 17.89 = $27.11
Since PVGO is uncertain, most investors would prefer Abell
Machines, despite its lower level of earnings
 Earnings
Before Interest, Taxes,
Depreciation and Amortization
 Tool: Stock price / EBITDA
 Seek firms with lower stock price/EBITDA
 Not as popular as others because firms may
claim expenses as investments in assets,
reducing EBITDA
Cash Flows
Changes in cash arising from business operations
 Tool: Stock Price/Operating cash flow
 Generally seek firms with lower ratios
 Modification:
 Use Free Cash Flow
• Operating cash flow less required investment in plant
and equipment
• Excess is money available to investors
PEG Ratios
 Price/earnings
ratio dividend by dividend
growth rate
 Investors seek PEG ratios less than 1.0
 Problems:
• Identifying earnings (Past? Forecast?)
• Identifying growth rate (1-year forecast?, 5year forecast?)
The Required Return
Real Portion:
• Return for saving instead of spending money
• Relatively stable in the 3-4 percent range
Inflation Adjustment:
• Reflects changes in general price level
• Relatively stable in the 3 percent range
Risk Premium:Depends on
– Firm conditions
– Overall economic conditions
Note: Small changes in any of these can result in large
changes in firm valuation
Changes in Stock Price
 Primary
Long-Term Driver of Change
• Earnings – or lack thereof
 Primary
Short-term Driver of Price Change
• Changes in investor sentiment
• Relatively stable in the 3 percent range
 Note:
Both are difficult to predict
Equity Risk Premium
 Extra
return on equity
• 8.4% higher than Treasury bills
• 6.7% higher than Treasury bonds
• In any year stocks could be lower
– After all, this is an equity “risk” premium
 Note:
Beta is multiplied by the equity risk
premium in the capital asset pricing model
Anticipated Equity
Risk Premium Changes
Forecasts suggest a diminishing equity risk
• One reason is the anticipated higher costs for raw
Note: The market sets these, not individual
• Though investors could sell shares not providing
sufficient returns
• The sale increases supply, reducing price, and
increasing returns to the buyer!
Greenspan Model
General indicator of whether the stock market is
over- or undervalued
 Mentioned in 1997 Federal Reserve Board
 Alan Greenspan was Chairman of the Federal
Reserve Board at that time
 Model: YieldU.S. Treasury note less P/ES&P 500
 Positive Result: Stock market overvalued
 Negative Result: Stock market undervalued
Changing PE Multiples
The amount individuals are willing to pay for a dollar of
earnings varies
Long-run average is 16
Varies over time
Returns will come from higher earnings and higher
price/earnings ratios
A companies earnings cannot be manipulated by investors
However, investors can buy firms with lower P/E ratios
• Yet, such firms are not expected to have as high a rate of earnings
• Hence, the lower price/earning ratio