Chapter 13 Equity Valuation Bodie, Kane, and Marcus Essentials of Investments Tenth Edition Valuation Approaches and Techniques Approaches to Equity Valuation Discounted Cash Flow Techniques Relative Valuation Techniques • Present Value of Dividends (DDM) • Price/Earnings Ratio (PE) •Present Value of FCFF •Price/Cash flow ratio (P/CF) •Present Value of FCFE •Price/Book Value Ratio (P/BV) •Price/Sales Ratio (P/S) Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2 Dividend Discount Models π·1 π0 = π−π π0 : the value of the stock π·1 : next period expected dividend π: is the required rate of return π: is the constant dividend growth rate Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 3 Dividend Discount Models-Use to Value • A stock paid a dividend of £1.50 a share last year which is expected to grow at a rate of 8.0% forever. If an investor requires a 12% return, what is the value of the stock today? D1 P0 ο½ rοg 1.50(1 ο« 0.08) ο½ ο½ £40.50 0.12 ο 0.08 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4 Dividend Discount Models-Use to Compute Implied Growth Rate • Suppose that the current price and the most recent dividend of Alco company are £24.25 and £1.10, respectively. If the required return on Alco is 8.5%, what is the implied growth rate π·0 (1 + π) 1.10(1 + π) π0 = = = £24.25 π−π (0.085 − π) • Rearranging 1.10 + 1.10π = 2.06125 − 24.25π Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 5 Dividend Discount Models Used to Compute Required Returns • For stock with market price = intrinsic value, expected holding period return • πΈ π = π·ππ£πππππ π¦ππππ + πΆππππ‘ππ πππππ π¦ππππ Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6 Dividend Discount Models • Dividends are appropriate as a measure of cash flow in the following cases: • The company has a history of dividend payments • The dividend policy is clear and related to earnings • The perspective is that of a minority shareholder Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7 Dividend Discount Models • You collected the following data on XXX Company. Determine whether the dividend discount model is an appropriate model to value XXX. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 8 Dividend Discount Models-Use to Compute Price Multiple We begin with the constant growth model: D1 P0 ο½ r οg Divide both sides of the equation by next year’s predicted earnings results in D1 / E1 P0 / E1 ο½ rοg This is the leading price to earnings ratio. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9 Dividend Discount Models-Use to Compute Price Multiple D1 / E1 P0 / E1 ο½ rοg • The primary determinants of a P/E ratio are the required rate of return and the growth rate. • The same factors that affect a stock’s price affect the stock P/E ratio Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10 Dividend Discount Models-Use to Compute Price Multiple You expect a firm to pay out 30% of its earnings as dividends. Earnings and dividends are expected to grow at a constant rate of 6%. If you require a 13% return on the stock, what is the stock’s expected P/E ratio? D1 / E1 0.3 P0 / E1 ο½ ο½ ο½ 4.3 rοg 0.13 ο 0.06 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 11 Dividend Discount Models-Use to Compute Price Multiple Recall that we estimated the P/E ratio in the previous example to be 4.3. If you forecast firm earnings next year of £2.75, what is the value of the stock today? P0 e P0 ο½ ( E1 ) ο½ 4.3(£2.75) ο½ £11.83 E1 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12 Present Value of Growth Opportunities • The value of an asset equals to the current earning stream divided by the required returns, plus the present value of growth opportunities (PVGO) πΈ1 π0 = + πππΊπ π πΈ1 no growth earning level Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 13 Present Value of Growth Opportunities • Suppose Matrix, Inc. share is trading at £60 with expected earning per share of £5 and that the required rate of returns on the company’s share is 10%. Assume that the company is correctly priced compute the PVGO and the portion of the P/E ratio related to PVGO? £60 = 5 + πππΊπ 10% πππΊπ = £10 π £60 = = 12 πΈ 5 π 10 πππΊπ = =2 πΈ 5 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 14 Strength and Limitations of Gordon Growth Model • Strengths: • Applicable to stable, mature dividend paying companies • Can be applied to indexes • Useful to compute implied growth rate, required rate of return and value of growth opportunities • Weaknesses • Valuations are very sensitive to growth and required returns estimates • Both are also difficult to estimate with precision • Cannot be applied to non-dividend paying stock • Unpredictable pattern of growth would make using difficult Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15 Dividend Discount Models • Life Cycles and Multistage Growth Models • Two-stage DDM • DDM in which dividend growth assumed to level off only at future date • Multistage Growth Models • Allow dividends per share to grow at several different rates as firm matures Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16 Dividend Discount Models: Two Stage Example • Consider the following information: • The firm’s dividends are expected to grow at g = 20% until t = 3 yrs. • At the start of year four, growth slows to gs= 5%. • The stock just paid a dividend Div0 = $1.00 • Assume a market capitalization rate of k = 12% • What is the price, P0, of this stock? D0 ο΄ (1 ο« g ) D0 ο΄ (1 ο« g )t D0 ο΄ (1 ο« g )t ο΄ (1 ο« g s ) P0 ο½ ο« ... ο« ο« (1 ο« k ) (1 ο« k )t (1 ο« k ) t ο΄ ( k ο g s ) D0 ο΄ (1 ο« .2)3 ο΄ (1 ο« .05) $1ο΄ (1 ο« .2) $1ο΄ (1 ο« .2) 2 $1ο΄ (1 ο« .2) 3 ο½ ο« ο« ο« (1 ο« .12) (1 ο« .12) 2 (1 ο« .12)3 (1 ο« .12)3 ο΄ (.12 ο .05) ο½ $1.07 ο« $1.15 ο« $1.23 ο« $18.45 ο½ $21.90 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 17 Getting the Needed Components • Use the CAPM Model ππ = π πΉπ + π½π (π π − π πΉπ ) • Use Factor models ππ = ππ + ππ1 πΉ1 + ππ2 πΉ2 + β― + πππΎ πΉπΎ Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 18 Getting the Needed Components Or build up approach 1. Real Risk Free rate (RRFR) : which is a function of the supply and demand for capital 2. Premium for expected inflation (IP): which compensated for loss of purchasing power 3. Risk premium (RP): which compensated the investors for the uncertainty about the return r = (1+RRFR)(1+IP)(1+RP)-1 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 19 Estimating Company Growth g The g represents the earnings and dividend growth rate in the constant growth model. g = (b)(ROE), where RR = earning retention ratio ROE = return on equity b = 1 – dividend pay out ratio ROE = (Profit Margin)(total asset turnover)(equity multiplier) Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 20 Estimating Growth - Problem • Use the following information about a firm to estimate the firm’s growth rate (g) • Dividend pay out ratio = 25% • Profit Margin = 3% • Equity multiplier = 2.2 • Total asset turnover = 1.8 ROE = (3%)(1.8)(2.2) = 11.9% b = (1 – 0.25) = 0.75 g = (0.75)(11.9%) = 8.9% Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 21 Price-Earnings Ratios • P/E Ratio for Firm Growing at Long-Run Sustainable Pace π0 • πΈ1 = 1−π π−(π ππΈ×π) Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 22 Effect of ROE and Plowback on Growth and P/E Ratio Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 23 Figure 13.6 P/E Ratios Residential construction Major airlines Tobacco products Telecom services Integrated oil & gas Auto manufacturers Water utilities Aerospace/defense Chemical products Food products Health care plans Asset management Money center banks Pharmaceuticals Cable TV Data storage Restaurants Home improvement Security software Application software 0 5 10 15 20 25 30 35 40 P/E ratio Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 24 Free Cash Flow Valuation Approaches • Free cash flow models are more appropriate: • If dividends are unrelated to earnings • Firm has no dividend payment history • free cash flows are associate with profitability • When the valuation perspective is that of a controlling shareholder Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 25 Free Cash Flow to the Firm (FCFF) Vs. Free Cash Flow to Equity Holders (FCFE) • FCFF is the cash available to all of the firm’s investors that includes shareholders and bondholders after the firm buys and sells products, provides services, pays its cash operating expenses and makes short and long term investments • FCFE is the cash available to common shareholders after funding capital requirements, working capital needs and debt financing requirements Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 26 Free Cash Flow Valuation Approaches • Free Cash Flow for Firm (FCFF) • πΉπΆπΉπΉ = πΈπ΅πΌπ 1 − π‘π + π·ππππππππ‘πππ − πΆππππ‘ππ ππ₯ππππππ‘π’πππ − πΌππππππ π ππ πππΆ • EBIT = Earnings before interest and taxes • π‘π = Corporate tax rate • NWC = Net working capital • Free Cash Flow to Equity Holders (FCFE) • πΉπΆπΉπΈ = πΉπΆπΉπΉ − πΌππ‘ππππ π‘ ππ₯ππππ π × 1 − π‘π + πΌππππππ ππ ππ πππ‘ ππππ‘ Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 27 Free Cash Flow Valuation Approaches • Estimating Terminal Value using Constant Growth Model • πΉπππ π£πππ’π = • ππ = 1+πΉπΆπΉπΉπ‘ π π‘=1 (1+ππ΄πΆπΆ)π‘ + ππ (1+ππ΄πΆπΆ)π πΉπΆπΉπΉπ+1 ππ΄πΆπΆ−π • WACC = Weighted average cost of capital Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 28 FCF Valuation Approaches: FCFF Example • Suppose FCFF = $1 mil for years 1-4 and then is expected to grow at a rate of 3%. Assume WACC = 15% T PT FCFF ο« t (1 ο« WACC )T t ο½1 (1 ο« WACC ) $1, 000, 000 ο΄ 1.03 4 $1, 000, 000 .15 ο .03 ο½ο₯ ο« (1 ο« .15)t (1 ο« .15) 4 t ο½1 ο½ $ 7, 762, 527 FirmValue ο½ ο₯ • If 500,000 shares are outstanding, what is the predicted price of this stock if the firm has $5,000,000 of debt? $7, 762, 527-$5,000,000 P0 ο½ ο½ $5.53 500, 000 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 29 Free Cash Flow Valuation Approaches • Market Value of Equity • ππππππ‘ π£πππ’π ππ πππ’ππ‘π¦ = • ππ = πΉπΆπΉπΈπ‘ π π‘=1 (1+π )π‘ πΈ ππ + (1+ππΈ )π πΉπΆπΉπΈπ+1 ππΈ −π Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 30 FCF Valuation Approaches: FCFE Example • Suppose FCFE = $900,000 for years 1-4 and then is expected to grow at a rate of 3%. Assume ke = 18% T PT FCFE Market Value of Equity ο½ ο₯ ο« t t (1 ο« k ) (1 ο« k ) t ο½1 e e $900, 000 ο΄ 1.03 4 $900, 000 .18 ο .03 ο½ο₯ ο« t (1 ο« .18) 4 t ο½1 (1 ο« .18) ο½ $ 2, 500,851 • If there are 500,000 shares outstanding, what is the predicted price of this stock? Why can debt be ignored? $ 2, 500,851 P0 ο½ ο½ $5.00 500, 000 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 31 Spreadsheet 13.2: FCF FCFF -521.0 5200.3 5444.8 Terminal value 5689.4 106504.6 FCFE 1160.0 2760.1 3050.2 3340.3 85210.4 C. Discount rate calculations 0.9 Current beta assumes fixed debt ratio after 2015 from Value Line Unlevered beta terminal growth tax_rate 0.686 0.025 0.35 current beta /[1 + (1-tax)*debt/equity)] r_debt risk-free rate 0.042 0.029 YTM in 2012 on A+ rated LT debt market risk prem MV equity Debt/Value from Value Line 0.08 57420 100940 Row 3 x Row 11 0.32 0.29 0.26 0.23 0.20 Levered beta k_equity 0.900 0.101 0.871 0.099 0.844 0.097 0.819 0.095 0.797 0.093 0.093 unlevered beta x [1 + (1-tax)*debt/equity] from CAPM and levered beta WACC PV factor for FCFF 0.077 1.000 0.078 0.928 0.078 0.860 0.079 0.797 0.080 0.738 0.080 0.738 (1-t)*r_debt*D/V + k_equity*(1-D/V) Discount each year at WACC PV factor for FCFE 1.000 0.910 0.830 0.758 0.694 0.694 Discount each year at k_equity -483 1056 4474 2291 4341 2313 4201 2318 78641 59136 Intrinsic val Equity val Intrin/share 91174 63674 35.37 67114 67114 37.29 D. Present values PV(FCFF) PV(FCFE) linear trend from initial to final value Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 32 Relative Valuation Techniques • Value can be determined by comparing 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 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 33 Question: Price Earning Ratio • Market data on M&S Fashions and Basic Designs Trailin Leading g P/E P/E 5 year Growth rate Beta M&S 10.0 8.7 11.0% 1.3 Basic Designs 14.0 12.7 9.0% 1.4 Peer Median 13.3 12.1 11.0% 1.3 • Evaluate the value and the P/E of each stock based on the method of comparable Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34 Price to Earnings Ratios in Valuation Reasons for using P/Es in valuation: • Earnings are the primary driver of stock value • P/Es are widely used and accepted by investors • Low P/E stocks may outperform in the long run on a relative basis Drawbacks: • Make no sense when EPS is negative • There is a volatile transitory component of EPS • Accounting choices affect P/Es Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35 Price to Book Value Ratio in Valuation Calculation • BV = shareholder’s equity • Ratio uses per share values or aggregate values Example: Don Corp. had BV of equity of £3.3 million in 2013 with 5 million shares outstanding. The firm’s stock sells for £12 per share. What is the firm’s P/BV ratio? BV per share = £3.3 mil / 5 mil shares = £0.66 P/BV = £12/ £0.66 = 18.2 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36 Question: Price to Book Value • Dell computer corporation competes in the personal computer industry. The table down shows its relative P/B Firm P/B Dell 10.14 Peer Mean 5.06 Peer Median 2.71 • Make an inference on Dell’s value? Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37 Rationale of P/B • Almost always positive, rarely negative • Stable and not volatile • Really suitable for banks and financial institutions where most assets are liquid • It is suitable to value companies going out of business • There is evidence that this ratio explains differences in long term returns Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 38 Shortcomings P/B • Intangibles are not adequately reflected • Can be misleading when the asset size of comparable firms depend on the business model • Difference in accounting standards and in their application may obscure the true investment made by shareholders • Inflation and technological change add more ambiguity Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 39 Price-to Sales Ratio in Valuation Price to sales ratios are: • Useful even for distressed firms as sales will be positive • More difficult to manipulate than EPS and BV • Less volatile than P/Es • Very useful for start ups (no earnings) and firms in mature or cyclical industries • Studies showed that P/S (like P/BV and P/E) are negatively related to long run average stock returns Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 40 Price to Sales Ratio in Valuation Drawbacks of P/S ratios: • High sales growth does not guarantee high operating profits • P/S ratio does not reflect different cost structures across firms • While less subject to accounting distortions than EPS and BV, revenue recognition methods can still distorts sales Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 41 Price to Sales Ratio in Valuation Calculation: ratio uses per share values or aggregate values Example: Don Corp. had 2013 sales revenue of £50 million and 5 million shares outstanding. The firm’s stock sells for £12 per share. What is the firm’s P/S ratio? Sales per share = £ 50 mil / 5 mill shares = £10 P/S = £12.00/£10.00 = 1.2 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 42 Price to Cash Flow in Valuation Advantages of Price to Cash Flow Ratios: • Cash flows are more difficult to manipulate than earnings • Widely used by institutional investors • P/CF is more stable than P/E • With CF, there is no problem with earning quality • Studies suggest that P/CF is negatively related to long run average stock returns Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 43 Price to Cash Flow in Valuation Drawbacks of P/CF • Using FCFE is theoretically preferable to CFO but it is more volatile • Many definitions of cash flows are used, analyst must ensure consistency Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 44 The Aggregate Stock Market • Forecasting Aggregate Stock Market • Earnings multiplier applied at aggregate level • Forecast corporate profits for period • Derive estimate of aggregate P/E ratio based on long-term interest rates • Some analysts use aggregate DDM Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 45 Earnings Yield of S&P 500 versus 10-Year Treasury Bond Yield 16% 14% Treasury yield 12% Earnings yield 10% 8% 6% 4% 2% Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2012 2009 2006 2003 2000 1997 1994 1991 1988 1985 1982 1979 1976 1973 1970 1967 1964 1961 1958 1955 0% 46 S&P 500 Forecasts Treasury bond yield Pessimistic Scenario 3.3% Most Likely Scenario 2.8% Optimistic Scenario 2.3% Earnings yield 6.5% 6.0% 5.5% Resulting P/E ratio 15.4 16.7 18.2 EPS forecast 134 134 134 Forecast for S&P 500 2,062 2,233 2,436 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 47
