Five Forces
Chapter 11: Introduction to
Security Valuation
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0
Industry and Company Analysis
Overview of the Valuation Process
§ Two General Approaches
§ Top-down, three-step approach
§ 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
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Industry and Company Analysis
Overview of the Valuation Process
§ The Three-Step Top-Down Process
§ First examine the influence of the general
economy on all firms and the security
markets
§ Then analyze the prospects for various
global industries with the best outlooks in
this economic environment
§ Finally turn to the analysis of individual
firms in the preferred industries and to the
common stock of these firms.
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11-2
Industry and Company Analysis
Three-Step Valuation Approach
§ General Economic Influences
§ Fiscal policy initiatives, such as tax credits or tax cuts,
can encourage spending
§ Monetary policy though controlling money supply growth
or interest rate therefore affects all segments of an
economy and that economy’s relationship with other
economies
§ Inflation causes changes in the spending and savings
behavior of consumers and corporations
§ Other events such as war, political upheavals in foreign
countries, or international monetary devaluations exert
strong effects on the economies
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11-3
Industry and Company Analysis
Three-Step Valuation Approach
§ Industry Influences
§ Identify global industries that will prosper or
suffer in the long run or during the expected
near-term economic environment
§ Different industries react to economic
changes at different points in the business
cycle
§ Alternative industries have different
responses to the business cycle
§ Demographic factor and international
exposure will also have different impacts on
11-4
different types of industries
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Industry and Company Analysis
Three-Step Valuation Approach
§ Company Analysis
§ The purpose of company analysis to identify the best
companies in a promising industry
§ This involves examining a firm’s past performance, but
more important, its future prospects
§ It needs to compare the estimated intrinsic value to the
prevailing market price of the firm’s 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
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11-5
Industry and Company Analysis
Does the Three-Step Process
Work?
§ Studies indicate that most changes in an
individual firm’s earnings can be attributed to
changes in aggregate corporate earnings and
changes in the firm’s industry
§ Studies have also found a relationship
between aggregate stock prices and various
economic series such as employment,
income, or production
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11-6
Industry and Company Analysis
Exhibit 11.1
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10-7
Industry and Company Analysis
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:
§ The stream of expected returns, and
§ The required rate of return on the
investment
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Industry and Company Analysis
Theory of Valuation
§ Stream of Expected Returns
§ Form of returns
Valuation models exist to
handle each of these
§ Earnings
different types of cash
§ Cash flows
flows/returns
§ 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
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Industry and Company Analysis
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, Don’t
Buy
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11-10
Industry and Company Analysis
Valuation of Preferred Stock
§ Owner of preferred stock receives a promise
to pay a stated dividend, usually quarterly, for
perpetuity
§ Since payments are only made after the firm
meets its bond interest payments, there is
more uncertainty of returns
•
Dividend
V=
kp
V=
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$8
.09
Assume a preferred stock has a
$100 par value and a dividend of
$8 a year and a required rate of
return of 9 percent
= $88.89
11-11
Industry and Company Analysis
Valuation of Common Stock
§ Two General Approaches
§ Discounted Cash-Flow Techniques
§ Present value of some measure of cash
flow, including dividends, operating cash
flow, and free cash flow
§ Relative Valuation Techniques
§ Value estimated based on its price
relative to significant variables, such as
earnings, cash flow, book value, or sales
§ See Exhibit 11.2
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Industry and Company Analysis
Exhibit 11.2
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Industry and Company Analysis
Valuation of Common Stock
§ Both of these approaches and all of these valuation
techniques have several common factors:
§ All of them are significantly affected by investor’s
required rate of return on the stock because this
rate becomes the discount rate or is a major
component of the discount rate;
§ All valuation approaches are affected by the
estimated growth rate of the variable used in the
valuation technique
GIGO!
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Industry and Company Analysis
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
(sufficient number of comps)
§ aggregate market and company’s industry are not
at a valuation extreme (think 1999 tech bubble)
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LOS 33.a Compare/Identify
CFAI pg. 227, Schweser pg. 95
Discounted Dividends
Discounted Cash Flow Valuation
§ An asset’s intrinsic value is the present value
of its expected future cash flows.
¥ CF
t
V0 = å
t=1
t
(1+ r)
Very important
concept!
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LOS 33.a Compare/Identify
CFAI pg. 227, Schweser pg. 95
Discounted Dividends
Various Measures of Cash Flow
in Valuation
§ Measures of cash flow
§ Dividends = cash paid to shareholders, used
in DDM
§ Free cash flow = cash available to pay
shareholders, broader scope
§ Residual income = economic profit
§ Key point: Valuation metric (e.g., dividends or
FCF) must be measurable and related to
earnings power
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LOS 33.a Compare/Identify
CFAI pg. 227, Schweser pg. 95
Discounted Dividends
Dividends
§ Advantages
§ Less volatile than other cash flow measures
§ Theoretically justified – dividends are what you
receive when you buy a stock
§ Accounts for reinvested earnings to provide a
basis for increased future dividends
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LOS 33.a Compare/Identify
CFAI pg. 227, Schweser pg. 95
Discounted Dividends
Dividends
§ Disadvantages
§ Non-dividends paying firms
§ Dividends artificially small for tax reasons
§ Dividends may not reflect the control
perspective desired by the investor
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LOS 33.a Compare/Identify
CFAI pg. 227, Schweser pg. 95
Discounted Dividends
Dividends Suitability
§ Situations when appropriate
§ Company has history of paying dividends
§ Board of directors has a dividend policy that has
an understandable and consistent relationship to
profitability
§ Minority shareholder takes a non-control
perspective
§ Mature firms, profitable but not fast growth
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Five Forces
Is A DDM Appropriate?
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Five Forces
Solution….
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LOS 33.b Calculate/Interpret
CFAI pg. 233, Schweser pg. 98
Discounted Dividends
Dividend Discount Models
§ The Rule: Value is present value of all
future dividends discounted at required
return
¥
§ That is: V0 =
å
t =1
Dt
(1 + r )
t
The basic
model
§ Problem: Requires estimation of infinite
stream of CFs
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LOS 33.b Calculate/Interpret
CFAI pg. 233, Schweser pg. 98
Discounted Dividends
Multiple-Period DDM
§ Again the model takes the present value of all
future cash flows
V0 =
D1
Dn
+...
+
+
(1+ r)1
(1+ r)n (1+ r)n
n
V0 = å
Dt
t
(1+
r)
t=1
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Pn
+
Pn
(1+ r)n
24
Five Forces
Example: 2 Period DDM
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Five Forces
Solution
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LOS 33.c Calculate/Explain
CFAI pg. 236, Schweser pg. 101
Discounted Dividends
Gordon Growth Model
V0 =
D0 ´ (1 + g)
(r – g)
D1
=
(r – g)
e
h
t
h
t
i
w
l
u
f
e
r
a
!
c
s
t
p
i
Be
r
c
s
b
u
s
where:
D = dividend
g = sustainable growth rate
r = required return on equity
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27 - 1
LOS 33.c Calculate/Explain
CFAI pg. 236, Schweser pg. 101
Discounted Dividends
DDM: Constant Growth (Gordon)
Assumptions:
1. Dividend (D1) expected in one year
2. Dividends grow at constant rate (g) forever
3. Growth rate less than required return (r > g)
Situations in which model is useful:
1. Mature (late in life cycle) firms
2. Broad-based equity index
3. Terminal value in more complex models
4. International valuation
5. Can be used to calculate P/E ratio (SS 12)
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Five Forces
Perpetual Growth Rate Estimates
§ The Gordon Growth Model is very sensitive to small
changes in input values (r and g)
§ Perpetual growth rate (g) should bear a resemblance
to overall economic growth in a nation over a long
period of time
§ U.S. economy has historically grown at rates of
approximately 3.0%
§ Rates above 3% should be viewed as suspect in
nature!
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LOS 33.c Calculate/Explain
CFAI pg. 236, Schweser pg. 101
Discounted Dividends
DDM: Constant Growth (Gordon)
Example
§ Doug Inc.,:
§ Paid a dividend yesterday of $1.50
§ Dividends are expected to grow at a
long-term constant rate of 5%
§ Required return is 10%
§ Calculate the intrinsic value
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LOS 33.c Calculate/Explain
CFAI pg. 236, Schweser pg. 101
Discounted Dividends
Gordon Growth Model Example
§ Correct answer
V0 = ($1.50 × 1.05) / (0.10 – 0.05) = $31.50
§ Incorrect answer
V0 = ($1.50) / (0.10 – 0.05) = $30.00
The numerator was not increased by 5%
Be Careful!
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31 - 1
Five Forces
Gordon Growth Model Example
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Five Forces
Solution
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LOS 33.e Calculate/Interpret
CFAI pg. 246, Schweser pg. 103
Discounted Dividends
PV of Growth Opportunities
§ Equity value has two components:
1. Value of no growth firm (E1/r) (i.e.,
assets/earnings currently in place)
2. Present value of future growth
opportunities (PVGO)
§ Model:
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Five Forces
PVGO Thoughts
§ For growth oriented companies, a significant
amount of their total value is comprised of
future growth opportunities
§ In contrast, companies in low growth
industries (utilities) have low PVGO ratios, as
most of their value comes from assets in
place
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LOS 33.e Calculate/Interpret
CFAI pg. 246, Schweser pg. 103
Discounted Dividends
PV of Growth Opportunities
Example: ABV Inc., shares sell for $80.
Next year’s expected EPS = $4.00. If the
required return is 20%, compute the PVGO:
$4.00
$80 =
+ PVGO
0.20
PVGO = $80 – $20 = $60
Point: Market assigns 75% of the price
($60/$80) to future growth; expensive
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36 - 2
Five Forces
Multistage Models
§ Assumption of Gordon Growth Model for constant dividend
growth into perpetuity is unrealistic for most firms
§ Growth for most firms can be higher than GDP rates for a period
of time due to competitive advantages
§ But, ultimately, growth slows down over time to mimic growth in
overall economy
§ Multistage models are applicable to a wider range of firms
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LOS 33.i,j Explain/Justify
CFAI pg. 252, Schweser pg. 108
Discounted Dividends
Two-Stage DDM
§ Assumes stages of growth:
§ First: Fixed period of supernormal growth
§ Then: Indefinite growth at normal level
§ Useful in cases when growth rate is expected to
drop suddenly:
§ Patent expiration (pharmaceutical firm)
§ Firm enters mature phase of life cycle after a
rapid growth stage
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LOS 33.i,j Explain/Justify
CFAI pg. 252, Schweser pg. 108
Discounted Dividends
Two-Stage DDM
§ Problem: GGM constant g assumption unrealistic
§ Solution: Assume rapid growth for n years, then
long-term sustainable growth
§ Two-stage
assumes a
drop-off in
growth
Important!
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39 - 1
LOS 33.l,n Calculate/Interpret/Explain
CFAI pg. 252, Schweser pg. 113
Discounted Dividends
Application: The Two-Stage Model
§ Two stages of growth:
1. Initial high-growth phase
2. Perpetual stable-growth phase
§ Two approaches:
1. Formula
2. Timeline
§ Suggestion: Use the timeline (or
spreadsheet approach)—it provides the
flexibility to solve many types of problems
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Five Forces
Two Stage Model
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Five Forces
Two Stage Example
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Five Forces
Solution
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Five Forces
Time Line Method
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Five Forces
Time Line Method (Continued)
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LOS 33.l Calculate/Interpret
CFAI pg. 252, Schweser pg. 113
Discounted Dividends
The H-Model
§ Problem: Two-stage model assumes high growth
rate will suddenly drop
§ The H-model: More realistic assumption
§ Firm will start with high growth rate
§ Growth declines linearly over a transition period
T = “2H” years
§ Note: Only an approximation method; more
accurate the shorter the declining growth period
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LOS 33.i,j Explain/Justify
CFAI pg. 252, Schweser pg. 108
Discounted Dividends
The H-Model
§ Assumes a gradual decay in g as firm matures
over a transition period
Dividend
Growth (g)
3%
Stage 1
Stage 2
4 years
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Time
07-L2-MP2-SS12-S945
15%
47
LOS 33.l Calculate/Interpret
CFAI pg. 252, Schweser pg. 113
Discounted Dividends
The H-Model Formula
Short-term high
growth rate
Most recent
dividend
H = Transition period/2
é D0 ´ (1 + gL ) ù D0 ´ H ´ ( gS - gL )
V0 = ê
ú+
r - gL
r - gL
ë
û
Required return
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Long-term low
growth rate
48 - 5
LOS 33.l Calculate/Interpret
CFAI pg. 252, Schweser pg. 113
Discounted Dividends
Example: H-Model
§ Example – BTeam Inc.,:
§ Currently pays a dividend of $1.30
§ Stage one growth rate is 25%
§ Growth is expected to decay over five years
§ Constant growth rate of 5% thereafter
§ Required return is 14%
Calculate the intrinsic value of BTeam stock
using the H-Model.
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LOS 33.l Calculate/Interpret
CFAI pg. 252, Schweser pg. 113
Discounted Dividends
Solution: H-Model
(just memorize the formula; it’s not difficult!)
éëD0 × (1+ gL ) ùû + éëD0 ×H× ( gS – gL ) ùû
V0 =
r – gL
5
é
ù
éë$1.30 × (1.05 ) ùû + ê$1.30 × × ( 0.25 – 0.05 ) ú
2
ë
û
=
0.14 – 0.05
= $22.39
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50 - 1
LOS 33.i,j Explain/Justify
CFAI pg. 252, Schweser pg. 108
Discounted Dividends
DDM: Multi-Stage Models
Three-stage model: Two approaches
1. Three distinct phases, simply add an
additional growth stage to the two-stage
model
§ Growth, transition, and mature
2. High-growth phase + H-model pattern
§ High followed by linearly declining
followed by perpetual growth
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Five Forces
Three Stage DDM
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Five Forces
Three Stage Solution
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LOS 33.i Explain/Justify
CFAI pg. 252, Schweser pg. 108
Discounted Dividends
The Multi-Period Models
§ Strengths
§ Ability to model many growth patterns
§ Solve for V, g, and r
§ Weaknesses
§ Require high-quality inputs (GIGO)
§ Value estimates sensitive to g and r
§ Model suitability very important
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LOS 33.o Calculate/Interpret/Demonstrate
CFAI pg. 266, Schweser pg. 122
Discounted Dividends
SGR: The Sustainable Growth Rate
§ SGR (g) = sustainable growth rate in earnings
and dividends if we assume:
§ Growth uses internally generated equity
§ Capital structure remains unchanged
§ Several key ratios held constant
§ Formula:
g = retention rate (rr) × NI/SE
g = rr × ROE
SGR tells us how fast a firm can grow via internally generated funds
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LOS 33.o Calculate/Interpret/Demonstrate
CFAI pg. 266, Schweser pg. 122
Discounted Dividends
Calculating SGR
§ Example: Compute SGR for Green, Inc.:
§ Payout ratio = 25%
§ EPS = $1.00
§ BVPS is $10.00
§ ROE of 10%
SGR = Retention rate (rr) × ROE
SGR = (1 – DIV/EPS) × Net Inc./Equity
SGR = (1 – 0.25) × 10% = 7.5%
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Five Forces
Calculating SGR
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Five Forces
Calculating SGR: Solution
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Discounted Dividends
The Price-Cash Flow Ratio
§ Why Price/CF Ratio
§ Companies can manipulate earnings but
Cash-flow 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 = the price/cash flow ratio for firm j
Pt = the price of the stock in period t
CFt+1 = expected cash low per share for firm j
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11-59
Discounted Dividends
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
Pt
P
/
BV
=
§ The Formula
j
BV
t +1
where:
P/BVj = the price/book value for firm j
Pt = the end of year stock price for firm j
BVt+1 = the estimated end of year book value per share for firm j
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Discounted Dividends
Price/Book Ratio…..
§ Studies have indicated that an investment strategy
based on buying stocks with low P/B ratios relative to
their peers/market, has tended to perform reasonably
well.
§ Book value is useful for firms with consistent
accounting practices, and can be applied to firm’s
with negative earnings or cash flow.
§ However, the P/B ratio can’t be used to compare
firms across industries because asset intensity
varies dramatically (accounting firm versus
manufacturing firm).
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Discounted Dividends
Price/Book Value….
§ There are several factors that influence a firm’s P/B ratio.
§ ROE is one of the more important factors. Firms that can post
industry leading ROE figures tend to trade at a premium to the
market on a P/B basis.
§ Examining a firm’s P/B ratio over time can prove useful in evaluating
where a firm’s current valuation stands relative to past levels.
§ Also, compare to firms in the same industry as well, but look for
large differences in leverage ratios, as this can skew ROE.
§ P/B ratios are also influenced by overall market valuation trends as
well, so compare P/B relative to S&P
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Discounted Dividends
Berkshire Hathaway…..
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Discounted Dividends
The World’s Most Valuable Brands, According to Brand Finance
Brand value
accounts for
roughly half of
Google’s current
market cap!
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Discounted Dividends
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
P
P/Sj =
t
St +1
where: P/Sj = the price to sales ratio for Firm j
Pt = the price of the stock in Period t
St+1 = the expected sales per share for Firm j
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Discounted Dividends
Arguments for P/S
ØUseful for distressed firms
ØSales revenue hard to manipulate
ØP/S ratio less volatile than P/E
ØUseful for mature, cyclical, and zeroincome stocks
ØStudies show P/S explains difference in
LR average returns
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Discounted Dividends
Arguments Against P/S
ØSales do not imply profits
ØDoes not capture different cost
structures
ØRevenue recognition methods can
distort reported sales
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