
A. Understand the relationship between intrinsic value and market value

B. Understand the various types of valuation models, including balance sheet, dividend discount models, and PE ratios

C. Understand other key metrics used in valuing securities

• What is intrinsic value?
• The present value of a firm’s cash flows discounted by the firm’s required rate of return
• What is the firm’s market value (or price)?
• The total value of a firm’s outstanding shares times its market price
•
In an efficient market, what should this relationship be?
• In a truly efficient market, the intrinsic value should equal its market value
• What happens if it doesn’t?

(continued)
 How do you identify mis-priced securities?
•
Determine the intrinsic or fair value of the security.
This can be done by many methods:
•
Models, i.e. CAPM, APT (E(r s
) = r f
+ b s
[E(r
M
) - r f
])
•
Fundamental analysis
• Balance sheet methods
• Dividend Discount Models (DDMs)
• Then you compare the fair value to the current price

(continued)
 Do all analysts look at companies the same way?
• No. If you have 30 analysts, you will generally have more than 60 sets of intrinsic values.
 How much is intrinsic value used in the real world?
• It is used much in terms of equity valuation and financial analysis. These have a more solid foundation and are not as affected by key assumptions
• It is not used as much with DDM’s and PV models, as slight changes in assumptions can have large changes in a company’s intrinsic value. Also these models assume a longer time frame generally.

(continued)
 If DD and PV models is not used as much in the real world, why are we learning them?
• The concepts are critical to understanding finance
•
It can add value in specific cases and companies
•
It can be used to support your recommendations from other models if assumptions are stated clearly

(continued)
 How do you determine Intrinsic Value?
•
It is a value assigned by the analyst
•
It is based on specific theories and assumptions
• Analysts use specific models for estimation
• Lots of models exist
• Remember, these models/assumptions are proxies for reality – not reality

(continued)
 What happens if the intrinsic value is greater than the market price?
•
Intrinsic Value > Market Price
• Buy
•
Intrinsic Value < Market Price
• Sell or Short Sell
•
Intrinsic Value = Market Price
• Hold or Fairly Priced or valued
•
These models are not as accurate as investors (or students) would like.
• They are more indicators than directors
•
It is more an art than a science!

 Do you understand the relationship between intrinsic value and market value or price?

 Fundamental Stock Analysis: Models of Equity
Valuation
•
Basic Types of Models
• 1. Balance Sheet Models
•
Book Value
• Liquidation Value
•
Replacement Value
• 2. Discounting Models
•
Free Cash Flow to the Firm (FCFF)
• Free Cash Flow to Equity (FCFE)
•
3. Dividend Discount Models
• 4. Price/Earning Ratios

• Balance sheet models assume that the intrinsic value of the firm is the value of its assets.
• What is the value of the firms assets?
•
Is it the value on the books?
•
Is it the value we could really get for the assets
(liquidation value)?
•
Is it the value we could get to replace the assets?

(continued)
 1.A. Book Value (per share)
Look at the book value: Equity / shares outstanding
Example: Ford
Assets 243,283 million
Liabilities 219,736 “
Owners Equity 23,547 “
Shares Outstanding 1,169 “
What is the Book Value per share?
$23,547/1,169 = Book value of $20.14 per share
Logic: the value of the assets should be equal to their value on the books.
Be careful as book value does not tell you depreciation methods or the true value of the assets
(they may be worthless)

(continued)
 1.B. Liquidation value (per share)
The amount of money realized by breaking up the firm, selling assets and repaying its debt
•
Company A has a market value of $250 million
(mn) with $50 mn in debt, cash of $150 mn and other assets likely worth $200 mn if sold today.
•
What is the liquidation value?
•
Liquidation value is the cash on hand and what they could liquidate the other assets for, I.e.
150+200-50 = $300 mn
• Logic: if market price falls below liquidation value, the firm becomes a takeover target as investors buy the company and sell it in pieces

(continued)
 1.C. Replacement Cost (per share)
The amount of money it would take to replace the tangible and intangible assets of a company
• Company B is a trucking company valued at $25 mn.
Since Company C takes 60% of the company’s business and is planning to expand, you know that its
CEO could replicate the trucking company for $20 million and build her own trucking division.
• What is the replacement cost for the trucking company? $20 million
• Logic: If the market value gets too high above the replacement cost, competitors would try to replicate the firm and entering competition would drive down the market value of all trucking firms.

(continued)
 1.D. Tobin’s q
It is the ratio of a firm’s market price to its replacement cost
In the long run, the market price to replacement cost will tend toward 1 as investors correctly value the replacement cost of the assets
But differences will remain over periods of time
Logic: Investors will be willing to purchase the company as long as the company’s market price is below the replacement cost. As soon as its price is greater than the replacement cost, competition will come in, dropping the price to close to its replacement cost.

 Discounting models assume the intrinsic value of the company is the present value of the firms’ expected future cash flows. It is useful when:
•
The company does not pay dividends
•
Dividends paid differs from what the firm could pay
•
Free cash flows align with profitability within a specific forecast period
•
The investor takes a control perspective

(continued)

2.A. Free Cash Flow to the Firm (FCFF)
• FCFF is the cash flow available to the company’s suppliers of capital after all operating expenses
(including taxes) are paid and working and fixed capital investments are made.
•
FCFF = cash prior to the payment of interest to the debt holders
FCFF = EBIT - taxes + depreciation (non-cash costs) – capital spending – increase in net working capital – change in other assets + terminal value
Discount this at the firm’s WACC
Firm Value = Operating free cash flow
WACC – growth
OFCF

(continued)
 2.B. Free Cash Flows to Equity (FCFE)
FCFE is the cash flow available to the company’s equity shareholders after all operating expenses, interest, and principle repayments have been made and necessary investments in working capital and fixed capital have been made
FCFE = Adjusts cash flows for debt repayments
FCFE = EBIT – interest - taxes + depreciation
(non-cash costs) – capital expenditures – increase in net working capital – principal debt repayments + new debt issues + terminal value.
Discount at k = required return on equity
Firm Value = Free Cash Flows to Equity/( k – growth
FCFE
)

(continued)
 Calculation Note for Discounting Models:
•
Determine the appropriate discount rate
•
Set up each of the individual cash flows
• Discount each of the individual cash flows
• Discount the final cash flow assuming a constant growth rate = cash flow / (k – g)
• The question remains whether the final cash flow representative of all future cash flows
• Sum all the discounted cash flows
• Make adjustments as required

 Models which take into account discounting expected future cash flows to gain a reference for the value of a company
• Dividend Discount Models
 General Model

Constant Growth Model

(continued)
V o
 t



1
( 1
D t
 k ) t
3.a. General Model
 V o
= Sum [D t
/(1+k) t ]
V
0
= Value of Stock
D t
= Dividend k = Required return

(continued)
 3.b. Constant Growth Rate Model
V o
= D o
(1+g)/(k-g)
This is for stocks that are growing at a constant growth rate (assumed for perpetuity) g = constant perpetual growth rate b = plowback or retention ratio (rr)
Note: take out the g and the formula becomes the no growth model
E
1
= $5.00 b = 40%
(1-b) = 60% k = 15%
D
1
= $3.00 g = 8%
V
0
= 3.00 / (.15 - .08) = $42.86

(continued)
 Estimating Dividend Growth Rates g = ROE x b
• g = growth rate in dividends
•
ROE = Return on Equity for the firm
• b = plowback or retention percentage rate
•
(1- dividend payout percentage rate)
• Internal Growth Rate (ROE x (1-payout)
• This is the rate that the company can continue to grow without any additional external financing
• Note: if the firm distributes all its earnings, there is nothing to allow the firm to continue to grow

(continued)
 More Changes to the DDM
•
What about growth opportunities?
•
Do those impact the value of the company?
• Does the DDM only look at dividends?
• What about earnings on specific projects?
• Can we fix the DDM to look at the value of new projects?
• There are a number of different DDM models that can handle each of these situations

(continued)



 The constant growth dividend discount model can be used for both for the valuation of companies and for the estimation of long-term total return of a stock.
Assume:
$20.00 = the price of a stock today, 8% = expected growth rate of dividends, and $0.60 = Annual dividend one year forward
A. Using only the data above, compute the expected long-term total return on the stock using the constant growth dividend discount model. Show calculations.
B. Briefly discuss two disadvantages of the constant growth dividend discount model in its application to investment analysis.
C. Identify two alternative methods to the dividend discount model for the valuation of companies

A. Expected Return = k = D1/Po + g = .60/20 +.08 =
11%
B. The model assumes that the dividend growth rate is forever constant. Therefore, the model cannot be applied to firms that currently do not pay dividends.
Second, the model is inappropriate when g > k
(which presumably cannot persist indefinitely).
Third, the model cannot handle firms with variable dividend growth paths.
C. One can use either P/E multiples or market-to-book multiples exhibited by other firms in the same industry.

 M & A Departments often use PE’s as one way of valuing companies. They find similar public companies to the ones they want to make public, they estimate their fair trading PE range, and then they apply the PE range to the new company.
•
The fair trading PE range times the EPS gives the price per share.

 In 1996 Montgomery Asset Management of
San Francisco California, a non-public company, was looking to be sold as its owner,
Montgomery Securities, needed cash to build up its other operations. Assume it had $10 billion in assets and earns $20 million in revenues per year. Assuming similar asset management companies were being sold at 8-
10 times earnings, what is MAM worth?

 Assuming an 8-10 range for PE, MAM would be worth between $160-200 million.

(continued)
 P/E Ratios are a function of two factors
•
Required Rates of Return (k)
• Expected growth in Dividends
 Uses
•
Valuation of new companies
•
Relative valuation versus market and industry
• Note: this is used extensively in the industry.
Research has found that low PE stocks have given a higher return to Investors than high PE stocks over the last 70 years

(continued)

•
Price Earnings = Price per share/Average Common diluted Earnings Per Share
•
Forward or Prospective PE = Current Price /
Forward EPS
•
Historic PE = Year-end Price/Year-end EPS
•
Normalized PE = Current Price/normalized earnings
(earnings adjusted to take into account the cycles in the economy)
• Earnings Yield (E/P) = 1 / Price Earnings

(continued)
 Benefits and Pitfalls of P/Es
 Benefits
•
Used extensively in the industry
• Generally low PE firms outperform high PE firms
 Pitfalls
• Earnings are accounting earnings, which can be manipulated through depreciation, inventory, etc.
• Earnings can fluctuate widely around a trend
•
You cannot know if the PE is high or low unless you compare it to a trend, to long-run growth prospects, to an industry, or to the market

(continued)
 P/E Ratio with no expected growth
P
0
= E
1
/ k
P
0
/ E
1
= 1 / k where:
• E
1
- expected earnings for next year
•
E
1 is equal to D payout)
1 under no growth (100%
• k - required rate of return

(continued)
 P/E Ratio with Constant Growth
P
0
= D
1
/ (k –g) = E
1
(1-b) / [ k – (b x ROE)
P
0
/ E
1
= (1 – b ) / [ k – (b x ROE)] where:
• b = earnings retention ratio
•
ROE = Return on Equity
•
Note: since we do not know what P
1 will be, the
EMH states that the best estimate of tomorrow’s price is today’s price, hence we use P
0 or today’s price

 Company XYZ has earnings per share this year of E
0
$2.50, growth of 0%, and a discount rate from the
=
CAPM of k = 12.5%. What should its PE be?


Answer:
•
With no growth (and 100% payout), the price of
XYZ would be P
0
= D/k = $2.50/.125 = $20.00.
•
Its PE would be PE = 1/k = 1/.125 = 8.0x or PE
= P
0
/EPS
1
= 20/2.50 = 8.0x
Note: PE is independent of currency, so there is no dollar sign in front of it. It is a ratio.

Company XYZ now is under new management, and they no longer distribute all their earnings as dividends, with b (or rr) = 60% ROE = 15% (1-b) = 40%. With EPS
0 this year of $2.50, k = 12.5%, calculate E
1
, D
1
, g, and their new PE ratio be?
Answer:
E
1
= $2.50 (1 + (.6)(.15)) = $2.73
D
1
= $2.73 (1-.6) = $1.09
g = 9% or .6 * 15%
P
0
= 1.09/(.125-.09) = $31.14
PE = 31.14/2.73 = 11.4x or
PE = (1 - .60) / (.125 - .09) = 11.4x
(generally format PE to one decimal point and place an “x” behind it)

 Explain why the following statements are true / false / uncertain.
• a. Holding all else constant, a firm will have a higher P/E if its beta is higher.
• b. P/E will tend to be higher when ROE is higher (assuming plowback is positive).
• c. P/E will tend to be higher when the plowback rate is higher.

a. False. Higher beta means that the risk of the firm is higher and the discount rate applied to value the cash flows is higher. For any expected path of earnings and cash flows the present value of the cash flows, and therefore, the price of the firm will be lower when risk is higher. Thus the ratio of price to earnings will be lower.
b. True. Higher ROE means more valuable growth opportunities.
c. Uncertain. The answer will depend on a comparison of the expected rate of return on reinvested earnings versus the market capitalization rate. If the expected rate of return on the firm’s projects is higher than the market capitalization rate, the P/E ratio will increase as the plowback ratio increases.





Even Better Products has come out with a new and improved product. As a result, the firm projects an
ROE of 20%, and it will maintain a plowback ratio of 0.30 or 30%. Its earnings this year will be $2 per share. Investors expect a 12% rate of return on the stock.
At what price and P/E ratio would you expect the firm to sell?
What is the present value of growth opportunities?
(Remember V
D
0
0
= E
1
(1+g)/(k-g) – E
1
/k + PVGO so PVGO =
/k)
What would be the P/E ratio and the present value of growth opportunities if the firm planned to reinvest only 20% of its earnings?

a.
b.
c.
Price and P/E ratio?
g = ROE x b = 20% x .30 = 6%
D
1
= $2(1-b) = $2(1 - .30) = $1.40
P
0
= D
1
/(k – g) = $1.40/(.12 - .06) = $23.33 so P/E =
23.33/2 =11.7x
Present value of growth opportunities?
PVGO = P
B = 20%
0
– EPS
0
/k = 23.33 – 2.00/.12 = $6.67
G = ROE x b = 20% x .20 = 4%
D1 = $2(1 – b) = $2(1 - .20) = $1.60
Po = D
1
10
/(k-g) = $1.60/(.12 - .04) = $20 P/E = 20/2 =
PVGO = P
0
– EPS
0
/K = 20 – 2.00/ .12 = $3.33

 Any questions on methods of equity valuation?


What are the key valuation metrics?
 PE, PBV, PS, DY, POCF, PEBIT, PEVITDA,
P/IGR, and P/EGR
 Why are they important?
 They relate the current market price to key profitability variables
 They relate the company’s PE ratio to certain types of growth

(PE=P/EPS)

PE Ratio
• The most common measures of a firm’s stock price relative to its earnings--what you are paying for $1 of earnings.
 How is it analyzed?
•
Versus its historical average
•
If lower that than its history, it may indicate it is moving into more attractive territory, i.e., growth is increasing
• Versus the market.
•
Gives a historical view. If it is trading at a lower relative PE, it may be becoming more attractive.
• Versus the industry
• If the relative PE versus the Industry is declining, it may indicate the stock is becoming more attractive.

(PB=P/BVS)


P/BV or PB or Market to Book
 Gives the relationship between the stock price and the book value of the firm (i.e. owners equity).
How it is analyzed?

If the PB ratio is high when compared to peer firms, the stock may be overvalued, all else being equal.

If the PB is negative, the firm is in serious trouble.

Remember that owners’ equity is based on accounting depreciation and may not have relevance to the actual value of the assets of the company.
 Generally, the higher the P/BV (or the lower its inverse, Book to Price) the more expensive the company.

(PS=P/SPS)



Price to Sales

Sales multiples are sometimes an indicator of growth in sales and hence future profits.
How it is analyzed?

Can be positive or negative
 Note that growth in sales translates into growth in profits only if the other drivers of profits are sustained, i.e. profit margins, turnover, etc.

New companies

New companies like PS ratios when they don’t have any earnings.
But if earnings fail to materialize, then PS ratios are irrelevant.
Generally, the lower the PS ratio, the more attractive the company, all else being equal

(DY=DPS/P)


Dividend Yield

Certain companies are known for their high dividend payouts

Historically we have seen an overall decline in the market’s dividend yield as firms decided that they could use dividend payouts more effectively in their own firms
How is it analyzed?

DY assesses the amount of dividend an investor will receive for his dollar if invested at the current share price.

A high dividend yield can be perceived as both positive and negative. Positively, as you have a return of capital; negatively, as the company has no better use for the funds

(POCF=P/OCFS)


Price to Operating Cash Flow

P/OCF is an important measure of a firm’s health
 It gives an assessment of the firm’s power to generate operating cash flow on a price per share basis
How is it analyzed?

Firms that are generating a high amount of cash are perceived to be more attractive than firms which are not generating cash

Generally, the lower the P/OCF the more attractive the firm

(PEBIT=P/EBITS)


Price to Earnings before Interest and Taxes

In evaluating firms which are potential takeover targets or which are not making earnings, analysts often use Price/EBIT, which they would use instead of Price Earnings (as there are not earnings).

This gives the relevant ratio assuming the firm had no other expenses, i.e. debts, taxes, etc.
 This was used in valuing the high-flying tech firms
How is it analyzed?
 Generally the lower the ratio, the more attractive the company

Be careful as this ratio says nothing about overall profits, but only operating earnings.

(PEBITDA=P/EBITDAS)


Price to Earnings Before Interest and Taxes and
Depreciation and Amortization

Used to put a price on firms which have no earnings but are generating cash and which may be attractive as acquisition candidates

P/EBITDA is similar to the Price/EBIT, except that it includes depreciation and amortization, which are non-cash charges
How is it analyzed?

Takeover firms are concerned with the amount of cash firms are generating assuming no other charges and taxes. Generally the lower the ratio, the more attractive the company

(PE/Internal Growth Rate or g)


PE to Internal Growth Rate (which is a proxy for a firm’s sustainable growth rate)

Used to relate a company’s PE to its sustainable growth rate
How is it analyzed?

A low PE stock with a high internal growth rate will have a low ratio, while a high PE stock with a low
IGR will have a high ratio.

Generally the lower the ratio, the more attractive the company .

(PE/EPS Growth)


Price Earnings to Earnings Growth

Another takeoff on the PE to growth ratio
 Sometimes used this as a screening device, only looking at companies whose PE divided by
Earnings growth rates are 1 or less
How is it analyzed?

Generally, companies are more attractive when this ratio is lower, as they have not only higher earnings, but those earnings are expected to growth in the near future.
 Can be very volatile due to the volatility of earnings per share growth

Due to volatility, some investors prefer the PE to
IGR above

 Do you have any questions on the various types of metrics used in valuing companies?

 Portfolio managers and analysts often compare a company’s Price Earnings ratio to measures of growth as indicators of value. Which of the two measures, PE to IGR or PE to EPS growth, will be more stable and why?

 The PE to IGR will be more stable as ROE is generally in the 5-35% range, and earnings per share growth can be anywhere from –100% to +200% depending on the company.

A.
Do you understand the relationship between intrinsic value and market value?
B.
Are you familiar with the various types of valuation models, including balance sheet, dividend discount models, and PE ratios?
C.
Do you understand other key metrics used in valuing securities?