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Chapter 13
Equity Valuation
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Good Company= Good stock?
Good Company
Bad Company
Cheap stock
Buy
Avoid
Expensive stock
Avoid
Sell
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Fundamental Stock Analysis: Models
of Equity Valuation
• Outline
– Balance sheet appoach
– Dividend Discount Models
• Constant dividend growth model
• Non-constant dividend growth model
– Price/Earning Ratio models
– Free Cash Flow(FCF) models
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Intrinsic Value and Market Price
• Intrinsic Value
– The present value of all future cash flows
– The true intrinsic value is not observable
– Variety of models are used for estimation
• Market Price
– Consensus value of current market participants
(buyers and sellers)
– Price of last stock market transaction
• Trading Signal
– IV > MP(discount, on sale) Buy
– IV < MP(too expensive) Sell or Short Sell
– IV = MP(fair) Hold
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Intrinsic Value and Market Price
• In the long-run, market price should
converge to intrinsic value
• Remember: value(intrinsic) is what you
get, price(market) is what you pay. Pay
less, get more!
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Balance Sheet Valuation
• A share of stock represents a slice of the
ownership( F assets are claims on real assets)
– Claims of Equity (on balance sheet)
• Book Value: net worth of a company as
reported on balance sheet
• However, BV and MV could be significantly
different
– BV represents past, while MV represents future
– Stocks are also Claims of future Earnings and
Dividends.
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Balance Sheet Valuation
• BV is still relevant in stock valuation
• Is BV a floor of stock price?
– BV(Equity)=Asset-Liability
– When MV is much lower than BV, the whole
company can be sold at a higher price than MV
– However, Asset can be overvalued (Goodwill). Net
tangible assets might be more useful.
– Examples: BBI
• Should I be concerned if MV/BV is too high?
– Rich evaluation invites competition
– Competition and Tobin’s Q (MV/replacement cost)
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Book value and stock price: reality
check
• Most stocks are sold at a price higher
than book value
• Researches show that, on average and
over long term, lower Price/Book stock
has higher return
– Higher Risk of low P/B stock
– Investors chasing glamour stock(high P/B)
stock
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Dividend Discount Models:
General Model

Dt
Vo  
t
t  1 (1  k )
• V0 = Value of Stock
• Dt = Dividend
• k = required return
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No Growth Model
D
Vo 
k
• Stocks that have earnings and dividends that
are expected to remain constant
• Preferred Stock
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No Growth Model: Example
D
Vo 
k
E1 = D1 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33
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Constant growth stock
• A stock whose dividends are expected to
grow forever at a constant rate, g.
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t
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Constant Growth Model
Do (1  g )
Vo 
kg
• g = constant perpetual growth rate
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What happens if g > ks?
• If g > ks, the constant growth formula
leads to a negative stock price, which
does not make sense.
• The constant growth model can only be
used if:
– ks > g
– g is expected to be constant forever
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What is the stock’s market value?
• K=13%
• D0 = $2 and g is a constant 6%,
• Using the constant growth model:
D1
$2.12
P0 

k s - g 0.13 - 0.06
$2.12

0.07
 $30.29
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What would the expected price
today be, if g = -5%?, if g=0?
• When g=-5% D1=1.9, P=1.9/(13%+5%)=10.56
• When g=0, The dividend stream would be a
perpetuity.
0
1
2
3
ks = 13%
...
2.00
2.00
PMT $2.00
P0 

 $15.38
k
0.13
^
2.00
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Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?
• Can no longer use just the constant growth
model to find stock value.
• However, the growth does become
constant after 3 years.
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Valuing common stock with
nonconstant growth
0 r = 13%
s
1
g = 30%
D0 = 2.00
2
g = 30%
2.600
3
g = 30%
3.380
4
...
g = 6%
4.394
4.658
2.301
2.647
3.045
46.114
54.107
^
= P0
P$ 3 
4.658
0.13  0.06
 $66.54
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Nonconstant growth:
What if g = 0% for 3 years before longrun growth of 6%?
0 k = 13% 1
s
g = 0%
2
g = 0%
D0 = 2.00
2.00 2.00
3
g = 0%
4
...
g = 6%
2.12
2.00
1.77
1.57
1.39
20.99
25.72
^
= P0
P$ 3 
2.12
0.13  0.06
 $30.29
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Practical problem with dividend model
• How to estimate g
– Using historical average
– When ROE and dividend payout ratio are
constant:
– Dividend growth rate=Return on Equity*plowback
ratio
– g=ROE* b
– Derive the relationship
» Dividend will grow the same rate as Earning
(constant dividend payout ratio)
» Earning will grow at the same rate as Equity
(constant ROE)
» Equity will grow at ROE*b
• How to estimate k
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Practical problem with dividend model
• Dividend model is forward looking.
Inputs are future dividends, which are
not observable
• Historical dividends and dividend growth
rate are not an accurate estimates of
future dividend growth rate
• Many companies are not paying
dividends
• For those who pay, dividend growth rate
can change dramatically overtime
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Price Earnings Ratios
• What is P/E
– P/E=current stock price/annual earning per share
– It measures how much investors are willing to pay
for $1 of current earnings
– If earning is constant, P/E measures the number
of years for investor to breakeven
– Earning yield, (E/P, the reverse/reciprocal of P/E)
measures your current return on investment
– From 1920-1990, P/E average is about 15
• Uses
– Relative valuation
– Extensive Use in industry
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The simple P/E approach
• Current(trailing) PE approach:
– Find E
– Assign a reasonable P/E ratio
– P=E*assigned P/E
• Forward PE approach
– Find forward E
– Assign a reasonable forward P/E ratio
– Price target in the future=forward
E*assigned forward P/E
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P/E=?
• P/E Ratios are a function of two factors
– Required Rates of Return (k)
– Expected growth in Dividends
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Pitfalls in Using PE Ratios
• Investors make fatal mistakes when:
– PE with abnormal once-only Es.
– PE with skewed E due to GAAP (AAPL
subscription treatment of iPhone revenue)
– Inflated PE: When earning is close to 0
– Negative PE
• Solution
– Normalized PE
– Forward PE (option vs. facts)
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Free Cash Flow (FCF):
• Def: Cash available to the firm (or equity
holder) net of capital expenditures.
• Idea: FCF is the cash shareholder
(investor) can withdraw from the
company without affecting its normal
operation and expansion
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FCF: Calculating
• FCFE=NI+Dep-Capital ExpenditureIncrease in NWC
• Practically: Cash Flow from Operating
Activity-Capital expenditure
• MV=PV of all Future FCF