Security Valuation Learning Objectives

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Security ValuationLearning Objectives

• 1. Top-down and Bottom-up Approaches to Security
  Valuation
• 2. Discounted Cash Flow Valuation Approach
• 3. Dividend Discount Model (DDM) and its Logic
• 4. Application of DDM to Value Supernormal Growth
  Firms.
• 5. Application of Relative Valuation Models

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The Investment Decision Process

• Determine the required rate of return
• Evaluate the investment to determine if its
  market price is consistent with your required
  rate of return
• Estimate the value based on expected cash flows
  and your required rate of return
• Compare this intrinsic value to the market price
  
• If Intrinsic Value gt Market Price, Buy
• If Intrinsic Value lt Market Price, Dont Buy

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Valuation Process

• Two approaches
• 1. Top-down, three-step approach
• 2. 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

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Top-down overview of the valuation process

• Economic Analysis
• Business cycles, government policy,
  indicators, trade, public
• attitudes, legislation, inflation, GDP
  growth, ect.

Industry Analysis Structure, supply-demand
relationships, quality and cost elements,
gov't. regulation, financial norms and
standards, et. cetera
Company Analysis Forecasts, balance
sheet--income statement analysis, flow-of-funds
analysis, accounting policy and
footnotes, management,research, return, risk
GE
Other stocks GM, Xerox, Caterpillar,
3M, Merck, Motorola, Delta, Intel.
Portfolio management
Portfolio Assets
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Does the Three-Step Process Work?

• An analysis of the relationship between rates of
  return for the aggregate stock market,
  alternative industries, and individual stocks
  showed that most of the changes in rates of
  return for individual stock could be explained by
  changes in the rates of return for the aggregate
  stock market and the stocks industry

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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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Stream of Expected Returns

• Form of returns
• Earnings
• Cash flows
• Dividends
• Interest payments
• Capital gains (increases in value)
• Time pattern and growth rate of returns

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Required Rate of Return

• Determined by
• 1. Economys risk-free rate of return, plus
• 2. Expected rate of inflation during the holding
  period, plus
• 3. Risk premium determined by the uncertainty of
  returns

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Valuation Approaches

• Two Approaches to Equity Valuation

Discounted Cash Flow Techniques
Relative Valuation Techniques

• Price/Earnings Ratio (P/E)
• Price/Cash flow ratio (P/CF)
• Price/Book Value Ratio (P/BV)
• Price/Sales Ratio (P/S)

• Present Value of Dividends (DDM)
• Present Value of Operating Cash Flow
• Present Value of Free Cash Flow

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Why and When to Use the Discounted Cash Flow
Valuation Approach

• The measure of cash flow used
• Dividends
• Cost of equity as the discount rate
• Operating cash flow
• Weighted Average Cost of Capital (WACC)
• Free cash flow to equity
• Cost of equity
• Dependent on growth rates and discount rate

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Why and When to Use the 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
• aggregate market is not at a valuation extreme

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Discounted Cash-Flow Valuation Techniques

• Where
• Vj value of stock j
• n life of the asset
• CFt cash flow in period t
• k the discount rate that is equal to the
  investors required rate of return for asset j,
  which is determined by the uncertainty (risk) of
  the stocks cash flows

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The Dividend Discount Model (DDM)-Infinite
Holding Period

• The value of a share of common stock is the
  present value of all future dividends

Where Vj value of common stock j Dt dividend
during time period t k required rate of return
on stock j
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The Dividend Discount Model (DDM)-Finite Holding
Period

• If the stock is not held for an infinite period,
  a sale at the end of year 2 would imply
• Selling price at the end of year two is the value
  of all remaining dividend payments, which is
  simply an extension of the original equation

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The Dividend Discount Model (DDM)-Constant Growth
Rate

• Infinite period model assumes a constant
• growth rate for estimating future dividends
• Where
• Vj value of stock j
• D0 dividend payment in the current period
• g the constant growth rate of dividends
• k required rate of return on stock j
• n the number of periods, which we assume to be
  infinite

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The Dividend Discount Model (DDM)-Constant Growth
Rate

• Infinite period model can be reduced to
• Where D1 is the expected dividend, defined as
• D1 D0 (1g)
• 1. Estimate the required rate of return (k)
• 2. Estimate the dividend growth rate (g)

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The Dividend Discount Model (DDM)-Constant Growth
Rate

• Assumptions of DDM
• 1. Dividends grow at a constant rate
• 2. The constant growth rate will continue for an
  infinite period
• 3. The required rate of return (k) is greater
  than the infinite growth rate (g)

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Required Rate of Return (k)

• Three factors influence an investors required
  rate of return
• The economys real risk-free rate (RRFR)
• The expected rate of inflation (I)
• A risk premium (RP)
• How to estimate k
• K Rf ? (Rm Rf)
• K Bond yieldERP

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Expected Growth Rate of DividendsROE Based

• Determined by
• the growth of earnings
• the proportion of earnings paid in dividends
• In the short run, dividends can grow at a
  different rate than earnings due to changes in
  the payout ratio
• Earnings growth is also affected by compounding
  of earnings retention
• g (Retention Rate) x (Return on Equity)
• RR x ROE

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Estimating Growth Based on History

• Historical growth rates of sales, earnings, cash
  flow, and dividends
• Three techniques
• 1. arithmetic or geometric average of annual
  percentage changes
• 2. linear regression models
• 3. long-linear regression models
• All three use time-series plot of data

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How to Calculate g

• Historical ROE and Payout
• Year Dividend g (1-Payout) x ROE
• 1.38 (1 - .50) x .16 8
• 1.49
• 1.67 Average of two methods 8
• 1.75
• g 8

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Infinite Period DDM and Growth Companies

• Growth companies have opportunities to earn
  return on investments greater than their required
  rates of return
• To exploit these opportunities, these firms
  generally retain a high percentage of earnings
  for reinvestment, and their earnings grow faster
  than those of a typical firm
• This is inconsistent with the infinite period DDM
  assumptions

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Valuation with Supernormal Growth

• Example The last dividend paid (D0) was 2.00.
  The required rate of return is 14 percent. The
  dividends are expected to grow at the following
  rates. What is the value of this stock?
• Year dividend
• 1-3
  25
• 4-6
  20
• 7-9
  15
• 10 on
  9

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Computation of Value for Stock of Company with
Supernormal Growth
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Operating Cash Flow Model

• Derive the value of the total firm by discounting
  the total operating cash flows prior to the
  payment of interest to the debt-holders
• Then subtract the value of debt to arrive at an
  estimate of the value of the equity

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Operating Cash Flow Model

• Where
• Vj value of firm j
• n number of periods assumed to be infinite
• OCFt the firms operating cash flow in period t
• WACC firm js weighted average cost of capital

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Operating Cash Flow Model

• Similar to DDM, this model can be used to
  estimate an infinite period
• Where growth has matured to a stable rate, the
  adaptation is

Where OCF1operating cash flow in period 1 gOCF
long-term constant growth of operating free
cash flow
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Operating Cash Flow Model

• Assuming several different rates of growth for
  OCF, these estimates can be divided into stages
  as with the supernormal dividend growth model
• Estimate the rate of growth and the duration of
  growth for each period

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Present Value of Free Cash Flows to Equity

• Free cash flows to equity are derived after
  operating cash flows have been adjusted for debt
  payments (interest and principle)
• The discount rate used is the firms cost of
  equity (k) rather than WACC

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Present Value of Free Cash Flows to Equity

• Where
• Vj Value of the stock of firm j
• n number of periods assumed to be infinite
• FCFt the firms free cash flow in period t
• K j the cost of equity

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Free Cash Flow to Equity Model

• FCFE NI Depreciation Capital Expenditure -
  ?Working Capital Principal Repayment New Debt
  Issues.
• If capital expenditures and working capital is
  expected to be financed at the target debt ratio
  (?) and principal repayment are made from new
  debt issues, FCFE can be written as
• FCFE NI (1- ?) (Capital Expenditure -
  Depreciation) (1- ?) ?Working Capital.

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Free Cash Flow to Equity Model

• FCF is a measure of what firm can payout as
  dividend. Dividend can be greater than or less
  than FCF and is influenced by
• Desire for stability
• Future Investment Needs
• Signaling Affect.
• P0 EFCE All assumptions about dividend
• (K g) valuation model apply.

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Relative Valuation Techniques

• Value can be determined by comparing to similar
  stocks based on relative ratios
• Relevant variables include
• Price/earnings
• Cash flow
• Book value
• Sales
• The most popular relative valuation technique is
  based on price to earnings

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Earnings Multiplier Model

• The infinite-period dividend discount model
  indicates the variables that should determine the
  value of the P/E ratio
• Dividing both sides by expected earnings during
  the next 12 months (E1)

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Earnings Multiplier Model

• As an example, assume
• Dividend payout 50
• Required return 12
• Expected growth 8
• D/E .50 k .12 g.08

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Earnings Multiplier Model

• A small change in either or both k or g will have
  a large impact on the multiplier
• D/E .50 k.13 g.08 P/E 10
• D/E .50 k.12 g.09 P/E 16.7
• D/E .50 k.11 g.09 P/E 25

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How to Estimate EPS

• Estimated EPS Net Income
• Shares Outstanding
• EPS can also be derived
• EPS ROE Book value per share
• EPS NI E NI
• E Shares Shares
• Where ROE Profit Margin Total Asset Turnover
  Equity Multiplier

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Earnings Multiplier Model

• Given current earnings of 2.00 and growth of 9
• You would expect E1 to be 2.18
• D/E .50 k.12 g.09 P/E 16.7
• V 16.7 x 2.18 36.41
• Compare this estimated value to market price to
  decide if you should invest in it

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The Price-Sales Ratio

• Strong, consistent growth rate is a requirement
  of a growth company
• Sales is subject to less manipulation than other
  financial data

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The Price-Sales Ratio

• Match the stock price with recent annual sales,
  or future sales per share
• This ratio varies dramatically by industry
• Profit margins also vary by industry
• Relative comparisons using P/S ratio should be
  between firms in similar industries
• Average stock price should encompass a long lime
  period

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The Price-Sales Model

• Price-to-Sales Model (10 year Average Price
  Ratios are assumed)
• Average Price/Average Sales Per Share
• 19.41/14.551.33 Price to sales ratio
• Vt P/S ratioEstimated SPS(t1)
• 1.3324.6532.78

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The Price-Cash Flow Ratio

• Companies can manipulate earnings
• Cash-flow is less prone to manipulation
• Cash-flow is important for fundamental valuation
  and in credit analysis
• Price-to-Cash Flow Model
• Average Price/Average Cash Flow Per Share
• 19.41/1.3714.17 Cash flow per share ratio
• Vt P/CFEstimated CFPS (t1)
• Vt 14.17 2.41 34.15

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The Price-Book Value Ratio

• Price-to-Book Value Model
• Average Price/Average book value per share
• 19.41/6.013.23 price to book value ratio
• Vt P/BVEstimated BVPS(t1)
• Vt 3.23 10.5 33.91

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The Price-Book Value Ratio

• Widely used to measure bank values (most bank
  assets are liquid (bonds and commercial loans)
• Fama and French study indicated inverse
  relationship between P/BV ratios and excess
  return for a cross section of stocks

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The Price-Book Value Model

• Price to Book Value Ratio
• 1. Po DPS1
• (K-g) where DPS1EPS(1g)payout
  ratio
• 2. Po EPSo Payout (1g)
• (K-g)
• - where EPSequity/shares
  NI/equityBVROE
• 3. Po BVo ROE Payout (1g)
• (K-g)

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Investment Valuation Models

• 4. Po PBV ROE Payout (1g)
• BVo (K-g)
• - i. if ROE depends on expected earnings, or
• - ii. If payout ratio remains constant 4 becomes
  5
• 5. P0 PBV ROE Payout
• BVo (K-g)
• - The relationship of
• - PBV increase? ROE increase
• - PBV increase ? Payout increase
• - PBV increase? g increase
• - PBV decrease? K increase

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Investment Valuation Models

• Formula can be simplified
• g ROE (1-payout)
• ROEPayout ROE - g
• PBV(ROE-g) / (k-g)
• Implications
• A) ROEgtk?PgtBV ROEltk?PltBV ROEk?PBV
• B) PBV decreases if k increases.
• C) Larger (R-k)? greater PBV