Fundamental Valuation

Fundamental Analysis So, in addition to (or instead of) studying such charts, why not examine accounting data? Notions of Book Value, Liquidation Value, Replacement Value Book value is a historical cost, accounting notion. Liquidation value is like a market price that can be received for dumping assets. Replacement value is a market price at which roughly similar assets can be acquired. For a car rental company whose assets are largely a fleet of used cars, easily available market prices for second-hand vehicles makes the notion of replacement value easy to obtain. What about an oil rig? Comparables (relative) Valuation vs absolute valuation

Shiller P/E Ratio, S&P 500 till 2017

CCMRM efforts at a “good” India CAPE !

Valuation by Comparables- Example The Amazon Story: February 1999 to about now ESTIMATE 1 1. World market for books/CDs/videos = $100 B say Amazon gets 10% in 5 years (like Walmart) = $ 10 B   2. Net profit margin for retailers is 1-4% But Amazon will be like Dell at 7%, income= $700 M 3.Historically, slow growth firms have P/E of 10 Fast growth firms have P/E of 75 Amazon is fast growth so 75 * 700 = $ 53 B (market cap) 4. Shares outstanding 160 million so target price = 53000/160 = $ 332 per share ESTIMATE 2 Conservative profit margin forecast of 5%  Historically, retailers have a price to sales ratio of 2-3 times revenues (of $ 2 B)  Amazon will have 4 times Market cap of $ 8B.   Price = 8000/160 = $ 50 per share REAL SCENARIO Currently, 465 million shares priced at $ 370 per share Market cap = $ 170 B.

Intrinsic Value Vs Market Price How do prices adjust to intrinsic value? We saw one way with the risk-premium example and the CAPM Key things to stress Valuations are a long-term idea There are as many models as they are analysts Serious errors in valuation are driven more by the character of market data rather not accounting data They serve as due diligence (homework) Are more appropriate when large pools of capital are deployed Bias of models (Spring 2009 was a major buy signal)

Dividend (cash flow) discount models Cash flow data can be employed from any point on it, sales/EBITDA/Net Income/EPS/Dividends depending on which series is more reliable for the company at hand. Dividend Yield = Dividend/Price Dividend Payout = $ Dividends/$ Earnings (per share) Retention Ratio (b) = 1 – Payout Ratio Basic idea is that intrinsic value for a stock is the present value of all future cash flows discounted appropriately. Interaction between dividend (or other) payout policy, buybacks, price targets and analyst forecasts

Valuation of constant cash flows 0 1 2 3 4 ∞ Po 3 3 3 3 3 Compare Intrinsic Value(15) vs. Market Price ($35) DECISION: DO NOT BUY Typically used for preferred stock where dividend flows exist and are predictable. Realistic specification of dividend policy for common stock ? What if dividends tend to grow? Dividends (D) constant at $3 per share Required rate of return (k) = 20% Intrinsic value (Po) = 3/0.2 = $15 (Present value of the perpetuity) Formula= D/k

Valuation of cash flows which grows at constant rate Valuation of infinite cash flows assume that the dividends grow at a constant rate of ‘g’ Say dividends grow at constant rate g = 10% 0 1 2 3 4 ∞ Po 3 3.3 3.63 3 3.3 3.63 3 Intrinsic Value (Po) = ---------- + ---------- + ----------- + ……. = ------------ = $ 30 (1.20) (1.20)2 (1.20)3 (0.2-0.1)

Discount Rate Discount Rate (k) The k=20% discount rate is the rate of return that investors require to invest in the stock. Reverse formula as: k = (D1/P0) + g = (3/30) + 0.1= 20% P1 = D2/(k-g) = 3.3/0.1 = $33. (or price appreciates 10%) Realistic specification of dividend policy? Discount Rate (k) Dividend Income (10%) Capital Gain (10%)

Two stage growth models Expected Earnings E1 = $ 5 per share; Div. payout = 60%, D1 = 5 * 0.6 = 3; Required Rate of Return = 20% Assume: Earnings and dividends will grow at 10% per year for the next 3 years and then at 4% per year forever. 0 1 2 3 4 ∞ How to discount cash flows ? In two parts: a) first discount as constant growth till year 3 Po 3.0 3.3 3.63 3.78 (D4 = D3(1.04) = 3.78) b) then each cash flow upto year 3 3.0 3.30 3.63 23.625 a) P3 = 3.78/(.20-.04) = 23.625 b) P0 = ------ + ------- + ------- + --------- = $20.57 (1.20) (1.20)2 (1.20)3 (1.20)3 Multi-stage growth (3-stage model was popular at Lynch) Expectations investing: Can rework the model to judge rate of growth implied in current stock prices and then whether that rate of growth is likely to occur, and how long that rate of growth would have to persist, before making an investment decision.

Limitation of Dividend Discount Models Volatility of prices is more than the volatility of dividends k must be greater than g, otherwise model breaks down. What if no dividends are paid ? Use other cash flows, from operations, EBITDA, free cash flow? Where does g come from? Sustainable growth notion, compressed into g= ROE * retention rate.

Sustainable Growth Think of this g as an “equilibrium” or “target” growth rate. So, attempt to maintain all financial ratios at “optimal” levels. Any growth away from this sustainable growth causes imbalances. Beginning-of-year balance sheet Income statement CA 300 CL 200 Sales 1000 NFA 400 Debt 150 Cost of Goods 800 Equity 350 Earnings before tax 200 TA 700 TL 700 EAT 100 Dividends 30 Retained Earnings 70 For simplicity, assume full capacity, so that 10% growth requires a proportional increase in assets from 700 to 770. Financed only by retained earnings. Thus, end-of-year balance sheet will look like: End-of-year balance sheet CA 330 CL 200 NFA 440 Debt 150 Equity 420 (350 +70) TA 770 TL 770 Represents sales growth of 10% from previous year. Costs increase proportionately

Sustainable Growth Retained earnings provided all the funds needed to grow at 10%. More funds available from “spontaneous” sources i.e. CL. Not using them causes ratios to change. So, can possibly achieve more growth (above 10%) Suppose growth of 15% in sales (and assets) is possible and funds are also generated from CL and debt from 15% spontaneous growth. The end-of-year balance sheet will look like: End-of-year balance sheet CA 345 CL 230.0 Spontaneous NFA 460 Debt 172.5 liability change Equity 420.0 (350 +70) TA 805 TL 822.5 Now have too much money. Still more growth possible!  

Sustainable Growth Suppose growth of 20% in sales was reflected in the previous income statement. Asset levels now need to be 20% higher. End-of-year balance sheet CA 360 (300) CL 240 (200) NFA 480 (400) Debt 180 (150) Equity 420 (350) TA 840 (700) TL 840 (700) Notice that all the ratios remain unchanged! This 20% rate is the sustainable growth rate. It is the rate of growth that is manageable without resort to additional equity financing. Debt and current liabilities have increased “spontaneously.”