Valuation by Comparables Chapter Summary Objective: To introduce fundamental stock analysis by describing different types of valuation models. Valuation by Comparables Intrinsic Value Versus Market Price Dividend Discount Models Earnings, Growth and Price-Earnings Ratios Free-Cash Flow Valuation

Fundamental Analysis: Models of Equity Valuation Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios Estimating Growth Rates and Opportunities

Financial Ratios from Statements Book value Revenue and income (growth) Valuation ratios (P/E, P/B, P/S, P/CF, PEG) Profitability measures Industry comparisons

Balance Sheet Relationships Accounting Equation B.V. (Equity) = B.V. (Assets) – B.V. (Debt) B.V. (Assets) = Liquidation value or Replacement value (Tobin’s q) Market Value M.V. (Equity) = M.V. (Assets) – M.V. (Debt) M.V. (Assets) = P.V. (Operating Income)

Limitations of Book Value Book value is an application of arbitrary accounting rules Can book value represent a floor value? Better approaches Liquidation value Replacement cost

Intrinsic Value Versus Market Price Summary Reminder Objective: to introduce fundamental stock analysis by describing different types of valuation models. Valuation by Comparables Intrinsic Value Versus Market Price Dividend Discount Models Earnings, Growth and Price-Earnings Ratios Free-Cash Flow Valuation

Intrinsic Value and Market Price Self assigned Value Variety of models are used for estimation Market Price Consensus value of all potential traders Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced

Intrinsic and Market Valuation Intrinsic Value = Exp. (future dividends and price of sale) discounted at RADR Single period V0 = [E(D1)+E(P1)] / (1+k) k = market capitalization rate V0 = n x P0 + B (equity + debt - market) Optng. Inc. = n x D + I (payments to equity and debt - intrinsic)

Dividend discount models Summary Reminder Objective: to introduce fundamental stock analysis by describing different types of valuation models. Valuation by comparables Intrinsic Value Versus Market Price Dividend discount models Earnings, growth and price-earnings ratios Free-cash flow valuation

Dividend Discount Models: General Model V0 = Value of Stock Dt = Dividend k = required return

Constant Growth Model g = constant perpetual growth rate

Constant Growth Model: Example E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86

DDM Implications The constant-growth rate DDM implies that a stock’s value will be greater: The larger its expected dividend per share. The lower the market capitalization rate, k. The higher the expected growth rate of dividends. The stock price is expected to grow at the same rate as dividends.

Estimating Dividend Growth Rates g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate = (1- dividend payout percentage rate)

Specified Holding Period Model PN = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held

Figure 16.1 Dividend Growth for Two Earnings Reinvestment Policies

Partitioning Value: Growth and No Growth Components PVGO = Present Value of Growth Opportunities E1 = Earnings per share for period 1

Partitioning Value: Example ROE = 20% d = 60% b = 40% E1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8%

Partitioning Value: Example (cont’d) Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities

Figure 16.2 Value Line Survey Report on Honda Motor

Estimating Honda’s Value Expected dividends for Honda: 2013 $.78 2015 $ .92 2014 $.85 2016 $1.00 g = ROE x b Since the dividend payout ratio is 25% and ROE is 10%, the “steady-state” growth rate is 7.5%.

Estimating Honda’s Value (cont’d) Honda’s beta is 0.95 and the risk-free rate is 2%. If the market risk premium is 8%, then k is given by: k = 2% + 0.95(8%) = 9.6% Therefore:

Estimating Honda’s Value (cont’d) Finally, Estimated value = $38.29 In 2012, one share of Honda Motor Company Stock sold for $32.88.

Summary Reminder Objective: to introduce fundamental stock analysis by describing different types of valuation models. Valuation by comparables Intrinsic Value Versus Market Price Dividend discount models Earnings, growth and price-earnings ratios Free-cash flow valuation

Price-Earnings Ratios and Growth P/E Ratios are a function of two factors Required Rates of Return (k) Expected growth in Dividends Uses Relative valuation Extensive Use in industry

Price-Earnings Ratio and Growth The ratio of PVGO to E / k is the ratio of firm value due to growth opportunities to value due to assets already in place (i.e., the no-growth value of the firm, E / k ).

P/E Ratio: No Expected Growth When PVGO = 0 E1 - expected earnings for next year E1 is equal to D1 under no growth P/E rises dramatically with PVGO. High P/E indicates that the firm has ample growth opportunities.

P/E Ratio with Constant Growth P/E increases: As ROE increases As plowback increases, as long as ROE>k b = retention ratio ROE = Return on Equity

PVGO and Growth The ratio of PVGO to E / k is the ratio of firm value due to growth opportunities to value due to assets already in place (i.e., the no-growth value of the firm, E / k ).

Numerical Example: No Growth E0 = $2.50 g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8

Numerical Example with Growth b = 60% ROE = 15% (1-b) = 40% k = 12.5% g = 9% E1 = $2.50 (1 + (.6)(.15)) = $2.73 D1 = $2.73 (1-.6) = $1.09 P0 = 1.09/(.125-.09) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 - .60) / (.125 - .09) = 11.4

Figure 16.3 Earnings Growth for Two Companies

ROE & Plowback vs. Growth & P/E

P/E and Growth Rate Wall Street rule of thumb: The growth rate is roughly equal to the P/E ratio. “If the P/E ratio of Coca Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.” Quote from Peter Lynch in One Up on Wall Street.

P/E Ratios and Stock Risk When risk is higher, k is higher; therefore, P/E is lower.

Pitfalls in P/E Analysis Use of accounting earnings Historical costs May not reflect economic earnings Earnings Management Choices of GAAP Reported earnings fluctuate around the business cycle

Figure 16.4 P/E Ratios and Inflation

Figure 16.5 Normalized Earnings per Share for CNQ and Magna

Figure 16.6 P/E Ratios for CNQ and Magna

Fig. 16.7 P/E Ratios for Different Industries 2012

Other Valuation Ratios Price-to-Book Price-to-Cash-Flow Price-to-Sales

Figure 16.8 Market Valuation Statistics

Summary Reminder Objective: to introduce fundamental stock analysis by describing different types of valuation models. Valuation by comparables Intrinsic Value Versus Market Price Dividend discount models Earnings, growth and price-earnings ratios Free-cash flow valuation

The Free Cash-Flow Approach Basis: the intrinsic value of a firm is the present value of all its net cash-flows to shareholders Estimate the value of the firm as a whole PV of cash-flows, with all-equity financing plus NPV of tax shields from using debt Value of equity = value of firm less market value of all non-equity claims

Free Cash Flow to the Firm Discount rate is the firm’s cost of capital Components of free cash flow After tax EBIT Depreciation Capital expenditures Increase in net working capital

Free Cash Flow to Equity FCFE = FCFF adjusted by A.T. interest expense and adjustments to net debt, or FCFE =FCFF  Interest expense  (1 tc) + Increase in net debt

Value of Firm and Equity Firm value = (FCFF + terminal value) capitalized at the WACC Equity value = (FCFE + terminal value) capitalized at the cost of equity Both terminal values are found from the constant growth model for equilibrium free- cash flows (V = CF / (k-g)

Comparing the Valuation Models In practice Values from these models may differ Analysts are always forced to make simplifying assumptions Problems with DCF Calculations are sensitive to small changes in inputs Growth opportunities and growth rates are hard to pin down

Comparing Valuation Models In practice Values from these models may differ Analysts are always forced to make simplifying assumptions Problems with DCF Calculations are sensitive to small changes in inputs Growth opportunities and growth rates are hard to pin down

Appendix Summary Objective: Recall the basic elements of the Dividend Discount Model. General model No-growth model Growth model and patterns

General Model V0 = Value of Stock Dt = Dividend k = required return

No Growth Model Stocks that have earnings and dividends that are expected to remain constant Preferred Stock

No Growth Model: Example E1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33

Constant Growth Model g = constant perpetual growth rate

Constant Growth Model: Example E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86