McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Stock Valuation – estimating growth and discount rates, plus a look at comparables Module 4.3

Estimates of Parameters  The value of a firm depends upon its growth rate, g, and its discount rate, R. Where does g come from? g = Retention ratio × ROE (eq 9.8) Payout Ratio = dividend per share / earnings per share Retention Ratio = 1 – dividend payout ratio

9-2 Digging into ROE  Please read this wikipedia link:  ROE is typically described as the product of three other ratios: net margin, asset turnover, and leverage. Net margin and asset turnover are typically deemed decent measures of managerial skill.  So, not ROEs are created equally. Warren Buffet likes firms that improve ROE by improving net margin and asset turnover (the first two ratios).

9-3 Where Does R Come From?  Asset pricing models like the CAPM (coming soon) or from our dividend growth model  The discount rate can be broken into two parts. The dividend yield The growth rate (in dividends)  In practice, there is a great deal of estimation error involved in estimating R AND g. If g is estimated from ROE, and ROE is based on accounting numbers, then you know there is a lot room for error!

9-4 Using dividend growth model (DGM) to Find R  Start with the DGM: Rearrange and solve for R, shows R as sum of dividend yield and growth rate : Dividend yield growth rate

Growth Opportunities  Growth opportunities are opportunities to invest in positive NPV projects.  The value of a firm can be conceptualized as the sum of the value of a firm that pays out 100% of its earnings as dividends plus the net present value of the growth opportunities.

9-6 NPVGO Model: Example Consider a firm that has forecasted EPS of $5, a discount rate of 16%, and is currently priced at $75 per share.  We can calculate the value of the firm as a cash cow.  So, NPVGO must be: $75 - $31.25 = $43.75

Comparables  Comparables are used to value companies based primarily on multiples.  Common multiples include: Price-to-Earnings Enterprise Value Ratios

9-8 Price-Earnings Ratio  The price-earnings ratio is calculated as the current stock price divided by annual EPS. The Wall Street Journal uses last 4 quarter’s earnings

9-9 PE and NPVGO  Recall,  Dividing every term by EPS provides the following description of the PE ratio:  So, a firm’s PE ratio is positively related to growth opportunities and negatively related to risk (R)

9-10 Enterprise Value Ratios  The PE ratio focuses on equity, but what if we want the value of the firm?  Use Enterprise Value: EV = market value of equity + market value of debt - cash  Like PE, we compare the value to a measure of earnings. From a firm level, this is EBITDA, or earnings before interest, taxes, depreciation, and amortization. EBITDA represents a measure of total firm cash flow  The Enterprise Value Ratio = EV / EBITDA

9-11 Common Stock Market Reporting Gap has been as high as $21.89 in the last year. Gap has been as low as $9.41 in the last year. Gap pays a dividend of 34 cents/share. Given the current price, the dividend yield is 3.1%. Given the current price, the PE ratio is 8 times earnings. 8,829,800 shares traded hands in the last day’s trading. Gap ended trading at $11.06, which is up 45 cents from yesterday.