1 Chapter 10 Equity Valuation Tools Portfolio Construction, Management, & Protection, 5e, Robert A. Strong Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

2 “Things are different now.” (The four most dangerous words in finance.)

3 Introduction u More than 10,000 different listed stocks u By simply buying a diversified portfolio you could earn an average rate of return u Who wants to be average? u This chapter provides insight to: The source of stock value Why value changes

4 Stock as a Present Value u Investors price stock on the basis of anticipated inflows u Since dividends are the only cash reward for investing, a popular valuation model is the dividend discount model

5 Relationship of World Exchanges (cont’d) u International capital markets continue to show independent price behavior International diversification offers potential advantages Repeating the Evans and Archer methodology for international securities should result in a lower level of systematic risk

6 Valuation of Apple Computer Example Microsoft pays a $0.50 dividend. This is expected to grow at a rate of 7%. The required rate of return is 10%. Based on the dividend discount model, what is the value of Microsoft’s common stock?

7 Valuation of Apple Computer (con’d) Example Stock price = Next dividend / Required return in Excess of anticipated dividend growth rate Stock price= $0.50 (1.07) / [0.10 – 0.07] = $0.535 / 0.03 = $18

8 Valuation of Apple Computer (con’d) Example Small errors in estimation result in huge changes in estimated stock price value! Increase dividend growth rate by ten percent (to 7.7%) Stock price= $0.50 (1.077) / [0.10 – 0.077] = $ / = $23.41 That is a 30% increase!

9 Accounting Versus Finance Perspectives uAccount looks at past and present to determine: Where firm is (balance sheet) How it got there (income statement) uFinance looks at the future

10 Present Value of Growth Opportunities u Present value equals Valuation of current earnings –Assuming earnings and required return stay constant Present value of growth opportunities (PVGO) u This technique essentially identifies PVGO u PVGO is estimated and less certain u Hence, investors tend to prefer stocks with lower PVGO values

11 Present Value of Growth Opportunities Example Abell Machines is priced at $34, had earning of $1.45 over the past year, and a required return of 9.5 percent. Bell Retailers is priced at $45, had earnings of $2.20 over the past year, and a required return of 12.3 percent. Which company has the lower PVGO value?

12 Present Value of Growth Opportunities (con’d) PV = E/K + PVGO Hence, PV – E/K = PVGO PVGO of Abell Machines: $34 - $1.45 / = $34 - $15.26 = $18.74 PVGO of Bell Retail: $45 - $2.2/0.123 = $45 – = $27.11 Since PVGO is uncertain, most investors would prefer Abell Machines, despite its lower level of earnings

13 EBITDA u Earnings Before Interest, Taxes, Depreciation and Amortization u Tool: Stock price / EBITDA u Seek firms with lower stock price/EBITDA ratios u Not as popular as others because firms may claim expenses as investments in assets, reducing EBITDA

14 Cash Flows u Changes in cash arising from business operations u Tool: Stock Price/Operating cash flow u Generally seek firms with lower ratios u Modification: u Use Free Cash Flow Operating cash flow less required investment in plant and equipment Excess is money available to investors

15 PEG Ratios u Price/earnings ratio dividend by dividend growth rate u Investors seek PEG ratios less than 1.0 u Problems: Identifying earnings (Past? Forecast?) Identifying growth rate (1-year forecast?, 5- year forecast?)

16 The Required Return u Real Portion: Return for saving instead of spending money Relatively stable in the 3-4 percent range u Inflation Adjustment: Reflects changes in general price level Relatively stable in the 3 percent range u Risk Premium:Depends on –Firm conditions –Overall economic conditions u Note: Small changes in any of these can result in large changes in firm valuation

17 Changes in Stock Price u Primary Long-Term Driver of Change Earnings – or lack thereof u Primary Short-term Driver of Price Change Changes in investor sentiment Relatively stable in the 3 percent range u Note: Both are difficult to predict

18 Equity Risk Premium u Extra return on equity 8.4% higher than Treasury bills 6.7% higher than Treasury bonds In any year stocks could be lower –After all, this is an equity “risk” premium u Note: Beta is multiplied by the equity risk premium in the capital asset pricing model

19 Anticipated Equity Risk Premium Changes u Forecasts suggest a diminishing equity risk premium One reason is the anticipated higher costs for raw materials u Note: The market sets these, not individual investors Though investors could sell shares not providing sufficient returns The sale increases supply, reducing price, and increasing returns to the buyer!

20 Greenspan Model u General indicator of whether the stock market is over- or undervalued u Mentioned in 1997 Federal Reserve Board publication u Alan Greenspan was Chairman of the Federal Reserve Board at that time u Model: Yield U.S. Treasury note less P/E S&P 500 u Positive Result: Stock market overvalued u Negative Result: Stock market undervalued

21 Changing PE Multiples u The amount individuals are willing to pay for a dollar of earnings varies u Long-run average is 16 u Varies over time u Returns will come from higher earnings and higher price/earnings ratios u A companies earnings cannot be manipulated by investors u However, investors can buy firms with lower P/E ratios Yet, such firms are not expected to have as high a rate of earnings growth Hence, the lower price/earning ratio