1. Lecture 16 Market Based Valuation & Justified Price Multiples Investment Analysis

2. Dividend Yield The dividend yield (D/P) is the ratio of the common dividend to the market price. It is most often used for valuing indexes. Advantages: – Dividend yield contributes to total investment return. – Dividends are not as risky as the capital appreciation component of total return. Disadvantages: – The focus on dividend yield is incomplete because it ignores capital appreciation. – The dividend displacement of earnings concept argues that dividends paid now displace future earnings, which implies a trade-off between current and future cash flows. Investment Analysis

3. Dividend Yield The total return on an investment has two components: dividend yield and capital appreciation. Dividend yield (D/P) is the ratio of trailing or leading dividend by current market price per share. Trailing D/P = 4 x most recent quarterly dividend / market price per share Leading D/P = forecasted dividends over next four quarters / market price per share ASSIGNMENT (Calculating Dividend Yield) XYZ Inc. just paid a dividend of $0.50 per share. The consensus forecasted dividend for XYZ Inc. over the next four quarters are $0.50, $0.55, $0.60 and $0.65. The current market price is $47.50. Calculate the leading and trailing dividend yield. Investment Analysis

4. Justified P/E Multiple The justified P/E price multiple is a P/E ratio with the “P” in the numerator equal to the fundamental value derived from a valuation model. The two most common forms are the leading P/E, which is based on the earnings forecast for next period and the trailing P/E, which is based on the earnings for the previous period. Both of these can be derived from DDM: D 1 / E 1 Justified-Leading-P/E= P 0 / E 1 = = 1-b / r-g r – g D 0 x (1+g)/E 0 Justified-Trailing-P/E= =(1-b) x (1+g) / r-g r-g By examining the formulas for justified (leading and trailing) P/E, we can conclude that the fundamental factors that affect P/E are expected growth rate and required return (which is related to risk). The justified P/E ratios are: – Positively related to the growth rate of expected cash flows, whether defined as dividends or free cash flows, all else equal. – Inversely related to the stock’s required rate of return, all else equal. Investment Analysis

5. Justified P/B Multiple Justified – Leading – P/B = ROE – g / r – g We can draw two useful conclusions from this formula concerning the fundamentals that influence the P/B ratio: – P/B increases as ROE increases, all else equal. – The larger the spread between ROE and r, all else equal, the higher the P/B ratio. This makes sense if you remember that ROE is the return on the firm’s investment projects and r is the required return. The larger the spread, all else equal, the more value the firm is creating through its investment activities and the higher is its market value as represented by “V0.” We can then use fundamental forecasts of ROE, r and g to find a value for this ratio. Investment Analysis

6. Justified P/S Multiple Given that net profit margin (PM) is equal to E0/S0, w can also restate the GGM as: Justified – P 0 /S 0 = (E 0 / S 0 ) x (1 – b) x (1 + g) / r –g Net profit margin (E 0 /S 0 ), thus influences P/S directly as well as indirectly through its effect on the sustainable growth, g: g = b x PM x (Sales / Assets) x (Assets / Shareholder’s equity) This means that the P/S ratio will increase, all else equal, if: – Profit margin increases – Earnings growth rate increases Investment Analysis

7. Justified P/S Multiple (cont’d …) We can also do a little algebra and solve P/S as a function of railing P/E, which might be an easier formula to remember: Justified P 0 /S 0 = (E 0 /S 0 ) x [(1-b) x (1+g) / r-g] = Net Profit margin x Justified Trailing P/E ASSIGNMENT (Question 2) A stock has dividend payout ratio of 40%, a return on equity (ROE) of 8.3%, an EPS of $4.25, sales per share of $218.75 and an expected growth rate in dividends and earnings of 5%. Shareholders require a return of 10% on their investment. Calculate the justified P/S multiple based on these fundamentals. Investment Analysis

8. Justified P/CF Multiple The justified price to cash flow based on fundamentals can be calculated by finding the value of the stock using a DCF model and dividing the result by the chosen measure of cash flow. For example, equity value using the single stage FCFF model: Justified P 0 /FCFE 0 = 1 + g / r – g P/CF will increase, all else equal, if: – Required return decreases – Growth rate increases Investment Analysis

9. Justified Dividend Yield The dividend yield relative to fundamentals may be expressed in terms of the GGM as: Justified D 0 / P 0 = r – g / 1 + g Dividend yield is: – Positively related to the required rate of return. – Negatively related to the forecasted growth rate in dividends. Investment Analysis