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Equity Valuation Models
Investments Cover image CHAPTER 18 Equity Valuation Models Slides by Richard D. Johnson McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
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Models of Equity Valuation
Balance Sheet Models Book Value Dividend Discount Models Price/Earning Ratios
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Table 18.1Financial Highlights for Microsoft Corporation, March 8, 2006
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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
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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
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Dividend Discount Models: General Model
V0 = Value of Stock Dt = Dividend k = required return
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No Growth Model Stocks that have earnings and dividends that are expected to remain constant. Preferred Stock
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No Growth Model: Example
E1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33
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g = constant perpetual growth rate
Constant Growth Model g = constant perpetual growth rate
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Constant Growth Model: Example
E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / ( ) = $42.86
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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)
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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
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Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies
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Partitioning Value: Example
ROE = 20% d = 60% b = 40% E1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8%
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Partitioning Value: Example
Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities
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Table 18.2 Financial Ratios in Two Industries
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Figure 18.2 Value Line Investment Survey Report on Hewlett Packard
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P/E Ratios are a function of two factors
Price Earnings Ratios 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
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P/E Ratio: No Expected Growth
E1 - expected earnings for next year E1 is equal to D1 under no growth k - required rate of return
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P/E Ratio with Constant Growth
b = retention ratio ROE = Return on Equity
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Numerical Example: No Growth
E0 = $ g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8
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Numerical Example with Growth
b = 60% ROE = 15% (1-b) = 40% E1 = $2.50 (1 + (.6)(.15)) = $2.73 D1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P0 = 1.09/( ) = $31.14 PE = 31.14/2.73 = 11.4 PE = ( ) / ( ) = 11.4
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Table 18.3 Effect of ROE and Plowback on Growth and the P/E Ratio
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Pitfalls in P/E Analysis
Use of accounting earnings Earnings Management Choices on GAAP Inflation Reported earnings fluctuate around the business cycle.
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Figure 18.3 P/E Ratios and Inflation
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Figure 18.4 Earnings Growth for Two Companies
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Figure 18.5 Price-Earnings Ratios
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Figure 18.6 P/E Ratios for Different Industries, 2006
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Other Comparative Value Approaches
Price-to-book ratio Price-to-sales ratio Price-to-cash-flow ratio
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Figure 18.7 Market Valuation Statistics
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Free Cash Flow Approach
Discount the free cash flow for 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
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Steps to Forecasting the Aggregate Market
Step 1: Forecast corporate profits Step 2: Estimate the earnings multiple using long-term interest rates Step 3: Product is the estimate for aggregate level
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Figure 18.8 Earnings Yield of S&P 500 versus 10-Year Treasury-Bond Yield
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Table 18.4 S&P 500 Forecasts Under Various Scenarios
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