1. Chapter 13
Equity Valuation

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

3. 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

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

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

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

7. Constant Growth Model
g = constant perpetual growth rate

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

9. 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)

10. Shifting Growth Rate Model
g1 = first growth rate
g2 = second growth rate
T = number of periods of growth at g1

11. Shifting Growth Rate Model: Example
D0 = $ g1 = 20% g2 = 5%
k = 15% T = 3 D1 = 2.40
D2 = D3 = D4 = 3.63
V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 +
D4 / ( ) ( (1.15)3
V0 = = $30.40

12. 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

13. Partitioning Value: Growth and No Growth Components
PVGO = Present Value of Growth Opportunities
E1 = Earnings Per Share for period 1

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

15. Partitioning Value: Example
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities

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

17. 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

18. P/E Ratio with Constant Growth
b = retention ration
ROE = Return on Equity

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

20. 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