2. Valuation by Comparables
Chapter Summary
Objective: To introduce fundamental stock analysis by describing different types of valuation models.
Valuation by Comparables
Intrinsic Value Versus Market Price
Dividend Discount Models
Earnings, Growth and Price-Earnings Ratios
Free-Cash Flow Valuation

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

4. Financial Ratios from Statements
Book value
Revenue and income (growth)
Valuation ratios (P/E, P/B, P/S, P/CF, PEG)
Profitability measures
Industry comparisons

5. Balance Sheet Relationships
Accounting Equation
B.V. (Equity) = B.V. (Assets) – B.V. (Debt)
B.V. (Assets) = Liquidation value or
Replacement value (Tobin’s q)
Market Value
M.V. (Equity) = M.V. (Assets) – M.V. (Debt)
M.V. (Assets) = P.V. (Operating Income)

6. 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

7. Intrinsic Value Versus Market Price
Summary Reminder
Objective: to introduce fundamental stock analysis by describing different types of valuation models.
Valuation by Comparables
Intrinsic Value Versus Market Price
Dividend Discount Models
Earnings, Growth and Price-Earnings Ratios
Free-Cash Flow Valuation

8. 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

9. Intrinsic and Market Valuation
Intrinsic Value = Exp. (future dividends and price of sale) discounted at RADR
Single period V0 = [E(D1)+E(P1)] / (1+k)
k = market capitalization rate
V0 = n x P0 + B (equity + debt - market)
Optng. Inc. = n x D + I (payments to equity and debt - intrinsic)

10. Dividend discount models
Summary Reminder
Objective: to introduce fundamental stock analysis by describing different types of valuation models.
Valuation by comparables
Intrinsic Value Versus Market Price
Dividend discount models
Earnings, growth and price-earnings ratios
Free-cash flow valuation

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

12. Constant Growth Model
g = constant perpetual growth rate

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

14. DDM Implications
The constant-growth rate DDM implies that a stock’s value will be greater:
The larger its expected dividend per share.
The lower the market capitalization rate, k.
The higher the expected growth rate of dividends.
The stock price is expected to grow at the same rate as dividends.

15. 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)

16. 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

17. Figure 16.1 Dividend Growth for Two Earnings Reinvestment Policies

18. Partitioning Value: Growth and No Growth Components
PVGO = Present Value of Growth
Opportunities
E1 = Earnings per share for period 1

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

20. Partitioning Value: Example (cont’d)
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities

21. Figure 16.2 Value Line Survey Report on Honda Motor

22. Estimating Honda’s Value
Expected dividends for Honda:
2013 $ $ .92
2014 $ $1.00
g = ROE x b
Since the dividend payout ratio is 25% and ROE is 10%, the “steady-state” growth rate is 7.5%.

23. Estimating Honda’s Value (cont’d)
Honda’s beta is 0.95 and the risk-free rate is 2%. If the market risk premium is 8%, then k is given by:
k = 2% (8%) = 9.6%
Therefore:

24. Estimating Honda’s Value (cont’d)
Finally,
Estimated value = $38.29
In 2012, one share of Honda Motor Company Stock sold for $32.88.

25. Summary Reminder
Objective: to introduce fundamental stock analysis by describing different types of valuation models.
Valuation by comparables
Intrinsic Value Versus Market Price
Dividend discount models
Earnings, growth and price-earnings ratios
Free-cash flow valuation

26. Price-Earnings Ratios and Growth
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

27. Price-Earnings Ratio and Growth
The ratio of PVGO to E / k is the ratio of firm value due to growth opportunities to value due to assets already in place (i.e., the no-growth value of the firm, E / k ).

28. P/E Ratio: No Expected Growth
When PVGO = 0
E1 - expected earnings for next year
E1 is equal to D1 under no growth
P/E rises dramatically with PVGO.
High P/E indicates that the firm has ample growth opportunities.

29. P/E Ratio with Constant Growth
P/E increases:
As ROE increases
As plowback increases, as long as ROE>k
b = retention ratio ROE = Return on Equity

30. PVGO and Growth
The ratio of PVGO to E / k is the ratio of firm value due to growth opportunities to value due to assets already in place (i.e., the no-growth value of the firm, E / k ).

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

32. Numerical Example with Growth
b = 60% ROE = 15% (1-b) = 40%
k = 12.5% g = 9%
E1 = $2.50 (1 + (.6)(.15)) = $2.73
D1 = $2.73 (1-.6) = $1.09
P0 = 1.09/( ) = $31.14
PE = 31.14/2.73 = 11.4
PE = ( ) / ( ) = 11.4

33. Figure 16.3 Earnings Growth for Two Companies

34. ROE & Plowback vs. Growth & P/E

35. P/E and Growth Rate
Wall Street rule of thumb: The growth rate is roughly equal to the P/E ratio.
“If the P/E ratio of Coca Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.”
Quote from Peter Lynch in One Up on Wall Street.

36. P/E Ratios and Stock Risk
When risk is higher, k is higher; therefore, P/E is lower.

37. Pitfalls in P/E Analysis
Use of accounting earnings
Historical costs
May not reflect economic earnings
Earnings Management
Choices of GAAP
Reported earnings fluctuate around the business cycle

38. Figure 16.4 P/E Ratios and Inflation

39. Figure 16.5 Normalized Earnings per Share for CNQ and Magna

40. Figure 16.6 P/E Ratios for CNQ and Magna

41. Fig. 16.7 P/E Ratios for Different Industries 2012

42. Other Valuation Ratios
Price-to-Book
Price-to-Cash-Flow
Price-to-Sales

43. Figure 16.8 Market Valuation Statistics

44. Summary Reminder
Objective: to introduce fundamental stock analysis by describing different types of valuation models.
Valuation by comparables
Intrinsic Value Versus Market Price
Dividend discount models
Earnings, growth and price-earnings ratios
Free-cash flow valuation

45. The Free Cash-Flow Approach
Basis: the intrinsic value of a firm is the present value of all its net cash-flows to shareholders
Estimate the value of the firm as a whole
PV of cash-flows, with all-equity financing
plus NPV of tax shields from using debt
Value of equity = value of firm less market value of all non-equity claims

46. Free Cash Flow to 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

47. Free Cash Flow to Equity
FCFE = FCFF adjusted by A.T. interest expense and adjustments to net debt, or
FCFE =FCFF  Interest expense  (1 tc) + Increase in net debt

48. Value of Firm and Equity
Firm value = (FCFF + terminal value) capitalized at the WACC
Equity value = (FCFE + terminal value) capitalized at the cost of equity
Both terminal values are found from the constant growth model for equilibrium free- cash flows (V = CF / (k-g)

49. Comparing the Valuation Models
In practice
Values from these models may differ
Analysts are always forced to make simplifying assumptions
Problems with DCF
Calculations are sensitive to small changes in inputs
Growth opportunities and growth rates are hard to pin down

50. Comparing Valuation Models
In practice
Values from these models may differ
Analysts are always forced to make simplifying assumptions
Problems with DCF
Calculations are sensitive to small changes in inputs
Growth opportunities and growth rates are hard to pin down

51. Appendix Summary
Objective: Recall the basic elements of the Dividend Discount Model.
General model
No-growth model
Growth model and patterns

52. General Model
V0 = Value of Stock
Dt = Dividend
k = required return

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

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

55. Constant Growth Model
g = constant perpetual growth rate

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