1. 1 Solvay Business School – Université Libre de Bruxelles 1 Part 2 : Asset Valuation & Portfolio theory (6 hrs) 2.1. Case study 1 : buy side & sell side analysis of a large corporate – requirements 2.2. Financial statements analysis 2.3. Rating attribution process 2.4. Equity valuation models + exercises (20/10) 2.5. Portfolio modelling + exercises (27/10) Investments - Lecture n°4

2. 2 Solvay Business School – Université Libre de Bruxelles 2 Valuation - Introduction Different views : Intrinsic values - based on present and on expected values. Replacement cost of assets (Tobin’s q) - based on past book value, even corrected Three equivalent models based on intrinsic value: 1. DDM : Dividend Discount Model 2. ECM : Earning Capital Model 3. FCF : Free Cash Flows

3. 3 Solvay Business School – Université Libre de Bruxelles 3 1. Dividend Discount Model (DDM) Definition : Intrinsic value of a stock = sum of expected future dividends, actualised at a rate k Several main parameters / uncertainties: Firm parameters : Profit of the firm :  Payout ratio : (1-b) leading to : Dividend amount : D = . (1-b) Growth rate of dividend : g, such as : D t+1 = (1+g). D t

4. 4 Solvay Business School – Université Libre de Bruxelles 4 1.2. DDM - Parameters Market parameters : Risk-free interest rate (r f ) Equity premium of the stock (r i – r f )  leading to : discount rate k k = discount rate of capital, linked to the risk of the asset = market capitalisation rate Determination of k : - key point - key difficulty

5. 5 Solvay Business School – Université Libre de Bruxelles 5 1.2. DDM - Parameters In case of equity : k = r = expected return of the share = div 1 + (P 1 - P 0 ) P 0 ! k is Supposed to be constant over time (strong hypothesis) It implies : - stability of the risk-free rate - stability of the risk premium - stability of beta by : k i =  i. (r p – r f ) + r f (CAPM)

6. 6 Solvay Business School – Université Libre de Bruxelles 6 1.3. DDM - Simple Form a) We have, if D is constant (Zero-Growth Model) b) If D is supposed to grow at a constant rate “g” over time, with: D t+1 =(1+g). D t. The value of the equity of the firm becomes (Constant Growth Model) - “Gordon - Shapiro” model :

7. 7 Solvay Business School – Université Libre de Bruxelles 7 By : we have : "Discounted cash-flow formula" (DCF) Mean to infer k (without portfolio modelling) if the stock trades at intrinsic value. k = required return by the market for a given stock. It can be computed by observing the dividend yield and by estimating the growth rate of dividends. 1.4. Inferring k

8. 8 Solvay Business School – Université Libre de Bruxelles 8 1.5. DDM - Implications (1) 1. The Constant Growth Model implies that a stock's value will be greater:  The larger its dividend per share (d) - High yield  The higher the expected growth rate of dividends (g) - High growth  The lower the market capitalisation rate (k) - Low risk

9. 9 Solvay Business School – Université Libre de Bruxelles 9 1.5. DDM - Implications (2) 2. The stock price is expected to grow at the same rate as dividends, g: g = growth rate of earnings,but, since dividends are proportional to earnings (hyp. of the model) then g = also the growth rate of dividends Concept check : What if dividends are not proportional to earnings?

10. 10 Solvay Business School – Université Libre de Bruxelles 10 By the Gordon -Shapiro relation, g and k are key in the determination of P/E. -g : expected growth rate of earnings -k : discount rate of earnings We have : g = (ROE new investment) x (1-payout) Meaning : Growth of earnings = generation rate of income * retention ratio g = ROE * b(1) 1.6. ROE and g

11. 11 Solvay Business School – Université Libre de Bruxelles 11 By (1), we have : (2) Where : E 1 = expected earnings of the firm in the next period So : P 0 /E 1 rises when ROE rises And : P 0 /E 1 rises for higher levels of b, as long as : ROE > k So a firm should undertake a new investment only if ROE > k Meaning : if money is supposed to generate higher return if invested within the firm (on new projects) than on the status quo. 1.6. ROE and g

12. 12 Solvay Business School – Université Libre de Bruxelles 12 The firm is thus better to rise its retention ratio if its new investment projects yield more than what the firm remunerates its shareholders (k) => endogeneity of b, then ….. By (2), we have : if stocks trade at intrinsic value And we have :  V < E if ROE < k  V > E if ROE > k 1.6. ROE and g

13. 13 Solvay Business School – Université Libre de Bruxelles 13 1.7. Multiple Growth Model More complex version of DDM: multistage version for various values of g over time : Observe current D Estimate growth rate of D : stages 1 Estimate number of stages Estimate growth rate per stage Estimate payout ratio (at different stages) Formula :

14. 14 Solvay Business School – Université Libre de Bruxelles 14 Estimation of g of a limited number of years (N) The formula becomes : After a medium-term period (N) : reasonable to g estimate at the same expected growth rate of the economy. 1.7. Multiple Growth Model

15. 15 Solvay Business School – Université Libre de Bruxelles 15 If k = g V 0 = expected earning per share 12 mths (EPS) = E 1 k Earning Capitalisation Model Analysts estimate the stock value by multiplying their forecast of next years EPS by a P/E multiple derived by empirical rules. 2. Earning Capitalisation Model (ECM)

16. 16 Solvay Business School – Université Libre de Bruxelles 16 Remind: EPS ratio = 1/ (P/E ratio) = E/P = "earning yield" Note : High perspectives often lead to high P/E, but also paired with high prices -> do not confuse perspectives and valuations. Pitfalls of the use of P/E ratio P/E is based on accounting earnings => bias due to accounting rules Sensitive to business cycle. P/E often calculated on past accounting earnings rather than expected. 2. ECM & Price-Earning Ratio

17. 17 Solvay Business School – Université Libre de Bruxelles 17 Definition Where C 1 = FCF = Operating CF - taxes - investments = cash not retained or reinvested in the business. Dividends per share are the same as FCF per share. Modigliani-Miller (1958): no impact of the financing method of the firm over its value. MM showed also:DDM = Capitalised earnings = FCF approach to value a firm 3. Method of the Free Cash Flow (FCF)

18. 18 Solvay Business School – Université Libre de Bruxelles 18 What if ? The dividends distributed are very low? The firm is risky? The firm is mature? The firm is at a young development stage?... Valuation methods

19. 19 Solvay Business School – Université Libre de Bruxelles 19 First common view : No impact if D rises, as k and g rise at the same (inflation) rate : same growth rate of inflation "i" on all variables : no impact on real return. Diverging views: Economic shocks cause a simultaneous increase in nominal price and a decrease in real earning (and dividends). Negative correlation between inflation and firm value (Fama). Inflation introduces a greater uncertainty, so stocks are perceived to be riskier and k rises, so stock prices fall, or are lower than they should (Malkiel). 4. Impact of Inflation

20. 20 Solvay Business School – Université Libre de Bruxelles 20 Diverging views: Higher inflation leads to lower dividends for tax reasons due to lower after-tax real earnings (Feldstein). There is “money illusion”: nominal interest rate is perceived as real -> stocks are undervalued (k is overstated) in period of higher inflation (Modigliani and Cohn). ILLUSTRATION ING Valuation Model : see examples of graphs per sectors and per countries. 4. Impact of Inflation