1. Equity Valuation Models Chapter 18

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

3. Intrinsic Value - 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 Intrinsic Value and Market Price

4. V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model

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

6. E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 No Growth Model: Example

7. g = constant perpetual growth rate Constant Growth Model

8. E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / (.15 -.08) = $42.86 Constant Growth Model: Example

9. g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1- dividend payout percentage rate) Estimating Dividend Growth Rates

10. P N = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held Specified Holding Period Model

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

12. ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% g =.20 x.40 =.08 or 8% Partitioning Value: Example

13. V o = value with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example

14. 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 Price Earnings Ratios

15. E 1 - expected earnings for next year - E 1 is equal to D 1 under no growth k - required rate of return P/E Ratio: No Expected Growth

16. b = retention ratio ROE = Return on Equity P/E Ratio with Constant Growth

17. E 0 = $2.50 g = 0 k = 12.5% P 0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 Numerical Example: No Growth

18. b = 60% ROE = 15% (1-b) = 40% E 1 = $2.50 (1 + (.6)(.15)) = $2.73 D 1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P 0 = 1.09/(.125-.09) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 -.60) / (.125 -.09) = 11.4 Numerical Example with Growth

19. Pitfalls in P/E Analysis Use of accounting earnings - Historical costs - May not reflect economic earnings Reported earnings fluctuate around the business cycle

20. Inflation and Equity Valuation Inflation has an impact on equity valuations Historical costs underestimate economic costs Empirical research shows that inflation has an adverse effect on equity values - Research shows that real rates of return are lower with high rates of inflation

21. Potential Causes of Lower Equity Values with Inflation Shocks cause expectation of lower earnings by market participants Returns are viewed as being riskier with higher rates of inflation Real dividends are lower because of taxes