1. CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cover image

2. 18- 2 Cover image  Balance Sheet Models –Book Value  Dividend Discount Models  Price/Earning Ratios Models of Equity Valuation

3. 18- 3 Cover image Table 18.1Financial Highlights for Microsoft Corporation, March 8, 2006

4. 18- 4 Cover image 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

5. 18- 5 Cover image  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

6. 18- 6 Cover image V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model

7. 18- 7 Cover image Stocks that have earnings and dividends that are expected to remain constant. Preferred Stock No Growth Model

8. 18- 8 Cover image E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 No Growth Model: Example

9. 18- 9 Cover image g = constant perpetual growth rate Constant Growth Model

10. 18- 10 Cover image 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

11. 18- 11 Cover image 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

12. 18- 12 Cover image 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

13. 18- 13 Cover image Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies

14. 18- 14 Cover image 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

15. 18- 15 Cover image V o = value with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example

16. 18- 16 Cover image Table 18.2 Financial Ratios in Two Industries

17. 18- 17 Cover image Figure 18.2 Value Line Investment Survey Report on Hewlett Packard

18. 18- 18 Cover image  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

19. 18- 19 Cover image  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

20. 18- 20 Cover image b = retention ratio ROE = Return on Equity P/E Ratio with Constant Growth

21. 18- 21 Cover image 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

22. 18- 22 Cover image 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

23. 18- 23 Cover image Table 18.3 Effect of ROE and Plowback on Growth and the P/E Ratio

24. 18- 24 Cover image Pitfalls in P/E Analysis  Use of accounting earnings –Earnings Management –Choices on GAAP  Inflation  Reported earnings fluctuate around the business cycle.

25. 18- 25 Cover image Figure 18.3 P/E Ratios and Inflation

26. 18- 26 Cover image Figure 18.4 Earnings Growth for Two Companies

27. 18- 27 Cover image Figure 18.5 Price-Earnings Ratios

28. 18- 28 Cover image Figure 18.6 P/E Ratios for Different Industries, 2006

29. 18- 29 Cover image Other Comparative Value Approaches  Price-to-book ratio  Price-to-sales ratio  Price-to-cash-flow ratio

30. 18- 30 Cover image Figure 18.7 Market Valuation Statistics

31. 18- 31 Cover image 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

32. 18- 32 Cover image 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

33. 18- 33 Cover image Figure 18.8 Earnings Yield of S&P 500 versus 10-Year Treasury-Bond Yield

34. 18- 34 Cover image Table 18.4 S&P 500 Forecasts Under Various Scenarios

35. 18- 35 Cover image Two Stage DDM