1. comm 324 --- W. Suo Slide 1

2. comm 324 --- W. Suo Slide 2 Estimating Growth  Balance sheet  Historical  Analyst forecast

3. comm 324 --- W. Suo Slide 3 YearCal YEPS% ChangeLog(EPS) 119910.42-0.8675 219920.41-2.38-0.8916 319930.40-2.44-0.9163 419940.5845.00-0.5447 519950.6512.07-0.4308 619960.7210.77-0.3285 719970.8213.89-0.1985 819980.9313.41-0.0726 919991.0715.05-0.0667 1020001.2718.69-0.2390 Estimating Historical Growth: GE

4. comm 324 --- W. Suo Slide 4 Regression Models  Regression for EPS  Regression for log (eps)

5. comm 324 --- W. Suo Slide 5 Example  AMA growth rate in earnings per share = 13.79%  GMA growth rate in earnings per share = (1.27/0.42)1/9 -1 = 13.08%  Linear regression: EPS = 0.2033 + 0.0952*t R-square = 94.5% EPS increased 9.52 cent per year Growth rate in earnings per share = Coefficient on linear regression/Average EPS = 0.0952/0.727 = 13.10%  Log Linear regression: Log(EPS) = -1.1288 + 0.1335*t R-square = 95.8% Coefficient on the time variable can be viewed as a measure of compound percent growth in earning per share: earning grew at 13.35 per share.  Other more advanced models

6. comm 324 --- W. Suo Slide 6 Analyst Estimates of Growth  Who do analysts follow? Market cap Institutional holding Trading volume  Information Firm specific Macro =economic information that might impact future growth Competitors Private information about the firm public information other than earning  Quality of their forecasts?

7. comm 324 --- W. Suo Slide 7  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 Earnings, Growth and Price- Earnings Ratios

8. comm 324 --- W. Suo Slide 8 P/E Ratio  No Growth  With growth

9. comm 324 --- W. Suo Slide 9 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

10. comm 324 --- W. Suo Slide 10 E 1 = $2.50 (1 + (.6)(.15)) = $2.73 D 1 = $2.73 (1-.6) = $1.09 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 b = 60% ROE = 15% (1-b) = 40% k = 12.5% g = 9%

11. comm 324 --- W. Suo Slide 11 The Price Earnings Ratio  The Price-Earnings Ratio (PE) is often used to value stocks by Estimating EPS Estimating a PE ratio Multiplying the two to obtain an estimate of the share price

12. comm 324 --- W. Suo Slide 12 The Price Earnings Ratio

13. comm 324 --- W. Suo Slide 13 The Price Earnings Ratio

14. comm 324 --- W. Suo Slide 14 Analyzing the P-E Ratio  If the constant growth DDM is divided by EPS 1  Thus the P-E ratio has 3 primary determinants  A risk-adjusted discount rate of k > g As k increases the P-E ratio decreases  A growth rate, g As g increases the P-E ratio increases  A cash dividend payout ratio of D 1 /E 1 or (1 – b)

15. comm 324 --- W. Suo Slide 15 Analyzing the P-E Ratio As the payout ratio increases, g decreases and the P-E ratio is unaffected  This can also be demonstrated as

16. comm 324 --- W. Suo Slide 16 Battel Example  Reconsider the Battel example Battel’s D 0 = $2, g = 2%, k = 10%  stock price of $25.50 If we expect E 1 to be $3, Battel’s P-E ratio is 8.5

17. comm 324 --- W. Suo Slide 17 P-E Ratio  Many fundamental analysts multiply a stock’s EPS by the P-E ratio to estimate the stock’s price Can even use this method if the firm does not pay a dividend by imputing a payout ratio Can also use this procedure for stocks that do pay dividends  Can compare a stock price estimate obtained with the P-E ratio approach to the DDM approach The two methods will probably lead to similar values If the two values differ greatly, further analysis may enable the analyst to obtain a better estimate

18. comm 324 --- W. Suo Slide 18 P-E Ratios of Zero Dividend Stocks  Companies that pay no dividends, such as Microsoft, are problematic for DDM cash dividends are the only cash flow in the model  By reformulating the DDM in terms of earnings, this problem can be overcome Example: Microsoft’s average cost of equity is 40% (k); its growth rate is 36% and it has a P-E of 40. Based on this, we can impute a dividend payout ratio

19. comm 324 --- W. Suo Slide 19 Microsoft Example  The imputed dividend payout ratio of 160% suggests that market values $1 of Microsoft earnings at $1.60 Perhaps the market places a high value on Microsoft’s policy of retaining all earnings to finance growth

20. comm 324 --- W. Suo Slide 20 Example of Two Approaches  Given Coca-Cola paid a dividend in 1999 of $0.64 per share 1 – b = 65.3% EPS = $0.98 k = 20.7% per year for equity Growth of 19.7% in the annual dividend  Using the DDM, Coca-Cola’s stock is valued at

21. comm 324 --- W. Suo Slide 21 Example of Two Approaches  Using the P-E ratio approach, Coca-Cola is valued at

22. comm 324 --- W. Suo Slide 22 The k – g Spread  The denominator (k – g) in both the DDM and the P-E ratio approach plays an important role in stock valuation For instance, in the Coca-Cola example on the previous slide, k – g was 0.01 or 1% Regardless of the actual values of k or g, if the difference had been 1%, the value of Coca-Cola would have been the same  Further examination of the constant growth DDM shows that

23. comm 324 --- W. Suo Slide 23 The k – g Spread  This analysis shows that The stock’s k – g spread should equal the stock’s cash dividend yield (D 1 /P 0 ) Given that the S&P500 cash dividend yield has steadily decreased since 1983, the k – g spread should narrow, implying higher P-E ratios and a bullish stock market If S&P500 cash dividend yields continue to fall, the rate of capital gains (or g) must rise in order for k to remain constant If g rises, the implication is a bullish market

24. comm 324 --- W. Suo Slide 24 Analysis of Growth Investing  The DDM can be used to analyze growth stocks Suppose a firm will earn E 1 if it doesn’t buy any new assets If it retains earnings b*E 1 and buys a new asset it will grow at ROE  In year 2 the new asset will earn (ROE)*b*E 1 per year  After the first year the firm will again pay out all EPS as dividends  This firm can be valued as

25. comm 324 --- W. Suo Slide 25 Analysis of Growth Investing  The earnings in the numerator of that equation can be separated into Perpetual annual earnings from the old assets—EPS 1 Perpetual annual earnings from the new assets—ROE x RR x EPS 1 —that begin in year 2  The previous equation can be rewritten as

26. comm 324 --- W. Suo Slide 26 Analysis of Growth Investing  The Net Present Value (NPV) of an asset is defined as PV cash flows – cost of asset The NPV (at t=1) of the asset bought in year 1 is the PV of the perpetual cash flows less the new asset’s cost  In time 0 terms the NPV 0 is

27. comm 324 --- W. Suo Slide 27 Analysis of Growth Investing  Substituting the NPV of the new asset into the previous equation  If a firm buys new assets every year, the equation is reformulated as

28. comm 324 --- W. Suo Slide 28 Growth Stock Investing  Growth stocks have high growth rates in sales and earnings, and high P-E ratios Usually also have low cash dividend yields and high ROE  Empirical evidence suggests that in the long-run value stocks (low P-E, below average growth rates and high dividends) tend to outperform growth stocks Perhaps because growth firms retain earnings and invest in zero or negative NPVs Results in a larger firm, but no growth in PV of stock price  Above analysis suggests that security analysts should try to determine the profitability of firm's investment opportunities

29. comm 324 --- W. Suo Slide 29 Pitfalls in P/E Analysis  Use of accounting earnings Historical costs May not reflect economic earnings  Reported earnings fluctuate around the business cycle

30. comm 324 --- W. Suo Slide 30 The Free Cash-Flow Approach  Fundamental idea: 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 It equals the present value of cash-flows, assuming all- equity financing plus the net present value of tax shields created by using debt;  Derive the value of equity by subtracting the market value of all non-equity claims