1. Investment Management © 2008 Equity Valuation Models Lectured by Chandra Wijaya

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

3. 3 3 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

4. 4 4 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

5. 5 5 V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model

6. 6 6 Stocks that have earnings and dividends that are expected to remain constant. Preferred Stock No Growth Model

7. 7 7 E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 No Growth Model: Example

8. 8 8 g = constant perpetual growth rate Constant Growth Model

9. 9 9 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

10. 10 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

11. 11 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

12. 12 Dividend Growth for Two Earnings Reinvestment Policies

13. 13 PVGO = Present Value of Growth Opportunities E 1 = Earnings Per Share for period 1 Growth & No Growth Components of Value

14. 14 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. 15 V o = value with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example

16. 16 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

17. 17 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

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

19. 19 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

20. 20 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

21. 21 Effect of ROE and Plowback on Growth and the P/E Ratio

22. 22 Pitfalls in P/E Analysis Use of accounting earnings Historical costs May not reflect economic earnings Inflation Reported earnings fluctuate around the business cycle.

23. 23 P/E Ratios and Inflation

24. 24 Earnings Growth for Two Companies

25. 25 Price-Earnings Ratios

26. 26 Other Valuation Ratios Price-to-Book Price-to-Cash Flow Price-to-Sales

27. 27 Market Valuation Statistics

28. 28 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.

29. 29 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.

30. 30 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

31. 31 Categories of Stock Blue chip stock Income stocks Cyclical stocks Defensive stocks Growth stocks Speculative stocks Penny stocks

32. 32 Categories of Stock Blue Chip Stock Blue chip has become a colloquial term meaning “high quality” Some define blue chips as firms with a long, uninterrupted history of dividend payments The term blue chip lacks precise meaning, but some examples are: Coca-Cola Union Pacific General Mills

33. 33 Categories of Stock Income Stocks Income stocks are those that historically have paid a larger-than-average percentage of their net income as dividends The proportion of net income paid out as dividends is the payout ratio The proportion of net income retained is the retention ratio

34. 34 Categories of Stock Cyclical Stocks Cyclical stocks are stocks whose fortunes are directly tied to the state of the overall national economy Examples include steel companies, industrial chemical firms, and automobile producers

35. 35 Categories of Stock Defensive Stocks Defensive stocks are the opposite of cyclical stocks They are largely immune to changes in the macroeconomy and have low betas Examples include retail food chains, tobacco and alcohol firms, and utilities

36. 36 Growth Stocks Categories of Stock Growth stocks do not pay out a high percentage of their earnings as dividends and may be good candidates for above- average returns. They reinvest most of their earnings into investment opportunities Many growth stocks do pay dividends

37. 37 Categories of Stock  A speculative stock has a high probability of a loss and a small probability of a large profit. Most speculative stocks are relatively new companies with representation in the technology, bioresearch, and pharmaceutical industries  Penny stocks refer to unusually risky, especially inexpensive shares. Penny stocks sell for $1 per share or less

38. 38 Categories of Stock Categories Are Not Mutually Exclusive An income stock or a growth stock can also be a blue chip E.g., Potomac Electric Power Defensive or cyclical stocks can be growth stocks E.g., Dow Chemical is a cyclical growth stock