22-2

Valuation: Fundamental Analysis

• Fundamental analysis models a
company’s value by assessing its current
Equity Valuation Models and future profitability.
• The purpose of fundamental analysis is to
identify mispriced stocks relative to some
measure of “true” value derived from
financial data.

22-3 22-4

Models of Equity Valuation Valuation by Comparables

• Balance Sheet Models • Compare valuation ratios of firm to

• Dividend Discount Models (DDM) industry averages.
• Price/Earnings Ratios
• Free Cash Flow Models • Ratios like price/sales are useful for
valuing start-ups that have yet to
generate positive earnings.
 22-5 22-6

Limitations of Book Value Intrinsic Value vs. Market Price

• The return on a stock is composed of
• Book values are based on historical cost, dividends and capital gains or losses.
not actual market values.
• It is possible, but uncommon, for market E ( D1 )   E ( P1 )  P0 
value to be less than book value. Expected HPR= E (r ) 
P0
• “Floor” or minimum value is the liquidation
value per share.
• The expected HPR may be more or less
• Tobin’s q is the ratio of market price to than the required rate of return, based on
replacement cost. the stock’s risk.

22-7 22-8

Required Return Intrinsic Value and Market Price

• CAPM gives the required return, k: • The intrinsic value (IV) is the “true” value,
according to a model.
k  rf    E (rM )  rf  • The market value (MV) is the consensus
value of all market participants

• If the stock is priced correctly, k Trading Signal:

should equal expected return. IV > MV Buy
• k is the market capitalization rate. IV < MV Sell or Short Sell
IV = MV Hold or Fairly Priced
 22-9 22-10

Dividend Discount Models (DDM) Constant Growth DDM

D1 D2 D3
V0     ...
1  k 1  k  1  k 3
D0 1  g 
2
D
V0   1
• V0 =current value; Dt=dividend at
kg kg
time t; k = required rate of return
g=dividend growth rate
• The DDM says the stock price
should equal the present value of all
expected future dividends into
perpetuity.

22-11 22-12

Example 22.1 Preferred Stock and the

Example 22.2 Constant Growth DDM
DDM
• No growth case • A stock just paid an annual dividend of
$3/share. The dividend is expected to
• Value a preferred stock paying a
grow at 8% indefinitely, and the market
fixed dividend of $2 per share when
capitalization rate (from CAPM) is 14%.
the discount rate is 8%:
 22-13 22-14

DDM Implications Estimating Dividend Growth Rates

• The constant-growth rate DDM implies that a

stock’s value will be greater: g  ROE x b
1. The larger its expected dividend per share.
2. The lower the market capitalization rate, k. g = growth rate in dividends
3. The higher the expected growth rate of ROE = Return on Equity for the firm
dividends. b = plowback or retention percentage rate
• The stock price is expected to grow at the
(1- dividend payout percentage rate)
same rate as dividends.

22-15 22-16

Figure 22.1 Dividend Growth for Two

Present Value of Growth Opportunities
Earnings Reinvestment Policies
• The value of the firm equals the value
of the assets already in place, the no-
growth value of the firm,
• Plus the NPV of its future investments,
• Which is called the present value of
growth opportunities or PVGO.
 22-17 22-18

Present Value of Growth Opportunities Example 22.4 Growth Opportunities

• Firm reinvests 60% of its earnings in
• Price = No-growth value per share + projects with ROE of 10%,
PVGO capitalization rate is 15%. Expected
E1 year-end dividend is $2/share, paid out
P0   PVGO of earnings of $5/share.
k
• g=ROE x b = 10% x .6 = 6%

22-19 22-20

Example 22.4 Growth Opportunities Life Cycles and Multistage Growth Models

• Expected dividends for Honda:

2010 $.50 2012 $ .83
2011 $.66 2013 $1.00
• PVGO =Price per share – no-growth value per
share • Since the dividend payout ratio is
30% and ROE is 11%, the “steady-
state” growth rate is 7.7%.
 22-21 22-22

Honda Example Honda Example

• Honda’s beta is 0.95 and the risk-free rate • Finally,
is 3.5%. If the market risk premium is 8%,
then k is: $0.50 $0.66 $0.83 $1  $31.68
V2009    
• k=3.5% + 0.95(8%) = 11.1% 1.111 1.1112 1.1113 1.1114
• Therefore:
• In 2009, one share of Honda Motor
Company Stock was worth $23.04.

22-23 22-24

Price-Earnings Ratio and Growth Price-Earnings Ratio and Growth

• The ratio of PVGO to E / k is the ratio of • When PVGO=0, P0=E1 / k. The stock is
firm value due to growth opportunities to valued like a nongrowing perpetuity.
value due to assets already in place (i.e.,
the no-growth value of the firm, E / k ). • P/E rises dramatically with PVGO.

P0 1  PVGO 
 1 • High P/E indicates that the firm has ample
E1 k  E 
 k  growth opportunities.
 22-25 22-26

Table 22.3 Effect of ROE and Plowback on

Price-Earnings Ratio and Growth Growth and the P/E Ratio
• P/E increases:
– As ROE increases
– As plowback increases, as long as ROE>k

P0 1 b

E1 k  ROE x b

22-27 22-28

P/E and Growth Rate P/E Ratios and Stock Risk

• Wall Street rule of thumb: The growth rate

is roughly equal to the P/E ratio. • When risk is higher, k is higher;
therefore, P/E is lower.
• “If the P/E ratio of Coca Cola is 15, you’d expect
the company to be growing at about 15% per
year, etc. But if the P/E ratio is less than the P 1 b
growth rate, you may have found yourself a 
bargain.” E kg

Quote from Peter Lynch in One Up on Wall Street.

 22-29 22-30

Figure 22.3 P/E Ratios of the S&P 500

Pitfalls in P/E Analysis
Index and Inflation

• Use of accounting earnings

– Earnings Management
– Choices on GAAP
• Inflation
• Reported earnings fluctuate around the
business cycle

22-31 22-32

Figure 22.4 Earnings Growth for Two Figure 22.6 P/E Ratios for Different
Companies Industries, 2007
 22-33 22-34

Figure 22.7 Market Valuation

Other Comparative Value Approaches
Statistics
• Price-to-book ratio
• Price-to-cash-flow ratio
• Price-to-sales ratio

22-35 22-36

Free Cash Flow Approach Comparing the Valuation Models

• Value the firm by discounting free cash

flow at WACC. • In practice
• Free cash flow to the firm, FCFF, – Values from these models may differ
equals: – Analysts are always forced to make
After tax EBIT simplifying assumptions
Plus depreciation
Minus capital expenditures
Minus increase in net working capital
 22-37 22-38

Table 22.4 S&P 500 Price Forecasts Under

The Aggregate Stock Market Various Scenarios

• Explaining Past Behavior

• Forecasting the Stock Market