CHAPTER 18 Equity Valuation

Models

Investments, 8th edition

Bodie, Kane and Marcus

Slides by Susan Hine

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Models of Equity Valuation

• Balance Sheet Models

– Book Value
• Dividend Discount Models
• Price/Earning Ratios

18-2
 Table 18.1 Financial Highlights for
Microsoft Corporation, October 25, 2007

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 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

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 Expected Holding Period Return

• The return on a stock investment comprises

cash dividends and capital gains or losses
– Assuming a one-year holding period

E ( D1 )   E ( P1 )  P0 
Expected HPR= E ( r ) 
P0

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 Required Return

• CAPM gave us required return:

k  rf    E (rM )  rf 

• If the stock is priced correctly

– Required return should equal expected
return

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 Intrinsic Value and Market Price
• 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

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 Specified Holding Period

V  D  1D 2
 ...  DH
P H

(1 k ) (1 k ) (1 k )

0 1 2 H

PH = the expected sales price for the stock at

time H
H = the specified number of years the stock is
expected to be held

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Dividend Discount Models: General
Model


Dt
Vo  
t  1 (1  k )
t

V0 = Value of Stock
Dt = Dividend
k = required return

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 No Growth Model

D
Vo 
k
• Stocks that have earnings and dividends
that are expected to remain constant
– Preferred Stock

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No Growth Model: Example

D
Vo 
k
E1 = D1 = $5.00
k = .15
V0 = $5.00 /.15 = $33.33

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 Constant Growth Model

Do (1  g )
Vo 
kg

g = constant perpetual growth rate

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Constant Growth Model: Example

Do (1  g )
Vo 
kg

E1 = $5.00 b = 40% k = 15%

(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86

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Estimating Dividend Growth Rates

g  ROE  b
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)

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Figure 18.1 Dividend Growth for Two
Earnings Reinvestment Policies

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Present Value of Growth Opportunities

• If the stock price equals its IV, growth rate is

sustained, the stock should sell at:
D1
P0 
kg

• If all earnings paid out as dividends, price

should be lower (assuming growth
opportunities exist)

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Present Value of Growth Opportunities
Continued
• Price = No-growth value per share + PVGO
(present value of growth opportunities)

E1
P0   PVGO
k

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 Partitioning Value: Example

ROE = 20% d = 60% b = 40%

E1 = $5.00 D1 = $3.00 k = 15%

g = .20 x .40 = .08 or 8%

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Partitioning Value: Example Continued
3
Vo   $42.86
(.15.08)
5
NGVo   $33.33
.15
PVGO  $42.86  $33.33  $9.52

Vo = value with growth

NGVo = no growth component value
PVGO = Present Value of Growth Opportunities

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 Life Cycles and Multistage Growth
Models
T
(1  g1 )t DT (1  g 2 )
P0  D0  
t 1 (1  k ) t
( k  g 2 )(1  k )T

• g1 = first growth rate

• g2 = second growth rate
• T = number of periods of growth at g1

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Multistage Growth Rate Model: Example

D0 = $2.00 g1 = 20% g2 = 5%
k = 15% T=3 D1 = 2.40
D2 = 2.88 D3 = 3.46 D4 = 3.63

V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 +

D4 / (.15 - .05) ( (1.15)3
V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

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Table 18.2 Financial Ratios in Two
Industries

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Figure 18.2 Value Line Investment
Survey Report on Honda Motor Co.

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 Price Earnings Ratios

• 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

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P/E Ratio: No Expected Growth

E1
P0 
k
P0 1

E1 k
• E1 - expected earnings for next year
– E1 is equal to D1 under no growth
• k - required rate of return

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P/E Ratio: Constant Growth

D1 E1 (1  b)
P0  
k  g k  (b  ROE )
P0 1 b

E1 k  (b  ROE )

b = retention ratio
ROE = Return on Equity

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Numerical Example: No Growth

E0 = $2.50 g=0 k = 12.5%

P0 = D/k = $2.50/.125 = $20.00

PE = 1/k = 1/.125 = 8

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 Numerical Example: Growth

b = 60% ROE = 15% (1-b) = 40%

E1 = $2.50 (1 + (.6)(.15)) = $2.73
D1 = $2.73 (1-.6) = $1.09
k = 12.5% g = 9%
P0 = 1.09/(.125-.09) = $31.14
PE = 31.14/2.73 = 11.4
PE = (1 - .60) / (.125 - .09) = 11.4

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Table 18.3 Effect of ROE and Plowback
on Growth and the P/E Ratio

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 P/E Ratios and Stock Risk

• Holding all else equal

– Riskier stocks will have lower P/E
multiples
– Higher values of k; therefore, the P/E
multiple will be lower
P 1 b

E kg

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 Pitfalls in P/E Analysis

• Use of accounting earnings

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

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Figure 18.3 P/E Ratios of the S&P 500
Index and Inflation

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Figure 18.4 Earnings Growth for Two
Companies

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Figure 18.5 Price-Earnings Ratios

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Figure 18.6 P/E Ratios for Different
Industries, 2007

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

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Figure 18.7 Market Valuation Statistics

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 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

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 Comparing the Valuation Models

• In practice
– Values from these models may differ
– Analysts are always forced to make
simplifying assumptions

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 The Aggregate Stock Market

• Explaining Past Behavior

• Forecasting the Stock Market

18-40
Figure 18.8 Earnings Yield of S&P 500
versus 10-Year Treasury-Bond Yield

18-41
Table 18.4 S&P 500 Price Forecasts
Under Various Scenarios

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