Chapter 18 Equity Valuation Fundamental Stock Analysis Models

Chapter 18 Equity Valuation

Fundamental Stock Analysis: Models of Equity Valuation • Basic Types of Models • Balance Sheet Models • Dividend Discount Models • Price/Earning Ratios • Estimating Growth Rates and Opportunities Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Dividend Discount Models: General Model • V 0 = Value of Stock • Dt = Dividend • k = required return Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

No Growth Model • Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

No Growth Model: Example E 1 = D 1 = $5. 00 k =. 15 V 0 = $5. 00 /. 15 = $33. 33 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Constant Growth Model • g = constant perpetual growth rate Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Constant Growth Model: Example E 1 = $5. 00 b = 40% k = 15% (1 -b) = 60% D 1 = $3. 00 g = 8% V 0 = 3. 00 / (. 15 -. 08) = $42. 86 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Estimating Dividend Growth Rates • g = growth rate in dividends • ROE = Return on Equity for the firm • b = plowback or retention percentage rate • (1 - dividend payout percentage rate) Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Estimating Growth via historical info. • Dividend in 2000 was $1. • Dividend in 2006 was $1. 80 • Growth is (1. 80/1)^(1/6)-1 = 10. 29% Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Specified Holding Period Model • PN = the expected sales price for the stock at time N • N = the specified number of years the stock is expected to be held Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Partitioning Value: Growth and No Growth Components • PVGO = Present Value of Growth Opportunities • E 1 = Earnings Per Share for period 1 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Partitioning Value: Example • ROE = 20% d = 60% b = 40% • E 1 = $5. 00 D 1 = $3. 00 k = 15% • g =. 20 x. 40 =. 08 or 8% Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Partitioning Value: Example Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Free Cash Flow to Equity A much better model is to apply discount models to FCFE which may more accurately reflect a firms value. FCFE = Net Income + depreciation – Cap. Expend. – change in working capital – principal debt repayments + new debt issues. Apply model as per usual. Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Free Cash Flow to Equity • If the firm finances a fixed percentage of its capital spending and investments in working capital with debt, the calculation of FCFE is simplified. Let DR be the debt ratio, debt as a percentage of assets. In this case, FCFE can be written as • FCFE = NI – (1 – DR)(Capital Spending + change in Working Capital – Depreciation) • When building FCFE valuation models, the logic, that debt financing is used to finance a constant fraction of investments, is very useful. This equation is pretty common. Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Let’s look at an example http: //faculty. etsu. edu/trainor/FNCE%2033 00/Lowes. doc Another interesting site you may want to use: http: //caps. fool. com/Ticker. aspx? source=i caedilnk 9950012&ticker=LOW Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Free Cash flow to the Firm • FCFF = EBIT(1 -tax rate) + Dep. – Cap. Expenditures – Change in WC – Change in other assets. • Again, proceed as normal(replace dividends with FCFF) but discount at firms cost of capital. • You find value of firm. To find value of equity, simply subtract off debt. Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

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 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

P/E Ratio: No expected growth • E 1 - expected earnings for next year • E 1 is equal to D 1 under no growth • k - required rate of return Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

P/E Ratio with Constant Growth • b = retention ration • ROE = Return on Equity Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Numerical Example: No Growth E 0 = $2. 50 g=0 k = 12. 5% P 0 = D/k = $2. 50/. 125 = $20. 00 PE = 1/k = 1/. 125 = 8 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Numerical Example with Growth 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 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Pitfalls in Using PE Ratios • Flexibility in reporting makes choice of earnings difficult • Pro forma earnings may give a better measure of operating earnings • Problem of too much flexibility Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Other types of Valuation • Use Price/sales • Price/Cash flow • All relative valuation models rely on the market to be fairly valued. What is a good Price/Sales ratio? Relies on comparisons which may or may not be valued accurately. Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.