Equity Valuation Recap

Lesson #15 – Equity Valuation (10/28)

Dividend discount models and valuation ratios

13.1 – 13.4, H15, H16

13.1 – Valuation by Comparables

• Basically look at the prices and multiples of various firms and compare it to your firm.

• Ex. Microsoft’s P/E ratio is 9.2, compared to the industry standard of 15.3. This may imply that Microsoft is undervalued.
• However Microsoft’s Equity value to book value ratio is 4.6 compared to the industry standard of 4.8. This implies that Microsoft may be correctly valued.

• The SEC basically requires almost all public companies to file their financial info via EDGAR
• Book Value is the net worth of a company according to a firm’s balance sheet.

Limitation of Book value

• Book values are based on their original cost of acquisition (less some depreciation) whereas market values measure current values of assets and liabilities.

• Market prices take into account concepts like brand name (goodwill) whereas the book value doesn’t.
• Book value is not always a good measure of the “floor price” of a firm because there are firms where the book value is considerably less than its market price – these companies are usually in distress.

• A better measure of a floor for the stock price is the firm’s liquidation value – the net amount that can be realized by selling the assets of a firm and paying off all debt

• If the market price of equity drops below a firm’s liquidation value then it’s a good takeover target since they can just acquire the company then liquidate it

• There is also the concept of replacement cost or basically the cost to replace a firm’s assets (assets minus liabilities).

• Basically analysts argue that the market value of the firm cannot get too far above its replacement cost since if so, competitors will come in and try to replicate, which would eventually drive down the market value of all firms, until it becomes equal with replacement cost.

• Tobin’s q is the ratio of market value of the firm to replacement cost.

• In this view, in the long run the ratio of market price to replacement cost will eventually tend towards 1.

13.2 – Intrinsic Value vs. Market Price

Expected HPR    =   E(r)   =            [pic 1]

•  is the expected Dividend in Year 1[pic 2]
•  is the expected share price in Year 1[pic 3]
•  is the current share price[pic 4]

• Basically the Expected HPR is the sum of the:

• Expected dividend yield =  [pic 5]
• The Capital Gains Yield =   [pic 6]

• So what is the REQUIRED rate of return for the stock?
• Well the CAPM says that when stock market prices are at equilibrium levels, the rate of return that investors can expect to earn on a security is [pic 7]
• So the CAPM may be viewed as providing the rate of return an investor can expect given that the security’s risk is measured by beta – this is the return that investors will require of any other investment with equivalent risk.

• Therefore if a stock is priced “fairly” then its expected return will equal its required return.

• In this sense, security analysts will try to find underpriced stocks aka. a higher expected return over its required return.

• If a stock’s expected return is higher than its required return, then an active investor would want to hold more of that stock, than a passive investor would.
• Basically we’re comparing the intrinsic value of a stock to its market value.

• Intrinsic value is the present value of a firm’s expected future net cash flows discounted by the required rate of return (denoted by k)
• So assuming a 1 year horizon and forecast that the stock can be sold at the end of the year at price  = $52 and a dividend of  = $4, required rate of return = k, the intrinsic value is:[pic 8][pic 9]

• =        =       [pic 10][pic 11][pic 12]
• If the stock was currently priced at $48, then you could say that the stock is underpriced compared to its intrinsic value – is a positive alpha stock

• In market equilibriums, the current market price will reflect the intrinsic value estimates of all market participants

• Differences between intrinsic value and market value implies that some investors must disagree with some or all of the market consensus estimates of ,  and k.[pic 13][pic 14]

• A common term for the market consensus value of the required rate of return (k) is the market capitalization rate – the market consensus estimate of the appropriate discount rate for a firm’s cash flows. (CONCEPT CHECK 13.1)

13.3 – Dividend Discount Models

• The Dividend Discount Model (DDM) calculates the intrinsic value of a firm equal to the present value of all expected future dividends.

=            [pic 15][pic 16]

• The present value of all expected future dividends into perpetuity
• Although it may not be obvious, the DDM DOES take into account capital gains (price of selling stock) since the capital gains will be determined by the dividend forecasts at the time the stock is sold and is therefore part of the stock’s value.

Constant Growth DDM

• The real caveat of the DDM is that we need to forecast the growth of dividends in the future
• One method is the make a simple assumption that dividends will grow at a constant, stable growth rate (denoted by g). So if g = 0.05 and the most recently paid dividend was  = $3.81[pic 17]

    =     =    3.81 * 1.05    =    4.00[pic 18][pic 19]

    =     =    3.81 *    =    4.20[pic 20][pic 21][pic 22]

    =     =    3.81 *    =    4.41 etc.[pic 23][pic 24][pic 25]

• Basically the equation for the Constant Growth DDM is:

=         note the current value   and the future (expected) value of [pic 26][pic 27][pic 28][pic 29]