Chapter 13 (exam 3)

Chapter 13 (exam 3) - Chapter 13 Chapter Equity Valuation...

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Unformatted text preview: Chapter 13 Chapter Equity Valuation Fundamental Analysis Fundamental Present value approach » Capitalization of expected income » Intrinsic value: discounted value of the expected stream of cash flows Multiple of earnings approach » Valuation relative to a financial performance measure » Justified P/E ratio Present Value Approach Present Estimated intrinsic value is compared to the current market price Intrinsic value of a security is Cash Flows Value of security = ∑ (1 + k) t t =1 n Required Inputs Required Discount rate » Required rate of return: minimum expected rate to induce purchase » The opportunity cost of dollars Expected cash flows » Dividends or other cash payouts over the life of the investment Expected Cash Flows Expected Dividends: paid out of earnings Retained earnings enhance future earnings and ultimately dividends → Imply growth and future dividends Imply Dividend Discount Model Dividend Current value of a share of stock is the discounted value of all future dividends D1 D2 D∞ Pcs = + + ... + 1 2 ∞ (1 + k cs ) (1 + k cs ) (1 + k cs ) Dt =∑ t t = 1 (1 + k cs ) ∞ Dividend Discount Model Dividend To implement the DDM, we model the estimated growth rate of dividends There are three growth rate cases: Zero­growth rate Constant growth rate Multiple growth rate Zero-Growth DDM Zero-Growth Assume no growth in dividends » Fixed dollar amount of dividends reduces the security to a perpetuity » Similar to preferred stock because dividend remains unchanged D0 P0 = k cs Constant-Growth DDM Constant-Growth D1 P0 = k−g Assume a constant growth in dividends Dividends expected to grow at a constant rate, g, over time D1 is the expected dividend at end of the first period » D1 = D0 x (1+g) Constant-Growth DDM Constant-Growth Model implies that stock prices grow at the same rate as dividends If the required rate of return decreases, intrinsic value increases If the expected dividend growth rate increases, intrinsic value increases Required Return Required CAPM gave us required return: k = Rf + B[E(Rm)­Rf] If the stock is priced correctly → Required return should equal expected return Required return should equal expected return Estimating Growth Estimating g = ROE x b where: g = growth rate in dividends ROE = return on equity b = plowback or retention rate > (1­ dividend payout rate) Example Problems Example Hillside Homes Inc. has preferred stock outstanding that pays an annual dividend of $10.80. Its price is $110. What is the yield on the preferred stock? k = D/P = 10.80/110 = 9.8% Example Problems Example Stagnant Iron and Steel currently pays a dividend of $4.20. They plan to maintain the dividend at this level for the foreseeable future as no future growth is anticipated. If the required rate of return is 12 percent, what is the price of the common stock? P0 = D/K = 4.20/.12 = $35 Example Problems Example Sterling Corp. paid a dividend of $.80 last year. The dividend is expected to grow at a constant rate of 10 percent. The required rate of return is 15 percent. What is the stock price? P0 = D1 / (k – g) = .88/(.15 ­ .10) = $17.60 Example Problems Example Oxford Land Management Company has had the following pattern of earnings per share over the last five years: 2006 2007 2008 2009 2010 $4.00 4.20 4.41 4.63 4.86 The earnings per share have grown at a constant rate and will continue to do so in the future. Dividends represent 40% of earnings. Example Problems Example What are the expected earnings and dividends for the next year (2011)? g = 4.99% (rounded to 5%) E1 = 5.10 D1 = 2.04 Example Problems Example A firm will pay a $4.80 dividend at the end of the year. The firm has a stock price of $50 and a constant growth rate of 4%. Compute the expected return. k = (D1/P0) + g k = (4.80/50) + .04 k = 13.6% Multistage Growth Models Multistage Multiple growth rates: two or more expected growth rates in dividends Assume rapid growth for T periods followed by steady growth Multistage Growth Models Multistage (1+ g ) DT (1+ g 2) + Po= D ∑ o t T ( k − g 2)(1+ k ) t= 1 (1+ k ) t T 1 g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1 Multistage Growth Models Multistage First present value covers the period of super­ normal (or sub­normal) growth Second present value covers the period of stable growth » Expected price uses constant­growth model as of the end of super­ (sub­) normal period » Value at T must be discounted to time zero Example:: Valuing equity with growth of Example Valuing equity with growth of 30% for 3 years, then a long-run constant 30% for 3 years, then a long-run constant 30% 30% growth of 6% growth of 6% growth growth 0 k=16% 1 g = 30% g = 30% D0 = 4.00 2 g = 30% 3 4 g = 6% Example #2 Example D0 = $2.00 g1 = 20% g2 = 5% k = 15% T = 3 D1=2.40 D2= 3.46 V0 = D1/(1.15) + D2/(1.15^2)…etc. V0 = 30.42 Specified Holding Period Model Specified = V0 D+D (1+ k ) (1+ k ) 1 2 1 + ... 2 + N DP (1+ k ) N N PN = the expected sales price at time N N = the specified number of years the stock is expected to be held ________________________________ Intrinsic Value and Market Price Intrinsic Market Price → Consensus value of all potential traders Consensus value → Current market price will reflect intrinsic value estimates Current market price will Trading Signal IV > MP …. Buy IV < MP …. Sell or Short Sell IV = MP …. Hold or Fairly Priced P/E Ratio or Earnings Multiplier Approach Approach Alternative approach often used by security analysts P/E ratio is the strength with which investors value earnings as expressed in stock price Divide the current market price of the stock by the latest 12­month earnings Price paid for each $1 of earnings P/E Ratio Approach P/E To estimate share value P0 = estimated earnings x justified P/E ratio P/E ratio can be derived from D1 D1/E1 Po = or Po /E1 = k-g k-g P/E Ratio Approach P/E The higher the expected growth rate, g, the higher the P/E The higher the required rate of return, k, the lower the P/E Understanding the P/E Ratio Understanding P/E ratios reflect investors’ expectations about the growth potential of a stock as well as the risk involved Higher P/Es generally go with stocks whose earnings are expected to grow rapidly In general, there is an inverse relationship between P/E ratios and interest rates Pitfalls in Using P/E Ratios Pitfalls Flexibility in reporting makes choice of earnings difficult Problem of too much flexibility P/E Ratios P/E Other Valuation Techniques Other Price­to­book value ratio » Ratio of share price to stockholder equity as measured on the balance sheet » Price paid for each $1 of equity Price­to­sales ratio » Ratio of company’s market value (price times number of shares) divided by sales » Market valuation of a firm’s revenues ...
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This note was uploaded on 12/10/2011 for the course FIN 401 taught by Professor Staff during the Spring '08 term at Miami University.

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