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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 ZeroGrowth DDM
ZeroGrowth
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 ConstantGrowth DDM
ConstantGrowth
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) ConstantGrowth DDM
ConstantGrowth 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 longrun constant
30% for 3 years, then a longrun 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 =
kg
kg 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.
 Spring '08
 STAFF
 Valuation

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