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Unformatted text preview: Equity Valuation Professor Ruslan Goyenko F a l l 2 1 1 Relative valuation by comparables P/E ratios can be different for several reasons Different growth Different risk But looking at PE ratios for firms that are comparable, can be useful for relative valuation (Also useful if you believe in value anomaly) Other comparables Startup firms often have no dividends or earnings for long periods of time Can look at sales Under what assumption should two firms trade at the same multiple of sales? Similarly, if firms have no sales, can look at web page visits, for example Gordon growth model Model tells us How firms grow When is growth good Some terminology: Book value of equity (BE): amount of money invested by equity holders plus cumulative retained earnings (RE) Retained earnings (RE): earnings not distributed as dividends Plowback Ratio (b): The fraction of earnings that is retained and reinvested b) (1 EPS Div t t × = Gordon growth model (2) More terminology: Cost of Equity (rE): discount rate Return on Equity (ROE): The amount of expected Earnings per Share EPS you get back next period per dollar of Book Equity (per share) this period ROE should be called Return on Book Equity Note: ROE is not equal to cost of equity rE ROE BE EPS t 1 t × = + b ROE BE b EPS BE BE 1 t t 1 t t × × = × = Example Consider a firm with BE0 = $50 , ROE = 10%, a plowback ratio of b=0.5 , and a cost of equity rE = 8%. Firm lives forever. What is EPS1 ? What is Div1 ? What is BE1 ? What is EPS2 ? What is Div2 ? What is BE2 ? What is the dividend growth rate g ? What is the current stock price P0 ? Example (2) Today Time 1 BE0=$50 ROE = 10% EPS1=$5 Dividend : (1b)EPS1=$2.5 Retained Earnings : RE1 = b x EPS1=$2.5 BE1 = BE0 +RE1=$52.5 Example (3) EPS1 is based on last year’s BE and ROE 50% of year 1’s earnings will be paid out as dividends The retained earning is the part of the EPS1 that is plowed back into the firm (b=50%) Thus the book equity at the end of year 1 is $50 $5 0.1 $50 ROE EPS 1 = × = × = BE $2.5 5 $ 5 . EPS b RE 1 1 = × = × = $2.50 EPS * ) 1 ( D 1 1 = = b iv $52.50 $5 * 5 . $50 * 1 1 = + = + = EPS b BE BE Example (4) EPS2 is based on year 1’s book equity BE 1 and ROE 50% of year 2’s earnings will be paid out as...
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 Spring '08
 RUSLANGOYENKO
 Dividend

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