Chapter 13 Equity Valuation 13.1 Valuation by Comparables 13-2 Fundamental Stock Analysis: Models of Equity Valuation Basic Types of Models - Balance Sheet Models - Dividend Discount Models - Price/Earnings Ratios 13-3 Models of Equity ValuationValuation models using comparables - Look at the relationship between price and various determinants of value for similar firms The internet provides a convenient way to access firm data. Some examples are: - EDGAR - Finance.yahoo.com 13-4 Table 13.1 Microsoft Corporation Financial Highlig hts 2009 13-5 Valuation MethodsBook value - Value of common equity on the balance sheet - Based on historical values of assets and liabilities, which may not reflect current values - Some assets such as brand name or specialized skills are not on a balance sheet 13-6 Valuation Methods Market value of the shareholders’ equity - Current market value of assets minus current market value of liabilities : Market value of assets may be difficult to ascertain. - Market value based on stock price - Better measure than book value of the worth of the stock to the investor. - Stock prices reflect the value of the firm as a going concern. 13-7 Valuation Methods Is book value a floor value for market value of equity? (The market price never fall below the book value?) - While it is not common, there are always some firms selling at a market price below book value. EX) Firm in distress Citigroup in 2009 was selling at only 20% of book value. 13-8 Valuation Methods (Other Measures) Liquidation value - A better measure of a floor for the stock price - Net amount realized from sale of assets and paying off all debt - Firm becomes a takeover target if market value stock falls below this amount, so liquidation value may se rve as floor to value. 13-9 13.2 Intrinsic Value Versus Market Price 13-10 [...]... the stock price rebounded above its pre-announcement value 13- 32 T  (1 + g1 )t  DT (1 + g2 ) V0 = D0 ∑ + t  (1 + k)  (k − g2 )(1 + k)T  t =1 13- 33 $2.40 $2.88 $3.46 $3.63 V0 = + + + 2 3 1.15 1.15 1.15 (0.15 − 0.05)(1.15) 3 13- 34 Attractive investment opportunities More representative of mature firms 13- 35 Figure 13. 2 Honda Motor B A C D E 13- 36 ... its risk Investors will want buy more of it 13- 17 13. 3 Dividend Discount Models For now assume price = intrinsic value 13- 18 Basic Dividend Discount Model   Already established that V0 = V1 will be V1 = Assume the stock will be selling for its intrinsic value next year, then V1 = P1 V0 = + More generally, for a holding period of H years, V0 = + + · · · · · + 13- 19 Given that firms are “going concern”,... P0 (1 + g ) k−g 13- 25 Estimating the growth rate of dividends, we can compute stock’s market capitalization (k) If the stock is selling at its intrinsic value, then E(r) = k, k = D1/P0 + g  This equation is known also as the discounted cash flow (DCF) formula 13- 26 Stock Prices and Investment Opportunities g = growth rate in dividends is a function of two variables: - ROE = Return on Equity for the... ) k Price = No-growth value per share + PVGO P0 = E1/K + PVGO = $40 + $17.14 = $57.14 13- 30 Figure 13. 1 Dividend Growth for Two Earnings Reinvestment Policies Click to edit Master text styles Second level Third level Fourth level Fifth level (for a given ROE) High reinvestment increases stock price only if ROE > k 13- 31 Value of Growth Opportunities In reality, dividends cuts almost always are accompanied... 13- 13 Expected Holding Period Return EX) rf = 6%, E(rM) – rf = 5%, β = 1.2 k = rf + β  E (rM ) − rf    k = 6% + 1.2 X 5% = 12% From prior example, expected HPR = 16.7% The rate of return the investor expects exceeds the required rate based on its risk by a margin of 4.7%  Undervalued  The investor will want to include more of this stock in the portfolio than a passive strategy would dictate 13- 14... = = $53.00 0.10 - 0.06 13- 23 D0 × (1 + g ) D1 V0 = = ; g = perpetual growth rate in dividends k−g k−g The constant-growth DDM is valid only when g is less than k The constant growth rate DDM implies that a stock’s value will be greater: - The larger its expected dividend per share - The lower the market capitalization rate, k - The higher the expected growth rate of dividends 13- 24   Implies that the... and for a one year holding period may be found as: E(D1 ) + E(P1 ) V0 = 1+ k 13- 15 Market Price - Consensus value of all traders - In equilibrium, the current market price will equal intrinsic value Trading Signals - If V0 > P0 - If V0 < P0 - If V0 = P0 Undervalued, Buy Overvalued, Sell or Short Sell Hold as it is Fairly Priced 13- 16   From example, V0 = = $50 Equivalently, at a price of $50, the investor... ratio and/or its ROE 13- 27 Value of Growth Opportunities Value with 100% dividend payout Cash Cow, Inc (CC) E1 = $5 D1 = $5 b = 0; therefore g = 0 k = 12.5% ; Find VCC ROE = 12.5% VCC = $5.00 = $40 0.125 g = ROE × b Growth Prospects (GP) E1 = $5 D1 = $5 b = 0; therefore g = 0 k = 12.5%, Find VGP ROE = 15% VGP = $5.00 = $40 0.125 Should either or both firms retain some earnings? 13- 28 Value of Growth... VGP = $2.00 = $57.14 0.125 - 0.09 13- 29 Value of Growth Opportunities Value of assets in place for GP = $40.00 (value with all dividends paid out, with R OE = 12.5%) Value of growth opportunities with ROE = 15% may be inferred from the differen ce between the new VGP = $57.14 and the no growth value of $40.00  The increase in the stock price reflects that planned investments provid e an expected rate... one-year holding period Expected HPR= E ( r ) = E ( D1 ) + [ E ( P ) − P0 1 ] P0 13- 11 Expected Holding Period Return   EX) Expected dividend per share = $4 The current price of share = $48 The expected price at the end of a year = $52 Expected HPR = E(r) = E ( D1 ) + [ E ( P ) − P0 1 Expected HPR= = = 0.167=16.7% E ( r ) = P0 ] 13- 12 Required Return If the stock is priced correctly, required return should . Chapter 13 Equity Valuation 13. 1 Valuation by Comparables 13- 2 Fundamental Stock Analysis: Models of Equity Valuation Basic Types of Models - Balance. examples are: - EDGAR - Finance.yahoo.com 13- 4 Table 13. 1 Microsoft Corporation Financial Highlig hts 2009 13- 5 Valuation MethodsBook value - Value of common equity on the balance sheet - Based on. Models - Balance Sheet Models - Dividend Discount Models - Price/Earnings Ratios 13- 3 Models of Equity ValuationValuation models using comparables - Look at the relationship between price and