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Lecture Investments (8th edition): Chapter 18 - Zvi Bodie, Alex Kane, Alan J. Marcus

Chapter 18 - Equity valuation models. This chapter describes the valuation models that stock market analysts use to uncover mispriced securities. The models presented are those used by fundamental analysts, those analysts who use information concerning the current and prospective profitability of a company to assess its fair market value. We start with a discussion of alternative measures of the value of a company. | CHAPTER 18 Equity Valuation Models Balance Sheet Models Book Value Dividend Discount Models Price/Earning Ratios Models of Equity Valuation Table 18.1 Financial Highlights for Microsoft Corporation, October 25, 2007 Limitations of Book Value Book value is an application of arbitrary accounting rules Can book value represent a floor value? Better approaches Liquidation value Replacement cost Expected Holding Period Return The return on a stock investment comprises cash dividends and capital gains or losses Assuming a one-year holding period Required Return CAPM gave us required return: If the stock is priced correctly Required return should equal expected return Intrinsic Value Self assigned Value Variety of models are used for estimation Market Price Consensus value of all potential traders Trading Signal IV > MP Buy IV MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced Intrinsic Value and Market Price PH = the expected sales price for the stock at time H H = the specified number of years the stock is expected to be held Specified Holding Period V0 = Value of Stock Dt = Dividend k = required return Dividend Discount Models: General Model Stocks that have earnings and dividends that are expected to remain constant Preferred Stock No Growth Model E1 = D1 = $5.00 k = .15 V0 = $5.00 /.15 = $33.33 No Growth Model: Example g = constant perpetual growth rate Constant Growth Model E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86 Constant Growth Model: Example g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1- dividend payout percentage rate) Estimating Dividend Growth Rates Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies Present Value of Growth Opportunities If the stock price equals its IV, growth rate is sustained, the stock should sell at: If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist) Present .