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Lecture Investments (6/e) - 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. | Chapter 18 Equity Valuation Models Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios Estimating Growth Rates and Opportunities Models of Equity Valuation 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 Sell or Short Sell IV = MP Hold or Fairly Priced Intrinsic Value and Market Price 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 PN = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held Specified Holding Period Model PVGO = Present Value of Growth Opportunities E1 = Earnings Per Share for period 1 Growth & No Growth Components of Value ROE = 20% d = 60% b = 40% E1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8% Partitioning Value: Example Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example P/E Ratios are a function of two factors Required Rates of Return (k) Expected growth in Dividends Uses Relative valuation Extensive Use in industry Price Earnings Ratios E1 - expected earnings for next year E1 is equal to D1 under no growth k - required rate of return P/E Ratio: No Expected Growth b = retention ratio ROE = Return on Equity P/E Ratio with Constant Growth E0 = $2.50 g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 Numerical Example: No Growth b = 60% ROE = 15% (1-b) = 40% E1 = $2.50 (1 + (.6)(.15)) = $2.73 D1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P0 = 1.09/(.125-.09) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 - .60) / (.125 - .09) = 11.4 Numerical Example with Growth Pitfalls in P/E Analysis Use of accounting earnings Historical costs May not reflect economic earnings Reported earnings fluctuate around the business cycle. Other Valuation Ratios Price-to-Book Price-to-Cash Flow Price-to-Sales Inflation and Equity Valuation Inflation has an impact on equity valuations. Historical costs underestimate economic costs. Empirical research shows that inflation has an adverse effect on equity values. Research shows that real rates of return are lower with high rates of inflation. Lower Equity Values with Inflation Shocks cause expectation of lower earnings by market participants. Returns are viewed as being riskier with higher rates of inflation. Real dividends are lower because of taxes.