Equity Valuation Review

8-1 Equity Valuation

8-2 Intrinsic Value and Market Price n Intrinsic Value - 'True' Value - present value of all future cash flows - Variety of models are used for estimation n Market Price - Consensus value of all potential traders n Trading Signal - IV > MP Buy - IV < MP Sell or Short Sell - IV = MP Hold or Fairly Priced

8-3 Intrinsic/Fundamental Value n Value a company, or its securities, by taking the discounted value of future cash flows. n ࠵? is the discount rate ࠵? ! = $ "#! ∞ ࠵?࠵? " 1 + ࠵? "

8-4 Cash Flows n Which cash flows should you focus on? - Dividends - Earnings - Free Cash Flow n How should you calculate the discount rate? - Required rate of return - CAPM - Other methods?

8-5 Forecasting future cash flows n An Economy-Industry-Company (EIC) analysis is a common way of forecasting future cash flows. n Economy - GDP, unemployment, interest rates, government spending, consumer sentiment, tax rate changes, commodity prices, currency predictions

8-6 Forecasting future cash flows n Industry - competition, growth, bargaining power etc. n Company - financial statement analysis - dig deeper i.e. 10K

8-7 First, Some Symbols n E t = earnings per share at time t. n D t = dividends per share at time t. n k = the discount or "market capitalization" rate.

8-8 The Dividend Discount Model n Step 1: we use what is called a "no-arbitrage" rule: - The first part on the right is the dividend yield and the second is the capital gain. - The expected rate of return is often called the market capitalization rate. - Where does this come from? It is the rate of return on the stock of a comparably risky company. (what kind of risk?) ( ) 0 0 1 0 1 return of rate Expected P P P P D k - + = º

8-9 Dividend Discount Model n Step 2: Do algebra and flip this formula around to get: n Step 3: We can do the same thing for tomorrow's price n So if we substitute this in the above we get k P D P + + = 1 1 1 0 k P D P + + = 1 2 2 1 ( ) ( ) 2 2 2 2 1 2 2 1 1 1 0 1 1 1 1 1 1 k P k D k D k k P D D k P D P + + + + + = + + + + = + + =

8-10 Dividend Discount Model n Step 4: We can keep doing this until we are blue in the face: n Here, H is how far we are looking ahead. n Step 5: If H is infinity, then the last term gets really really tiny (because of discounting) and we get the dividend discount formula: ( ) ( ) ( ) H H H H k P k D k D k D P + + + + + + + + = 1 1 1 1 2 2 1 0  ( ) ( ) ( ) å ¥ = + = + + + + + + = 1 3 3 2 2 1 0 1 1 1 1 t t t k D k D k D k D P 

8-11 No Growth Model n The zero-growth dividend discount model is perhaps most appropriate for high-grade preferred stock. n The only inputs required are k (the discount or capitalization rate) and D 0 (the current dividend level). n Since the current dividend never changes, the formula is ( ) k D k D P t t 0 1 0 0 1 = å + ¥ = =

8-12 No Growth Model: Example 33 33 15 00 5 15 00 5 0 0 0 0 . $ / . . $ P k D P . k . $ D E o = = = = = =

8-13 The constant-growth DDM n Assume that dividends grow at a constant rate g (% per year). The numerator of our formula now changes, and we obtain a different, but still simple, valuation model. ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) g k D g k g D k g D k g D k g D k D k D P t t t - = ÷ ÷ ø ö ç ç è æ - + = å + + = + + + + + + = + + + + = ¥ = 1 0 1 0 2 2 0 0 2 2 1 0 1 1 1 1 1 1 1 1 1  

8-14 Constant Growth Model: Example Assume cash flows grow at a constant rate of 2% ࠵? ! = ࠵? ! = $5 ࠵? = .15 ࠵? = 0.02 ࠵? ! = ࠵? $ ࠵? − ࠵? ࠵? ! = 5(1.02) 0.15 − 0.02 = $39.23

8-15 More complicated DDMs n So far, we have assumed a steady growth in perpetuity. n It is more realistic to recognize that the growth rate in earnings and the payout ratio may both change over time. n All sorts of variations of Dividend Discount Models (DDMs) have been used in practice. To illustrate the general procedure, though, consider a three-stage model that breaks up the time horizon into three stages.

8-16 A three-stage DDM n Growth Stage - High earnings growth - Low payout ratio n Transition Stage - Slower earning growth - Increasing payout ratio n Maturity Stage - Stable earnings growth and payout ratio - Can use the constant-growth DDM at this point to calculate a "terminal value" n The challenge is to forecast accurately the three earnings growth and payout ratio values, and to estimate the duration of each of the first two stages.