Financial Markets

Unit 5: Equity Valuation James Birnbaum

1

Equity Valuation:
The evaluation of any investment needs to incorporate:
The value of today
And all the cash flows generated throughout its life time

1. Price/Earnings ratio (P/E) method:
Simply put, the p/e ratio is the price an investor is paying for $1 of a
company's earnings or profit. In other words, if a company is
reporting basic or diluted earnings per share of $2 and the stock is
selling
for $20 per share, the p/e ratio is 10 ($20 per share divided by $2
earnings per share = 10 p/e).

A relatively simple method to apply the mean price-earnings (PE) ratio
(expected) of all publicly traded competitors in the respective industry to
the firms expected earning.

Valuation per share = (Expected earnings of firm per share) x (Mean industry P/E)

Implicit assumption: The growth in earnings in future years will be
similar to that of the industry.

NOTE: There are three reasons why investors may get different values:
Investors may use different forecast models.
Different measure of earnings (ex. EBITDA or EBIT or CF etc.).
Different ideas about which firm can represent the industry
average.
Limitations of P/E Method:
- Inaccurate valuation due to:
Forecasting error
Mistake in composing industry composite
- Reliability of P/E over time is not for certain.

2. The one-period valuation model:
2


P
0

D
1
(1+k
e
)
+
P
1
(1+k
e
)

P
0
= The current price of the stock
D
1
= The dividend paid at the end of year 1
P
1
= The price at the end of the first period

3. The generalized dividend valuation model:
Simply said this model is like model (2) but extended to any number of
time periods.

P
0

t1
D
t
(1+k
e
)
t


4. The Gordon Growth Model:
Assumption: Dividend grows continuously at the constant rate forever.

P
0

D
0
(1+g)
(k
0
g)

D
1
(k
0
g)

D
0
= The most recent dividend paid
k
0
= The required return on investment equity
g = The expected constant growth rate in dividends
D
1
= The dividend paid at the end of year 1

Required rate of return:
To value a firm based on discounted cash flows, the required rate of
return (discount rate) is required.
A rate of return, reflects the risk free interest rate + a risk premium.
Generally: Higher risk = Higher return
No complete agreement on:
The ideal measure of risk
The way risk should be used to derive the required rate of return
3

Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory.

Market risk (or nondiversifiable risk or systematic risk):
The possibility for an investor to experience losses due to factors that affect
the overall performance of the financial markets. Market risk, also called
"systematic risk," cannot be eliminated through diversification, though it
can be hedged against. The risk that a major natural disaster will cause a
decline in the market as a whole is an example of market risk.
Idiosyncratic risk (or diversifiable risk or unsystematic risk):
Company or industry specific risk that is inherent in each investment. The
amount of unsystematic risk can be reduced through appropriate
diversification.

1. Capital Asset Pricing Model (CAPM):
Based upon Markowitz on diversification and modern portfolio theory.
Enables economists and investors to measure quantitatively the
tradeoffs
Between asset return and risk.
The focus of CAPM is precisely on the systematic risk.

ER
i
R
F
+
i
E(R
M
) R
F
[ ]

ER
i
= The expected return on the asset
R
F
= The risk-free rate of return

i
= The sensitivity of the asset returns to market return
ER
M
= The expected return of the market
[E(R
M
) R
F
] = Expected market risk premium

Assumptions behind CAPM:
a. Rational Expectations
b. Investors have a single-period investment horizon
c. Perfect, frictionless markets:
No Transaction cost
No personal income tax
Stock prices are not affected by the buying and selling
actions of individual investors.
The quantities of assets are fixed and assets are perfectly
4

divisible.
d. There exists a risk-free rate at which investors can lend and
borrow unlimited amounts.
e. Investments are limited to a universe of publicly traded financial
assets.
f. Homogeneous expectations (ie. Everyone has the same stock
expectation).

2. Arbitrage Pricing Theory (APT):
The APT assumes that returns on assets are generated by a number of
industry wide and market wide factors. The APT views risk more generally
than just the beta of a security with the market portfolio.

NOTE: APT is an asset pricing model based on the idea that an asset's
returns can be predicted using the relationship between that same asset
and many common risk factors. Created in 1976 by Stephen Ross, this
theory predicts a relationship between the returns of a portfolio and the
returns of a single asset through a linear combination of many
independent macro-economic variables.

APT relies on three key propositions:
I. A factor model
II. Sufficient securities to diversify away idiosyncratic risk
III. Persistence of arbitrage opportunities are not allowed.

The principal strength of the APT:
No arbitrage conditions should hold for any subset of securities.
Not necessary to identify all risky assets or a market portfolio, Rolls
critique.
Use the APT to describe relative prices for a set of securities of interest
rather than the whole population of risky assets.

NOTE: Systematic risk can arise from various sources such as:
Uncertainty of the business cycle, Monetary policies, etc.
5

CAPM assumes implicitly (and maybe wrongly!) that each stock has the
same relative sensitivity to each systematic risk. CAPM may ignore the
subtle differences between individual securities.


The APT model:
E(r
i
) R
F
+ b
ij
j1
J

j
or
E(r
i
) R
F
+[E(R
1
) R
F
]
1
+... +[E(R
n
) R
F
]
n


The expected return of security i equals to:
A risk-free rate plus risk premium for bearing un-diversifiable
systematic risks.

j
is the extra expected return required because of the securitys
sensitivity to the j
th
factor.

Problems associated with APT:
o Extremely general
o No evidence as to what might be an appropriate multi-factor model.
o Factor analysis
o A joint test of the APT and the relevancy of the factors.
3/30/2013 8:48:00 AM
6


3/30/2013 8:48:00 AM
7