Security Analysis

Review
David Myers FIN 324
David Hobson Myers, 2010

Myths of Valuation
Myth 1
Since valuation models are quantitative, valuation is objective

Myth 2
A well-researched and well-done valuation is timeless

Myth 3
A good valuation provides a precise estimate of value
David Hobson Myers, 2010

Myths of Valuation
Myth 4
The more quantitative a model, the better the valuation

Myth 5
To make money on valuation, you have to assume that markets are inefficient

Myth 6
The product of valuation is what matters; the process of valuation is not important.
David Hobson Myers, 2010

Three Approaches to Valuation

Discounted Cash Flow Relative Valuation Contingent Claims

David Hobson Myers, 2010

DCF

CFt V = t t =1 (1 + r )
V firm =
t =1 n

Vequity =
t =1

CFequityt

(1 + k e )t

CFfirm t

(1 + WACC )t
David Hobson Myers, 2010

WACC = Cost of equity [Equity/(Debt+Equity)] + Cost of Debt [Debt/(Debt + Equity)]

CAPM
CAPM needs three inputs
Riskless asset Risk premium Beta

E ( R i ) = R f + E (R m ) R f i
David Hobson Myers, 2010

Riskless Rates & Risk Premiums

Risk free rate
1. no default risk
Governments print the money Nominal terms

2. No reinvestment risk
Actual return = Expected return Zero coupon bonds

Purists view
Different rates for each period

Duration matching strategy

David Hobson Myers, 2010

Fisher Approximation
Nominal Returns = Real Returns + Inflation Observed Risk-Free Rates include expectations of real returns and future inflation

David Hobson Myers, 2010

Equity Risk Premium

CAPM, APM, Multifactor models
E (R ) = R f + j (Riskpremiu m ) j
j =1 j =k

Historical Risk Premiums

Time period Risk-free rate (consistent with E(R)) Arithmetic vs. geometric averages
Arithmetic is BUE
David Hobson Myers, 2010

Emerging Markets Risk Premiums

1. Equal exposure to country risk
E (Rus ) = R f + j (USRP ) + CRP 1 + ibrazil E (R Brazil ) = (1 + E ( Rus )) 1+ i us

2. Proportional exposure to country risk E (Rus ) = R f + j (USRP + CRP ) 3. Preferred (country & market separate)
E (R j ,us ) = R f + j (USRP) + j (CRP )
David Hobson Myers, 2010

Fundamental Beta
Beta of a firm determined by 3 variables
Type of business
Cyclical, discretionary products

Degree of operating leverage

Cost structure
Fixed /total costs Degree of operating leverage = % change in operating profit/% change in sales

Financial leverage

L = U 1+ (1 ) D E

( )]

David Hobson Myers, 2010

Bottom up Betas
Step 1: What business/industry Step 2: Comparable firms, average beta Step 3: Unlevered comparable betas Step 4: Unlevered beta using value weighted average of comparables Step 5: Levered beta

David Hobson Myers, 2010

Terminal Values
Estimating Terminal Value
T

P0 =
t =1

Ct PT + t (1 + rt ) (1 + rt ) t

PT =

CT +1 rg

PT is the terminal value

perpetuity or liquidation value or multiples
David Hobson Myers, 2010

Stable Growth
Valuation most sensitive to gS Firm growth cannot be greater than economies in which in functions Growth < Discount rate, g < r Growth approaches risk-free rate
David Hobson Myers, 2010

Key Assumptions
When the firm enters stable growth
Length of Competitive Advantage Period

What the firm characteristics are in stable growth

Beta approaches 1 Industry averages ROE, ROC Increased debt

How the transition is made from high (abnormal) to stable growth

David Hobson Myers, 2010

EQUITY VALUATION WITH DIVIDENDS

Dividends Net Income * Payout Ratio = Dividends Expected Growth Retention Ratio * Return on Equity

Firm is in stable growth: Grows at constant rate forever

Terminal Value= Dividend Value of Equity Dividend 1 Dividend 2 Dividend 3 Dividend 4 Dividend 5 Dividend ......... n

n+1

Forever Discount at Cost of Equity

Cost of Equity

Riskfree Rate : - No default risk - No reinvestment risk - In same currency and in same terms (real or nominal as cash flows

Beta - Measures market risk

Risk Premium - Premium for average risk investment

Type of Business

Operating Leverage

Financial Leverage

Base Equity Premium

Country Risk Premium

David Hobson Myers, 2010

Financing Weights Debt Ratio = DR

EQUITY VALUATION WITH FCFE

Cashflow to Equity Net Income - (Cap Ex - Depr) (1- DR) - Change in WC (!-DR) = FCFE Expected Growth Retention Ratio * Return on Equity

Firm is in stable growth: Grows at constant rate forever

Value of Equity

FCFE 1

FCFE 2

FCFE 3

FCFE 4

FCFE 5

.........

Terminal Value= FCFE FCFE n

n+1 /(k

Forever Discount at Cost of Equity

Cost of Equity

Riskfree Rate : - No default risk - No reinvestment risk - In same currency and in same terms (real or nominal as cash flows

Beta - Measures market risk

Risk Premium - Premium for average risk investment

Type of Business

Operating Leverage

Financial Leverage

Base Equity Premium

Country Risk Premium

David Hobson Myers, 2010

The Building Blocks of Valuation

Choose a
Cash Flow Dividends Expected Dividends to Stockholders Net Income - (1- ) (Capital Exp. - Deprecn) - (1- ) Change in Work. Capital = Free Cash flow to Equity (FCFE) [ = Debt Ratio] & A Discount Rate Cost of Equity Basis: The riskier the investment, the greater is the cost of equity. Models: CAPM: Riskfree Rate + Beta (Risk Premium) APM: Riskfree Rate + Betaj (Risk Premiumj): n factors Cost of Capital WACC = ke ( E/ (D+E)) + kd ( D/(D+E)) k d = Current Borrowing Rate (1-t) E,D: Mkt Val of Equity and Debt EBIT (1- tax rate) - (Capital Exp. - Deprecn) - Change in Work. Capital = Free Cash flow to Firm (FCFF) Cashflows to Equity Cashflows to Firm

The Essence of relative valuation?

Compare to the values assessed by the market for similar or comparable assets.
identify comparable assets and obtain market values for these assets standardized values, since the absolute prices cannot be compared compare the standardized value or multiple to comparable asset, controlling for any differences and then judge whether the asset is under or over valued

Relative valuation is pervasive

Most valuations on Wall Street are relative valuations.
Almost 85% of equity research reports are based upon a multiple and comparables. More than 50% of all acquisition valuations are based upon multiples Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments.

Multiples are just standardized estimates of price

Standardize
Earnings of the asset
Price/Earnings Ratio (PE) and variants (PEG and Relative PE) Value/EBIT Value/EBITDA Value/Cash Flow

Book value of the asset

Price/Book Value(of Equity) (PBV) Value/ Book Value of Assets Value/Replacement Cost (Tobins Q)

Revenues generated by the asset

Price/Sales per Share (PS) Value/Sales

Asset or Industry Specific Variable (Price/kwh, Price per ton of steel ....)

Conventional Usage: A Summary

Sector
Cyclical Manufacturing High Tech, High Growth

Multiple Used
PE, Relative PE PEG

Rationale

Often with normalized earnings Big differences in growth across firms Assume future margins will be good Firms in sector have losses in early years and earnings can vary depending on depreciation method Generally no cap ex investments from equity earnings Book value often marked to market If leverage is similar across firms If leverage is different

High Growth/No Earnings Heavy Infrastructure

PS, VS VEBITDA

REIT

P/CF

Financial Services Retailing

PBV PS VS

Black-Scholes Formula
Value a European call option on a nondividend paying stock The Black-Scholes pricing formula is

C0 = S 0 N (d1 ) Xe rT N (d 2 ) d1 = ln (S 0 X ) + r + 2 2 T T
David Hobson Myers, 2010

d 2 = d1 T

Factors Affecting Option Prices

Increase in Variable Stock Price E xercise Price T im e to m atu rity Stock volatility Interest rates C ash dividends Call + + + + Put + + + +

David Hobson Myers, 2010