Equity Valuation

❂ Basic Types of Models

• Balance sheet models

• Dividend discount models
• EPS (cashflow) discount models

❂ Modeling Framework
• Deterministicdynamics
• Stochastic dynamics
 Fair Value vs Market Price
❂ Fair Value
• Self assigned Value
• Variety of models are used for estimation

❂ Market Price
• Consensus value assessment by all market participants

❂ Trading Signal

• FV > MP: Buy

• FV < MP: Sell or Short Sell
• FV = MP: Hold or Fairly Priced
 Dividend Discount Models
❂
∞
Dt
Vo = ∑
t =1 (1 + k )
t

V0 = Value of Stock
Dt = Dividend
k = required return
 No Growth Model
❂ D
Vo =
k
Where the stock has earnings and dividends that are
expected to remain constant foreever.

Example: Preferred Stock

 No Growth Model: Example
❂
D
Vo =
k
E1 = D1 = $5.00
k = .15

Then, V0 = $5.00 / .15 = $33.33

 Constant Growth Model
❂
Do (1 + g )
Vo =
k−g

g = constant perpetual growth rate

Constant Growth Model: Example
❂
Do (1 + g )
Vo =
k−g
E1 = $5.00 b = 40% (1-b) = 60%
k = 15% D1 = $3.00 g = 8%
(b: EPS retention ratio)

V0 = 3.00 / (.15 - .08) = $42.86

 Estimating Dividend Growth Rates

❂ g = ROE × b

❂ g = growth rate in dividends

❂ ROE = Return on Equity for the firm
❂ b = EPS retention rate (1- dividend payout ratio)
Partitioning Value: Growth and No Growth Components

❂ E1
Vo = +PVGO
k
Do (1 +g ) E1
PVGO = −
( k −g ) k

❂ PVGO = Present Value of Growth Opportunities

❂ E1 = Earnings Per Share for period 1

 Partitioning Value: Example

ROE = 20% b = 40%

E1 = $5.00 D1 = $3.00 k = 15%

g = .20 x .40 = .08 or 8%

 Partitioning Value: Example
❂ 3
Vo = = $42.86
(.15−.08)
5
NGVo = = $33.33
.15
PVGO = $42.86 − $33.33 = $9.52

• Vo = value with growth

• NGVo = no growth component value
• PVGO = Present Value of Growth Opportunities
 Multi-Period Dividend-Discount Model

V = D + D 1 2
... + DN
+P N

(1+ k ) (1+ k ) (1+ k )

0 1 2 N

PN = expected sales price of stock at time N

N = number of years the stock is to be held
 Practical Difficulties with DDM

❂ Some firms do not pay dividends

❂ Can you forecast future dividends?
❂ Can you predict the terminal liquidation
value Pn ?
❂ What about the discount rate k?
(perhaps, the CAPM? The APT?)
 Multi-Period Earnings-Discount Model

❂
(1 − b) E1 (1 − b) E 2 (1 − b) E N + P N
V0= + ... +
(1 + k )1 (1 + k ) 2 (1 + k ) N

PN = expected sales price of stock at time N

N = number of years the stock is to be held
 Practical Concerns with EDM

❂ EPS forecasts are available from I/B/E/S, First

Call, Zacks, ….
❂ Dividend payout ratio (1-b) can be estimated,
either based on cash dividend or dividend-in-kind

❂ But, what about Pn and k?

 P/E Ratios

P0 d
=
E k − g

d: dividend payout ratio

k: cost-of-capital (or, risk-adjusted discount rate)
g: EPS growth rate
 P/E Example
k = 12.5% g = 9% d = 40%

Thus, P/E = (1 - .60) / (.125 - .09) = 11.4

If E = $2.73, we have

P = 11.4 X 2.73 =$31.14

 Problems with P/E Ratios
❂ What is E ?
• E = trailing 12-month EPS?

• E = 12-month-forward EPS?

❂ What is g ?
• g = average historical EPS growth?

• g = expected next-yr EPS growth?

• g = long-run EPS growth?