12-1 McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

CHAPTER 12

Equity Valuation

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Fundamental of Stock Analysis: Models of Equity Valuation

• Basic Stock Valuation Models– Dividend Discount Models– Valuation multiples – Free Cash Flow model (covered in Fin 350)

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Intrinsic Value and Market Price

• Intrinsic Value (IV)– What the stock is worth (based on various estimation

techniques)

• Market Price– Consensus value of all potential traders

• Trading Signal IV > MP Stock is ______________________________ IV < MP Stock is ______________________________ IV = MP Stock is Fairly Priced: ___________________

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Constant Growth Model

• V0 = Value of Stock at t = 0• D1 = Dividend in year 1• k = required return• g = constant perpetual growth rate

Vo Dk g1

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Required rate of return: beta = 1.25, rf = 5%, and rM = 13%.

k = rf + (rM - rf)= 5% + (1.25) (8%) = 15%.

Use the CAPM to calculate k:

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Constant Growth Model: Example

D1 = $3.00 k = 15% g = 8%

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

Vo D gk go

( )1

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Estimating Dividend Growth Rates

• g = growth rate in dividends• ROE = Return on Equity for the firm• b = retention rate (dividend payout = 1 - b)

g ROE b

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Nonconstant Growth Model

• A firm is expected to have high growth for n years, followed by constant growth at rate gc.

• Steps:1. Calculate dividends to n+1.2. Calculate the stock value at n using constant growth model

and gC.

3. The stock value at t=0 (P0) is the present value of D1, to Dn plus the present value of Pn, discounted at the req ret (rs).

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Price Earnings Ratios

• P/E Ratios are primarily a function of two factors– _________________________________________– Expected _________________________________

• Use: Relative valuation

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Estimating stock value using P/E Ratios

• To use P/E to estimate firm value, we can use– firm’s historical relationship between P and E

(adjusted for changes in __________________ ___________________________

– average P/E for the industry (adjusted for differences in ___________________________

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Figure 12-6 P/E Ratios

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Other Valuation Ratios & Approaches

• Price-to-book• Price-to-cash flow• Price-to-sales• Present Value of Free Cash Flow

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Figure 12-7 Market Valuation Statistics