CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The...

35
CHAPTER 18 CHAPTER 18 Investments Investments Equity Valuation Equity Valuation Models Models Slides by Slides by Richard D. Johnson Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin McGraw-Hill/Irwin Cover image

Transcript of CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The...

Page 1: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

CHAPTER 18CHAPTER 18

InvestmentsInvestments

Equity Valuation Equity Valuation ModelsModels

Slides bySlides by

Richard D. JohnsonRichard D. Johnson

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reservedCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/IrwinMcGraw-Hill/Irwin

Cover image

Page 2: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

18- 18- 22

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Balance Sheet Models– Book Value

Dividend Discount ModelsPrice/Earning Ratios

Models of Equity Valuation

Page 3: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

18- 18- 33

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Table 18.1Financial Highlights for Microsoft Corporation, March 8, 2006

Page 4: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Limitations of Book Value

Book value is an application of arbitrary accounting rules

Can book value represent a floor value?Better approaches

– Liquidation value

– Replacement cost

Page 5: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Intrinsic Value– Self assigned Value– Variety of models are used for estimation

Market Price– Consensus value of all potential traders

Trading Signal– IV > MP Buy– IV < MP Sell or Short Sell– IV = MP Hold or Fairly Priced

Intrinsic Value and Market Price

Page 6: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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VD

ko

t

tt

( )11

VD

ko

t

tt

( )11

V0 = Value of Stock

Dt = Dividend

k = required return

Dividend Discount Models: General Model

Page 7: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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VD

ko

Stocks that have earnings and dividends that are expected to remain constant.

Preferred Stock

No Growth Model

Page 8: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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E1 = D1 = $5.00

k = .15

V0 = $5.00 / .15 = $33.33

VD

ko

No Growth Model: Example

Page 9: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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VoD g

k g

o

( )1

VoD g

k g

o

( )1

g = constant perpetual growth rate

Constant Growth Model

Page 10: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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VoD g

k g

o

( )1

VoD g

k g

o

( )1

E1 = $5.00b = 40% k = 15%

(1-b) = 60% D1 = $3.00 g = 8%

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

Constant Growth Model: Example

Page 11: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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g ROE b g ROE b

g = growth rate in dividends

ROE = Return on Equity for the firm

b = plowback or retention percentage rate (1- dividend payout percentage rate)

Estimating Dividend Growth Rates

Page 12: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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)1()1()1(...2

21

10

kPD

kD

kDV N

NN

PN = the expected sales price for the stock at time N

N = the specified number of years the stock is expected to be held

Specified Holding Period Model

Page 13: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies

Page 14: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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ROE = 20% d = 60% b = 40%

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

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

Partitioning Value: Example

Page 15: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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V

NGV

PVGO

o

o

3

15 0886

5

1533

86 33 52

(. . )$42.

.$33.

$42. $33. $9.

V

NGV

PVGO

o

o

3

15 0886

5

1533

86 33 52

(. . )$42.

.$33.

$42. $33. $9.

Vo = value with growth

NGVo = no growth component value

PVGO = Present Value of Growth Opportunities

Partitioning Value: Example

Page 16: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Table 18.2 Financial Ratios in Two Industries

Page 17: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Figure 18.2 Value Line Investment Survey Report on Hewlett Packard

Page 18: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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P/E Ratios are a function of two factors– Required Rates of Return (k)

– Expected growth in Dividends

Uses– Relative valuation

– Extensive Use in industry

Price Earnings Ratios

Page 19: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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PE

kP

E k

01

0

1

1

PE

kP

E k

01

0

1

1

E1 - expected earnings for next year– E1 is equal to D1 under no growth

k - required rate of return

P/E Ratio: No Expected Growth

Page 20: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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)(

1

)(

)1(

1

0

110

ROEbk

b

E

P

ROEbk

bE

gk

DP

)(

1

)(

)1(

1

0

110

ROEbk

b

E

P

ROEbk

bE

gk

DP

b = retention ratio

ROE = Return on Equity

P/E Ratio with Constant Growth

Page 21: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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E0 = $2.50 g = 0 k = 12.5%

P0 = D/k = $2.50/.125 = $20.00

PE = 1/k = 1/.125 = 8

Numerical Example: No Growth

Page 22: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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b = 60% ROE = 15% (1-b) = 40%

E1 = $2.50 (1 + (.6)(.15)) = $2.73

D1 = $2.73 (1-.6) = $1.09

k = 12.5% g = 9%

P0 = 1.09/(.125-.09) = $31.14

PE = 31.14/2.73 = 11.4

PE = (1 - .60) / (.125 - .09) = 11.4

Numerical Example with Growth

Page 23: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Table 18.3 Effect of ROE and Plowback on Growth and the P/E Ratio

Page 24: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Pitfalls in P/E Analysis

Use of accounting earnings– Earnings Management

– Choices on GAAP

InflationReported earnings fluctuate around the

business cycle.

Page 25: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Figure 18.3 P/E Ratios and Inflation

Page 26: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Figure 18.4 Earnings Growth for Two Companies

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Figure 18.5 Price-Earnings Ratios

Page 28: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Figure 18.6 P/E Ratios for Different Industries, 2006

Page 29: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Other Comparative Value Approaches

Price-to-book ratioPrice-to-sales ratioPrice-to-cash-flow ratio

Page 30: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Figure 18.7 Market Valuation Statistics

Page 31: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Free Cash Flow Approach

Discount the free cash flow for the firmDiscount rate is the firm’s cost of capitalComponents of free cash flow

– After tax EBIT

– Depreciation

– Capital expenditures

– Increase in net working capital

Page 32: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Steps to Forecasting the Aggregate Market

Step 1: Forecast corporate profitsStep 2: Estimate the earnings multiple

using long-term interest ratesStep 3: Product is the estimate for

aggregate level

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Figure 18.8 Earnings Yield of S&P 500 versus 10-Year Treasury-Bond Yield

Page 34: CHAPTER 18 Investments Equity Valuation Models Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin.

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Table 18.4 S&P 500 Forecasts Under Various Scenarios

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