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Week 5: Equity analysis IV (Dividend discount model (sustainable growth…
Week 5: Equity analysis IV
Basic principles of equity valuation
Valuation process
Determine the required rate of return
Determine if its market price is consistent with the intrinsic value
Dividend discount model
A. No growth model
B. Constant growth model
value vs return (p.10)
sustainable growth rate
g = ROE x b
b = retention rate = 1 - dividend payout ratio
dividend payout ratio = cash dividend paid/ net income
measures the ability of the firm to maintain its profitability and financial policies
value of growth opportunities
high reinvestment increases stock price only if ROE > k
C. Multi- stage growth model (p17-18)
Valuation using price multiplies
P/E ratio
a function of
required rate of return (k) - inverse relationship
expected growth in dividends - direct relationship
riskier firm => higher k => lower P/E
high P/E => high expected growth but not necessary high stock returns
Free Cash Flows model
A. FCFs to Firm
B. FCFs to Equity holders
Residual income model (
discounted abnormal earnings method
)
Equity value = Book value + PV expected future abnormal earnings
Abnormal earnings = Net income - (equity cost of capital)*(book value)
When to use RIM?
Firms having negative CFs for many years but expecting positive CFs for some points in the future
A great deal of uncertainty in forecasting terminal value
Firms not paying dividends or having unpredictable dividend patterns
Drawbacks of RIM (page 35)
Price/ book value (P/B ratio)
depends on
the magnitude of future abnormal ROE
growth in book value ( = 1 + (ROE-r)/(r-g) )
Valuation using price multiples
P/CF (price to cash flow): less subject to accounting manipulation?
P/S (price to sales): useful for firms with low or negative earnings in early growth stage
trailing vs forward multiples
potential impact of financial leverage on the multiples
Enterprise value
= Market value of equity + Market value of debt - Cash
Valuation implementation
estimating the cost of debt and cost of equity
estimating terminal value: is the
final year of forecast
and represents PV of future of abnormal earnings or FCFs for the remainder of firm's life