Week 5: Equity analysis IV

Basic principles of equity valuation

Valuation process

  1. Determine the required rate of return
  1. 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?

  1. Firms having negative CFs for many years but expecting positive CFs for some points in the future
  1. A great deal of uncertainty in forecasting terminal value
  1. 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