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Equity Analysis I: Valuation Models

Valuation

Valuation is the estimation of an asset’s value based either on variables perceived to be related to future investment returns or on comparisons with similar assets.

Why Is It Important?

Valuation is one of the most important steps in investments and portfolio managementTo get good return on your investment, you need to buy undervalued securities and sell overvalued securitiesIt is therefore critical to determine the fair value (intrinsic value or fundamental value) of the security

Investment Decision or Recommendation

BuyWhen …

HoldWhen …

SellWhen …

Valuation Models

Absolute valuation models

Relative valuation models

Valuation of Stocks

Discounted cash flow valuation models view the intrinsic value of common stock as the present value of its expected future cash flows.

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Discounted Cash Flow Valuation Model

Basic formula

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Valuation of Stocks: An Example

We expect a stock to generate cash flows of $100 in one year, $150 in two years, and $200 in three years. What is the value of this stock today?

Valuation of Stocks

In contrast to risk-free debt, future cash flows for equity investment are not known with certainty – they are risky.The most common approach to dealing with risky cash flows involves two adjustments.

Two challenges

The first challenge of applying DCF models is to define what we mean by future cash flows and, forecast what they will be in the future.The second challenge is to estimate the appropriate rate of return to use for discounting cash flows back to the present, the discount rate.The definitions of discount rate and cash flow must be coordinated.

Discount Rate

In choosing a discount rate, we want it to reflect both the time value of money and the riskiness of the stock.

Cost of Equity

Two approaches to determining cost of equityCAPMBond yield

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An Example

Suppose the beta of XYZ is 0.75. The risk-free rate is 4%. The market risk premium is 6%. What is the expected return or required rate of return for XYZ stock?

Dividend Discount Model (DDM)

DDM defines cash flows as dividendsIn practice, analysts usually view investment value as driven by earningsEarnings = dividends + retained earningsPayout ratio = dividends/earningsBut retained earnings help generate future dividends

DDM

DDM is the simplest and oldest present value approach to valuing stocks.If an investor buys a stock and hold it for one year.

If the investor holds the stock for n years

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An Example

You expect GM to pay $2 dividend next year and the price to be $58 in one year. The required rate of return for GM is 10%. What is your estimate of the value of GM stock?

DDM

If the investor holds the stock forever

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Gordon Growth Model

The Gordon Growth Model assumes that the dividends grow at a constant rate g

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An Example

The required rate of return for JCP is 8.8%. You believe a stable growth rate of 6% is reasonable. JCP’s current dividend is $0.50. What is the value of JCP stock? If the current market price for JCP is $25, is JCP undervalued or overvalued?

Gordon Growth Model

The model’s required rate of return and growth rate should reflect long term expectationsModels values are very sensitive to both the required rate of return and the growth rateSensitivity analysis

Implied dividend growth rate

Given price, the current dividend, and the required rate of return, we can infer the dividend growth rate reflected in price assuming Gordon growth model.An analysis can then judge whether the implied dividend growth rate is reasonable.

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An Example

Beta: 1.1; risk free rate: 5.6%; market risk premium: 6%; Current dividend: $2; What dividend growth rate would be required to justify a $40 price?

An Example

Beta: 1.1; risk free rate: 5.6%; market risk premium: 6%; Current dividend: $2; What dividend growth rate would be required to justify a $40 price?

Determinants of Growth Rates

The dividend earnings ratio is called the payout ratio, denoted as bretention rate = 1- payout ratiog = b × ROE

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Determinants of Growth Rates

g = b × ROEYear 1 Year 2

Equity $10 m $11.5 mNet Income $2.5 m $2.875 mRetained Earnings $1.5 m $1.725 mDividend $1 m $1.15 m

g = ROE × (1-b) = 25% × 60% = 15%

Determinants of Growth Rates

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P/E and Gordon Growth Model

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The Present Value of Growth Opportunities

a no growth company distributes all of its earnings as dividends

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An Example

CTWS stock; expected earnings next year $1.27; dividend payout ratio: 70%; dividend growth rate: 3.7%; required rate of return: 6.2%; current price:$30What is the value of CTWS stock? What is the present value of growth opportunity?

An Example

CTWS stock; expected earnings next year $1.27; dividend payout ratio: 70%; dividend growth rate: 3.7%; required rate of return: 6.2%; current price:$30

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Strengths of Gordon Growth Model Weaknesses

Values sensitive to the assumed growth rate and required rate of returnNot applicable to non-dividend-paying stockNot applicable to unstable-growth, dividend-paying stocks

Multi-stage DDM

When forecasting an earnings growth rate far above the economy’s nominal growth rate, analysts should use a multi-stage DDM in which the final-stage growth rate reflects a growth rate that is more plausible relative to the economy’s nominal growth rate, rather than using the Gordon growth model.

An Example

ABC just paid a dividend of $2. The dividend is expected to grow at 20% per year for two years and then grows at 5% per year indefinitely. What is the intrinsic value of the ABC stock according to the DDM? Assuming the required rate of return is 10%.

0 1 2 3 4 . . .

$2 $2.4 $2.88 $3.024 $3.1752 . . .

Growth Perpetuity

An Example

The intrinsic value of the stock is the present value of all its expected dividends

DDM

Dividends are not as volatile as earnings areLess sensitive to short-term fluctuations in underlying valueAnalysts often view DDM values as reflecting long-run intrinsic value

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DDM

A lot of companies do not pay dividendsNot profitableToo profitable

Free Cash Flow Valuation

Discounted cash flow valuation views the intrinsic value of a security as the present value of its expected future cash flows.Unlike dividends, free cash flow models are based on cash flows available for distribution

Free Cash Flow

Free cash flow to the firm (FCFF) is cash flow from operations minus capital expenditure

FCF Valuation

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FCFF

FCFF=Net Income available to common shareholders + net noncash charges + interest expense × (1-Tax Rate) – investment in fixed capital – investment in working capitalNoncash charges

Depreciationamortization

An Example

??FCFF140.36127.6116WC605550500Fixed asset118.00107.2897.52Net Income50.5845.9741.8Tax @30%18.9717.2515.68Int. Exp.54.4549.545Dep.242220200EBITDA200320022001

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WACC

If we use the FCFF valuation model, we are defining cash flows as cash flows available to bondholders, common stockholders, and preferred stockholders, if any.We need to use the weighted-average cost of capital – the weighted average cost of equity, the after-tax cost of debt, and the cost of preferred stock.