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APPROACHES TO EQUITY VALUATION: 13.1-13.2
Lets do the mechanics first, then talk about the problems.
1. Book Value, Liquidation Value, Replacement Value
What do they mean, what do they measure, and how do we estimate them?
Think generically in terms of individual/corporate B/S net worth, accounting
numbers versus market numbers. Car rental company illustration.
2. Comparables (relative) Valuation vs absolute valuation
Work with reported measures and with SGB spreadsheet, Price/Earnings,
Price/Book, Price/Cash Flow etc.
3. Intrinsic Value vs. market price
How do prices adjust to intrinsic value? We saw one way with the riskpremium example and the CAPM.
4. Key things to stress:
 valuations are a long-term idea
 there are as many models as they are analysts
 serious errors in valuation are driven more by the character of
market data rather not accounting data.
 that they serve as due diligence (homework),
 are more appropriate when large pools of capital are deployed.
 Bias of models (Spring 2009 was a major buy signal).
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ILLUSTRATION FOR VALUATION BY COMPARABLES:
AN OLDIE BUT A GOODIE- THE AMAZON STORY: February 1999
to about now.
PART A:
I.
World market for books/CDs/videos
= $100 B
 say Amazon gets 10% in 5 years (like Walmart) = $ 10 B
II
Net profit margin for retailers is 1-4%
 But Amazon will be like Dell at 7%, income
= $700 M
III
Historically slow growth firms have P/E of 10
Fast growth firms have P/E of 75
 Amazon is fast growth so 75 * 700 = $ 53 B (market cap)
IV
Shares outstanding 160 million so target price = 53000/160
$ 332 per share
PART B.
Conservative profit margin forecast of 5%
Historically, retailers have a price to sales ratio of 2-3 times revenues (of $ 2
B)
 Amazon will have 4 times
 Market cap of $ 8B.
 Price = 8000/160 = $ 50 per share
PART C
Currently, 380 million shares priced at $ 90 per share
Market cap = $ 34.2 B.
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13.3. Dividend (and cash flow) discount models
Motivate using a standard income statement, cash flow data can be employed
from any point on it, sales/EBITDA/Net Income/EPS/Dividends depending on
which series is more reliable for the company at hand.
Dividend Yield
Dividend Payout
Retention Ratio (b)
= Dividend/Price
= $ Dividends/$ Earnings (per share)
= 1 – Payout Ratio
Basic idea that intrinsic value for a stock is the present value of all future cash
flows discounted appropriately.
Discuss interaction between dividend (or other) payout policy, buybacks,
price targets and analyst forecasts
I. Constant Dividends
Say, dividends are constant at $ 3 per share.
Required Rate of Return = 20% = k
Intrinsic Value = P0
1
|
3
2
|
3
= 3/0.2 = $ 15
3
|
3
4
|
3
(PV of perpetuity)
Compare Intrinsic Value(15) vs. Market Price ($35)
DECISION: DO NOT BUY
Typically used for preferred stock where dividend flows exist
And are predictable.
Realistic specification of dividend policy for common stock ?
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What if dividends tend to grow?
II. Constant dividend growth
Say dividends grow at constant rate g = 10%
Intrinsic Value P0
1
|
3
2
|
3.3
3
4
|
|
3.63
3
3.3
D1
P0 = ------- + ------- +… = ------- = 3/(0.2-0.1) = $30
(1.20) (1.20)2
(k-g)
The k=20% discount rate is the rate of return that investors
require to invest in the stock. This 20% comes from
10% as dividend income and 10% as cap. gains (g).
Reverse formula as: k = (D1/P0) + g = (3/30) + 0.1= 20%
P1 = D2/(k-g) = 3.3/0.1 = $33. (or price appreciates 10%)
Realistic specification of dividend policy?
III. Two-stage growth
Expected Earnings E1 = $ 5 per share
Div. payout = 60%, D1 = 5 * 0.6 = 3.
Required Rate of Return = 20%
Assume: Earnings and dividends will grow at 10% per year for the next
3 years and then at 4% per year forever.
How to discount cash flows ?
In two parts: a) first discount as constant growth till year 3
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b) then each cash flow upto year 3
Intrinsic Value = P0
1
2
3
4
|
|
|
|
3.0 3.30 3.63 3.78
D4 = D3 (1.04) = 3.78
a)
b)
P3 = 3.78/(.20-.04)= 23.625
3.0
3.30
3.63
23.625
P0 = ------ + ------- + ------- + --------- = $20.57
(1.20) (1.20)2 (1.20)3 (1.20)3
IV. Multi-stage growth (3-stage model was popular at Lynch)
V. Expectations investing: Can rework the model to judge rate of
growth implied in current stock prices and then whether that rate of
growth is likely to occur, and how long that rate of growth would have
to persist, before making an investment decision.
VI. Limitations of DDM’s
a) Volatility of prices is more than the volatility of dividends
b) K must be greater than g, otherwise model breaks down.
c) what if no dividends are paid ? Use other cash flows, from operations,
EBITDA, free cash flow?
d) Where does g come from? See sustainable growth notion below,
compressed into g= ROE * retention rate.
e) BOOK DISCUSSES NO-GROWTH AND GROWTH- IGNORE
THIS.
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SUSTAINABLE GROWTH (not in the book).
Think of this g as an “equilibrium” or “target” growth rate
that firms aspire to. So, attempt to maintain all financial ratios at
“optimal” levels. Any growth away from this sustainable growth causes
imbalances. Consider a beginning-of-year balance sheet as:
CA
NFA
300
400
TA
700
CL
Debt
Equity
TL
200
150
350
700
During the year, the following income statement applies:
Sales
Cost of Goods
Earnings before tax
EAT
Dividends
Retained Earnings
1000
800
200
100
30
70
this represents sales
growth of 10% from
previous year. Costs
increase proportionally.
For simplicity, assume full capacity, so that 10% growth requires a
proportional increase in assets from 700 to 770. Financed only by
retained earnings. Thus, end-of-year balance sheet will look like:
CA
NFA
330
440
TA
770
CL
Debt
Equity
TL
200 Current and debt
150 ratios change
420 (350 + 70)
770
Retained earnings provided all the funds needed to grow at 10%. More
funds available from “spontaneous” sources i.e. CL. Not using them
causes ratios to change. So, can possibly achieve more growth (above
10%)
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Suppose growth of 15% in sales (and assets) is possible and funds are
also generated from CL and debt from 15% spontaneous growth. The
end-of-year balance sheet will look like:
CA
NFA
345
460
TA
805
CL
Debt
Equity
TL
230.0 spontaneous
172.5 liab change
420.0 (350 + 70)
822.5
Now have too much money. Still more growth possible!
Suppose growth of 20% in sales was reflected in the
previous income statement. Asset needs now 20% higher.
CA
NFA
360 (300)
480 (400)
TA
840 (700)
CL
Debt
Equity
TL
240
180
420
840
(200)
(150)
(350)
(700)
Notice that all the ratios remain unchanged!
This 20% rate is the sustainable growth rate. It is the rate of growth that
is manageable without resort to additional equity financing. Debt and
current liabilities have increased “spontaneously.”
Book formula: A simple way to solve for this growth rate is:
ROE (BOY) * retention ratio = (100/350) * 0.7= 20%.
Unlimited growth beyond 20% is possible (and without affecting ratios)
but only with additional equity financing!!
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Say desire g = 25%, from the same income statement.
CA
NFA
375 (300)
500 (400)
TA
875 (700)
CL
Debt
Equity
TL
250 (200)
187.5 (150)
420 (350)
857.5
Need additional financing of 17.5. Can obtain without changing the
leverage ratio, by splitting between debt and equity.
Although done for 1-year in the above example, as sustainable growth =
ROE * b, these numbers tend to vary widely over time .
The common practice is to use a Dupont equation, and estimate ROE
from:
net income
sales
total assets
ROE = -------------- * -------------- * --------------Sales
total assets
equity
= profit margin * asset turnover * leverage
where the ratios are long-run averages.
13.4 P/E analysis and growth.
Intuitive idea is that P/E = 15, implies that the price is 15 * earnings.
If the firm is not growing, it would take 15 years to recover the price paid in
terms of the earnings stream (less if you discount it).
If the firm is growing, then you will recover price faster.
But what kind of earnings are we talking about? Forward/Trailing/Operating/
And how are earnings managed? (Accounting classes/next set of notes).
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