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Equity Valuation Models
Lectured by
Chandra Wijaya
Investment Management
© 2008
Models of Equity Valuation
Basic Types of Models
Balance Sheet Models
Dividend Discount Models
Price/Earning Ratios
Estimating Growth Rates and
Opportunities
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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
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Intrinsic Value and Market Price
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
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Dividend Discount Models: General Model

Dt
Vo  
t
t  1 (1  k )
V0 = Value of Stock
Dt = Dividend
k = required return
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No Growth Model
D
Vo 
k
Stocks that have earnings and dividends that
are expected to remain constant.
Preferred Stock
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No Growth Model: Example
D
Vo 
k
E1 = D1 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33
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Constant Growth Model
Do (1  g )
Vo 
kg
g = constant perpetual growth rate
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Constant Growth Model: Example
Do (1  g )
Vo 
kg
E1 = $5.00 b = 40%
k = 15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
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Estimating Dividend Growth Rates
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)
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Specified Holding Period Model
P
D
D
D

... 
V 
(1 k ) (1 k )
(1 k )
1
0
N
2
1
2
N
N
PN = the expected sales price for the stock at
time N
N = the specified number of years the stock is
expected to be held
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Dividend Growth for Two Earnings Reinvestment Policies
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Growth & No Growth Components of Value
E1
Vo 
 PVGO
k
Do (1  g )
E1
PVGO 

(k  g)
k
PVGO = Present Value of Growth
Opportunities
E1 = Earnings Per Share for period 1
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Partitioning Value: Example
ROE = 20% d = 60% b = 40%
E1 = $5.00 D1 = $3.00 k = 15%
g = .20 x .40 = .08 or 8%
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Partitioning Value: Example
3
Vo 
 $42.86
(.15.08)
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NGVo 
 $33.33
.15
PVGO  $42.86  $33.33  $9.52
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities
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Price Earnings Ratios
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
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P/E Ratio: No Expected Growth
E1
P0 
k
P0
1

E1
k
E1 - expected earnings for next year
E1 is equal to D1 under no growth
k - required rate of return
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P/E Ratio with Constant Growth
D1
E1(1  b)
P0 

k  g k  (b  ROE )
P0
1 b

E1 k  (b  ROE )
b = retention ratio
ROE = Return on Equity
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Numerical Example: No Growth
E0 = $2.50
g=0
k = 12.5%
P0 = D/k = $2.50/.125 = $20.00
PE = 1/k = 1/.125 = 8
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Numerical Example with Growth
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
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Effect of ROE and Plowback on Growth and the P/E
Ratio
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Pitfalls in P/E Analysis
Use of accounting earnings
Historical costs
May not reflect economic earnings
Inflation
Reported earnings fluctuate around the
business cycle.
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P/E Ratios and Inflation
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Earnings Growth for Two Companies
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Price-Earnings Ratios
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Other Valuation Ratios
Price-to-Book
Price-to-Cash Flow
Price-to-Sales
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Market Valuation Statistics
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Inflation and Equity Valuation
Inflation has an impact on equity
valuations.
Historical costs underestimate
economic costs.
Empirical research shows that inflation
has an adverse effect on equity values.
Research shows that real rates of return
are lower with high rates of inflation.
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Lower Equity Values with Inflation
Shocks cause expectation of lower
earnings by market participants.
Returns are viewed as being riskier with
higher rates of inflation.
Real dividends are lower because of
taxes.
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Free Cash Flow Approach
Discount the free cash flow for the firm
Discount rate is the firm’s cost of capital
Components of free cash flow
After tax EBIT
Depreciation
Capital expenditures
Increase in net working capital
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Categories of Stock
Blue chip stock
Income stocks
Cyclical stocks
Defensive stocks
Growth stocks
Speculative stocks
Penny stocks
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Categories of Stock
Blue Chip Stock
Blue chip has become a colloquial term
meaning “high quality”
Some define blue chips as firms with a
long, uninterrupted history of dividend
payments
The term blue chip lacks precise meaning,
but some examples are:
Coca-Cola
Union Pacific
General Mills
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Categories of Stock
Income Stocks
Income stocks are those that historically
have paid a larger-than-average
percentage of their net income as
dividends
The proportion of net income paid out as
dividends is the payout ratio
The proportion of net income retained is the
retention ratio
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Categories of Stock
Cyclical Stocks
Cyclical stocks are stocks whose
fortunes are directly tied to the state of
the overall national economy
Examples include steel companies,
industrial chemical firms, and
automobile producers
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Categories of Stock
Defensive Stocks
Defensive stocks are the opposite of
cyclical stocks
They are largely immune to changes in the
macroeconomy and have low betas
Examples include retail food chains,
tobacco and alcohol firms, and utilities
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Categories of Stock
Growth Stocks
Growth stocks do not pay out a high
percentage of their earnings as dividends
and may be good candidates for aboveaverage returns.
They reinvest most of their earnings into
investment opportunities
Many growth stocks do pay dividends
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Categories of Stock
 A speculative stock has a high probability
of a loss and a small probability of a large
profit.
Most speculative stocks are relatively new
companies with representation in the technology,
bioresearch, and pharmaceutical industries
 Penny stocks refer to unusually risky,
especially inexpensive shares.
Penny stocks sell for $1 per share or less
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Categories of Stock
Categories Are Not
Mutually Exclusive
An income stock or a growth stock can
also be a blue chip
E.g., Potomac Electric Power
Defensive or cyclical stocks can be
growth stocks
E.g., Dow Chemical is a cyclical growth
stock
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