EQUITY VALUATION MODELS

Sankarshan Basu

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Valuation: Fundamental Analysis

• Fundamental analysis models base value on

current and future profitability

• It identifies mispriced stocks relative to some

measure of “true” value derived from financial
data

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Models of Equity Valuation

• Balance Sheet Models

• Dividend Discount Models (DDM)
• Price/Earnings Ratios
• Free Cash Flow Models

3
Valuation by Comparables

• Compare valuation ratios of firm to industry

averages

• Ratios like price/sales are useful for valuing

start-ups that have yet to generate positive
earnings

4
Limitations of Book Value

• Book values are based on historical cost, not

actual market values

• It is possible, but uncommon, for market value

to be less than book value

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Liquidation Value and Tobin’s Q

• Liquidation Value: Amount of Money that could be realized by

breaking up the firm, selling its assets, repaying its debt, and
distributing the remainder to the shareholders
– “Floor” or minimum value is the liquidation value per share

• Replacement Cost: Reproduction cost of Assets minus

Liabilities
– Tobin’s q: ratio of market price to replacement cost
– Tobin’s q trends towards 1

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Intrinsic Value vs. Market Price

• The return on a stock is composed of

dividends and capital gains or losses
E ( D1 )   E ( P1 )  P0 
Expected HPR= E (r ) 
P0

• The expected HPR may be more or less than

the required rate of return
– Variation based on the stock’s risk

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Required Return

• CAPM gives the required return, k:

k  rf    E ( rM )  rf 

• If the stock is priced correctly, k = expected

return
• k is the market capitalization rate

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Intrinsic Value and Market Price

• The intrinsic value (IV) is the “true” value,

according to a model
• The market value (MV) is the consensus value
of all market participants

Trading Signal:
IV > MV Buy
IV < MV Sell or Short Sell
IV = MV Hold or Fairly Priced
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Dividend Discount Models (DDM)

D1 D2 D3
V0     ...
1  k 1  k  1  k 
2 3

• V0 = current value
• Dt = dividend at time t
• k = required rate of return
• DDM says V0 = the present value of all
expected future dividends into perpetuity

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Constant Growth DDM
(1 of 2)

D0 1  g  D1
V0  
kg kg
• V0 = current value
• Dt = dividend at time t
• k = appropriate risk-adjusted interest rate
• g = dividend growth rate

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Preferred Stock and the DDM

• No growth case (fixed dividends)

• Value a preferred stock paying a fixed dividend
of $2 per share when the discount rate is 8%:

$2
Vo   $25
0.08  0

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Constant Growth DDM
(2 of 2)

• A stock just paid an annual dividend of $3/share

• Dividend is expected to grow at 8% indefinitely
• Market capitalization rate is 14%

D1 $3.24
V0    $54
k  g .14  .08

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DDM Implications

• The constant-growth rate DDM implies that a

stock’s value will be greater:
1. The larger its expected dividend per share
2. The lower the market capitalization rate, k
3. The higher the expected growth rate of
dividends

• The stock price is expected to grow at the

same rate as dividends

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Estimating Dividend Growth Rates

g  ROE x b
• g = growth rate in dividends
• ROE = Return on Equity
• b = plowback or retention rate (1 - dividend
payout rate)

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Present Value of Growth Opportunities

• The value of the firm equals:

– The value of the assets already in place
• No-growth value of the firm

– Plus, the NPV of its future investments

• Present value of growth opportunities or PVGO

• Price = No-growth value per share + PVGO

E1
P0   PVGO
k
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Growth Opportunities
(1 of 2)

• Firm reinvests 60% of its earnings

• Projects generate ROE of 10%
• Capitalization rate is 15%
• Expected year-end dividend is $2/share
• Earnings of $5/share
• g = ROE × b = 10% × .6 = 6%
$2
P0   $22.22
.15  .06
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Growth Opportunities
(2 of 2)

$2
P0   $22.22
.15  .06

• PVGO = Price per share - no-growth value per

share
$5
PVGO  $22.22   $11.11
.15

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 Life Cycles and Multistage Growth Models
Firms typically pass through life cycles

Early Years Later Years

• Ample opportunities for profitable • Attractive opportunities for reinvestment

reinvestment in the company may become harder to find.

• Competitors may have not entered the • Competitors enter the market
market.

• Payout ratios are low • Payout ratios are high

• Growth is correspondingly rapid. • Dividend growth slows because the

company has fewer investment
opportunities.

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GE Example
(1 of 3)

• Expected dividends for GE:

• Dividend payout ratio = 53%

• ROE = 19.5%
g  .195  (1  .53)  .0917  9.17%

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GE Example
(2 of 3)

• GE’s β = 1.10
• rf = 2.5%
• Market risk premium = 8%, then k is:

k  .025  1.10  (.08)  .113  11.3%

• Therefore:
D2021 $1.60  1.0917 
P2020    $75.83
kg 0.113  0.0917

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 GE Example
(3 of 3)

• Finally,
$1.04 $1.22 $1.41 $1.60  $75.83
V2016   2
 3
 4
 $53.40
1.113 1.113 1.113 1.113

• In 2016, one share of GE Stock was worth

$53.40

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Price-Earnings Ratio and Growth
(1 of 3)

• The ratio of PVGO to E/k is the ratio of firm

value due to growth opportunities to value
due to assets already in place (no-growth)
 
P0 1  PVGO 
 1
E1 k  E 
 k 

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Price-Earnings Ratio and Growth
(2 of 3)

• When PVGO = 0, P0 = E1/k. The stock is valued

like a nongrowing perpetuity

• P/E rises dramatically with PVGO

• High P/E indicates that the firm has ample

growth opportunities

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Price-Earnings Ratio and Growth
(3 of 3)

• P/E increases:
– As ROE increases
– As plowback increases, if ROE > k
– As plowback decreases, if ROE < k
– As k decreases

P0 1 b

E1 k  ROE x b

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Effect of ROE and Plowback on Growth and the P/E
Ratio

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P/E and Growth Rate

• Wall Street: The growth rate is roughly equal

to the P/E ratio

• “If the P/E ratio of Coca Cola is 15, you’d

expect the company to be growing at about
15% per year, etc. But if the P/E ratio is less
than the growth rate, you may have found
yourself a bargain.”
Quote from Peter Lynch in One Up on Wall Street

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P/E Ratios and Stock Risk

• When risk is higher, k is higher; therefore, P/E

is lower

P 1 b

E kg

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Pitfalls in P/E Analysis

• Use of accounting earnings

– Earnings Management
– Choices on GAAP

• Inflation

• Reported earnings fluctuate around the

business cycle
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Other Comparative Value Approaches

• Price-to-book ratio

• Price-to-cash-flow ratio

• Price-to-sales ratio

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Free Cash Flow To the Firm Approach
(1 of 2)

• Value the firm by discounting free cash flow at

WACC
• Free cash flow to the firm, FCFF, equals:
– After tax EBIT
– Plus depreciation
– Minus capital expenditures
– Minus increase in net working capital
FCFF  EBIT  (1  t )  Depreciation  Cap. Exp.  NWC

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Free Cash Flow To the Firm Approach
(2 of 2)

• Value of the Firm:

T
FCFFt Vt
FirmValue   
t 1 (1  WACC ) (1  WACC )
t T

• Where FCFFT 1
Vt 
WACC  g

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Free Cash Flow to Equity Approach
(1 of 2)

• Free cash flow to equity, FCFE, equals:

– FCFF
– Minus after tax interest
– Plus, increase in debt
FCFE  FCFF  Interest  (1  t )  Debt

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Free Cash Flow to Equity Approach
(2 of 2)

• Intrinsic Value of Equity:

T
FCFEt ET
IntrinsicValue of Equity   
t 1 (1  k E ) t
(1  k E )T

• Where
FCFET 1
ET 
kE  g

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Comparing the Valuation Models

• In practice
– Values from these models may differ
– Analysts are always forced to make simplifying
assumptions
• Problems with DCF
– Calculations are sensitive to small changes in
inputs
– Growth opportunities and growth rates are hard
to pin down
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Comparing the Valuation Models, GE

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The Aggregate Stock Market

• Use of earnings multiplier approach at

aggregate level

• Some analysts use aggregate version of DDM

• S&P 500 taken as leading economic indicator

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