Stock Valuation and Portfolio Management

1
Stock Valuation and Portfolio Management

• Quick review of fundamental valuation and
  relative valuation
• Valuation of the market
• Active portfolio management (separate set of
  slides)

2
Purpose of valuation

• Intrinsic value
• Fundamental value
• A variety of models are used for estimation
• Market Price
• Reflects the markets expectation of the firms
  potential
• Trading Signal
• IV gt MP ? Buy
• IV lt MP ? Sell or short sell
• IV MP ? Hold, price is fair

3
Fundamental ValuationDividend Discount Models

• V0 value of Stock at time 0
• Dt dividend at time t
• k required rate of return
• Problem infinite stream of future dividends
  difficult to forecast

4
No Growth Model

• For stocks that have dividends that are expected
  to remain constant
• Perpetual stream collapses to a simple formula
• Example preferred stock with fixed stream of
  dividends

5
Constant Growth Model

• g constant dividend growth rate
• This is the Gordon growth model

6
Implication of the Constant Growth Model

• If market price P0 V0, then
• Stock prices grow at the same rate as dividends
• and
• i.e., required rate of return total stock
  return (dividend yield plus capital gain)

7
Estimating Dividend Growth Rates
g dividend growth rate ROE firms return on
equity net profit / equity b plowback
or earnings retention ratio (1 -
dividend payout ratio)
8
Stock Prices and Investment Opportunities

• Consider a plowback ratio b 0
• Pay out everything ? no growth
• Suppose E1 5, and k 15, then
• Question if firm retains a portion of its
  earnings for reinvestment, will V0 be higher or
  lower?

9
Numerical Example

• Plowback 40 percent of earnings
• ROE 20 b 40
• E1 5.00 k 15

D1 5.00 x .60 3.00 g .20 x .40
.08 Note ROE gt k in this example
10
Partitioning Value
V0 value with growth NGV0 no growth
component value PVGO PV of growth opportunities
11
In Other Words.
12
The Free Cash Flow Approach

• Another fundamental valuation approach
• Dividend is discretionary - some firms do not pay
  dividends, difficult to forecast
• Model based on the present value of free cash
  flow instead (Free cash flow that is not tied
  up)
• Cash flow - less discretionary, easier to
  forecast

13
Multistage Growth Model

• Two or more expected growth rates in dividends or
  free cash flows
• Assume growth at a rapid rate for n periods,
  followed by steady growth
• Where R - rapid, S - steady (R gt S)
• Last term discounted Pn

14
B. Relative Valuation Price-Earnings Ratio

• Popular approach among buy-side analysts and
  portfolio managers, particularly during the tech
  bubble
• P/E analysis easy to explain, easy to calculate,
  less assumptions
• P/E ratio
• Divide current market price by forward 12-month
  earnings per share
• Price paid for each 1 of earnings

15
Relationship between P/E and the DDM

• Relate the P/E ratio to the dividend discount
  model
• No growth

• (E1 is equal to D1 under no growth)

16
Relationship between P/E and the DDM

• Constant growth

17
Example of P/E Analysis
Nortel example (January 24, 2003) P/E Industry
average 21 Analysts estimate for NT
20 EPS Analysts estimate for NT
0.10 Valuation P/E2004 x E2004 20 x 0.10
2
18
Pitfalls in P/E Analysis

• 1. Issues with earnings
• E.g., Integrity of earnings
• 2. Relative valuation
• Problems with the methodology itself
• Industry average P/E a good benchmark?
• What if industry as a whole is overvalued (or
  undervalued)?
• Bursting of technology bubble usefulness called
  into question
• Lack of true comparables, even within the same
  industry

19
Other Ratios

• P/E analysis some firms do not have earnings ?
  many hi-tech firms during the technology bubble
  (e.g., Amazon)
• Popular alternatives
• 1. Price-to-Sales (P/S)
• Ratio of companys market value divided by sales
• Market valuation of a firms revenues

20
Other Ratios (Contd)

• 2. Price-to-Cash-Flow
• Earnings may not be a true reflection of firms
  health
• Firm may show a loss even though its generating
  cash, e.g., tax purposes, buyouts and mergers,
  one-time writeoffs, depreciation schedulesetc.
• 3. Price-to-book (P/B), or to enterprise value
  (EV)

21
B. Valuation of the Market

• Is the aggregate stock market overvalued?
  Undervalued?
• As with firm-level valuation, the two most
  important factors are
• Interest rate (related to discount rate)
• Corporate news (related to cash flow, earnings,
  dividends)
• At the market-level, corporate profits are
  strongly related to the macroeconomy, e.g., GDP
  forecasts

22
Valuation of the Market (Contd)

• Methodologies
• Apply a PV model, e.g., DDM, to the aggregate
  market
• Dividend data are available for the entire
  market. Can use a constant growth model
• The Fed Model popularized by Ed Yardeni
• Simple comparison of the forward earnings yield
  (E1/P0) and 10-year Treasury yield (Y0)

23
Valuation of the Market (Contd)

• Method based on past relationship of the two
  variables
• If equal fair value
• Numerical example
• E1 54.09, Y0 4.5. P0 1038 Hence, Y0 lt
  E1/P0
• and the market is considered undervalued
• If Y0 gt E1/P0, market considered overvalued

24
Valuation of the Market (Contd)

• Model has never been sanctioned by the Federal
  Reserve, but is widely followed and referred to
  in the financial community
• See handout