COMMON STOCK VALUATION

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Chapter 13

• COMMON STOCK VALUATION

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Fundamental Analysis

• analysts (or investors) try to determine the
  intrinsic value of a stock
• If
• intrinsic value lt current market value
• overpriced ? sell stock
• intrinsic value lt current market value
• underpriced ? buy stock

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Determining Intrinsic Value

• various methods
• we will look at several
• all are based on estimates of what will happen
  in the future
• no method is perfect as based on estimates of
  certain (unknown) parameters
• cannot predict the future exactly, can only make
  best guess
• therefore, can never true intrinsic value, only
  your best estimate

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• two analysts may come up with different estimates
  of intrinsic value if
• They use different valuation models
• or
• They use the same model but have different
  parameter estimates

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• If fundamental analysis of intrinsic values is
  based on
• estimates, is it useful?
• Yes!
• Investors need to make buy/sell decisions based
  on what the stock is priced at and what they feel
  it should be worth
• Need way to determine what it should be worth
• Different investors can have different estimates
  
• ? this is what creates trading

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Two Common Valuation Methods

• Present Value Approach
• dividend discount model (DDM)
• Free Cash Flow Valuation
• Value stock based on value of cashflows it
  generates for the investor
• 2) Relative Valuation Approach
• (a) Price-earnings ratio
• (b) other ratios (price to book, price to sales
  etc.)
• Value stock by looking at how similar stocks are
  valued by the market

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Present Value Approach- Dividend Discount Model

• the value of any stock (or other security) is
  the present value of future cashflows coming from
  the stock
• for a stock, cashflows received by investors are
  the dividends
• intrinsic value of share PV of all future
  dividends

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• to implement, need estimates of two things
• 1) required return on the stock
• 2) all future dividends

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• required return on stock depends on
• general level of interest rates in economy
• risk level of stock
• estimating future dividends
• impossible to predict exactly what all future
• dividends will be
• typically, simplifying assumptions are used
• Three cases
• 1) Zero Growth
• 2) Constant Growth
• 3) Multiple Growth

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Zero Growth Model

• Assume that firm does not reinvest anything in
  itself,
• pays out all earnings as dividends
• it should experience no growth over time
• D0 EPS0
• and D0 D1 D2 ...
• DDM becomes a perpetuity

This simple model would generally never apply
to common stocks (applies to straight
convertible shares)
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Constant Growth Model

• dividends are expected to grow at a constant
  rate, g, forever
• DDM becomes a growing perpetuity

where D1 D0(1g)
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• The constant growth model shows the basic factors
  which affect stock prices

Firm Profitability (via dividends)

• Level of interest rates
• Risk level of stock

Future profitability (via dividends)
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• in constant growth model, g is growth rate in
  dividends and is also expected appreciation in
  stock price
• the expected (required) return to the investor
  can be broken down in to a dividend yield and a
  capital gain yield (g)
• in practice, this simple model would only apply
  to a stock with very stable (in terms of growth)
  dividends typically in a fully mature and
  non-cyclical industry

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Multiple Growth Model

• dividends are expected to grow at different
  rates over different periods
• eventually, dividends enter a period of stable,
  long term growth which goes on forever
• common to use 2 or 3 different growth rates in
  practice, or to estimate first few dividends
  directly and then assume growth rate(s)

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Where

• the dividends (D1 to Dn1) have to be estimated
  directly
• using the estimated growth rates

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Problems with Present Value Approach

• in theory, DDM is correct but implementation can
  be hard
• parameters (next dividends, growth rate(s),
  required return) must be estimated and this is
  the hard part
• we will look at methods to estimate required
  return, earnings, dividends and growth rates a
  little later in course
• the intrinsic value calculated can be very
  sensitive to assumptions made

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• DDM best suited to firms which maintain stable
  payout ratios
• DDM best suited for firms which have reasonably
  stable growth rates
• does not work well for cyclical firms or firms
  with erratic earnings
• DDM may work reasonably well for firms in mature
  industries with stable profits (or growing at
  stable rate) and an established dividend policy

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Another Present Value Approach- Free Cash Flow
Valuation

• Many firms do not currently pay dividends
• Theoretically, DDM will work, but extremely
  difficult to estimate when dividends will begin
  and what growth rate will be
• Alternative to DDM is calculating present value
  of Free Cash Flow

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• Two approaches
• Free Cash Flow to Equity (FCFE)
• Free Cash Flow to the Firm (FCFF)
• Free Cash Flow to Equity
• Estimate how much cash the firm could pay out as
  dividends if it wanted to FCFE
• Think of this as potential dividends
• Calculate present value of future FCFE to get
  value of equity

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Free Cash Flow to Equity

• FCFE Net Income
• Depreciation
• Capital Expenditures
• Change in non-cash Working Capital
• Net New Debt Issued

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Free Cash Flow to Equity

• Similar to DDM, estimate a growth rate and then
  discount at the required return on equity
• Total value of Equity
• Divide this number by number of shares
  outstanding to get estimate of intrinsic value of
  one share

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Free Cash Flow to Firm

• FCFF represents the cashflow available each that
  could be distributed to all security holders
  (i.e. shareholders and debt holders)
• FCFF FCFE Net New debt Interest(1-tax)

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Free Cash Flow to Firm

• FCFF Net Income
• Depreciation
• - Capital Expenditures
• - Change in non-cash Working Capital
• Interest (1 tax rate)

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Free Cash Flow to Firm

• Estimate growth rate for FCFF
• Discount future FCFF at the weighted average cost
  of capital (WACC)
• Value of Firm
• This is value of overall firm, to get share value
  subtract value of debt and divide by number of
  shares

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Estimating Intrinsic Value- Relative Valuation
Approach

• value a stock by comparing it to other stocks
• usually done by comparing the level of some
  accounting variable such as earnings, sales or
  book value
• in some industries non-accounting numbers might
  be used (e.g. of subscribers in the cable
  industry, amount of oil reserves in oil industry)

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• whatever the basis of comparison, the process is
  essentially the same
• determine what the relationship between the
  variable and the stock price should be
• use this and the level of the variable for the
• firm to value the stock

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• by far the most common relative valuation
  approach is based on the price-earnings ratio
  (P\E ratio)

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P/E Ratios

• Price of a stock alone does not tell you if it
  is expensive or cheap
• price must be measured relative so something
• most common is earnings
• how much does the stock cost per dollar of
  earnings the firm generates?

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• Using P\E ratios in valuation

determine what P\E should be
justified P/E ratio
EPS times justified P\E ratio
estimated intrinsic value
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• newspapers often report current P\E ratios for
  stocks
• usually based on trailing earnings (EPS for
  previous year EPS0)
• stock valuation generally done using forward
  earnings
• estimate of EPS for next year (EPS1 the
  future)

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Estimating Justified P\E Ratio
Four basic methods 1) based on fundamentals of
firm (using DDM model) 2) industry average 3)
historic average for the firm (or the industry)
4) relative to market overall
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Justified P\E from Fundamentals

• if assume the constant growth DDM holds, can be
  shown that

• gives justified P\E based on payout ratio and
  estimates of kcs and g to calculate justified P\E
• multiply by estimate of EPS1 to get intrinsic
  value

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• the P\E ratio justified by fundamentals also
  shows the factors that determine the P\E ratio
• 1) a higher payout ratio means a higher P\E
  ratio, all else being equal
• 2) a higher required return (risk) means a lower
  P\E ratio, all else being equal
• 3) a higher growth rate means a higher P\E ratio,
  all else being equal
• all else being equal never really holds since
  all three variables are related to each other

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• The formula for P/E from fundamentals (and the
  formulae for other ratios that follow) is derived
  from a simple DDM with a single, stable growth
  rate (D/(k-g))
• As such, it is only applicable in cases where
  that formula would apply (mature, stable
  companies)
• Generally, these formulae are not actually used
  to generate estimates of P/E (or the other
  ratios), but rather to understand the factors
  that make a ratio higher or lower.

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• e.g. if a stock has a lower P/E than industry
  average but is considered lower risk, then the
  lower P/E may be appropriate. Similarly, a stock
  with higher growth will have a higher P/E.
• These ideas are sometimes utilized in a
  regression framework e.g. for many firms you
  have growth rates and P/E ratios. Regress P/E on
  growth to determine the relationship. Based on
  another firms growth rate you can then use the
  regression parameters to estimate what an
  appropriate P/E should be.

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• Comparison to Industry Average
• average P\E ratio of comparable firms
• may have to make adjustments for differences
• e.g. differences in growth potential, risk level
  etc.
• Comparison to Historic P\E Ratio for Firm
• average P\E ratio for the firm in the past
• or, average P\E ratio for industry in the past
• have to adjust for changes in the firm/industry

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Average Industry P\E Ratios
Averages over 1999-2004 in Canada Autos and
Auto Parts 16.93 Banks 13.19 Biotechnolog
y 34.11 Metals and Mining 24.58 Steel
14.48 Food and Staples Retailing 17.52 Ut
ilities 17.58 Retailing 12.61
Source FPinfomart.ca
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• Comparison to Market Overall
• company or industrys P\E ratio relative to
  ratio for market
• e.g. if firm has P\E ratio that is historically
  1.5 times as big as average market ratio, use
  that fact and current market P\E to estimate
  firms P\E
• Average P/E on TSX approximately 16 to 18 on
  average

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Problems with Using P\E Ratio for Valuation

• if other firms are over- or under-valued in the
  market than estimating P\E ratio by looking at
  industry or market can simply repeat the error
• if earnings are negative, P\E ratio meaningless
• earnings can be very volatile, makes P\E ratios
  very volatile

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P/E Ratios over time

• average P/E since 1999 for Steel sector

Source FPinfomart.ca
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Market-to-Book Ratio

• price divided by book value of equity per share
• determine justified market-to-book and multiply
  by book value to estimate intrinsic value
• Advantages
• - Book value of equity (BV) less volatile than
  EPS
• - BV rarely negative
• Disadvantages
• - BV based on accounting numbers, may have little
  
• meaning for some types of firms
• - comparison of firms difficult if accounting
  standards different

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• justified market to book ratio estimated in same
  ways as P\E
• from fundamentals, assuming constant growth DDM

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Price-Sales Ratio

• price divided by sales per share
• determine justified price-sales ratio and
  multiply by sales per share to estimate intrinsic
  value
• Advantages
• - sales not as volatile as earnings
• - sales do not depend on accounting standards
  very much
• - sales never negative
• Disadvantages
• - sales do not reflect cost structure of the firm

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• justified sales-price ratio can be estimated in
  same four ways as the other ratios
• from fundamentals, assuming constant growth DDM