BM410: Investments

1
BM410 Investments

• Equity Valuation

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Objectives

• A. Understand the relationship between intrinsic
  value and market value
• B. Understand the various types of valuation
  models, including balance sheet, dividend
  discount models, and PE ratios
• C. Understand other key metrics used in valuing
  securities

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The Relationship between Intrinsic Value and
Market Value

• What is intrinsic value?
• The present value of a firms cash flows
  discounted by the firms required rate of return
• What is the firms market value (or price)?
• The total value of a firms outstanding shares
  times its market price
• In an efficient market, what should this
  relationship be?
• In a truly efficient market, the intrinsic value
  should equal its market value
• What happens if it doesnt?

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Intrinsic Value (continued)

• How do you identify mis-priced securities?
• Determine the intrinsic or fair value of the
  security. This can be done by many methods
• Models, i.e. CAPM, APT (E(rs) rf bs E(rM) -
  rf )
• Fundamental analysis
• Balance sheet methods
• Dividend Discount Models (DDMs)
• Then you compare the fair value to the current
  price

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Intrinsic Value (continued)

• Do all analysts look at companies the same way?
• No. If you have 30 analysts, you will generally
  have more than 60 sets of intrinsic values.
• How much is intrinsic value used in the real
  world?
• It is used much in terms of equity valuation and
  financial analysis. These have a more solid
  foundation and are not as affected by key
  assumptions
• It is not used as much with DDMs and PV models,
  as slight changes in assumptions can have large
  changes in a companys intrinsic value. Also
  these models assume a longer time frame
  generally.

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Intrinsic Value (continued)

• If DD and PV models is not used as much in the
  real world, why are we learning them?
• The concepts are critical to understanding
  finance
• It can add value in specific cases and companies
• It can be used to support your recommendations
  from other models if assumptions are stated
  clearly

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Intrinsic Value (continued)

• How do you determine Intrinsic Value?
• It is a value assigned by the analyst
• It is based on specific theories and assumptions
• Analysts use specific models for estimation
• Lots of models exist
• Remember, these models/assumptions are proxies
  for reality not reality

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Intrinsic Value (continued)

• What happens if the intrinsic value is greater
  than the market price?
• Intrinsic Value gt Market Price
• Buy
• Intrinsic Value lt Market Price
• Sell or Short Sell
• Intrinsic Value Market Price
• Hold or Fairly Priced or valued
• These models are not as accurate as investors (or
  students) would like.
• They are more indicators than directors
• It is more an art than a science!

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Questions

• Do you understand the relationship between
  intrinsic value and market value or price?

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B. Understand Various Types of Equity Valuation
Models

• Fundamental Stock Analysis Models of Equity
  Valuation
• Basic Types of Models
• 1. Balance Sheet Models
• Book Value
• Liquidation Value
• Replacement Value
• 2. Discounting Models
• Free Cash Flow to the Firm (FCFF)
• Free Cash Flow to Equity (FCFE)
• 3. Dividend Discount Models
• 4. Price/Earning Ratios

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Balance Sheet Models

• Balance sheet models assume that the intrinsic
  value of the firm is the value of its assets.
• What is the value of the firms assets?
• Is it the value on the books?
• Is it the value we could really get for the
  assets (liquidation value)?
• Is it the value we could get to replace the
  assets?

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Balance Sheet Models (continued)

• 1.A. Book Value (per share)
• Look at the book value Equity / shares
  outstanding
• Example Ford
• Assets 243,283 million
• Liabilities 219,736
• Owners Equity 23,547
• Shares Outstanding 1,169
• What is the Book Value per share?
• 23,547/1,169 Book value of 20.14 per share
• Logic the value of the assets should be equal
  to their value on the books.
• Be careful as book value does not tell you
  depreciation methods or the true value of the
  assets (they may be worthless)

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Balance Sheet Models (continued)

• 1.B. Liquidation value (per share)
• The amount of money realized by breaking up the
  firm, selling assets and repaying its debt
• Company A has a market value of 250 million (mn)
  with 50 mn in debt, cash of 150 mn and other
  assets likely worth 200 mn if sold today.
• What is the liquidation value?
• Liquidation value is the cash on hand and what
  they could liquidate the other assets for, I.e.
  150200-50 300 mn
• Logic if market price falls below liquidation
  value, the firm becomes a takeover target as
  investors buy the company and sell it in pieces

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Balance Sheet Models (continued)

• 1.C. Replacement Cost (per share)
• The amount of money it would take to replace the
  tangible and intangible assets of a company
• Company B is a trucking company valued at 25 mn.
  Since Company C takes 60 of the companys
  business and is planning to expand, you know that
  its CEO could replicate the trucking company for
  20 million and build her own trucking division.
• What is the replacement cost for the trucking
  company? 20 million
• Logic If the market value gets too high above
  the replacement cost, competitors would try to
  replicate the firm and entering competition would
  drive down the market value of all trucking firms.

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Balance Sheet Models (continued)

• 1.D. Tobins q
• It is the ratio of a firms market price to its
  replacement cost
• In the long run, the market price to replacement
  cost will tend toward 1 as investors correctly
  value the replacement cost of the assets
• But differences will remain over periods of time
• Logic Investors will be willing to purchase the
  company as long as the companys market price is
  below the replacement cost. As soon as its price
  is greater than the replacement cost, competition
  will come in, dropping the price to close to its
  replacement cost.

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Discounting Models

• Discounting models assume the intrinsic value of
  the company is the present value of the firms
  expected future cash flows. It is useful when
• The company does not pay dividends
• Dividends paid differs from what the firm could
  pay
• Free cash flows align with profitability within a
  specific forecast period
• The investor takes a control perspective

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Discounting Models (continued)

• 2.A. Free Cash Flow to the Firm (FCFF)
• FCFF is the cash flow available to the companys
  suppliers of capital after all operating expenses
  (including taxes) are paid and working and fixed
  capital investments are made.
• FCFF cash prior to the payment of interest to
  the debt holders
• FCFF EBIT - taxes depreciation (non-cash
  costs) capital spending increase in net
  working capital change in other assets
  terminal value
• Discount this at the firms WACC
• Firm Value Operating free cash flow
• WACC growth OFCF

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Discounting Models (continued)

• 2.B. Free Cash Flows to Equity (FCFE)
• FCFE is the cash flow available to the companys
  equity shareholders after all operating expenses,
  interest, and principle repayments have been made
  and necessary investments in working capital and
  fixed capital have been made
• FCFE Adjusts cash flows for debt repayments
• FCFE EBIT interest - taxes depreciation
  (non-cash costs) capital expenditures
  increase in net working capital principal debt
  repayments new debt issues terminal value.
  Discount at k required return on equity
• Firm Value Free Cash Flows to Equity/(k
  growth FCFE)

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Discounting Models (continued)

• Calculation Note for Discounting Models
• Determine the appropriate discount rate
• Set up each of the individual cash flows
• Discount each of the individual cash flows
• Discount the final cash flow assuming a constant
  growth rate cash flow / (k g)
• The question remains whether the final cash flow
  representative of all future cash flows
• Sum all the discounted cash flows
• Make adjustments as required

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3. Dividend Discount Models

• Models which take into account discounting
  expected future cash flows to gain a reference
  for the value of a company
• Dividend Discount Models
• General Model
• Constant Growth Model

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Dividend Discount Models (continued)

• 3.a. General Model
• Vo Sum Dt/(1k)t
• V0 Value of Stock
• Dt Dividend
• k Required return

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Dividend Discount Models (continued)

• 3.b. Constant Growth Rate Model
• Vo Do (1g)/(k-g)
• This is for stocks that are growing at a constant
  growth rate (assumed for perpetuity)
• g constant perpetual growth rate
• b plowback or retention ratio (rr)
• Note take out the g and the formula becomes the
  no growth model
• 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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Dividend Discount Models (continued)

• Estimating Dividend Growth Rates
• g ROE x b
• g growth rate in dividends
• ROE Return on Equity for the firm
• b plowback or retention percentage rate
• (1- dividend payout percentage rate)
• Internal Growth Rate (ROE x (1-payout)
• This is the rate that the company can continue to
  grow without any additional external financing
• Note if the firm distributes all its earnings,
  there is nothing to allow the firm to continue to
  grow

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Dividend Discount Models (continued)

• More Changes to the DDM
• What about growth opportunities?
• Do those impact the value of the company?
• Does the DDM only look at dividends?
• What about earnings on specific projects?
• Can we fix the DDM to look at the value of new
  projects?
• There are a number of different DDM models that
  can handle each of these situations

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Dividend Discount Models (continued)

• The constant growth dividend discount model can
  be used for both for the valuation of companies
  and for the estimation of long-term total return
  of a stock. Assume
• 20.00 the price of a stock today, 8
  expected growth rate of dividends, and 0.60
  Annual dividend one year forward
• A. Using only the data above, compute the
  expected long-term total return on the stock
  using the constant growth dividend discount
  model. Show calculations.
• B. Briefly discuss two disadvantages of the
  constant growth dividend discount model in its
  application to investment analysis.
• C. Identify two alternative methods to the
  dividend discount model for the valuation of
  companies.

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Answer

• A. Expected Return k D1/Po g .60/20 .08
  11
• B. The model assumes that the dividend growth
  rate is forever constant. Therefore, the model
  cannot be applied to firms that currently do not
  pay dividends. Second, the model is
  inappropriate when g gt k (which presumably cannot
  persist indefinitely). Third, the model cannot
  handle firms with variable dividend growth paths.
• C. One can use either P/E multiples or
  market-to-book multiples exhibited by other firms
  in the same industry.

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Valuing Companies using PE Ratios

• M A Departments often use PEs as one way of
  valuing companies. They find similar public
  companies to the ones they want to make public,
  they estimate their fair trading PE range, and
  then they apply the PE range to the new company.
• The fair trading PE range times the EPS gives the
  price per share.

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PE Ratio Example

• In 1996 Montgomery Asset Management of San
  Francisco California, a non-public company, was
  looking to be sold as its owner, Montgomery
  Securities, needed cash to build up its other
  operations. Assume it had 10 billion in assets
  and earns 20 million in revenues per year.
  Assuming similar asset management companies were
  being sold at 8-10 times earnings, what is MAM
  worth?

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Answer

• Assuming an 8-10 range for PE, MAM would be worth
  between 160-200 million.

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Price Earnings Ratios (continued)

• P/E Ratios are a function of two factors
• Required Rates of Return (k)
• Expected growth in Dividends
• Uses
• Valuation of new companies
• Relative valuation versus market and industry
• Note this is used extensively in the industry.
  Research has found that low PE stocks have given
  a higher return to Investors than high PE stocks
  over the last 70 years

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Price Earnings Ratios (continued)

• Price Earnings Key Terms
• Price Earnings Price per share/Average Common
  diluted Earnings Per Share
• Forward or Prospective PE Current Price /
  Forward EPS
• Historic PE Year-end Price/Year-end EPS
• Normalized PE Current Price/normalized earnings
  (earnings adjusted to take into account the
  cycles in the economy)
• Earnings Yield (E/P) 1 / Price Earnings

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Price Earnings Ratios (continued)

• Benefits and Pitfalls of P/Es
• Benefits
• Used extensively in the industry
• Generally low PE firms outperform high PE firms
• Pitfalls
• Earnings are accounting earnings, which can be
  manipulated through depreciation, inventory, etc.
• Earnings can fluctuate widely around a trend
• You cannot know if the PE is high or low unless
  you compare it to a trend, to long-run growth
  prospects, to an industry, or to the market

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Price Earnings Ratios (continued)

• P/E Ratio with no expected growth
• P0 E1 / k
• P0 / E1 1 / k
• where
• E1 - expected earnings for next year
• E1 is equal to D1 under no growth (100 payout)
• k - required rate of return

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Price Earnings Ratios (continued)

• P/E Ratio with Constant Growth
• P0 D1 / (k g) E1 (1-b) / k (b x ROE)
• P0 / E1 (1 b ) / k (b x ROE)
• where
• b earnings retention ratio
• ROE Return on Equity
• Note since we do not know what P1 will be, the
  EMH states that the best estimate of tomorrows
  price is todays price, hence we use P0 or
  todays price

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PE Example No Growth

• Company XYZ has earnings per share this year of
  E0 2.50, growth of 0, and a discount rate
  from the CAPM of k 12.5. What should its PE
  be?
• Answer
• With no growth (and 100 payout), the price of
  XYZ would be P0 D/k 2.50/.125 20.00.
• Its PE would be PE 1/k 1/.125 8.0x or
  PE P0 /EPS1 20/2.50 8.0x
• Note PE is independent of currency, so there is
  no dollar sign in front of it. It is a ratio.

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PE Example Growth

• Company XYZ now is under new management, and they
  no longer distribute all their earnings as
  dividends, with b (or rr) 60 ROE 15 (1-b)
  40. With EPS0 this year of 2.50, k 12.5,
  calculate E1, D1, g, and their new PE ratio be?
• Answer
• E1 2.50 (1 (.6)(.15)) 2.73
• D1 2.73 (1-.6) 1.09
• g 9 or .6 15
• P0 1.09/(.125-.09) 31.14
• PE 31.14/2.73 11.4x or
• PE (1 - .60) / (.125 - .09) 11.4x
  (generally format PE to one decimal point and
  place an x behind it)

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Problem

• Explain why the following statements are true /
  false / uncertain.
• a. Holding all else constant, a firm will have a
  higher P/E if its beta is higher.
• b. P/E will tend to be higher when ROE is higher
  (assuming plowback is positive).
• c. P/E will tend to be higher when the plowback
  rate is higher.

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Answer

• a. False. Higher beta means that the risk of the
  firm is higher and the discount rate applied to
  value the cash flows is higher. For any expected
  path of earnings and cash flows the present value
  of the cash flows, and therefore, the price of
  the firm will be lower when risk is higher. Thus
  the ratio of price to earnings will be lower.
• b. True. Higher ROE means more valuable growth
  opportunities.
• c. Uncertain. The answer will depend on a
  comparison of the expected rate of return on
  reinvested earnings versus the market
  capitalization rate. If the expected rate of
  return on the firms projects is higher than the
  market capitalization rate, the P/E ratio will
  increase as the plowback ratio increases.

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Problem

• Even Better Products has come out with a new and
  improved product. As a result, the firm projects
  an ROE of 20, and it will maintain a plowback
  ratio of 0.30 or 30. Its earnings this year
  will be 2 per share. Investors expect a 12
  rate of return on the stock.
• At what price and P/E ratio would you expect the
  firm to sell?
• What is the present value of growth
  opportunities? (Remember V0 E1/k PVGO so
  PVGO D0(1g)/(k-g) E1/k)
• What would be the P/E ratio and the present value
  of growth opportunities if the firm planned to
  reinvest only 20 of its earnings?

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Answer

• Price and P/E ratio?
• g ROE x b 20 x .30 6
• D1 2(1-b) 2(1 - .30) 1.40
• P0 D1/(k g) 1.40/(.12 - .06) 23.33 so
  P/E 23.33/2 11.7x
• Present value of growth opportunities?
• PVGO P0 EPS0/k 23.33 2.00/.12 6.67
• B 20
• G ROE x b 20 x .20 4
• D1 2(1 b) 2(1 - .20) 1.60
• Po D1/(k-g) 1.60/(.12 - .04) 20 P/E
  20/2 10
• PVGO P0 EPS0/K 20 2.00/ .12 3.33

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Questions

• Any questions on methods of equity valuation?

42
Understand the Key Valuation Metrics in Valuing
Securities

• What are the key valuation metrics?
• PE, PBV, PS, DY, POCF, PEBIT, PEVITDA, P/IGR, and
  P/EGR
• Why are they important?
• They relate the current market price to key
  profitability variables
• They relate the companys PE ratio to certain
  types of growth

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1.  Price/Earnings (PEP/EPS)

• PE Ratio
• The most common measures of a firms stock price
  relative to its earnings--what you are paying for
  1 of earnings.
• How is it analyzed?
• Versus its historical average
• If lower that than its history, it may indicate
  it is moving into more attractive territory,
  i.e., growth is increasing
• Versus the market.
• Gives a historical view. If it is trading at a
  lower relative PE, it may be becoming more
  attractive.
• Versus the industry
• If the relative PE versus the Industry is
  declining, it may indicate the stock is becoming
  more attractive.

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2.  Price/Book (PBP/BVS)

• P/BV or PB or Market to Book
• Gives the relationship between the stock price
  and the book value of the firm (i.e. owners
  equity).
• How it is analyzed?
• If the PB ratio is high when compared to peer
  firms, the stock may be overvalued, all else
  being equal.
• If the PB is negative, the firm is in serious
  trouble.
• Remember that owners equity is based on
  accounting depreciation and may not have
  relevance to the actual value of the assets of
  the company.
• Generally, the higher the P/BV (or the lower its
  inverse, Book to Price) the more expensive the
  company.

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3. Price/Sales (PSP/SPS)

• Price to Sales
• Sales multiples are sometimes an indicator of
  growth in sales and hence future profits.
• How it is analyzed?
• Can be positive or negative
• Note that growth in sales translates into growth
  in profits only if the other drivers of profits
  are sustained, i.e. profit margins, turnover,
  etc.
• New companies
• New companies like PS ratios when they dont have
  any earnings. But if earnings fail to
  materialize, then PS ratios are irrelevant.
• Generally, the lower the PS ratio, the more
  attractive the company, all else being equal

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4. Dividend Yield (DYDPS/P)

• Dividend Yield
• Certain companies are known for their high
  dividend payouts
• Historically we have seen an overall decline in
  the markets dividend yield as firms decided that
  they could use dividend payouts more effectively
  in their own firms
• How is it analyzed?
• DY assesses the amount of dividend an investor
  will receive for his dollar if invested at the
  current share price.
• A high dividend yield can be perceived as both
  positive and negative. Positively, as you have a
  return of capital negatively, as the company has
  no better use for the funds

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5. Price/Operating Cash Flow (POCFP/OCFS)

• Price to Operating Cash Flow
• P/OCF is an important measure of a firms health
• It gives an assessment of the firms power to
  generate operating cash flow on a price per share
  basis
• How is it analyzed?
• Firms that are generating a high amount of cash
  are perceived to be more attractive than firms
  which are not generating cash
• Generally, the lower the P/OCF the more
  attractive the firm

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6. Price/EBIT (PEBITP/EBITS)

• Price to Earnings before Interest and Taxes
• In evaluating firms which are potential takeover
  targets or which are not making earnings,
  analysts often use Price/EBIT, which they would
  use instead of Price Earnings (as there are not
  earnings).
• This gives the relevant ratio assuming the firm
  had no other expenses, i.e. debts, taxes, etc.
• This was used in valuing the high-flying tech
  firms
• How is it analyzed?
• Generally the lower the ratio, the more
  attractive the company
• Be careful as this ratio says nothing about
  overall profits, but only operating earnings.

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7. Price/EBITDA (PEBITDAP/EBITDAS)

• Price to Earnings Before Interest and Taxes and
  Depreciation and Amortization
• Used to put a price on firms which have no
  earnings but are generating cash and which may be
  attractive as acquisition candidates
• P/EBITDA is similar to the Price/EBIT, except
  that it includes depreciation and amortization,
  which are non-cash charges
• How is it analyzed?
• Takeover firms are concerned with the amount of
  cash firms are generating assuming no other
  charges and taxes. Generally the lower the ratio,
  the more attractive the company

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8. PE to IGR (PE/Internal Growth Rate or g)

• PE to Internal Growth Rate (which is a proxy for
  a firms sustainable growth rate)
• Used to relate a companys PE to its sustainable
  growth rate
• How is it analyzed?
• A low PE stock with a high internal growth rate
  will have a low ratio, while a high PE stock with
  a low IGR will have a high ratio.
• Generally the lower the ratio, the more
  attractive the company.

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9. PE to Earnings Growth (PE/EPS Growth)

• Price Earnings to Earnings Growth
• Another takeoff on the PE to growth ratio
• Sometimes used this as a screening device, only
  looking at companies whose PE divided by Earnings
  growth rates are 1 or less
• How is it analyzed?
• Generally, companies are more attractive when
  this ratio is lower, as they have not only higher
  earnings, but those earnings are expected to
  growth in the near future.
• Can be very volatile due to the volatility of
  earnings per share growth
• Due to volatility, some investors prefer the PE
  to IGR above

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Questions

• Do you have any questions on the various types of
  metrics used in valuing companies?

53
Problem

• Portfolio managers and analysts often compare a
  companys Price Earnings ratio to measures of
  growth as indicators of value. Which of the two
  measures, PE to IGR or PE to EPS growth, will be
  more stable and why?

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Answer

• The PE to IGR will be more stable as ROE is
  generally in the 5-35 range, and earnings per
  share growth can be anywhere from 100 to 200
  depending on the company.

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Review of Objectives

1. Do you understand the relationship between
   intrinsic value and market value?
2. Are you familiar with the various types of
   valuation models, including balance sheet,
   dividend discount models, and PE ratios?
3. Do you understand other key metrics used in
   valuing securities?