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Chapter 5 Stock Valuation
FINANCIALMARKET (E2020)
Addis Ababa University
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Chapter 4
Stock and equity valuation
Overview
Major approaches to valuing common stocks using fundamental security analysis include:
Discounted cash flow (DCF) techniques
Earnings multiplier approach
Relative valuation metrics
DCF techniques attempt to estimate the value of a stock (its intrinsic value) using a present value analysis. For example, using the Dividend Discount Model, the future stream of dividends to be received from a common stock is discounted back to the present at an appropriate discount rate (that is, the investor’s required rate of return) and summed. Alternative DCF versions discount such variables as free cash flow. The end result is an estimate of the current “fair value” or intrinsic value of the stock.
The multiplier approach attempts to estimate intrinsic value by multiplying an estimated firm characteristic by an estimated multiple. The most prominent multiplier approach relies on estimated earnings per share (EPS) and the earnings multiplier, the P/E ratio.
Discounted Cash Flow Models
The classic method of calculating the estimated value of any security is the DCF model, which is based on a present value analysis.
✓ The DCF model estimates the value of a security by discounting its expected future cash flows back to the present and adding them together.
The estimated value of a security is equal to the discounted (present) value of the future stream of cash flows that an investor expects to receive from the security:
To use such a model, an investor must: 1. Estimate the amount and timing of the future cash flows 2. Estimate an appropriate discount rate 3. Use these two components in a present value model to estimate the intrinsic value of the security, V0 , and then compare V0 to the current market price of the security
To use such a model, an investor must:
Estimate the amount and timing of the future cash flows
Estimate an appropriate discount rate
Use these two components in a present value model to estimate the intrinsic value of the security, V0, and then compare V0 to the current market price of the security
✓ The intrinsic value for a stock is simply its estimated value—what the investor believes the stock is worth.
Growth Rate Cases For The DDM
####### THE ZERO GROWTH RATE MODEL‐
A zero growth rate equates to a fixed dollar dividend that does not change over time. For‐ ‐ example, a firm pays a dividend of $1 a share annually, and there is no expectation that the dividend will change. The zero growth rate dividend case reduces to a perpetuity.‐
Where D0 is the constant dollar dividend expected for all future time periods and k is the opportunity cost or required rate of return for the stock.
The no growth DDM is commonly used to value traditional preferred stock, which, as discussed‐ in Chapter 2, has an infinite life and pays a fixed dividend. The annual amount of preferred dividends is calculated by multiplying the stated dividend rate by the par value of the preferred stock.
A Present Value Process The discounting process is not apparent when the perpetuity formula is applied in the zero growth rate case. Nevertheless, the formula accounts for all dividends from‐ now to infinity in this case, as with the other DDM cases. It is simply a mathematical fact not to mention a great calculation convenience that dividing a constant dollar amount by the discount rate, k, produces a result equivalent to discounting each dividend from now to infinity separately and summing all of the present values.
✓ In using a DDM to value a stock, an investor discounts the future stream of dividends from now to infinity. This fact tends to be overlooked.
THE CONSTANT GROWTH RATE MODEL‐
A well known scenario in valuation is the case in which dividends are expected to grow at a‐ constant growth rate over time. This constant growth rate model is shown as‐
Where D1 is the dividend expected to be received at the end of Year 1.
####### THE MULTIPLE GROWTH RATE MODEL‐
Multiple growth is defined as a situation in which a company’s expected future growth in dividends is described using two or more growth rates (one of which could be zero). Although any number of growth rates is possible, most stocks can be described using two or possibly three different growth rates.
The Two Stage Growth Rate Model A well known multiple growth rate model is the two stage‐ ‐ ‐ ‐ model. This model assumes near term growth at a rapid rate for some period (typically, 2 to 10‐ years) followed by a steady long term growth rate that is sustainable (i., a constant growth‐ ‐ rate). This can be described in equation form as
(b) Determining the length of the abnormal growth period is quite difficult to do in practice. Will it last 5 years or 12 years?
(c) The model as described previously assumes an immediate transition from unusual growth to constant growth, while in reality the transition may not take place that quickly.
How Capital Gains are Accounted For: The estimated future price is built into the DDM in Equation 10-2—it is simply not visible. To see this, ask yourself at what price you can expect to sell your stock at some point in the future. Assume, for example, that you purchase the stock today and plan to hold it for three years. The price you receive three years from now will reflect the buyer’s expectations of dividends from that point forward (at the end of Years 4, 5, etc.). Your estimated price today of the stock, V0 , is equal to
But P3 (the estimated price of the stock at the end of Year 3), is, in turn, equal to the discounted value of all future dividends from Year 4 to infinity. That is,
Other Discounted Cash Flow Approaches
The DDM is certainly not the only DCF model used by investors and analysts; however, all DCF models rely on the same basic concepts—an estimation of future cash flows discounted back to today using a discount rate that reflects the time value of money and the risk involved.
FREE CASH FLOW TO EQUITY
The DCF model that relies on cash flows to equity is referred to as the Free Cash Flow To Equity (FCFE) model. It differs from the DDM discussed previously in that FCFE measures what a firm could pay out in dividends, rather than what they actually do pay out.
Dividends are at times higher than FCFE and at other times lower. Note the FCFE variable is on a per share basis.‐
Definition of Free Cash Flow to Equity FCFE is defined as the cash flow available to the
firm’s owners (stockholders). It equals cash remaining after interest and principal repayments on debt, capital expenditures (both to maintain existing assets and provide for new assets needed for growth), and operating working capital expenditures. It can be calculated as
Implementing the Model : To implement this model for a firm whose cash flows are growing at a stable rate, an analyst could apply the constant growth format discussed with the DDM. This‐ results in the following equation:
FREE CASH FLOW TO THE FIRM
Free cash flow to the firm (FCFF) is similar to the definition of FCFE. The major differences arise from the use of debt financing, including both the repayment of existing debt, and the interest thereon, and the sale of new debt.
Definition of Free Cash Flow to the Firm FCFF is defined as the cash flows available to all the firm’s claimholders (common and preferred stock and bonds) after making fixed and operating working capital expenditures.
####### INTRINSIC VALUE AND MARKET PRICE
The end objective of a DCF analysis is an estimate of intrinsic value. What does intrinsic value indicate? It is simply the estimated value of the stock today, derived from estimating and discounting the future cash flows. How is it used? Investors and analysts specify a relationship between the intrinsic value, V0 , of an asset and its current market price.
Security analysis can be viewed as a search for undervalued or overvalued stocks. Most investors believe that stocks are not always priced at their intrinsic values, thereby leading to buy and sell opportunities.
Other Multipliers
The multiplier approach is commonly applied with estimated EPS and appropriate P/E; however, many analysts rely on alternative multipliers in deriving the intrinsic value for a stock. The valuation procedure using these alternative multipliers works in the same manner as the earnings multiplier approach. Specifically, the investor estimates the relevant firm characteristic and the appropriate multiplier. By multiplying the two together, the investor obtains an estimate of intrinsic value, V0. The most popular multipliers include the following:
PRICE TO BOOK (P/B) PRICE TO SALES (P/S) PRICE TO CASH FLOW (P/CF) ENTERPRISE VALUE TO EBITDA (EV/EBITDA)
Using Alternative Multipliers As noted previously, each of the alternative multipliers can be used in the same manner as the earnings multiplier to arrive at an estimate of a security’s intrinsic value. For example, assume that an investor estimates the revenue of IBM at $110 per share for next year. Also assume that the investor estimates the appropriate P/S ratio [ (P 0 /S 1 ) A] of IBM to be 1. By multiplying the two values, the investor arrives at an estimate for IBM’s intrinsic value as shown below:
Relative Valuation Metrics
####### PRICE/EARNINGS (P/E) RATIO
The P/E ratio (multiple) is one of the most widely mentioned and discussed variables pertaining to a common stock and will typically appear in some form in any report from an analyst or an investment advisory service. As a definition, the P/E ratio is simply the price investors are willing to pay per dollar of firm earnings. For example, a stock priced at $100, with most recent 12 month EPS of $5, has a P/E of 20 and is said to be selling for a multiple of 20 times trailing‐ 12 month (TTM) earnings. Likewise, a firm with EPS of $2 that is selling for $100 has a P/E‐ of 40 and is selling at 40 times earnings.
The typical P/E ratio is calculated as the current stock price divided by the firm’s latest
12 month EPS. This P/E ratio is frequently referenced as the trailing P/E because it uses‐
trailing 12 month EPS. As such, it tells investors the price currently being paid per $1 of‐ earnings.
The typical P/E ratio relies on historical earnings and is not particularly useful for valuation purposes. Therefore, analysts generally use a modified version of the ratio when deriving stock values. For valuing a stock, analysts generally make a forecast of next year’s EPS and project an appropriate P/E ratio they expect is relevant for the firm. Next year’s expected EPS, E1, can be found by taking this year’s EPS, E0, and compounding it one period by the expected growth rate, g.
An appealing aspect of this approach is its apparent simplicity—multiply two variables together to derive an estimate of intrinsic value. However, the problem is that both variables used in this model, next period’s EPS and the appropriate P/E ratio, are both estimates and therefore are subject to misestimating. The appropriate P/E ratio (P 0 /E 1 ) A is the investor’s estimate of the price that investors in aggregate should pay per dollar of estimated firm earnings.
####### PRICE/BOOK (P/B) RATIO
####### PRICE/SALES (P/S) RATIO
####### PRICE/CASH FLOW (P/CF) RATIO
####### ENTERPRISE VALUE/EBITDA (EV/EBITDA) RATIO
ECONOMIC VALUE ADDED ANALYSIS
Chapter 5 Stock Valuation
Course: FINANCIALMARKET (E2020)
University: Addis Ababa University
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