Week 2B

MFIN 833
Equity Valuation Models
INVESTMENTS | BODIE, KANE, MARCUS

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Valuation: Fundamental Analysis
• Fundamental analysis models a company’s

value by assessing its current and future
profitability.
• The purpose of fundamental analysis is to
identify mispriced stocks relative to some
measure of “true” value derived from financial
data.
18-2 INVESTMENTS | BODIE, KANE, MARCUS

Models of Equity Valuation
• Balance Sheet Models

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

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.

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.
• “Floor” or minimum value is the liquidation
value per share.
• Tobin’s q is the ratio of market price to
replacement cost.
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, based on the stock’s risk.

Required Return
• CAPM gives the required return, k:
rf + β  E (rM ) − rf 
k=
• If the stock is priced correctly, k should equal

expected return.
• k is the market capitalization rate.

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
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
• The DDM says the stock price should equal the
present value of all expected future dividends
into perpetuity.
Constant Growth DDM
D0 (1 + g ) D1
V0 = =
k−g k−g
k= appropriate risk-adjusted interest rate
g= dividend growth rate

Example 18.1 Preferred Stock and the DDM
• No growth case
• Value a preferred stock paying a fixed
dividend of €2 per share when the
discount rate is 8%:

Example 18.2 Constant Growth DDM
• A stock just paid an annual dividend of

£3/share. The dividend is expected to grow at
8% indefinitely, and the market capitalization
rate (from CAPM) is 14%.

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.

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)

Figure 18.1 Dividend Growth for Two
Earnings Reinvestment Policies

Present Value of Growth Opportunities
• The value of the firm equals the value of the

assets already in place, the no-growth value of
the firm,
• Plus the NPV of its future investments,
• Which is called the present value of growth
opportunities or PVGO.

Present Value of Growth Opportunities
• Price = No-growth value per share + PVGO
E1
P
=0 + PVGO
k

Example 18.4 Growth Opportunities
• Firm reinvests 60% of its earnings in projects with

ROE of 10%, capitalization rate is 15%. Expected
year-end dividend is €2/share, paid out of
earnings of €5/share.
• g=ROE x b = 10% x .6 = 6%

Example 18.4 Growth Opportunities

Life Cycles and Multistage Growth Models
• Expected dividends for Honda:

2013 $.78 2015 $ .92
2014 $.85 2016 $1.00
• Since the dividend payout ratio is 25% and

ROE is 10%, the “steady-state” growth rate is
7.5%.

Honda Example
• Honda’s beta is 0.95 and the risk-free rate is
2%. If the market risk premium is 8%, then k
is:
• k=2% + 0.95(8%) = 9.6%
• Therefore:
D2017 D2016 (1 + g ) $1(1.075)
P2016 = = = = $51.19
k−g k−g 0.096 − 0.075

Honda Example
• Finally,
$0.78 $0.85 $0.92 $1 + $51.19

V2012 = + 2
+ 3
+
1.096 1.096 1.096 1.096 4
• In 2012, one share of Honda Motor Company

Stock was worth $32.88.

Price-Earnings Ratio and Growth
• 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 (i.e., the no-
growth value of the firm, E / k ).
P0 1  PVGO 
= 1+
E1 k  E 
 k 

• 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.

• P/E increases:
– As ROE increases
– As plowback increases, as long as ROE>k
P0 1− b
=
E1 k − ROE x b

Table 18.3 Effect of ROE and Plowback on
Growth and the P/E Ratio

P/E and Growth Rate
• Wall Street rule of thumb: 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.

P/E Ratios and Stock Risk
• When risk is higher, k is higher; therefore, P/E is

lower.
P 1− b
=
E k−g

Pitfalls in P/E Analysis
• Use of accounting earnings

– Earnings Management
– Choices on GAAP
• Inflation
• Reported earnings fluctuate around the business
cycle

Figure 18.3 P/E Ratios of the S&P 500 Index
and Inflation

Figure 18.4 Earnings Growth for Two
Companies

Figure 18.6 P/E Ratios for Different
Industries, 2012

Other Comparative Value Approaches
• Price-to-book ratio
• Price-to-cash-flow ratio
• Price-to-sales ratio

Figure 18.7 Market Valuation Statistics

Free Cash Flow Approach
• 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

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

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

Table 18.4 S&P 500 Price Forecasts Under
Various Scenarios

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MFIN 833

Equity Valuation Models

INVESTMENTS | BODIE, KANE, MARCUS

• Fundamental analysis models a company’s

18-2 INVESTMENTS | BODIE, KANE, MARCUS

• Balance Sheet Models

18-3 INVESTMENTS | BODIE, KANE, MARCUS

• Compare valuation ratios of firm to industry

• Ratios like price/sales are useful for valuing

18-4 INVESTMENTS | BODIE, KANE, MARCUS

• The return on a stock is composed of dividends

• The expected HPR may be more or less than the

18-6 INVESTMENTS | BODIE, KANE, MARCUS

• CAPM gives the required return, k:

• If the stock is priced correctly, k should equal

18-7 INVESTMENTS | BODIE, KANE, MARCUS

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

• V0 =current value; Dt=dividend at time t; k =

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• A stock just paid an annual dividend of

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• The value of the firm equals the value of the

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• Price = No-growth value per share + PVGO

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• Firm reinvests 60% of its earnings in projects with

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• Expected dividends for Honda:

• Since the dividend payout ratio is 25% and

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$0.78 $0.85 $0.92 $1 + $51.19

• In 2012, one share of Honda Motor Company

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• P/E rises dramatically with PVGO.

• High P/E indicates that the firm has ample

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Quote from Peter Lynch in One Up on Wall Street.

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

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• Use of accounting earnings

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• Value the firm by discounting free cash flow at

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• Use of earnings multiplier approach at