LCASTO

CHAPTER 11
SECURITY VALUATION PRINCIPLES
 LCASTO
LEARNING OBJECTIVES
CH. 11 Security Valuation Principles
Learning Objectives
• Explain the two major approaches to the investment process
• Explain the specifics and logic of the top-down (three-step) approach
• Enumerate the empirical evidence that supports the usefulness of the
top-down approach
• Explain the required inputs while valuing an asset
• Explain the decision process that takes place after valuing an asset
• Explain how to determine the value of bonds and preferred stock
• Explain the two primary approaches to the valuation of common stock
• Explain what condition is it best to use the present value of cash flow
approach for valuing a company’s equity
• Explain what condition is it best to use the relative valuation techniques
for valuing a company’s equity
• Explain how to apply discounted cash flow valuation approach and what
are the major discounted cash flow valuation techniques
• Explain the dividend discount model (DDM) and its logic
• Explain the effect of the DDM’s assumptions when valuing a company’s
growth
• Explain how to apply the present value of operating cash flow technique
and free cash flow to equity technique as well as the relative valuation
approach
 OVERVIEW OF THE VALUATION
• Two General Approaches
• Top-down, three-step approach
• Bottom-up, stock valuation, stock picking approach
• The difference between the two approaches is the perceived importance of
economic and industry influence on individual firms and stocks
• Both of these approaches can be implemented by either fundamentalists or
technicians
• The Three-Step Top-Down Process
• First examine the influence of the general economy on all firms and the
security markets
• Then analyze the prospects for various global industries with the best outlooks
in this economic environment
• Finally turn to the analysis of individual firms in the preferred industries and to
the common stock of these firms.
EXHIBIT 11.1
 THREE-STEP VALUATION APPROACH
General Economic Influences
• Fiscal policy initiatives, such as tax credits or tax cuts, can encourage spending
• Monetary policy though controlling money supply growth or interest rate therefore
affects all segments of an economy and that economy’s relationship with other
economies
• Inflation causes changes the spending and savings behavior of consumers and
corporations
• Other events such as war, political upheavals in foreign countries, or international
monetary devaluations exert strong effects on the economies
Industry Influences
• Identify global industries that will prosper or suffer in the long run or during the
expected near-term economic environment
• Different industries react to economic changes at different points in the business cycle
• Alternative industries have different responses to the business cycle
• Demographic factor and international exposure will also have different impacts on
different types of industries
 THREE-STEP VALUATION APPROACH
Company Analysis
• The purpose of company analysis to identify the best companies in a promising industry
• This involves examining a firm’s past performance, but more important, its future
prospects
• It needs to compare the estimated intrinsic value to the prevailing market price of the
firm’s stock and decide whether its stock is a good investment
• The final goal is to select the best stock within a desirable industry and include it in your
portfolio based on its relationship (correlation) with all other assets in your portfolio
Does it Work?
• Studies indicate that most changes in an individual firm’s earnings can be attributed to
changes in aggregate corporate earnings and changes in the firm’s industry
• Studies have also found a relationship between aggregate stock prices and various
economic series such as employment, income, or production
• An analysis of the relationship between rates of return for the aggregate stock market,
alternative industries, and individual stocks showed that most of the changes in rates of
return for individual stock could be explained by changes in the rates of return for the
aggregate stock market and the stock’s industry
 THEORY OF VALUATION
• The value of an asset is the present value of its expected returns
• To convert this stream of returns to a value for the security, you must discount this
stream at your required rate of return

Stream of Expected Returns

• Form of returns
• Earnings
• Cash flows
• Dividends
• Interest payments
• Capital gains (increases in value)

• Time pattern and growth rate of returns

• When the returns (Cash flows) occur
• At what rate will the return grow
 THEORY OF VALUATION
Required Rate of Return
• Reflect the uncertainty of return (cash flow)
• Determined by economy’s risk-free rate of return, plus
• Expected rate of inflation during the holding period, plus
• Risk premium determined by the uncertainty of returns
• Business risk
• Financial risk
• Liquidity risk
• Exchanger rate risk and country

Investment Decision Process: A Comparison of Estimated Values and

Market Prices
• You have to estimate the intrinsic value of the investment at your required rate of return
and then compare this estimated intrinsic value to the prevailing market price
• If Estimated Value > Market Price, Buy
• If Estimated Value < Market Price, Don’t Buy
 VALUATION OF BONDS
Valuation of Bonds is relatively easy because the size and time pattern
of cash flows from the bond over its life are known:
• Interest payments are made usually every six months equal to one-half the coupon rate
times the face value of the bond:
• The principal is repaid on the bond’s maturity date
• The bond value is defined as the present value of its future interest and principle
payments

Cash Inflows of a Bond

105

5 5 5 5 5 5 5 5 5
1 2 3 4 5 6 7 8 9 10
 VALUATION OF BONDS – AN EXAMPLE
Assume in 2012, a $10,000 par value bond due in 2027 with 10% coupon will pay
$500 every six months for its 15-year life. What is the bond price if the required rate
of return is 10%?
Present value of the interest payments
$500 x 15.3725 = The bond value
$7,686 $7,686+$2,314=$10,000
The present value of the principal
$10,000 x .2314 =
$2,314
• The $10,000 valuation is the amount that an investor should be willing to pay for this
bond, given the required rate on a bond of 10%
• If the required rate of return changes, then bond value will change inversely.
• What is the bond value if the return is 12%?
$500 x 13.7648 = $6,882
$10,000 x .1741 = 1,741
Total value of bond at 12 percent = $8,623
• If required return increases (decreases) then price of bond decreases (increases).
 VALUATION OF PREFERRED STOCK
• Owner of preferred stock receives a promise to pay a stated dividend, usually quarterly, for
perpetuity
• Since payments are only made after the firm meets its bond interest payments, there is
more uncertainty of returns
• Tax treatment of dividends paid to corporations (80% tax-exempt) offsets the risk premium
• The value is simply the stated annual dividend divided by the required rate of return on
preferred stock (kp)
Dividend
V 
kp

• Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required
rate of return of 9 percent
V = $8 / 0.09 = $ 88.89
• Given a market price, you can derive its promised yield
Dividend
kp 
Price

• At a market price of $85, this preferred stock yield would be

Kp = $8 / $85 = 9.41%
 POP QUIZ
ABC Company pays a 25-cent dividend every month and the required rate of return is 6%
per year, then the expected value of the stock is:

a. $4.17
b. $8.33
c. $50
d. None of the above

Answer: C
$0.25 / (.06/12) = $50
Or
($0.25 x 12) / 0.06 = $50 .50
P/E  .50 / .05 10 .0
.13 - .08

11-12
 VALUATION OF COMMON STOCK
Two General Approaches
• Discounted Cash-Flow Techniques - Present value of some measure of cash flow, including dividends,
operating cash flow, and free cash flow
• Relative Valuation Techniques - Value estimated based on its price relative to significant variables, such as
earnings, cash flow, book value, or sales

Both of these approaches and all of these valuation techniques have several common
factors:
• All of them are significantly affected by investor’s required rate of return on the stock because this rate
becomes the discount rate or is a major component of the discount rate;
• All valuation approaches are affected by the estimated growth rate of the variable used in the valuation
 VALUATION OF COMMON STOCK
WHY DIVIDEND CASH WHY RELATIVE VALUATION
FLOW APPROACH? TECHNIQUES?
• These techniques are obvious • Easier to do
choices for valuation because
• Provides information about how
they are the epitome of how
we describe value—that is, the the market is currently valuing
present value of expected cash stocks
flows • No guidance as to whether
• Dividends: Cost of equity as valuations are appropriate (best
the discount rate used when have comparable
entities)
• Operating cash flow: Weighted
Average Cost of Capital (WACC)
• Free cash flow to equity: Cost
of equity as the discount rate
• Dependent on growth rates
and discount rate
 VALUATION OF COMMON STOCK
Discounted Cash Flow (DCF) Valuation
METHODOLOGY
• It is an intrinsic value approach where an analyst
forecasts the business free cash flow into the
future and discounts it back to today at the
firm’s Weighted Average Cost of Capital (WACC)
as the discount rate
• It is performed by building a financial model and
requires an extensive amount of detail, analysis
and lots of assumptions
• DCF model will also often result in the most
accurate valuation.
• It allows the analyst to forecast different
scenarios, and perform a sensitivity analysis.
• For larger businesses, the DCF value is
commonly a sum-of-the-parts analysis, where
different business units are modeled individually
and added together.
DRAWBACKS
• The main limitation of DCF is that it requires
making many assumptions, like the estimate of
future cash flows which would rely on a variety
of factors
DISCOUNTED CASH FLOW VALUATION TECHNIQUES
The General Formula

t n
CFt
V j  t
t 1 (1  k )

Where:
Vj = value of stock j

n = life of the asset

CFt = cash flow in period t

k = the discount rate that is equal to

the investor’s required rate of return for
asset j,
 THE DIVIDEND DISCOUNT MODEL (DDM)
The value of a share of common stock is the present value of all future
dividends
D1 D2 D3 D
Vj     ... 
(1  k ) (1  k ) 2 (1  k ) 3 (1  k ) 
n
Dt

t 1 (1  k ) t

where:
Vj = value of common stock j
Dt = dividend during time period t
k = required rate of return on stock j

Two Types
• N-Period Model
• Infinite Period Model (Constant Growth Model)
 THE DIVIDEND DISCOUNT MODEL (DDM)
The N-Period Model
• If the stock is held for only N period, e.g. 2 years, and a sale at the end of year 2 would
imply:
D1 D2 SP j 2
Vj   2

(1  k ) (1  k ) (1  k ) 2

• The expected selling price, SPj2, of stock j at the end of Year 2 is crucial, which is in fact
the present value of future expected dividends
 N-PERIOD MODEL – AN EXAMPLE
Example
You are an investment analyst. Your client asked you to assess the viability of the
investment in ABC Corp. The client expects to hold the investment for three years and
sell it at the end of the holding period (end of the third year). You’ve forecasted that ABC
Corp. will pay dividends of $2.50 in the first year, $3 in the second year, and $3.25 in the
third year. You expect that at the end of the third year, the selling price of the company’s
stock will be $125 per share. The estimated cost of capital is 5%.

The current stock price is $110 per share.

 THE DIVIDEND DISCOUNT MODEL (DDM)
Infinite Period Model (Constant Growth Model)
• Assumes a constant growth rate for estimating all of future dividends

D 0 (1  g ) D 0 (1  g ) 2 D 0 (1  g ) n D1
Vj   2
 ...  Vj 
(1  k ) (1  k ) (1  k ) n k g
where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k = required rate of return on stock j
n = the number of periods, which we assume to be infinite

Assumptions of DDM
• Dividends grow at a constant rate
• The constant growth rate will continue for an infinite period
• The required rate of return (k) is greater than the infinite growth rate (g)
 INFINITE PERIOD MODEL – AN EXAMPLE
Example
A company whose stock is trading at $110 per share. This company requires an 8%
minimum rate of return (r) and will pay a $3 dividend per share next year (D 1), which is
expected to increase by 5% annually (g).

The value of the stock is calculated as follows:

V = $3 /(0.08 – 0.05) = $ 100

Therefore the stock is over valued by $10 in the market ($110 - $100). Sell the stock!
INFINITE PERIOD DDM AND GROWTH COMPANIES
• Growth companies have
opportunities to earn return on
investments greater than their
required rates of return
• To exploit these opportunities,
these firms generally retain a
high percentage of earnings for
reinvestment, and their earnings
grow faster than those of a
typical firm
• During the high growth periods
where g>k, this is inconsistent
with the constant growth DDM
assumptions
 POP QUIZ
A company’s dividend this year is $100, and the company’s cost of capital is 8%, with a
long-term dividend growth rate of 3%, the value of the stock is:

a. $2,000
b. $2,060
c. $1,250
d. None of the above

Answer: B
$100 (1.03) / (0.08 – 0.03) = $2,060

.50
P/E  .50 / .05 10 .0
.13 - .08

11-23
PRESENT VALUE OF OPERATING FREE CASH FLOWS
The Formula

where:
Vj = Value of the stock of firm j
n = number of periods assumed to be infinite
OFCFt = the firm’s operating free cash flow in period t
WACC j =firm j’s weighted average cost of capital

• Derive the value of the total firm by discounting the total operating cash flows prior to the
payment of interest to the debt-holders
• Then subtract the value of debt to arrive at an estimate of the value of the equity
• Similar to the DDM, we can have
• We have use a constant rate forever
• We can assume several different rates of growth for OCF, like the supernormal dividend
growth model
PRESENT VALUE OF FREE CASH FLOWS TO EQUITY
The Formula

n
FCFEt
V j  t
t 1 (1  k j )
where:
Vj = Value of the stock of firm j
n = number of periods assumed to be infinite
FCFEt = the firm’s free cash flow in period t
K j = the cost of equity

• “Free” cash flows to equity are derived after operating cash flows have been
adjusted for debt payments (interest and principal)
• These cash flows precede dividend payments to the common stockholder
• The discount rate used is the firm’s cost of equity (k) rather than WACC
 POP QUIZ
Statement 1: FCFE, as a method of valuation, is an alternative to the dividend discount
model (DDM), especially for cases in which a company does not pay a dividend
Statement 2: A measure of equity cash usage, free cash flow to equity calculates how
much cash is available to the equity shareholders of a company after all expenses,
reinvestment, and debt are paid.

a. Both statements are true

b. Both statements are false
c. Only Statement 1 is true
d. Only Statement 2 is true

Answer: A .50
P/E  .50 / .05 10 .0
.13 - .08

11-26
 EQUITY SECURITIES VALUATION
Multiples Approach
• Investors identify similar companies. A multiple is then computed for the comparable companies and
aggregated into a standardized figure using the average. The value identified as the key multiple among
the various companies is applied to the value of the firm under analysis to estimate its value.
• Forward looking multiples are favored over historical multiples
• Common examples include P/B, P/E, PEG, P/CF and P/S. Lower values of these multiples might indicate
better value

PRICE to BOOK (P/B)PRICE to EARNINGS (P/E)PRICE to CASHFLOW PRICE to SALES (P/S)

(P/CF)
The P/B ratio measures The P/E ratio relates a Normally used for high
the company’s valuation company's share price to Cashflows are less prone growth companies with no
of a relative to its book its earnings per share to manipulation than earnings yet
value. P/B lower than 1 is (EPS). It is inapplicable to earnings
normally a solid losing companies
investment
 EARNINGS MULTIPLIER MODEL
P/E Ratio: This values the stock based on expected annual earnings

Price/Earnings Ratio= Earnings Multiplier  Current Market Price

Expected 12 - Month Earnings

Combining the Constant DDM with the P/E ratio approach by dividing earnings
on both sides of DDM formula to obtain P D /E i 1 1

E1 k g
Thus, the P/E ratio is determined by
• Expected dividend payout ratio

• Required rate of return on the stock (k)

• Expected growth rate of dividends (g)

 EARNINGS MULTIPLIER MODEL
Assume the following information for AGE stock (1) Dividend payout = 50% (2) Required
return = 12% (3) Expected growth = 8%. What is the stock’s P/E ratio?

.50
P/E  .50 / .04 12 .5
.12 - .08

• In the previous example, suppose the current earnings of $2.00 and the growth rate of
9%. What would be the estimated stock price?
• Given D/E =0.50; k=0.12; g=0.09
P/E = 16.7
.50
• If you would expect E1 to be $2.18
P/E  .50 / .05 10 .0
.13 - .08
V = 16.7 x $2.18 = $36.41
• Compare this estimated value to market price to decide if you should invest in it

11-29
 POP QUIZ
Statement 1: P/E ratios are recommended for valuing start-up companies
Statement 2: The calculation of the P/E Ratio accounts only for the earnings and market
price of an equity share. It doesn’t look into whether a company is highly leveraged or
not.

a. Both statements are true

b. Both statements are false
c. Only Statement 1 is true
d. Only Statement 2 is true

Answer: D

.50
P/E  .50 / .05 10 .0
.13 - .08

11-30
IMPLEMENTING THE RELATIVE VALUATION TECHNIQUE

First Step:
• Compare the valuation ratio for a company to the comparable ratio for the market, for
stock’s industry and to other stocks in the industry
• Is it similar to these other P/Es
• Is it consistently at a premium or discount

Second Step:
• Explain the relationship
• Understand what factors determine the specific valuation ratio for the stock being
valued
• Compare these factors versus the same factors for the market, industry, and other
stocks
Challenge
• Finding the right comparable peer
 ESTIMATING THE INPUTS: k and g
• Valuation procedure is the same for
securities around the world
• The two most important input variables
are :
• The required rate of return (k)
• The expected growth rate of earnings
and other valuation variables (g) such
as book value, cash flow, and dividends
• These two input variables differ among
countries in the world
• The quality of these estimates are key
 REQUIRED RATE OF RETURN (k)
• The investor’s required rate of return must be estimated regardless of the
approach selected or technique applied
• This will be used as the discount rate and also affects relative-valuation
• Three factors influence an investor’s required rate of return:
• The economy’s real risk-free rate (RRFR)
• The expected rate of inflation (I)
• A risk premium (RP)

The Economy’s Real Risk-Free Rate

• Minimum rate an investor should require
• Depends on the real growth rate of the economy
• (Capital invested should grow as fast as the economy)
• Rate is affected for short periods by tightness or ease of credit markets
 REQUIRED RATE OF RETURN (k)
The Expected Rate of Inflation
• Investors are interested in real rates of return that will allow them to increase their
rate of consumption
• The investor’s required nominal risk-free rate of return (NRFR) should be increased to
reflect any expected inflation:

NRFR [1  RRFR][1  E (I)] - 1

where:
E(I) = expected rate of inflation

The Risk Premium

• Causes differences in required rates of return on alternative investments
• Explains the difference in expected returns among securities
• Changes over time, both in yield spread and ratios of yields
TIMATING THE REQUIRED RETURN FOR FOREIGN SECURITI
Foreign Real RFR
• Should be determined by the real growth rate within the particular economy
• Can vary substantially among countries

Inflation Rate
• Estimate the expected rate of inflation, and adjust the NRFR for this expectation
NRFR=(1+Real Growth)x(1+Expected Inflation)-1
• See Exhibit 11.6

Risk Premium
• Must be derived for each investment in each country
• The five risk components vary between countries
• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk
EXHIBIT 11.6
 EXPECTED GROWTH RATE

Estimating Growth From

Fundamentals
• Determined by
 growth of earnings
 proportion of earnings paid in
dividends
• In the short run, dividends can grow at
a different rate than earnings if the
firm changes its dividend payout ratio
• Earnings growth is also affected by
earnings retention and equity return
g* = (Retention Rate) x (Return on
Equity)
= RR x ROE
 EXPECTED GROWTH RATE
Breakdown of ROE

Indicates the Measure financial Indicates

firm’s leverage. It operating
profitability on indicates how efficiency and
sales management has reflect the asset
decided to finance and capital
the firm requirements of
business
 SUSTAINABLE GROWTH RATE

What is SGR (g*)

• The sustainable growth rate (SGR) is
the maximum rate of growth that a
company can sustain without having to
finance growth with additional equity or
debt.
• It is the rate at which the company can
grow while using its own internal
revenue without borrowing from
outside sources
• Achieving the SGR can help a company
prevent being over-leveraged and avoid
financial distress.

IF YOU WANNA GROW FASTER THAN SUSTAINABLE GROWTH RATE (g*), INCREASE EQUITY!
 EXPECTED GROWTH RATE
Estimating Growth Based on History
• Historical growth rates of sales, earnings, cash flow, and dividends
• Three techniques
• Arithmetic or geometric average of annual percentage changes
• Linear regression models
• Log-linear regression models
• All three use time-series plot of data

Estimating Dividend Growth for Foreign Stocks

• The underlying factors that determine the growth rates for foreign stocks are similar to
those for U.S. stocks
• The value of the equation’s components may differ substantially due to differences in
accounting practices in different countries
• Retention Rate
• Net Profit Margin
• Total Asset Turnover
• Total Asset/Equity Ratio