Lecture 7: Equity Valuation
EQUITY VALUATION Shareholders’ equity net worth of common equity=assets-liabilities book value: the value recognised in a firm’s financial statements (balance sheet) book value of asset: the original cost of acquisition less some adjustment for depreciation Limitations of book value market price of assets change over time many assets such as the value of a good brand or specialised expertise may not even be included on the financial statements but certainly influence market value depreciation allowances are used to allocate the original cost of the asset over several years but do not reflect loss of actual value
EQUITY VALUATION Alternative measures of firm value Liquidation value: Net amount realized by selling assets of firm and paying off debt; it represents the firm’s floor value, below which the firm becomes attractive as a takeover target Replacement cost: Cost to replace firm’s assets less liabilities; it represents the firm’s ceiling value, above which competitive pressure will drive down the market value Tobin’s q: Ratio of firm’s market value to replacement cost; in the long run this ratio tend toward 1, but the evidence is that it can differ from 1 for very long periods of time.
TABLE MICROSOFT FINANCIAL HIGHLIGHTS, JAN 2012 Price per share $ Common shares outstanding (billion) Market capitalization ($ billion ) Latest 12 Months Sales ($ billion ) EBITDA ($ billion) Net income ($ billion ) Earnings per share $ Industry Valuation Microsoft Avg P/E ratio Price/Book Price/Sales Price/Cash flow PEG Profitability ROE (%) ROA (%) Operating profit margin (% ) Net profit margin (% )
INTRINSIC VALUE VERSUS MARKET PRICE = expected dividend per share = current share price = expected end-of-year price The expected return on a stock investment comprises cash dividends and capital gains or losses.
INTRINSIC VALUE VERSUS MARKET PRICE In equilibrium, investors’ required rate of return, which is usually estimated with an asset pricing model such as CAPM, should equal expected rate of return. Otherwise, there will be buying and selling pressure for the stock. Intrinsic Value Present value of firm’s expected future net cash flows discounted by required rate of return. In equilibrium, the current market price will reflect the intrinsic value estimates of all market participants. Otherwise, buying or selling pressure. Market Capitalization Rate k Market-consensus estimate of appropriate discount rate for firm’s cash flows.
INTRINSIC VALUE VERSUS MARKET PRICE •
DIVIDEND DISCOUNT MODELS •
DIVIDEND DISCOUNT MODELS •
DIVIDEND DISCOUNT MODELS •
DIVIDEND DISCOUNT MODELS Life Cycles and Multistage Growth Models Two-stage DDM DDM in which dividend growth assumed to level off only at future date Multistage Growth Models Allow dividends per share to grow at several different rates as firm matures
PRICE-EARNINGS RATIOS •
PRICE-EARNINGS RATIOS •
TABLE EFFECT OF ROE AND PLOWBACK ON GROWTH AND P/E RATIO
PRICE-EARNINGS RATIOS •
PRICE-EARNINGS RATIOS Pitfalls in P/E Analysis Earnings Management Practice of using flexibility in accounting rules to improve apparent profitability of the firm Large amount of discretion in managing earnings
FIGURE P/E RATIO OF S&P 500 AND INFLATION 60P/E ratio50Inflation rate403020100195519601965197019751980198519901995200020052010
FIGURE EARNINGS GROWTH FOR TWO COMPANIES per share (1995 = )
FIGURE PRICE-EARNINGS RATIOS 60Con EdIntel50403020100199519971999200120032005200720092011P/E ratio
FIGURE P/E RATIOS Aerospace/ Integrated oil & Money center Health care Computer Telecom Industrial Electric Home Chemical Application Asset Food Auto Heavy Business 0102030405060P/E ratio
PRICE-EARNINGS RATIOS Combining P/E Analysis and the DDM Estimates stock price at horizon date Other Comparative Valuation Ratios Price-to-book: Indicates how aggressively market values firm Price-to-cash-flow: Cash flow less affected by accounting decisions than earnings Price-to-sales: For start-ups with no earnings
FIGURE VALUATION RATIOS FOR S&P 500
FREE CASH FLOW VALUATION APPROACHES •
FREE CASH FLOW VALUATION APPROACHES •
FREE CASH FLOW VALUATION APPROACHES •
FREE CASH FLOW VALUATION APPROACHES •
FREE CASH FLOW VALUATION APPROACHES Comparing Valuation Models Model values differ in practice Differences stem from simplifying assumptions Problems with DCF Models DCF estimates are always somewhat imprecise Investors employ hierarchy of valuation Real estate, plant, equipment Economic profit on assets in place Growth opportunities
THE AGGREGATE STOCK MARKET Forecasting Aggregate Stock Market Earnings multiplier applied at aggregate level Forecast corporate profits for period Derive estimate of aggregate P/E ratio based on long-term interest rates Some analysts use aggregate DDM
FIGURE EARNINGS YIELD OF S&P 500 VERSUS 10-YEAR TREASURY BOND YIELD 16%Treasury yieldEarnings yield14%12%10%8%6%4%2%0%195519601965197019751980198519901995200020052010
TABLE S&P 500 FORECASTS Pessimistic Most Likely Optimistic Scenario Scenario Scenario Treasury bond yield % % % Earnings yield % % % Resulting P/E ratio EPS forecas t93 93 93 Forecast for S&P 500 1431 1550 1691
