An Introduction to

Security Valuation

Chapter 11
 Analysis of Alternative Economies and Security
Markets.
Objective: Decide how to allocate investment funds
among countries and within countries to bonds,
stocks, and cash
Analysis of Alternative Industries
Objective: Based upon the economic and
market analysis, determine which
industries will prosper and which industries
Overview of will suffer on a global basis and within
countries.
the Investment Analysis of Individual Companies and
Stocks
Process Objective: Following the selection
of the best industries,
determine which
companies within
these industries will
prosper and
which stocks
are
undervalued
 Why Economic Analysis?

 Monetary and fiscal policy measures enacted by various agencies of

national governments influence the aggregate economies of those
countries.
 The resulting economic conditions influence all industries and companies
within the economies.
 Basis for All Valuation Approaches

 The use of valuation models in investment decisions (i.e., in decisions on

which assets are under valued and which are over valued) are based upon
a perception that markets are inefficient and make mistakes in assessing value
an assumption about how and when these inefficiencies will get corrected
 In an efficient market, the market price is the best estimate of value. The
purpose of any valuation model is then the justification of this value.
Approaches to Equity Valuation
 Relative Valuation

 The value of any asset can be estimated by looking at how the market prices
“similar” or ‘comparable” assets.
 Information Needed: To do a relative valuation, you need
an identical asset, or a group of comparable or similar assets
a standardized measure of value (in equity, this is obtained by dividing
the price by a common variable, such as earnings or book value)
and if the assets are not perfectly comparable, variables to control for the
differences
 Price to Earning Ratio (P/E)

 A financial ratio that evaluates the relationship between a stock's Market

Price and its Earnings Per Share (EPS).
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙
EPS
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝒔𝒉𝒂𝒓𝒆𝒔

𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆
P/E
𝑬𝑷𝑺

 Advantages: Simple calculation, reflects both the company's performance

and market sentiment.
 Limitations: with negative EPS, unable to use P/E and the profit can be easily
affected by personal purpose.
 Price to Book Value Ratio (P/BV)

 P/BV ratio is the ratio of the market price of a stock to the book value of that
stock.
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Book value per share
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝒔𝒉𝒂𝒓𝒆𝒔

𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆 𝑴𝒂𝒓𝒌𝒆𝒕 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒂𝒕𝒊𝒐𝒏

P/BV
𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 𝑶𝒘𝒏𝒆𝒓 𝒔 𝑬𝒒𝒖𝒊𝒕𝒚

 Advantages: More stable than EPS, even loss-making businesses can be

valued
 Limitations: BV may not reflect the true market value of the asset because
sometimes BV was recorded many years ago and is no longer correct.
 Price to Sales Ratio (P/S)

 P/S ratio is the ratio of the market price of a stock to revenue of that stock.

𝑻𝒐𝒕𝒂𝒍 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 (𝒔𝒂𝒍𝒆𝒔)

Sale per share
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝒔𝒉𝒂𝒓𝒆𝒔

𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆 𝑴𝒂𝒓𝒌𝒆𝒕 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒂𝒕𝒊𝒐𝒏

P/S
𝑺𝒂𝒍𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 𝑻𝒐𝒕𝒂𝒍 𝒔𝒂𝒍𝒆𝒔

 Advantages: more accurate and reliable than P/E

 Limitations: simple valuation method based on revenue without going into
the potential factors, growth rate or risks of the business.
 Discounted Cash Flow Techniques

 In discounted cash flow valuation, the value of an asset is the present value
of the expected cash flows on the asset.
 To use discounted cash flow valuation, you need:
to estimate the life of the asset
to estimate the cash flows/dividend during the life of the asset
to estimate the discount rate to apply to these cash flows to get present value
 Market Inefficiency: Markets are assumed to make mistakes in pricing assets
across time, and are assumed to correct themselves over time, as new
information comes out about assets.
 Dividend Discount Model (DDM)

 Value of share is the present value of future dividend

 At some point the earning must be translated to cashflow to shareholders.

PV0 + + + +

PV0: Present value of stock price

Di: Dividend for each year
K : Required rate of return (discount rate)
 Dividend Discount Model (DDM)

 What happens when the stock is not held for an infinite period?
 A sale of the stock at the end of Year 3 would imply the following formula:

PV0 + + +

SP3: the sale price for stock at the end of Year 3

 Gordon Growth Model

P0

P0: Present value of stock price

g : growth rate must be constant
k : Required rate of return (discount rate) > g
 A NONCONSTANT GROWTH MODEL

 Company A will have a dividend growth rate of 20% over the next ten years
and an 8% perpetual growth rate after that.
 D1 = $1
 K = 12%
NONCONSTANT GROWTH MODEL
Present Value
Dividend PV factor (12%)
Year of Dividends
(g=20%) = 1/(1+12%)^n
First 10 years
1 1.00 0.89 0.89
2 1.20 0.80 0.96
3 1.44 0.71 1.02
4 1.73 0.64 1.10
5 2.07 0.57 1.18
6 2.49 0.51 1.26
7 2.99 0.45 1.35
8 3.58 0.40 1.45
9 4.30 0.36 1.55
10 5.16 0.32 1.66
 A NONCONSTANT GROWTH MODEL

 Company B will have a current dividend (D0) of $1 a share. The following are
the expected annual growth rates for dividends. K=14%
Year 1-3 = 25%
Year 4-6 = 20%
Year 7-9 = 15%
Year 10 on = 9%
 Present Value
Year Dividend PV factor
of Dividends
1 1.25 0.877 1.096
2 1.56 0.769 1.202
3 1.95 0.675 1.318
4 2.34 0.592 1.388
5 2.81 0.519 1.461
6 3.38 0.455 1.538
7 3.88 0.399 1.551
8 4.46 0.350 1.565
9 5.13 0.307 1.578
10 5.59
PV from 1 to 9 $12.7
PV of 9th year price $34.4
Total PV $47.1