An Introduction to Security

Financial Instruments Valuation

Questions to be answered:
Week 3
• What are the two major approaches to the
investment process?
Security Valuation
• What are the specifics and logic of the top-down
(three-step) approach?
Reilly & Brown
• When valuing an asset, what are the required
Chapter 11
inputs?
• What are the two primary approaches to the
valuation of common stock?

An Introduction to Security
The Investment Decision Process
Valuation
• What is the dividend discount model (DDM) and • Determine the required rate of return
what is its logic? • Evaluate the investment to determine if its
• What are the major relative valuation ratios? market price is consistent with your
• What two general variables need to be estimated required rate of return
in any of the cash flow models and will affect all – Estimate the value of the security based on its
of the relative valuation models? expected cash flows and your required rate of
return
– Compare this intrinsic value to the market price
to decide if you want to buy it

Valuation Process Top-Down, Three-Step Approach

• Two approaches: 1. General economic influences
– Decide how to allocate investment funds among
– 1. Top-down, three-step approach countries, and within countries to bonds, stocks, and
– 2. Bottom-up, stock valuation, stock picking cash
approach 2. Industry influences
• The difference between the two approaches is the – Determine which industries will prosper and which
industries will suffer on a global basis and within
perceived importance of economic and industry
countries
influence on individual firms and stocks
3. Company analysis
• We will only look at the Top-down approach (the
– Determine which companies in the selected industries
other will be covered next semester) will prosper and which stocks are undervalued

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 Does the Three-Step Process Work? Theory of Valuation
• An asset is valuable if its value ≥ market price
Studies found significant relationships:
• The value of an asset is the present value of its
• Firm’s earnings and expected returns
– aggregate corporate earnings
• You expect an asset to provide a stream of
– firm’s industry returns while you own it
• Aggregate stock prices and • To convert this stream of returns to a value for
– macro series such as employment and GDP the security, you must discount this stream at
• Firm’s rates of stock return and your required rate of return
– return for the aggregate stock market • This requires estimates of:
– return for the stock’s industry – (i) The stream of expected returns, and
– (ii) The required rate of return on the investment

Theory of Valuation Some Basic Discounting

(single payment)
(i) Stream of Expected Returns
• How much would you pay for £1 to be
• Form of returns
paid in 1, 2, …, or 10 years?
– Earnings; Cash flows; Dividends; Interest
payments; Capital gains (increases in value) • Clearly, longer periods  less value.
• Time pattern and growth rate of returns • This is called the Present Value
(ii) Required Rate of Return (determined by)
– 1. Economy’s risk-free rate of return, plus
– 2. Expected rate of inflation
– 3. Risk premium determined by the uncertainty of where r is the required rate of return.
returns

Some Basic Discounting Some Basic Discounting

(annuity) (perpetuity)
• How much would you pay for £1 to be • How much would you pay for £1 to be
paid every year for 10 years? paid every year for ever?
• This is called annuity • This is called perpetuity

It can be shown that this is equal to It can be shown that this is equal to

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 Valuation of Alternative Investments Valuation of Bonds
(Bonds)
• Valuation of Bonds is relatively easy • Example: in 2002, a $10,000 bond due in
because the size and time pattern of cash 2017 with 10% coupon
– How many years? Hint: Can a one year 2002 bond be due in 2002?
flows from the bond over its life are known
• Discount these payments at the investor’s
1. Interest payments are made usually every six
months equal to one-half the coupon rate times the required rate of return (if the risk-free rate is
face value of the bond 9% and the investor requires a risk premium
2. The principal is repaid on the bond’s maturity of 1%, then the required rate of return would
date be 10%)

Valuation of Bonds Valuation of Bonds

Present value of the interest payments is an (more risk averse investor)
annuity for thirty periods at one-half the
required rate of return: Alternatively, assuming an investor requires a 12
$500 × 15.3725 = $7,686 percent return on this bond, its value would be:
The present value of the principal is similarly $500 × 13.7648 = $6,882
discounted: $10,000 × 0.1741 = 1,741
$10,000 × 0.2314 = $2,314 Total value of bond at 12 percent = $8,623
Total value of bond at 10 percent = $10,000 Higher rates of return lower the value!

So the fair value of this bond is $10,000. Compare the computed value to the market price of the bond to
determine whether you should buy it.

Valuation of Preferred Stock Valuation of Preferred Stock

• Owner of preferred stock receives a promise to
pay a stated dividend, usually quarterly, for • Assume a preferred stock has a $100 par value
perpetuity and a dividend of $8 a year and a required rate
• Since payments are only made after the firm of return of 9 percent
meets its bond interest payments, there is more
uncertainty of returns
• Given a market price, you can derive its
• Tax treatment of dividends paid to corporations promised yield
(80% tax-exempt) offsets the risk premium
• The value is simply the stated annual dividend
divided by the required rate of return on preferred • At a market price of $85, this preferred stock
stock (kp= r) yield would be

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 Approaches to the Discounted cash flow approach
Valuation of Common Stock
Dependent on some factors, namely:
Two approaches have developed • The rate of growth and the duration of growth of the
cash flows
1. Discounted cash-flow valuation
• The estimate of the discount rate
• Present value of some measure of cash flow,
including dividends, operating cash flow, and free
cash flow • The measure of cash flow used
2. Relative valuation technique – Dividends (discount rate: Cost of equity)
– Operating cash flow (discount rate: Weighted Average
• Value estimated based on its price relative to
Cost of Capital (WACC))
significant variables, such as earnings, cash flow,
book value, or sales – Free cash flow to equity (discount rate: Cost of equity)

Discounted Cash-Flow
Relative Valuation Approach
Valuation Techniques
• Provides information about how a given
stock compares with
– aggregate market
Where:
– alternative industries
Vj = value of stock j
– individual stocks within industries
n = life of the asset
CFt = cash flow in period t
• No guidance as to whether valuations are
k = the investor’s required rate of return for asset j, which is appropriate
determined by the uncertainty (risk) of the stock’s cash flows – best used when we have comparable entities
– aggregate market is not a valid benchmark

Valuation Approaches The Dividend Discount Model

and Specific Techniques (DDM)
Approaches to Equity Valuation
The value of a share of common stock is the
present value of all future dividends

Discounted Cash Flow Relative Valuation

Techniques Techniques
• Present Value of Dividends (DDM) • Price/Earnings Ratio (PE)
•Present Value of Operating Cash Flow •Price/Cash flow ratio (P/CF) Vj = value of common stock j

•Present Value of Free Cash Flow •Price/Book Value Ratio (P/BV) Dt = dividend during time period t

•Price/Sales Ratio (P/S) k = required rate of return on stock j

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 The Dividend Discount Model The Dividend Discount Model
(DDM) (DDM)
If the stock is not held for an infinite period, a Stocks with no dividends are expected to
sale at the end of year 2 would imply: start paying dividends at some point, say
year three...

Selling price at the end of year two is the Where:

value of all remaining dividend payments,
D1 = 0
which is simply an extension of the original
equation D2 = 0

The Dividend Discount Model The Dividend Discount Model

(DDM) (DDM)
Infinite period model assumes a constant The formula
growth rate for estimating future dividends

Where:
can be reduced to:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends 1. Estimate the required rate of return (k)
k = required rate of return on stock j 2. Estimate the dividend growth rate (g)
n = the number of periods, which we assume to be infinite

Infinite Period DDM Infinite Period DDM

and Growth Companies and Growth Companies
Assumptions of DDM: • Growth companies have opportunities to earn return
on investments greater than their required rates of
1. Dividends grow at a constant rate return
2. The constant growth rate will continue for • To exploit these opportunities, these firms generally
an infinite period retain a high percentage of earnings for
3. The required rate of return (k) is greater reinvestment, and their earnings grow faster than
than the (infinite) growth rate (g) those of a typical firm
• This is inconsistent with the infinite period DDM
assumptions

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 Infinite Period DDM and Grwth Comp Valuation with Temporary
Limitations: Supernormal Growth
• The infinite period DDM assumes constant
growth for an infinite period, but abnormally Assume a 14 percent required rate of
high growth usually cannot be maintained return and dividend growth of:
indefinitely
• Temporary conditions of high growth cannot Dividend
Year Growth Rate
be valued using DDM. However,…..
1-3: 25%
• Combine the models to evaluate the years of 4-6: 20%
supernormal growth and then use DDM to 7-9: 15%
compute the remaining years at a sustainable 10 on: 9%
rate (as shown in the next example)

Valuation with Temporary Computation of Value for Stock of Company

Supernormal Growth with Temporary Supernormal Growth

The value equation becomes

Other Discounting Tech. Relative Valuation Techniques

• Present Value of Operating Free Cash
• Value can be determined by comparing two
Flows (accounting definition)
similar stocks based on relative ratios
– As DDM except:
• Dividend  OCF • Relevant variables include earnings, cash
• k  WACC (weighted average cost of capital) flow, book value, and sales
• Present Value of Free Cash Flows to Equity • The most popular relative valuation
– As DDM except: technique is based on price to earnings
• Dividend  FCF
• k (required rate of return on equity) is the same

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 Earnings Multiplier Model Earnings Multiplier Model

• This values the stock based on expected The infinite-period DDM corresponds to the P/E
ratio. To see this write the price according to
annual earnings
DDM
• The price earnings (P/E) ratio, or

Divide both sides by expected earnings during

Earnings Multiplier the next 12 months (E1)

Earnings Multiplier Model Earnings Multiplier Model

As an example, assume:
Thus, the P/E ratio is determined by – Dividend payout = 50%
1. Expected dividend payout ratio – Required return = 12%
2. Required rate of return on the stock (k) – Expected growth = 8%
– D/E = .50; k = .12; g=.08
3. Expected growth rate of dividends (g)

Earnings Multiplier Model Earnings Multiplier Model

A small change in either or both k or g will have a
large impact on the multiplier Example:
Current earnings of $2 and growth of 9%
D/E = 0.50; k=0.13; g=0.08

P/E = 0.50/(0.13-0.08) = 0.50/0.05 = 10

You expect E1 to be $2.18
D/E = .50; k=.12; g=.09
D/E = 0.50; k=0.12; g=0.09
P/E = (D/E)/(k-g) = 16.7
P/E = 0.50/(0.12-0.09) = 0.50/0.03 = 16.7
V = P = 16.7 x $2.18 = $36.41
D/E = 0.50; k=0.11; g=0.09
P/E = 0.50/(0.11-0.09) = 0.50/0.02 = 25
Compare this estimated value to market price
to decide if you should invest in it

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 The Price-Cash Flow Ratio The Price-Book Value Ratio
• Widely used to measure bank values (most bank
• Companies can manipulate earnings
assets are liquid: bonds and commercial loans)
• Cash-flow is less prone to manipulation • Fama and French study indicated inverse
• Cash-flow is important for fundamental relationship between P/BV ratios and excess
valuation and in credit analysis return for a cross section of stocks
• The ratio is given by

Where: Pt = the end of year stock price for firm j

P/CFj = the price/cash flow ratio for firm j
BVt+1 = the estimated end of year book value per share for firm j
Pt = the price of the stock in period t
CFt+1 = expected cash low per share for firm j

The Price-Book Value Ratio The Price-Sales Ratio

• Be sure to match the price with either a
recent book value number, or estimate the • Strong, consistent growth rate is a requirement of
book value for the subsequent year a growth company
• Can derive an estimate based upon • Sales is subject to less manipulation than other
financial data
historical growth rate for the BV series or
use the growth rate implied by the formula
g = (ROE) × (Retention Rate)
• To derive the estimate of BV as • Where P is the price and S is sales during the year
BV(t+1) = g × BV(t)

The Price-Sales Ratio Estimating the Inputs

• Match the stock price with recent annual • Valuation procedure is the same for securities
sales, or future sales per share around the world,
• This ratio varies dramatically by industry • But the inputs
• Profit margins also vary by industry – required rate of return (k)
– expected growth rate of earnings (g)
• Relative comparisons using P/S ratio should
– book value, cash flow, dividends
be between firms in similar industries
• Differ across countries

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 Required Rate of Return (k) Required Rate of Return (k)
The investor’s required rate of return must
be estimated regardless of the approach Three factors influence an investor’s
selected or technique applied required rate of return:
• This will be used as the discount rate and also • The economy’s real risk-free rate (RRFR)
affects relative-valuation • The expected rate of inflation (I)
• It is not used in present value of operating cash • A risk premium (RP)
flow which uses WACC

The Economy’s Real Risk-Free Rate The Expected Rate of Inflation

• Minimum rate an investor should require • Investors are interested in real rates of
• Depends on the real growth rate of the return that will allow them to increase their
economy rate of consumption
– (Capital invested should grow as fast as the • The investor’s required nominal risk-free
economy) rate of return (NRFR) should be increased
• Rate is affected for short periods by tightness to reflect any expected inflation:
or ease of credit markets (i.e. sup/dem)
Where:
E(I) = expected rate of inflation

Estimating the Required Return

The Risk Premium
for Foreign Securities
• Causes differences in required rates of • Foreign Real RFR
return on alternative investments – Should be determined by the real growth rate
within the particular economy
• Explains the difference in expected returns
– Can vary substantially among countries
among securities
• Inflation Rate
• Changes over time, both in yield spread and
– Estimate the expected rate of inflation, and adjust
ratios of yields the NRFR for this expectation

NRFR=(1+Real Growth)×(1+Expected Inflation)-1

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 Risk Premium Expected Growth Rate of Dividends
• Must be derived for each investment in each • Determined by
country – the growth of earnings
• The five risk components vary between – the proportion of earnings paid in dividends
countries: • In the short run, dividends can grow at a different
– Business risk rate than earnings due to changes in the payout
– Financial risk ratio
– Liquidity risk • Growth of earnings is affected by compounding of
earnings retention
– Exchange rate risk
ge = (Retention Rate) × (Return on Equity)
– Country risk
= RR × ROE

Breakdown of ROE Estimating Growth Based on History

• Historical growth rates of sales, earnings, cash
flow, and dividends
• Three techniques
1. arithmetic or geometric average of annual
percentage changes
2. linear regression models
Profit Total Asset Financial 3. log-linear regression models
= ×
Margin Turnover
× Leverage • All three use time-series plot of data

Estimating Dividend Growth

for Foreign Stocks
The Internet
Investments Online
Differences in accounting practices affect
the components of ROE
www.financenter.com
• Retention Rate www.moneyadvisor.com
• Net Profit Margin www.jamesko.com/financial_calculator.htm
• Total Asset Turnover
http://fpc.net66.com
• Total Asset/Equity Ratio

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