Equity Valuation and Analysis

The challenge for the

portfolio manager and
investor:
- accept market efficiency?
- adopt a passive or active stance?
- fundamental vs. technical
approaches?
K. Hartviksen

Stock Prices and Investment

Opportunities

When choosing
D1
P0
DDMs, you must take
kg
into account the phase
in the product life
cycle that the firm is
in
g ROE b
In the constantgrowth model, you
Where :
need to estimate g
b the plowback ratio
(growth rate)

Alternate Approach Using the nogrowth DDM

A firm that is basically in a steady
state where it is reasonable to
expect that dividends will remain
relatively constant.
If, that same firm decided to
reduce current dividends and
reinvest some of those earnings
back into the company, the firms
value will rise by the NPV of
projects accepted. NPV = present
value of growth opportunities =
PVGO

E1
P0
PVGO
k

Earnings, Growth and PriceEarnings Ratios

When companies dont pay cash dividends,

alternative approaches to valuation are
required.
The Price-earnings ratios is also known as
the p/e multiple

It tells you how many times trailing earnings

the stock trades for.

Earnings, Growth and PriceEarnings Ratios

Logically, then, the
P/E will increase as
the ROE increases,
sothe growth rate of
a firm is dependent on
its capital budgeting
processes. Invest in
projects with a return
less than k and the
value of the firm falls.

P0 1
PVGO
1

E1 k
E/k
P0
1 b

E1 k ( ROE b)

Earnings, Growth and PriceEarnings Ratios

Riskier stocks will
have a higher required
return k and therefore
a lower P/E

P0 1 b

E1 k g
P0
1 b

E1 k ( ROE b)

Earnings, Growth and PriceEarnings Ratios - Pitfalls

Denominator
contains accounting
earnings and this does
not equal economic
earnings.
Inflation tends to
cause accounting
earnings to be
overstatedtherefore
P/Es tend to be lower
in inflation times.

P0 1 b

E1 k g
P0
1 b

E1 k ( ROE b)

Earnings, Growth and PriceEarnings Ratios

Peter Lynchs rule of thumb (see page 513)

P/E of any company should be equal to its

growth rate (if it is to be fairly priced)
If you find a P/E lower than its growth rate
the stock is a bargain

Top-Down Versus Bottom-Up

A number of investment styles exist.

An investment style represents a unique approach
to picking stocks and managing a portfolio.
Two basic styles are growth versus value.
Growth styles generally are suited to a top-down
approach
Value styles are suited to a bottom-up approach.

a.

b.

Problem 14 - 1

D1 / P0 + g

.16
g

=
=

2/50 + g
.12

P0

D1 / k - g

2 / (.16 - .05) = $18.18

The price falls in response to the more pessimistic dividend forecast. The
forecast for current earnings, however, is unchanged. Therefore,
the P/E ratio must fall. The lower P/E ratio is evidence of the
diminished optimism concerning the firms growth prospects.
K. Hartviksen

Problem 14 - 2
a.

g = ROE b = 16 .5 = 8%
D1 = $2(1 - b) = $2(1 - .5) = $1
P0

b.

P3

D1 / k - g

$1 / (.12 - .08) = $25.00

P0(1 + g)3

$24(1.08)3 = $31.49

K. Hartviksen

Problem 14 - 3
a.

This director is confused. In the context of the

constant growth model that P0 = D1 / (k g), it is
true that price is higher when dividends are higher
holding everything else constant. But everything
else will not be constant. If the firm raises the
dividend payout rate, the growth rate g will fall,
and stock price will not necessarily rise. In fact if
ROE>k, price will fall.

K. Hartviksen

Problem 14 - 4
A.

k = 6 + 1.25 (14 - 6) = 16%

g = 2/3 9% = 6%
D1 = E0(1+ g)(1 - b) = 3(1.06)(1/3) = 1.06
P0 = D1 / (k - g) = 1.06 / (.16 - .06) = $10.60

B.

Leading P0/E1 = 10.60/3.18 = 3.33

Trailing P0/E0 = 10.60/3 = 3.53

Problem 14 - 4 ...
C.

PVGO = P0 - (EPS0/k) = 10.60 - (3/.16) = -8.15

The low P/E ratios and negative PVGO are due to a poor ROE, 9%, that
is less than the market capitalization rate, 16%.

D.

Now, you revise b to 1/3, g to 1/3 .09 = .03, and D1

to E0(1.03)(2/3) = 2.06.
Thus, V0 = 2.06/ (.16 - .03) = $15.85.
V0 increases because the firm pays out more earnings instead of
reinvesting them at a poor ROE. This information is not yet known to
the rest of the market.

Problem 14 - 5

Because beta = 1.0, k = market return,

15%.
Therefore:
15% = D1/P0 + g
= 4% +g
= = 11%

K. Hartviksen

Problem 14 - 6
FI Corporation
a.

g = 5%; D1 = $8; k = 10%

P0 = D1 / (k - g) = $8 / (.10 - .05) = $160

b.

The dividend payout ratio is 8/12 = 2/3, so the payout ratio is b =

1/3. The implied value of ROE on future investments is found by
solving: g = b ROE with g = 5% and b = 1/3. ROE = 15%

c.

The price assuming ROE = k is just EPS/k. P0=$12/.10 = $120.

Therefore the market is paying $40 per share ($160 - $120) for
growth opportunities.

Problem 14 - 7
a.
b.

K = 4% + 1.15 (10% - 4%) = 10.9%

Using Emmas short term growth projections of 25%,
we obtain a two-stage DDM value as follows:
Capitalization rate =
Time
1
2
3
4
4

0.109

Dividend
Calculation Dividend
PVIF
0.287 0.901713
0.359 0.813087
0.449 0.733171
0.562 0.66111
43.875 0.66111
Present Value =

Present
Value
0.258792
0.291898
0.329194
0.371544
29.00621
$30.26

Problem 14 7
c.

With these new assumptions, Disney stock has an

intrinsic value below its market price of $37.75. This
analysis indicates a sell recommendation. Even
though Disneys 5-year growth rate increases so does
its beta and risk premium. The intrinsic value falls.

Problem 14 - 8
High-Flyer Stock
k
=
=
=

= rf + (kM - rf)
.10 + 1.5 (.15 - .10)
.10 + .075
.175

and g = .05
Therefore: P0 = D1 / (k - g) = $2.50/ (.175 -.05) = $20

Problem 14 - 9
Stock
Market Capitalization rate, k
Expected return on equity, ROE
Estimated earnings per share, E1
Estimated dividends per share, D1
Current market price per share, P0
a.
b.
c.
d.

10%
14%
$2.00
$1.00
$27

10%
12%
$1.65
$1.00
$25

Dividend payout ratio, 1 - b

.5
.606
Growth rate, g = ROE b
7%
4.728%
Intrinsic value, V0
$33.33
$18.97
Stock A is the one you would invest in since its intrinsic value exceeds its
price. You might want to sell short stock B.

Problem 14 - 10
a. It is true that NewSoft sells at higher multiples of
earnings and book value than Capital Corp. But this
difference may be justified by NewSofts higher expected
growth rate of earnings and dividends. NewSoft is in a
growing market with abundant profit and growth
opportunities. Capital Corp is in a mature industry with
fewer growth prospects. Both the price-to-earnings and
price-to-book ratios will reflect the prospect of growth
opportunities, implying that the ratios for these firm ratios
do not necessarily imply mispricing.

Problem 14 10
b.

c.

The most important weakness of the constant-growth

dividend discount model in this application is that it
assumes forever constant growth rate of dividends.
While dividends may be on a steady growth path for
Capital Corp., which is a more mature firm, that is far
less likely to be a realistic assumption for NewSoft.
NewSoft should be valued using a multi-stage DDM
which allows for rapid growth in the early years, but that
recognizes that growth ultimately must slow to a more
sustainable rate.

Problem 14 - 11

Nogro Corporation
a. P0 = $10, E1 = $2, b= .5, ROE = .2
k =

D1/P0 + g

D1 = .5 $2 = $1
g = b ROE = .5 .2 = .1
Therefore, k = $1/$10 + .1 = .1 + .1 = .2 or 20%
b.

Since k = ROE, the NPV of future investment opportunities is zero:

PVGO = P0 - (EPS0/k) = 10 - 10 = 0

c.

Since k = ROE, the stock price would be unaffected by cutting the

dividend and investing the additional earnings.

Problem 14 - 11
d. Again, this should have no impact on the stocks price
since the NPV of the investments would be zero.

Problem 14 13
Xyrong Corporation
A.

k = rf + [E(rM) - rf] = 8% + 1.25 (15% - 85) = 16.4%

g = b ROE = .6 20% = 12%
V0 = (D0(1 + g)) / (k - g) = ($4 1.12) / (.164 - .12) = $101.82

B.

P1 = V1 = V0(1 + g) = $101.82 1.12 = $114.04

E(r) = [D1 + P1 - P0] / P0 = ($4.48 + $114.04 - $100)/$100
= 18.52%

Problem 14 - 15
A.

The formula for a multistage DDM model with two distinct growth stages
consisting of a first stage with five years of above-normal growth followed
by a second stage of normal constant growth is:
D6
P0

D1
(1+k)1

D2
(1+k)2

D3
(1+k)3

D4
(1+k)4

D5
(1+k)5

(k - g)
(1 + k)5

= $2.29/(1.1) + $2.75/(1.1)2 + $3.30/(1.1)3 + $3.96/(1.1)4 + $4.75/(1.1)5 +

(($5.09)/(.10 - .07)) / (1.1)5
= $117.84

Problem 14 - 15 ...
B. Phillip Morris P/E (12/31/91)

= $80.25/$4.24 = 18.9

S&P 500 P/E (12/31/91) = $417.09/$16.29

= 25.6

Phillip Morris relative P/E = 18.9/25.6 = .74

C. Phillip Morris book value (12/31/91) = $12,512/920 = $13.60 per share
Phillip Morris P/B (12/31/91)
= $80.25/$13.60
= 5.90
S&P 500 P/B (12/31/91) = $417.09 / $161.08 = 2.59
Phillip Morris relative P/B = 5.90/2.59 = 2.28

Problem 14 - 16
A. Multistage Dividend Discount Model
Advantages
1. Excellent for comparing greatly
different companies
2. Solid theoretical framework
3. Ease in adjusting for risk levels.
4. Dividends relatively easy to project.
5. Dividends not subject to distortions
from arbitrary accounting rules.
6. Flexibility in use and more realistic
than constant growth model.

Disadvantages
1. Need to forecast well into the
future
2. Problem with non-dividend paying
companies.
3. Problem with high growth
companies (g>k)
4. Problems projecting forever after
ROE and payout ratio.
5. Small changes in assumptions can
have big impact.
6. Need technology for more advanced
Models.

Problem 14 - 16
Absolute and Relative Price/Earnings Ratio
Advantages
1. Widely used by investors
2. Easy to compare with market and
other companies in specific
Industries.

Disadvantages
1. Difficult with volatile earnings.
2. Need to determine what is a normal
P/E ratio.
3. Difficult to project earnings.
4. Effect of accounting differences.
5. Many factors influence multiples.
6. Can be used only for relative rather
than absolute measurement
7. Doesnt address quality of earnings.
8. Problem with companies with no
income.

Problem 14 - 16
Absolute and Relative Price/Book Ratio
Advantages
Disadvantages
1. Incorporates some concept of asset 1. Subject to differing accounting rules.
Values.
2. Easy to compute even for
2. Affected by non-recurring items.
companies with volatile or negative
earnings.
3. Easy to compare with market and
3. Subject to historical costs.
specific industries.
4. Book may be poor guide to actual
asset values.
5. Ignores future earnings prospects and
growth potential.

Problem 14 - 16 b.
B.

Support can be given to either position.

Philip Morris is undervalued because:
1. DDM indicates intrinsic value above current market price.
2. Given forecasts of dividends over two stages, DDM is best to use
for this situation and should be given more weight.
3. P/E below market despite past growth and forecast of superior
future growth.
4. P/E relative below 10-year average.
Continued..

Problem 14 - 16 b.
B.
Philip Morris is overvalued because:
1. P/B considerably higher than market.
2. P/B relative higher than 10-year average.
3. DDM discount rate used should be higher than markets
due to large potential risks in cigarette manufacturing
business (although whether this risk is systematic is far
from clear).
4. P/E on Philip Morris should be low relative to market and
past growth due to risks inherent in its business.

Problem 14 - 22

One forecast of the expected return on the stock market

would be the bill rate plus the historical average risk
premium on the market of 7% per year. Applying a 15%
rate to the current level gives the answer.

Problem 14 - 23
A. The robotics process entails higher fixed costs and lower
variable (labour) costs. This firm therefore will perform
better in a boom and worse in a recession. For example,
costs will rise less rapidly than revenue when sales
volume expands during a boom.
B. Because its profits are more sensitive to the business
cycle, the robotics firm will have the higher beta.

Problem 14 - 24

Deep recession:

Superheated economy:
Healthy expansion:

Stagflation:

Health care (a non-cyclical industry

arguably demographically influenced)
Steel production (cyclical industry)
Housing construction (cyclical but
interest-rate sensitive)
Gold mining (counter-cyclical)

Problem 14 - 26

Oil wells:

Computer hardware:
Computer software:
Genetic engineering:
railroads:

Decline (Environmental pressures,

decline in early-developed new oil
fields)
consolidation
consolidation
start-up
relative decline

Problem 14 - 27
A. General Autos. Pharmaceuticals are less of a
discretionary purchase than automobiles.
B. Friendly Airlines. Travel expenditure is more sensitive to
the business cycle than movie consumption.

Problems 14 - 33
a.
b.
c.
d.

(iv)
(iii)
(iv)
(iii)
(iii)
(iv)
(iii)
(I)