Essentials of Investments

Eleventh Edition
Bodie, Kane, and Marcus

Chapter 13
Equity Valuation

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
further distribution permitted without the prior written consent of McGraw-Hill Education.
 13.1 Equity Valuation

Book Value
• Net worth of common equity according to a firm’s
balance sheet
Limitations of Book Value
• Liquidation value: Net amount realized by selling
assets of firm and paying off debt
• Replacement cost: Cost to replace firm’s assets
• Tobin’s q: Ratio of firm’s market value to replacement
cost

© 2019 McGraw-Hill Education. 13-2

Apple and Alphabet Financial Highlights, April
2017
Apple Alphabet
TABLE 13.1 Price per share 142.71 844.04

Financial highlights Common shares outstanding (billion)

Market capitalization ($ billion)
5.25
748.7
0.70
589.0
for Apple and Latest 12 Months

Alphabet (Google) Sales ($ billion)

EBITDA ($ billion)
218.12
69.75
90.27
29.86
Net income ($ billion) 45.22 19.48
Earnings per share 8.33 27.88
Valuation
Price/Earnings 13.92 30.28
Price/Book 5.67 4.20
Price/Sales 3.43 6.52
PEG 1.70 1.32
Profitability
ROE (%) 34.69 15.02
ROA (%) 11.85 9.41
Operating profit margin (%) 27.15 26.27
Net profit margin(%) 20.73 21.58

© 2019 McGraw-Hill Education. 13-3

13.2 Intrinsic Value versus Market Price (1 of 3)
E  D1  + E  P1   P0 
Expected HPR = E  r  =
P0
• E(D1) = expected dividend per share
• P0 = current share price
• E(P1) = expected end-of-year price
Example: Suppose you purchased a share of DAR Inc. for
$40 in January. You expect to sell it for $42 in December and
expect to receive a dividend of $2.42 during that year. What is
your expected HPR?
E (D1 ) +[E (P1 )  P0 ] $2.42 + $42  40
HPR = E (r ) = = = .1105 = 11.05%
P0 40
© 2019 McGraw-Hill Education. 13-4
13.2 Intrinsic Value versus Market Price (2 of 3)

Intrinsic Value
• Present value of firm’s expected future net cash flows
discounted by required RoR
Market Capitalization Rate
• Market-consensus estimate of appropriate discount
rate for firm’s cash flows

© 2019 McGraw-Hill Education. 13-5

13.2 Intrinsic Value versus Market Price (3 of 3)

Intrinsic Value
E  D1  + E  P1 
V0 =
1+ k
For holdingperiodH
D1 D2 DH + PH
V0 = + +.....+
1+ k  1+ k  2
 1+ k 
H

Dividend Discount Model (DDM)

• Formula for intrinsic value of firm equal to present
value of all expected future dividends

© 2019 McGraw-Hill Education. 13-6

 13.3 Dividend Discount Models (1 of 4)

Constant-Growth DDM
• Form of DDM that assumes dividends will grow at
constant rate
D1
V0 =
k g
• Implies stock’s value greater if:
• Larger dividend per share
• Lower market capitalization rate, k
• Higher expected growth rate of dividends

© 2019 McGraw-Hill Education. 13-7

 13.3 Dividend Discount Models (2 of 4)

For stock with market price = intrinsic value, expected

holding period return

E  r  = Dividend yield + Capital gains yield

D1 P1  P0 D1
+ = +g
P0 P0 P0

© 2019 McGraw-Hill Education. 13-8

 13.3 Dividend Discount Models (3 of 4)

Stock Prices and Investment Opportunities

• Dividend payout ratio
• Percentage of earnings paid as dividends
• Plowback ratio/earnings retention ratio
• Proportion of firm’s earnings reinvested in business
• Present value of growth opportunities (PVGO)
• Price = No-growth value per share + PVGO

E1
P0 = + PVGO
k

© 2019 McGraw-Hill Education. 13-9

 13.3 Dividend Discount Models (4 of 4)

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

© 2019 McGraw-Hill Education. 13-10

 13.3 Dividend Discount Models: Two Stage
Example
Consider the following information:
• The firm’s dividends are expected to grow at g = 20% until t = 3
yrs.
• At the start of year four, growth slows to gs= 5%.
• The stock just paid a dividend Div0 = $1.00
• Assume a market capitalization rate of k = 12%
What is the price, P0, of this stock?
D0 ×(1+ g ) D0 ×(1+ g )t D0 ×(1+ g )t ×(1+ g s )
P0 = +...+ +
(1+ k ) (1+ k )t (1+ k )t ×( k  g s )
$1×(1+.2) $1×(1+.2)2 $1×(1+.2)3 D0 ×(1+.2)3 ×(1+.05)
= + + +
(1+.12) (1+.12) 2
(1+.12) 3
(1+.12)3 ×(.12  .05)
= $1.07 + $1.15 + $1.23 + $18.45 = $21.90

© 2019 McGraw-Hill Education. 13-11

13.3 Dividend Discount Models: Stock Value

The Constant Growth Model states that a stocks value

will be greater
• The larger its expected dividend per share.
• The lower the market capitalization rate, k.
• The higher the expected growth rate of dividends.

© 2019 McGraw-Hill Education. 13-12

13.3 Dividend Growth and Reinvestment

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© 2019 McGraw-Hill Education. 13-13
 13.4 Price-Earnings Ratios (1 of 5)

Price Earnings Ratio and Growth Opportunities

• Price-earnings multiple
• Ratio of stock’s price to earnings per share
• Determinant of P/E ratio
 
P0 1  PVGO 
=  
E1 k  E1

 k 

© 2019 McGraw-Hill Education. 13-14

 13.4 Price-Earnings Ratios (2 of 5)

P/E Ratio for Firm Growing at Long-Run Sustainable

Pace
P0 1 b
=
E1 k   ROE × b 
PEG Ratio
• Ratio of P/E multiple to earnings growth rate

© 2019 McGraw-Hill Education. 13-15

Table 13.3 Effect of ROE and Plowback on
Growth and P/E Ratio

© 2019 McGraw-Hill Education. 13-16

 13.4 Price-Earnings Ratios (3 of 5)

P/E Ratios and Stock

P 1 b
=
E k g
• All else equal, riskier stocks have lower P/E multiples,
higher required RoR, k

© 2019 McGraw-Hill Education. 13-17

 P/E Ratio and Inflation

FIGURE 13.3 P/E ratio of the

S&P 500 versus inflation rate.
Annual averages,1955-2016.

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© 2019 McGraw-Hill Education. 13-18
 13.4 Price-Earnings Ratios (4 of 5)

Pitfalls in P/E Analysis

• Earnings Management
• Practice of using flexibility in accounting rules to
improve apparent profitability of firm
• Large amount of discretion in managing earnings

© 2019 McGraw-Hill Education. 13-19

Figure 13.4 Earnings Growth for Two
Companies

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© 2019 McGraw-Hill Education. 13-20
Figure 13.5 Price-Earnings Ratios

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© 2019 McGraw-Hill Education. 13-21
 13.4 Price-Earnings Ratios (5 of 5)

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

© 2019 McGraw-Hill Education. 13-22

Figure 13.6 Valuation Ratios for S&P 500

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© 2019 McGraw-Hill Education. 13-23
 13.5 Free Cash Flow Valuation Approaches
(1 of 4)
Free Cash Flow for Firm (FCFF)
• FCFF = EBIT(1 − tc) + Depreciation − Capital
expenditures − Increase in NWC
• EBIT = Earnings before interest and taxes
• tc = Corporate tax rate
• NWC = Net working capital
Free Cash Flow to Equity Holders (FCFE)
• FCFE = FCFF−Interest expense × (1 − tc) + Increase in
net debt

© 2019 McGraw-Hill Education. 13-24

 13.5 Free Cash Flow Valuation Approaches
(2 of 4)
Estimating Terminal Value using Constant Growth Model
1+ FCFFt PT
Firmvalue =  t =1
T
+
 1+ WACC   1+ WACC 
t T

FCFFT +1
PT =
WACC  g
WACC = Weightedaveragecost of capital

© 2019 McGraw-Hill Education. 13-25

13.5 FCF Valuation Approaches: FCFF Example

Suppose FCFF = $1 mil for years 1-4 and then is

expected to grow at a rate of 3%. Assume WACC = 15%
T
FCFF PT
Firmvalue =  +
 1+ WACC   1+ WACC 
t T
t =1

$1,000,000×1.03
4
$1,000,000 .15  .03
= +
 1+.15   1+.15 
t 4
t =1

= $7,762,527

If 500,000 shares are outstanding, what is the predicted

price of this stock if the firm has $5,000,000 of debt?
 $7,762,527  $5,000,000
P0 =  = $5.53
500,000

© 2019 McGraw-Hill Education. 13-26

 13.5 Free Cash Flow Valuation Approaches
(3 of 4)
Market Value of Equity
FCFEt PT
Market value of equity =  t =1
T
+
 1+ kE   1+ kE 
t T

FCFET +1
PT =
kE  g

© 2019 McGraw-Hill Education. 13-27

13.5 FCF Valuation Approaches: FCFE Example
Suppose FCFE = $900,000 for years 1-4 and then is
expected to grow at a rate of 3%. Assume ke = 18%
T
FCFE PT
Market Value of Equity =  t
+ t
t =1 (1+ k e ) (1+ k e )
$900,000×1.03
4
$900,000 .18  .03
= t
+
t =1 (1+.18) (1+.18)4
= $ 2,500,851
If there are 500,000 shares outstanding, what is the
predicted price of this stock? Why can debt be ignored?
 $ 2,500,851
P0 =  = $5.00
500,000
© 2019 McGraw-Hill Education. 13-28
Spreadsheet 13.2: FCF
Spreadsheet
s are
available in
Connect

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© 2019 McGraw-Hill Education. 13-29
 13.5 Free Cash Flow Valuation Approaches
(4 of 4)
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

© 2019 McGraw-Hill Education. 13-30

 13.6 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

© 2019 McGraw-Hill Education. 13-31

Figure 13.7 Earnings Yield of S&P 500 versus 10
Year Treasury Bond Yield

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© 2019 McGraw-Hill Education. 13-32
 S&P 500 Forecasts

TABLE 13.4 S&P 500 index forecasts under various

scenarios
Pessimistic Most Likely Optimistic
Scenario Scenario Scenario
Treasury bond yield 3.0% 2.5% 2.0%
Earnings yield 5.4% 4.9% 4.4%
Resulting P/E ratio 18.52 20.41 22.73
EPS forecast 126 126 126
Forecasts for S&P 500 2,333 2,571 2,864

Note: The forecasts for the earnings yields on the S&P 500 equals the Treasury-
bond yield plus 2.4%. The P/E ratio is the reciprocal of the forecast earnings yield.

© 2019 McGraw-Hill Education. 13-33

 Appendix of Image Long Descriptions

© 2019 McGraw-Hill Education. 14-34

@2019 McGraw Hill Education.
 13.3 Dividend Growth and Reinvestment
Appendix Long Description
Dividends per share (dollars) is on the vertical axis, and
year is on the horizontal. High reinvestment slopes from
(0, 2) to (30, 10). Low reinvestment slopes from (0, 3.8)
to (30, 5).

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© 2019 McGraw-Hill Education. 13-35

Figure 13.3 P/E Ratio and Inflation Appendix
Long Description
The inflation rate is displayed on the horizontal axis and
the P/E ratio of the S and P 500 is plotted on the vertical
axis. The relationship shows a gently decreasing
concave up curve as the inflation rate increases from 0
to 15%. The model fits well beyond an inflation rate of
6%. Prior to that there is a good deal of variability.

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© 2019 McGraw-Hill Education. 13-36

 Figure 13.4 Earnings Growth for Two
Companies Appendix Long Description
PepsiCo has grown more rapidly over this time period
while Consolidated Edison has remained relatively
horizontal at about an earnings per share of 1.0.

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© 2019 McGraw-Hill Education. 13-37

 Figure 13.5 Price-Earnings Ratios Appendix
Long Description
The P/E Ratio for PepsiCo has decreased from 2001 to
2009. Beyond that point it rose slightly. The P/E ratio for
Consolidated Edison rose slightly from 2001 to 2004,
then decreased slightly until 2009, and has been
increasing slightly since then.

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© 2019 McGraw-Hill Education. 13-38

 Figure 13.6 Valuation Ratios for S&P 500
Appendix Long Description
The levels of these ratios differ considerably, for the most
part they track each other fairly closely, with upturns and
downturns at the same times.

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© 2019 McGraw-Hill Education. 13-39

 Spreadsheet 13.2: FCF Appendix Long
Description
The input data are the P/E Ratio, Capital spending per share, long
term debt in millions, shares (millions), earnings per share, and
working capital. The cash flow calculations are the profits, interest,
change in working capital, depreciation, capital spending, F C F F,
and F C F E in millions. The discount rate calculations are the
current beta, the unlevered beta, the terminal growth, the tax rate,
the debt rate, the risk free rate, the market risk premium, the M V
equity, the debt/value, and levered beta, k equity, W A C C, the P V
factor for F C F F and the P V factor for F V F E. Finally, the present
values for F C F F and F C F E are computed.

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© 2019 McGraw-Hill Education. 13-40

Figure 13.7 Earnings Yield of S&P 500 versus 10 Year
Treasury Bond Yield Appendix Long Description

Yield (percent) is on the vertical axis, and the years 1955

to 2018 are on the horizontal. Treasury yield trends
upward from 2.5 percent in 1955 to peak at 14 percent in
1981, dropping unsteadily to 2 percent in 2017. Earnings
yield starts at 8 percent in 1955, trends between 5 and 6
percent until 1973, after which it peaks to 12 percent in
1974 and 13 percent in 1979. It drops unsteadily to 2
percent in 2009, climbs back to 6.5 percent in 2011, and
ends at 5 percent in 2017. All values are approximations.
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© 2019 McGraw-Hill Education. 13-41