Asset Valuation Equity Investments

8/8/2019 Asset Valuation Equity Investments

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Asset Valuation: Equity Investments

1.A: An Introduction to Security Valuation

a: Explain the top-down approach and its underlying logic to the security valuation process.

Step 1 General economic influences: fiscal policy: tax cuts encourage spending and tax

increases discourage spending. monetary policy: a restrictive policy reduces the availability of

funds and causes interest rates to rise putting upward pressures on costs. In addition to fiscal

and monetary actions you must also consider the economic consequences of political

changes around the globe. From a global portfolio perspective you have to consider the

economic events in other countries.

Step 2 Industry influences: The next step in the valuation process is to identify those

industries that will prosper or suffer during the time frame of your economic forecast. You

should consider the cyclical nature of the industry under study. Some industries are cyclical,

some are contra cyclical and some are non-cyclical. Finally, your analysis should also account

for foreign economic shifts. In general, an industrys prospects within the global business

environment determine how well or poorly individual firms in the industry do.

Step 3Company Analysis: After determining the industrys outlook you should compare the

individual firms performance within the entire industry using financial ratios and cash flow

values. Your goal is to identify the best company in a promising industry. This involves not

only examining the firms past performance, but also its future prospects.

b: Calculate the value of a preferred stock, assuming a perpetual dividend.

Valuation of preferred stock is easy since the dividend is fixed and the preferreds life is

infinite (its a perpetuity) appears in the upper right hand corner. Again, the only problem is

determining kP. Because of default risk factors, the preferreds discount rate (kP) should be

above the firms bond rate (kB). But since dividends paid by one corporation to another

corporation are 80% tax exempt, preferred yields are below the firms highest-grade bond

yields.

preferred value= D + D +...+ D = D(1 +kp)1 (1 + kp)2 (1 + kp) kp

Example: value the preferred of a company that pays a $5 annual dividend. The firms bonds

are currently yielding 8.5% and preferred shares are selling to yield fifty basis points below

the firms bond yield.

Step 1: determine the discount rate. 8.5% - .5% = 8%

Step 2: value the preferred. D/kP = $5/.08 = $62.50

c: Calculate the value of a common stock, using the dividend discount model (DDM) for both a

one-year holding period and a multiple-year holding period.


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Example: what is the value of a stock that last year paid a $1 dividend, if you think: next

years dividend will be 10% higher; the stock will be selling for $25 at year end; the risk free

rate of interest is 5%, the market return is 10% and the stocks beta is 1.2?

Step 1: solve for the discount rate. ke = .05 + (1.2)(.1 - .05) = 11%.

Step 2: find the PV of the future dividend. FV = D1 = $1(1.1) = $1.10; n = 1; i=11; PV= $.99.

Step 3: find the PV of the future price: FV = $25, n = 1; i = 11; PV = $22.52.

Step 4: sum steps 2 and 3. The current value based on the investors expectations is $.99 +

$22.52 = $23.51.

Modeling a stock's value with a multiple-year holding period just expands the one-year

approach to forecasting two or three years' worth of dividends and the terminal price of the

stock at the end of the period.

d: Calculate the value of a common stock, using the infinite period DDM.

There is one multiperiod model that uses a different approach though.

Stock Value = D0(1 + g)1 + D0(1 + g)2 + D0(1 + g)3 +...+ D0(1 + g)(1 + ke)1 (1 + ke)2 (1 + ke)3 (1 + ke)

This is the infinite period model. The infinite period model assumes that the growth rate (g)

in dividends between years is constant. So next years dividend D1 is just D0(1 + g) and thesecond years dividend is just D0 (1 + g)2. The equation using this assumption looks like what

appears above.

This equation simplifies to the infinite period dividend discount model.

Projected Stock Value P0= D0(1 + g) = D1ke- g ke- g

Note: this model is also called the constant growth DDM in the literature.

e: Calculate the value of a common stock for a company experiencing temporary supernormal

growth.

The infinite period DDM doesn't work with growth companies. Growth companies are firms

that currently have the ability to earn rates of return on investments that are currently above

their required rates of return. The infinite period DDM assumes the dividend stream grows at

a constant rate forever while growth companies have high growth rates in the early years that

level out at some future time. The high early or supernormal growth rates will also generally

exceed the required rate of return. Since the assumptions (constant g and k>g) don't hold, the

infinite period DDM cannot be used to value growth companies.


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A more realistic approach to supernormal growth companies and companies that don't pay

dividends is to combine the multiperiod model with the infinite period model.

In the temporary supernormal growth model you must:

1. Project the size and duration of the supernormal dividend growth rate, (g supernormal)

2. Forecast what the normal growth rate will be at the end of the supernormal growth

period, (g future normal)

3. Determine the discount rate, ke

f: Show how to use the DDM to develop an earnings multiplier model and explain the factors in

the DDM that affect a stock's price-to-earnings (P/E) ratio.

Example: A firm has an expected dividend payout ratio of 60%, a required rate of return of

11%, and an expected dividend growth rate of 5%. What is the firms expected P/E ratio? Ifyou expect next years earnings (E1) to be $3.50, what is the value of the stock today?

Step 1: estimate the P/E ratio: .6/(.11 - .05) = 10

Step 2: calculate the value estimate: (E1)(P/E estimate) = ($3.50)(10) = $35.00

Note 1: the main determinant of the size of the P/E ratio is the difference between k and g.

Note 2: the relevant P/E ratio you should study is the expected (P0/E1) ratio not the historical

(P0/E0) ratio

Note 3: the P/E ratio is just a restatement of the DDM. So anything that influences stock

prices through the DDM will also have the same effect on the P/E ratio.

g: Explain the relationship among the nominal risk-free rate, the risk-free rate, and the expected

rate of inflation.

Nominal risk free rate = (1 + real risk-free rate)(1 + expected inflation) - 1

Example: the real rate is 4 percent and the expected inflation rate is 3 percent.

The nominal risk-free rate = (1.04)(1.03) 1 = 1.0712 1 = 7.12%.

The nominal rate is frequently estimated by summing the real rate and the inflation

expectation.

Estimate of the nominal risk-free rate = 4% + 3% = 7%

h: Discuss the risk factors to be assessed in determining a country risk premium for use in

estimating the required return for foreign securities.

Business riskis a function of the variability of economic activity within a country and

the average operating leverage used by firms within the country.


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Firms in different countries assume significantly different financial risk.

Countries with small or inactive capital markets offer significant liquidity risk.

The uncertainty in exchange rates causes exchange rate risk.

Finally, country riskarises from unexpected economic and political events.

i: Estimate the dividend growth rate, given the components of return on equity and incorporating

the retention rate.

Note: Why does g equal (RR)(ROE) for a stable but expanding company? Assume ROE is

constant and that new funds come solely from earnings retention. What is the firm's growth

rate given that the firm earns 10% on equity of $100 and pays out 40% of earnings in

dividends?

Earnings in period 1:(.10)($100) = $10. Dividend in period 1: (.40)( $10) = $ 4.

Retention in period 1:($10)(1-.4) = $ 6 so Earnings in period 2: (.10)($100) + (.10)($6) =$10.60.

Dividend in period 2:(.40)($10.60) = $4.24.

Analysis of growth: earnings growth = ($10.60 - $10)/$10 = 6% and dividend growth =

($4.24 - $4)/$4 = 6%.

Analysis of stock price: assume k = 10%.

Price at the beginning of period 1 = D1/(k - g) = $4/(.10 - .06) = $100.

Price at the beginning of period 2 = D2/(k - g) = $4.24/(.10 - .06) = $106

The stock's price will grow at a 6 percent rate just like earnings and dividends.

What caused this growth? Earnings on the new retained earnings. Growth = (ROE)(Retention

rate) = (.1)(1 - .4) = 6%.

j: Describe a process for developing estimated inputs to be used in the DDM, including the

required rate of return and expected growth rate of dividends.

Estimating the inputs: the valuation models are dominated by the inputs k and g, so it isimportant that you understand how they are estimated and what they mean.

The required rate of return (k)is influenced by:

1. The economys real risk-free rate, which is determined by the supply and demand for

capital in the country.

2. The expected rate of inflation in the country, which will cause investors to demand

higher nominal rates of interest to compensate for their potential loss of purchasing

power.


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c: Estimate the value of, and explain the level of and changes in the earnings multiplier of a stock

market series.

A two-part valuation procedure of a stock market series or index:

1. Estimate the future earnings per share for the stock market series. (EFuture)

2. Estimate a future earnings multiplier for the stock market series. (P/EFuture)

Note: empirical evidence shows that the earnings multiplier is a more volatile variable than

earnings.

After you estimate the future earnings per share (E) and future earnings multiplier (P/E) you

multiply them together to get an estimate ofwhat the stock market series will be worth at

the end of the period.

End of period index value = (Efuture)(P/EFuture)

d: Calculate the expected rate of return for a stock market series.

Example: you forecast that next period g will be 9%, k will be 12%, the dividend payout will

be 40%, and the indexs earnings will be $300. Thus you feel that the cash dividend of the

index will be $120 next period. The index is currently at 3,600. What will the return on the

index be for the period based on your projections?

Step 1: calculate the P/E ratio. (.4)/(.12 .09) = 13.333X

Step 2: calculate the expected value of the index at year-end.

(P/E)(E) = (13.333)(300)= $4,000.

Step 3: calculate the expected return. [120 + (4000 3600)]/3600 = .1444 = 14.44%

e: Explain how the top-down approach can be used to analyze the valuation of world stock

markets.

The procedure used here for analyzing a U.S. market index can be used to analyze any

market index. The expected return should be calculated for all non-U.S. markets, especially

the major world markets.

Market index PE ratios will vary across national borders because of different economic

outlooks, GDP, capital investments, industrial production, inflation, and interest rates.

1.C: Industry Analysis

a: Describe the process for estimating earnings per share (EPS) for an industry and estimate the

EPS for an industry.


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Step 1. Forecasting sales per share. The three techniques used to forecast sales are: a.

industry life cycle analysis, b. input-output analysis, and c. studying industry relationships.

Step 2. Analyze the competition within the industry. The earnings forecast should be

preceded with an analyses of the competitive structure for the industry. A review of thecompetitive nature of the industry is necessary because the profitability of a specific firm in an

industry is heavily influenced the competitive environment in which it must do business and

the profitability of the industry as a whole.

Step 3. Forecasting the industry profit margin: (a) this step requires the analyst to estimate

the industry gross profit margin using economic variables related to the industry. Multiplying

the projected EBDIT profit margin times the industry sales per share estimate yields an

estimate of the industrys earnings per share before depreciation, interest and taxes, (b) using

time series analysis the analyst can then forecast the industrys depreciation per share (D),

interest expense per share (I) and tax rate (T).

Step 4. Putting it all together (estimating earnings per share). The analysts can now forecast

industry earnings per share using the following formula:

Estimated EPS = [(sales per share estimate)(EBDIT %) - D - I](1 - T)

b: Describe the industry life cycle and identify an industry's stage in its life cycle.

1. Pioneering phase: during the start up phase the industry experiences modest sales

growth and very small or negative profit margins. The market is small and firms incur

major developmental costs.

2. Rapid accelerating growth phase: during this stage markets develop for the

industrys products and demand grows rapidly. There is limited competition among

the few firms in the industry, and profit margins will be very high. High sales growth

and profit margins.

3. Mature growth phase: here, sales growth is still above normal, but growth is no

longer accelerating. Competition increases and profit margins begin to decline. The

number of competitors increases and profit margins move toward normal levels.

4. Stabilization and market maturity phase: this is the longest phase. Industry growth

rates will approach the growth rate of the aggregate economy. Competition produces

tight profit margins and ROEs become competitive (normal).

5. Deceleration of growth and decline: here demand shifts away from the industry.

Growth of substitute products causes declining profit margins.

c: Describe the basic forces that determine industry competition.

Rivalry among the existing competitors: Rivalry increases when many firms of relatively

equal size compete within an industry. Slow growth leads to competition when firms fight for

market share, and high fixed costs leads to price cutting as firms try to operate at full capacity.


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Threat of new entrants: Look for things that discourage new entrants like barriers to entry

and economies of scale. Why? New entrants represent increased competition.

Threat of substitute products: Substitute products limit the profit potential of an industry.

Why? They limit the prices firms can charge. The more commodity like the product, the

greater the competition and the lower the profit margin.

Bargaining power of buyers: The ability of buyers to bargain for lower prices or higher

quality when purchasing between competing firms within an industry influences the selling

firms profitability.

Bargaining power of suppliers: The ability of suppliers to raise prices or lower quality

influences industry profitability. Suppliers are more powerful if there are just a few of them and

if they are more concentrated than firms in the industry to which they sell.

d: Describe two techniques for estimating an earnings multiplier for an industry and estimate the

earnings multiplier for an industry.

Macroanalysis of an industry multiplierassumes there is a relationship between the

markets k and g and the industrys k and g. This technique adjusts the industry multiplier

upwards or downwards based on the projected marketmultiple.

Microanalysis of an industry multipliercan take a direction of change approach where

industry variables are studied and then used to adjust the existing industry multiple upward or

downward. The preferred approach though is the specific multiplier estimate method since it

generates an actual point estimate of the multiplier. The specific multiplier approach estimates

the industry dividend payout ratio (D/E), required rate of return (k) and growth rate. Estimatethe dividend payout ratio (D/E) based on past industry trends and current economic events.

Estimate the required rate of return (k) for the industry. The risk free rate and inflation

forecasts will come from the general economic forecast. The industry risk premium can be

developed using either:

1. The fundamental approach where the industrys business risk, financial risk, liquidity

risk, exchange rate risk and country risk are considered.

2. The portfolio theory approach where the industrys beta is determined by regression

analysis and put into the CAPM.

The industrys expected growth rate is estimated using the sustainable growth [g = (retention

rate)(ROE)] framework. Coupling the general economic forecast with the relevant industry

analysis, ROE should be projected by combining the industrys estimated profit margin, total

asset turnover and financial leverage.

e: Discuss factors that should be considered when conducting global industry analysis.

Because so many firms are active in foreign markets and because the proportion of foreign

sales is growing for so many firms, you must expand industry analysis to include the effects offoreign firms on global trade and industry returns. Differences in accounting treatments and


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the impact of exchanges rate fluctuations must be carefully considered in a global industry

analysis.

1.D: Company Analysis and Stock Selection

a: Describe and estimate the expected earnings per share (EPS) and earnings multiplier for acompany.

There are four steps in estimating the value of a company:

1. Estimating a company's earnings per share (EPS).

2. Estimating a company's earnings multiplier (P/E).

3. Estimating the future value of the firm's stock.

4. Making the investment decision.

EPS = [(Sales per share)(EBITDA%) - D - I] (1 - T)

There are two methods for estimating a company's earnings multiplier: 1) macroanalysis and,

2) microanalysis.

P/E = (D/E1) / (k - g)

b: Describe and compute price/book value, price/cash flow, and price/sales ratios.

Price/book value ratio (P/BV). The price/book value is defined as the market value of the

company divided by its book value. P/BV ratios are used a great deal in the valuation of

financial stocks. Why? Because in theory the book value of the firm's assets should be pretty

close to the market value of its assets. However, in practice the two can differ dramatically.

High P/BV ratios can result from large amounts of fixed assets being carried at historical

costs, while low P/BV ratios can occur when assets (like bad debts) are worth less than book

value. Variance from one could also indicate mispricing.

Price/cash flow ratio(P/CF). The price/cash flow ratio is defined as the market value of the

company divided by its cash flow. The P/CF ratio should be used in conjunction with the P/E

ratio because earnings (the denominator of the P/E ratio) are subject to accounting gimmicks

and manipulation. Cash flows are typically more stable. As cash flow numbers have become

more available, interest in this ratio has increased.

Price/sales ratio(P/S). The price/sales ratio is defined as the market value of the company

divided by its sales. Sales are typically seen as the accounting variable least likely to be

manipulated. Sales growth directly influences cash flows and earnings.

c: Describe economic value added (EVA) market value added (MVA), and the franchise factor.

Economic value added (EVA). Note: EVA is a registered trademark of Stern, Stewart, &

Co. Corporate investments are analyzed using net present value techniques. The presentvalue of a projects future cash flows are discounted at the firms weighted average cost of


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capital and then compared to the cost of the project. If a firm takes on projects with positive

NPVs, value has been added to the firm. EVA is used to measure the performance of

managements ability to add value to the firm over the years through the investment decisions

they make. EVA is calculated each year by comparing the firms net operating profit less its

adjusted taxes (NOPLAT) to the firms total cost of capital in dollars.

Market value added (MVA). EVA demonstrates the performance of management. MVA

measures how much the market has paid for this performance. MVA is calculated as: market

value of the firm (market value of the firms debt and equity) less the capital invested in the

firm = market value added. When analyzing MVA, you are looking for positive changes over

time.

The franchise factor. This calculation looks at the value added to the firm from a franchise.

The firms observed P/E ratio equals its base P/E ratio plus the value added to this P/E ratio

by holding a franchise. The firms observed P/E = the firms base P/E + the franchise P/E.

d: Discuss factors tht should be considered when conducting global company analysis.

1. Earnings per share analysis

2. Common stock statistics

Absolute P/E ratios and P/E ratios relative to the average P/E ratio in the

local market. Two stocks with fairly similar P/E ratios could have different

relative valuations in different countries due to variations in accounting

conventions or social attitudes.

Price to book value ratios. These ratios also reflect differences in relative

valuation among countries.

Share price performance. You must study real performance and performance

relative to the local market. The latter comparison is important because it

shows the effect of international diversification and the necessity of

considering exchange rate movements when making foreign investments.

Individual company analysis. International or domestic, the individual

strengths and weaknesses of the firm are the basis for value.

1.E: Technical Analysis

a: Explain the underlying assumptions of technical analysis.

Values and thus prices are determined by supply and demand.

Supply and demand is driven by both rational and irrational behavior.

Security prices move in trends that persist for long periods of time.

While the cause for changes in supply and demand are difficult to determine, the

actual shifts in supply and demand can be observed in market price behavior.

b: Explain how technical analysis differs from fundamental analysis.


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Fundamentalists, through their research, look for changes in the basis of value which

eventually leads to changes in the supply and demand for the stock. Technicians look for

evidence of changes in supply and demand through market signals and indicators. Efficient

market followers say all this looking is a hopeless and profitless exercise since prices will

change instantaneously to information changes.

1. Fundamentalists look for reasons why the valuation band will shift upward. The shift

will happen when they find it. Price changes will occur over a period of days or weeks

as analysts determine the situation.

2. Technicians look for signs that the valuation band has moved. Price changes will

occur over long periods of time.

3. Efficient market followers say when it happens the price will shift instantaneously.

Technical analysis, fundamental analysis, and efficient markets theory are not mutually

exclusive concepts.

c: Discuss the advantages of technical analysis.

It's quick and easy.

It does not involve messing with data and adjusting foraccountingproblems.

It incorporates psychological as well as economic reasons behind price changes.

It tells when to buy; not why investors are buying.

d: Discuss the challenges to technical analysis.

The vast majority of studies have found that prices do not move in trends based on

statistical tests of autocorrelation and runs. That is, past price patterns may not be

repeated in the future. Efficient market followers say that the market appears to react

quickly to the release of new information.

If technical trading rules worked, the market would self-destruct. This is called the

self-fulfilling prophecy.

If a technical trading proved to be successful, others would copy it. As more traders

implement the strategy, its value will be neutralized.

Interpreting the rules is too subjective and the decision variables change over time.

e: Identify expamples of each of the major categories of technical indicators.

Contrary-opinion technicians use the following technical indicators:

Mutual fund cash positions

Investor credit balances in brokerage accounts

Investment advisory opinions

OTC vs. NYSE volume


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CBOE put/call ratio

Futures traders bullish on stock index futures

Smart money technicians use the following technical indicators:

The confidence index (CI)

T-bill - Eurodollar yield spread

Short sales by specialists

Debit balances in brokerage accounts (margin debt)

2.: Discounted Cash Flow Applications

a: Calculate the price of a stock using the constant growth dividend discount model.

Example: What is the value of a stock that paid a $2 dividend last year if dividends are

expected to grow at a 5% rate forever? The required rate of return is 12%.

Step 1: Determine next period's dividend, D1

D1 = D0 (1 + g)

D1 = $2.00(1.05) = $2.10

Step 2: Use the constant growth DDM to determine the stock price.

P0 = D1 / r - g

P0 = $2.10 / (.12 - .05) = $30.00 per share

b: Describe the circumstances for which use of the constant growth dividend discount model is

appropriate.

Using the constant growth dividend discount model is only appropriate when the following

assumptions are met:

1. The stock pays dividends and they grow at a constant rate

2. The constant growth rate, g, continues for an infinite period

3. The required rate of return, r, must be greater than g. If not, the math will not work.

c: Explain supernormal growth and calculate the price of a stock using the two-stage dividend

discount model.

Example: You are assigned to determine the value of the stock of a growth company. For

years 1 through 4, the company is growing at a supernormal rate of 20%. From year 5 on,

growth slows to a long-term sustainable rate of 5%. D1 = $1 and r = 10%. Solve for P0.


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Step 1: Project dividends into the future based on g = 20% for n = 1-4, and g = 5% for n = 5

on. D1 = $1, D2 = $1.20, D3 = $1.44, D4 = $1.73, and D5 = $1,82.

Step 2: Find the value of the stock at the end of year 4 based on D5 = $1.82. P4 = D5 / r - g =

1.82 / (.1 - .05) = $36.40.

Step 3: Find present value of the cash stream at r = 10%.

PV D1: FV = 1.00, N = 1, I/Y = 10, PV = 0.91

PV D2: FV = 1.20, N = 2, I/Y = 10, PV = 0.99

PV D3: FV = 1.44, N = 3, I/Y = 10, PV = 1.08

PV D4: FV = 1.73, N = 4, I/Y = 10, PV = 1.18

PV D5: FV = 36.40, N = 4, I/Y = 10, PV = 24.86

Value = PV sum of the future cash flows = 29.02

d: Calculate the value of a company using a free cash flow to equity (FCFE) model.

Example: You are assigned to value the stock of Microware Corporation, which has 13 million

shares outstanding. You have decided that the required return on Microware stock is 15%.

Based on your expectations of earnings growth rates and industry prospects, you also predictMicroware will sell at a multiple of 30 times predicted FCFE in four years. Based on your

calculations, Microware will have the following free cash flows for the next four years,

respectively: 10 million, 12 million, 15 million, and 20 million.

Step 1: Find the present value of each year's free cash flow to equity.

10 / (1.15) = $8.70 million

12 / (1.15)2 = $9.07 million

15 / (1.15)3 = $9.86 million

20 / (1.15)4 = $11.44 million

Step 2: Multiply the final FCF by the FCF multiple, and find the present value.

FCFE4 = $20 million, FCF multiple = 30, So 20 * 30 = $600 million

600 / (1.15)4 = $343.05 million

Step 3: Add the discounted values and divide by the number of shares outstanding to find the

estimate price per share.

8.70 + 9.07 + 9.86 + 11.44 + 343.05 = 382.12 million


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$382.12 million / 13 million = $29.39 per share

e: Calculate the dollar-weighted and time-weighted rate of return of a portfolio.

Dollar-weighted return:

1. Determine the timing of each cash flow and whether the cash flow is an inflow (+) or

an outflow (-).

2. Net out the cash flows for each period and set the present value of cash inflows equal

to the present value of cash outflows.

3. Solve for r to find the dollar-weighted rate of return. This can be done using trial and

error, the IRR function on a financial calculator, or a spreadsheet.

Time-weighted return:

1. Break the evaluation period into two subperiods based on timing of cash flows.

2. Calculate the HPR for each holding period.

3. Take the geometric mean of the annual returns to find the annualized time-weighted

rate of return over the measurement period.

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Asset Valuation Equity Investments