Chapter 5. Equity Markets
Chapter 5. Equity Markets
1
Content
• Overview of equity market
• Some trading regulations in HOSE
• Equity Indexes
• Market Efficiency
• Equity Valuation: Concepts and Basic Tools
2
Overview of equity market
• Equity securities represent ownership claims on a
company’s net assets.
• As an asset class, equity plays a fundamental role
in investment analysis and portfolio manage- ment
because it represents a significant portion of many
individual and institutional investment portfolios.
3
Overview of equity market
• The study of equity securities is important for many
reasons.
– First, the decision on how much of a client’s portfolio to allocate to
equities affects the risk and return characteristics of the entire
portfolio.
4
Overview of equity market
5
Equity Markets Ranked by Total Market Capitalization at
the End of 2017 (Billions of US Dollars)
6
Real Returns on Global Equity Securities,
Bonds, and Bills During 1900–2017
7
Annualized Real Returns on Asset Classes
for the World Index, 1900–2017
8
Annualized Real Returns on Asset Classes and Risk
Premiums for the World Index since 1900–2017
9
International Comparisons of Stock Ownership:
2004–2014
10
Equity markets
• Primary market trading
– Public offerings and private placements.
11
Private equity
• Private equity securities are issued primarily to
institutional investors via non-public offerings,
such as private placements.
• There are three primary types of private equity
investments: venture capital, leveraged buyouts,
and private investment in public equity (or PIPE).
12
Private equity
• The objective of private equity investing is to
increase the ability of the company’s management
to focus on its operating activities for long-term
value creation.
• The strategy is to take the “private” company
“public” after certain profit and other benchmarks
have been met.
13
Public equity
• When a firm goes public, it issues stock in the primary
market in exchange for cash.
• Going public has two effects on the firm.
– It changes the firm’s ownership structure by increasing the number
of owners.
15
Public equity
• Ownership and Voting Rights
– Owners of small companies also tend to be the
managers. In publicly traded firms, most shareholders
are not the managers.
– Ownership of common stock entitles shareholders to a
number of rights.
§ Normally, only the owners of common stock are
permitted to vote on certain key matters concerning
the firm.
§ Many investors assign their vote to management
through the use of a proxy. 16
Common shares
• Common shares represent an ownership interest in a
company and give investors a claim on its operating
performance, the opportunity to participate in the corporate
decision-making process, and a claim on the company’s
net assets in the case of liquidation.
– Callable common shares give the issuer the right to buy back the
shares from shareholders at a price determined when the shares
are originally issued.
17
Preference shares
• Preference shares are a form of equity in which payments
made to preference shareholders take precedence over
any payments made to common stockholders.
– Cumulative preference shares are preference shares on which
dividend payments are accrued so that any payments omitted by
the company must be paid before another dividend can be paid to
common shareholders.
18
Public Equity
• Participation in Stock Markets
– Investors can be classified as individual or institutional
§ Individual investments commonly exceeds 50% of
the total equity.
§ Because of the size of investment, institutional
investors can significantly affect stock market prices.
19
Institutional Use of Stock Markets
20
Public Equity
• How Investor Decisions Affect Stock Prices
– When there is a shift in the demand for shares or the supply of
shares for sale, the equilibrium price changes.
– Lockup
§ Prevents the original owners of the firm and the VC firms from
selling their shares for a specified period.
• Timing of IPOs
– Initial public offerings tend to occur more frequently during bullish
stock markets. 23
Google’s IPO
• On August 18, 2004, Google engaged in an IPO that
generated $1.6 billion.
• Estimating the Stock’s Value - investors multiplied Google’s
earnings per share by Yahoo!’s price-earnings ratio.
• Google’s Communication to Investors before the IPO -
Google provided substantial financial information about its
operations and recent performance.
• The Auction Process – Google used a Dutch auction
process allowing all investors to submit a bid for its stock by a
specific deadline.
• Results of Google’s Dutch Auction - resulted in a price of
$85 per share.
24
Facebook’s IPO
• On May 18, 2012, Facebook engaged in an IPO
that generated $16 billion.
• Facebook’s opening price was $38/share. The
price fluctuated through the day with a high of
about $43. Many traders lost experienced
substantial profits are losses in the first day
• Three months after the opening, the price fell to
$20/share.
• Lesson - A company can be very valuable yet
overpriced. 25
Initial Public Offerings
• Abuses in the IPO Market
– Spinning - occurs when the underwriter allocates
shares from an IPO to corporate executives who may
be considering an IPO or to another business that will
require the help of a securities firm.
– Laddering - brokers encourage investors to place first-
day bids for the shares that are above the offer price.
This helps to build upward price momentum investors
multiplied Google’s earnings per share by Yahoo!’s
price-earnings ratio.
26
Initial Public Offerings
• Abuses in the IPO Market
– Excessive Commissions - Some brokers have
charged excessive commissions when demand was
high for an IPO. Investors were willing to pay the price
because they could normally recover the cost from the
return on the first day.
– Distorted Financial Statements - Even though
financial statements to summarize revenue, expenses,
and financial condition, accountants still have much
flexibility in their reporting process, and therefore still
can exaggerate earnings.
27
Stock Offerings and Repurchases
• Secondary Stock Offerings
– A secondary stock offering is a new stock offering by a specific
firm whose stock is already publicly traded.
• Stock Repurchases
– Firms tend to repurchase some of their shares when share prices
are at very low levels.
– New York Stock Exchange (NYSE) is by far the largest with two
broad types of members.
29
Stock Exchanges
• Over-the-Counter Market
– Stocks not listed on the organized exchanges are traded in the
over-the-counter (OTC) market.
– OTC Bulletin Board - lists stocks that have a price below $1 per
share, which are sometimes referred to as penny stocks.
– Pink Sheets - The OTC market has where even smaller stocks
are traded. Some of the stocks have very little trading volume and
may not be traded at all for several weeks.
30
Stock Exchanges
• Stock Index Quotations
– Dow Jones Industrial Average - value-weighted average of stock
prices of 30 large U.S. firms.
33
Types of orders
• Limit order (LO)
• Order which is executed at the opening order
matching price (ATO)
• Order which is executed at the closing order
matching price (ATC)
• Market order (MP)
• Stop order
34
Limit order (LO)
• The buy/sell order at a certain price or better.
– Buy 1000 shares of DHG at VND109.000 → The
investors are willing to buy at VND109.000 or less
– Sell 1000 shares of DHG at VND109.000 → The
investors are willing to sell at VND109.000 or more
35
Order which is executed at the
opening order matching price (ATO)
• ATO is buy or sell order that is to be matched at
the opening price.
• ATO orders receive higher priority than limit
orders when comparing to match.
• ATO orders are entered into the trading system in
time for periodic order matching to determine the
opening price and will be automatically cancelled
at the end of the opening session if they are not
executed or partially matched.
36
Order which is executed at the
closing order matching price (ATC)
• Similar to the ATO order but applied in time for
periodic order matching to determine the closing
price.
37
Market order (MP)
• Market order is a buy/sell order to be executed at lowest offer price/
highest bid price.
• Once inputting into the trading system, the MP sell order will be
immediately executed at the lowest offer price and the MP buy order
will be immediately executed at the highest bid price.
40
Market order (MP)
Stock ABC (Reference price: 14.0; limit up price:
14.7; limit down price 13.3):
44
Matching principles
• Price Priority:
– Buy orders at higher price will take precedence.
– Sell orders at lower price will take precedence.
• Time Priority:
– In case buy or sell orders at the same price, those
which entered into the trading system earlier will take
precedence in execution.
45
Periodic order matching – call market
• The method is made on the basis of comparing
buy orders and sell orders of stocks in a specified
time. Principles to determine the price as follows:
– The executed price that reaches largest transaction
volume.
– If more than one price satisfies the above condition,
the price which is similar or closest with nearest
matching order price will be selected.
46
Example of Call auction
• Stock P
Buying Selling
Price
Order code Volume Volume Order code
M1 10,000 119 10,000 B1
M2 5,500 115 15,000 B2, B3
M3 7,000 114 4,000 B4
47
Continuous order matching
• This method is made on the basis of comparing
buy orders and sell orders immediately when they
are input into the trading system.
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Continuous order matching
• Stock V; ceiling price :119 ; reference price: 114,
floor price: 109.
49
Continuous order matching
50
Continuous order matching
51
Continuous order matching
52
Continuous order matching
53
Margin Trading
• Using only a portion of the proceeds for an
investment
• Borrow remaining component
• Margin arrangements differ for stocks and futures
54
Stock Margin Trading
• Greatest margin
– Currently 30%
– Set by the securities companies
• Minimum margin
– Minimum level the equity margin can be (called
“maintenance” in USA)
• Margin call
– Call for more equity funds
55
Margin Trading - Initial Conditions
X Corp $70
50% Initial Margin
30% Minimum Margin
1000 Shares Purchased
Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000
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Margin Trading - Minimum Margin
Stock price falls to $60 per share
New Position
Stock $60,000 Borrowed $35,000
Equity $25,000
57
Margin Trading - Margin Call
• How far can the stock price fall before a margin
call?
1,000 ´ P - $35,000
= 30%
1,000 ´ P
Therefore, P = $50
Note: 1,000xP – Amount Borrowed = Equity
58
Margin Trading
• Advantages
– Allows use of financial leverage
– Magnifies profits
• Disadvantages
– Magnifies losses
– Interest expense on margin loan
– Margin calls
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Margin Formulas
• Basic Margin Formula
Value of securities - Debit balance
Margin =
Value of securities
V - D
=
V
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Leveraging effect of margin purchases
• You buy 200 shares of XYZ at $100, expecting a
30% appreciation of the stock in one year:
– Initial margin: 50%
– Financed by a 9% loan for one year
– Expected net return: 51%
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Effect of Margin on Security Returns
62
Margin Formulas
• Return on Invested Capital
64
Short Sales
• Purpose: to profit from a decline in the price of a
stock or security
Mechanics
• Borrow stock through a dealer
• Sell it and deposit proceeds and margin in an
account
• Close out the position: buy the stock and return it
to the owner
65
Short Sale - Initial Conditions
Z Corp 100 Shares
50% Initial Margin
30% Minimum Margin
$100 Initial Price
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Short Sale - Minimum Margin
Stock Price Rises to $110
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Short Sale - Margin Call
How much can the stock price rise before a margin
call?
$15,000 - 100 ´ P
= 30%
100 ´ P
So, P = $115.38
Note: $15,000 = Initial margin + sale proceeds
68
Short Selling
• Advantages
– Chance to profit when stock price declines
• Disadvantages
– Limited return opportunities: stock price cannot go
below $0.00
– Unlimited risks: stock price can go up an
unlimited amount
– If stock price goes up, short seller still needs to buy
shares to pay back the “borrowed” shares to the broker
– Short sellers may not earn dividends
69
Security Market Indexes
• Index Definition and Calculations of Value and
Returns
• Index Construction and Management
• Uses of Market Indexes
• Equity Indexes
70
Index Definition and Calculations of
Value and Returns
• A security market index represents a given
security market, market segment, or asset class.
Most indexes are constructed as portfolios of
marketable securities.
• The value of an index is calculated on a regular
basis using either the actual or estimated market
prices of the individual securities, known as
constituent securities, within the index.
71
Index Definition and Calculations of
Value and Returns
• A price return index, also known as a price
index, reflects only the prices of the constituent
securities within the index.
• A total return index, in contrast, reflects not only
the prices of the constituent securities but also the
reinvestment of all income received since
inception.
72
Index Definition and Calculations of
Value and Returns
• Calculation of Single-Period Returns
• Calculation of Index Values over Multiple Time
Periods
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Calculation of Single-Period Returns
• Price return can be calculated in two ways:
– the percentage change in value of the price return
index, or
– the weighted average of price returns of the constituent
securities.
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Calculation of Single-Period Returns
75
Calculation of Single-Period Returns
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Calculation of Single-Period Returns
• Total return can be calculated in two ways:
– the percentage change in value of the total return
index, or
– the weighted average of total returns of the constituent
securities.
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Calculation of Single-Period Returns
78
Calculation of Single-Period Returns
79
Calculation of Index Values over
Multiple Time Periods
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Index Construction and Management
• Target Market and Security Selection
• Index Weighting
• Index Management: Rebalancing and Reconstitution
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Target Market and Security Selection
• Identify the target market, market segment, or
asset class that the index is intended to represent;
• Determine the number of securities and the
specific securities to include in the index.
82
Index Weighting
• The weighting decision determines how much of
each security to include in the index and has a
substantial impact on an index’s value.
• Indexes can be
– price weighted
– equal weighted
– market-capitalization weighted, or
– fundamentally weighted.
83
Index Weighting - Price Weighting
The simplest method to weight an index and the one used by
Charles Dow to construct the Dow Jones Industrial Average
is price weighting. In price weighting, the weight on each
constituent security is determined by dividing its price by the
sum of all the prices of the constituent securities. The weight
is calculated using the following formula:
84
Example of a Price-Weighted Equity Index
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Index Weighting - Price Weighting
• The primary advantage of price weighting is its
simplicity.
• The main disadvantage of price weighting is that it
results in arbitrary weights for each security. In
particular, a stock split in any one security causes
arbitrary changes in the weights of all the
constituents’ securities.
86
Index Weighting - Price Weighting
Impact of 2-for-1 Split in Security A
87
Index Weighting - Equal Weighting
• Equal weighting assigns an equal weight to each
constituent security at inception.
88
Example of an Equal-Weighted Equity
Index
89
Index Weighting - Equal Weighting
• Advantage
– Simplicity
• Disadvantages
– Securities that constitute the largest fraction of the target
market value are underrepresented, and securities that
constitute a small fraction of the target market value are
overrepresented.
– After the index is constructed and the prices of
constituent securities change, the index is no longer
equally weighted. Therefore, maintaining equal weights
requires frequent adjustments (rebalancing) to the index.
90
Index Weighting - Market-Capitalization
Weighting
• In market-capitalization weighting, or value
weighting, the weight on each constituent security
is determined by dividing its market capitalization
by the total market capitalization (the sum of the
market capitalization) of all the securities in the
index.
• Market capitalization or value is calculated by
multiplying the number of shares out- standing by
the market price per share.
91
Index Weighting - Market-Capitalization
Weighting
• The market-capitalization weight of security i is:
92
Example of a Market-Capitalization-
Weighted Equity Index
93
Index Weighting - Market-Capitalization
Weighting
• Advantage
– Constituent securities are held in proportion to their
value in the target market.
• Disadvantage
– Constituent securities whose prices have risen the
most (or fallen the most) have a greater (or lower)
weight in the index → overweight stocks that have
risen in price (and may be overvalued) and
underweight stocks that have declined in price (and
may be undervalued).
94
Index Weighting - Fundamental Weighting
• Fundamental weighting attempts to address the
disadvantages of market-capitalization weighting
by using measures of a company’s size that are
independent of its security price to determine the
weight on each constituent security.
• These measures include book value, cash flow,
revenues, earnings, dividends, and number of
employees.
95
Index Weighting - Fundamental Weighting
• Some fundamental indexes use a single measure,
such as total dividends, to weight the constituent
securities, whereas others combine the weights
from several measures to form a composite value
that is used for weighting.
96
Index Weighting - Fundamental Weighting
• Relative to a market-capitalization-weighted index,
a fundamental index with weights based on such
an item as earnings will result in greater weights
on constituent securities with earnings yields
(earnings divided by price) that are higher than the
earnings yield of the overall market-weighted
portfolio. Similarly, stocks with earnings yields less
than the yield on the overall market-weighted
portfolio will have lower weights.
97
Index Weighting - Fundamental Weighting
For example, suppose there are two stocks in an index. Stock A has a
market capitalization of €200 million, Stock B has a market
capitalization of €800 million, and their aggregate market capitalization
is €1 billion (€1,000 million). Both companies have earnings of €20
million and aggregate earnings of €40 million. Thus, Stock A has an
earnings yield of 10 percent (20/200) and Stock B has an earnings
yield of 2.5 percent (20/800). The earnings weight of Stock A is 50
percent (20/40), which is higher than its market-capitalization weight of
20 percent (200/1,000). The earnings weight of Stock B is 50 percent
(20/40), which is less than its market-capitalization weight of 80
percent (800/1,000). Relative to the market-cap-weighted index, the
earnings-weighted index over-weights the high-yield Stock A and
under-weights the low-yield Stock B.
98
Index Weighting - Fundamental Weighting
• The most important property of fundamental weighting is
that it leads to indexes that have a “value” tilt. That is, a
fundamentally weighted index has ratios of book value,
earnings, dividends, etc. to market value that are higher
than its market- capitalization-weighted counterpart.
• In contrast to the momentum “effect” of market-
capitalization-weighted indexes, fundamentally weighted
indexes generally will have a contrarian “effect” in that the
portfolio weights will shift away from securities that have
increased in relative value and toward securities that have
fallen in relative value whenever the portfolio is
rebalanced.
99
Index Management: Rebalancing and
Reconstitution
• Rebalancing refers to adjusting the weights of the
constituent securities in the index.
• Reconstitution is the process of changing the
constituent securities in an index.
100
Uses of Market Indexes
• Gauges of Market Sentiment
• Proxies for Measuring and Modeling Returns,
Systematic Risk, and Risk-Adjusted Performance
• Proxies for Asset Classes in Asset Allocation
Models
• Benchmarks for Actively Managed Portfolios
• Model Portfolios for Investment Products
101
Equity Indexes
• Broad Market Indexes
• Multi-Market Indexes
• Sector Indexes
• Style Indexes
102
Broad Market Indexes
• A broad equity market index represents an entire given
equity market and typically includes securities representing
more than 90 percent of the selected market.
– Shanghai Stock Exchange Composite Index (SSE) is a market-
capitalization-weighted index of all shares that trade on the
Shanghai Stock Exchange.
104
MSCI Global Investable Market Indexes (as of October 2018)
105
Sector Indexes
• Sector indexes represent and track different
economic sectors - such as consumer goods,
energy, finance, health care, and technology - on
either a national, regional, or global basis.
• Because different sectors of the economy behave
differently over the course of the business cycle,
some investors may seek to overweight or
underweight their exposure to particular sectors.
107
Sector Indexes
• Sector indexes are organized as families; each
index within the family represents an economic
sector.
• Sector indexes play an important role in
performance analysis because they provide a
means to determine whether a portfolio manager
is more successful at stock selection or sector
allocation.
108
Style Indexes
• Style indexes represent groups of securities
classified according to market capitalization,
value, growth, or a combination of these
characteristics.
• They are intended to reflect the investing styles of
certain investors, such as the growth investor,
value investor, and small-cap investor.
109
Style Indexes
• Market Capitalization indexes represent
securities categorized according to the major
capitalization categories: large cap, midcap, and
small cap.
• Value/Growth Classification: Some indexes
represent categories of stocks based on their
classifications as either value or growth stocks.
– Different index providers use different factors and
valuation ratios (low price-to-book ratios, low price-to-
earnings ratios, high dividend yields, etc.) to distinguish
between value and growth equities.
110
Style Indexes
• Market Capitalization and Value/Growth
Classification
– Large-Cap Value
– Mid-Cap Value
– Small-Cap Value
– Large-Cap Growth
– Mid-Cap Growth
– Small-Cap Growth
111
Market Efficiency
• The Concept of Market Efficiency
• Forms of Market Efficiency
• Market Pricing Anomalies
112
The Concept of Market Efficiency
• Market efficiency concerns the extent to which
market prices incorporate available information.
• If market prices do not fully incorporate
information, then opportunities may exist to make
a profit from the gathering and processing of
information.
113
The Concept of Market Efficiency
• The Description of Efficient Markets
• Market Value versus Intrinsic Value
• Factors Contributing to and Impeding a Market’s
Efficiency
• Transaction Costs and Information-Acquisition
Costs
114
The Description of Efficient Markets
• An informationally efficient market (an efficient
market) is a market in which asset prices reflect
new information quickly and rationally.
• An efficient market is thus a market in which asset
prices reflect all past and present information.
115
Market Value versus Intrinsic Value
• Market value is the price at which an asset can
currently be bought or sold.
• Intrinsic value (sometimes called fundamental
value) is, broadly speaking, the value that would
be placed on it by investors if they had a complete
understanding of the asset’s investment
characteristics
116
Market Value versus Intrinsic Value
• If investors believe a market is highly efficient,
they will usually accept market prices as
accurately reflecting intrinsic values.
• If investors believe an asset market is relatively
inefficient, they may try to develop an independent
estimate of intrinsic value.
117
Factors Contributing to and Impeding
a Market’s Efficiency
• Market Participants
• Information Availability and Financial Disclosure
• Limits to Trading
118
Transaction Costs and Information-
Acquisition Costs
• Transaction costs: Practically, transaction costs
are incurred in trading to exploit any perceived
market inefficiency. Thus, “efficient” should be
viewed as efficient within the bounds of
transaction costs.
• Information-acquisition costs: Practically,
expenses are always associated with gathering
and analyzing information.
119
Forms of Market Efficiency
• Weak Form
• Semi-Strong Form
• Strong Form
• Implications of the Efficient Market Hypothesis
120
Forms of Market Efficiency
121
Weak Form
• Price reflects all information contained in market
trading data (past prices, volume, dividends,
interest rates, etc.).
• So an investor can not use past prices to identify
mispriced securities.
• Technical analysis:
– Refers to the practice of using past patterns in stock
prices (and trades) to identify future patterns in prices.
– Is not profitable in a market which is at least weak form
(i.e., weakly) efficient. 122
Semi-Strong Form
• Price reflects all publicly available information.
• So an investor can not use publicly available information to
identify mispriced securities.
• Fundamental analysis:
– Refers to the practice of using financial statements,
announcements, and other publicly available information about
firms to pick stocks.
125
Implications of the Efficient Market Hypothesis
• The implications of efficient markets to investment
managers and analysts are import- ant because they affect
the value of securities and how these securities are
managed. Several implications can be drawn from the
evidence on efficient markets for developed markets:
– Securities markets are weak-form efficient, and therefore,
investors cannot earn abnormal returns by trading on the basis of
past trends in price.
127
128
129
Implications for Investment Strategies
• Attempt to benefit from anomalies in practice is
not easy
• Investors face challenges when they attempt to
translate statistical anomalies into economic
profits.
• Investors would likely be uncomfortable investing
their funds in a strategy that has no compelling
underlying economic rationale.
130
Behavioral Finance and Efficient Markets
• Behavioral finance uses human psychology, such
as behavioral biases, in an attempt to explain
investment decisions.
• Whereas behavioral finance is helpful in
understanding observed decisions, a market can
still be considered efficient even if market
participants exhibit seemingly irrational behaviors,
such as herding.
131
Equity Valuation: Concepts and Basic Tools
• Dividend Discount Model
• Gordon Growth Model
• Multistage Dividend Discount Models
• Multiplier Models
132
Dividend Discount Model
133
Dividend Discount Model
Example: For the next three years, the annual
dividends of a stock are expected to be €2.00,
€2.10, and €2.20. The stock price is expected to be
€20.00 at the end of three years. If the required rate
of return on the shares is 10 percent, what is the
estimated value of a share?
134
Gordon Growth Model
• With a constant growth assumption :
D2 = D1 (1+ g)
D3 = D2 (1+ g) = D1 (1+ g)2
135
Gordon Growth Model
• Assume r > g:
136
Gordon Growth Model
• Estimate dividend
• Estimate the required rate of return (CAPM -
Capital Asset Pricing Model) :
r = R f + β (Rm − R f )
137
Gordon Growth Model
• Estimate the sustainable growth rate:
138
Multistage Dividend Discount Models
• The two-stage DDM assumes that at some point the company
will begin to pay dividends that grow at a constant rate, but prior
to that time the company will pay dividends that are growing at a
higher rate than can be sustained in the long run.
140
Multistage Dividend Discount Models
141
Multistage Dividend Discount Models
Example: The current dividend, D0, is $5.00.
Growth is expected to be 10 percent a year for
three years and then 5 percent thereafter. The
required rate of return is 15 percent. Estimate the
intrinsic value.
142
Multistage Dividend Discount Models
• H-model
143
Multistage Dividend Discount Models
Françoise Delacour, a portfolio manager of a US-based diversified
global equity portfolio, is researching the valuation of Vinci SA
(NYSE Euronext: DG). Vinci is the world’s largest construction
company, operating chiefly in France (approximately two-thirds of
revenue) and the rest of Europe (approximately one-quarter of
revenue). Through 2003, DG paid a single regular cash dividend
per fiscal year. Since 2004 it has paid two dividends per (fiscal)
year, an interim dividend in December and a final dividend in May.
Although during the past five years total annual dividends grew at
less than 3 percent per year, Delacour foresees faster future
growth.
144
Multiplier Models
• The term price multiple refers to a ratio that
compares the share price with some sort of
monetary flow or value to allow evaluation of the
relative worth of a company’s stock.
• Some practitioners use price ratios as a screening
mechanism. If the ratio falls below a specified
value, the shares are identified as candidates for
purchase, and if the ratio exceeds a specified
value, the shares are identified as candidates for
sale.
145
Multiplier Models
• Price-to-earnings ratio (P/E): the ratio of the stock
price to earnings per share.
• Price-to-book ratio (P/B): the ratio of the stock
price to book value per share.
• Price-to-sales ratio (P/S): the ratio of stock price to
sales per share.
• Price-to-cash-flow ratio (P/CF): the ratio of stock
price to some per-share measure of cash flow.
146
The Method of Comparables
• The method of comparables is the most widely
used approach for analysts reporting valuation
judgments on the basis of price multiples.
• The economic rationale underlying the method of
comparables is the law of one price: Identical
assets should sell for the same price.
147
The Method of Comparables
• The methodology involves using a price multiple to
evaluate whether an asset is fairly valued,
undervalued, or overvalued in relation to a benchmark
value of the multiple.
• Choices for the benchmark multiple include the
multiple of a closely matched individual stock or the
average or median value of the multiple for the stock’s
industry.
• Some analysts perform trend or time- series analyses
and use past or average values of a price multiple as
a benchmark.
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Multiplier Models
• Example: Telefónica S.A., a world leader in the
telecommunication sector, provides communication,
information, and entertainment products and services in
Europe, Africa, and Latin America. It has operated in its
home country of Spain since 1924, but as of 2017, more
than 75 percent of its business was outside its home
market.
• Deutsche Telekom AG provides network access,
communication services, and value-added services via
fixed and mobile networks. It generates more than half of
its revenues outside its home country, Germany.
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Multiplier Models
• Advantage
– Multiples allow for relative comparisons, both cross-
sectional.
– Multiples can be calculated easily and many multiples
are readily available from financial websites and
newspapers.
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Multiplier Models
• Caution is necessary. A stock may be relatively
undervalued when compared with its benchmarks but
overvalued when compared with an estimate of intrinsic
value as determined by one of the discounted cash flow
methodologies.
• Differences in reporting rules among different markets and
in chosen accounting methods can result in revenues,
earnings, book values, and cash flows that are not easily
comparable. These differences can, in turn, result in
multiples that are not easily comparable.
• The multiples for cyclical companies may be highly
influenced by current economic conditions.
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