The Investment Decision Process

vDetermine the required rate of return

vEvaluate the investment to determine if its market price is

consistent with your required rate of return

ØEstimate the value of the security based on its expected cash flows
and your required rate of return

ØCompare this intrinsic value to the market price to decide if you want
to buy it

2
Valuation Process

vTwo approaches

Ø1. Top-down, three-step approach

Ø2. Bottom-up, stock valuation, stock picking approach

vThe difference between the two approaches is the perceived
importance of economic and industry influence on individual
firms and stocks.

3
Top-Down, Three-Step Approach
1. General economic influences
Ø Decide how to allocate investment funds among countries, and within countries to
bonds, stocks, and cash
2. Industry influences
Ø Determine which industries will prosper and which industries will suffer on a global
basis and within countries
3. Company analysis
Ø Determine which companies in the selected industries will prosper and which stocks
are undervalued
4
Does the Three-Step Process Work?
v Studies indicate that most changes in an individual firm’s earnings can be attributed
to changes in aggregate corporate earnings and changes in the firm’s industry
v If you are trying to stay ahead of the market quarter by quarter, then this is the best
way approach to follow
v Studies have found a relationship between aggregate stock prices and various
economic series such as employment, income, or production
v An analysis of the relationship between rates of return for the aggregate stock
market, alternative industries, and individual stocks showed that most of the changes
in rates of return for individual stock could be explained by changes in the rates of
return for the aggregate stock market and the stock’s industry.
5
Bottom-Up, stock valuation, stock picking approach

v Bottom-up investing looks at company-specific fundamentals like

financials, supply and demand, and the kinds of goods and
services offered by a company.

6
Theory of Valuation

v The value of an asset is the present value of its expected returns

v You expect an asset to provide a stream of returns while you own it
v To convert this stream of returns to a value for the security, you must
discount this stream at your required rate of return.
v This requires estimates of:
ØThe stream of expected returns, and

ØThe required rate of return on the investment

7
Stream of Expected Returns
v First item to estimate

v Two considerations:
ü Form of returns
Ø Earnings
Ø Cash flows
Ø Dividends
Ø Interest payments
Ø Capital gains (increases in value)
ü Time pattern and growth rate of returns

8
Required Rate of Return

vSecond item to estimate

Determined by

Ø Economy’s risk-free real rate of return, plus

Ø Expected rate of inflation during the holding period, plus

Ø Risk premium determined by the uncertainty of returns

9
Uncertainty of Returns
v Internal characteristics of assets
Ø Business risk (BR)
Ø Financial risk (FR)
Ø Liquidity risk (LR)
Ø Exchange rate risk (ERR)
Ø Country risk (CR)
v Market determined factors
Ø Systematic risk (beta) or
Ø Multiple APT factors
10
Investment Decision Process

vA Comparison of Estimated Values and Market Prices

ØIf Estimated Value > Market Price

=> Buy
ØIf Estimated Value < Market Price

=> Don’t Buy

11
PART I
Valuation of Bonds

Valuation of Bonds is relatively easy because the size and time

pattern of cash flows from the bond over its life are known
1. Interest payments are made usually every six months equal to
one-half the coupon rate times the face value of the bond

2. The principal is repaid on the bond’s maturity date

13
EXAMPLE

In 2012, a $10,000 bond due in 2017 with a 10% coupon will pay
$500 every six months for 15-year-life.
If the prevailing nominal risk-free rate is 7% and the investor
requires a 3% risk premium on this bond, because there is some
probability of default, the required rate of return would be 10%

14
SOLUTION
Present value of the semiannual interest payments is an annuity for 30 periods
at one-half the required rate of return (5%):

$500 x 15.3725 = $7,686

The present value of the principal is similarly discounted at 5% for 30 periods:

$10,000 x .2314 = $2,314

Total value of bond at 10 percent = $10,000

15
SOLUTION

The $10,000 valuation is the amount that an investor should be

willing to pay for this bond, assuming that the required rate of
return on a bond of this risk class is 10 percent.
If the market price of the bond is above this value, the investor
should not buy it because the promised yield to maturity will be
less than the investor’s required rate of return.

16
SOLUTION
Alternatively, assuming an investor requires a 12 percent return on this bond, its
value would be:
$500 x 13.7648 = $6,882
$10,000 x .1741 = 1,741
Total value of bond at 12 percent = $8,623
Higher rates of return lower the value!
Or, if you want a higher rate of return, you will pay not much for an asset.
You would compare this computed present value to the market price of the bond to
determine whether you should invest in it.

17
PART II
Valuation of Preferred Stock

v Owner of preferred stock receives a promise to pay a stated

dividend, usually quarterly, for perpetuity
v Since payments are only made after the firm meets its bond
interest payments, there is more uncertainty of returns

v Tax treatment of dividends paid to corporations (80% tax-

exempt) offsets the risk premium

19
Valuation of Preferred Stock

The value is simply the stated annual dividend divided by the

required rate of return on preferred stock (kp)
Dividend
V =
kp
Ex: Assume a preferred stock has a $100 par value and a dividend of
$8 a year and a required rate of return of 9 percent.
$8
V = = $88.89
.09

20
Valuation of Preferred Stock

Conversely, given a market price, you can derive its promised yield:
Dividend
kp =
Price
Ex: Assume a preferred stock has a $100 par value and a dividend of
$8 a year and a required rate of return of 9 percent.

At a market price of $85, this preferred stock yield would be:

$8
kp = = .0941
$85.00
21
Valuation of Common Stock

Two general approaches have developed:

Ø1. Discounted cash-flow valuation

Present value of some measure of cash flow, such as dividends, operating
cash flow, and free cash flow

Ø2. Relative valuation technique

Value estimated based on its price relative to significant variables, such as
earnings, cash flow, book value, or sales

22
Valuation of Common Stock

These two approaches have some factors in common

vBoth are affected by:

ØInvestor’s required rate of return: k­ÞV¯

ØEstimated growth rate of the variable used: g­ÞV­

23
Approaches to Equity Valuation

v Discounted Cash Flow Techniques v Relative Valuation Techniques

Ø Present Value of Dividends (DDM) Ø Price/Earnings Ratio (PE)

Ø Present Value of Operating Cash Flow
Ø Price/Cash flow ratio (P/CF)
Ø Present Value of Free Cash Flow
Ø Price/Book Value Ratio (P/BV)

Ø Price/Sales Ratio (P/S)

24
Approaches to Equity Valuation
Why and When to use the Discounted Cash Flow Valuation Approach?

v The measure of cash flow used

ØDividends: Cost of equity as the discount rate

ØOperating cash flow: Weighted Average Cost of Capital (WACC)

ØFree cash flow to equity: Cost of equity

v Dependent on growth rates and discount rate

25
Approaches to Equity Valuation

Why and When to Use the Relative Valuation Techniques?

v Provides information about how the market is currently valuing stocks

Ø aggregate market

Ø alternative industries

Ø individual stocks within industries

v No guidance as to whether valuations are appropriate; best used when:

Ø have comparable entities

Ø aggregate market is not at a valuation extreme

26
Approaches to Equity Valuation
Discounted Cash-Flow Valuation Techniques
¥
CFt
Vj = å
t =1 (1 + k )
t

Vj = value of stock j

n = life of the asset

CFt = cash flow in period t
k = the discount rate that is equal to the investor’s required rate of return for asset
j, which is determined by the uncertainty (risk) of the stock’s cash flows
27
Discounted Cash Flow Techniques
The Dividend Discount Model (DDM)
D1 D2 D3 D¥
Vj = + + + ... +
(1 + k ) (1 + k ) (1 + k )
2 3
(1 + k ) ¥
¥
Dt
=å
t =1 (1 + k ) t

Vj = value of common stock j

Dt = dividend during time period t

k = required rate of return on stock j

28
Discounted Cash Flow Techniques

The Dividend Discount Model (DDM)

If the stock is not held for an infinite period, a sale at the end of year
2 would imply:
D1 D2 SPj 2
Vj = + +
(1 + k ) (1 + k ) 2
(1 + k ) 2
Selling price at the end of year two is the value of all remaining
dividend payments, which is simply an extension of the original
equation

29
Discounted Cash Flow Techniques

The Dividend Discount Model (DDM)

Stocks with no dividends are expected to start paying dividends at
some point
D1 D2 D3 D¥
From 3 year: V j = (1 + k ) + (1 + k ) 2 + (1 + k ) 3 + ... + (1 + k ) ¥
Where:
D1 = 0
D2 = 0
30
Discounted Cash Flow Techniques
The Dividend Discount Model (DDM)
Infinite period model assumes a constant growth rate for estimating future dividends

D0 (1 + g ) D0 (1 + g ) 2 D0 (1 + g ) n
Vj = + + ... +
Vj = value of stock j (1 + k ) (1 + k ) 2
(1 + k ) n

D0 = dividend payment in the current period

g = the constant growth rate of dividends

k = required rate of return on stock j

n = the number of periods, which we assume to be infinite

31
Discounted Cash Flow Techniques

The Dividend Discount Model (DDM)

This can be reduced to: D1

Vj =
k-g
Ø Estimate the required rate of return (k)

Ø Estimate the dividend growth rate (g)

32
Discounted Cash Flow Techniques

Infinite Period DDM and Growth Companies

Assumptions of DDM:
Ø1. Dividends grow at a constant rate
Ø2. The constant growth rate will continue for an infinite period

Ø3. The required rate of return (k) is greater than the infinite growth
rate (g)

33
Discounted Cash Flow Techniques

Infinite Period DDM and Growth Companies

Ø Growth companies have opportunities to earn return on
investments greater than their required rates of return
Ø To exploit these opportunities, these firms generally retain a high
percentage of earnings for reinvestment, and their earnings grow
faster than those of a typical firm
Ø This is inconsistent with the infinite period DDM assumptions

34
Discounted Cash Flow Techniques

Infinite Period DDM and Growth Companies

Ø The infinite period DDM assumes constant growth for an infinite
period, but abnormally high growth usually cannot be maintained
indefinitely
Ø Risk and growth are not necessarily related
Ø Temporary conditions of high growth cannot be valued using the
CGR-DDM

35
Discounted Cash Flow Techniques

Valuation with Temporary Supernormal Growth

Combine the models to evaluate the years of supernormal growth

and then use DDM to compute the remaining years at a sustainable
rate

Example: With a 14 percent required rate of return, a most recently

paid dividend of $2.00 per share, and dividend growth of?

36
Discounted Cash Flow Techniques

Valuation with Temporary Supernormal Growth

Dividend
Year Growth Rate
1-3: 25%
4-6: 20%
7-9: 15%
10 on: 9%

37
Discounted Cash Flow Techniques

Valuation with Temporary Supernormal Growth

The value equation becomes

2.00(1.25) 2.00(1.25) 2 2.00(1.25) 3
Vi = + +
1.14 1.14 2 1.14 3
2.00(1.25) 3 (1.20) 2.00(1.25) 3 (1.20) 2
+ 4
+
1.14 1.14 5
2.00(1.25) 3 (1.20) 3 2.00(1.25) 3 (1.20) 3 (1.15)
+ 6
+
1.14 1.14 7
2.00(1.25) 3 (1.20) 3 (1.15) 2 2.00(1.25) 3 (1.20) 3 (1.15) 3
+ 8
+
1.14 1.14 9
2.00(1.25) 3 (1.20) 3 (1.15) 3 (1.09)
(.14 - .09)
+
(1.14) 9
38
Discounted Cash Flow Techniques
Computation of Value for Stock of Company with Temporary Supernormal Growth
Discount Present Growth
Year Dividend Factor Value Rate
1 $ 2.50 0.8772 $ 2.193 25%
2 3.13 0.7695 $ 2.408 25%
3 3.91 0.6750 $ 2.639 25%
4 4.69 0.5921 $ 2.777 20%
5 5.63 0.5194 $ 2.924 20%
6 6.76 0.4556 $ 3.080 20%
7 7.77 0.3996 $ 3.105 15%
8 8.94 0.3506 $ 3.134 15%
9 10.28 0.3075 $ 3.161 15%
10 11.21 9%
a b
$ 224.20 0.3075 $ 68.943
$ 94.365
a
Value of dividend stream for year 10 and all future dividends, that is
$11.21/(0.14 - 0.09) = $224.20
b
The discount factor is the ninth-year factor because the valuation of the
remaining stream is made at the end of Year 9 to reflect the dividend in
Year 10 and all future dividends.
39
Discounted Cash Flow Techniques

Value of Operating Free Cash Flows

t =n
OCFt
Vj = å
t =1 (1 + WACC j )
t

Vj = value of firm j
n = number of periods assumed to be infinite
OCFt = the firms operating free cash flow in period t
WACC = firm j’s weighted average cost of capital
40
Discounted Cash Flow Techniques

Value of Operating Free Cash Flows

Similar to DDM, this model can be used to estimate an infinite period
Where growth has matured to a stable rate, the adaptation is
OCF1
Vj =
WACC j - g OCF

OCF1=operating free cash flow in period 1

gOCF = long-term constant growth of operating free cash flow
41
Discounted Cash Flow Techniques

Value of Operating Free Cash Flows

Ø Assuming several different rates of growth for OCF, these

estimates can be divided into stages as with the supernormal
dividend growth model

Ø Estimate the rate of growth and the duration of growth for each
period.

42
Discounted Cash Flow Techniques

Value of Free Cash Flows to Equity

Ø “Free” cash flows to equity are derived after operating cash flows
have been adjusted for debt payments (interest and principle)
Ø The discount rate used is the firm’s cost of equity (k) rather than
WACC

43
Discounted Cash Flow Techniques

Value of Free Cash Flows to Equity

n
FCFt
Vj = å
t =1 (1 + k j )
t

Vj = Value of the stock of firm j

n = number of periods assumed to be infinite

FCFt = the firm’s free cash flow in period t

K j = the cost of equity

44
Relative Valuation Techniques

v Value can be determined by comparing to similar stocks based on

relative ratios
v Relevant variables include earnings, cash flow, book value, and
sales

v The most popular relative valuation technique is based on price to

earnings

45
Relative Valuation Techniques

Earnings Multiplier Model

Ø This values the stock based on expected annual earnings

Ø The price earnings (P/E) ratio, or

Current Market Price

Earnings Multiplier =
Expected Twelve - Month Earnings

46
Relative Valuation Techniques
Earnings Multiplier Model
The infinite-period dividend discount model indicates the variables that should
determine the value of the P/E ratio
D1
Pi =
k-g
Dividing both sides by expected earnings during the next 12 months (E1)

Pi D1 / E1
=
E1 k-g

47
Relative Valuation Techniques
Earnings Multiplier Model
Thus, the P/E ratio is determined by

1. Expected dividend payout ratio Pi D1 / E1

=
2. Required rate of return on the stock (k) E1 k-g
3. Expected growth rate of dividends (g)

48
Relative Valuation Techniques
Earnings Multiplier Model

As an example, assume:
.50
ØDividend payout = 50% P/E =
.12 - .08
ØRequired return = 12%
= .50/.04
ØExpected growth = 8%
= 12.5
ØD/E = .50; k = .12; g=.08

49
Relative Valuation Techniques
Earnings Multiplier Model

A small change in either or both k or g will have a large impact on

the multiplier
Pi D1 / E1
=
E1 k-g
Example
D/E = .50; k=.13; g=.08

P/E = .50/(.13-/.08) = .50/.05 = 10

50
Relative Valuation Techniques
Earnings Multiplier Model
D/E = .50; k=.13; g=.08 P/E = 10

D/E = .50; k=.12; g=.09 P/E = 16.7

D/E = .50; k=.11; g=.09

P/E = .50/(.11-/.09) = .50/.02 = 25

Given current earnings of $2.00 and growth of 9%

D/E = .50; k=.12; g=.09 P/E = 16.7

51
 Relative Valuation Techniques
Earnings Multiplier Model
Given current earnings of $2.00 and growth of 9%

You would expect E1 to be $2.18

D/E = .50; k=.12; g=.09 P/E = 16.7

V = 16.7 x $2.18 = $36.41

Compare this estimated value to market price to decide if you should invest in it

52
Relative Valuation Techniques
The Price-Cash Flow Ratio
Ø Companies can manipulate earnings

Ø Cash-flow is less prone to manipulation

Ø Cash-flow is important for fundamental valuation and in credit analysis
Pt
P / CFi =
P/CFj = the price/cash flow ratio for firm j
CFt +1
Pt = the price of the stock in period t

CFt+1 = expected cash low per share for firm j

53
Relative Valuation Techniques
The Price-Book Value Ratio
Ø Widely used to measure bank values (most bank assets are liquid (bonds and
commercial loans)
Ø Fama and French study indicated inverse relationship between P/BV ratios
and excess return for a cross section of stocks
Pt
P/BVj = the price/book value for firm j
P / BV j =
Pt = the end of year stock price for firm j BVt +1
BVt+1 = the estimated end of year book value per share for firm j
54
Relative Valuation Techniques
The Price-Book Value Ratio
Ø Be sure to match the price with either a recent book value number, or
estimate the book value for the subsequent year
Ø Can derive an estimate based upon historical growth rate for the series or
use the growth rate implied by the (ROE) X (Ret. Rate) analysis

55
Relative Valuation Techniques
The Price-Sales Ratio
Ø Strong, consistent growth rate is a requirement of a growth company

Ø Sales is subject to less manipulation than other financial data

Pj
= price to sales ratio for firm j
P Pt Sj
=
S S t +1 Pt = end of year stock price for firm j
S t +1 = annual sales per share for firm j during Year t

56
Relative Valuation Techniques
The Price-Sales Ratio
Ø Match the stock price with recent annual sales, or future sales per share

Ø This ratio varies dramatically by industry

Ø Profit margins also vary by industry

Ø Relative comparisons using P/S ratio should be between firms in similar

industries

57
Estimating the Inputs
The Required Rate of Return and The Expected Growth Rate of
Valuation Variables
Valuation procedure is the same for securities around the world, but the
required rate of return (k) and expected growth rate of earnings and other
valuation variables (g) such as book value, cash flow, and dividends differ
among countries

58
Estimating the Inputs
Required Rate of Return (k)
The investor’s required rate of return must be estimated regardless of the
approach selected or technique applied:
Ø This will be used as the discount rate and also affects relative-valuation

Ø This is not used for present value of free cash flow which uses the required
rate of return on equity (K)

Ø It is also not used in present value of operating cash flow which uses WACC

59
Estimating the Inputs
Required Rate of Return (k)
Three factors influence an investor’s required rate of return:

Ø The economy’s real risk-free rate (RRFR)

Ø The expected rate of inflation (I)

Ø A risk premium (RP)

(Review Chapter 1)

60
Estimating the Inputs
Expected Growth Rate of Dividends
vDetermined by

Øthe growth of earnings

Øthe proportion of earnings paid in dividends

vIn the short run, dividends can grow at a different rate than earnings due to
changes in the payout ratio

vEarnings growth is also affected by compounding of earnings retention

g = (Retention Rate) x (Return on Equity) = RR x ROE
61
Estimating the Inputs
Expected Growth Rate of Dividends
vDetermined by

Øthe growth of earnings

Øthe proportion of earnings paid in dividends

vIn the short run, dividends can grow at a different rate than earnings due to
changes in the payout ratio

vEarnings growth is also affected by compounding of earnings retention

g = (Retention Rate) x (Return on Equity) = RR x ROE
62
Estimating the Inputs
Breakdown of ROE
ROE =

Net Income Sales Total Assets

= ´ ´
Sales Total Assets Common Equity

Profit Total Asset Financial

= Margin
x Turnover x Leverage

63
Estimating the Inputs
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
3. long-linear regression models
All three use time-series plot of data
64
Estimating the Inputs
Estimating Dividend Growth for Foreign Stocks
Differences in accounting practices affect the components of ROE
Ø Retention Rate

Ø Net Profit Margin

Ø Total Asset Turnover
Ø Total Asset/Equity Ratio

65