Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 11
Chapter 11 - An Introduction to
Security Valuation
Questions to be answered:
• What are the two major approaches to the
investment process?
• What are the specifics and logic of the top-down
(three-step) approach?
• What empirical evidence supports the usefulness
of the top-down approach?
• When valuing an asset, what are the required
inputs?
Chapter 11 - An Introduction to
Security Valuation
• After you have valued an asset, what is the
investment decision process?
• How do you determine the value of bonds?
• How do you determine the value of preferred
stock?
• What are the two primary approaches to the
valuation of common stock?
Chapter 11 - An Introduction to
Security Valuation
• Under what conditions is it best to use the
present value of cash flow approach for valuing a
company’s equity?
• Under what conditions is it best to use the
present value of cash flow approach for valuing a
company’s equity?
• How do you apply the discounted cash flow
valuation approach and what are the major
discounted cash flow valuation techniques?
Chapter 11 - An Introduction to
Security Valuation
• What is the dividend discount model (DDM) and
what is its logic?
• What is the effect of the assumptions of the DDM
when valuing a growth company?
• How do you apply the DDM to the valuation of a
firm that is expected to experience temporary
supernormal growth?
• How do you apply the relative valuation
approach?
Chapter 11 - An Introduction to
Security Valuation
• What are the major relative valuation ratios?
• How can you use the DDM to develop an
earnings multiplier model?
• What does the DDM model imply are the factors
that determine a stock’s P/E ratio?
• What two general variables need to be estimated
in any of the cash flow models and will affect all
of the relative valuation models?
Chapter 11 - An Introduction to
Security Valuation
• How do you estimate the major inputs to the stock
valuation models (1) the required rate of return and
(2) the expected growth rate of earnings and
dividends?
• What additional factors must be considered when
estimating the required rate of return and growth for
foreign security?
The Investment Decision Process
• Determine the required rate of return
• Evaluate the investment to determine if its
market price is consistent with your required
rate of return
– Estimate the value of the security based on its
expected cash flows and your required rate of return
– Compare this intrinsic value to the market price to
decide if you want to buy it
 Valuation Process
• Two approaches
– 1. Top-down, three-step approach
– 2. Bottom-up, stock valuation, stock picking
approach
• The difference between the two approaches
is the perceived importance of economic
and industry influence on individual firms
and stocks
Top-Down, Three-Step Approach
1. General economic influences
– Decide how to allocate investment funds among countries,
and within countries to bonds, stocks, and cash
2. Industry influences
– Determine which industries will prosper and which
industries will suffer on a global basis and within countries
3. Company analysis
– Determine which companies in the selected industries will
prosper and which stocks are undervalued
 Does the Three-Step Process
Work?
• 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
 Does the Three-Step Process
Work?
• Studies have found a relationship between
aggregate stock prices and various
economic series such as employment,
income, or production
 Does the Three-Step Process
Work?
• 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
 Theory of Valuation
• The value of an asset is the present value of
its expected returns
• You expect an asset to provide a stream of
returns while you own it
 Theory of Valuation
• To convert this stream of returns to a value
for the security, you must discount this
stream at your required rate of return
 Theory of Valuation
• To convert this stream of returns to a value
for the security, you must discount this
stream at your required rate of return
• This requires estimates of:
– The stream of expected returns, and
– The required rate of return on the investment
 Stream of Expected Returns
• Form of returns
– Earnings
– Cash flows
– Dividends
– Interest payments
– Capital gains (increases in value)
• Time pattern and growth rate of returns
 Required Rate of Return
• Determined by
– 1. Economy’s risk-free rate of return, plus
– 2. Expected rate of inflation during the holding
period, plus
– 3. Risk premium determined by the uncertainty
of returns
 Investment Decision Process: A
Comparison of Estimated Values and
Market Prices

If Estimated Value > Market Price, Buy

If Estimated Value < Market Price, Don’t Buy
 Valuation of Alternative
Investments
• 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
 Valuation of Bonds
• Example: in 2002, a $10,000 bond due in
2017 with 10% coupon
• Discount these payments at the investor’s
required rate of return (if the risk-free rate is
9% and the investor requires a risk premium
of 1%, then the required rate of return
would be 10%)
 Valuation of Bonds
Present value of the interest payments is an
annuity for thirty periods at one-half the
required rate of return:
$500 x 15.3725 = $7,686
The present value of the principal is similarly
discounted:
$10,000 x .2314 = $2,314
Total value of bond at 10 percent = $10,000
 Valuation of Bonds
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
 Valuation of Bonds
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
 Valuation of Bonds
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!
Compare the computed value to the market price of
the bond to determine whether you should buy it.
 Valuation of Preferred Stock
• Owner of preferred stock receives a promise
to pay a stated dividend, usually quarterly,
for perpetuity
• Since payments are only made after the firm
meets its bond interest payments, there is
more uncertainty of returns
• Tax treatment of dividends paid to
corporations (80% tax-exempt) offsets the
risk premium
 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
 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
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
 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
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 
.09
 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
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
 Valuation of Preferred Stock
Given a market price, you can derive its
promised yield
 Valuation of Preferred Stock
Given a market price, you can derive its
promised yield Dividend
kp 
Price
 Valuation of Preferred Stock
Given a market price, you can derive its
promised yield Dividend
kp 
Price

At a market price of $85, this preferred stock

yield would be $8
kp   .0941
$85.00
 Approaches to the
Valuation of Common Stock
Two approaches have developed
1. Discounted cash-flow valuation
• Present value of some measure of cash flow,
including dividends, operating cash flow, and free
cash flow
2. Relative valuation technique
• Value estimated based on its price relative to
significant variables, such as earnings, cash flow,
book value, or sales
 Approaches to the
Valuation of Common Stock
The discounted cash flow approaches are
dependent on some factors, namely:
• The rate of growth and the duration of growth
of the cash flows
• The estimate of the discount rate
Why and When to Use the Discounted
Cash Flow Valuation Approach
• The measure of cash flow used
– Dividends
• Cost of equity as the discount rate
– Operating cash flow
• Weighted Average Cost of Capital (WACC)
– Free cash flow to equity
• Cost of equity
• Dependent on growth rates and discount rate
 Why and When to Use the
Relative Valuation Techniques
• Provides information about how the market is
currently valuing stocks
– aggregate market
– alternative industries
– individual stocks within industries
• No guidance as to whether valuations are
appropriate
– best used when have comparable entities
– aggregate market is not at a valuation extreme
 Discounted Cash-Flow
Valuation Techniques
t n
CFt
Vj  
t 1 (1  k )
t
Where:
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
 Valuation Approaches
and Specific Techniques
Approaches to Equity Valuation
Figure 13.2

Discounted Cash Flow Relative Valuation

Techniques Techniques
• Present Value of Dividends (DDM) • Price/Earnings Ratio (PE)
•Present Value of Operating Cash Flow •Price/Cash flow ratio (P/CF)
•Present Value of Free Cash Flow •Price/Book Value Ratio (P/BV)
•Price/Sales Ratio (P/S)
 The Dividend Discount Model
(DDM)
The value of a share of common stock is the
present value of all future dividends
D1 D2 D3 D
Vj     ... 
(1  k ) (1  k ) 2
(1  k ) 3
(1  k ) 
n
Dt
 Where:
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
 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
 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
The Dividend Discount Model
(DDM)
Stocks with no dividends are expected to
start paying dividends at some point
The Dividend Discount Model
(DDM)
Stocks with no dividends are expected to
start paying dividends at some point, say
year three...
D1 D2 D3 D
Vj     ... 
(1  k ) (1  k ) 2
(1  k ) 3
(1  k ) 
 The Dividend Discount Model
(DDM)
Stocks with no dividends are expected to
start paying dividends at some point, say
year three...
D1 D2 D3 D
Vj     ... 
(1  k ) (1  k ) 2
(1  k ) 3
(1  k ) 
Where:
D1 = 0
D2 = 0
The Dividend Discount Model
(DDM)
Infinite period model assumes a constant
growth rate for estimating future dividends
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    ... 
Where:
(1  k ) (1  k ) 2
(1  k ) n

Vj = value of stock j
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
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    ... 
(1  k ) (1  k ) 2
(1  k ) n
D1
This can be reduced to: Vj 
kg
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    ... 
(1  k ) (1  k ) 2
(1  k ) n
D1
This can be reduced to: Vj 
kg
1. Estimate the required rate of return (k)
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    ... 
(1  k ) (1  k ) 2
(1  k ) n
D1
This can be reduced to: Vj 
kg
1. Estimate the required rate of return (k)
2. Estimate the dividend growth rate (g)
 Infinite Period DDM
and Growth Companies
Assumptions of DDM:
1. Dividends grow at a constant rate
2. The constant growth rate will continue for
an infinite period
3. The required rate of return (k) is greater
than the infinite growth rate (g)
 Infinite Period DDM
and Growth Companies
Growth companies have opportunities to earn
return on investments greater than their required
rates of return
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
This is inconsistent with the infinite period DDM
assumptions
 Infinite Period DDM
and Growth Companies
The infinite period DDM assumes constant
growth for an infinite period, but
abnormally high growth usually cannot be
maintained indefinitely
Risk and growth are not necessarily related
Temporary conditions of high growth cannot
be valued using DDM
 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
 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
For example:
With a 14 percent required rate of return
and dividend growth of:
Valuation with Temporary
Supernormal Growth
Dividend
Year Growth Rate
1-3: 25%
4-6: 20%
7-9: 15%
10 on: 9%
 Valuation with Temporary
Supernormal Growth
The value equation becomes
2.00(1.25) 2.00(1.25) 2 2.00(1.25) 3
Vi   2

1.14 1.14 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
 
1.148 1.14 9
2.00(1.25) 3 (1.20) 3 (1.15) 3 (1.09)
(.14  .09)

(1.14) 9
Computation of Value for Stock of Company
with Temporary Supernormal Growth
Discount Present Growth
Year Dividend Factor Value Rate
Exhibit 11.3
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.
 Present Value of
Operating Free Cash Flows
• Derive the value of the total firm by
discounting the total operating cash flows
prior to the payment of interest to the debt-
holders
• Then subtract the value of debt to arrive at
an estimate of the value of the equity
 Present Value of
Operating Free Cash Flows

t n
OCFt
Vj  
t 1 (1  WACC j )
t
 Present Value of
Operating Free Cash Flows
t n
OCFt
Vj  
t 1 (1  WACC j )
t

Where:
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
 Present 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 
Where: WACC j  g OCF
OCF1=operating free cash flow in period 1
gOCF = long-term constant growth of operating free cash
 Present Value of
Operating Free Cash Flows
• Assuming several different rates of growth
for OCF, these estimates can be divided into
stages as with the supernormal dividend
growth model
• Estimate the rate of growth and the duration
of growth for each period
 Present Value of
Free Cash Flows to Equity
• “Free” cash flows to equity are derived after
operating cash flows have been adjusted for
debt payments (interest and principle)
• The discount rate used is the firm’s cost of
equity (k) rather than WACC
 Present Value of
Free Cash Flows to Equity
n
FCFt
Vj  
Where: 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
 Relative Valuation Techniques
• Value can be determined by comparing to
similar stocks based on relative ratios
• Relevant variables include earnings, cash
flow, book value, and sales
• The most popular relative valuation
technique is based on price to earnings
 Earnings Multiplier Model
• This values the stock based on expected
annual earnings
• The price earnings (P/E) ratio, or
Earnings Multiplier
Current Market Price

Expected Twelve - Month Earnings
Earnings Multiplier Model
The infinite-period dividend discount model
indicates the variables that should
determine the value of the P/E ratio
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
 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)
 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
 Earnings Multiplier Model
Thus, the P/E ratio is determined by
1. Expected dividend payout ratio
2. Required rate of return on the stock (k)
3. Expected growth rate of dividends (g)

Pi D1 / E1

E1 kg
Earnings Multiplier Model
As an example, assume:
– Dividend payout = 50%
– Required return = 12%
– Expected growth = 8%
– D/E = .50; k = .12; g=.08
Earnings Multiplier Model
As an example, assume:
– Dividend payout = 50%
– Required return = 12%
– Expected growth = 8%
– D/E = .50; k = .12; g=.08

.50
P/E 
.12 - .08
 .50/.04
 12.5
 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
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
D/E = .50; k=.13; g=.08

Pi D1 / E1

E1 kg
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
D/E = .50; k=.13; g=.08
P/E = .50/(.13-/.08) = .50/.05 = 10

Pi D1 / E1

E1 kg
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
D/E = .50; k=.13; g=.08 P/E = 10

Pi D1 / E1

E1 kg
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
D/E = .50; k=.13; g=.08 P/E = 10
D/E = .50; k=.12; g=.09

Pi D1 / E1

E1 kg
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
D/E = .50; k=.13; g=.08 P/E = 10
D/E = .50; k=.12; g=.09
P/E = .50/(.12-/.09) = .50/.03 = 16.7
Pi D1 / E1

E1 kg
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
D/E = .50; k=.13; g=.08 P/E = 10
D/E = .50; k=.12; g=.09 P/E = 16.7

Pi D1 / E1

E1 kg
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
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

Pi D1 / E1

E1 kg
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
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
Pi D1 / E1

E1 kg
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier
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 = 25

Pi D1 / E1

E1 kg
 Earnings Multiplier Model
A small change in either or both k or g will
have a large impact on the multiplier

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

 Earnings Multiplier Model
Given current earnings of $2.00 and growth of
9%

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

 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
 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
 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
 The Price-Cash Flow Ratio
• Companies can manipulate earnings
• Cash-flow is less prone to manipulation
• Cash-flow is important for fundamental
valuation and in credit analysis
 The Price-Cash Flow Ratio
• Companies can manipulate earnings
• Cash-flow is less prone to manipulation
• Cash-flow is important for fundamental
valuation and in credit analysis

Pt
P / CFi 
CFt 1
 The Price-Cash Flow Ratio
• Companies can manipulate earnings
• Cash-flow is less prone to manipulation
• Cash-flow is important for fundamental
valuation and in credit analysis
Pt
P / CFi 
Where:
CFt 1
P/CFj = the price/cash flow ratio for firm j
Pt = the price of the stock in period t
CFt+1 = expected cash low per share for firm j
 The Price-Book Value Ratio
Widely used to measure bank values (most
bank assets are liquid (bonds and
commercial loans)
Fama and French study indicated inverse
relationship between P/BV ratios and
excess return for a cross section of stocks
The Price-Book Value Ratio

Pt
P / BV j 
BVt 1
 The Price-Book Value Ratio
Pt
P / BV j 
BVt 1
Where:
P/BVj = the price/book value for firm j
Pt = the end of year stock price for firm j
BVt+1 = the estimated end of year book value
per share for firm j
 The Price-Book Value Ratio
• Be sure to match the price with either a
recent book value number, or estimate the
book value for the subsequent year
• 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
 The Price-Sales Ratio
• Strong, consistent growth rate is a
requirement of a growth company
• Sales is subject to less manipulation than
other financial data
The Price-Sales Ratio

P Pt

S St 1
 The Price-Sales Ratio
P Pt

S St 1
Where:
Pj
 price to sales ratio for firm j
Sj
Pt  end of year stock price for firm j
St 1  annual sales per share for firm j during Year t
 The Price-Sales Ratio
• Match the stock price with recent annual
sales, or future sales per share
• This ratio varies dramatically by industry
• Profit margins also vary by industry
• Relative comparisons using P/S ratio should
be between firms in similar industries
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
 Required Rate of Return (k)
The investor’s required rate of return must be
estimated regardless of the approach selected
or technique applied
• This will be used as the discount rate and also
affects relative-valuation
• This is not used for present value of free cash flow
which uses the required rate of return on equity (K)
• It is also not used in present value of operating cash
flow which uses WACC
 Required Rate of Return (k)
Three factors influence an investor’s
required rate of return:
• The economy’s real risk-free rate (RRFR)
• The expected rate of inflation (I)
• A risk premium (RP)
The Economy’s Real Risk-Free Rate
• Minimum rate an investor should require
• Depends on the real growth rate of the
economy
– (Capital invested should grow as fast as the
economy)
• Rate is affected for short periods by
tightness or ease of credit markets
 The Expected Rate of Inflation
• Investors are interested in real rates of
return that will allow them to increase their
rate of consumption
 The Expected Rate of Inflation
• Investors are interested in real rates of
return that will allow them to increase their
rate of consumption
• The investor’s required nominal risk-free
rate of return (NRFR) should be increased
to reflect any expected inflation:
 The Expected Rate of Inflation
• Investors are interested in real rates of
return that will allow them to increase their
rate of consumption
• The investor’s required nominal risk-free
rate of return (NRFR) should be increased
to reflect any expected inflation:
Where: NRFR  [1  RRFR][1  E (I)] - 1
E(I) = expected rate of inflation
 The Risk Premium
• Causes differences in required rates of
return on alternative investments
• Explains the difference in expected returns
among securities
• Changes over time, both in yield spread and
ratios of yields
Estimating the Required Return
for Foreign Securities
• Foreign Real RFR
– Should be determined by the real growth rate
within the particular economy
– Can vary substantially among countries
• Inflation Rate
– Estimate the expected rate of inflation, and adjust
the NRFR for this expectation
NRFR=(1+Real Growth)x(1+Expected Inflation)-1
 Risk Premium
• Must be derived for each investment in each
country
• The five risk components vary between
countries
 Risk Components
• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk
Expected Growth Rate of Dividends
• Determined by
– the growth of earnings
– the proportion of earnings paid in dividends
• In the short run, dividends can grow at a different rate
than earnings due to changes in the payout ratio
• Earnings growth is also affected by compounding of
earnings retention
g = (Retention Rate) x (Return on Equity)
= RR x ROE
 Breakdown of ROE

ROE 

Net Income Sales Total Assets

  
Sales Total Assets Common Equity

Profit Total Asset Financial

= Margin
x Turnover x Leverage
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
 Estimating Dividend Growth
for Foreign Stocks
Differences in accounting practices affect
the components of ROE
• Retention Rate
• Net Profit Margin
• Total Asset Turnover
• Total Asset/Equity Ratio
 The Internet
Investments Online
www.financenter.com
www.moneyadvisor.com
www.jamesko.com/financial_calculator.htm
http://fpc.net66.com
End of Chapter 11
–An Introduction to Security
Valuation
 Future topics
Chapter 12
• Macroeconomic and Market Analysis:
The Global Asset Allocation Decision