AN INTRODUCTION TO
SECURITY VALUATION
1
INTRODUCTION
An investment is a commitment of funds for a period of
time to derive a rate of return that would compensate the
investor for the time during which the funds are invested,
for the expected rate of inflation during the investment
horizon, and for the uncertainty involved.
From this definition, we know that the first step in making
an investment is determining your required rate of return.
You must estimate the intrinsic value of the security based
on its expected cash flows and your required rate of return.
After you have completed estimating a security’s intrinsic
value, you compare this estimated intrinsic value to the
prevailing market price to decide whether or not you want 2
to buy the security.
INTRODUCTION
There are two general approaches to the valuation
process:
The top down, three-step approach
The bottom-up, stock valuation, stock picking approach
Advocates of the top-down, three-step approach believe
that both the economy/market and the industry effect
have a significant impact on the total returns for
individual stocks.
The bottom-up, stock picking approach contend that it is
possible to find stocks that are undervalued relative to
their market price, and these stocks will provide superior
returns regardless of the market and industry outlook. 3
4
THEORY OF VALUATION
The value of an asset is the present value of its expected
returns.
An estimate of the expected returns from an investment
encompasses not only the size but also the form, time
pattern, and uncertainty of returns, which affect the
required rate of return.
The required rate of return on an investment is
determined by:
The economy’s real risk-free rate of return,
The expected rate of inflation during the holding period
A risk premium that is determined by the uncertainty of
5
returns
INVESTMENT DECISION PROCESS: A COMPARISON
OF ESTIMATED VALUES AND MARKET PRICES
6
VALUATION OF BONDS
Calculating the value of bonds is relatively easy because
the size and time pattern of cash flows from the bond
over its life are known. A bond typically promises the
following:
Interest
payments every six months equal to one-half the
coupon rate times the face value of the bond
The payment of the principal on the bond’s maturity date
7
EXAMPLE 1
A $10,000 bond due in 2027 with a 10 percent coupon
will pay $500 every six months for its 15-year life. In
addition, the bond issuer promises to pay the $10,000
principal at maturity in 2027.
If the prevailing nominal risk-free rate is 7 percent and
the investor requires a 3 percent risk premium on this
bond because there is some probability of default, the
required rate of return would be 10 percent.
Find the present value of the bond?
Find the present value of the bond, if annual required
rate of return is 12%?
8
VALUATION OF PREFERRED STOCK
The owner of a preferred stock receives a promise that it
will pay a stated dividend, usually each quarter, for an
infinite period. Preferred stock is a perpetuity because it
has no maturity.
The issuer of this stock does not have the same legal
obligation to pay investors as do issuers of bonds.
This reduced legal obligation increases the uncertainty of
returns, investors should require a higher rate of return
on a firm’s preferred stock than on its bonds.
9
VALUATION OF PREFERRED STOCK
Consider a preferred stock has a $100 par value and a dividend of
$8 a year. Because of the expected rate of inflation, the uncertainty
of the dividend payment, and the tax advantage to you as a
corporate investor, assume that your required rate of return on this
stock is 9 percent. Therefore, the value of this preferred stock to you
is:
Assuming a current market price of $85, is it under valued or over
valued.
The promised yield would be:
10
11
WHY AND WHEN TO USE THE DISCOUNTED
CASH FLOW VALUATION APPROACH
The reduced form of the dividend discount model (DDM) is
very useful when discussing valuation for a stable, mature
entity where the assumption of relatively constant growth of
dividends for the long term is appropriate.
Operating free cash flow a very useful model when
comparing firms with diverse capital structures because you
determine the value of the total firm and then subtract the
value of the firm’s debt obligations to arrive at a value for
the firm’s equity.
A potential difficulty with these cash flow techniques is that
they are very dependent on the two significant inputs
The growth rates of cash flows (both the rate of growth and the
12
duration of growth)
The estimate of the discount rate
WHY AND WHEN TO USE THE RELATIVE
VALUATION TECHNIQUES
An advantage of the relative valuation techniques is that
they provide information about how the market is
currently valuing stock at several levels—that is, the
aggregate market, alternative industries, and individual
stocks within industries.
The relative valuation techniques are appropriate to
consider under two conditions:
You have a good set of comparable entities—that is,
comparable companies that are similar in terms of industry,
size, and, it is hoped, risk.
The aggregate market and the company’s industry are not at a
valuation extreme—that is, they are not either seriously 13
undervalued or seriously overvalued.
DISCOUNTED CASH FLOW VALUATION
TECHNIQUES
14
THE DIVIDEND DISCOUNT MODEL
(DDM)
15
EXAMPLE 2: ONE YEAR HOLDING
PERIOD
Assume the company we are analyzing earned $2.50 a share last year
and paid a dividend of $1 a share. Assume further that the firm has been
fairly consistent in maintaining this 40 percent payout over time. The
consensus of financial analysts is that the firm will earn about $2.75
during the coming year and will raise its dividend to $1.10 per share.
The long-run forward P/E of stocks is between 12 and 16. Using the P/E
ratio find the price of the stock?
The long-run dividend yield on stocks has been between 1.50 percent
and 5.00 percent, but in recent years (since 1980) it has been 1.50 to
4.00 percent.
Using the dividend yield procedures find the sale price of the stock?
Assume that 10-year government bonds are yielding 6 percent, and you
believe that a 4 percent risk premium over the yield of these bonds is
appropriate for this stock. Thus, you specify a required rate of return is?
16
Find the value of the stock. If the expected sale price after 1 year is 38?
MULTIPLE-YEAR HOLDING PERIOD
The exact estimate of the future dividends depends on
two projections.
The first is your outlook for earnings growth because
earnings are the source of dividends.
The second projection is the firm’s dividend policy, which
can take several forms
The easiest dividend policy is to assume that the firm
enjoys a constant growth rate in earnings and maintains a
constant dividend payout.
This set of assumptions implies that the dividend stream
will experience a constant growth rate that is equal to the
earnings growth rate. 17
CONSTANT GROWTH MODEL
To use this model for valuation, you must estimate:
The required rate of return (k)
The expected constant growth rate of dividends (g).
After estimating g, it is a simple matter to estimate D1
because it is the current dividend (D0) times (1 + g).
18
EXAMPLE 3: CONSTANT GROWTH
MODEL
Consider the example of a stock with a current dividend
of $1 a share. You believe that, over the long run, this
company’s earnings and dividends will grow at 7
percent; your estimate of g is 0.07. For the long run, you
expect a nominal risk-free rate of about 6 percent and a
risk premium for this stock of 5 percent.
Find value of stock?
Find value of stock if required rate increase by 1%?
Find the value of stock if growth rate increase by 1%?
19
EXAMPLE 4: VALUATION WITH
TEMPORARY SUPERNORMAL GROWTH
The Bourke Company has a current dividend (D0) of $2 a
share. The following are the expected annual growth
rates for dividends. The required rate of return for the
stock (the company’s cost of equity) is 14 percent. Find
value of stock?
20
21
22
PRESENT VALUE OF OPERATING FREE
CASH FLOWS
In this model, you are deriving the value of the total firm
because you are discounting the operating free cash
flows prior to the payment of interest to the debt holders
but after deducting funds needed to maintain the firm’s
asset base (capital expenditures). Also, because you are
discounting the total firm’s operating free cash flow, you
would use the firm’s weighted average cost of capital
(WACC) as your discount rate.
23
PRESENT VALUE OF FREE CASH FLOWS
TO EQUITY
The third discounted cash flow technique deals with
“free” cash flows to equity, which would be derived after
operating free cash flows have been adjusted for debt
payments (interest and principal).
Notably, because these are cash flows available to equity
owners, the discount rate used is the firm’s cost of equity
(k) rather than the firm’s WACC.
24
25
26
27
RELATIVE VALUATION TECHNIQUES
The relative valuation techniques implicitly contend that it is
possible to determine the value of an economic entity (i.e.,
the market, an industry, or a company) by comparing it to
similar entities on the basis of several relative ratios that
compare its stock price to relevant variables that affect a
stock’s value, such as earnings, cash flow, book value, and
sales.
Relative valuation ratios:
price/earnings (P/E)
price/cash flow (P/CF)
price/book value (P/BV)
price/sales (P/S)
The P/E ratio is also referred to as the earnings multiplier 28
model,
EARNINGS MULTIPLIER MODEL
29
EXAMPLE 5
As an example, if we assume a stock has an expected
dividend payout of 50 percent, a required rate of return
of 12 percent, and an expected growth rate for dividends
of 8 percent, this would imply that the stock’s P/E ratio
should be?
Given D/E is 50 percent, required rate of return is 12
percent, growth rate is 9 percent and current earning is $
2.
Find the expected value of the stock?
30
EXAMPLE 6
Find P/E if required rate of is 13 percent?
Find P/E if growth rate is 9 percent?
Find P/E if required rate of return is 11 percent and
growth rate is 9 percent?
31
THE PRICE/CASH FLOW RATIO
32
THE PRICE/BOOK VALUE RATIO
33
THE PRICE/SALES RATIO
34
NOMINAL RISK FREE RATE OF RETURN
35
EXPECTED GROWTH RATES
36
BREAKDOWN OF ROE
37
