Absolute and relative security valuation

Transcription

1 Absolute and relative security valuation Bertrand Groslambert Skema Business School Portfolio Management 1 Course Outline Introduction (lecture 1) Presentation of portfolio management Chap.2,3,5 Introduction to Bloomberg Modern Portfolio Theory (lectures 2-4) The risk return framework Chap.1 Efficient capital markets Chap.6 The price of risk Chap.7,8 Asset pricing models Chap.9 Fundamental Analysis (lectures 5-8) Analysis of financial statement Chap.10 Industry analysis Chap.12,13 Absolute and relative valuation analysis Chap.11, 14 Stock market valuation analysis Chap.12 Technical analysis (lecture 9) Chap.15 The asset management industry (lecture 10) Portfolio management strategies Chap.16 The different types of investment companies Chap.24 Evaluation of portfolio performance Chap.25 NB: chapters refer to Reilly & Brown 8th and 9th ed. Portfolio Management 2 1

2 Top-Down versus Bottom-Up Top-Down 1 ) Market selection 2 ) Industry selection Bottom-Up 1 ) Stock picking 2 ) Influence of the industry 3 ) Market influence 3 ) Stock picking Portfolio Management 3 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 Portfolio Management 4 2

3 Valuation Approaches and Specific Techniques Two techniques for Equity Valuation A. Discounted Cash Flow Techniques Present Value of Dividends (DDM) Present Value of Free Cash Flow to Equity (FCFE) Present Value of Free Cash Flow to the Firm (FCFF) or Operating Cash Flow (OCF) B. Relative Valuation Techniques Price/Earnings Ratio (PE) Price/Cash flow ratio (P/CF) Price/Book Value Ratio (P/BV) Price/Sales Ratio (P/S) Portfolio Management 5 Estimating Intrinsic Value A. Discounted cash flows (DCF) 1. Present value of dividends (DDM) 2. Present value of free cash flow to equity (FCFE) 3. Present value of free cash flow (FCFF) or Operating Cash Flow (OCF) Portfolio Management 6 3

4 Discounted Cash-Flow Valuation Techniques V t n CFt (1 k j t Where: t 1 ) V j = value of stock j n = life of the asset CF t = 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 Portfolio Management 7 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 V j (1 k) (1 k) (1 k) (1 k) n t1 D t (1 k) t Where: V j = value of common stock j D t = dividend during time period t k = required rate of return on stock j Portfolio Management 8 4

5 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: V j D D SP 1 2 j ( 1 k) (1 k) (1 k) Portfolio Management 9 The Dividend Discount Model (DDM) 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 D3 D4 D SP j 2 2 (1 k) (1 k) (1 k) PV( SP D3 (1 k) 3 2 j D3 D4 D 2 (1 k) (1 k) (1 k) ) 2 (1 k) D4 (1 k) 4 D (1 k) Portfolio Management 10 5

6 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 V j (1 k) (1 k) (1 k) (1 k) Where: D 1 = 0 and D 2 = 0 Portfolio Management 11 The Dividend Discount Model (DDM) Stocks with no dividends are expected to start paying dividends at some point. Portfolio Management 12 6

7 The Dividend Discount Model (DDM) Infinite period model assumes a constant growth rate for estimating future dividends Where: V V j = value of stock j j 2 n D0 ( 1 g) D0 (1 g) D0 (1 g)... 2 n (1 k) (1 k) (1 k) D 0 = 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 Portfolio Management 13 Infinite Period DDM Infinite period, constant growth rate model 2 n D0 ( 1 g) D0 (1 g) D0 (1 g) V j... 2 n (1 k) (1 k) (1 k) with n This can be reduced to: 1. Estimate the required rate of return (k) 2. Estimate the dividend growth rate (g) Portfolio Management 14 V j D1 k g 7

8 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) Growth companies have opportunities to earn return on investments greater than their required rates of return 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 Portfolio Management 15 Infinite period DDM with Temporary Supernormal Growth First evaluate the years of supernormal growth and then use the DDM to compute the remaining years at a sustainable rate Suppose a firm paying 2 of dividend with the following dividend growth pattern and a14% required rate of return Dividend Year Growth Rate % % % 10 on 9% Portfolio Management 16 8

9 Valuation with Temporary Supernormal Growth The Value of the Stock = (1.25) 2.00(1.25) 2.00(1.25) V i (1.25) (1.20) 2.00(1.25) (1.20) (1.25) (1.20) 2.00(1.25) (1.20) (1.15) (1.25) (1.20) (1.15) 2.00(1.25) (1.20) (1.15) (1.25) (1.20) (1.15) (1.09) (.14.09) 9 (1.14) Portfolio Management 17 3 Required Rate of Return (k) The investor s required rate of return will be used as the discount rate This is not used for present value of present value of operating cash flow which uses WACC Portfolio Management 18 9

10 Required Rate of Return (k) Three factors influence an investor s required rate of return: The economy s real risk-free rate (RRFR) 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 (I) 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 A risk premium (RP) 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 Portfolio Management 19 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 Portfolio Management 20 10

11 Risk Premium The risk premium is based on five risk components Must be derived for each investment in each country Portfolio Management 21 The Five Risk Components Business risk Financial risk Liquidity risk Exchange rate risk Country risk Portfolio Management 22 11

12 Required Rate of Return Estimate Nominal risk-free interest rate Risk premium Market-based risk estimated from the firm s characteristic line using regression: R stock E(RFR) stock [E(R market ) E(RFR)] This gives you the risk as estimated by all market participants Using your own five risk components analysis, you can adjust the beta and make your estimate Portfolio Management 23 Required Rate of Return Estimate Bloomberg EQRP Portfolio Management 24 12

13 Expected Growth Rate 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 Portfolio Management 25 Breakdown of ROE ROE Net Income Sales Sales Total Assets Total Assets Common Equity Profit Total Asset Financial x Margin Turnover Leverage = x Portfolio Management 26 13

14 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. log-linear regression models All three use time-series plot of data Portfolio Management 27 Remember the Industry Life Cycle Portfolio Management 28 14

15 Growth Rate Estimates Average Dividend Growth Rate n D D n 0 1 Sustainable Growth Rate = RR X ROE Portfolio Management 29 Walgreen Beta Portfolio Management 30 15

16 Walgreen Cost of Equity WACC command on Bloomberg Portfolio Management 31 Walgreen Cost of Equity (EQRP command on Bloomberg) Portfolio Management 32 16

17 Walgreen Long Term Growth Rate Bloomberg FA Dupont Analysis Portfolio Management 33 Walgreen DDM Portfolio Management 34 17

18 Free Cash Flow to the Firm FCFF FCFF (also called Operating Cash Flow): + Net Income + Depreciation/Amt Expense + Change in Working Capital + Other Non-cash Adjustments + Interest Expense After Tax - Capital Expenditures CF from operations Portfolio Management 35 Free Cash Flow to the Firm FCFF Bloomberg FA then «Create Custom» Portfolio Management 36 18

19 Present Value of Free Cash Flow to the Firm Firm Value FCFF 1 WACC g FCFF Where: FCFF 1 Free cash flow in period 1 WACC Firm s weighted average cost of capital g FCFF Firm s constant infinite growth rate of free cash flow g = (RR)(ROIC) RR = the average retention rate ROIC = EBIT (1-Tax Rate)/Total Capital Portfolio Management 37 Calculation of WACC where: W E k W D I WACC = W E k + W D i Proportion of equity in total capital After-tax cost of equity (from the SML) Proportion of debt in total capital After-tax cost of debt Portfolio Management 38 19

20 Walgreen WACC Portfolio Management 39 Present Value of Free Cash Flow to Equity FCFE = + Net Income + Depreciation Expense - Capital Expenditures - D in Working Capital - Principal Debt Repayments + New Debt Issues Portfolio Management 40 20

21 Walgreen FCFE (Bloomberg FA custom) Portfolio Management 41 Present Value of Free Cash Flow to Equity Value FCFE k 1 g FCFE FCFE 1 Expected free cash flow in period 1 K Required rate of return on equity for the firm g FCFE Expected constant growth rate of free cash flow to equity for the firm Portfolio Management 42 21

22 Estimating Intrinsic Value B. Relative valuation techniques 1. Price earnings ratio (P/E) 2. Price cash flow ratios (P/CF) 3. Price book value ratios (P/BV) 4. Price sales ratio (P/S) And so on Portfolio Management 43 Earnings Multiplier Model P/E This values the stock based on expected annual earnings The price earnings (P/E) ratio, or Earnings Multiplier Current Market Price Expected 12 - Month Earnings Portfolio Management 44 22

23 Earnings Multiplier Model The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio P i Dividing both sides by expected earnings during the next 12 months (E 1 ) k D 1 g P i E D1 / E k g 1 Portfolio Management 45 1 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) P i E 1 D k 1 / E g 1 Portfolio Management 46 23

24 Additional Measures of Relative Value Price/Book Value Ratio Price/Cash Flow Ratio Price-to-Sales Ratio Portfolio Management 47 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 P / CF P t i CF Where: t1 P/CF j = the price/cash flow ratio for firm j P t = the price of the stock in period t CF t+1 = expected cash low per share for firm j Portfolio Management 48 24

25 Where: The Price-Book Value Ratio P / BV t1 P/BV j = the price/book value for firm j P t = the end of year stock price for firm j BV t+1 = the estimated end of year book value per share for firm j j Pt BV Portfolio Management 49 The Price-Sales Ratio Match the stock price with firm s expected sales per share Relative comparisons using P/S ratio should be between firms in similar industries P S P S P S t j j Pt S t1 t1 Where: price to sales ratio for firm end of year stock price for firm annual sales per share for firm j during Year t Portfolio Management 50 j j 25

26 Implementing the Relative Valuation Technique First step: Compare the valuation ratio for a company to the comparable ratio for the market, for stock s industry and to other stocks in the industry to determine how it compares Second step: Explain the relationship IS IT JUSTIFIED? Portfolio Management 51 Walgreen Relative Valuation Bloomberg command RV then custom Portfolio Management 52 26

27 Growth Companies and Growth Stocks Growth company are the ones with management and opportunities that yield rates of return greater than the firm s required rate of return Growth stocks are not necessarily growth companies A growth stock has a higher rate of return than other stocks with similar risk Superior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks Portfolio Management 53 Growth Companies and Growth Stocks Defensive companies future earnings are more likely to withstand an economic downturn Low business risk Not excessive financial risk Stocks with low or negative systematic risk Cyclical Companies and Stocks Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return Speculative Companies and Stocks Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return Portfolio Management 54 27

28 Value versus Growth Investing Growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued Value stocks appear to be undervalued for reasons besides earnings growth potential Value stocks usually have low P/E ratio or low ratios of price to book value Portfolio Management 55 Historical P/E Bands Historical P/E bands informs us about At which PE the company used to be traded The historical EPS growth rate and its trends What will the forecast PER at current stock price Portfolio Management 56 28

29 Historical P/E Bands In Dec 2011, Ford Motors EPS were $1.5 What would have been Ford stock price if: If PER was at 5 If PER was at 9 If PER was at 13 If PER was at 17 => PER = 5 x $1.5 => Price = $7.5 => PER = 9 x $1.5 => Price = $13.5 => PER = 13 x $1.5 => Price = $19.5 => PER = 17 x $1.5 => Price = $25.5 We do the same at the end of each quarter with the EPS as of this date Portfolio Management 57 P/E Bands Ford Motor Portfolio Management 58 29

30 Ford Motor historical EPS Portfolio Management 59 P/E Bands Mac Donald s Portfolio Management 60 30

31 Mac Donald s historical EPS Portfolio Management 61 P/E Bands Microsoft Portfolio Management 62 31

32 Microsoft historical EPS Portfolio Management 63 P/E bands Walgreen Portfolio Management 64 32

33 Walgreen historical EPS Walgreen EPS since 1989 Portfolio Management 65 P/E bands CVS Portfolio Management 66 33

34 CVS historical EPS CVS EPS since 1989 Portfolio Management 67 Efficient Markets Opportunities are mostly among less wellknown companies To outperform the market you must find disparities between stock values and market prices - and you must be correct Concentrate on identifying what is wrong with the market consensus and what earning surprises may exist Portfolio Management 68 34

35 Analyst Conflicts of Interest Investment bankers may push for favorable evaluations Corporate officers may try to convince analysts Analyst must maintain independence and have confidence in his or her analysis Portfolio Management 69 35