CHAPTER 10 EQUITY VALUATION: CONCEPTS AND BASIC TOOLS. Presenter Venue Date

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1 CHAPTER 10 EQUITY VALUATION: CONCEPTS AND BASIC TOOLS Presenter Venue Date

2 ESTIMATED VALUE AND MARKET PRICE Undervalued: Fairly valued: Overvalued: Intrinsic value > market price Intrinsic value = market price Intrinsic value < market price

3 DEALING WITH UNCERTAINTY Confidence in intrinsic value estimate Uncertainties related to model appropriateness and the correct value of inputs

4 MAJOR CATEGORIES OF EQUITY VALUATION MODELS Present value models Dividend discount models Free cash flow models Multiplier models Share price multiples Enterprise value multiples Asset-based valuation models Adjustments to book value

5 PRESENT VALUE MODELS Value of an investment = present value of expected future benefits Future benefits = dividends Future benefits = free cash flow D t V V 0 t 0 (1 r) t1 (1 t 1 FCFE r) t t

6 PREFERRED STOCK VALUATION (NON- CALLABLE, NON-CONVERTIBLE SHARES) Perpetual V $ r D $91.67 Maturity at time period n V 0 n t 1 Dt F t n (1 r ) (1 r ) 12 GBP2.00 GBP20.00 V GBP31.01 ( ) ( ) 0 t 12 t 1

7 THE EFFECT OF OPTIONS ON THE PRICE OF A PREFERRED SHARE Call option May be exercised by the issuer Lower share price Retraction (put) option May be exercised by the investor Higher share price

8 THE GORDON GROWTH MODEL Assumptions: Dividends are the correct metric to use for valuation purposes. The dividend growth rate is forever: It is perpetual and never changes. The required rate of return is also constant over time. The dividend growth rate is strictly less than the required rate of return. V V 0 0 t D0 (1 g) D0 (1 g) D1 t t1 (1 r) r g r g EUR5.00(1 0.04) EUR

9 WHEN IS THE GORDON GROWTH MODEL MOST APPROPRIATE FOR VALUING EQUITY? Dividendpaying company Insensitive to the business cycle Mature growth phase Use the Gordon growth model

10 ESTIMATING A LONG-TERM GROWTH RATE Earnings retention rate (b) Return on equity (ROE) Dividend growth rate (g) % 6.00%

11 MULTISTAGE DIVIDEND DISCOUNT MODEL Rapidly growing companies Company will pass through different stages of growth Use multistage dividend discount model Growth is expected to improve or moderate

12 THE TWO-STAGE DIVIDEND DISCOUNT MODEL L n S n L n n n n n t t t S g g D D g r D V r V r g D V 1 1 ) (1 ) ( Dividends grow at rate g S for n years and rate g L thereafter:

13 THE TWO-STAGE DIVIDEND DISCOUNT MODEL (CONTINUED FROM PREVIOUS SLIDE) $ ) (1 $ ) (1 $ ) (1 $ $5.50 $ $ $ ) (1 0.10) $5.00(1 $ ) $5.00(1 $ ) $5.00(1 $ ) $5.00( V V V D D D D

14 PRICE MULTIPLES Group or sector of stocks Use price multiples as a screen Identify overvalued and undervalued stocks

15 POPULAR PRICE MULTIPLES Price-to-earnings ratio (P/E) Price-to-book ratio (P/B) Price-to-sales ratio (P/S) Price-to-cash flow ratio (P/CF) Stock price earnings per share Stock price book value per share Stock price sales per share Stock price cash flow per share

16 PRICE MULTIPLES FOR TELEFÓNICA AND DEUTSCHE TELEKOM Telefónica Deutsche Telekom (1) Total assets ( billions) Asset growth 5.7% 2.8% % 7.3% -- (2) Net revenues ( billions) Revenue growth 2.7% 6.6% % 2.0% -- (3) Net cash flow from operating activities ( billions) Cash flow growth 5.1% 1.3% % 3.5% -- (4) Book value of common shareholders equity ( billions) Debt ratio: 80.4% 78.4% 81.7% 65.0% 62.6% 61.8% 1 [(4) (1)] (5) Net profit ( billions) Earnings growth 14.3% 37.9% % 81.3% -- (6) Weighted average number of 4,646 4,759 4,779 4,340 4,339 4,353 shares outstanding (millions) (7) Price per share ( ) Price-to-revenue ratio (P/R): (7) [(2) (6)] P/CF: (7) [(3) (6)] P/B: (7) [(4) (6)] P/E: (7) [(5) (6)] Sources: Company websites: and

17 JUSTIFIED VALUE OF A MULTIPLE Fundamentals or cash flow predictions Discounted cash flow model Justified value of a multiple

18 JUSTIFIED FORWARD P/E FOR NESTLÉ P Required Rate of Return = 12 percent Constant Dividend Growth Rate Dividend Payout Ratio 40.0% 42.5% 45.0% 47.5% 50.0% 7.0% % % % % % % % P algebra D1 0 D1 / E1 p r g E1 r g r g

19 THE METHOD OF COMPARABLES Method of comparables Time series analysis Cross-sectional analysis Comparison to past or average values Comparison to benchmark or peer group

20 PRICE-TO-SALES RATIO DATA FOR MAJOR AUTOMOBILE MANUFACTURERS (2009) Company P/S General Motors 0.01 Ford Motor 0.14 Daimler 0.27 Nissan Motor 0.32 Honda Motor 0.49 Toyota Motor 0.66

21 P/E DATA FOR CANON Year Price (a) EPS (b) P/E (a) (b) , , , , , Sources: EPS and P/E data are from Canon s website: P/E is based on share price data from the Tokyo Stock Exchange.

22 ENTERPRISE VALUE MULTIPLES Market capitalization Market value of preferred stock Market value of debt Cash and equivalents Enterprise value Enterprise value (EV) EBITDA EV/EBITDA

23 EV/OPERATING INCOME DATA FOR NINE MAJOR MINING COMPANIES Company Ticker Symbol EV (C$ millions) Operating Income (OI) (C$ millions) EV/OI BHP Billiton BHP 197, , Rio Tinto RIO 65, , Anglo American AAL 48, , Barrick Gold ABX 35, , Goldcorp G 28, Newmont Mining NEM 22, , AngloGold Ashanti AU 19, Alcoa AA 17, , Freeport-McMoRan Copper & Gold FCX 11, , Source:

24 ASSET-BASED VALUATION Book value of assets and liabilities Estimation process or processes Market value of assets and liabilities Market value of equity = market value of assets market value of liabilities

25 ASSET-BASED VALUATIONS: POTENTIAL PROBLEMS Difficulties determining market (fair) values Book values differ significantly from market values Intangible assets Hyper- or rapidly rising inflation

26 ASSET-BASED VALUATION VERSUS DISCOUNTED PRESENT VALUE APPROACHES Company to be valued Valuation approaches Valuation inputs Airline in financial distress Present value models Asset-based valuation Airline stopped the dividend and is losing money and burning cash Routes, flight agreements, equipment, and aircraft have value

27 ADVANTAGES AND DISADVANTAGES Present value models Multiplier models Asset-based valuation Theoretically appealing and provide a direct computation of intrinsic value Input uncertainty can lead to poor estimates of value Ratios are easy to compute and analysis is easily understood Problems with selecting a peer group or comps Consistent with the notion that a business is worth the sum of its parts Difficulties determining market value and the value of intangible assets

28 SUMMARY Overvalued, fairly valued, or undervalued securities Major categories of equity valuation models Present value models: dividend discount models and free cash flow models Multiplier models: price ratios and enterprise value ratios Asset-based valuation Advantages and disadvantages of equity valuation models