FINA 3080

Investment Analysis and

Portfolio Management
Prof. Chao Ying
Lecture 6A
More on Valuing Equity

FINA 3080 Prof. Chao Ying 1

 Hard to know value dk caslftrs , maturity
equity cuz
,
dunlins
Constant Growth Model default ,

risk etc
,
• If we assume
,

– Dividends today are equal to D0

– Dividends grow at a constant rate g per year forever
– Investors discount dividends at the risky discount rate k
• Then value V0 can be calculated
∞
Dt
Vo = ∑
𝐷𝐷0 (1 + 𝑔𝑔) 𝐷𝐷0 (1 + 𝑔𝑔)2 𝐷𝐷0 (1 + 𝑔𝑔)3
𝑉𝑉0 = + + +. . .
(1 + 𝑘𝑘)2 (1 + 𝑘𝑘)3
t =1 (1 + k )
t (1 + 𝑘𝑘)
+ 𝐷𝐷0 (1 + 𝑔𝑔)
𝑉𝑉0 =
𝑘𝑘 − 𝑔𝑔
Note : k >
g 2
FINA 3080 Prof. Chao Ying
 Q1: DDM
The constant-growth dividend discount model
(DDM) can be used only when the ________.

A) growth rate is less than or equal to the

required return
B) growth rate is greater than or equal to the
required return
C) growth rate is less than the required return
D) growth rate is greater than the required
return

FINA 3080 Prof. Chao Ying

 Q1: DDM
The constant-growth dividend discount model (DDM)
can be used only when the ________. 𝐷𝐷0 (1 + 𝑔𝑔)
𝑉𝑉0 =
𝑘𝑘 − 𝑔𝑔
A) growth rate is less than or equal to the required
return
B) growth rate is greater than or equal to the
required return
C) growth rate is less than the required return
D) growth rate is greater than the required return

FINA 3080 Prof. Chao Ying

 Lecture 6A Overview
• DDM, Returns and EMH
– Expected return
– Unexpected return
– Return and efficient market hypothesis (EMH)

• Analyzing the value of growth opportunities

– Payout policies that maximize shareholder value

• Price-to-earnings ratios
FINA 3080 Prof. Chao Ying 5
Three Independent Conditions Related
to DDM under EMH
1. EMH (no arbitrage) holds at time t  𝑃𝑃𝑡𝑡 = 𝑉𝑉𝑡𝑡

𝐷𝐷0 (1+𝑔𝑔) 𝐷𝐷1

2. Constant DDM holds  𝑉𝑉0 = =
𝑘𝑘−𝑔𝑔 𝑘𝑘−𝑔𝑔

𝑃𝑃1 +𝐷𝐷1
3. HPR is the sum of dividend and capital gain: 𝐻𝐻𝑃𝑃𝐻𝐻 =
𝑃𝑃0
−1
↑
Initial investment

FINA 3080 Prof. Chao Ying 6

 Q2:HPR
You put up $50 at the beginning of the year for
an investment. The value of the investment
grows 4% and you earn a dividend of $3.50.
Your HPR was ________.

A) 4%
B) 3.5%
8+1
C) 7% -

D) 11%
=
11%
FINA 3080 Prof. Chao Ying
 Q2:HPR
You put up $50 at the beginning of the year for
an investment. The value of the investment
grows 4% and you earn a dividend of $3.50.
Your HPR was ________.

A) 4%
𝑃𝑃1 + 𝐷𝐷1
B) 3.5% 𝐻𝐻𝑃𝑃𝐻𝐻 =
𝑃𝑃0
−1
C) 7% 50 ∗ 1 + 4% + 3.5
= − 1 = 11%
D) 11% 50

FINA 3080 Prof. Chao Ying

 Returns in the DDM under the EMH
• Rule 1: Price grow at the same rate as dividend (g )

Condition 2 𝐷𝐷1
𝑉𝑉0 =
𝑘𝑘 − 𝑔𝑔

Dividend 𝑉𝑉1 =
𝐷𝐷1 (1+𝑔𝑔)
𝑘𝑘−𝑔𝑔 𝐷𝐷1
grow at g 𝑃𝑃0 = 𝑃𝑃1
 𝑘𝑘 − 𝑔𝑔  𝑃𝑃 − 1 = g
𝐷𝐷1 (1+𝑔𝑔) 0
𝑃𝑃0 = 𝑉𝑉0 𝑃𝑃1 =
𝑘𝑘−𝑔𝑔
Condition 1 
𝑃𝑃1 = 𝑉𝑉1

value
price =

FINA 3080 Prof. Chao Ying 9

 Returns in the DDM under the EMH
• Rule 2: Expected stock returns are given by 0
k, which
equals to expected dividend yield plus growth rate
𝑉𝑉1
Condition 3 𝑃𝑃1 + 𝐷𝐷1
𝐻𝐻𝑃𝑃𝐻𝐻 = −1
 𝑃𝑃0 𝐷𝐷1 (1 + 𝑔𝑔)
Condition 1 𝑉𝑉1 +𝐷𝐷1 + 𝐷𝐷1
= −1 𝑘𝑘 − 𝑔𝑔
𝑉𝑉0  =
𝐷𝐷1
−1 𝑉𝑉0
𝑘𝑘 − 𝑔𝑔
Condition 2
𝐷𝐷1 1 + 𝑔𝑔 + 𝐷𝐷1 𝑘𝑘 − 𝑔𝑔 − 𝐷𝐷1
=
𝐷𝐷1

=k

𝑃𝑃1 +𝐷𝐷1 𝑃𝑃1 𝐷𝐷1 𝐷𝐷1 𝐷𝐷1

𝐻𝐻𝑃𝑃𝐻𝐻 = -1= -1+ = 𝑔𝑔 + = 𝑔𝑔 + = 𝑔𝑔 + 𝑘𝑘 − 𝑔𝑔 = 𝑘𝑘
𝑃𝑃0 𝑃𝑃0 𝑃𝑃0 𝑉𝑉0 𝐷𝐷1 /(𝑘𝑘−𝑔𝑔)
Maths
magic
FINA 3080 Prof. Chao Ying 10
 Expected Returns in the EMH
• Expected return: If the world didn’t change,
what would an investor earn on a given asset?
– CAPM
• Riskless rate plus beta times market risk premium
– Historical method
• Average past returns on “comparable” companies
– Constant growth DDM Ck -

g) g
• E(return) = Expected dividend yield plus growth rate
• We can use the first two estimates as k in DDM
FINA 3080 Prof. Chao Ying 11
 Unexpected Returns in the EMH
• These returns occur when the world changes
– Changes in either required returns or dividend streams

• Realized Ret= Expected Ret + Unexpected Ret

𝑟𝑟�𝑖𝑖,𝑡𝑡 = 𝐸𝐸𝑡𝑡−1 𝑟𝑟�𝑖𝑖,𝑡𝑡 + 𝜀𝜀𝑖𝑖𝑡𝑡 , 𝜀𝜀𝑖𝑖𝑡𝑡 ~𝑁𝑁 (0, 𝜎𝜎𝑖𝑖𝑡𝑡 2 )

• Positive 𝜀𝜀𝑖𝑖𝑡𝑡 means good news

• A larger 𝜎𝜎𝑖𝑖𝑡𝑡 means the stock is more volatile

FINA 3080 Prof. Chao Ying 12

 Unexpected Returns in the EMH
return:AP-1 (P.
P5 =

• Realized returns exceed expected returns when

– Required returns decrease unexpectedly kD P, R
=>

– Dividend growth increases unexpectedly gX=4,p

– Current dividends increase unexpectedly 1) DED,p

• Some events result in unexpected capital gains

(future price increases), whereas others result in
unexpected income (dividend increases)

FINA 3080 Prof. Chao Ying 13

Returns Beyond the EMH: market is not always efficient

• In the EMH, price changes equal value changes

• In inefficient markets, mispricing fluctuates, too

--

– Mispricing may go away over your holding period

– Mispricing may just diminish
– Mispricing may even increase

• HPR depends critically on which case prevails

FINA 3080 Prof. Chao Ying 14

 Returns and the EMH: Example (1)

• Example: HPR when mispricing vanishes in 1 year

(today is mispricing, but becomes efficient after 1 year)
– D1 = 2, k = 10%, g = 8%, but Price is just $90
𝐷𝐷1 2
– 𝑉𝑉0 = = = 100 > 𝑃𝑃0 = 90: underpriced
𝑘𝑘−𝑔𝑔 2%

– Mispricing vanishes: then 𝑉𝑉1 = 𝑃𝑃1 .

when
– What is the HPR under this case?

FINA 3080 Prof. Chao Ying 15

 Returns and the EMH:
• 1-year HPR=(D1+P1)/P0-1
• If market is efficient at year t then Pt = Vt
• If market is efficient at both year 0 and year 1
then HPR=k, the required return
• If market is only efficient at year 1, then HPR
depends on the mispricing of P0
a) If P0 > V0 then HPR<k r

b) If P0 < V0 then HPR>k -

FINA 3080 Prof. Chao Ying 16

 Returns and the EMH:
• Let DDM be valid
• P0 =$90, V0 =$100, k=10%
underpriced by $10 or 10% of intrinsic value
• If market is efficient after one year,
then (D1+P1)= (D1+V1)= V0 (1+k) =$110
HPR= (D1+P1)/ P0 -1=22.2%>k
because now
stock is underpriced at year 0

FINA 3080 Prof. Chao Ying 17

(D1+V1)= V0 (1+k)
𝐷𝐷1 1 + 𝑔𝑔
𝑉𝑉1 + 𝐷𝐷1 = + 𝐷𝐷1
𝑘𝑘 − 𝑔𝑔
𝐷𝐷1 1 + 𝑔𝑔 + 𝑘𝑘 − 𝑔𝑔
=
𝑘𝑘 − 𝑔𝑔
𝐷𝐷1 1+𝑘𝑘
=
𝑘𝑘−𝑔𝑔
= 𝑉𝑉0 1 + 𝑘𝑘
↑N price
0

FINA 3080 Prof. Chao Ying 18

 Returns and the EMH: Example (2)
• 1-year HPR= Expected return=22.2%
• Expected return can be decomposed
• Expected return=abnormal return (α) +required return
𝐸𝐸 𝑟𝑟𝑖𝑖 = 𝛼𝛼𝑖𝑖 + 𝑘𝑘𝑖𝑖
• Required return is k =10%
• Therefore, abnormal return (α) is 22.2% -
10%=12.2%
note: Abnormal return is
expected
-

- -

FINA 3080 Prof. Chao Ying 19

 Decompose return
• Expected return=abnormal return (α) +required return
𝐸𝐸 𝑟𝑟𝑖𝑖 = 𝛼𝛼𝑖𝑖 + 𝑘𝑘𝑖𝑖
• Realized Ret= Expected Ret + Unexpected Ret
𝑟𝑟�𝑖𝑖,𝑡𝑡 = 𝐸𝐸𝑡𝑡−1 𝑟𝑟�𝑖𝑖,𝑡𝑡 + 𝜀𝜀𝑖𝑖𝑡𝑡 = 𝛼𝛼𝑖𝑖 + 𝑘𝑘𝑖𝑖 + 𝜀𝜀𝑖𝑖𝑡𝑡 ,
𝜀𝜀𝑖𝑖𝑡𝑡 ~𝑁𝑁 (0, 𝜎𝜎𝑖𝑖𝑡𝑡 2 )
• When 𝜀𝜀𝑖𝑖𝑡𝑡 is not zero: unexpected news
• When 𝛼𝛼𝑖𝑖 is not zero: mispricing
↳ market inefficiency

FINA 3080 Prof. Chao Ying 20

Returns and the EMH: Example (3)
note: what is efficient after 1
year
• Now, one year later, g decreases from 8% to 5%
unexpectedly. What is realized return?
ame

𝐷𝐷1 (1+𝑔𝑔) 2∗1.05

• �
One year later, 𝑉𝑉1 = = = 42
𝑘𝑘−𝑔𝑔 10%−5%
�1 +𝐷𝐷1
𝑃𝑃 �1 +𝐷𝐷1
𝑉𝑉 42+2
• Realized Ret= �0
𝑃𝑃
−1= �0
𝑃𝑃
−1=
90
−
1 = −51.1%
• Unexpected Ret=Realized Ret - Expected Ret=
-51.1%-22.2%=-73.3%
2

FINA 3080 Prof. Chao Ying 21

Stock Prices and Investment Policy:
where does 𝐷𝐷0 and 𝑔𝑔 come?
• Firm pays out a fraction of earnings as dividends
• Fraction reinvested (not paid) is the plowback
ratio b
• By definition, we can write D = (1-b)E
• g = b*ROE: fraction on the new investment *
return on equity (ROE)
• Substituting these in the DDM shows:
𝐷𝐷1 (1 − 𝑏𝑏)𝐸𝐸1
𝑉𝑉0 = =
𝑘𝑘 − 𝑔𝑔 𝑘𝑘 − 𝑏𝑏 ∗ 𝐻𝐻𝑅𝑅𝐸𝐸 22
FINA 3080 Prof. Chao Ying
 Interpreting Growth in the DDM
(1−𝑏𝑏)𝐸𝐸1 𝐸𝐸1 𝑏𝑏𝐸𝐸1
𝑉𝑉0 = = + (𝐻𝐻𝑅𝑅𝐸𝐸/𝑘𝑘 − 1)
𝑘𝑘−𝑏𝑏∗𝑅𝑅𝑅𝑅𝐸𝐸 𝑘𝑘 𝑘𝑘−𝑔𝑔
𝐷𝐷1 𝐸𝐸1
• If b = 0, then 𝐷𝐷1 = 𝐸𝐸1 and 𝑔𝑔 = 0. So 𝑉𝑉0 = =
𝑘𝑘−𝑔𝑔 𝑘𝑘
• When b > 0, it will generate a positive PVGO
(present value of growth opportunities).
• There are two components of value
– No-growth: perpetuity of current earnings
– Growth: net returns on future invested capital
– Price = No-growth value per share + PVGO
E1
P0 = + PVGO
k
FINA 3080 Prof. Chao Ying 23
 Interpreting Growth in the DDM

(1−𝑏𝑏)𝐸𝐸1 𝐸𝐸1 𝑏𝑏𝐸𝐸1

𝑉𝑉0 = = + (𝐻𝐻𝑅𝑅𝐸𝐸/𝑘𝑘 − 1)
𝑘𝑘−𝑏𝑏∗𝑅𝑅𝑅𝑅𝐸𝐸 𝑘𝑘 𝑘𝑘−𝑔𝑔

• Shareholder value is maximized when the firm

*
– Reinvests in (sets b = 1 for) projects with ROE > k
* (the new project has a higher return than the required return)
*

Important – Pay dividends (sets b = 0 for) projects with ROE < k

FINA 3080 Prof. Chao Ying 24

 Partitioning Value: Example
used
• ROE = 20% b = 40% % of earning
on
→
investments
• E1 = $5.00 D1 = $3.00 k = 15%
• g =ROE*b= .20 x .40 = .08 or 8%

(1−𝑏𝑏)𝐸𝐸1 1−0.4 ∗5
• 𝑉𝑉0 = = = 42.857
𝑘𝑘−𝑏𝑏∗𝑅𝑅𝑅𝑅𝐸𝐸 0.15−0.4∗0.2
𝐸𝐸1 𝑏𝑏𝐸𝐸1 𝑅𝑅𝑅𝑅𝐸𝐸 5 0.2∗5 0.2
• 𝑉𝑉0 = + −1 = + −1
𝑘𝑘 𝑘𝑘−𝑔𝑔 𝑘𝑘 0.15 0.15−0.08 0.15
= 33.333 + 9.524=42.857

FINA 3080 Prof. Chao Ying 25

 Dividend Growth for Two Earnings Reinvestment Policies

• With Limited money, you can either:

– Pay more dividend today so reinvest less
– Pay less dividend today but reinvest more
FINA 3080 Prof. Chao Ying 26
 P/E Ratio
𝑃𝑃𝑡𝑡−1
• P/E Ratio: current price/ next year’s earning
𝐸𝐸𝑡𝑡
• For one dollar earning next year, how much money I
would like to pay for it today.
• No Expected Growth (g = b*ROE)
– pay out all dividends and no reinvestment
E1
– E1 - expected earnings for next year P0 =
– E1 is equal to D1 under no growth k
• k - required rate of return P0 1
=
E1 k
27
FINA 3080 Prof. Chao Ying
P/E Ratio with Constant Growth Rate

𝐷𝐷𝐷 𝐸𝐸𝐷(1 − 𝑏𝑏)

𝑃𝑃𝑃 = =
𝑘𝑘 − 𝑔𝑔 𝑘𝑘 − (𝑏𝑏 × 𝐻𝐻𝑅𝑅𝐸𝐸)
𝑃𝑃0 1−𝑏𝑏 1 − 𝑏𝑏
= =
𝐸𝐸1 𝑘𝑘−(𝑏𝑏×𝑅𝑅𝑅𝑅𝐸𝐸) 𝑘𝑘 − 𝑔𝑔

b = plowback ratio
ROE = return on equity

28
FINA 3080 Prof. Chao Ying
Effect of ROE and Plowback on Growth and the P/E Ratio

= 𝑏𝑏 ∗ 𝐻𝐻𝑅𝑅𝐸𝐸

𝑃𝑃0 1 − 𝑏𝑏
=
𝐸𝐸1 𝑘𝑘 − 𝑔𝑔

• Growth grate increases in b and ROE (quality of new project).

• When ROE<k, PE ratio decreases in b: better pay dividend
• When ROE>k, PE ratio increases in b: better reinvest
FINA 3080 Prof. Chao Ying 29
 Price-to-earnings Ratios
• From the DDM, P/E = (1-b)/(k-g)
• A firm will have a high P/E ratio when
– Investors expect the firm to grow rapidly (high g)
– Investors view the firm as relatively safe (low k)
• P/E ratios change all the time
– As firm growth prospects change
• Example: China reduces tariffs on imported medicines
– As firm risk and required returns change
• Example: The riskless interest rate fluctuates all the time

FINA 3080 Prof. Chao Ying 30

 P/E Ratios and Valuation
• Analysts use earnings multiples to value stocks
• Idea: forecast E and P /E and multiply them
• Problems with P/E valuation methods
– It’s hard to forecast earnings
– Earnings Management
– Inflation affect earnings (business cycle)
– P/E ratios change all the time
– P/E ratios differ across firms for many reasons

31
FINA 3080 Prof. Chao Ying
 Example: P/E Ratio valuation
• Let P0=$50, E1=$2, no dividend
• Earnings growth at rate 30% for next 5 years
• Analyst forecasts the P/E=20 for next 5 years
• What’s the expected P3 after 3 years
E(P3)= E[(P3/E4)]*E[E4]= 20*$2*(1+30%)3 =$87.88
• What’s the annualized HPR over 3 years?
b/c no dividend, (1+HPR3)3=E(P3)/P0
HPR = 20.7%

32
FINA 3080 Prof. Chao Ying
 Lecture 6: Assignments
• Finish reading chapter 18.1-4 and 5.1-2
• Practice problems in BKM:
• PS: Ch. 5 (2, 5-6, 8, 12-14, 17-18); Ch. 6 (1-3, 5, 8-12,
14, 16, 18, 20);
• CC: Ch. 5 (1, 6); Ch. 6(1, 3)

FINA 3080 Prof. Chao Ying 33