An Introduction to

Security Valuation
Mark Jhunrel D. Rosada November 26, 2020
Graduate Studies, CBAA
MSU-IIT
 After you read this chapter, you should be
able to answer the following questions:
• 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?
• After you have valued an asset, what is the investment decision
process?
• How do you determine the value of bonds?

An Introduction to Security Valuation Rosada, November 2020 | Page 1

 After you read this chapter, you should be
able to answer the following questions:
• How do you determine the value of preferred stock?
• What are the two primary approaches to the valuation of common
stock?
• 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 relative valuation
techniques 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?

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 After you read this chapter, you should be
able to answer the following questions:
• 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 present value of operating cash flow
technique?
• How do you apply the present value of free cash flow to equity
technique?

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 After you read this chapter, you should be
able to answer the following questions:
• How do you apply the relative valuation approach?
• 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 valuation
approach?

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 After you read this chapter, you should be
able to answer the following questions:
• 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, cash flows, or dividends?

• What additional factors must be considered when estimating the

required rate of return and growth rate for a foreign security?

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 Valuation
• a process of deciding whether or not you’re going to invest on a
specific security and what investment you’re going to put your
money into.
• 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 to buy the security.

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 Valuation Process
Two general approaches to the valuation process:
• Top-down, three-step approach
both the economy/market and the industry effect have a significant impact
on the total returns for individual stocks.

• Bottom-up, stock valuation, stockpicking approach

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.

An Introduction to Security Valuation Rosada, November 2020 | Page 7

 Investment Process
• Analysis of Alternative
Economies and Security
Markets
• Analysis of Alternative
Industries
• Analysis of Individual
Companies and Stocks

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 Why a Three-step Valuation Process?
General Economic Influences

Monetary policy
refers to the actions undertaken by a nation's central bank to control
money supply and achieve macroeconomic goals that promote sustainable
economic growth.

Fiscal policy
the means by which a government adjusts its spending levels and tax rates
to monitor and influence a nation's economy.

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 Why a Three-step Valuation Process?
Industry Influences

• Strikes within a major producing country,

• Import or export quotas or taxes,
• A worldwide shortage or an excess supply of a resource or product,
• Government-imposed regulations on an industry
• Demographics

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 Why a Three-step Valuation Process?
Company Analysis

• Involves examining a firm’s past performance and, more important,

its future prospects.
• Estimate its value using one of several valuation models.
• Compare your estimated intrinsic value to the prevailing market
price of the firm’s stock and decide whether its stock is a good
investment.

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 Does the Three-Step Process Work?

• First, studies indicated that most changes in an individual firm’s

earnings could be attributed to changes in aggregate corporate
earnings and changes in earnings for the firm’s industry, with the
aggregate earnings changes being more important.

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 Does the Three-Step Process Work?

• Second, studies by Moore and Cullity (1988) and Siegel (1991)

found a relationship between aggregate stock prices and various
economic series, such as employment, income, and production.

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 Does the Three-Step Process Work?

• Third, 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
stocks could be explained by changes in the rates of return for the
aggregate stock market and the stock’s industry.

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 Theory of Valuation
Required inputs in asset valuation:

(1) the stream of expected returns

(2) the required rate of return on the investment (its discount rate).

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 Stream of Expected Returns (Cash Flows)
Forms of Returns
The returns from an investment can take many forms, including earnings,
cash flows, dividends, interest payments, or capital gains (increases in value)
during a period.

Time Patterns and Growth Rate of Returns

An estimate of when you will receive the returns or cash flows is required
to calculate an accurate value for a security

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 Required Rate of Return
The required rate of return on an investment is determined by:

(1) the economy’s real risk-free rate of return, plus

(2) the expected rate of inflation during the holding period, plus
(3) a risk premium that is determined by the uncertainty of returns.

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 Investment Decision Process: A Comparison
of Estimated Values and Market Prices

• If Estimated Intrinsic Value > Market Price, Buy or Hold it if You Own It.
• If Estimated Intrinsic Value < Market Price, Don’t Buy or Sell it if You Own It

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 Valuation of Bonds
A bond typically promises the following:

1. Interest payments every six months equal to one-half the coupon

rate times the face value of the bond
2. The payment of the principal on the bond’s maturity date

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 Valuation of Bonds
Example
• In 2012, 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.
Therefore, assuming the bond issuer does not default, the investor
knows what payments (cash flows) will be made and when they will
be made. 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.

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 Valuation of Bonds
•Present
  value of an annuity:
= PMT

If payments occur more than once a year:

1. convert the stated interest rate into a “periodic rate”, that is dividing the
stated annual rate to the number of payments per year
2. convert the years into number of periods, that is multiplying the number
of years and the periods per year

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 Valuation of Bonds
•Present
  value of an annuity:
= PMT

= $500 × 15.3725
= $7,686
(Present Value of Interest Payments at 10 Percent)

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 Valuation of Bonds
•Present
  value of the principal payment:
PV = FV x

= $10,000 × 0.2314
= $2,314
(Present Value of the Principal Payment at 10 Percent)

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 Valuation of Bonds

Present Value of Interest Payments $500 × 15.3725 = $ 7,686

Present Value of Principal Payment $10,000 × 0.2314 = 2,314
Total Present Value of Bond at 10 Percent = $ 10,000

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 Valuation of Bonds
Exercise
• In 2012, 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.
Therefore, assuming the bond issuer does not default, the investor
knows what payments (cash flows) will be made and when they will
be made. With a 12% required rate of return. 

(Answer)Total Present Value of Bond at 12 Percent = $8,623

 

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 Valuation of Preferred Stock
•Payments
  are made only after the firm meets its bond interest
payments.
• No maturity
• Paid through dividends

Value of preferred stock: Promise yield if price is given:

V= =

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 Valuation of Common Stock

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 Why and When to Use the Discounted Cash
Flow Valuation Approach
Cash Flow Measure:
Dividends
cash flows that go directly to the equity investor, which implies that you
should use the cost of equity as the discount rate
Operating Free Cash Flows
generally described as cash flows after direct costs (cost of goods and
selling, general and administrative expenses)
Free Cash Flows to Equity
a measure of cash flows similar to the operating free cash flow, but after
payments to debt holders, which means that these are cash flows available
to equity owners.
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 Why and When to Use the Relative
Valuation Techniques
The relative valuation techniques are appropriate to consider under
two conditions:

1. 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.
2. The aggregate market and the company’s industry are not at a
valuation extreme—that is, they are not either seriously
undervalued or seriously overvalued.

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 Discounted Cash Flow Valuation Techniques
•Basic
  Valuation Model:
=
where:
= value of Stock j
n = life of the asset
= cash flow in Period t
k = the discount rate that is equal to the investors, required rate of return for
Asset j, which is determined by the uncertainty (risk) of the asset’s cash
flows.

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 The Dividend Discount Model (DDM)

•where:
 
= value of common Stock j
= dividend during Period t
k = required rate of return on Stock j

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 The Dividend Discount Model (DDM)
If stock is not held for an infinite period:

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 The Dividend Discount Model (DDM)
If stock is not held for an infinite period:

Expected selling price of stock at the end of year 2:

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 The Dividend Discount Model (DDM)
•If  is discounted back to the present by , the equation becomes:

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 Different Holding Periods

• One-year Holding Period

• Multiple-year Holding Period
• Infinite Period Model
assumes that investors estimate future dividend payments for an
infinite number of periods.

The Dividend Discount Model (DDM) Rosada, November 2020 | Page 35

 Infinite Period Model
•  

where:
= the value of Stock j
= the dividend payment in the current period
g = the constant growth rate of dividends
k = the required rate of return on Stock j
n = the number of periods, which we assume to be infinite

The Dividend Discount Model (DDM) Rosada, November 2020 | Page 36

 Infinite Period Model

Reduced form of DDM:

The Dividend Discount Model (DDM) Rosada, November 2020 | Page 37

 Infinite Period Model
Required estimates:

(1) the required rate of return (k)

(2) the expected constant growth rate of dividends (g).

The Dividend Discount Model (DDM) Rosada, November 2020 | Page 38

 Infinite Period Model
Example:
• 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,
which implies that you expect the dividend next year (D1) to be
$1.07. For the long run, you expect a nominal risk-free rate of about
6 percent and a risk premium of 5 percent. Therefore, you set your
long-run required rate of return on this stock at 11 percent; your
estimate of k is 0.11.

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 Infinite Period Model
•g =  0.07
k = 0.11
= $1.07 ($1.00 × 1.07)

V = = = $26.75

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 Infinite Period DDM and Growth Companies
DDM Assumptions:

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).

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 Infinite Period DDM and Growth Companies
Reasons for DDM assumptions’ inconsistency with growth companies:

• The infinite period DDM assumes dividends will grow at a constant

rate for an infinite period. This assumption seldom holds for
companies currently growing at above-average rates.
• During the periods when these firms experience abnormally high
rates of growth, their rates of growth probably exceed their
required rates of return.

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 Valuation with Temporary Supernormal
Growth
• The
  Bourke Company has a current dividend () of $2 a share. The
required rate of return for the stock (the company’s cost of equity)
is 14 percent. The following are the expected annual growth rates
for dividends.

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 Valuation with Temporary Supernormal
Growth

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 Valuation with Temporary Supernormal
Growth

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 Present Value of Operating Free Cash Flows

•where:
 
= value of Firm j
n = number of periods assumed to be infinite
= the firm, s operating free cash flow in Period t
= Firm j’s weighted average cost of capital

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 Present Value of Operating Free Cash Flows
•OFCF
  for an infinite period:

where:
= operating free cash flow in Period 1 equal to  (1 + )
= long-term constant growth rate of operating free cash flow

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 Present Value of Free Cash Flows to Equity
•  

where:
= value of the stock of Firm j
n = number of periods assumed to be infinite
= the firm’s free cash flow to equity in Period t

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 Present Value of Free Cash Flows to Equity
•  

where:
= value of the stock of Firm j
n = number of periods assumed to be infinite
= the firm’s free cash flow to equity in Period t

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 Relative Valuation Techniques
Relative valuation ratios:

(1) price/earnings (P/E)

(2) price/cash flow (P/CF)
(3) price/book value (P/BV)
(4) price/sales (P/S)

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 Earnings Multiplier Model or Price/Earnings
Ratio
 
Price/Earnings Ratio =

DDM as P/E Ratio:

=
Divided by (expected earnings during the next 12 months):
=

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 Earnings Multiplier Model or Price/Earnings
Ratio
DDM implies that the P/E ratio is determined by:

1. The expected dividend payout ratio (dividends divided by earnings)

2. The estimated required rate of return on the stock (k)
3. The expected growth rate of dividends for the stock (g)

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 The Price/Cash Flow Ratio
 
The price to cash flow ratio is computed as follows:

P/ =

where:
P/ = the price=cash flow ratio for Firm j
= the price of the stock in Period t
= the expected cash flow per share for Firm j

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 The Price/Book Value Ratio
 
The P/BV ratio is specified as follows:

P/ =

where:
P/ = the price/book value ratio for Firm j
= the price of the stock in Period t
= the estimated end-of -year book value per share for Firm j

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 The Price/Sales Ratio
 
The specific P/S ratio is:

P/ =

where:
P/ = the price to sales ratio for Firm j
= the price of the stock in Period t
= the expected sales per share for Firm j

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 Estimating the Inputs: The Required Rate of Return and
the Expected Growth Rate of Valuation Variables
Required Rate of Return (k)

Three factors influence an equity investor’s required rate of return (k):

1. The economy’s real risk-free rate (RRFR)
2. The expected rate of inflation (I)
3. A risk premium (RP)

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 Estimating the Inputs: The Required Rate of Return and
the Expected Growth Rate of Valuation Variables
The Economy’s Real Risk-Free Rate
This is the absolute minimum rate that an investor should require.

The Expected Rate of Inflation

These expectations determine how large an effect a given policy action will
have on economic activity.
Nominal risk-free rate of return (NRFR):
NRFR = {[1-RRFR][1+E(I)]}

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 Estimating the Inputs: The Required Rate of Return and
the Expected Growth Rate of Valuation Variables

The Risk Premium

The risk premium (RP) causes differences in the required rates of return
among alternative investments that range from government bonds to
corporate bonds to common stocks.

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 Estimating the Required Return for Foreign
Securities
Foreign Real RFR
estimated rate can vary substantially among countries due to differences
in an economy’s real growth rate.
Inflation Rate
rate of inflation typically varies substantially among countries.
Risk Premium
the five risk components differ substantially between countries: business
risk, financial risk, liquidity risk, exchange rate risk, and country risk.

An Introduction to Security Valuation Rosada, November 2020 | Page 59

 Expected Growth Rates
Estimating Growth from Fundamentals

Growth rate depends on:

1. the proportion of earnings it retains and reinvests in new assets
2. the rate of return it earns on these new assets.

g = (1 – payout ratio) × (Return on Equity)

= (Retention Rate) × (Return on Equity)
= RR × ROE

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 Expected Growth Rates
 
Breakdown of ROE

ROE ratio into three components:

ROE = × ×
= Profit Margin × Total Asset Turnover × Financial Leverage

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 Expected Growth Rates
 
Estimating Growth Based on History

Three techniques:
• arithmetic or geometric average of annual percentage changes
• linear regression models
= a + bt
• log-linear regression models
ln () = a + bt

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 Expected Growth Rates
Estimating Dividend Growth for Foreign Stocks

• Retention Rates
• Net Profit Margin
• Total Asset Turnover
• Total Asset/Equity Ratio

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 The End

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