Fundamental Stock Analysis:

Models of Stock Valuation

 2013 – Equity Investments & Markets

 Introduction
 Sometimes we can observe a market value for the security, and
we are interested in assessing whether it is overvalued or
undervalued (e.g.: stock analysts)
 Sometimes, there is no market value and we are trying to
construct one for bargaining or transaction purposes. (e.g.: a
corporation wants to sell a division. What should the price be?)
 Both of these situations call for equity valuation, and this the
most common kind of valuation problem
 We use the discounted-cash-flow or present value model
 This model relates the price of a stock to its expected future
cash flows-dividends-discounted to the present using a
constant or time-varying discount rate

© 2013 - Equity Investments &

Markets 2
 Present Values
 We first assume constant discount rate/expected stock return
 The stock is bought, held for some period of time (dividends are
collected) and then sold. The share is valued as the present value of the
expected dividends and the proceeds from the sale: intrinsic value, V
 Dividends are paid annually and the time-0 dividend (D 0) has just been
paid. The stock will be bought and held for one year. The present value is:
V0 = E(D1 + P1)/(1 + k)
 If V0 = P0, then expected rate of return coincides with the discount rate k
1 + k = E(D1 + P1)/P0
 Two main issues arise in the valuation problem:
 Choice of the appropriate discount rate
 Estimation of future cash-flows

© 2013 - Equity Investments &

Markets 3
 Choice of the Appropriate Discount Rate
 The discount rate can be found using the CAPM. From the
SML:
k = rF + [E(rM) – rF]
 Consider the following valuation problem for DataMirror
at the beginning of 2009
The beta for DataMirror is DM = .75
The average annual rate of return on the TSX index, 2000-
2012 is E(rM) = .1497
The risk-free rate (annual rate) is rF = .075. We have
k = 0.075 + (.75  .0747) = .1310
© 2013 - Equity Investments &
Markets 4
 Future Cash Flows:
The Dividend Discount Model (DDM)
 Assume constant growth of dividends
 Dividends are expected to grow at a constant rate g forever:
E(D2) = E(D1)(1 + g), E(D3) = E(D1)(1 + g)2, …
 The present value of all of the cash-flows generated by the stock is
given by:

V0 = E(D1)/(1 + k) + E(D2)/(1 + k)2 + E(D3)/(1 + k)3 + …

= D0(1 + g)/(1 + k) + D0(1 + g)2/(1 + k)2 + D0(1+g)3/(1+k)3 + …
= D0(1 + g)/(k – g) = E(D1)/(k – g)

 Note that this result is valid only when k > g. If g > k, the present
value of the dividend is infinite

© 2013 - Equity Investments &

Markets 5
 GE Example
 g = 10.86% (“3-yr est. EPS growth”)
 D0 = 1.24 (“Annual Dividend”)
 D1 = (1+g)×D0=1.1086 × 1.24 = 1.37

 β = 0.75 (“beta”)
 rf = 3%; ErM– rf = 8% (current risk-free rate;
historical average risk premium)
 k = 3% + 0.75 × 8% = 9.00% < g
 Can’t use constant growth model
© 2013 - Equity Investments &
Markets 6
GE

© 2013 - Equity Investments &

Markets 7
Contd.

© 2013 - Equity Investments &

Markets 8
 Expected Rate of Return
 Note that, based on the previous model, the expected rate
of capital gains on a stock equals
[E(V1) – V0]/V0 = [E(D2) – E(D1)]/E(D1)
= [E(D1)(1 + g) – E(D1)]/E(D1) = g
 Hence, we have:
k = E(D1)/V0 + [E(V1) – V0]/V0 = [E(D1)/V0]+ g
 The expected rate of return on a stock is the sum of the
expected dividend yield and expected capital gains, where
the latter coincides with the growth rate of dividends
© 2013 - Equity Investments &
Markets 9
 Remark 1
 A “growth” stock is one whose expected rate of return is
mainly due to the expected growth of cash flows
 Conversely, a “value” stock is one whose expected rate of
return is mainly due to the expected dividend yield
 In the case of DataMirror, 2000 dividends amounted to $.50, or,
disregarding compounding issues, an annual dividend of D 0 = 2
 Then we can proxy the rate of growth of dividends g with the
expected growth rate of earnings for the next five years (from
analysts forecasts): g = 5%
 In summary, V0 = (2  1.05)/(0.1310 – 0.05) = 25.92
 The theoretical valuation is remarkably close to actual price of
$26.75

© 2013 - Equity Investments &

Markets 10
 Contd.
 V0 < P0 is equivalent to the asset plotting “below” the SML
 V0 > P0 is equivalent to the asset plotting “above” the SML
 The intrinsic value of a stock is very sensitive to changes in k and g:
dV0/dk (1/V0) = – [1/(k – g)] and
dV0/dg (1/V0) = [(1 + k)/(1 + g)][1/(k – g)]
 For DataMirror, we have:
dV0/dk (1/V0) = –12.34 and
dV0/dg (1/V0) = 13.29
 This means that if k increases by 1%, the price of DataMirror drops
by 12.34%. If g increases by 1%, the price of DataMirror increases
by 13.29%

© 2013 - Equity Investments &

Markets 11
 Remark 2
 The Gordon growth model can be applied either to the total value of a
firm and its total cash payments to shareholders or to the price per share
and dividends per share
 We can use the Gordon growth model to think about changes in the
valuation of the US stock market. If the dividend-price ratio falls, this
must be because
 g rises,
 k falls,
 or both
 Different investors may have different views about this. For example,
you may be willing to buy shares at a high price because you believe
that g is high
 I may hold off because I think g is low and therefore a high price
implies a low k and hence a low return on the investment

© 2013 - Equity Investments &

Markets 12
 The Two-Stage Dividend-Growth Model
 The previous discussion assumes that dividends grow at a
constant rate forever
 Let g1 denote the growth rate for the first n years
 Let g2 denote the growth rate for the remaining life of the
firm. We have:
V0 = D0  [(1 + g1)/(k – g1)]  [1 – ((1 + g1)/(1 + k))n] +
D0  (1 + g1)n  [(1 + g2)/(k – g2)]  [1/(1 + k)n]
 The intrinsic value of the firm equals the present value of a
growing annuity plus the present value of a deferred
growing perpetuity
© 2013 - Equity Investments &
Markets 13
 Example
 Consider again DataMirror stock at the beginning of 2009
 Assume g1 = .05 for the first five years, and then g2 = .06
forever

 The intrinsic value is given by

V0 = 2  1.05/(.131 – .05)  [1 – (1.05/1.131)5] +
2  (1.05/1.131)5  1.06/(.131 – .06)

= 8.05 + 20.59 = 28.64

© 2013 - Equity Investments &

Markets 14
 Dividends and Earnings:
Where Does the Growth Come From?
 While the cash flows generated by stock ownership are the cash
dividends distributed by the firm, stock valuation is sometimes
performed in terms of earnings, rather than dividends
 Hence it is important to understand the relationship between the
two
 Assume a constant rate of growth of dividends:
1 + g = Dt/Dt-1
 Dividends: constant fraction (1 – b) of the earnings produced by
the firm,
Dt = (1 – b)  Et
b: retention or plowback ratio
1 – b: payout ratio
© 2013 - Equity Investments &
Markets 15
 Contd.
 Earnings: proportional to the physical assets (book value) of the equity
shares, K,
Et = ROE  Kt-1
 Hence, we have:
Kt = Kt-1 + bEt = Kt-1 + (bROE  Kt-1) = Kt-1(1 + bROE)

The capital stock, and hence earnings and dividends, grow at the rate:

g = b  ROE = Plowback ratio  ROE

The rate of growth of dividends increases with b, the retention ratio,

and ROE
 Example
© 2013 - Equity Investments &
Markets 16
 ROE
 In turn, the rate of return on equity depends on the rate of
return on assets, ROA, the book value of equity, K, the book
value of debt, DEBT, the rate of interest paid on the debt, i,
and the tax rate:

ROE = [(K+DEBT)/K]  ROA + [1 – (K+DEBT)/K]  i  (1-t)

= ROA + (DEBT/K)  [ROA – i  (1 – t)]
where [1 – (K+DEBT)/K] = DEBT/K. Equity is equivalent to a
portfolio long 1 + DEBT/K in the assets of the firm and short
DEBT/K in corporate bonds. Since interest payments are tax
deductible, the rate of return on the corporate bonds is reduced
by a factor equal to the corporate tax rate

© 2013 - Equity Investments &

Markets 17
 Decision to Reinvest
 The share price depends on the decision to reinvest in the firm:

V0 = E(D1)/(k – g) = E(E1)(1 – b)/[k – (b  ROE)]

Similarly, we can write the price-earnings ratio as:

V0/E0 = (1 + g)(1 – b)/[k – (b  ROE)]

 If ROE = k, V0 = E(E1)/k: the current intrinsic value does not
depend on b (fraction reinvested)
 Intuition:
k is the rate at which you are “borrowing”
ROE is the rate at which you are investing
© 2013 - Equity Investments &
Markets 18
 Discussion
 If ROE = k, you are “break even” (reinvestment only just covers its
opportunity cost and does not add value)

 If ROE > k, you want to increase b: V0  + as b  k/ROE < 1

(the value of the firm increases with b because reinvestment is
profitable)
 If ROE < k, you want to decrease b: V0  0 as b  1 (the value of
the firm decreases with b because reinvestment is not profitable)
 E(E1)/k: value of the firm when
 ROE = k and/or
b=0

© 2013 - Equity Investments &

Markets 19
 Implications 1
 How can managers increase the value of the firm
they work for?
 Increase earnings today (for example by cutting
costs or increasing sales at profitable prices)
 Increase ROE (by identifying profitable
investments that will yield high returns)
 Retain earnings as long as investments are
available that have ROE > k. Otherwise pay them out

© 2013 - Equity Investments &

Markets 20
 Implications 2
 How can unscrupulous managers temporary increase the value
of the firm they work for?
 Increase reported earnings today (by accounting tricks that
postpone costs and accelerate revenues)
 Increase investors’ perception of ROE (by telling
superficially convincing stories about future growth
opportunities)
 Retain all earnings in order to support the story that the firm
has good growth opportunities
 To protect themselves against this type of manipulation,
investors rely on (i) accountants, (ii) stock analysts, (iii)
securities regulation

© 2013 - Equity Investments &

Markets 21
 PVGO
 Differences between V0 and E(E1)/k: value of reinvesting
future earnings into the firm, the present value of growth
opportunities (PVGO)

PVGO = V0 – [E(E1)/k]

 High PVGO stock: “growth” stock

 Low PVGO stock: “value” stock

© 2013 - Equity Investments &

Markets 22
 P/E ratio and Growth Opportunities
 With changing notation:
P0/E1 = (1/k) + (PVGO/E1)
= [1 + PVGO/(E1/k)]/k

 PVGO/(E1/k) is the ratio of growth to no growth value

 A firm with relatively high growth opportunities will have
a relatively high P/E ratio
 For such a firm, price is based on expectations of future
growth, not current earnings
© 2013 - Equity Investments &
Markets 23
 Example
 Consider Dorel Industries at the beginning of 2010. We have
E0 = 4.50 and D0 = 2.00
Assume the growth rate of earnings: g1 = .1654 for the first five years and
the growth rate g2 = .06 afterwards
 Also assume the retention ratio for the first five years to be equal to the
current retention ratio
b1 = (4.5 – 2)/4.5 = .5556
 In the long-run, the retention ratio is derived from the expected growth rate
g2, using ROA = .18, DEBT/K = 23.2, and i  (1 – t) = .0475
b2  ROE = g2
Hence b2 = g2/ROE = .06/[.18 + .2320  (.18 – .0475)] = .2847
 The cost of capital for Dorel Industries is estimated at
k = .1378

© 2013 - Equity Investments &

Markets 24
 Contd.
 Based on this information, we can compute the present value of the cash
flows for the first five years:
2  [1.1654/(.1378 – .1654)][1 – (1.1654/1.1378) 5] = 10.75
 The theoretical value at time 5 is given by:
V5 = 4.5  1.16545  (1 – .2847)  [1.06/(.1378 – .06)] = 94.27
 Hence, the theoretical value at time 0 is given by:
V0 = 10.75 + (94.27/1.13785) = 60.19
which should be compared to an actual price of $79 in February 2010

 We can now calculate the present value of growth opportunities

(PVGO) as:
PVGO = 79 – [4.5*(1.1654)/.1378] = 40.95

© 2013 - Equity Investments &

Markets 25
 Final Remarks 1
We can also calculate:
V0/E(E1) = (1 – b)/[k – (b  ROE)]
 It shows that P/E ratios depend on k, PVGO, ROE, b, and
choice of accounting methods
 P/E ratios are also affected by inflation and business cycle
effects
 Note that earnings here should be economic earnings, but
accounting earnings are used in practice
 Also note that future earnings are what really matters, but
historical earnings are often used (“trailing” vs. “leading” P/E
ratios)
© 2013 - Equity Investments &
Markets 26
 Peter Lynch’s P/E Ratio Rule of Thumb
“The P/E ratio of any company that’s fairly priced
will equal its growth ratio …
… If the P/E ratio of Coca Cola is 15 you’d expected
the company to be growing at 15% per year, etc…”
From “One Up on Wall Street”, pg. 198
In other words P/E = g, or PEG = 1

© 2013 - Equity Investments &

Markets 27
 Example
 Consider the following example:
 rF = 8%, rM = 16%, =1, ROE = 16%, and b = 40%
 It follows: k = rF + (rM – rF) = 16%
 It also follows: g = ROE  b = 0.16  0.4 = 0.064
 Therefore, P0/E1 = (1-0.4)/(0.16-0.064) = 6.26
 Since g = 6.4% and P/E = 6.26, the rule of thumb seems to be
approximately accurate in this case
 However, for other cases, the rule does not work well
 Hence, actual estimation of the growth rate is advisable

© 2013 - Equity Investments &

Markets 28
 P/E Ratios and Stock Risk
 Riskier stocks have lower P/E/ ratios
 We know: P0/E1 = (1 – b)/(k – g)
 We also know: k = rF + (rM – rF)
 It follows that: P0/E1 = (1 – b)/[rF + (rM – rF) – g]
 As beta increases, the denominator increases and the P/E ratio
decreases
 Of course, numerous risky companies have high P/E ratios
 However, if two companies are identical in every way, then
the riskier one will have a lower P/E ratio

© 2013 - Equity Investments &

Markets 29
 Life Cycles and Multi-stage Growth
Models
 The constant growth DDM assumes that growth rates, and
therefore the plowback ratios, remain constant forever
 In reality firms at different stages of the life cycle will have
different investment opportunities
 For example, utilities, typically in the maturity stage, have
limited investment opportunities. Hence we expect the utility to
have high dividend payout ratio and low growth
 Semiconductor manufacturers, typically in the start up stage or
consolidation stage, have many investment opportunities. Hence
we expect the semiconductor manufacturer to have low dividend
payout ratio and high growth

© 2013 - Equity Investments &

Markets 30
 Contd.
 It is therefore, unrealistic to assume a constant
dividend, or a constant growth

 A multistage version of the DDM takes varying

levels of growth into account

© 2013 - Equity Investments &

Markets 31
 Alternative Valuation Techniques
 In practice, the cash-flow analysis described before is
complemented by information based on industry ratios
 Price-earnings ratio: given the average price-ratio for the
industry, we can calculate the intrinsic value of the stock. We
have:
V0 = E0  avg(P0/E0)
 Similarly, we can use the average market-to-book ratio:
V0 = K0  avg(P0/K0)
 Also, we can use the average price-to-sales ratio:
V0 = S0  avg(P0/S0)

© 2013 - Equity Investments &

Markets 32
 P/E Ratio
 Note that we can also relate cash-flow analysis to these
other valuation techniques:
 For the price-earnings ratio, we have:

V0/E0 = D0/E0[(1 + g)/(k – g)] = (1 – b)[(1 + g)/(k – g)]

where D0/E0 = 1 – b: payout ratio.

The leading multiple is more appropriate for valuation, but

to use it we need to forecast E next year for all of the
comparable firms
© 2013 - Equity Investments &
Markets 33
 Market-to-Book Ratio

V0/K0 = (E0/K0)(D0/E0)[(1 + g)/(k – g)] = ROE  (V0/E0)

= ROE(1 – b)[(1 + g)/(k – g)]

where E0/K0 = ROE: rate of return on equity

 V/K ratios are determined by risk, growth prospects, and

ROE
 Firms with low V/K and high ROE are potentially
undervalued; and firms with high V/K and low ROE are
possibly overvalued
© 2013 - Equity Investments &
Markets 34
 Advantages/Disadvantages
 K provides a relatively stable and simple benchmark
 Given consistent accounting standards, comparable across
firms
 Can be used for cases where E < 0
 Not comparable across jurisdictions with different
accounting standards
 Affected by accounting decisions on inventories,
depreciation, etc.
 Not very useful in cases where there are not a lot of fixed
assets

© 2013 - Equity Investments &

Markets 35
 Price-to Sales Ratio
V0/S0 = (E0/S0)(D0/E0)[(1 + g)/(k – g)] =   (V0/E0)
where E0/S0 = : profit margin.
 V/S increases with profit margin, the payout ratio, and the
growth rate, and it decreases with risk
 Firms with high V/S and low profit margins might be
overvalued, firms with low P/S and high profit margin
could be undervalued
 V/S multiples are widely used to value privately held
companies and to compare value across publicly traded
companies
© 2013 - Equity Investments &
Markets 36
 Advantages/Disadvantages
 Can always calculate it (unlike V/E and V/K which might
be negative)
 Revenue is less distorted by accounting decisions
 More stable than V/E multiples since S doesn’t fluctuate as
much as E over the business cycle
 Can be very misleading if the firm has cost control
problem
 May not be comparable across firms with different
strategies

© 2013 - Equity Investments &

Markets 37
 Applications: Telus and Molson
 At the beginning of 2010 Telus had the following ratios:
(P0/E0) = 27.09 vs avg(P0/E0) = 18.15
(P0/K0) = 2.39 vs avg(P0/K0) = 2.57
(P0/S0) = 1.11 vs avg(P0/K0) = .81
 Hence based on these comparisons it is hard to tell whether
Telus is undervalued or overvalued relative to the rest of the
industry
 Consider Molson at the beginning of 2010. We have
1 – b = .74
Expected growth rate g = .06
We also have k = .1113, ROE = .15, and  = .047

© 2013 - Equity Investments &

Markets 38
 Contd.
 We can calculate the theoretical ratios. We have:

V0/E0 = .74  [1.06/(.1113 – .06)] = 15.29

V0/K0 = .15  15.29 = 2.29
V0/S0 = .047  15.29 = .719

 These theoretical ratios can be compared to the actual

ratios of 17.02, 2.44, and .78
 Hence we may conclude that Molson is slightly overvalued

© 2013 - Equity Investments &

Markets 39
 Wrap-Up of Multiples
 Assess the firm’s value based in that of publicly traded
comparables
 Cash-flow-based value multiples
MV of firm/Earnings, MV of firm/EBITDA, MV of
firm/FCF
 Cash-flow-based price multiples
Price/Earnings (P/E), Price/EBITDA, Price/FCF
 Asset-based multiples
MV of firm/BV of assets, MV of equity/BV of equity

© 2013 - Equity Investments &

Markets 40
 Procedure
 Hope: Firms in the same business should have similar
multiples (e.g. P/E)
 Step : Identify firms in the same business as the firm
you want to value
 Step : Calculate P/E ratio for comps and come up with
an estimate of P/E for the firm you want to value (e.g. take
the average of comps P/E)
 Step : Multiply the estimated P/E by the actual Net
Income of the firm you want to value

© 2013 - Equity Investments &

Markets 41
 Step 1. Select Comparable Companies
 Tradeoff between similarity and sample size

 Exclude abnormal firms (merging, restructuring,

changing strategic direction, etc.)

 Commonly used criteria include: industry

classification, technology, clientele, size, leverage

© 2013 - Equity Investments &

Markets 42
 Step 2. Select Appropriate Bases for Multiples
 Which to use? Earnings, sales? book values?
 General observation: the higher up the income
statement, the less it is subject to choice of accounting
methods, but the less it reflects differences in
operating efficiency across firms

© 2013 - Equity Investments &

Markets 43
 Step 3. Average Multiples across Comparable
Firms and Forecast Future Bases
 Allows the calculation for a “fair price” for a dollar of earnings,
or book value of equity, or sales, etc.
 Important implicit assumption: ability of firms to convert the
bases into cash is the same
 In order to use earnings to estimate value, we need to project
next year’s earnings and multiply by the average P/E ratio (but
what about future years)
 Fir example, if we want to use sales/franchise, we have to
forecast the number of franchises
 In a last step, we value the firm. This seems straightforward, but
we may need to do further analysis to resolve different estimates
from different multiples

© 2013 - Equity Investments &

Markets 44
 Remarks
 For firms with no earnings or limited asset base (e.g. hi-teach)
 price-to-patents multiples
 price-to-subscribers multiples
 or even price-to-Ph.D. multiples!
 Many others are used in specific industries: e.g. passengers per
mile flown, sales per franchise
 For transactions, can also use multiples for comparable
transactions (e.g. similar takeovers)
 Multiples based on equity value (or stock price, e.g. P/E) as
opposed to total firm value ignore effect of leverage on the cost
of equity (or assume the firms have similar leverage)
 be aware if comps. have very different leverage

© 2013 - Equity Investments &

Markets 45
 Leverage Problems
 To mitigate leverage related problems, analysts sometimes
use multiples to value the entire firm
 The same basic procedures apply, except that the multiples
must be redefined appropriately, e.g. rather than P/E, we
might use Total Firm Value/ Operating Income
 To obtain the value of equity, subtract the value of all non-
equity claims (e.g. debt, preferred shares( from estimated
total firm value

© 2013 - Equity Investments &

Markets 46
 Comparables: Pros and Cons
 Incorporate a lot of information from other valuation
in a simple way
 Embodies market consensus about discount rates and
growth rate
 Free-ride on market’s information
 Can provide discipline in valuation process by
ensuring that your valuation is in line with other
valuations

© 2013 - Equity Investments &

Markets 47
 Comparables: Pros and Cons
 Implicitly assumes all companies are alike in growth rates, cost
of capital and business composition. Hard to find true comps
 Hard time incorporating firm specific information. Particularly
problematic if operating changes are going to be implemented
 Accounting differences, particularly with earnings and equity-
based measures. Multiples of FCF and EBITDA preferable for
this reason
 Book values can vary across firms depending on age of PPE
 If everyone uses comps, who actually does fundamental
analysis?

© 2013 - Equity Investments &

Markets 48