Equity Valuation

Bodie, Kane and MarcusEssentials of Investments 9th Global Edition

13

13.1 EQUITY VALUATION

Book ValueNet worth of common equity

according to a firm’s balance sheetLimitations of Book Value

Liquidation value: Net amount realized by selling assets of firm and paying off debt

Replacement cost: Cost to replace firm’s assets

Tobin’s q: Ratio of firm’s market value to replacement cost

TABLE 13.1 MICROSOFT FINANCIAL HIGHLIGHTS, JAN 2012

Price per share $28.25Common shares outstanding (billion) 8.41Market capitalization ($ billion) 237.6

Latest 12 MonthsSales ($ billion) 71.12EBITDA ($ billion) 30.15Net income ($ billion) 23.48Earnings per share $2.75

Valuation MicrosoftIndustry

AvgP/E ratio 10.3 17.5Price/Book 4.0 10.5Price/Sales 3.3 2.7Price/Cash flow 13.9 20.5PEG 1.1 1.2

ProfitabilityROE (%) 44.16 24.9ROA (%) 17.33Operating profit margin (%) 38.78 8.58Net profit margin (%) 33.01 23.2

13.2 INTRINSIC VALUE VERSUS MARKET PRICE

= expected dividend per share = current share price = expected end-of-year price

13.2 INTRINSIC VALUE VERSUS MARKET PRICE

Intrinsic Value Present value of firm’s expected future net cash flows

discounted by required RoR Market Capitalization Rate

Market-consensus estimate of appropriate discount rate for firm’s cash flows

13.2 INTRINSIC VALUE VERSUS MARKET PRICE

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13.3 DIVIDEND DISCOUNT MODELS•  

13.3 DIVIDEND DISCOUNT MODELS

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13.3 DIVIDEND DISCOUNT MODELS•  

13.3 DIVIDEND DISCOUNT MODELS

13.3 DIVIDEND DISCOUNT MODELS Life Cycles and Multistage Growth Models

Two-stage DDM

DDM in which dividend growth assumed to level off only at future date

Multistage Growth Models Allow dividends per share to grow at several different

rates as firm matures

13.4 PRICE-EARNINGS RATIOS

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13.4 PRICE-EARNINGS RATIOS

1999200020012002200320042005200620070

5

10

15

20

25

P/E Ratios

NBKKFHZain

13.4 PRICE-EARNINGS RATIOS

2000 2001 2002 2003 2004 2005 2006 2007

-20%

-10%

0%

10%

20%

30%

40%

Growth Rate

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13.4 PRICE-EARNINGS RATIOS•  

TABLE 13.3 EFFECT OF ROE AND PLOWBACK ON GROWTH AND P/E RATIO

13.4 PRICE-EARNINGS RATIOS

The P/E ratio of any company that’s fairly priced will equal its growth rate. I’m talking here about growth rate of earnings…if the the P/E ratio of Coca-Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.

13.4 PRICE-EARNINGS RATIOS

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FIGURE 13.3 P/E RATIO OF S&P 500 AND INFLATION

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20100

10

20

30

40

50

60

P/E ratio

Inflation rate

13.4 PRICE-EARNINGS RATIOS Pitfalls in P/E Analysis

Earnings Management

Practice of using flexibility in accounting rules to improve apparent profitability of firm

Large amount of discretion in managing earnings

FIGURE 13.6 P/E RATIOS

BiotechBusiness software

Heavy constructionTrucking

Auto manufacturersRestaurants

Food productsAsset management

Application softwareChemical products

PharmaceuticalsHome improvement

Electric utilitiesIndustrial metalsTelecom services

Computer systemsHealth care plans

Money center banksIntegrated oil & gasAerospace/defense

0 10 20 30 40 50 60

57.8

34.7

32.4

28.0

25.3

21.4

21.1

17.5

17.5

17.4

17.2

16.5

15.6

14.9

14.7

13.2

11.8

11.0

10.2

8.5

P/E ratio

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Basic M

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Cons

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Goo

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Cons

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Tele

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Banks

Insu

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Fina

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Tech

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Para

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0

5

10

15

20

25

30

P/E as of end of 2012

13.4 PRICE-EARNINGS RATIOS Combining P/E Analysis and the DDM

Estimates stock price at horizon date Other Comparative Valuation Ratios

Price-to-book: Indicates how aggressively market values firm

Price-to-cash-flow: Cash flow less affected by accounting decisions than earnings

Price-to-sales: For start-ups with no earnings Creative ratios

FIGURE 13.7 VALUATION RATIOS FOR S&P 500

13.5 FREE CASH FLOW VALUATION APPROACHES

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13.5 FREE CASH FLOW VALUATION APPROACHES

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13.5 FREE CASH FLOW VALUATION APPROACHES

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13.5 FREE CASH FLOW VALUATION APPROACHES

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13.5 FREE CASH FLOW VALUATION APPROACHES

Comparing Valuation Models Model values differ in practice Differences stem from simplifying assumptions

Problems with DCF Models DCF estimates are always somewhat imprecise Investors employ hierarchy of valuation

Real estate, plant, equipmentEconomic profit on assets in placeGrowth opportunities

13.6 THE AGGREGATE STOCK MARKET

Forecasting Aggregate Stock Market Earnings multiplier applied at aggregate level

Forecast corporate profits for periodDerive estimate of aggregate P/E ratio based on long-term interest rates

Some analysts use aggregate DDM

FIGURE 13.8 EARNINGS YIELD OF S&P 500 VERSUS 10-YEAR TREASURY BOND YIELD

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20100%

2%

4%

6%

8%

10%

12%

14%

16%Treasury yield

Earnings yield

TABLE 13.4 S&P 500 FORECASTS

Pessimistic Scenario

Most Likely Scenario

Optimistic Scenario

Treasury bond yield 3.6% 3.1% 2.6%

Earnings yield 6.5% 6.0% 5.5%

Resulting P/E ratio 15.4 16.7 18.2

EPS forecast 93 93 93

Forecast for S&P 500 1431 1550 1691