R-B-Ch.11 Valuation - Points to Refresh

Ch. 11 Valuation

The Investment Decision Process

-Determine the required rate of return
-Evaluate the investment to determine if its market price is consistent with your required rate of return
---Estimate the value of the security based on its expected cash flows and your required rate of return
---Compare this intrinsic value to the market price to decide if you want to buy it

-If Estimated Value > Market Price, Buy
-If Estimated Value < Market Price, Don’t Buy

Theory of Valuation

The value of an asset is the present value of its expected returns

To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return

This requires estimates of:
The stream of expected returns, and
The required rate of return on the investment

Form of returns:

Earnings
Cash flows
Dividends
Interest payments
Capital gains (increases in value)

One has to estimate time pattern and growth rate of returns

Required Rate of Return is determined by(Refer Chpater 1):

1. Economy’s risk-free rate of return, plus
2. Expected rate of inflation during the holding period, plus
3. Risk premium determined by the uncertainty of returns

Approaches to the Valuation of Common Stock

Two major approaches have been developed
1. Discounted cash-flow valuation
Present value of some measure of cash flow, including dividends, operating cash flow, free cash flow and residual income

2. Relative valuation technique
Value estimated based on its price relative to significant variables, such as earnings, cash flow, book value, or sales

Dividend discount model:
Infinite constant growth model V = D1/k-g

Two period growth model or multiperiods of above-normal growth models: Discount the dividends expected during above normal growth periods and add it to the last stage normal growth value.

Assumptions of DDM:
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)

Analyst has to provide estimates that are in alignment with the above assumptions.

Relative Valuation Techniques

Value can be determined by comparing to similar stocks based on relative ratios
Relevant variables include earnings, cash flow, book value, and sales
The most popular relative valuation technique is based on price to earnings

Earnings Multiplier Model

This compares relative value of the stocks based on expected annual earnings

The price earnings (P/E) ratio, or Earnings Multiplier

= Current market price/expected annual earnings

The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio

P = D1/k-g

P/E1 = (D1/E1)/k-g

Thus, the P/E ratio is determined by
1. Expected dividend payout ratio
2. Required rate of return on the stock (k)
3. Expected growth rate of dividends (g)

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

The investor’s required rate of return must be estimated regardless of the approach selected or technique applied.

This will be used as the discount rate and also affects relative-valuation.

Three factors influence an investor’s required rate of return:
The economy’s real risk-free rate (RRFR)
The expected rate of inflation (I)
A risk premium (RP)

The Economy’s Real Risk-Free Rate

Minimum rate an investor should require
Depends on the real growth rate of the economy
(Capital invested should grow as fast as the economy)
Rate is affected for short periods by tightness or ease of credit markets

Expected Growth Rate of Dividends

Determined by
the growth of earnings
the proportion of earnings paid in dividends
In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio

Earnings growth is also affected by compounding of earnings retention
g = (Retention Rate) x (Return on Equity)

= RR x ROE


Finding historical growth rates of sales, earnings, cash flow, and dividends

Three techniques
1. arithmetic or geometric average of annual percentage changes
2. linear regression models
3. long-linear regression models
All three use time-series plot of data