Canadian Securities Ch18 PDF

CANADIAN SECURITIES MOHAMMAD SAFAVI Date: November 4, 2024| Website: safavim.com 1  Chapter 18 Equity...

CANADIAN SECURITIES MOHAMMAD SAFAVI Date: November 4, 2024| Website: safavim.com 1  Chapter 18 Equity Chapter Valuation Title Models INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON Slides Prepared by Dinesh Gajurel, Ph.D., University of New Brunswick INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited  Chapter Overview Valuation by Comparables Intrinsic Value vs Market Price Dividend Discount Models The Price-Earnings Ratio Free Cash Flow Valuation Approaches The Aggregate Stock Market INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-3  Valuation by Comparables Purpose of fundamental analysis is to identify stocks that are mispriced relative to some measure of “true” value that can be derived from observable financial data Valuation ratios are commonly used to assess the valuation of one firm compared to others in the same industry INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-4  Limitations of Book Value Shareholders are sometimes called “residual claimants” Book values are based on historical cost, while market values measure the current values of assets and liabilities Market values generally will not match historical values INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-5  Liquidation Value and Tobin’s Q Net amount that could be realized by selling the assets of a firm after paying the debt is liquidation value – Good representation of a “floor” for the stock’s price Replacement cost is the cost to replace a firm’s assets – Tobin’s q is the ratio of market value of the firm to replacement cost ▪ Trends towards 1 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-6 Table 18.1: Financial highlights for Microsoft Corporation INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-7  Intrinsic Value vs. Market Price The return on a stock is composed of dividends and capital gains or losses E (D 1 ) + E (P 1 ) − P 0  Expected HPR = E (r ) = P0 The expected HPR may be more or less than the required rate of return – Variation based on the stock’s risk INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-8  Required Return CAPM gives the required return, k:     k = r + β E  r  − r  f   M f If the stock is priced correctly, k = expected return k is the market capitalization rate INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-9 Example You expect the price of IBX stock to be $61.30 per share a year from now. Its current market price is $52, and you expect it to pay a dividend one year from now of $2.30per share. a. What are the stock's expected dividend yield, its rate of price appreciation (the capital gains yield), and the total holding-period return? b. If the stock has a beta of 1.15, the risk-free rate is 6% per year, and the expectedrate of return on the market portfolio is 14% per year, what is the required rate ofreturn on IBX stock? c. What is the intrinsic value of IBX stock, and how does it compare to the currentmarket price? INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-10 Solution a. Dividend yield = $2.30/$52 =4% Capital gains yield = (61.3-52)/52 = 18% E (D 1 ) + E (P 1 ) − P 0  Total return = 4% + 18% = 22% Expected HPR = E (r ) = P0 b. k = 6% + 1.15 (14% - 6%) = 15.2% c. Vo =($2.30+$61.3)/1.152 = $55.21 which exceeds the market price. This would indicate a "buy" opportunity. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-11  Intrinsic Value and Market Price The intrinsic value (IV) is the “true” value, according to a model The market value (MV) is the consensus value of all market participants Trading Signal: ▪ IV > MV → Buy ▪ IV < MV → Sell ▪ IV = MV → Hold INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-12  Dividend Discount Models (DDM) D1 D2 D3 V0 = + + + 1 + k (1 + k )2 (1 + k )3 V0 = current value Dt = dividend at time t k = required rate of return DDM says V0 = the present value of all expected future dividends into perpetuity INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-13  Constant Growth DDM D0 (1 + g ) D1 V0 = = k-g k-g V0 = current value Dt = dividend at time t k = appropriate risk-adjusted interest rate g = dividend growth rate INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-14  Constant Growth DDM: Example A stock just paid an annual dividend of $3/share Dividend is expected to grow at 8% indefinitely Market capitalization rate is 14% D1 $3.24 V0 = = = $54 k - g.14 −.08 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-15 Example Deployment Specialists pays a current (annual) dividend of $1.00 and is expected to grow at 20% for 2 years and then at 4% thereafter. If the required return for Deployment Specialists is 8.5%, what is the intrinsic value of its stock? (Do not round intermediate calculations. Round your answer to 2 decimal places.) INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-16 Example Jand, Inc., currently pays a dividend of $1.22, which is expected to grow indefinitely at 5%. If the current value of Jand’s shares based on the constant-growth dividend discount model is $32.03, what is the required rate of return? (Do not round intermediate calculations. Enter your answer as a percentage rounded to the nearest whole number.) Rate of Return = 9 ± 0.01% INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-17  Preferred Stock and the DDM No growth case (fixed dividends) Value a preferred stock paying a fixed dividend of $2 per share when the discount rate is 8%: $2 V0 = = $25 0.08 − 0 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-18  DDM Implications The constant-growth rate DDM implies that a stock’s value will be greater: 1. The larger its expected dividend per share 2. The lower the market capitalization rate, k 3. The higher the expected growth rate of dividends The stock price is expected to grow at the same rate as dividends D0 (1 + g ) D1 V0 = = k-g k-g INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-19 Example A firm pays a current dividend of $1.00 which is expected to grow at a rate of 5% indefinitely. If current value of the firm’s shares is $35.00, what is the required return based on the constant-growth dividend discount model (DDM)? Gordon DDM = 8% INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-20 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-21 Discounted Cash Flow (DCF) Formula DCF formula often used in rate hearings for regulated public utilities Focus on “fair” profit INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-22 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-23 Dividend Growth for Two Earnings Reinvestment Policies Long-Term Shareholder Value: o The takeaway is that higher reinvestment strategies can lead to greater long-term dividends, even if shareholders receive smaller dividends in the short term. This is a key trade-off between immediate cash payouts and future value appreciation through reinvestment. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-24  Present Value of Growth Opportunities Present value of growth opportunities (PVGO) is the net present value of a firm’s future investments The value of the firm is the sum of the following: – Value of assets already in place (no-growth value) – Net present value of the future investments the firm will make, or PVGO ▪ or PVGO E1 P0 = + PVGO k INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-25  E1 P0 = + PVGO k In this formula for the Present Value of Growth Opportunities (PVGO), E1 represents the expected earnings of the stock for the next period (typically one year from now). P0: The current price of the stock. E1: Expected earnings for the next period. k: Required rate of return (often derived from CAPM). PVGO: Present Value of Growth Opportunities, representing the portion of the stock’s current price that is attributed to future growth potential. This formula shows that the current stock price (P0) consists of two components: the earnings from current operations (i.e., E1/k) and the value investors place on future growth opportunities (PVGO). INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-26 Example Tri-coat Paints have a current market value of $41 per share with earnings of $3.64. What is the present value of its growth opportunities (PVGO) if the required return is 9%? (Do not round intermediate calculations. Round your answer to 2 decimal places.) PVGO = $0.56 ± 0.01 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-27  Life Cycles and Multistage Growth Models Firms typically pass through life cycles with very different dividend profiles Early years: – Ample opportunities for profitable reinvestment in the company – Payout ratios are low – Growth is correspondingly rapid Later years: – Attractive opportunities for reinvestment may become harder to find; production capacity is enough to meet market demand – More competition; firms choose to higher dividend payout ratio INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-28 Financial Ratios in Two Industries INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-29  Present Value of Growth Opportunities The ratio of PVGO to E/k is equivalent to the component of firm value due to growth opportunities to the value reflecting assets already in place – When PVGO = 0, P0 = E1/k , its like a perpetuity. – As PVGO becomes an increasingly dominant contributor to price, the P/E ratio can rise dramatically – P/E ratio reflects the market’s optimism concerning a firm’s growth prospects INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-30  Present Value of Growth Opportunities (continued) P/E increases: – As ROE increases – As plowback, b, increases, if ROE > k – As plowback decreases, if ROE < k P0 1− b – As k decreases = E1 k − ROE x b The plowback ratio (also known as the retention ratio), represented by b in the formula, is the portion of a company's earnings that is retained and reinvested in the business rather than paid out as dividends to shareholders. It can be calculated as: b=1−Dividend Payout Ratio INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-31 Effect of ROE and Plowback on Growth and the P/E Ratio INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-32  P/E and Growth Rate Wall Street rule of thumb suggests the growth rate ought to be roughly equal to the P/E ratio “If 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.” Peter Lynch in One Up on Wall Street INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-33  P/E Ratios and Stock Risk Holding all else equal, riskier stocks will have lower P/E multiples Riskier firms will have higher required rates of return, that is, higher values of k, which means the P/E multiple will be lower P 1− b = E k−g INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-34  Pitfalls in P/E Analysis Denominator in the P/E ratio is accounting earnings, which are influenced somewhat by arbitrary accounting rules – Historical costs – May not reflect economic earnings – Earnings Management – Choices on GAAP Inflation Reported earnings fluctuate around the business cycle INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-35  P/E Ratios of the S&P 500 Index and Inflation INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-36 Earnings Growth for Two Companies INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-37 P/E Ratios for Two Companies INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-38 P/E Ratios for Different Industries INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-39  CAPE Models Cyclically adjusted P/E ratio – Shiller suggests a “cyclically adjusted” P/E ratio (CAPE) to avoid the problems associated with using P/E ratios over different phases of the business cycle – Idea is to divide the stock price by an estimate of sustainable long-term earnings rather than current earnings ▪ Proposed using average inflation-adjusted earnings over an extended period, such as 10 years INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-40 Other Comparative Valuation Ratios Price-to-book ratio – Ratio of price per share divided by book value per share Price-to-cash-flow ratio – Cash flow is less affected by accounting decisions than are earnings – Ratio of price to cash flow per share Price-to-sales ratio – Useful for start-up firms that do not have earnings – Ratio of stock price to the annual sales per share INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-41 Market Valuation Statistics INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-42 Free Cash Flow To the Firm Approach (FCFF) 1. Discount the FCFF at the weighted-average cost of capital to find the value of entire firm – Free cash flow to the firm, FCFF, is the after- tax cash flow generated by the firm’s operations, net of investments in fixed as well as working capital 2. Subtracting the value of debt results in the value of equity FCFF = EBIT × 1 − t𝑐 + Depreciation − Cap. Exp. −ΔNWC INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-43 Example Eagle Products’ EBIT is $300, its tax rate is 21%, depreciation is $20, capital expenditures are $60, and the planned increase in net working capital is $30. What is the free cash flow to the firm? (Round your answer to 1 decimal place.) FCFF = (EBIT − Dep) × (1 − t) + Dep − Cap − ΔNWC = ($300 − $20) × (0.79) + $20 − $60 − $30 = $151.2 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-44  Free Cash Flow To the Firm Approach (continued) Value of the Firm: T FCFFt Vt Firm Value =  (1 + WACC ) t =1 t + (1 + WACC )T Where FCFFT + 1 Vt = WACC − g This formula represents the valuation of a firm's total value using the Discounted Cash Flow (DCF) approach. Specifically, it calculates the Firm Value by discounting the Free Cash Flows to the Firm (FCFF) and the terminal value at the Weighted Average Cost of Capital (WACC). INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-45  T FCFFt Vt Firm Value =  (1 + WACC ) t =1 t + (1 + WACC ) T 1. Firm Value: The total value of the firm, including both debt and equity. 2. FCFF (Free Cash Flow to the Firm): This is the cash flow generated by the firm after accounting for operating expenses and capital expenditures, but before paying interest and principal on debt. It represents the cash flow available to all of the firm's capital providers. 3. WACC (Weighted Average Cost of Capital): This is the required rate of return that reflects the firm's cost of capital from all sources (equity, debt, etc.), weighted by the proportion of each source in the firm’s capital structure. 4. TTT: The forecast period, or the time horizon over which the FCFF is projected. 5. VTV_TVT: The terminal value at the end of the forecast period, which estimates the value of the firm's cash flows beyond the forecast period. It’s often calculated based on the assumption of a stable growth rate. The formula works as follows: 𝐹𝐶𝐹𝐹𝑡 The first term σ𝑇𝑡=1 represents the present value of the projected FCFF over the (1+𝑊𝐴𝐶𝐶)𝑡 forecast period. 𝑉𝑡 The second term is the present value of the terminal value, which captures the (1+𝑊𝐴𝐶𝐶)𝑡 firm's value at the end of the forecast period, assuming the business will continue indefinitely. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-46  Free Cash Flow to Equityholders (FCFE) Alternative approach is to focus on FCFE, discounting those directly at the cost of equity to obtain the market value of equity Free cash flow to equityholders, FCFE – Differs from FCFF by after-tax expenditures, as well as by cash flow associated with net issuance or repurchase of debt FCFE = FCFF − Interest × 1 − t𝑐 + ΔDebt INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-47  Free Cash Flow to Equityholders (continued) Intrinsic Value of Equity: T FCFE t ET Intrinsic Value of Equity =  (1 + k ) t =1 t + (1 + k E )T E Where FCFE T +1 ET = kE − g INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-48  Comparing the Valuation Models In practice – Values from these models may differ – Analysts are always forced to make simplifying assumptions Problems with DCF – Calculations are sensitive to small changes in inputs – Growth opportunities and growth rates are hard to pin down INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-49 Comparing the Valuation Models, Rio Tinto INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-50  The Aggregate Stock Market Most popular approach to valuing the overall stock market is the earnings multiplier approach applied at the aggregate level Some analysts use aggregate version of DDM rather than an earnings multiplier approach S&P 500 taken as leading economic indicator INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-51  Earnings Yield, S&P 500 vs 10-Year Treasury Bond INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-52 S&P 500 Price Forecasts Under Various Scenarios INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-53  Summary One approach to firm valuation is to focus on the firm’s book value. Another approach is to focus on the present value of expected future dividends. The dividend discount model holds that the price of a share of stock should equal the present value of all future dividends per share, discounted at an interest rate commensurate with the risk of the stock. Dividend discount models give estimates of the intrinsic value of a stock. The constant-growth dividend discount model is best suited for firms that are expected to exhibit stable growth rates over the foreseeable future. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-54  Summary The P/E ratio is a useful measure of the market’s assessment of the firm’s growth opportunities. The expected growth rate of earnings is related both to the firm’s expected profitability and to its dividend policy. Any DDM can be related to a simple capitalized earnings model by comparing the expected ROE on future investments to the market capitalization rate. The free cash flow approach is the one used most of- ten in corporate finance. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 18-55