Investment Past Paper PDF - Equity Valuation Models, Lecture 2

MN-2066: Investments: Assets; Equities and Bonds Equity Valuation Models Lecture 2 Rongxin Chen [email protected] 1 Learning Objectives Understand the role of a security’s intrinsic value...

MN-2066: Investments: Assets; Equities and Bonds Equity Valuation Models Lecture 2 Rongxin Chen [email protected] 1 Learning Objectives Understand the role of a security’s intrinsic value in the context of fundamental analysis. Be able to evaluate a firm using the appropriate dividend discount model (DDM) and the Price/Earnings (P/E) ratio. 2 Fundamental Analysis Definition: Analysing a company’s value by accessing its current and future profitability. Purpose: To identify mispriced stocks. Steps: 1. Measure the “true” (or intrinsic value) using financial data. 2. Compare the market price with intrinsic value. 3 Fundamental Analysis Balance Sheet Models o Book value per share, liquidation value per share, etc. Holding-Period Return (HPR) Dividend Discount Models (DDM) Free Cash Flow Models 4 Holding-Period Return (HPR) Expected HPR = Expected Dividend + Expected price appreciation One-year expected HPR: 𝐸 𝐷! + [𝐸 𝑃! − 𝑃" ] 𝐸 𝑟 = 𝑃" 5 Holding-Period Return: Required Return Capital Asset Pricing Model (CAPM) gives the required rate of return (𝑘): 𝑘 = 𝑟# + 𝛽[𝐸 𝑟$ − 𝑟# ] o 𝑟! = Risk-free rate; o 𝛽 = Beta of the investment; o 𝐸 𝑟" = Expected return of the market. 6 Holding-Period Return: Trading Signal Holding-Period Return > Required Rate of Return è Underpriced è Buy Holding-Period Return < Required Rate of Return è Overpriced è Sell or Short Sell 7 Example Q1: Stock ABC has an expected dividend per share of $4, the current price of a share is $48, and the expected price at the end of year is $52. What is the 1-year HPR of stock ABC? 8 Example Q2: Suppose that the risk-free rate is 6%, the market risk premium is 5%, and the beta of ABC is 1.2, what is the required rate of return of Stock ABC? 9 Example Q3: Based on what you calculated in Q1&2, would you recommend buying or selling Stock ABC? 10 Dividend Discount Models (DDM) Intrinsic Value (V): The sum of present value of dividends and the expected price: 𝐷" + 𝑃" 𝑉! = 1+𝑘 How to estimate 𝑷𝟏 ? 𝐷# + 𝑃# 𝑃" = 𝑉" = 1+𝑘 So that: 𝐷" 𝐷# + 𝑃# 𝑉! = + 1 + 𝑘 (1 + 𝑘)# 11 Dividend Discount Models (DDM) For a holding period of H years: 𝐷# 𝐷$ 𝐷% + 𝑃% 𝑉" = + $ + …+ 1 + 𝑘 (1 + 𝑘) (1 + 𝑘)% If continue to substitute for price indefinitely: 𝐷# 𝐷$ 𝐷& 𝑉" = + $ + & + … 1 + 𝑘 (1 + 𝑘) (1 + 𝑘) 12 Dividend Discount Models (DDM) The stock price should be the present value of all expected future dividends. Capital gains should be ignored? o Not necessary. o Key assumption of DDM: Any capital gains will be reflected in the future dividends. o One of the limitations of DDM. 13 Constant Growth DDM Assume that dividends are trending upward at a stable growth rate (𝑔). DDM becomes: 𝐷" (1 + 𝑔) 𝐷" (1 + 𝑔)# 𝐷" (1 + 𝑔)$ 𝑉" = + # + $ + … 1+𝑘 (1 + 𝑘) (1 + 𝑘) And the equation can be simplified to: 𝐷" (1 + 𝑔) 𝐷% 𝑉" = = 𝑘−𝑔 𝑘−𝑔 o N.B. The stock price is expected to grow at the same rate as dividends. 14 Example Q: A stock just paid an annual dividend of $3 per share. The dividend is expected to grow at 8% indefinitely, and the market capitalization rate (from CAPM) is 14%. What is the intrinsic value of the stock based on DDM? 15 Constant Growth DDM What if there is no growth? o Dividends of stocks are expected to remain constant. § E.g., Preferred Stock o No Growth Model: 𝐷- 𝑉, = 𝑘 16 Example Q: Value a preferred stock paying a fixed dividend of $2 per share when the discount rate is 8%. 17 Constant Growth DDM Estimating the Dividend Growth Rate (𝑔) 𝑔 = 𝑅𝑂𝐸 × 𝑏 o 𝑔 = Sustainable Growth Rate on dividends o 𝑅𝑂𝐸 = Return on Equity o 𝑏 = Plowback Ratio (aka. Earning Retention Ratio) § 𝑏 = 1 – Dividend Payout Ratio 18 Constant Growth DDM Derivation: 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑔= 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑇𝑜𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = × 𝑇𝑜𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 = 𝑏 × 𝑅𝑂𝐸 19 Present Value of Growth Opportunities (PVGO) The value of a firm includes two parts: 1. No-growth value of the firm: The value of the assets in place. 2. PVGO: The net present value of future investment opportunities. 𝐸! 𝑃" = + 𝑃𝑉𝐺𝑂 𝑘 20 Example A firm reinvests 60% of its earnings in projects with ROE of 10%, capitalization rate is 15%. Expected year-end dividend is $2/share, paid out of earnings of $5/share. o At what price will the stock sell? o What is the present value of growth opportunities? o Why would such a firm be a takeover target for another firm? 21 Valuation by Comparable Valuation ratios: Used to assess the valuation of one firm compared to others in the same industry. o Price-to-earnings (P/E) ratio o Price-to-book ratio o Price-to-cash-flow ratio … 22 Price-to-Earnings (P/E) Ratio P/E Ratios and Growth P/E Ratios and Stock Risk Pitfalls in P/E Analysis 23 P/E Ratio and Growth Definition: The ratio of price per share to earnings per share. A useful indicator of expectations of growth opportunities. 𝑃, 1 𝑃𝑉𝐺𝑂 = (1 + ) 𝐸- 𝑘 𝐸/𝑘 o PVGO = 0 è 𝑃! = 𝐸"/𝑘: Non-growing perpetuity of 𝐸" o PVGO increases è P/E increases dramatically o High P/E è Ample growth opportunities 24 P/E Ratio and Growth Another view: 𝐷! 𝐸! (1 − 𝑏) 𝑃" 1−𝑏 𝑃" = = è = 𝑘 − 𝑔 𝑘 − 𝑅𝑂𝐸×𝑏 𝐸! 𝑘 − 𝑅𝑂𝐸×𝑏 o ROE increases è P/E increases o Plowback (𝑏) increases è P/E increases § Condition: ROE > 𝑘 25 P/E Ratio and Growth 26 N.B. Assumption: 𝑘 = 12% per year. P/E Ratio and Stock Risk P/E ratio in the context of the constant-growth model: 𝑃 1−𝑏 = 𝐸 𝑘−𝑔 o Firms’ risk is higher (𝛽) è Required Rate (𝑘) becomes higher è P/E is lower 27 Pitfalls in P/E Analysis Use of accounting earnings (cf. economic earnings) o Arbitrary accounting rules: § E.g., historical costs depreciation, inventory costs, etc. Inflation Reported earnings fluctuate around the business cycle 28 P/E Ratio of S&P 500 and Inflation rate Figure 18.3 P/E ratio of the S&P 500 versus inflation rate, 1955-2020. 29 P/E Ratios for different industries Figure 18.6 Forward P/E ratios for different industries Source: Web site of Prof. Aswath Damodaran, August 19, 2021. 30 Comparing the Valuation Models In practice: o (Estimated) Values from these models may differ. o Analysts are always forced to make simplifying assumptions: § The constant-growth stage § Depreciation method § Estimate of ROE … 31