Topic 8.

Equity Valuation (Chapter 13)

This topic describes the ways stock market analysts try to uncover mispriced securities
(fundamental analysis, active portfolio management).
II. Intrinsic Value Versus Market Price
Intrinsic value (V0): the present value of equityholders expected future net cash flows,
including all the dividends and the ultimate sale price of the stock, discounted by the required
rate of return of the stock.
Suppose ABC stock has an expected dividend per share, E(D1), the current price of a share, P0,
and the expected price at the end of a year is E(P1).
T0
T1
*---------------------------------------------*
V0
E(D1), E(P1)

V0

E ( D1 ) E ( P1 )
1 k

V0 > P0
V0 < P0

undervalued
overvalued

Required CAPM return (market capitalization rate)

k E ( ri ) rf i ( E (rM ) rf )

Example
You expect the price of IBX stock to be $59.77 per share a year from now. Its current market
price is $50, and you expect it to pay a dividend one year from now of $2.15 per share.
a. What is your expected HPR on IBX stock?
b. If the stock has a beta of 1.15, the risk-free rate is 6% per year, and the expected market
return is 14% per year, what is the required rate of return on IBX stock?
c. What is the intrinsic value of IBX stock, and how does it compare to the current market
price?

III. Dividend Discount Models

Stock intrinsic value equals the present value of all expected future dividends into perpetuity

V0

D3
D1
D2

.......
2
1 k (1 k )
(1 k )3

1. The constant growth DDM

We assume that dividends are trending upward at a stable growth rate of g.
D1=D0(1+g)
D2=D1(1+g)=D0(1+g)2
D3=D2(1+g)=D0(1+g)3..
The intrinsic value can be written as
D0 (1 g ) D0 (1 g ) 2 D0 (1 g ) 3
V0

.......
1 k
(1 k ) 2
(1 k ) 3
This equation can be simplified to
D (1 g )
D1
V0 0

kg
kg
Examples
(1) A preferred stock pays a fixed dividend of $2 per share and the discount rate is 8%. What
is the intrinsic value of the preferred stock?

(2)

High Flyer Industries just paid its annual dividend of $3 per share. The dividend
is expected to grow at a constant rate of 8% indefinitely. The required rate of return
according to High Flyers risk is 14%. What is the intrinsic value of the stock?

The constant growth DDM suggests that a stocks value will be greater:
(1) The larger its expected dividend per share.
(2) The lower the required rate of return.
(3) The higher the expected growth rate of dividend.
The stock value is expected to grow at the same rate (g) as dividends, V1 V0( 1 g )
E (r) =

D1
g = Dividend yield + Capital gains.
P0

Example:
a. IBXs stock dividend at the end of this year is expected to be $2.15, and it is expected to
grow at 11.2% per year forever. If the required rate of return on IBX stock is 15.2% per year,
what is its intrinsic value?
b. If IBXs current market price is equal to this intrinsic value, what is next years expected
price?
c. If an investor were to buy IBX stock now and sell it after receiving the $2.15 dividend a year
from now, what is the expected holding-period return?

2. Stock Prices and Investment Opportunities

Consider two companies, Cash Cow and Growth Prospects, each with expected earnings in the
coming year of $5 per share. Both companies pay out all of these earnings as dividends,
maintaining a perpetual dividend flow of $5 per share. If the required rate of return for both
companies are k=12.5%, both companies will be valued at $_______ per share.

Now suppose Growth Prospects changes its dividend policy: pay out 40% of its earnings as
dividend, and reinvest the rest in the company, plowback ratio (b)=60%, ROE=15%. What
happens with its stock price after Growth Prospects changes dividend policy?
Plowback ratio (b): the fraction of earnings reinvested in the firm, also called earnings retention
ratio. (E-D)/E
Dividend payout ratio: the fraction of earnings paid out as dividends. D/E

Present value of growth opportunities (PVGO):

PVGO
= Growth value (retain earnings) No-growth value (not retain earnings)
= Growth value (retain earnings)

E1
k

Lets consider another company, Cash Cow:

ROE=12.5%, k=12.5%, b=60%. What happens with its stock price?

PVGO= 0.
What if there is a third company called Takeover Target, ROE=10%, k=12.5%, b=60%, what
happens with its stock price?
3. Life Cycles and Multistage Growth Models

Firms typically pass through life cycles with very different investment opportunities.
In early years, there are ample opportunities for profitable reinvestment in the company. Payout
ratios are low.
When the firm matures, attractive opportunities for reinvestment become harder to find,
therefore, the firm may choose to increase the dividend payout ratio.

Multistage version of the dividend discount model:

Dividends in the early high-growth period are forecast and their combined present value is
calculated. Then once the firm is projected to settle down to a steady growth phase, the constant
growth DDM is applied to value the remaining stream of dividends.

Example:
Value Line provides explicit dividend forecasts for Honda Motor (HMC-ADR) over the relative
short term, with dividends rising from $0.72 in 2012 to $1 in 2015. The rapid growth rate cannot
be sustained indefinitely. Dividend forecasts of Honda are be obtained by using the explicit
forecasts for 2012-2015 and linear interpolation for the years between:

Now lets assume the dividend growth rate will be steady beyond 2015. Value Line forecasts a
(long term) dividend payout ratio of 0.25 and an ROE of 10%.
1. What is the long-term dividend growth rate?
2. Suppose we estimate that the beta of Honda is 0.90 and the risk-free rate is 2.9% and the risk
premium on the market portfolio is 8%. What is the required rate of return for Honda?
3. What is the intrinsic value of Honda in 2011?

IV. Price-Earnings Ratio and Growth Opportunity

P/E ratio might serve as a useful indicator of expectations of growth opportunities.
High P/E multiple appears to indicate that a firm is endowed with ample growth opportunities.

P0 1
PVGO
1
E1 k
E1 / k

 P/E ratio and ROE

E1 (1 b)
P0
k ( ROE b)

P0
1 b

E1 k ( ROE b)
1. P/E ratio increases with ROE. High ROE projects give the firm good opportunities for
growth.
2. P/E ratio and plowback ratio b
(i)
If ROE exceeds k, P/E ratio or stock price increases (decreases) as b increases
(decreases).
(ii)
If ROE is lower than k, P/E or stock price decreases (increases) as b increases
(decreases).
(iii)
If ROE just equals k, P/E and stock price is unaffected by the plowback ratio.

 P/E Ratio and Stock Risk

Holding everything else equal, riskier stocks will have lower P/E multiples.
P
1 b

E1 k g

Two factors affect P/E ratio:

P/E increases with growth potential, e.g., ROE.
P/E decreases with risk, beta.
What if a company does not pay dividend so we cannot use DDM?
V. Relative Valuation
The relative valuation concept is based on making comparisons to some benchmarks, e.g., the
market, an industry, or the stocks history, using P/E ratio and other ratios in order to determine
stock value.
Combining P/E analysis and the DDM
The Honda case: Value Line forecasted a P/E ratio for 2015 of 14, an EPS for 2015 of $4. What
is the intrinsic value of Honda in 2011?

PEG Ratio
P/E ratio divided by earnings growth rate, g
A common Wall Street rule of thumb:
The P/E ratio of any company that is fairly priced will equal its growth rate of earnings, i.e., the
PEG ratio should be about 1.
A lower PEG ratio (compared to the industry peers or the market) indicates that the stock is
underpriced.
Price-to-book ratio
8

 Price-to-cash flow ratio

Price-to-sales ratio

Section 13.6 is not required for reading.

Examples For Topic 8 (Chapter 13)

1.
a. Computer stocks currently provide an expected rate of return of 16%. MBI, a large
computer company, will pay a year-end dividend of $2 per share. If the stock is selling at $50
per share, what must be the markets expectation of the growth rate of MBI dividend?
b. If dividend growth forecasts for MBI are revised downward to 5% per year, what will
happen to the price of MBI stock? What (qualitatively) will happen to the companys priceearnings ratio? (Assume earnings forecast is unchanged.)

2. Explain why the following statements are true/false/uncertain.

a. Holding all else constant, a firm will have a higher P/E if its beta is higher.
b. P/E will tend to be higher when ROE is higher (assuming plowback is positive).
c. P/E will tend to be higher when the plowback rate is higher.

3. Your preliminary analysis of two stocks has yielded the information set forth below.
The market required rate for both stock A and stock B is 10% per year.
Stock A
14%
$2.00
$1.00
$27.00

Expected return on equity, ROE

Estimated earnings per share, E1
Estimated dividends per share, D1
Current market price per share, P0
a.
b.
c.
d.

Stock B
12%
$1.65
$1.00
$25.00

What are the expected dividend payout ratios for the two stocks?
What are the expected dividend growth rates of each?
What is the intrinsic value of each stock?
In which, if either, of the two stocks would you choose to invest?

CFA #7. Analyst Shaar has revised slightly her estimated earnings growth rate for Rio National
and , using normalized (underlying trend) EPS, which is adjusted for temporary impacts on
earnings, now wants to compare the current value of Rio Nationals equity to that of the industry,
on a growth-adjusted basis. Selected information about Rio National and the industry is given in
Table 13.10.

10

Table 13.10 Rio National Corp. vs. industry

Rio National
Estimated earnings growth rate
Current share price
Normalized (underlying trend) EPS for 2012
Weighted-average shares outstanding during 2012
Industry
Estimated earnings growth rate
Median price-earnings (P/E) ratio

11.00%
$25.00
$ 1.71
16,000,000
12.00%
19.90

Compared to the industry, is Rio Nationals equity overvalued or undervalued on a P/E-to-growth

(PEG) basis, using normalized (underlying) earnings per share? Assume that the risk of Rio
National is similar to the risk of the industry.

11

Answers to class examples

1.
a. P0=D1/(k-g)
k = D1/P0 + g
0.16 = 2/50 + g
g = 0.12
b. P0 = D1/ (k g) = 2/(0.16 0.05) = 18.18
The price falls in response to the more pessimistic dividend forecast. The forecast
for current earnings, however, is unchanged. Therefore, the P/E ratio must fall.
The lower P/E ratio is evidence of the diminished optimism concerning the firms
growth prospects.
2.

P
1 b

E1 k ROE * b

a. False. Higher beta means that the risk of the firm is higher and the discount rate applied to
value cash flows is higher. For any expected path of earnings and cash flows the present
value of the cash flows, and therefore, the price of the firm will be lower when risk is higher.
Thus, the ratio of price to earnings will be lower.
b. True. Higher ROE means more valuable growth opportunities.
c. Uncertain. The answer will depend on a comparison of expected rate of return on reinvested
earnings versus the market required rate. If the expected rate of return on the firms projects
is higher than the market required rate, then P/E will increase as the plowback ratio increases.
3.
bA=(2-1)/2=0.5
bB=(1.65-1)/1.65=0.394
Stock
a. Dividend payout ratio, 1-b
b. Growth rate, g = ROE * b
c. Intrinsic value, V0

D1
kg

A
0.50
7%

B
0.606
4.728%

$33.33

$18.97

d. Stock A is the one you would invest in since its intrinsic value exceeds its price. You
might want to sell short stock B.
CFA #7
Rio Nationals equity is relatively undervalued compared to the industry on a P/E-to-growth
(PEG) basis. Rio Nationals PEG ratio of 1.33 is below the industry PEG ratio of 1.66. The
lower PEG ratio is attractive because it implies that the growth rate at Rio National is available at
a relatively lower price than is the case for the industry. The PEG ratios for Rio National and the
industry are calculated below:

Rio National
12

Current price = $25.00

Normalized earnings per share = $1.71
Price-to-earnings ratio = $25/$1.71 = 14.62
Growth rate (as a percentage) = 11
PEG ratio = 14.62/11 = 1.33
Industry
Price-to-earnings ratio = 19.90
Growth rate (as a percentage) = 12
PEG ratio = 19.90/12 = 1.66

13

Three scenarios to demonstrate the impact of plowback ratio (b) on equity

valuation.
Firm Name
Expected EPS
CAPM return (k)
ROE
Assets (million)
# of shares (million)
V0 (b=0)
V0 (b=0.6)
PVGO
Implication

Growth Prospects
$5
12.5%
15%
100
3

Cash Cow
$5
12.5%
12.5%
100
2.5

$40
$40
$57.14
$40
$17.14
$0
Retaining earnings Retaining earnings
enhances (increases) has no effect on
the value of stock. the value of stock.

14

Takeover Target
$5
12.5%
10%
100
2
$40
$30.77
-$9.23
Retaining earnings
reduces (destroys)
the value of stock.