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Comprehensive Guide to Equity Valuation Models: Techniques and Insights

This chapter provides an in-depth analysis of various equity valuation models used to determine a stock's intrinsic value. It covers fundamental models, including Balance Sheet Models, Dividend Discount Models, and Price/Earning Ratios, emphasizing how to estimate growth rates and assess market price. Key concepts such as the Dividend Growth Model, the Importance of Return on Equity, and the impact of inflation on equity valuation are explored. Understand trading signals and learn to navigate the complexities of valuation methodologies for informed investment decisions.

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Comprehensive Guide to Equity Valuation Models: Techniques and Insights

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  1. Equity Valuation Models Chapter 18

  2. Models of Equity Valuation • Basic Types of Models • Balance Sheet Models • Dividend Discount Models • Price/Earning Ratios • Estimating Growth Rates and Opportunities

  3. Intrinsic Value and Market Price • Intrinsic Value • Self assigned Value • Variety of models are used for estimation • Market Price • Consensus value of all potential traders • Trading Signal • IV > MP Buy • IV < MP Sell or Short Sell • IV = MP Hold or Fairly Priced

  4. Dividend Discount Models: General Model V0 = Value of Stock Dt = Dividend k = required return

  5. No Growth Model Stocks that have earnings and dividends that are expected to remain constant. Preferred Stock

  6. No Growth Model: Example E1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33

  7. Constant Growth Model g = constant perpetual growth rate

  8. Constant Growth Model: Example E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86

  9. Estimating Dividend Growth Rates g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1- dividend payout percentage rate)

  10. Specified Holding Period Model PN = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held

  11. Growth & No Growth Components of Value PVGO = Present Value of Growth Opportunities E1 = Earnings Per Share for period 1

  12. Partitioning Value: Example ROE = 20% d = 60% b = 40% E1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8%

  13. Partitioning Value: Example Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities

  14. Price Earnings Ratios • P/E Ratios are a function of two factors • Required Rates of Return (k) • Expected growth in Dividends • Uses • Relative valuation • Extensive Use in industry

  15. P/E Ratio: No Expected Growth • E1 - expected earnings for next year • E1 is equal to D1 under no growth • k - required rate of return

  16. P/E Ratio with Constant Growth b = retention ratio ROE = Return on Equity

  17. Numerical Example: No Growth E0 = $2.50 g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8

  18. Numerical Example with Growth b = 60% ROE = 15% (1-b) = 40% E1 = $2.50 (1 + (.6)(.15)) = $2.73 D1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P0 = 1.09/(.125-.09) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 - .60) / (.125 - .09) = 11.4

  19. Pitfalls in P/E Analysis • Use of accounting earnings • Historical costs • May not reflect economic earnings • Reported earnings fluctuate around the business cycle.

  20. Other Valuation Ratios • Price-to-Book • Price-to-Cash Flow • Price-to-Sales

  21. Inflation and Equity Valuation • Inflation has an impact on equity valuations. • Historical costs underestimate economic costs. • Empirical research shows that inflation has an adverse effect on equity values. • Research shows that real rates of return are lower with high rates of inflation.

  22. Lower Equity Values with Inflation • Shocks cause expectation of lower earnings by market participants. • Returns are viewed as being riskier with higher rates of inflation. • Real dividends are lower because of taxes.

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