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Comprehensive Guide to Fundamental Analysis and Equity Valuation Models

This detailed overview explores essential models of equity valuation, including Balance Sheet Models, Dividend Discount Models, and Price/Earnings Ratios. It discusses methods for estimating growth rates, intrinsic value, and market price. The guide provides insights on trading signals and valuation approaches that can help investors gauge stock worth. Key models and assumptions, including factors affecting dividend policies and capital costs, are explained clearly, making it suitable for both novice and experienced investors looking to enhance their analysis skills.

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Comprehensive Guide to Fundamental Analysis and Equity Valuation Models

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  1. Security Analysis Part I

  2. Fundamental Analysis: 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 (DDM):General Model V0 = Value of Stock Dt = Dividend k = required return

  5. Special Cases • No growth: Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock • Example EPS1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33

  6. Constant Growth Model g = constant perpetual growth rate

  7. Constant Growth Model: Example EPS1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86

  8. Model-Building Assumptions • k > g (otherwise denominator would be negative, leading to a negative stock price) • Both k and g represent long-run averages • Ignores taxes, external financing and options • Allowing for taxes and debt financing is relatively easy • Allowing for executive stock options and warrants is more difficult

  9. Structural Changes in Cash Dividend Payments • Corporate earnings will be used for • Cash dividends paid to owners (shareholders) • Retained earnings reinvested in firm • Share buybacks to repurchase outstanding shares • Recently firms have decreased cash dividend growth rates and begun buying back stock • Examples: IBM, American Express, Coca-Cola

  10. Restating Present Value Models in Terms of Earnings • The retention ratio, or plowback ratio, b represents the portion of earnings not paid as dividends • Therefore, it is retained earnings • The payout ratio is (1 –b) • Thus, a firm’s dividend can be rewritten as • Dt = (1 – b)*EPSt • A firm can use retained earnings to either repurchase shares or to reinvest and earn the firm’s ROE • Reinvested earnings can finance internal growth at a periodic rate of g = b*ROE • Therefore, EPSt = EPS0 * (1+g)t = EPS0 [1 + b*(ROE)]t

  11. Restating Present Value Models in Terms of Earnings • Profitable firms can earn ROE > 0 by reinvesting RE in profitable projects or repurchasing shares • Share repurchases can increase EPS because the firm’s earnings are now spread out over fewer shares (called reverse dilution) • If the b>0, then the following equations are equivalent • Dt = (1 – b) EPSt • Dt = (1 – b) (1 + g)t EPS0 • Dt = (1 – b) [1 + b*(ROE)]t EPS0

  12. Reformulated Present Value Model • Substituting the basic discounted dividend model • If D1 is replaced with EPS1 (1 – b) in the constant DDM, we obtain: • This allows us the ability to examine how dividend policy impacts share value • Dividend policy is reflected in the retention rate b

  13. Dividend Policy Irrelevance • Since g = b*(ROE) • If a firm has an ROE on new investments equal to the risk-adjusted discount rate then • Thus, regardless of a firm’s initial EPS or riskiness, the firm’s value is unaffected by dividend policy, as RR is no longer in the equation • So, when ROE = k dividend policy is irrelevant

  14. Dividend Policy and Growth Firms • The relationship between a firm’s ROE and its discount rate determine the impact of dividend policy on firm value • A firm earning an ROE > discount rate is considered a growth firm • Declining firms have ROE below the discount rate, or ROE < k • When ROE = k dividend policy is irrelevant

  15. Example • Assume a firm has • An ROE of 15% • A discount rate, k, of 15% • A retention rate b of 66.67% • Leads to a growth rate of 0.6667 x .15 = 10% • Cash dividends growth rate of 10% • If these assumptions hold, the firm’s value will remain a constant $50 (in present value terms)

  16. Example

  17. 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

  18. Partitioning Value: Growth and No Growth Components PVGO = Present Value of Growth Opportunities E1 = Earnings per share for period 1

  19. Partitioning Value: Example ROE = 20% d = 60% b = 40% EPS1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8%

  20. Partitioning Value: Example (cont’d) Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities

  21. Two Stages of Growth DDM • A firm’s common stock may have one of the following growth patters in dividends • Two stages of positive growth (g1 and g2) • One constant positive growth rate • Zero growth • One constant negative growth rate

  22. Example • Battel Corporation has the following attributes: • Paid an annual dividend of $2 per share • Cost of equity capital is 10% • Cash dividends are growing at 2% annually • What is Battel’s stock worth?

  23. Example • Battel is now considering international expansion with the following adjustments • Same dividend as above, but now the expected growth rate is 4%, not 2%, and the increased risk is expected to increase the cost of equity to 11% • Battel’s value should increase to:

  24. Example • Example • Initial stock price: $25.50 • With international expansion: $29.71 • What if the international expansion caused Battel's growth rate to rise to 4% for only four years and then the growth rate dropped to the original estimate of 2% forever? • If the exposure to international risks increases Battel’s cost of equity to 11% permanently

  25. DDM Criticism • Critics argue that it is too difficult to accurately forecast future cash dividends • This criticism is true for some firms but not others • Example: Coca-Cola’s dividend payment is relatively easy to forecast even though its operations cover over 200 different countries • Critics then argue that, even if earlier dividends are relatively easy to forecast, longer-term dividends (say 50 to 100 years from now) are more difficult to determine • These long-range forecasts are unimportant

  26. DDM Criticism • Because the present value of these amounts are very low

  27. Implications • It is only essential to accurately forecast cash dividends for 10 years in order to use the DDM • Cash dividends in years 11-30 only need to be forecasted within  40% of their actual values • All cash dividends received from years 31 to infinity have a present value of only $1 or $2 • When a higher discount rate is used (as with smaller, riskier firms) it is only necessary to forecast dividends for a few years

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