Chapter 03
An Introduction to Security
Valuation
Content
• The specifics and logic of the top-down (three-step)
approach
• Valuing an asset
• Discounted Cash Flow Techniques
• Relative Valuation Techniques
Valuation Process
• Two approaches
– 1. Top-down, three-step approach
– 2. Bottom-up, stock valuation, stock picking
approach
• The difference between the two approaches
is the perceived importance of economic
and industry influence on individual firms
and stocks
Top-Down, Three-Step Approach
1. General economic influences
– Decide how to allocate investment funds among
countries, and within countries to bonds, stocks, and
cash
2. Industry influences
– Determine which industries will prosper and which
industries will suffer on a global basis and within
countries
3. Company analysis
– Determine which companies in the selected industries
will prosper and which stocks are undervalued
Does the Three-Step Process
Work?
• Studies indicate that most changes in an individual
firm’s earnings can be attributed to changes in aggregate
corporate earnings and changes in the firm’s industry
• Studies have found a relationship between aggregate
stock prices and various economic series such as
employment, income, or production
• An analysis of the relationship between rates of return
for the aggregate stock market, alternative industries,
and individual stocks showed that most of the changes
in rates of return for individual stock could be explained
by changes in the rates of return for the aggregate stock
market and the stock’s industry
Theory of Valuation
• The value of an asset is the present value of its expected
returns
• You expect an asset to provide a stream of returns while
you own it
• To convert this stream of returns to a value for the
security, you must discount this stream at your required
rate of return
• This requires estimates of:
– The stream of expected returns, and
– The required rate of return on the investment
Stream of Expected Returns
• Form of returns
– Earnings
– Cash flows
– Dividends
– Interest payments
– Capital gains (increases in value)
• Time pattern and growth rate of returns
Required Rate of Return
• Determined by
– 1. Economy’s risk-free rate of return, plus
– 2. Expected rate of inflation during the holding
period, plus
– 3. Risk premium determined by the uncertainty
of returns
Investment Decision Process: A
Comparison of Estimated Values and
Market Prices
If Estimated Value > Market Price, Buy
If Estimated Value < Market Price, Don’t Buy
Approaches to the
Valuation of Common Stock
Two approaches have developed
1. Discounted cash-flow valuation
• Present value of some measure of cash flow,
including dividends, operating cash flow, and free
cash flow
2. Relative valuation technique
• Value estimated based on its price relative to
significant variables, such as earnings, cash flow,
book value, or sales
Approaches to the
Valuation of Common Stock
The discounted cash flow approaches are dependent on some factors,
namely:
• The rate of growth and the duration of growth of the cash flows
• The estimate of the discount rate
• The measure of cash flow used
– Dividends
• Cost of equity as the discount rate
– Operating cash flow
• Weighted Average Cost of Capital (WACC)
– Free cash flow to equity
• Cost of equity
• Dependent on growth rates and discount rate
Why and When to Use the
Relative Valuation Techniques
• Provides information about how the market
is currently valuing stocks
– aggregate market
– alternative industries
– individual stocks within industries
• No guidance as to whether valuations are
appropriate
– best used when have comparable entities
– aggregate market is not at a valuation extreme
Valuation Approaches
and Specific Techniques
Approaches to Equity Valuation
Figure 13.2
Discounted Cash Flow Relative Valuation
Techniques Techniques
• Present Value of Dividends (DDM) • Price/Earnings Ratio (PE)
•Present Value of Operating Cash Flow •Price/Cash flow ratio (P/CF)
•Present Value of Free Cash Flow •Price/Book Value Ratio (P/BV)
•Price/Sales Ratio (P/S)
The Dividend Discount Model
(DDM)
The value of a share of common stock is the
present value of all future dividends
Where:
Vj = value of common stock j
Dt = dividend during time period t
k = required rate of return on stock j
The Dividend Discount Model
(DDM)
If the stock is not held for an infinite period, a
sale at the end of year 2 would imply:
The Dividend Discount Model
(DDM)
If the stock is not held for an infinite period, a
sale at the end of year 2 would imply:
Selling price at the end of year two is the
value of all remaining dividend payments,
which is simply an extension of the original
equation
The Dividend Discount Model
(DDM)
Infinite period model assumes a constant
growth rate for estimating future dividends
Where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k = required rate of return on stock j
n = the number of periods, which we assume to be infinite
The Dividend Discount Model
(DDM)
Infinite period model assumes a constant
growth rate for estimating future dividends
This can be reduced to:
The Dividend Discount Model
(DDM)
Infinite period model assumes a constant
growth rate for estimating future dividends
This can be reduced to:
1. Estimate the required rate of return (k)
The Dividend Discount Model
(DDM)
Infinite period model assumes a constant
growth rate for estimating future dividends
This can be reduced to:
1. Estimate the required rate of return (k)
2. Estimate the dividend growth rate (g)
Infinite Period DDM
and Growth Companies
Assumptions of DDM:
1. Dividends grow at a constant rate
2. The constant growth rate will continue for
an infinite period
3. The required rate of return (k) is greater
than the infinite growth rate (g)
Valuation with Temporary
Supernormal Growth
Combine the models to evaluate the years of
supernormal growth and then use DDM to
compute the remaining years at a
sustainable rate
For example:
With a 14 percent required rate of return
and dividend growth of:
Valuation with Temporary
Supernormal Growth
Dividend
Year Growth Rate
1-3: 25%
4-6: 20%
7-9: 15%
10 on: 9%
Earnings Multiplier Model
• This values the stock based on expected annual earnings
• The price earnings (P/E) ratio, or
Earnings Multiplier
the P/E ratio is determined by
1. Expected dividend payout ratio
2. Required rate of return on the stock (k)
3. Expected growth rate of dividends (g)
Earnings Multiplier Model
As an example, assume:
– Dividend payout = 50%
– Required return = 12%
– Expected growth = 8%
– D/E = .50; k = .12; g=.08
The Price-Book Value Ratio
Widely used to measure bank values (most bank assets are
liquid (bonds and commercial loans)
Fama and French study indicated inverse relationship
between P/BV ratios and excess return for a cross
section of stocks
Where:
P/BVj = the price/book value for firm j
Pt = the end of year stock price for firm j
BVt+1 = the estimated end of year book value per share for
firm j
The Price-Sales Ratio
• Strong, consistent growth rate is a requirement of a
growth company
• Sales is subject to less manipulation than other financial
data
The Price-Sales Ratio
• Match the stock price with recent annual
sales, or future sales per share
• This ratio varies dramatically by industry
• Profit margins also vary by industry
• Relative comparisons using P/S ratio should
be between firms in similar industries
Estimating the Inputs: The Required Rate
of Return and The Expected Growth Rate
of Valuation Variables
Valuation procedure is the same for securities
around the world, but the required rate of return
(k) and expected growth rate of earnings and other
valuation variables (g) such as book value, cash
flow, and dividends differ among countries
Required Rate of Return (k)
The investor’s required rate of return must
be estimated regardless of the approach
selected or technique applied
• This will be used as the discount rate and also
affects relative-valuation
• This is not used for present value of free cash flow
which uses the required rate of return on equity
(K)
• It is also not used in present value of operating
cash flow which uses WACC
Required Rate of Return (k)
Three factors influence an investor’s
required rate of return:
• The economy’s real risk-free rate (RRFR)
• The expected rate of inflation (I)
• A risk premium (RP)
