Equity

Valuation

13
1
QUESTION

A and B are listed stocks. A owns 20% of B. The market value

of that 20% of B equals 500 million. The current market of A is
only 400 million. A has positive net asset. Is it a bargain to
buy A?

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OUTCOMES

• Able to value stocks and market using

different valuation methods
• Understand the shortcomings of the
methods involved

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 13.1 EQUITY VALUATION
 Book Value (property firms: 12,16,17,101, low market
to book value: often below market value, application?)
 Net worth of common equity according to a firm’s balance
sheet
 Assets – Liabilities = net worth, can be very useful in Crisis
 Historical value!
 Limitations of Book Value

 Another measures of stock price

 Liquidation value: Net amount realized by selling assets of firm and
paying off debt
If market price drops below the liquidation value, worth
buying.
 May also be a target of takeover. Why?

 You buy the firm and then liquidate it for a higher value.

 Replacement cost: Cost to replace firm’s assets less liabilities

 Some believe if market value far above replacement cost =>
competitor enters the market
4
 Tobin’s q: Ratio of firm’s market value to replacement cost, tend
toward 1 theoretically. https://www.investopedia.com/terms/q/qratio.asp
TABLE 13.1 MICROSOFT FINANCIAL
Is it worth buying?
HIGHLIGHTS, JAN 2012
Is it an opportunity?
Price per share $28.25
Common shares outstanding (billion) 8.41
Market capitalization ($ billion) 237.6

Latest 12 Months
Sales ($ billion) 71.12
EBITDA ($ billion) 30.15
Net income ($ billion) 23.48
Earnings per share $2.75

Industry
Valuation Microsoft Avg
P/E ratio 10.3 17.5
Price/Book 4.0 10.5
Price/Sales 3.3 2.7
Price/Cash flow 13.9 20.5
PEG 1.1 1.2

Profitability
ROE (%) 44.16 24.9
ROA (%) 17.33 5
Operating profit margin (%) 38.78 8.58
Net profit margin (%) 33.01 23.2
 13.2 INTRINSIC VALUE VERSUS
MARKET PRICE
•

Covered in FM course

6
Note: we need to estimate stock intrinsic value to
determine if it is cheap to buy
 13.3 DIVIDEND DISCOUNT MODELS
• Covered in FM course

More dividend payout, good sign

Higher stock valuation if above mentioned is expected

CURRENT ISSUE.
YOU MAY TRY CATHIE WOOD’S VALUATION ON TESLA
Nio double its price in less than three weeks recently (Nov. 5, 2020)
How do we value that kinds of stocks currently losing money.

“In China’s smart EV market, we expect Nio to be a long term winner in the
premium space among Chinese brands vs. (Xpeng Inc.) XPEV, -
2.90% leading the mass market, while (BYD Co.) 1211, +1.03% should likely
see strong EV demand with rising external battery sales from 2022,” from
marketwatch.com. Its price almost triple since JP Morgan upgraded it target
price.

From the Internet, you can hear analysts, KOLs, discuss their optimism
about the stocks with lots of reasons like the size of China’s auto market, it is
not just a car manufacturer, it is also software company, it has Chinese
government supports, etc. Some have future projection of cash flows based
on market size it can earns, number of possible car sales, possible revenue
from other sectors, etc. Comparisons are also made with other EV
manufacturers. Over three thousand car makers existed in US! Basically big
three in US survived, where are they now? The futures? 8

Is it just a slack talk, or it comes with insights?

Valuation is basically based on what we learned from FM!
 13.3 DIVIDEND DISCOUNT MODELS
•

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EXAMPLE IN THE TEXT
-D1 = $5, if pay out all expected earning E1=D1, it can maintain a
perpetual dividend at this level, but no growth.
-Market capitalization rate, k, equals 12.5%

P0 = 5/0.125 = $40 (you should have learned it)

If the firm can earn 15% return for a new project, what would you do?
Not pay out all earning as dividend.
If plowback ratio = 0.6, i.e. 60% earnings retention ratio
Assume all-equities firm with plant and equipment of $100 million.
If return on investment, i.e. return on equity equals 15% => $15
million. Firm value increases by 0.6 x $15 million =$9 million or 9%
increase. Why 9%
g = ROE x b =15% x 0.6 =9%
P0= ? = D1/(k-g) = $2 /(0.125-0.09) = $57.14 assuming ROE and g
can be sustained
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P0 = E1/k + PVGO = $40 + $17.14
 13.3 DIVIDEND DISCOUNT MODELS
 Dividend discount model needs to be adjusted to fit into
the life cycle of stocks as firms may be in the
steady/mature stage.
 Two-stage or multi-stage growth model allowing
dividends to grow at several rates as firm
matures
 DDM in which dividend growth assumed to level
off only at future date (still remember what we
covered in financial management?)

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 13.4 PRICE-EARNINGS RATIOS
From basic financial management course, we learn market multiple methods. Among
them, PE ratio is commonly used.

An industrial average can be used to tell whether the price of a stock is expensive.

From the internet, you may see something like:

….. January 2022, the average P/E ratio of the oil and gas drilling sector
(oil and gas production and exploration) is 34.66.
The current S&P 500 10-year P/E Ratio is 11.78,
which puts the oil and gas drilling P/E ratio above the P/E of the index…..

Does it mean that the stock price is high (expensive) if its

PE ratio is higher than the index?

Some may argue that the stock may have higher beta, then we can adjust for beta.
Exxon with beta of 1.05, and PE ratio of about 10 October 20, 2022
(PE of S&P500: about 19)
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Or use PEG (coming slide) as alternative method.
13.4 PRICE-EARNINGS RATIOS
If you were choosing property firms,
hotel stocks in your project, P/E may
P0/E0 or be misleading (not representing the
core earning) without adjustment.
P0/E1
E1
P0 = + PVGO
k
 
P0 1  PVGO 
= 1 + 
E1 k  E1 
 k 
No growth: P/E = 40/5 =8
Growth: P/E=57.14/5=11.43 seems higher PE implies 13
expectation of higher growth opportunities
 13.4 PRICE-EARNINGS RATIOS
•

You should know how to get this formula.

PE increases with higher ROE,

makes sense in general

PEG <1,
Personal experience, may work well when market, in general,
is rising in an upward trend. You may want to try it yourselves.
14
Amazon: PEG >2 (June 2021), may be too expensive
TABLE 13.3 EFFECT OF ROE AND PLOWBACK ON GROWTH AND P/E RATIO

Can we increase stock price if we plowback more?

g=ROExb

g increases
with higher
b

PE may not
Increase with
Higher b

15

Assume k=12%
13.4 PRICE-EARNINGS RATIOS AND STOCK RISK
 When risk is higher, k is higher; therefore,
P/E is lower. Riskier stock should have lower
PE
P 1− b
=
E k−g
 Higher risk implies higher discount rate, so lower
PV of future expected cash flow. The firm’s PE
should go down if it is getting more risky. Higher g,
higher P/E, If same g, riskier stock implies higher k and
thus lower P/E

 How about startup firms with high PE?

 In practice, risky firm may not always have low PE.
 If a portfolio of low P/E stocks earns higher return than
a portfolio of high P/E stocks…… 16
FIGURE 13.3 P/E RATIO OF S&P 500
AND INFLATION
60
P/E ratio

50 Inflation rate

40
Textbook explanation: PE drops in the 1970s
when inflation spiked, earning may be affected by
higher inflation because higher replacement cost
30 of goods and capital equipment

20

10

0
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
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 13.4 PRICE-EARNINGS RATIOS
 Pitfalls in P/E Analysis
 Earnings Management
Practice of using flexibility in accounting
rules to improve apparent profitability of
firm
Large amount of discretion in managing

earnings
Business cycle affects PE

How to compare the PE of GM vs Tesla ?

10 vs 1521.65 (2013), PE of Tesla (among other EV
manufactures) is still very high in 2021 18
 FIGURE 13.4 EARNINGS GROWTH FOR
TWO COMPANIES Investors believe high earning
6.0
may not sustain leading to lower
Which stock would you choose? PE, the reverse is also true.
Next slide
Earnings per share (1995 = 1.0)

5.0

Con Ed Temporary lower earning

4.0
Intel leads to higher PE if price
remains, next slide
3.0

2.0

1.0

0.0
1995 1997 1999 2001 2003 2005 2007 2009 2011

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Knowing the EPS, how will the PE look like?
 FIGURE 13.5 PRICE-EARNINGS RATIOS
60

Con Ed Intel
50
Is it unexpected for Intel?

40
P/E ratio

30

20

10

0
1995 1997 1999 2001 2003 2005 2007 2009 2011
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 13.4 PRICE-EARNINGS RATIOS
 Combining P/E Analysis and the DDM
 DDM: Projection of revenue, cash flow, earning into five/ten years.

 Other Comparative Valuation Ratios

 Price-to-book (P/B): Indicates how aggressively market values firm
 Price-to-cash-flow (P/C): Cash flow less affected by accounting
decisions than earnings
 Price-to-sales (P/S): For start-ups with no earnings (next slide)
 Nio and Tesla are selling at about 13.5x price to sales multiples on
2020 sales projection. Oct 14, 2020 Forbes
 Are they (P/B, P/C and P/S) better than P/E? (next slide)

 Internet firms use price-to-hit too in the 1990s!

 Price to active users or value per users?
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 Projection of revenue, cash flow, earning into five/ten years.
FIGURE 13.7 VALUATION RATIOS FOR S&P
500

Which ratio should be used?

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 13.5 FREE CASH FLOW VALUATION
APPROACHES
•

Another approach: using free cash flow instead of using DDM

to value firms, especially firms paying no dividend
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 13.5 FREE CASH FLOW VALUATION
APPROACHES


FCFFt
Firm value = 
t =1 (1 + WACC )
t

Equity value = Firm value − Debt value

You can estimate the equity value once you have the firm value
24
WACC is the discount rate for the firm
 13.5 FREE CASH FLOW VALUATION
APPROACHES
•

Why consider equity?

TA=TD+TE
Firms’ asset can grow simply because the firm borrows more,
Will share price or share value goes up by simply borrowing more?

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 13.5 FREE CASH FLOW VALUATION
APPROACHES
•

Terminal value based on constant growth

KE, the cost of equity

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 EXAMPLE

Current FCFF (will grow steadily at 4%) $5 million

WACC (calculated based on Debt/Equity
ratio, ke, kd, You learned it from FM) 12.5%

Debt market value $20 million

10 million shares outstanding

Required return on equity, ke 12.0%

Cost of debt, kd 7.0%
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Tax rate 15%

 EXAMPLE CONTINUED
Firm value = FCFF1/(WACC – g)
=5 million x1.04/(0.125-0.04) =61.18 (61.1765) million

Equity value = Firm value – Debt value =61.18 -20 = 41.18 million

Equity value per share = 41.18 /10 =$4.118

Do you want to try Apple Inc.? Your exercise now!

You are given 15 minutes to find the task.
Computer is allowed
You can make a few assumptions so that you can finish the calculations

I did a calculation about 2 years ago, Apple was cheap

If I am lazy, from the internet I have Apple's Free Cash Flow per Share for the months
ended in Sep. 2020 was $1.09.
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Its free cash flow per share for the trailing twelve months (TTM) ended in Sep. 2020
was $4.18. WACC =8.24% (https://www.gurufocus.com),
you need to assume a model, constant growth or with terminal value, etc.
 Example I used around Jan. 2019 when Apple has a
price about $40/share using Free cash flow model
Free Cash Flow to the Firm (FCFF) =EBIT - Taxes +
Depreciation & Amortization - Capex – Change in Working
Capital

Example Apple (assumes it has only steady and low growth):

Expected FCFF(FCFF1) = 70 billion
WACC (discount rate) = 8.5%, Steady growth rate = 2%
=>Firm value (not stock value) based on FCFF using DDM using
FCFF = 70 billion/(0.085-0.02) =1077
You may compare it with say the enterprise value = $720 Billion
________________________________
Total Debt about 250 billion->TE=TA-TD=827 Billion, market value at
the time was about 700 Billion.
Debt figure from:
https://www.macrotrends.net/stocks/charts/AAPL/apple/total-liabilities
 13.5 FREE CASH FLOW VALUATION
APPROACHES
•

We can also apply terminal value for the firm

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SPREADSHEET 13.2 (REFERENCE, TRY IT IN YOUR SPARE TIME)
REFER TO THE EXCEL FILE

Terminal value
FCFF -521.0 5200.3 5444.8 5689.4 106504.6

FCFE 1160.0 2760.1 3050.2 3340.3 85210.4 assumes fixed debt ratio after 2015

C. Discount rate calculations

Current beta 0.9 from Value Line
current beta /[1 + (1-
Unlevered beta 0.686 tax)*debt/equity)]
terminal growth 0.025
tax_rate 0.35 from Value Line

r_debt 0.042 YTM in 2012 on A+ rated LT debt

risk-free rate 0.029
market risk prem 0.08
MV equity 57420 100940 Row 3 x Row 11
linear trend from initial to final
Debt/Value 0.32 0.29 0.26 0.23 0.20 value
unlevered beta x [1 + (1-
Levered beta 0.900 0.871 0.844 0.819 0.797 tax)*debt/equity]
k_equity 0.101 0.099 0.097 0.095 0.093 0.093 from CAPM and levered beta
(1-t)*r_debt*D/V + k_equity*(1-
WACC 0.077 0.078 0.078 0.079 0.080 0.080 D/V)
PV factor for
FCFF 1.000 0.928 0.860 0.797 0.738 0.738 Discount each year at WACC
PV factor for
FCFE 1.000 0.910 0.830 0.758 0.694 0.694 Discount each year at k_equity

D. Present values Intrinsic val Equity val Intrin/share

PV(FCFF) -483 4474 4341 4201 78641 91174 63674 35.37
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PV(FCFE) 1056 2291 2313 2318 59136 67114 67114 37.29
 13.5 FREE CASH FLOW VALUATION
APPROACHES
 Comparing Valuation Models
 DDM and FCF valuation models are supposed to be the
same (you may refer to the MM paper mentioned in the
textbook for those who are interested in knowing the
difference from the academic point of view)
 Model values differ in practice
 Differences stem from simplifying assumptions
 When a firm reach constant growth rate? What market
share can a firm acquired eventually? How to best
estimate ROE, etc.
 That’s why there are some analysts suggesting buying

while other recommend selling of the same stock.

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 13.6 THE AGGREGATE STOCK MARKET
 Forecasting Aggregate Stock Market
 Earnings multiplier applied at aggregate level
 Forecast corporate profits for period

 Derive estimate of aggregate P/E ratio based on

long-term interest rates (Why? see next slide:
Treasury yield may be a good forecast for earning
yield E/P)
 Some analysts use aggregate DDM

P/E estimation can be used for the market too.

Will P/E of S&P500 too high? Possibility of
market correction, crash, etc.
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FIGURE 13.8 EARNINGS YIELD OF S&P 500
VERSUS 10-YEAR TREASURY BOND YIELD
16%
Treasury yield
Earnings yield
14%

12%

10%

8%

6%

4%

2%

0%
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 34
TABLE 13.4 S&P 500 FORECASTS

Pessimistic Most Likely Optimistic

Scenario Scenario Scenario

Treasury bond yield 3.6% 3.1% 2.6%

Earnings yield (about
2.9% higher than T bond 3.6%+2.9%=
yield) 6.5% 6.0% 5.5%

Resulting P/E ratio

(1/Earning yield) 1/6.5%=15.4 16.7 18.2

EPS forecast 93 93 93

Forecast for S&P 500 1431 1550 1691

close estimate
Early 2012, S&P500 at 1350. Early 2013: actual around1500-1550 35
Want to try it to see if it works in 2018, 2019?
Why lower yield 2.6% (but not 3.6%) is considered as optimistic?
EXERCISES

How would you value stock of a fast-growing

restaurant/retail chain (say selling hot pot) in China?
How big can it be assuming the currently it has profit?

Let’s say we want the big picture to start with?

Based on the percentage of market share for the total industrial

revenue of 1.4 billion people.

Or Number of restaurants a city with the population say >0.5 million

can accommodate, then total number of cities with that population,
then total number of restaurants possible, then growth rate in
revenue together with inflation effect, then say P/E and target price. 36