Equity Valuation - Poslovni dnevnik

Equity Valuation

Self-Paced Tutorial Online tutorials for mini classes at: 2007? Hughey Center for Financial Services. All Rights Reserved.

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Introduction:

This tutorial is to be used in conjunction with the FI 640 Final Project or any other equity valuation. In it we will introduce the Dividend Discount, Free Cash Flow to Equity, and Free Cash Flow to the Firm models, as well as Relative Value analysis. We will discuss when to use these models, the variables associated with their employment, and how to search for those variables using Bloomberg, Reuters Knowledge, and Thomson One.

A cautionary note: The data this tutorial will lead you to analyze is historical data, with the exception of earnings estimates. You will apply growth rates to these historical data to estimate future revenues and costs. What must be remembered throughout this tutorial is that future revenues and future costs are what we seek to analyze, and that we download historical data to estimate these figures. Our valuation is thus based on estimated future data, not historical data alone!

The instructions provided for the retrieval of input variables suggest the repeated opening of Reuters Knowledge and other software. If you seek to retrieve more than one variable over the course of your analysis, it is not necessary to repeatedly open and close these software. You must simply leave the application running and change the required ticker information.

Dividend Discount Models

The DDM is the simplest present value approach to valuating common stocks. It estimates the company value based on the idea that the value of the equity equals all future dividends discounted back to today.

Gordon Growth Model or Constant Growth Model:

The Gordon Growth model (a.k.a the Constant Growth Model) relies on the principle that dividends grow indefinitely at a constant rate. Use this model if your stock meets the following criteria:

? It pays out 90% or more of its Net Income in dividends; ? Its leverage is expected to remain stable into the future; ? Its growth rates are expected to be comparable to or lower than the

economy's nominal growth rate.

P0 =

DPS0 (1 + g) + DPS0 (1 + g)2

(1 + re )

(1 + re )2

+ ...+ DPS0 (1 + g)n (1 + re )n

+ ...

This equation is a geometric series that can be simplified algebraically into:

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P0 =

DPS0 (1 + g) , or (re - g)

P0 =

DPS1 (re - g)

where DPS1 = Expected dividends next year re = Cost of Equity g = Growth rate in dividends forever P0 = Value of a share of stock today

The Variables

g = Growth rate in dividends forever

The implied dividend growth rate g equals the earning retention ratio (b) times the return on equity (ROE).

where

g = b ? ROE g = dividend growth rate b = earning retention rate (1 ? dividend payout ratio) ROE = return on equity

Here the assumption is very strong because we are using the concept of sustainable growth rate as the rate of dividend (and earnings) growth that can be sustained for a given level of return on equity, keeping the capital structure constant over time.

Finding ROE and b:

1. Open Thomson One Analytics 2. Enter the company's ticker symbol (i.e. HD for Home Depot), and click OK 3. Select Key Ratios under the Financials tab on the left navigation bar. Under

Profitability you will find the Return on Total Equity % and under Leverage you will find the Dividend Payout %.

For the FY 2004 the ROE = 21.5 % while the Dividend Payout is 14.4%, this implies that the dividend growth rate is:

g = (1 ? 0.144) ? 0.215 = 0.18404

re = Cost of Equity

The cost of equity can be found using the Capital Asset Pricing Model. The CAPM equation is as follows:

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re = rf + (rm - rf ) rf = the risk free rate (typically a US treasury yield that matches your investment horizon) = Beta (a measurement of a stocks return relative to the market) rm - rf = 5.5% = the historically accepted risk premium is 5.5% rf = the risk free rate

1. Use the Bloomberg terminal and enter the following command: TK 2. Click on the corresponding country (we will choose #14: USA) 3. Choose option #12 on the next screen for the most currently issued Bills, Notes,

and Bonds And it brings us to the following page:

4. Select the treasury bill/note/bond whose maturity most appropriately represents your holding period, and use its yield as the risk free rate. For example, 5.23% if the holding period is 1 month, or 4.61% if the holding period is 5 years.

= Beta Beta is a measure of risk. We will begin by entering the ticker of a company in which we are interested into Bloomberg. For example, let's say we're interested in Microsoft. So we enter the following command:

MSFT BETA And it brings us to the following page:

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1. In the range box we type the dates that give us an appropriate timeline by which to measure beta. The greater the number of years in your forecast, the greater the number of years you should use in your beta calculation. Five is generally a safe minimum.

2. The market index set as the default in the S&P500. You should change this if you feel another index better represents the risk associated with your market, or if you believe the S&P500 is not large enough a market.

3. For all intensive purposes we will use the raw beta as it presents us with a larger and more conservative cost of equity.

If you were to repeat this process with Home Depot, the Raw Beta you would pull is 1.08 and the cost of equity will be:

re = rf + (rm - rf ) re = 0.0461 + 1.08 * (0.055) = 10.55 %

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