B. Equity Valuation Models

• Try to find stocks that are mispriced relative to some measure of "true" value

1.  Valuation by comparables

• Look at stock price compared to different financial benchmarks

• EDGAR

a.  Ratios

(1) Price to earnings (P/E)

(2) Price to book value

(3) Price to sales

(4) Price to cash flow

(5) PEG - P/E divided by growth rate of earnings

• Compare with industry average

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b.  Alternatives to book value

• Book value based on historic costs

(1) Liquidation value

• Value if all assets sold and liabilities repaid

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(2) Replacement cost

• How much would it cost to replace assets minus liabilities

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(3) Tobin's q

• Ratio of market price to replacement cost

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2.  Intrinsic value vs. market price

• Intrinsic value - present value of all cash payments to investor

• Includes dividends and capital gains

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• Risk-adjusted interest rate

- Capital asset pricing model (CAPM):

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• Compare intrinsic value to current stock price

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3.  Dividend discount models

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a.  Constant-growth dividend discount model

• Assumes dividend growth rate will be constant

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• Stock value greater:

(1) the larger its expected dividend per share

(2) the lower market capitalization rate, k

(3) the higher the expected growth rate of dividends

• Stock price will grow at same rate as dividends

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b.  Stock prices and investment opportunities

• Dividend payout ratio - percentage of earnings paid out as dividends

• Plowback ratio (earnings retention ratio) - proportion of earnings reinvested in the business

- Tradeoff between dividends and future growth opportunities

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• Present value of growth opportunities - net present value of firm's future investments

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c.  Life cycles and two-stage growth models

• Different dividend policies in different stages

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d. Multistage growth models

• More than two stages involved

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4.  Price-earnings ratio (multiple)

• Ratio of price per share to earnings per share

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a.  P/E ratios and stock risk

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b.  Problems with P/E analysis

(1) Earnings are accounting earnings

• Earnings management - using accounting rules to improve the apparent profitability of firms

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(2) Earnings fluctuate with business cycle

• Should look at trend of future earnings

c.  P/E analysis and discounted dividend model

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5. Free cash flow valuation

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