VALUATION OF FINANCIAL ASSETS EQUITY VALUATION

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VALUATION OF FINANCIAL ASSETS EQUITY VALUATION

  1. 1. VALUATION OF FINANCIAL ASSETS EQUITY VALUATION
  2. 2. VALUATION FUNDAMENTALS <ul><li>Value = f(size, timing, risk) of future cash flows </li></ul><ul><li>Given investor rationality, the computed value = equilibrium value of a financial asset. </li></ul><ul><li>Given well-functioning markets, market price = equilibrium value. </li></ul><ul><li>Corollary: given well-functioning markets, the expected return on a financial asset = its required return. </li></ul>
  3. 3. VALUATION FUNDAMENTALS: DEBT VS. EQUITY <ul><li>Keys to security valuation (again) </li></ul><ul><ul><li>How large are the promised cash flows? </li></ul></ul><ul><ul><li>How long will the promised cash flows last? </li></ul></ul><ul><ul><li>How strong is the promise to pay? </li></ul></ul>
  4. 4. VALUATION FUNDAMENTALS: EQUITY INSTRUMENTS <ul><li>P 0 =  PV future dividends </li></ul><ul><li>Keys to Equity Valuation </li></ul><ul><ul><li>What is the nature of the future dividend stream? </li></ul></ul><ul><ul><li>Stable? Growing? Declining? </li></ul></ul><ul><ul><li> If growing, what is the appropriate estimated growth rate? </li></ul></ul><ul><ul><li>How uncertain is the future dividend stream? </li></ul></ul><ul><ul><li> What is the appropriate discount rate/required return? </li></ul></ul>
  5. 5. VALUATION FUNDAMENTALS: EQUITY INSTRUMENTS <ul><li>What is the nature of the future dividend stream? </li></ul><ul><ul><li>Three possibilities: </li></ul></ul><ul><ul><li>• g = 0, fixed  “zero-growth” model </li></ul></ul><ul><ul><li>• g  0, fixed  “constant-growth” model </li></ul></ul><ul><ul><li>• g  0, nonconstant  “supernormal growth” model </li></ul></ul>
  6. 6. EXAMPLE: ZERO-GROWTH STOCK <ul><li>Rust Belt Mfg., Inc. is in a mature (albeit static) industry; as a result, earnings and dividends are expected to exhibit no growth for the foreseeable future. The firm currently pays an annual dividend of $1.00 per share on its common stock. If the appropriate required return is 10%, what is the stock’s equlibrium value today? </li></ul><ul><li>Given no fundamental changes in the firm or the economy, what is the equilibrium value of Rust Belt’s common stock one year from today? </li></ul>
  7. 7. EXAMPLE: CONSTANT-GROWTH STOCK <ul><li>Unexciting Auto Corp.(UAC) builds vehicles used to haul gravel and other loads in a broad cross-section of industries. The firm’s earnings are expected to grow at an average annual rate of 5% for the foreseeable future. The firm is expected to pay a $1.00 dividend in one year, and the stocks of firms of similar risk yield 10%. What is the stock’s equlibrium value today? </li></ul><ul><li>Given no fundamental changes in the firm or the economy, what is the equilibrium value of UAC’s common stock one year from today? </li></ul>
  8. 8. EXAMPLE: SUPERNORMAL-GROWTH STOCK <ul><li>AmazingIdea.com provides inventors with the ability to perform low-cost online patent and trademark searches, and to register their inventions without having to deal with lawyers or other shady characters. The firm’s earnings are expected to grow at 25% annually for the next three years, but as others develop similar websites, the growth rate is expected to slow to 15% for the following three years, and 7% annually thereafter. The firm is expected to pay its first dividend in one year ($1.00 per share). Assume the appropriate required return is 10%. What is the stock’s equlibrium value today? </li></ul><ul><li>Given no fundamental changes in the firm or the economy, what is the equilibrium value of AI’s common stock one year from today? </li></ul>
  9. 9. SIDE ISSUE 1: WHERE DOES THE GROWTH RATE COME FROM? <ul><li>What is the appropriate growth rate? </li></ul><ul><ul><li>“ Bottom-up” Approach </li></ul></ul><ul><ul><li>g = plowback ratio  return on equity </li></ul></ul><ul><ul><li>= (1 - D 1 /P 0 )  ROE </li></ul></ul><ul><ul><li>Constant Growth Model Approach </li></ul></ul><ul><ul><li>g = cost of equity - dividend yield = R - D 1 /P 0 </li></ul></ul>
  10. 10. SIDE ISSUE 2: WHERE DOES THE TOTAL RETURN COME FROM? <ul><ul><li>Constant Growth Model Approach </li></ul></ul><ul><ul><li>Total return = dividend yield + capital gains yield </li></ul></ul><ul><ul><li>R = D 1 /P 0 + (P 1 - P 0 )/P 0 </li></ul></ul><ul><ul><li>Required return = return on investments of similar risk </li></ul></ul><ul><ul><li> = total return in equilibrium markets </li></ul></ul>
  11. 11. Stock Quotation from The Wall Street Journal (Fig. 8.2) NEW YORK STOCK EXCHANGE COMPOSITE TRANSACTIONS

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