> Calculate the intrinsic value of a firm using either a constant

growth or multistage dividend discount model.

> Calculate the intrinsic value of a stock using a dividend

discount model in conjunction with a price/earnings ratio.

> Assess the growth prospects of a firm from its P/E ratio.

412

Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill

Essentials of Investments, Companies, 2003

Fifth Edition

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The above sites have information on earnings

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stockscreener

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general_free_search.html?

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ou saw in our discussion of market efficiency that finding undervalued securi-

Y ties is hardly easy. At the same time, there are enough chinks in the armor of

the efficient market hypothesis that the search for such securities should not

be dismissed out of hand. Moreover, it is the ongoing search for mispriced securities

that maintains a nearly efficient market. Even infrequent discoveries of minor mis-

pricing justify the salary of a stock market analyst.

This chapter describes the ways stock market analysts try to uncover mispriced

securities. The models presented are those used by fundamental analysts, those ana-

lysts who use information concerning the current and prospective profitability of a

company to assess its fair market value. Fundamental analysts are different from

technical analysts, who essentially use trend analysis to uncover trading opportunities.

We discuss technical analysis in Chapter 19.

We start with a discussion of alternative measures of the value of a company.

From there, we progress to quantitative tools called dividend discount models that se-

curity analysts commonly use to measure the value of a firm as an ongoing concern.

Next, we turn to price“earnings, or P/E, ratios, explaining why they are of such inter-

est to analysts but also highlighting some of their shortcomings. We explain how P/E

ratios are tied to dividend valuation models and, more generally, to the growth

prospects of the firm.

Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill

Essentials of Investments, Companies, 2003

Fifth Edition

414 Part FOUR Security Analysis

12.1 BAL ANCE SHEET VALUATION METHODS

book value A common valuation measure is book value, which is the net worth of a company as shown

on the balance sheet. Table 12.1 gives the balance sheet totals for Intel to illustrate how to cal-

The net worth of

culate book value per share.

common equity

Book value of Intel stock at the end of September 2001 was $5.35 per share ($35,902 mil-

according to a firm™s

balance sheet. lion divided by 6,710 million shares). At the same time, Intel stock had a market price of

$20.00. In light of this substantial difference between book and market values, would it be fair

to say Intel stock was overpriced?

The book value is the result of applying a set of arbitrary accounting rules to spread the ac-

quisition cost of assets over a specified number of years; in contrast, the market price of a

stock takes account of the firm™s value as a going concern. In other words, the price reflects

the market consensus estimate of the present value of the firm™s expected future cash flows. It

would be unusual if the market price of Intel stock were exactly equal to its book value.

Can book value represent a “floor” for the stock™s price, below which level the market

price can never fall? Although Intel™s book value per share was less than its market price,

other evidence disproves this notion. While it is not common, there are always some firms

selling at a market price below book value. Clearly, book value cannot always be a floor for

the stock™s price.

A better measure of a floor for the stock price is the firm™s liquidation value per share.

liquidation value

This represents the amount of money that could be realized by breaking up the firm, selling its

Net amount that

assets, repaying its debt, and distributing the remainder to the shareholders. The reasoning be-

can be realized by

hind this concept is that if the market price of equity drops below the liquidation value of the

selling the assets of a

firm and paying off firm, the firm becomes attractive as a takeover target. A corporate raider would find it prof-

the debt. itable to buy enough shares to gain control and then actually liquidate because the liquidation

value exceeds the value of the business as a going concern.

Another balance sheet concept that is of interest in valuing a firm is the replacement

replacement cost

cost of its assets less its liabilities. Some analysts believe the market value of the firm can-

Cost to replace a

not get too far above its replacement cost because, if it did, competitors would try to repli-

firm™s assets.

cate the firm. The competitive pressure of other similar firms entering the same industry

would drive down the market value of all firms until they came into equality with replace-

ment cost.

This idea is popular among economists, and the ratio of market price to replacement cost is

known as Tobin™s q, after the Nobel Prize“winning economist James Tobin. In the long run,

Tobin™s q

according to this view, the ratio of market price to replacement cost will tend toward 1, but the

Ratio of market value

evidence is that this ratio can differ significantly from 1 for very long periods of time.

of the firm to

Although focusing on the balance sheet can give some useful information about a firm™s

replacement cost.

liquidation value or its replacement cost, the analyst usually must turn to the expected future

cash flows for a better estimate of the firm™s value as a going concern. We now examine the

quantitative models that analysts use to value common stock in terms of the future earnings

and dividends the firm will yield.

Assets Liabilities and Owners™ Equity

TA B L E 12.1

$44,231 Liabilities $8,329

Intel™s balance

sheet, Sept. Common equity $35,902

29, 2001 6,710 million shares outstanding

($millions)

Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill

Essentials of Investments, Companies, 2003

Fifth Edition

415

12 Equity Valuation

12.2 INTRINSIC VALUE VERSUS MARKET PRICE

The most popular model for assessing the value of a firm as a going concern starts from the

observation that the return on a stock investment comprises cash dividends and capital gains

or losses. We begin by assuming a one-year holding period and supposing that ABC stock has

an expected dividend per share, E(D1), of $4; that the current price of a share, P0, is $48; and

that the expected price at the end of a year, E(P1), is $52. For now, don™t worry about how you

derive your forecast of next year™s price. At this point we ask only whether the stock seems at-

tractively priced today given your forecast of next year™s price.

The expected holding-period return is E(D1) plus the expected price appreciation, E(P1) P0,

all divided by the current price P0.

E(D1) [E(P1) P0]

Expected HPR E(r)

P0

4 (52 48)

0.167 16.7%

48

Note that E( ) denotes an expected future value. Thus, E(P1) represents the expectation to-

day of the stock price one year from now. E(r) is referred to as the stock™s expected holding-

period return. It is the sum of the expected dividend yield, E(D1)/P0, and the expected rate of

price appreciation, the capital gains yield, [E(P1) P0]/P0.

But what is the required rate of return for ABC stock? We know from the capital asset pric-

ing model (CAPM) that when stock market prices are at equilibrium levels, the rate of return

that investors can expect to earn on a security is rf [E(rM) rf]. Thus, the CAPM may be

viewed as providing the rate of return an investor can expect to earn on a security given its risk

as measured by beta. This is the return that investors will require of any other investment with

equivalent risk. We will denote this required rate of return as k. If a stock is priced “correctly,”

its expected return will equal the required return. Of course, the goal of a security analyst is to

find stocks that are mispriced. For example, an underpriced stock will provide an expected re-

turn greater than the “fair” or required return.

Suppose that rf 6%, E(rM) rf 5%, and the beta of ABC is 1.2. Then the value

of k is

k 6% 1.2 5% 12%

The rate of return the investor expects exceeds the required rate based on ABC™s risk by a

margin of 4.7%. Naturally, the investor will want to include more of ABC stock in the portfo-

lio than a passive strategy would dictate.

Another way to see this is to compare the intrinsic value of a share of stock to its market

price. The intrinsic value, denoted V0, of a share of stock is defined as the present value of all intrinsic value

cash payments to the investor in the stock, including dividends as well as the proceeds from The present value of a

the ultimate sale of the stock, discounted at the appropriate risk-adjusted interest rate, k. firm™s expected future

Whenever the intrinsic value, or the investor™s own estimate of what the stock is really worth, net cash flows

discounted by the

exceeds the market price, the stock is considered undervalued and a good investment. In the

required rate of

case of ABC, using a one-year investment horizon and a forecast that the stock can be sold at

return.

the end of the year at price P1 $52, the intrinsic value is

E(D1) E(P1) $4 $52

V0 $50

1 k 1.12

Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill

Essentials of Investments, Companies, 2003

Fifth Edition

416 Part FOUR Security Analysis

Because intrinsic value, $50, exceeds current price, $48, we conclude that the stock is under-

valued in the market. We again conclude investors will want to buy more ABC than they

would following a passive strategy.

If the intrinsic value turns out to be lower than the current market price, investors should

market

buy less of it than under the passive strategy. It might even pay to go short on ABC stock, as

capitalization

we discussed in Chapter 3.

rate

In market equilibrium, the current market price will reflect the intrinsic value estimates of

The market-consensus all market participants. This means the individual investor whose V0 estimate differs from the

estimate of the

market price, P0, in effect must disagree with some or all of the market consensus estimates of

appropriate discount

E(D1), E(P1), or k. A common term for the market consensus value of the required rate of re-

rate for a firm™s cash

turn, k, is the market capitalization rate, which we use often throughout this chapter.

flows.

>

1. You expect the price of IBX stock to be $59.77 per share a year from now. Its cur-

Concept

rent market price is $50, and you expect it to pay a dividend one year from now of

CHECK $2.15 per share.

a. What is the stock™s expected dividend yield, rate of price appreciation, and

holding-period return?

b. If the stock has a beta of 1.15, the risk-free rate is 6% per year, and the ex-

pected rate of return on the market portfolio is 14% per year, what is the re-

quired rate of return on IBX stock?

c. What is the intrinsic value of IBX stock, and how does it compare to the current

market price?

12.3 DIVIDEND DISCOUNT MODELS

Consider an investor who buys a share of Steady State Electronics stock, planning to hold it

for one year. The intrinsic value of the share is the present value of the dividend to be received

at the end of the first year, D1, and the expected sales price, P1. We will henceforth use the

simpler notation P1 instead of E(P1) to avoid clutter. Keep in mind, though, that future prices

and dividends are unknown, and we are dealing with expected values, not certain values.

We™ve already established that

D1 P1

V0 (12.1)

1 k

While this year™s dividend is fairly predictable given a company™s history, you might ask how

we can estimate P1, the year-end price. According to Equation 12.1, V1 (the year-end value)

will be

D2 P2

V1

1 k

If we assume the stock will be selling for its intrinsic value next year, then V1 P1, and we

can substitute this value for P1 into Equation 12.1 to find