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YOU SHOULD BE ABLE TO:


> 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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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

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