Security Analysis – Must for

Portfolio Management
 Objective
 Understand the theoretical basis of a DCF

 Understand the weighted average cost of capital

 Understand the different terminal value approaches:

 Terminal Multiple method

 Perpetuity Growth method

 Derive an implied valuation range

 Application: Construct a DCF & WACC model

 Understanding of these security valuation method:

 The basic dividend discount model.

 The two-stage dividend growth model.

 Price ratio analysis.

Wisdom Words: You may find all of this too easy; in reality it is a problem that can’t be solved easily
 Security Analysis: Be Careful Out There

 Fundamental analysis is a term for studying a company’s accounting statements and other
financial and economic information to estimate the economic value of a company’s stock.

 The basic idea is to identify “undervalued” stocks to buy and “overvalued” stocks to sell.

 In practice however, such stocks may in fact be correctly priced for reasons not immediately
apparent to the analyst.
What is company ultimately worth?
 Cash in the investors’ pockets
 Two key questions about DCF?
 How much cash?

 When investors receive it?

 What is a DCF Analysis?
 Intrinsic value of the company –

 Theoretical vs. relative value

 Base on unlevered free cash flows (FCFs)

– Independent of capital structure
– Free cash flows available to all capital holders

 Value equals the sum of the present values (PV) of:

 Unlevered free cash flows &

 Projected terminal value

 Estimated value beyond the forecast period

 PV calculated by on a discount rate - Typically, weighted average cost of capital (WACC)

 Advantages of a DCF Valuation
 Intrinsic value based on projected FCFs

 Flexible, adaptable analysis

 How do changes in projections impact value?

 Growth rates

 Operating margins

 Synergies, expansion plans, etc.

 Objective calculation (through PV)

 Requires scrutiny of key drivers of value

 Always obtainable
 Challenges of DCF
 DCF results should be presented as a RANGE of estimated values not a single estimate!

 Cash flows from forecasts

 Possible bias (run sensitivities)

 Reliability

 Subjective valuation

 Based on numerous assumptions

 Highly sensitive to changes in:

 FCFs: growth rates & margins assumptions

 Estimated terminal value

 Assumed discount rate (beta, market conditions)

 Method of DCF
 Estimate the Cost of Capital

 Forecast Free Cash Flows (FCFs)

 Calculate the Present Values of FCFs

 Estimate the Terminal Value

 Derive an Implied Valuation Range

Sources for Forecasting Free Cash Flow
 Use standalone model projections for DCF and FCF projections

 Alternative cases to assess:

 Upside potential

 Downside risk

 Synergies usually treated as separate analysis

 Consider "steady state" forecast horizon

 Cash flows can be "sustained forever" (stable growth)

 Generally viewed NOT to exceed economy's growth rate

 Multi-stage projections
 Forecast horizon potentially can be in stages

 Concept: Slow growth over time to steady-state

 How long does it take to achieve steady state?

 Length varies by industry / situation

 Does the company have a sustainable advantage?

 Growth from single product with protected position?

 Generally speaking: As growth nears stable growth, risk and CAPX needs decline

 Closer to industry average?

 Calculating Free Cash Flow
EBITDA
Less: Depreciation and amortization

= EBIT
Less: Taxes (at the marginal tax rate)

= Tax-Effected EBIT or “NOPAT”

Plus: Depreciation and amortization

+/-: Changes in deferred taxes

Less: Capital expenditures

+/-:  Changes in net working capital

+/-:  Changes in other non-cash items

= Unlevered Free Cash Flow

 What is terminal value?
 Value of the business beyond the projections
– Used due to the impractical nature of extended forecast period (i.e., 20 or 30 years)

Projections ?

Value = Yes Value = ??

Yr 0 Yr N

 Two methods:

 Exit Multiple

 Assumes the business is worth (or "sold") a multiple of an operating statistic at the end of the projections

 Perpetuity Growth

 Assumes growth of FCFs at constant rate in perpetuity

 Perpetuity Growth Method
 Assumes the business grows at a constant rate in perpetuity

 Consider using "normalized" cash flow in final year

 Sustaining capital investment (i.e., Depreciation ~ CapEx)

 Steady state working capital needs

 Consider no deferred taxes

 Perpetuity growth formula:

 Which method to use when
 Perpetuity Growth Rate:

 Academically proven approach

 Exit Multiple

 More often used in practice

 Inherent difficulty in estimating when the company achieves "steady state”, perpetual growth rate growth

 Multiples commonly used for valuation

 Major considerations:

 How do you choose the appropriate multiple?

 Introduces relative value with intrinsic value approach

 Perpetuity Growth Rate is commonly used by practitioners for:

 Synergies

 Mature industries
Calculate Enterprise Value
 Calculate Equity Value

 Which balance sheet do you?

(1) Latest available (2) PV date – projected balance sheet

 Typically, use latest available share and option information

 Ideally, consistent timing with balance sheet items

 Footnote and use reasonable assumptions

Mid-period convention
 WACC
 Discount rate used to calculate the PV of future cash flows

 Required rate of return for both equity and debt investors

 Return commensurate with risk of the investment (i.e., target company or project, not the acquirer in an M&A
transaction)

 Where:
Ke = cost of equity (from CAPM)
Kd = cost of debt (current cost of borrowing from average yield to maturity) E = market value of equity
D = market value of debt
T = marginal tax rate
 Determining the cost of debt
 Ideally, observable in market

 Yield to maturity from long-term bond (10 years)

 Normally quoted as “Spread” over risk-free rate

 Estimate Kd when no publicly traded debt

 Obtain quote from capital markets

 Based on risk / credit profile

 Quote usually based on "spread" over risk-free benchmark

 Based on comparables

 Examine debt footnote

 Interest rate on recent issuance? Average cost of debt?

 Tax effect at the marginal rate

 Cost of Equity
 Cost of Equity (Ke) = an investor's expected rate of return including dividends & capital appreciation

 Greater risks require higher expected returns

 Equity investors have a residual claim on assets

 Subordinate claim to debt holders and preferred stockholders

 Ke often reflects perceived risk of an investment

 Utilities: low risk, low expected return

 Biotech: high risk, high expected return

 Ke difficult to estimate

 Not readily observable in the market

 CAPM
 Tool used to estimate required equity returns

 Equity investors expect higher return to taking higher risk

 Two types of risk:

 Systematic risk: market risk

 Unavoidable risk - Common to all risky securities

 Warrants a “risk premium” above a risk-free rate of return

 Beta measures the amount of an asset’s market risk

 Unsystematic risk: specific to a company

 Avoidable risk through diversification

 Warrants no “risk premium”

 The CAPM Formula

 Risk-free rate (rf)

– Typically, estimated by 10-year US Treasury

 Beta (B) - popular sources:

1) Barra's predicted betas (from FactSet)
2) Bloomberg (historical betas)
3) Average calculation from comparable companies

 Market risk premium (rm - rf)

 Common source: long-term horizon equity risk premium from Ibbotson Associates' SBBI: Valuation Edition
Yearbook
 Risk free rate
 Rate of return on a "riskless" investment

 Government securities best characterizes a "riskless" security

 Use the long-term rate that best matches the time frame of most investment or acquisition decisions

 Extension beyond forecast period accounts for terminal value

 In practice, use the market's risk-free benchmark

 Currently, the 10 year government bond

 Equity Beta
 An equity beta measures a the degree to which a company's equity returns vary with the return of the overall
market

 Beta of 1.0 = risky as overall market

 Expected returns will equal overall market returns

 Ideally, beta value should be an expected value

 Cost of equity is an expected return

 Barra supplies predicted betas (available via FactSet)

 Common to use historical betas

 Private company - Use an industry average beta

Un-levering and Re-levering Beta
 Issues with Cost of Capital
 Risks will vary from country to country

 Calculating cost of capital internationally more challenging

 Limited data

 Lack of integrated markets

 Emerging markets even more difficult!

 Possible to obtain country specific assumptions, especially with developed countries

 Equity risk premium & betas

 Risk-free rate (such as UK Treasury 10-year bond)

 Seek specialists and internal resources!

 The Dividend Discount Model

 The Dividend Discount Model (DDM) is a method to estimate the value of a share of stock by
discounting all expected future dividend payments. The basic DDM equation is:

D1 D2 D3 DT
P0    
1  k  1  k  1  k 
2 3
1  k  T
 In the DDM equation:
 P0 = the present value of all future dividends
 Dt = the dividend to be paid t years from now
 k = the appropriate risk-adjusted discount rate
 Example: The Dividend Discount Model
Suppose that a stock will pay three annual dividends of $200 per year, and the
appropriate risk-adjusted discount rate, k, is 8%.

In this case, what is the value of the stock today?

D1 D2 D3
P0   
1  k  1  k  1  k  3
2

$200 $200 $200

P0     $515.42
1  0.08  1  0.08  1  0.08 
2 3
DDM: Constant Growth Rate Model

 Assume that the dividends will grow at a constant growth rate g. The dividend next period (t + 1)
is:

D t 1  D t  1  g

So, D 2  D1  (1  g)  D 0  (1  g)  (1  g)

 For constant dividend growth for “T” years, the DDM formula becomes:

D1 (1  g)   1  g  
T

P0  1     if k  g
k  g   1  k  

P0  T  D 0 if k  g
 Example: Constant Growth Rate Model

 Suppose the current dividend is $10, the dividend growth rate is 10%, there will be 20 yearly
dividends, and the appropriate discount rate is 8%.

 What is the value of the stock, based on the constant growth rate model?

D 0 (1  g)   1  g  
T

P0  1    
k  g   1  k  

$10  1.10    1.10  

20

P0  1      $243.86
.08  .10   1.08  
 DDM: Perpetual Growth Model

 Assuming that the dividends will grow forever at a constant growth rate g.

 For constant perpetual dividend growth, the DDM formula becomes:

D 0   1  g D1
P0   (Important : g  k)
kg kg
 Example: Perpetual Growth Model
 Think about the electric utility industry.

 In 2007, the dividend paid by the utility company, DTE Energy Co. (DTE), was $2.12.

 Using D0 =$2.12, k = 6.7%, and g = 2%, calculate an estimated value for DTE.

$2.12  1.02 
P0   $46.01
.067  .02
 DDM: Estimating the Growth Rate

 The growth rate in dividends (g) can be estimated in a number of ways:

 Using the company’s historical average growth rate.

 Using an industry median or average growth rate.

 Using the sustainable growth rate.

 The Historical Average Growth Rate
 Suppose the Broadway Joe Company paid the following dividends:

 2002: $1.50 2005: $1.80

 2003: $1.70 2006: $2.00
 2004: $1.75 2007: $2.20

 The spreadsheet below shows how to estimate historical average growth rates, using arithmetic
and geometric averages.

Year: Dividend: Pct. Chg:

2007 $2.20 10.00%
2006 $2.00 11.11%
2005 $1.80 2.86% Grown at
2004 $1.75 2.94% Year: 7.96%:
2003 $1.70 13.33% 2002 $1.50
2002 $1.50 2003 $1.62
2004 $1.75
Arithmetic Average: 8.05% 2005 $1.89
2006 $2.04
Geometric Average: 7.96% 2007 $2.20
 The Sustainable Growth Rate
Sustainable Growth Rate  ROE  Retention Ratio

 ROE  (1 - Payout Ratio)

 Return on Equity (ROE) = Net Income / Equity

 Payout Ratio = Proportion of earnings paid out as dividends

 Retention Ratio = Proportion of earnings retained for investment

 Example: Sustainable Growth Rate
 In 2007, American Electric Power (AEP) had an ROE of 10.17%, projected earnings per share of
$2.25, and a per-share dividend of $1.56. What was AEP’s:

 Retention rate?

 Sustainable growth rate

 Payout ratio = $1.56 / $2.25 = .693

 So, retention ratio = 1 – .693 = .307 or 30.7%

 Therefore, AEP’s sustainable growth rate = .1017  .307 = .03122, or 3.122%

 Example: Sustainable Growth Rate

 What is the value of AEP stock, using the perpetual growth model, and a discount rate of 6.7%?

$1.56  1.03122 
P0   $44.96
.067  .03122

 The actual mid-2007 stock price of AEP was $45.41.

 In this case, using the sustainable growth rate to value the stock gives a reasonably accurate
estimate.
 Two-Stage Dividend Growth Model

 The two-stage dividend growth model assumes that a firm will initially grow at a rate g1 for T

years, and thereafter grow at a rate g2 < k during a perpetual second stage of growth.

 The Two-Stage Dividend Growth Model formula is:

D 0 (1  g1 )   1  g1    1  g1  D 0 (1  g 2 )
T T

P0  1     
k  g1   1  k    1  k  k  g2
 Two-Stage Dividend Growth Model
 Although the formula looks complicated, think of it as two parts:

 Part 1 is the present value of the first T dividends (it is the same formula we used for the
constant growth model).

 Part 2 is the present value of all subsequent dividends.

 So, suppose MissMolly.com has a current dividend of

D0 = $5, which is expected to shrink at the rate, g1 = 10% for 5 years, but grow at the rate, g2 = 4%
forever.

 With a discount rate of k = 10%, what is the present value of the stock?
 Two-Stage Dividend Growth Model
D 0 (1  g1 )   1  g1    1  g1  D 0 (1  g 2 )
T T

P0  1     
k  g1   1  k    1  k  k  g2

$5.00(0.90 )   0.90    0.90  5 $5.00(1  0.04)

5

P0  1     
0.10  ( 0.10)   1  0.10    1  0.10  0.10  0.04

 $14.25  $31.78

 $46.03.

 The total value of $46.03 is the sum of a $14.25 present value of the first five dividends, plus a
$31.78 present value of all subsequent dividends.
 Example: DDM “Supernormal” Growth
 Chain Reaction, Inc., has been growing at a phenomenal rate of 30% per year.

 You believe that this rate will last for only three more years.

 Then, you think the rate will drop to 10% per year.

 Total dividends just paid were $5 million.

 The required rate of return is 20%.

 What is the total value of Chain Reaction, Inc.?

 Example: DDM “Supernormal” Growth

 First, calculate the total dividends over the “supernormal” growth period:

Year Total Dividend: (in $millions)

1 $5.00 x 1.30 = $6.50
2 $6.50 x 1.30 = $8.45
3 $8.45 x 1.30 = $10.985

 Using the long run growth rate, g, the value of all the shares at Time 3 can be calculated as:

P3 = [D3 x (1 + g)] / (k – g)

P3 = [$10.985 x 1.10] / (0.20 – 0.10) = $120.835

 Example: DDM “Supernormal” Growth
 Therefore, to determine the present value of the firm today, we need the present value of $120.835 and the
present value of the dividends paid in the first 3 years:

D1 D2 D3 P3
P0    
1  k  1  k  2 1  k  3 1  k  3

$6.50 $8.45 $10.985 $120.835

P0    
1  0.20  1  0.20  2 1  0.20  3 1  0.20  3

 $5.42  $5.87  $6.36  $69.93

 $87.58 million.
 Discount Rates: DDM
 The discount rate for a stock can be estimated using the capital asset pricing model (CAPM ).
 Observations on DDM
 Simple to compute

 Not usable for firms that do not pay dividends

 Is sensitive to the choice of g and k (for growth and perpetual method)

 Not usable when g > k (for perpetual growth)

 k and g may be difficult to estimate accurately.

 Constant perpetual growth is often an unrealistic assumption

 More realistic when it accounts for two stages of growth (two-stage model)
 Price Ratio Analysis
 Price-earnings ratio (P/E ratio)

 Current stock price divided by annual earnings per share (EPS)

 Earnings yield

 Inverse of the P/E ratio: earnings divided by price (E/P)

 High-P/E stocks are often referred to as growth stocks, while low-P/E stocks are often referred to as
value stocks.
 Price Ratio Analysis
 Price-cash flow ratio (P/CF ratio)

 Current stock price divided by current cash flow per share

 In this context, cash flow is usually taken to be net income plus depreciation.

 Most analysts agree that in examining a company’s financial performance, cash flow can be more
informative than net income.

 Earnings and cash flows that are far from each other may be a signal of poor quality earnings.
 Price Ratio Analysis
 Price-sales ratio (P/S ratio)
 Current stock price divided by annual sales per share
 A high P/S ratio suggests high sales growth, while a low P/S ratio suggests sluggish sales
growth.

 Price-book ratio (P/B ratio)

 Market value of a company’s common stock divided by its book (accounting) value of equity
 A ratio bigger than 1.0 indicates that the firm is creating value for its stockholders.
 Price/Earnings Analysis, Intel Corp.
Intel Corp (INTC) - Earnings (P/E) Analysis

5-year average P/E ratio 27.30

Current EPS $.86
EPS growth rate 8.5%

Expected stock price = historical P/E ratio  projected EPS

$25.47 = 27.30  ($.86  1.085)

Mid-2007 stock price = $24.27

 Price/Cash Flow Analysis, Intel Corp.
Intel Corp (INTC) - Cash Flow (P/CF) Analysis

5-year average P/CF ratio 14.04

Current CFPS $1.68
CFPS growth rate 7.5%

Expected stock price = historical P/CF ratio  projected CFPS

$25.36 = 14.04  ($1.68  1.075)

Mid-2007 stock price = $24.27

 Price/Sales Analysis, Intel Corp. 6-
52

Intel Corp (INTC) - Sales (P/S) Analysis

5-year average P/S ratio 4.51

Current SPS $6.14
SPS growth rate 7%

Expected stock price = historical P/S ratio  projected SPS

$29.63 = 4.51  ($6.14  1.07)

Mid-2007 stock price = $24.27

 Numericals…
General Motors has 710 million shares trading at $55 per share and $69 billion in debt outstanding
(with a market value of $65 billion), on which it incurred an interest expense of $5 billion in the most
recent year. It also has $4 billion in preferred stock outstanding, trading at par, on which it paid a
dividend of $365 million. The stock has a beta of 1.10 and is rated A (which commands a spread of
1.25% over the treasury bond rate of 6.25%). The company faced a corporate tax rate of 40%.

A. What is the cost of equity for GM?

B. What is the after-tax cost of debt for GM?
C. What is the cost of preferred stock?
D. What is the cost of capital?
 Numericals…
The following is a list of companies, with prices, dividends per share and expected growth rates in
dividends (from analyst projections) for each company:

(Microsoft has an expected growth rate in earnings of 24% for the next five years.)

A. Estimate the cost of equity using the dividend growth model. Which, if any, of these firms may
be reasonable candidates for using this model? Why?
B. Estimate the cost of equity using the CAPM. (The thirty-year bond rate is 6.25%.)
C. Which estimate will you use in valuation and why?
 Numericals…
AIG has 1.13 billion shares traded at a market value of $32 per share, and $1.918 billion in book value
of outstanding debt (with an estimated market value of $2 billion). The equity has a book value of $5.5
billion, and the stock has a beta of 1.20. The firm paid interest expenses of $160 million in the most
recent financial year, is rated AAA and paid 35% of its income as taxes. The thirty-year government
bond rate is 6.25%, and AA bonds trade at a spread of twenty basis points (0.4%) over the treasury
bond rate.

A. What are the market value and book value weights on debt and equity?
B. What is the cost of equity?
C. What is the after-tax cost of debt?
D. What is the cost of capital?
 Numericals…
Ryder System is a full-service truck leasing, maintenance, and rental firm with operations in North
America and Europe. The following are selected numbers from the financial statements for 1992 and
1993 (in millions).

The firm had capital expenditures of $800 million in 1992 and $850 million in 1993. The working
capital in 1991 was $34.8 million, and the total debt outstanding in 1991 was $1.75 billion. There were
77 million shares outstanding, trading at $29 per share.

A. Estimate the cash flows to equity in 1992 and 1993.

B. Estimate the cash flows to the firm in 1992 and 1993.
C. Assuming that revenues and all expenses (including depreciation and capital expenditures)
increase 6%, and that working capital remains unchanged in 1994, estimate the projected cash
flows to equity and the firm in 1994. (The firm is assumed to be at its optimal financial leverage.)
D. How would your answer in (c) change if the firm planned to increase its debt ratio in 1994 by
financing 75% of its capital expenditures (net of depreciation) with new debt issues?
 Numericals…
The following are the earnings per share of Thermo Electron, a company that designs cogeneration
and resource recovery plants, from 1987 to 1992:

A. Estimate the arithmetic average growth rate in earnings per share from 1987 to 1992.

B. Estimate the geometric average growth rate in earnings per share from 1987 to 1992.

C. Why is Geometric higher than arithmetic?

 Numericals…
Johnson and Johnson, a leading manufacturer of healthcare products, had a return on equity in 1992
of 31.4%, and paid out 36% of its earnings as dividends. It earned a net income of $1,625 million on a
book value of equity of $5,171 million. As a consequence of healthcare reform, it is expected that the
return on equity will drop to 25% in 1993 and that the dividend payout ratio will remain unchanged.

A. Estimate the growth rate in earnings based upon 1992 numbers.

B. Estimate the growth rate in 1993, when the ROE drops from 31.4% to 25%.
C. Estimate the growth rate after 1993, assuming that 1993 numbers can be sustained
 Numericals…
Eastman Kodak was, in the view of many observers, in serious need of restructuring in 1994. In 1993,
the firm reported the following:
Net Income = $1,080 million
Interest Expense = $ 550 million
The firm also had the following estimates of debt and equity in the balance sheet:
Equity (Book Value) = $6,000 million
Debt (Book Value) = $6,880 million

The firm also paid out total dividends of $660 million in 1993. The stock was trading at $63, and there
were 330 million shares outstanding. (It faced a corporate tax rate of 40%.) Eastman Kodak had a beta
of 1.10.
Analysts believe that Kodak could take the following restructuring actions to improve its financial
strength:
• It could sell its chemical division, which has a total book value of assets of $2,500 million and has
only $100 million in earnings before interest and taxes.
• It could use the cash to pay down debt and improve its bond rating (leading to a decline in the
interest rate to 7%).
• It could reduce the dividend payout ratio to 50% and reinvest more back into the business.

A. What is the expected growth rate in earnings, assuming that 1993 numbers remain unchanged?
B. What is the expected growth rate in earnings, if the restructuring plan described above is put into
effect?
C. What will the beta of the stock be, if the restructuring plan is put into effect?