MBA: Financial Management in a Global Environment

You have learned about several different approaches for stock and company valuation including the Price-Earnings (or Price-EBITDA) Multiple Approach, which is a relative approach for stock valuation. After employing other approaches, you are now ready to apply the P-E multiple approach to valuing a publicly-held company in the EV sector with good growth potential that your company is considering to acquire. Your target company has been in business for several years since its IPO, but has not recorded a profit (or earnings) yet. As a newly-hired assistant to CFO, you are in charge of valuing your target company.

Discuss (a) what problems you might encounter in applying the P-E (or P-EBITDA) Multiple Approach to your target company; and (b) what alternative RELATIVE approach(es) you could use in place of the P-E (or P-EBITDA) Multiple Approach to value your target company. (Hints: Refer to my lecture video and class notes in Session II – Valuation of Stocks.)

Instructions:

Please post your initial response by 23:59 EST Day 4 of the Week, and comments on the posts of at least four classmates by 23:59 EST Due Date.

Each Discussion Topic carries 10 points (6 points for own answers and 4 points for responses to classmates’ posts). You must first post your own answers directly to the DT by Day 4 of the week before accessing other students’ answers. In addition, youshould post at least FOUR thoughtful and substantive responses to other classmates’ answers/comments by the due date in order to earn full 10 points for each DT. A mere “Yes, I agree” or “No, I don’t agree” type of responses will not be given any credit.

Additional bonus credit may be given to at least TWO additional substantive responses to classmates’ posts at DIFFERENT DATES as they are valued and enrich our online learning.

Concluding comments on each Discussion Topic will be posted on the Discussion folder after due date.

Session II:
Valuation of Securities
1. Determination of Interest Rates
2. Valuation of Bonds
3. Valuation of Stocks
36
DETERMINATION OF INTEREST RATES
Learning Objectives:
 Identify various factors that influence interest rates
 Explain how norminal interest rates are determined
 Explain and measure inflation premium, default risk premium, liquidity
premium, and maturity risk premium
 Describe what the yield curve is and how its shape is determined
 Explain the relationships between different yield curves and economic
conditions
——————————————————————————————————1.
Definition of Interest Rates
 Cost of Money: Price paid to Borrowed Money
 Reward for foregone current consumption
 Determined by the supply of and the demand for investment capital.
2.
Factors That Influence Interest Rates
1)
Production opportunities: the rate of return producers expect to earn on
invested capital
2)
Time preference for consumption: consumers’/savers’ time preferences
for current vs. future consumption.
3)
Risk: the possibility that the borrower would be default.
4)
Expected inflation
5)
Federal Reserve policy
k
6)
Federal budget deficits
S
7)
Foreign trade balance
8)
Business activity
D
Components of Interest Rates
$
3.
k
k
where
=
=
k*
+
kRF
IP
+
+
DRP +
DRP +
k
k*
IP
kRF
DRP
LP
MRP
=
=
=
=
=
=
=
nominal interest rate on a given security
real risk-free interest rate
inflation premium
nominal risk-free interest rate
default risk premium
liquidity premium
maturity risk premium
37
LP
LP
+
+
MRP
MRP
4.
Term Structure of Interest Rates
1)
Definition: The relationship between yields and maturities of securities,
depicted by Yield Curve.
 “normal” yield curve: upward-sloping
 “inverted” yield curve: downward-sloping
2)
Term Structure Theory
 Market segmentation theory
 Liquidity preference theory
 Expectations theory
Example) Determination of Interest Rates
Includes?
Type of
Security
Credit
Rating
Interest
Rate
IP DRP
LP MRP
Short-Term:
3-Month T-bill
“Risk-free”
7.44%
Yes
No
No
No
Long-Term:
30-year T-bond
“Risk-free”
8.86%
Yes
No
No
Yes
Corporate bond
AAA
9.41%
Yes
Corporate bond
AA
9.63%
Yes
Corporate bond
A
9.89%
Yes
Corporate bond
BBB
10.41%
Yes
Small
More
than AAA
More
than AA
More
than A
Depends
on
Yes
Corporation
Yes
Yes
Yes
Link for Treausry Yield Curve:
https://www.treasury.gov/resource-center/data-chart-center/interestrates/Pages/Historic-Yield-Data-Visualization.aspx
Reading – Grading Bonds on Inverted Curve (WSJ, 01/08/2007)
Reading – The Yield Curve Inverted (MarketWatch, 03/22/2019)
38
39
40
41
GENERAL VALUATION MODEL
 General Valuation Model or Discounted Cash Flow (DCF) Model
𝑛
𝐶𝐹1
𝐶𝐹2
𝐶𝐹𝑛
𝐶𝐹𝑡
𝑉0 =
+
+
⋯
+
=
∑
(1 + 𝑘1 ) (1 + 𝑘2 )2
(1 + 𝑘𝑛 )𝑛
(1 + 𝑘𝑡 )𝑡
𝑡=1
The valuation of an asset requires:
(i)
An estimate of expected future cash flows: CFt
(ii) An estimate of discount rate (or required rate of return) for each CFt: kt
(iii) Each CF should be discounted and these PVs are then summed to find
the value of an asset.
 Types of Cash Flows from Securities
a.
Bond
constant coupon interests:
Annuity
maturity value (= face value)
or selling price before maturity: Single sum
b.
Preferred Stock
constant preferred dividends:
Perpetuity
Common Stock
cash dividends:
selling price:
Perpetuity or Growing Perpetuity
Single sum
c.
42
VALUATION OF BONDS
Learning Objectives:
 Explain basic terminologies and key features of bonds
 Explain how bond prices are determined
 Describe and calculate a bond’s yield to maturity (or total return), current yield,
and capital gains yield
 Explain and measure interest rate risk for bonds with different maturities
——————————————————————————————————1.
Basic Terminology
Term
Notation
Unit
Note
Coupon interest rate
C
%
fixed
market interest rate
kd
%
varies
(= yield to maturity = cost of debt = return required by bondholders)
Coupon payment
I
$
C%*$1,000
Maturity
n
periods
Maturity, or par, value
M
$
$1,000
2.
Bond Valuation Model
Bond Value = PV of stream of interest payments + PV of maturity value
(PV of annuity)
(PV of a single sum)
𝑃0𝐵 =
𝐼
(1+𝑘𝑑 )
𝑃0𝐵 = ∑𝑛𝑡=1
+
𝐼
(1+𝑘𝑑 )
𝐼
(1+𝑘𝑑
)𝑡
2 + ⋯+
+
𝐼
𝑛 +
(1+𝑘𝑑 )
𝑀
(1+𝑘𝑑 )𝑛
𝑀
(1+𝑘𝑑 )𝑛
 Annual coupon payment: P0 = I * PVIFAkd,n + M * PVIFkd,n
 Semiannual coupon payment: P0 = I/2 * PVIFAkd/2,2n + M * PVIFkd/2,2n
For Financial Calculator:
INPUT
n or 2n
kd or kd/2
N
I/YR
PV
OUTPUT
?
43
I or I/2
1000
PMT
FV
3.
Bond Valuation Theorems
i)
Bond prices (P0) and market interest rates (kd) are inversely related.
ii)
premium
A bond will sell at
par
(6%)
when coupon rate (C)
discount
(4%)
>
= market rate (kd) (5%)
< iii) Regardless of the type of a bond, the market value of a bond will approach its par value as its maturity date approaches. iv) The longer a bond's maturity, the larger the price change in response to a given change in interest rates. A longer-term bond has greater interest rate risk than a shorter-term bond. 4. Bond contract features which affect the cost of the bond i) Restrictive covenants in bond indentures  A provision that requires the issuer to meet certain stated conditions.  Makes the bond safer offers a lower coupon. ii) Call provision  A provision that gives the issuer the right to call the bond for redemption before maturity.  Firms will exercise this option when interest rates go down.  Issuer must pay call price plus call premium.  Makes the bond riskier iii) offers a higher coupon. Sinking fund provision  A provision that requires the issuer to retire a portion of a bond issue each year.  Failure to make a sinking fund payment constitutes technical default.  The firm may call a certain number of bonds for redemption OR it may buy the required amount of bonds in the open market. The firm will choose the less costly method.  Makes the bond safer offers a lower coupon. 44 Example) Bond Valuation On December 31, 2019, XYZ Company issued a 10-year bond with a 14 percent coupon, payable semiannually. The required rate of return, kd, on this bond at that time of issue was 14 percent. 12/31/29 +$1,000.00 +$70.00 +$70.00 +$70.00 6/30/20 +$70.00 12/31/28 5 6/30/29 12/31/20 +$70.00 >
+$70.00
12/31/19
6
6/30/19
WSJ Quotation: XYZ 14s29
Value on 12/31/19
P0 = I/2(PVIFAkd/2, 2n) + M(PVIFkd/2, 2n )
= $70(PVIFA7%, 20) + $1,000(PVIF7%, 20)
= $70(10.5940) + $1,000(0.2584)
= $741.58 + $258.40  $1,000.00.
INPUT
20
7
N
I/YR
PV
OUTPUT
1000
45
70
1000
PMT
FV
Example) Bond Valuation: One Year Later
Now it’s 12/31/20 => Hence, XYZ bond is a 9-year bond:
If kd = 20%: P0 = $70(PVIFA10%,18) + $1,000(PVIF10%,18 )
= $70(8.2014) + $1,000(0.1799)
= $574.10 + $179.90 = $754.00.
Annual interest
Current yield =
$140
=
Price of bond
= 18.6%
$754
Total return = YTM = kd = 20% = Current yield + Capital gains yield
=> Capital gains yield = YTM – Current Yield = 20.0 % – 18.6%= 1.4%.
If kd = 14%: P0 = $70(PVIFA7%, 18) + $1,000(PVIF7%, 18)
= $70(10.0591) + $1,000(0.2959)
= $704.14 + $295.90  $1,000.00.
$140
Current yield =
= 14.0%
$1,000
If kd = 8%: P0 = $70(PVIFA4%,18) + $1,000(PVIF4%,18 )
= $70(12.6593) + $1,000(0.4936)
= $886.15 + $493.60 =$1,379.75
$140
Current yield =
= 10.1%
$1,379.75
=> Capital gains yield = 8% – 10.1% = -2.1% ? Capital loss?
Question: How can we check whether there is indeed a capital loss?
46
Example) Interest Rate Risk
Current Market
Current Market Value
Interest Rate (kd)
1-Year, 10% Bond
12-Year, 10% Bond
0%
$1,100.00
$2,200.00
5
1,047.62
1,443.16
10
1,000.00
1,000.00
15
956.52
728.97
20
916.67
556.08
Market Value of Bond, P0
($)
2,500
2,000
12-Year Bond
1,500
1,000
500
1-Year Bond
5
10
15
20
Market Interest Rate, kd(%)
47
VALUATION OF STOCK
Learning Objectives:
 Describe how to value preferred stock and common stock
 Explain the distinction between a stock’s market price and its intrinsic value
 Apply the constant dividend growth model and the non-constant/supernormal
growth model to estimate stock prices
 Apply the price-earnings multiple approach to estimate stock prices
——————————————————————————————————-
Preferred Stock Valuation
 Application of PV of Perpetuities
𝑝𝑠
𝑃0 =
∞
∑
𝐷
𝐷
𝐷
=
===>
𝑘
=
𝑝𝑠
𝑝𝑠
𝑡
𝑘𝑝𝑠
𝑃0
𝑡=1 (1 + 𝑘𝑝𝑠 )
Example)
Ohio Edison preferred stock currently sells at $41.00 with an
annual dividend rate of 8.80% and a par value of $50. If you buy Ohio Edition
preferred stock today, what rate of return would you expect?
– Annual preferred stock dividends = 8.8% x $50 = $4.40
– P0 = $4.40/ kps = $41.00 => kps = $4.40/$41.00 = 10.7%
48
Common Stock Valuation
Intrinsic Value vs. Market Price of Common Stock
 Outside investors, corporate insiders, and analysts use a variety of approaches to
estimate a stock’s intrinsic value (P0).
 Stocks with a price below (above) its intrinsic value are undervalued (overvalued).
 In equilibrium we assume that a stock’s price equals its intrinsic value.
 Approaches for Estimating Intrinsic Value of Common Stock
 Discounted dividend model
 Price-Earnings (P/E) multiple approach
 EVA approach
 Corporate valuation model (Free cash flow model)
49
DISCOUNTED DIVIDEND MODEL
1.
Simple one-period and two-period stock valuation model
𝑃0𝑠 =
𝐷1 +𝑃1
(1+𝑘𝑠 )
where
; 𝑃0𝑠 =
𝐷1
(1+𝑘𝑠 )
+
𝐷2 +𝑃2
(1+𝑘𝑠 )2
Dt = cash dividend in time t;
Pt = stock price in time t
ks = return required by common stockholders
2. Extended multi-period stock valuation model
In a muti-period case:
𝑃0𝑠 =
𝐷1
(1+𝑘𝑠 )
+
𝐷2
(1+𝑘𝑠 )2
+ ⋯+
𝐷∞
(1+𝑘𝑠 )∞
= ∑∞
𝑡=1
𝐷𝑡
(1+𝑘𝑠 )𝑡
(Discounted Dividend Model)
i) Constant dividend (no growth in dividend)
Dt = Dt+1 = D for all t
𝑃0𝑠 = ∑∞
𝑡=1
𝐷𝑡
(1+𝑘𝑠 )𝑡
=
𝐷1
𝑘𝑠
Example) XYZ company has paid its annual dividend of $ 5.00 this year,
and expects to maintain the same dollar amount of dividends for the coming
years. If the stockholders require a 20% return, how much should the stock be
priced?
Then, P0 = $5/.20 = $25.00
ii) Constant dividend growth
Dt = D0(1+g)t and gt+1 = gt = g for all t
D1 = Do(1 + g)
D2 = D1(1 + g) = Do (1 + g)2
.
.
.
Dn = Dn-1(1 + g) = Do (1 + g)n
50
𝑃0𝑠 = ∑∞
𝑡=1
𝐷𝑡
(1+𝑘𝑠 )𝑡
=
𝐷1
𝑘𝑠 −𝑔
=
𝐷0 (1+𝑔)
𝑘𝑠 −𝑔
Constant Dividend Growth Model (CDGM) or Gordon’s Model
Notes:
i)
ii)
g = 0, g < 0 ks < g, ks = g, D0 = 0 => YES, CDGM works.
=> NO, CDGM does not work.
Example) Owing to favorable market conditions, XYZ company now
expects to increase its earnings and thus dividends at the rate of 10% annual for
coming years. Assuming that other information stays the same (same
dividends this year and stockholders’ required return), how much should the
stock be priced?
𝑃0𝑠 =
𝐷1
𝑘𝑠 −𝑔
=
𝐷0 (1+𝑔)
=
𝑘𝑠 −𝑔
$5(1+.10)
(.20− .10)
= $55.00
iii) Non-constant (or Supernormal) dividend growth
0
1
2
–m
m+1
∞
|———|———|———————–|———-|———————>
non-constant
growth period
P0
constant (normal)
growth period
PV of dividends
during non-constant
growth period
=
𝑃0𝑠 = ∑𝑚
𝑡=1
𝑃0𝑠 = ∑𝑚
𝑡=1
𝑃0𝑠 = ∑𝑚
𝑡=1
𝑠
𝐷𝑡
𝑡 +
(1+𝑘𝑠 )
𝐷𝑡
(1+𝑘𝑠 )𝑡
𝐷𝑡
(1+𝑘𝑠 )
+
𝑡 +
𝐷
𝑘𝑠 −𝑔
1
(1+𝑘𝑠 )𝑚
1
+
𝑥 [𝑃𝑚𝑠 ]
𝐷
(1+𝑘𝑠 )𝑚
1
𝑥 [ 𝑚+1 + ⋯ +
(1+𝑘𝑠 )
𝐷
(1+𝑘𝑠 )
𝑚+1
]
𝑚𝑥 [
𝐷 (1+𝑔)
]
𝑘𝑠 −𝑔
𝑤ℎ𝑒𝑟𝑒 𝑃𝑚 = [ 𝑚+1 ] = [ 𝑚
51
PV of dividends
during constant
growth period
𝑘𝑠 −𝑔
𝐷∞
(1+𝑘𝑠 )∞
]
Example) Valuation of Stock with Nonconstant Divident Growth
(Information in blue is given for the problem.)
0
1
2
3
4———–> ∞
|—————|—————|————–m——— —-|————->
non-constant
growth period
constant (normal)
growth period
D0 =$2.00
gt ==>
g1=-10%
g2=+28%
g3=+13%
g4 = gn = +5%——>
Stockholders’ required rate of return, ks = 15%
—————————————————————————————————PV of dividends
during nonconstant
growth period
P0 =
𝑠
𝐷𝑡
𝑃𝑚
𝑠
𝑚
𝑃0 = ∑𝑡=1
+
(1+𝑘 )𝑡
(1+𝑘 )𝑚
𝑠
𝑠
+
PV of dividends
during constant
growth period
𝑤ℎ𝑒𝑟𝑒 𝑃𝑚𝑠 = [
𝐷𝑚+1
𝑘𝑠 −𝑔
𝐷 (1+𝑔)
]=[ 𝑚
𝑘𝑠 −𝑔
]
Step 1: Computing D1 through D3 during the nonconstant growth period
D1 = D0 (1+g1) = $2.00 x (1 – .1) = $1.80
D2 = D1 (1+g2) = $1.80 x (1 + .28) = $2.30
D3 = D2 (1+g3) = $2.30 x (1 + .13) = $2.60
Step 2: Computing D4 to find out P3 (that represents PV of dividends during the
constant growth period starting year 4)
D4 = D3 (1+g4) = $2.60 x (1 + .05) = $2.73
Then, P3 = D4/(ks – gn) = $2.73/(.15 – .05) = $27.30
Step 3: Combining all together,
𝑃0𝑠 =
$1.80
(1.15)
+
$2.30
(1.15)2
+
$2.60
(1.15)3
52
+(
1
$2.73
)3 [(.15−
1.15
.05)
] = $22.97
Question 1: Can the non-constant or super-normal dividend growth model be
applied to valuing stocks that currently pay no dividends?
 Conceptually, there are at least two possible ways to apply the model to valuing
non-dividend paying stocks:
 If one can estimate when and how much the firm will start paying dividends, as
well as their growth rate, etc. Then, one can proceed as in non-constant dividend
growth model.
 If one can estimate some future market price of the firm’s stock and discount it
back to the present.
 However, these ways are practically impossible to implement due to wide variations
of analysts forecasts on the estimates.
53
PRICE-EARNINGS (P/E) MULTIPLE APPROACH
1.
Factors that lead to a higher or lower P/E ratio or P-E multiple
– P/E multiple represents the price investors are willing to pay to get a dollar
of a firm’s earnings.
(Question: Why do some stocks sell at high P/E while others sell at low P/E?)
𝐷1
⁄𝐸
𝐷1
𝑠
1
𝑃
𝑃0 =
==> ⁄𝐸 =
𝑘 −𝑔
𝑘 −𝐵 𝑥 𝑅𝑂𝐸
𝑠
where
𝑠
E1 = earnings per share
B = retention (or plowback) ratio (= 1 – dividend payout ratio)
= 1- (D1/E1)
ROE = return on equity (return on investment)
=> g = growth rate of earnings and dividends = B x ROE
(e.g., B = 0.4; ROE = 15%; then earnings grow at the rate of 6%)
 The model implies that:
P/E will go up if
E1 declines (temporary decline in earnings)
ks declines (lower risk, thus lower required return)
ROE increases (more valuable growth opportunities)
Question: Is a high P/E stock overpriced or a low P/E stock underpriced?
Question: How can we find a bargain stock using stock’s P/E multiple?
Reading – Bargain Growth Stocks (WSJ, 10/19/2006)
54
2.
Underlying rationale of P/E multiple approach
– P/E multiple represents the price investors are willing to pay to get a dollar
of a firm’s earnings.
– Hence, investors are willing to pay the same P/E multiple for companies
that are in a similar size and doing a similar business in the same industry.
– P/E multiple approach is one of a few relative approaches used by security
analysts as it uses proxy companies as benchmarking.
3.
Steps for P/E multiple approach
Step 1: Select proxy firms (at least two) and collect their data.
Note: Proxy firms are firms:
a)
doing a similar business in the same industry and
b)
with a similar size in terms of sales and/or total assets.
Step 2: Estimate proxy firms’ P/E multiples and measure their average.
Step 3: Multiply the average by expected (or this year’s) earnings to back out
an estimate of the firm’s stock price.
PriceY = EPSY x (Price/EPS)Proxy firms
where Y = your company;
EPS = earnings per share;
(Price/EPS) = average P/E multiple of proxy firms
 Similar analysis can be applied to:
– Price to Sales (Revenue) multiple
– Price to Cash Flow multiple
– Market to book value multiple
55
Example) Stock Valuation Using P/E Multiple Approach
Information: (December 31, 20xx)
Y (My Company)
Jacobs Engr
Group
Stock symbol
JEC (NYSE)
Sales ($mil)
1,780.6
Price ($) = MVEPS
?
EPS ($)
1.80
P/E ratio
?
Dividend yield
0%
% Earned on total capital
12.5%
% Earned net worth
12.4%
Proxy Companies
Armstrong
Johns Manville
World
Corp.
ACK (NYSE)
JM (NYSE)
2,210
1,650
74
10
5.30
0.80
14.0
12.5
2.5%
1.6%
18.5%
13.0%
27.0%
18.5%
Source: Value Line Investment Survey, January 16, 20xx
Estimation:
 P/E multiple approach using the average:P/E multiple of proxy companies:
PriceY = 1.80Y x (14.0 + 12.5)/2 = $23.85: Estimated stock price
 P/E multiple approach using high and low P/E multiples of proxy companies:
PriceY = 1.80Y x 12.5 = $22.50: Estimated low-end stock price
PriceY = 1.80Y x 14.0 = $25.20: Estimated high-end stock price
===========================================================
Actual Stock Price of JEC on 12/31/20xx = $26 (High $32.6; Low $23.3)
===========================================================
Question 1: During late 1990s, security analysts encountered a difficulty in applying
the P/E multiple approach to many dot.com companies? What was the major issue?
Question 2: How was the application problem overcome?
56
The yield curve inverted — here are 5
things investors need to know
By William Watts
Published: Mar 25, 2019 1:55 p.m. ET
This article was originally published on March 22.
A closely watched measure of the yield curve briefly inverted Friday — with the yield on the 10-year
Treasury note falling below the yield on the 3-month T-bill — and rattled the stock market by underlining
investor worries over a potential recession.
Read: 5 key ways Wall Street and economists think about the yield curve
But while that particular measure is indeed a reliable recession indicator, investors may be pushing the
panic button prematurely. Here’s a look at what happened and what it might mean for financial markets.
See: Treasury yield curve inverts for first time since 2007, underlining recession worries
What’s the yield curve?
The yield curve is a line plotting out yields across maturities. Typically, it slopes upward, with investors
demanding more compensation to hold a note or bond for a longer period given the risk of inflation and
other uncertainties. An inverted curve can be a source of concern for a variety of reasons: short-term rates
could be running high because overly tight monetary policy is slowing the economy, or it could be that
investor worries about future economic growth are stoking demand for safe, long-term Treasurys, pushing
down long-term rates, note economists at the San Francisco Fed, who have led research into the
relationship between the curve and the economy.
They noted in an August research paper that, historically, the causation “may have well gone both ways”
and that “great caution is therefore warranted in interpreting the predictive evidence.”
What just happened?
The yield curve has been flattening for some time. On Friday, a global bond rally in the wake of weak
eurozone economic data pulled down yields. The 10-year Treasury note yield TMUBMUSD10Y, 1.85% fell as low as 2.42%, falling below the three-month T-bill yield at 2.455%. On Monday, the 10year yield stood at 2.395%, down more than 5 basis points, while the 3-month yield was down 0.8 basis
point at 2.447%.
Why does it matter?
The 3-month/10-year version that is the most reliable signal of future recession, according to researchers
at the San Francisco Fed. Inversions of that spread have preceded each of the past seven recessions,
including the 2007-2009 contraction, according to the Cleveland Fed. They say it’s offered only two false
positives — an inversion in late 1966 and a “very flat” curve in late 1998.
Is recession imminent?
A recession isn’t a certainty. Some economists have argued that the aftermath of quantitative easing
measures that saw global central banks snap up government bonds may have robbed inversions of their
reliability as a predictor. Since so many Treasurys are held by central banks, the yield can no longer be
seen as market-driven, economist Ryan Sweet of Moody’s Analytics, recently told MarketWatch’s Rex
Nutting.
Meanwhile, recessions in the past have typically came around a year after an inversion occurred. Data
from Bianco Research shows that the 3-month/10-year curve has inverted for 10 straight days six or more
times in the last 50 years, with a recession following, on average, 311 days later.