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1

Purpose:

to assess whether a stock is over or under valued

2

Method

find the true (intrinsic) value of the stock & compare it to the
current price

3

̝if IV ($10) > current price ($7)

stock is under valued & will ↑
over time to its IV

4

̝if IV ($10) < current price ($15),

the stock is over valued & will ↓
over time to its IV

5

Capm

rrequired = rriskfree + β * (rmarket – rriskfree)
rriskfree = 10-yr return on US treasury bond = 0.03
rmarket = 10-yr return on S&P 500 = 0.11

6

TYPES OF VALUATION MODELS

̝Discounted cash flow
̝P/E based

7

DCF Models

̝Fixed dividend models
○ Zero growth
̝Variable dividend models
○ Non-zero growth
○ Combined dividends
and earnings
○ Two-stage growth

8

P/E-based Models

̝P/E as an earnings
multiplier
̝Comparable companies
̝P/E for a zero growth
stock
̝P/E for a non-zero
growth stock

9

DCF MODELS: Zero Growth

Zero growth: Intrinsic value = dividend/r

○ Example 3: Guess' ! is 0.95. Its dividend has been $0.90 for
ten years. Find GES's intrinsic value. It closed at $22.63 on
Friday. Is it over or under valued?
r = 0.03 + 0.95 * (0.11 - 0.03) = 0.11
Intrinsic value = 0.90/0.11 = $8.18 Over

10

DCF MODELS: Non-zero Growth

Intrinsic valuet = Divt+1/(r – growth rate) = Div19/(r - g)
̝Example 5: Brady’s info is below. Use it to find BRC's IV. If it's
trading at $44.15, is it over or under valued?
! = 1.20 Div19 = $0.84 g = 0.015
r = 0.03 + 1.20 * (0.11 – 0.03) = 0.13
IV = 0.84/(0.13 - 0.015) = $7.30 Over

11

̝Combined dividends & earnings model— conceptual

Today 2019 2020 2021
buy stock get dividend get dividend get dividend, sell stock
○ So we have to find the dividends for 2019, 2020, and 2021, and
what we think the price of the stock will be in 2021.

12

̝Combined dividends & earnings model— formulas

Our dividends are earnings based, meaning that a particular
year's dividend is based on that year's EPS:
EPS0 + (1 + g) = EPS1 * Avg. DPO = Div1
○ The expected price of stock in 2021 is also earnings based:
Expected pricefinal year = EPSfinal year * Avg. P/E

Based on the previous slide, we must find the g, the avg DPO, the avg P/E,
and of course, r:
Dividend payout ratioavg = (DPO1 + DPO2 + DPO3)/3
EPSgrowth rate = return on equity * (1 – avg DPO)
P/Eaverage = (P/E1 + P/E2 + P/E3)/3