Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Seventh Editionby

Frank K. Reilly & Keith C. Brown

Chapter 13

Applying the DDM Valuation Model to the Market

• The stream of expected returns

• The time pattern of expected returns

• The required rate of return on the investment

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Applying the DDM Valuation Model to the Market

Determinants of the Earnings Multiplier:1. The expected dividend payout ratio

2. The required rate of return on the stock

3. The expected growth rate of dividends for the stock

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Market Valuation Using the Reduced Form DDM

• Estimating k and g for the U.S. equity market

• The nominal risk-free rate

• The equity risk premium

• The current estimate of Risk Premium and k

• Estimating the growth rate of dividends (g)g = f(b,ROE)

ROE = Net Income / Equity

Estimating Growth Rate

• Growth rate of dividends is equal to– Retention rate - the proportion of earnings

retained and reinvested – Return on equity (ROE) – rate of return earned

on investment An increase in either or both of these variables

causes an increase in the expected growth rate (g) and an increase in the earnings multiplier

Return on Equity (ROE)

EquityCommon

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Market Valuation Using the Free Cash Flow to Equity (FCFE) Model

FCFE is:+ Net Income

+ Depreciation Expense

- Capital Expenditures

- in Working Capital

- Principal Debt Repayments

+ New Debt issues

Market Valuation Using the Free Cash Flow to Equity (FCFE) Model

• The Constant Growth FCFE Model

• The Two Stage Growth FCFE Model

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Market Valuation Using Relative Valuation Approach

• The price-earnings ratio (P/E)

• The price-book value ratio (P/BV)

• The price-cash flow ratio (P/CF)

• The price-sales ratio (P/S)

Market Valuation Using Relative Valuation Approach

• Two-part valuation procedure

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Market Valuation Using Relative Valuation Approach

• Importance of both components of value1. Estimating the future earnings per share

for the stock-market series

2. Estimating a future earnings multiplier for the stock-market series

Estimating Expected Earnings Per Share

• Estimating expected earnings per share

Estimate sales per share for a stock-market series

Estimate the operating profit margin for the series

Estimate depreciation per share for the next year

Estimate interest expense per share for the next year

Estimate the corporate tax rate for the next year

• Estimating Gross Domestic Product

• Estimating sales per share for a market series

Estimating Expected Earnings Per Share

• Alternative estimates of corporate net profits– Direct estimate of the net profit margin based on recent

trends– Estimate the net before tax (NBT) profit margin– Estimate an operating profit margin to obtain EBITDA;

estimate depreciation and interest to arrive at EBT; estimate the tax rate (T) and multiply by (1-T) to estimate net income

Estimating Expected Earnings Per Share

• Estimating aggregate operating profit margins

– Capacity utilization rate

– Unit labor costs

– Rate of inflation

– Foreign competition

Estimating Expected Earnings Per Share

• Estimating depreciation expense

– time series trends

– estimate based on property, plant, and equipment

• sales and turnover

• depreciation

Estimating Expected Earnings Per Share

• Estimating interest expense– debt levels

• total assets

• expected capital structure

– interest rates

– subtract result from EBIT to estimate EBT

Estimating Expected Earnings Per Share

• Estimating the tax rate– depends on future political action

– multiply (1-T) times the EBT per-share to estimate the net income per share

Estimating the Earnings Multiplier for a Stock Market Series

• Determinants of the earnings multiplier– Dividend payout ratio– required rate of return on common stock– the expected growth rate of dividends for the stocks

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Estimating the Earnings Multiplier for a Stock Market Series

• Estimating the required rate of return (k)

– inversely related to the earnings multiplier

– determined by risk-free rate, expected inflation, and the risk premium for the investment

• Estimating the dividend payout ratio (D/E)

– active decision or residual outcome?

– time series plots

– long-run perspective

Estimating the Earnings Multiplier for a Stock Market

Series• Estimating an Earnings Mutiplier: An

Example– The Direction of Change Approach– Specific Estimate Approach

• Calculating an Estimate of the Value for the Market series

Other Relative Valuation Ratios

• Price to book value ratio (P/BV)

• Price to cash flow ratio (P/CF)

• Price to sales ratio (P/S)

Analysis of World Markets

• Individual country analysis– analyze economy and security markets before

analyzing alternative industries or companies– macro techniques– micro techniques– technical analysis– top down approach

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