Chapter 13 Equity valuation homework assignment

Business Finance

Harvard University

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hello, similar to the prior assignment you completed for me. This complete the attached excel document. the powerpoint chapter is also attached for reference if needed. thank you

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FIN 327 - Assigment on Chapter 13 - Equity Valuation Name: Mourad, Stephen Score (out of 15) 0 Instructions This assignment covers Chapter 13 on equity valuation. Please review the voice-over PowerPoint (in section "Chapter 13 Equity valuation - Online version" on Blackboard) before completing this assignment. Due date: The due date is April 20, 2020 at 19:00 PM PST. If you are sick or have difficult circumstances due to the virus, you can ask for an extension by e-mail. Points: This assignment counts for 8% of the class - see revised Syllabus on Blackboard for new scale. How to complete: THIS IS AN INDIVIDUALIZED ASSIGNMENT THAT MUST BE COMPLETED ON YOUR OWN. You do not have to do this questionnaire at a specific time, as long as you submit it before the due date. You do not have to do it all at once, you can save it and continue later. Enter your answers directly in the pale blue boxes below. When you are done, SAVE YOUR FILE!! (with your name) and submit it in the second midterm assignment section on Blackboard. If you are unable to load the file on Blackboard, you can e-mail me your file. For calculations, you can use Excel equations (e.g. =(1+2)/3) directly in the blue boxes. You can also do the calculations on your calculator, and enter the result in the blue boxes. TO COMPUTE A POWER FUNCTION, USE THE SYMBOL ^. For example, if you want to compute (1+0.1)3, you would type =(1+0.1)^3. If you cannot use Excel, you can alternatively use a printed version of this questionnaire. Please get in touch with me by e-mail if you need to use this option. In your e-mail, indicate if you can use a printer and if you can scan the completed questionnaire, for example with your phone. There is no partial credit for this assignment, please take the time to verify your answers. Academic honesty: You cannot work with other students for this assignment and the Academic honesty rules listed in the syllabus still apply in this online transition. Please confirm that you have read the statement below by typing your name in the pink box. The California State University system requires instructors to report all instances of academic misconduct to the Center for Student Rights and Responsibilities. Academic dishonesty will result in disciplinary review by the University and may lead to probation, suspension, or expulsion. Instructors may also, at their discretion, penalize student grades on any assignment or assessment discovered to have been produced in an academically dishonest manner. I certify that I understand the Academic honesty rules and that I have not received help when completing this questionnaire. Type your name: Part 1 - Your stock For questions 1-5, use the same stock as in the second midterm. The tab "Stock" gives you the following information about your stock: sector, beta, dividend growth (g), current dividend yield (D 0), Bloomberg estimate of the growth rate of dividends, and Bloomberg forecast for earnings in year 3. Question 1. Compute the market capitalization rate of your stock according to CAPM, using an assumption of rf=0.60% and E[rm ]=9.78%. You can find the beta for your stock in the tab “Stock.” You can type in the calculation directly in the blue box. Question 2. Can you use the Constant Growth Model to value your stock? Check one box: Yes No If your answer is yes, use the Constant Growth Model to compute the value of your stock (V0 in the notes). If your answer is no, explain why. Question 3. (a little harder, at least give it a try) To have more flexibility to reflect recent changes in economic conditions, you change from the Constant Growth Model to the more general Dividend Discount Model (DDM). Using that model, you assume that there are no dividends for the first year, i.e. D1=0. For the years afterwards, you assume that the dividends are unchanged. V0=D1/(1+k) + D2/(1+k)2+D3/(1+k)3+… General DDM equation (slide 25 of the notes) Dividend assumption for this question: D1=0, D2=D0x(1+g)2, D3=D0x(1+g)3, D4=D0x(1+g)4, … If we are plugging the new dividend assumptions in the DDM equation, we get: V0This question= D0x(1+g)2/(1+k)2+D0x(1+g)3/(1+k)3+… To avoid having to add an infinite number of terms, you rewrite this equation as a closed-form This question equation. Check the box next to the equation that is equivalent to V0 : V0 This question V0 This question V0 This question =D0(1+g)/(k-g) =D0(1+g)/(k-g)-D0(1+g)/(1+k) =D0/(k-g)2 V0This question=D0/(k-g) None of the above Questions 4 and 5. (1 point for P3 and 1 point for V0) Valuation method: For these questions, use the variation of the Dividend Discount Model (DDM) with a terminal price in the third year: V0=D1/(1+k) + D2/(1+k)2+D3/(1+k)3+P3/(1+k)3. Dividends: For the first three years, assume that dividends grow at the constant rate g given in the tab 2 3 "Stock," i.e. D1=D0(1+g), D2=D0(1+g) , and D3=D0(1+g) . Terminal value: For the terminal value assumption P3, you use a relative valuation approach (Value=Forecasted P/E ratio x Forecasted earnings). For the forecasted P/E ratio, you use the average P/E ratio for your stock's sector and apply it to the third year's forecasted earnings. The tab "Stock" gives you your stock's sector, a table with the P/E ratios by sector, and your stock's forecasted earnings for year 3. For this calculation, compute the components of V0 by filling the boxes below. Add the results in the last column to get V0. D1 x 1/(1+k) = D1/(1+k) 2 = D2/(1+k)2 D2 x 1/(1+k) D3 x 1/(1+k)3 = D3/(1+k) P3 x 1/(1+k)3 = P3/(1+k)3 3 Add the last column to get V0 --> Part 2 - Zoom Video Communications (ZM) For Questions 6-13, read the JP Morgan analyst report for Zoom (ZM) as of March 4, 2020. You can find the file "Zoom JP Morgan Report" in this assignment's section on Blackboard. Question 6. What is the approach used by the analyst to value Zoom? (Check one box) Relative valuation Discounted cash flow (DCF) with dividend discount model (DDM) Discounted cash flow (DCF) with constant growth model (CGM) Discounted cash flow (DCF) with free cash flows Question 7. Is it possible to use the Constant Growth Model to value Zoom? (Put an X in the box) Yes No If yes, what equation would you use? If no, why? Question 8. What is the discount rate used in the valuation? Question 9. What are FCFFs? (Just give the name, not the calculation) What is the analyst's assumption for the FCFF's growth in fiscal year 2020? Question 10. Use the "Company data" section to find the market capitalization of Zoom in millions. Use the report to find the price per share of Zoom (as of March 4, 2020) Question 11. What is the book value per share (BVPS) of Zoom for fiscal year 2019? Is the market price per share high compared to the book value per share? Question 12. What is the intrinsic value of Zoom according to JP Morgan's analyst? Use this intrinsic value and the market price of Zoom to explain whether the analyst would recommend buying or selling the stock? Question 13. According the the Summary of Financials table, the P/E ratio for Zoom for fiscal year 2020 is 336.7. Give one possible interpretation for this high P/E ratio. (There can be more than one answer.) Part 3 - Carnival Corporation (CCL) Questions 14-15 are based on Carnival Corporation, a cruise company. Since the beginning of the year, the stock of the company has declined by 84%. Question 14. You are a corporate raider and you think that cruises are not going to be popular in the next years. However, you are interested in the liquidation value of the company. What would be the corproate raider's profit if he(she) buys all the shares of Carnival, repays the existing debts, and sells the ships? (Use the information below in your answer. Give the answer in millions.) 528 million Number of shares outstanding: 27.169 million Cost of repaying existing debts: 43.896 million Proceeds from selling the ships: Market price per share (as of April 2, 2020): $7,97 Question 15. You consider using relative valuation to value Carnival. In particular, you are using the average forecasted P/E ratio of comparable companies as a multiple. You find that there are two other comparable companies and their forecasted P/E ratios are as follows: Forecasted P/E ratios of comparable companies Royal Carribean Cruises 5,8 Norwegian Cruise Line Holdings 3,0 The forecasted earnings per share of Carnival are: 1,33 What is the P/E ratio that you are using to value Carnival? Based on this P/E ratio and the forecasted earnings per share, what is the relative valuation of Carnival? Points Name: Mourad, Stephen Stock name: INTUIT INC Stock ticker: INTU Sector: Information Technology Beta: Dividend growth (g): 1,21 15,02% Current dividend (D0): 1,88 Forecasted earnings in year 3: 8,47 Forecasted P/E ratios by sector Sector Forecasted P/E ratio Communication Services Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Real Estate Utilities 19,70 28,06 25,47 19,69 8,44 21,82 16,30 22,82 24,63 27,60 17,17 FIN 327: Chapter 13 Readings Chapter 13, all (except PVGO) Exercises Chapter 13: 1, 2, 5, 6, 8, 10, 14, 15, 17 1 OUTLINE 1. Types of Value 2. Relative Valuation 3. Discounted Cash Flow Valuation (DCF) 4. Dividend Discount Model 5. Free Cash Flow 2 1. Types of Value • What’s the value of a firm? • The answer to this question is not unique. There are different types of values, for example: – – – – Book value Market value Liquidation value Intrinsic value • For intrinsic values, there can be as many computation methodologies as there are analysts. 1. Book Value • The book value is the net worth of common equity according to a firm’s balance sheet. This is obtained by subtracting a firm’s liabilities from its assets. • Book values represent an accountant’s view of the original cost of acquiring assets, with an adjustment for depreciation. • While financial analysts use information from financial statements, they are more interested in forward-looking measures of the firm’s value. 1. Liquidation Value • A firm’s liquidation value is the net amount that can be realized by selling the assets of a firm and paying off the debt. It provides a “floor” for the value of equity: If the market price of equity drops below the liquidation value of the firm, the firm becomes attractive as a takeover target. • This type of value is relevant for a corporate raider that considers taking over the firm and liquidating its assets. It can also be useful to analysts looking for potential takeover targets. 1. Market Value • The prices per share that you see on stock exchanges do not reflect book values, they reflect the market value of the shareholder’s equity investment, which is the difference between the current market value of assets and liabilities. • The market capitalization of a firm is obtained by multiplying the price per share by the number of shares outstanding. 1. Fundamental Analysts • A fundamental analyst looks for underpriced securities. He does not assume that market values are correct. • Using a valuation model (there are many), he computes the intrinsic value of the firm to assess whether the stock is a buy or a sell. If Intrinsic value > Market price If Intrinsic value < Market price 1. Fundamental Analysts • DCF (discounted cash flows) methods are commonly used to value stocks. These are “absolute” valuation methods. • Alternatively, analysts can use a relative valuation (or valuation by comparables) approach. In that case, the analyst identifies companies similar to the one they are trying to value. They judge whether the stock is underpriced or overpriced by comparing standardized measures (e.g. P/E ratio) across companies. 1. Fundamental Analysts • Sell-side analysts express their view of the value of the firm as a price target, which is typically the share price that they expect in one year. • In their reports, analysts cite the valuation method that they used to obtain their price targets. The most commonly cited approaches are multiples-based and DCF. Some analysts use a combination of approaches, e.g. 50% multiples-based/50% DCF. • The next 3 slides give examples. 1. Examples of Analyst Valuations 1. Examples of Analyst Valuations 1. Examples of Analyst Valuations 2. Relative Valuation • A simple and very common valuation method is to use a price-earnings multiple: 𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒 = 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝑃/𝐸 𝑟𝑎𝑡𝑖𝑜 × 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 Example • An analyst is using a P/E ratio of 15 to price the stock of XYZ. Using a price-earnings multiple approach, what is the value of the stock if the analyst forecasts earnings per share (EPS) of $2.00 per share for next year? By how much does the price increases if he revises his EPS forecast to $2.50? • Answer: Initially: 15 x $2.00 = $30.00. With revised earnings: 15 x $2.50 = $37.50 → a $7.50 increase 2. Relative Valuation • The previous example illustrates that estimated values can be very sensitive to earnings forecasts. • Analysts often revise their earnings forecasts after the company releases their quarterly earnings, which is one reason prices often jump on those days. • While this approach is computationally simple, it is not easy to determine the correct P/E ratio. Not every firm has comparable firms. P/E ratios change over time and by industry. 2. Relative Valuation Historical P/E ratios for S&P 500 index – 1954-2019 Dot.com bubble: Average P/E ratio of 30 Current market P/E ratio: 22.18 2. Relative Valuation 2. Relative Valuation • P/E ratios that are reported in financial media can use historical EPS (trailing 12 months EPS) or forecasted ones (using next year’s forecasted EPS). • Forward-looking measures are often more appropriate because historical ones have a number of issues: 1. 2. 3. No P/E ratio when earnings are negative or available for less than a year. Earnings are based on arbitrary accounting rules. Firms can use earnings management to manipulate numbers. Last year’s earnings can be affected by one-time events that are unlikely to repeat in the future. 2. Relative Valuation Most common forward P/E ratios are between 12-16 Source: Aswath Damodaran Less extreme P/E ratios when use forward earnings vs. past earnings 2. Relative Valuation Can be a warning sign of overpricing (too much hype) High P/E ratio (compared to what?) or Can reflect higher growth prospects for the firm 2. Relative Valuation • To adjust for growth, some analysts use the PEG ratio. A PEG ratio is the P/E ratio divided by the forecasted growth rate (multiplied by 100). • Some analysts use a rule-of-thumb where fairly priced companies should have a PEG ratio around 1. (Not theoretically motivated.) 2. Relative Valuation • Besides P/E ratios, analysts may use other ratios in valuing the firm: – Price-to-book – Price-to-cash-flow (can address concerns that earnings are manipulated by accounting practices) – Price-to-sales (useful for start-up firms with no earnings – can be affected by margins) • Ratios are a basis for rules-of-thumb, e.g. a P/E ratio of 15 can be interpreted as: “it takes 15 years to get back your investment if earnings don’t change.” 3. Discounted Cash Flow Valuation • With a discounted cash flow (DCF) approach, the analyst projects the cash flows of the firm and discounts them with a riskadjusted discount rate 𝑘. • The book covers two types of DCF approaches: dividend discount models (DDM) and free cash flows (FCF) models. Project future cash flows Discount them at an appropriate riskadjusted rate 3. Discounted Cash Flow Valuation Two approaches to project cash flows over time: 1. Project cash flows in perpetuity → Can be hard to be accurate after a few years 2. Project cash flows for a few years and assume that stock is sold at a terminal value → Valuations can be very sensitive to terminal value assumption 25 Cash Flows in perpetuity Cash Flows & Terminal Price 20 15 10 5 0 1 2 3 4 5 6 7 8 9 10 4. DDM • With the Dividend Discount Model (DDM), the value of the stock is equal to the present value of the stock’s future dividends, discounted at the market capitalization rate 𝑘. 𝐷1 𝐷2 𝐷3 𝑉0 = + + +⋯ 2 3 1 + 𝑘 (1 + 𝑘) (1 + 𝑘) 4. DDM • A common approach to compute the market capitalization rate 𝑘 is to use CAPM. Recall that with CAPM, the expected return of a firm is given by: 𝑘 = 𝑟𝑓 + 𝛽 𝐸[𝑟𝑀 ] − 𝑟𝑓 where 𝑟𝑓 is the risk free rate, 𝐸[𝑟𝑀 ] is the expected market return, and 𝐸[𝑟𝑀 ] − 𝑟𝑓 is the market risk premium. 4. DDM • Some common variations of the DDM: 1. Instead of projecting dividends for an infinite number of years, we can assume that the stock will be sold for a price 𝑃𝐻 in 𝐻 years: 𝐷1 𝐷2 𝐷𝐻 + 𝑃𝐻 𝑉0 = + + ⋯+ 2 1 + 𝑘 (1 + 𝑘) (1 + 𝑘)𝐻 2. Constant growth model (CGM): Assume that dividends grow at a constant growth rate 𝑔 3. Two-stage growth model: Assume that dividends grow at a constant rate 𝑔1 for a number of years, and then at a rate 𝑔2 afterwards. 4. DDM • The Constant Growth Model is convenient because it gives us a simple equation for the value of the stock: 𝐷0 (1 + 𝑔) 𝐷0 (1 + 𝑔)2 𝐷0 (1 + 𝑔)3 𝑫𝟏 𝑉0 = + + +⋯= 2 3 1+𝑘 (1 + 𝑘) (1 + 𝑘) 𝒌−𝒈 Some limitations: – Some stocks don’t have dividends – Can’t have 𝑔 > 𝑘 (use two-stage model for high growth firms) 4. DDM • While the CGM is too simplistic to be realistic in most cases, it gives us some intuition about the drivers of value. Higher Dividends → Higher Value Higher risk (𝑘) → Lower Value Higher Growth → Higher Value 4. Example • You project a dividend of $4 next year for XYZ company. The risk-free rate is currently 1% and the expected market return 12%. Consulting Yahoo! Finance, you find that the beta of XYZ is 1.0. If you project a growth rate of 5% for XYZ, what is the value of the stock according to the CGM? • Answer: 𝑘 = 1% + 1.0 × 12% − 1% = 12.0% $4 𝑉0 = = $57.14 12% − 5% 4. Example • Still with company XYZ, you consult Bloomberg and find that beta is 1.2 instead of 1.0.* How does that change the value of the stock? • Answer: 𝑘 = 1% + 1.2 × 12% − 1% = 14.2% $4 𝑉0 = = $43.48 0.142 − 0.05 → A decline of $43.48-$57.14=-$13.66 * In practice, this is not uncommon to have different betas because different providers use different historical periods. 4. Example • XYZ earns a new contract that will increase its growth rate from 5% to 6%. Assuming that its projected dividend for the year remains at $4 and that the discount rate is 𝑘=12%, what is the increase in the stock value? • Answer: – Initial value=$4/(0.12-0.05)=$57.14 – New value=$4/(0.12-0.06)=$66.67 → An increase of $66.67-$57.14=$9.53 4. Example • This example shows that values computed with CGM are very sensitive to the long-term assumptions 𝑘 and 𝑔. Keep in mind that models are subject to “Garbage-in-garbage-out problems”, sensitivity analysis is often warranted before acting on results. 5. FCF • The DDM is more appropriate for mature companies that pay regular dividends. • Many young growing companies (e.g. Tesla) don’t pay dividends. In their case, one possibility is to use a two-stage model with no dividends in the first stage. • A more practical solution is to use valuation methods that are based on free cash flows (which are cash flows available to the firm or the equityholders, net of capital expenditures) rather than dividends. 5. FCF • Free Cash Flows calculations typically: – Start ...
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