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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.
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typing your name in the pink box.
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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 โStock.โ 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+โฆ
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, โฆ
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+โฆ
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
โข Whatโs the value of a firm?
โข The answer to this question is not unique. There are
different types of values, for example:
โ
โ
โ
โ
Book value
Market value
Liquidation value
Intrinsic value
โข For intrinsic values, there can be as many
computation methodologies as there are analysts.
1. Book Value
โข The book value is the net worth of common equity
according to a firmโs balance sheet. This is obtained
by subtracting a firmโs liabilities from its assets.
โข Book values represent an
accountantโs view of the original cost
of acquiring assets, with an
adjustment for depreciation.
โข While financial analysts use information from
financial statements, they are more interested in
forward-looking measures of the firmโs value.
1. Liquidation Value
โข A firmโs 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 โfloorโ 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.
โข 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
โข The prices per share that you see on stock exchanges
do not reflect book values, they reflect the market
value of the shareholderโs equity investment, which
is the difference between the current market value
of assets and liabilities.
โข The market capitalization of a firm is obtained by
multiplying the price per share by the number of
shares outstanding.
1. Fundamental Analysts
โข A fundamental analyst looks for
underpriced securities. He does not
assume that market values are correct.
โข 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
โข DCF (discounted cash flows) methods are commonly
used to value stocks. These are โabsoluteโ valuation
methods.
โข 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
โข 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.
โข 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.
โข The next 3 slides give examples.
1. Examples of Analyst Valuations
1. Examples of Analyst Valuations
1. Examples of Analyst Valuations
2. Relative Valuation
โข A simple and very common valuation method is to
use a price-earnings multiple:
๐๐ก๐๐๐ ๐๐๐๐ข๐
= ๐น๐๐๐๐๐๐ ๐ก๐๐ ๐/๐ธ ๐๐๐ก๐๐ ร ๐น๐๐๐๐๐๐ ๐ก๐๐ ๐๐๐๐๐๐๐๐
Example
โข 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?
โข Answer: Initially: 15 x $2.00 = $30.00.
With revised earnings: 15 x $2.50 = $37.50
โ a $7.50 increase
2. Relative Valuation
โข The previous example illustrates that estimated
values can be very sensitive to earnings forecasts.
โข Analysts often revise their earnings forecasts after
the company releases their quarterly earnings, which
is one reason prices often jump on those days.
โข 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 โ 1954-2019
Dot.com bubble:
Average P/E ratio of 30
Current market P/E ratio: 22.18
2. Relative Valuation
2. Relative Valuation
โข P/E ratios that are reported in financial media can use
historical EPS (trailing 12 months EPS) or forecasted ones
(using next yearโs forecasted EPS).
โข 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 yearโs 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
โข 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).
โข Some analysts use a rule-of-thumb where fairly
priced companies should have a PEG ratio around 1.
(Not theoretically motivated.)
2. Relative Valuation
โข Besides P/E ratios, analysts may use other ratios in
valuing the firm:
โ Price-to-book
โ Price-to-cash-flow (can address concerns that earnings are
manipulated by accounting practices)
โ Price-to-sales (useful for start-up firms with no earnings โ
can be affected by margins)
โข Ratios are a basis for rules-of-thumb, e.g. a P/E ratio
of 15 can be interpreted as: โit takes 15 years to get
back your investment if earnings donโt change.โ
3. Discounted Cash Flow Valuation
โข With a discounted cash
flow (DCF) approach, the
analyst projects the cash
flows of the firm and
discounts them with a riskadjusted discount rate ๐.
โข 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 โ 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 โ 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
โข With the Dividend Discount Model (DDM), the value
of the stock is equal to the present value of the
stockโs future dividends, discounted at the market
capitalization rate ๐.
๐ท1
๐ท2
๐ท3
๐0 =
+
+
+โฏ
2
3
1 + ๐ (1 + ๐)
(1 + ๐)
4. DDM
โข A common approach to compute the market
capitalization rate ๐ is to use CAPM. Recall that with
CAPM, the expected return of a firm is given by:
๐ = ๐๐ + ๐ฝ ๐ธ[๐๐ ] โ ๐๐
where ๐๐ is the risk free rate, ๐ธ[๐๐ ] is the expected
market return, and ๐ธ[๐๐ ] โ ๐๐ is the market risk
premium.
4. DDM
โข 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 ๐๐ป in ๐ป years:
๐ท1
๐ท2
๐ท๐ป + ๐๐ป
๐0 =
+
+ โฏ+
2
1 + ๐ (1 + ๐)
(1 + ๐)๐ป
2. Constant growth model (CGM): Assume that
dividends grow at a constant growth rate ๐
3. Two-stage growth model: Assume that dividends
grow at a constant rate ๐1 for a number of years,
and then at a rate ๐2 afterwards.
4. DDM
โข The Constant Growth Model is convenient because it
gives us a simple equation for the value of the stock:
๐ท0 (1 + ๐) ๐ท0 (1 + ๐)2 ๐ท0 (1 + ๐)3
๐ซ๐
๐0 =
+
+
+โฏ=
2
3
1+๐
(1 + ๐)
(1 + ๐)
๐โ๐
Some limitations:
โ Some stocks donโt have dividends
โ Canโt have ๐ > ๐ (use two-stage model for high growth firms)
4. DDM
โข While the CGM is too simplistic to be realistic in most
cases, it gives us some intuition about the drivers of
value.
Higher Dividends
โ Higher Value
Higher risk (๐)
โ Lower Value
Higher Growth
โ Higher Value
4. Example
โข 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?
โข Answer: ๐ = 1% + 1.0 ร 12% โ 1% = 12.0%
$4
๐0 =
= $57.14
12% โ 5%
4. Example
โข 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?
โข Answer:
๐ = 1% + 1.2 ร 12% โ 1% = 14.2%
$4
๐0 =
= $43.48
0.142 โ 0.05
โ 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
โข 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 ๐=12%, what is the increase in the
stock value?
โข Answer:
โ Initial value=$4/(0.12-0.05)=$57.14
โ New value=$4/(0.12-0.06)=$66.67
โ An increase of $66.67-$57.14=$9.53
4. Example
โข This example shows that values computed with CGM
are very sensitive to the long-term assumptions ๐
and ๐. Keep in mind that models are subject to
โGarbage-in-garbage-out problemsโ, sensitivity
analysis is often warranted before acting on results.
5. FCF
โข The DDM is more appropriate for mature companies
that pay regular dividends.
โข Many young growing companies (e.g. Tesla) donโt
pay dividends. In their case, one possibility is to use a
two-stage model with no dividends in the first stage.
โข 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
โข Free Cash Flows calculations typically:
โ Start ...