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3157436 Stock Valuation and Investment Decisions Chapter 8 Cfa

3157436 Stock Valuation and Investment Decisions Chapter 8 Cfa

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Published by: Susheel Thakur on Feb 02, 2011
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ech stocks have been at the forefront of stock market news thepast few years. Often this sector, rather than blue-chipindustrials, drives the market—both up and down. TakeQualcomm, for example; a company that is a leading developerand supplier of digital wireless communications products and services.It pioneered Code Division Multiple Access (CDMA) technology, astandard for the wireless communications industry. Investors inQualcomm stock have experienced a roller coaster ride recently. Thefirm’s 1999 stock price started at $6.48 and soared steadily upward toend the year when it hits $176.13—
after s 
plitting 2-for-1 in May and4-for-1 in December. This represents an annual return of over 2,600%,the year’s best. The following year was another matter, however. Fearsof slowing growth sent the stock price into free-fall: It plummetedfrom $163.25 to $51.50, before rebounding to $82.19 at year end, fora
53% return. Even after the decline, the stock was still trading at aprice/earnings ratio of about 85 in early January 2001, a substantialpremium over the average P/E of 29 for the S&P 500.Despite Qualcomm’s fluctuating stock price, investors looked withfavor on the company’s earnings growth—94% from 1997 through2000, which far outstripped the S&P 500’s 14%. The companyconsistently met or exceeded quarterly earnings estimates, andanalysts project continued earning growth to $1.26 per share in 2001,an increase of 48% over 2000.What do all these numbers mean in terms of the value ofQualcomm’s stock? This chapter explains how to determine a stock’sintrinsic value by using dividend valuation, dividend-and-earnings,price/earnings, and other models. We also look at how to valuetechnology stocks. Finally, we’ll review the use of technical analysis asa way to assess the state of the market in general.
Adrienne Carter, “The Big Score,”
MoneyTechnology 2000 
, October 15, 2000,p.60; Morningstar Quicktake Report—Qualcomm
, downloadedfrom
, January 15, 2001; and Qualcomm Web site,
C H A P T E R 8
OALSAfter studying this chapter, youshould be able to:LG1
LG 2
Discuss the concepts ofintrinsic value and required rates ofreturn, and note how they are used.
LG 3
Determine the underlyingvalue of a stock using the dividendvaluation model, as well as otherpresent value– and price/earningsbased stock valuation models.
LG 4
Gain a basic appreciationof the procedures used to valuedifferent types of stocks, fromtraditional dividend-paying sharesto new-economy stocks with theirextreme price/earnings ratios.
LG 5
Describe the key attributesof technical analysis, including somepopular measures and proceduresused to assess the market.
LG 6
Discuss the idea of randomwalks and efficient markets and notethe challenges these theories holdfor the stock valuation process.
Obtaining a standard of performance that can be used to judge the investmentmerits of a share of stock is the underlying purpose of 
stock valuation.
Astock’s intrinsic value provides such a standard because it indicates the futurerisk and return performance of a security. The question of whether and towhat extent a stock is under- or overvalued is resolved by comparing its cur-rent market price to its intrinsic value. At any given point in time, the price of a share of common stock depends on investor expectations about the futurebehavior of the security. If the outlook for the company and its stock is good,the price will probably be bid up. If conditions deteriorate, the price of thestock will probably go down. Let’s look now at the single most important issuein the stock valuation process:
the future.
Valuing a Company and Its Future
the value of a stock is a function of its future returns,
theinvestor’s task is to use available historical data to project key financial vari-ables into the future. In this way, you can assess the future prospects of thecompany and the expected returns from its stock. We are especially interestedin dividends and price behavior.
Forecasted Sales and Profits
The key to our forecast is, of course, the futurebehavior of the
and the most important aspects to consider in thisregard are the outlook for sales and the trend in the net profit margin. Oneway to develop a sales forecast is to assume that the company will continue toperform as it has in the past and simply extend the historical trend. Forexample, if a firm’s sales have been growing at the rate of 10% per year, thenassume they will continue at that rate. Of course, if there is some evidenceabout the economy, industry, or company that suggests a faster or slower rateof growth, the forecast should be adjusted accordingly. More often than not,this “naive” approach will be about as effective as more complex techniques.Once the sales forecast has been generated, we can shift our attention tothe net profit margin. We want to know what kind of return on sales to expect.A naive estimate can be obtained by simply using the average profit marginthat has prevailed for the past few years. Again, it should be adjusted toaccount for any unusual industry or company developments. For most indi-vidual investors, valuable insight about future revenues and earnings can beobtained from industry or company reports put out by brokerage houses, advi-sory services (e.g.,
Value Line
), the financial media (e.g.,
), and from
Valuation:Obtaining aStandard ofPerformance
LG 1LG 2stock valuation
the process by which theunderlying value of a stockis established on the basis of itsforecasted risk and returnperformance.
 —As opticalnetworking companies caughtinvestors’ attention, theirmarket value soared. InSeptember 2000, this hypedrove the value of JDSUniphase to $96 billion, whichmade it the 36th most highlyvalued company in the world.Investors apparently turned ablind eye to the company’sfinancial results for the fiscalyear ended June 30, 2000: Itsrevenues were $1.4 billion andits losses $905 million. Forabout the same total marketcapitalization, you couldtheoretically buy all 11 of thefollowing major companies—the New York Times, Saks FifthAvenue, Georgia Pacific, T.Rowe Price, Delta Airlines,Tiffany & Co., Bear Stearns,FedEx, CVS, Gap, and JohnHancock—with aggregaterevenues of $115 billion and$6.4 billion in profits!
Jon Birger, Pablo Galarza,Laura Lallos, and Jeanne Lee, “BestStocks & Funds: Invest the SmartWay to Buy Tech,”
Money/Tech 2000 
,October 15, 2000, pp. 65–66.
various investor Web sites. Or, as the accompanying
 Investing in Action
box explains, you might even want to take a look at so-called “whisper forecasts” as a way to get a handle on earningsestimates.Given a satisfactory sales forecast and estimate of thefuture net profit margin, we can combine these two pieces of information to arrive at future earnings.
The “year
notation in this equation simply denotes a given calendar or fiscalyear in the future. It can be next year, the year after that, or any other year inwhich we are interested. Let’s say that in the year just completed, a companyreported sales of $100 million, we estimate that revenues will grow at an 8%annual rate, and the net profit margin should be about 6%. Thus estimatedsales next year will equal $108 million ($100 million
1.08). And, with a 6%profit margin, we should expect to see earnings next year of 
$108 million
Using this same process, we would then estimate sales and earnings
 for allother years
in our forecast period.
Forecasted Dividends and Prices
At this point we have an idea of the futureearnings performance of the company. We are now ready to evaluate theeffects of this performance on returns to common stock investors. Given a cor-porate earnings forecast, we need three additional pieces of information:An estimate of future dividend payout ratios.The number of common shares that will be outstanding over the forecastperiod.A future price/earnings (P/E) ratio.For the first two, unless we have evidence to the contrary, we can simply pro- ject the firm’s recent experience into the future. Payout ratios are usually fairlystable, so there is little risk in using a recent average figure. (Or, if a companyfollows a fixed-dividend policy, we could use the latest dividend rate in ourforecast.) It is also generally safe to assume that the number of common sharesoutstanding will hold at the latest level or perhaps change at some moderaterate of increase (or decrease) that’s reflective of the past.
Getting a Handle on the P/E Ratio
The only really thorny issue in thiswhole process is coming up with an estimate of the future P/E ratio—a figurethat has considerable bearing on the stock’s future price behavior. Generallyspeaking, the P/E ratio is a function of several variables, including:1.The growth rate in earnings.2.The general state of the market.3.The amount of debt in a companys capital structure.
Future after-taxearnings next yearNet profit marginexpected in year
Estimated salesfor year
Future after-taxearnings in year
Equation 8.1
For help researching a company, see the fol-lowing sites. At the ClearStation site, enter astock symbol and click on [Get Graphs].

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