Common Stock Valuation

Fundamental Analysis Approaches

 Present value approach
 Capitalization of expected income
 Intrinsic value based on the discounted value of the expected
stream of cash flows
 Multiple of earnings (P/E) approach
 Stock worth some multiple of its future earnings

Present Value Approach (Capitalization of Income)

 Intrinsic value of a security is


Dt
Po =  t
(1 + K e )
t 1
Ke = appropriate discount rate

 In using model, to estimate the intrinsic value of the security must:

 Discount rate (Capitalization Rate, Required Rate of Return)
 Required rate of return: minimum expected rate to induce
purchase given the level of risk
 The opportunity cost of dollars used for investment
 Expected cash flows and timing of cash flows
 Stream of dividends or other cash payouts over the life of
the investment
 Dividends paid out of earnings and received by
investors
 Earnings important in valuing stocks
 Retained earnings enhance future earnings and ultimately
dividends
 If use dividends in PV analysis, don’t use retained
earnings in the model
 Retained earnings imply growth and future
dividends
 Compared computed price to actual price

Dividend Discount Model

  Current value of a share of stock is the discounted value of all future
dividends
 Problems:
 Need infinite stream of dividends
 Dividends received 40-50 years in the future are worth very
little in present value with the discount rate is sufficiently
high (12%, 14%, 16%)
 Dividend stream is uncertain
 Dividends not guaranteed
 Declared by Board of Directors
 Must estimate future dividends
 Dividends may be expected to grow over time
 Must model expected growth rate of
dividends and the growth rate need not be
constant

Dividend Discount Model-Zero Growth

 Assume no growth in dividends
 Fixed dollar amount of dividends reduces the security to a perpetuity
Do
Po 
Kp
Kp = appropriate discount rate

 Similar to preferred stock because dividend remains unchanged

Dividend Discount Model-Constant Growth-Gordon Model

 Assumes a constant growth in dividends
 Dividends expected to grow at a constant rate, g, over time

D1
Po = D1 = Do (1 + g)
Ke - g

where
 g: growth rate
 ke: required return
 Ke > g
 D1 is the expected dividend at end of the
first period
 D1 =D0 (1+g)

 Implications of constant growth

 Stock prices grow at the same rate as the dividends (g)
  Problem: what if higher growth in price than dividends or
visa versa
 Stock total returns grow at the required rate of return
 Growth rate in price plus growth rate in dividends equals k,
the required rate of return
 A lower required return or a higher expected growth in dividends
raises prices

Reasons for Different Values of Same Stock

 Each investor may use their individual k
 Each investor has their own estimate of g

Dividend Discount Model-Multiple Growth

 Multiple growth rates: two or more expected growth rates in dividends
 Ultimately, growth rate must equal that of the economy as a whole
 The company/industry is maturing and when it reaches
maturity –grows at the rate of the economy
 Assume growth at a rapid rate for n periods followed by steady
growth
 Multiple growth rates approach:
 First present value covers the period of super-normal (or sub-
normal) growth
 Second present value covers the period of stable growth
 Expected price uses constant-growth model as of the end of
super- (sub-) normal period (time period m)
 Value at m must be discounted to time period zero

Two Period Growth Model:

m t
Do (1+ g 1 ) 1
Po =  t
+ m
( D m+1 )
(1+ K e ) (1+ K e ) K e - g 2
t=1

 m = length of time firm grows at g1

 g2 < k
 g1: growth rate for period 1
 g2 : growth rate for period 2
 ke: required return
  Example: required rate of return =18% Current dividend is 2.00
dividends are expected to grow at 12% for first 6 years then at 6%

 Present value of First 6-Years' Dividends:

Year Dividend P.V. Interest Factor Present Value

t Dt PVIF18.t = 1/(1 + .18)t Dt x PVIF18.t
1 $ 2.240 .874 $ 1.897
2 2.509 .718 1.801
3 2.810 .609 1.711
4 3.147 .516 1.624
5 3.525 .437 1.540
6 3.948 .370 1.461
PV (First 6-Years' Dividends $10.034
 Value of Stock at End of Year 6:
 P6 = D7/(Ke - g2) where g2 = .06
 D7 = D6(1 + g2) = 3.948(1 + .06) = $4.185
 P6 = 4.185/(.18 - .06) = $34.875
 Present Value of P6
 PV(P6) = P6/(1 + ke)6 = $34.875/(1 + .18)6 = $34.875 x .370 = $12.904
 Value of Common Stock (Po)
 Po = PV(First 6-Year's Dividends) + PV(P6) = 10.034 + 12.904 = 22.94

 Example using the two period growth formulae:

1 + g1 M
D1 [1 - ( ) ] D1 (1 + g1 )
M -1
(1  g 2)
1+ k
Po = +[
M
]
k - g1 (1 + k ) (k - g ) 2

 M= # of years growing at g1

2.24[1 - .7312] 2.24(1.76)(1.06)

+
.06 (.12)(2.6996)
 1.12 6
2.24[1 - ( ) ]
1.18 2.24(1.12 ) 5 (1.06)
P= +
.18 - .12 (.18 - .06)(1.18 ) 6

4.18
10.04 + = 10.04 + 12.90 = $22.94
.3239

What About Capital Gains?

 Is the dividend discount model only capable of handling dividends?
 Capital gains are also important
 Price received in future reflects expectations of dividends from that point
forward
 Discounting dividends or a combination of dividends and price
produces same results

No Dividend Model

CAPM =ˆr j = rf + B j ( r m - r f )

Intrinsic Value Implications

 “Fair” value based on the capitalization of income process
 The objective of fundamental analysis
 If intrinsic value >(<) current market price, hold or purchase (avoid or
sell) because the asset is undervalued (overvalued)
 Decision will always involve estimates

P/E Ratio
 P/E ratio is the strength with which investors value earnings as expressed
in stock price
 Divide the current market price of the stock by the latest 12-month
earnings
 Price paid for each $1of earnings

P/E Ratio or Earnings Multiplier Approach

 To estimate share value

P0
Po  E 1 ( Justified ( ))
E1
where
 E1 = estimated earnings
  Justified P/E
 Using market or industry P/E multiples as
benchmarks, the investor will try to establish
a multiple that the investor feels that the
stock will trade at in the future

 P/E ratio can be derived from ( if constant growth)

D1
P0 
kg

 Indicates the factors that affect the estimated P/E ratio

 Factors that Affect the estimated P/E

 Dividend Payout
 The higher the payout ratio, the higher the justified P/E
 Payout ratio is the proportion of earnings that are paid out
as dividends
 Required Rate of return
 The higher the required rate of return, k, the lower the justified P/E

 Expected growth rate

 The higher the expected growth rate, g, the higher the justified P/E

 g = (Retention rate) * (Return on earnings)

Understanding the P/E Ratio

 P/E should be higher for companies with earnings that are expected to
grow rapidly
 P/E should be higher for companies with less risk
 Can firms increase payout ratio to increase market price?
 P/E depends on the investors assumptions of future earnings
(growth factor) and risk
  Will future growth prospects be affected?
 Does rapid growth affect the riskiness of earnings?
 Will the required return be affected?
 Are some growth factors more desirable than others?
 P/E ratios reflect expected growth and risk

P/E Ratios and Interest Rates

 A P/E ratio reflects investor optimism and pessimism
 Related to the required rate of return
 As interest rates increase, required rates of return on all securities
generally increase
 P/E ratios and interest rates are indirectly related
 As required rate increases, the price of stock drops, and the P/E
must also fall

Which Approach Is Best?

 Best estimate is probably the present value of the (estimated) dividends
 Problems
 Can future dividends be estimated with accuracy?
 Investors like to focus on capital gains not dividends
 P/E multiplier remains popular for its ease in use and the objections to the
dividend discount model
 Problems
 Must estimate earnings which is the first step in estimating
dividends
 Complementary approaches?
 P/E ratio can be derived from the constant-growth version of the
dividend discount model
 Dividends are paid out of earnings
 Using both increases the likelihood of obtaining reasonable results
 Dealing with uncertain future is always subject to error

Other Multiples
 Price-to-book value ratio
 Ratio of share price to stockholder equity as measured on the
balance sheet
 Asset book value and market value must be similar to be
meaningful
 Sometimes used in valuing financial companies
 Comparison should be made to firm’s own ratio over time
as well as to the industry’s ratio
 Price paid for each $1 of equity
 Used as a Purchase Strategy
 Buy low price to book ratio stocks
  Comparison should be made to firm’s own ratio over time
as well as to the industry’s ratio
 Price-to-sales ratio
 Ratio of a company’s total market value (price times number of shares)
divided by its sales
 Indicates what the market is willing to pay for the firm’s revenues
 Used as a Purchase Strategy
 Buy low Price to Sales stock
 EVA
 EVA = difference between operating profits and a company’s true cost
of capital
 Positive—company has added value

Preferred Stock
 Order in bankruptcy (paid before common)
 Share ownership
 Mostly institutions—corporations
 Perpetuities
 Stated dividend amount
 Callable
 Many carry sinking funds to provide for potential liquidation
 Convertible (about half of the issues)
 Cumulative provision (usually)
 Typically no voting rights
 Tax Ramifications
 70% of preferred dividends received by Co. A. on Co. B not taxable
 lower return
 Preemptive rights - first priority to purchase new stock.
Dp

Po 
Kp

STOCK PERFORMANCE

 Risk-adjusted returns
 Risk Measures
 β - systematic risk
 σ - total risk
 Sharpe Index
 R - Rf
=


 Treynor Index

R - Rf
=


STOCK MARKET EFFICIENCY

 Weak-form: security prices reflect all market-related data from past.
 Semistrong: security prices reflect all past information but also public information.
 Strong: security prices reflect all information including private or insider
info.
 Tests
 Weak-form: regression analysis---look for non-random patterns in
security prices.
 Semistrong: Event studies
 Benchmark for abnormal returns
CAPM = r̂ j = rf + B j ( r m - r f )

 abnormal return

r j  r̂ j  e


r̂ j: estimated return
 rj: actual return
 e: is difference (error)
 Question: is e significantly different
from zero

Determinants of Stock Price Movements

 Economic Factors
 Interest Rates
 Impact of the dollar
 Other

 Abnormalities
 Jan Effect
 Technical Analysis

Evidence on Factors Affecting Prices

 Schiller
 smart-money investors
 noise traders
  Roll
 APT

SEARCH FOR UNDERVALUED STOCK

 Targets for Acquisition
 Why acquire?
 synergistic affects
 tax-shields
 replace inefficient management
 diversify co.
 Investors reaction:
 Positive share price movement for target with some negative
price movement for acquiring.

 ESOP
 Prevents takeover
 Employee ownership/productivity
 Inefficient companies avoid takeover & remain undervalued

 Overvalued - Companies issue new common stock

 Undervalued - Companies may repurchase (Treasury stock)

 LBO - group of managers form a group to purchase stock to buy

company - Use debt to buy (retire) the company's stock.
 reduced agency cost
 large debt

 International markets (stock)

 higher returns but
 smaller markets rise volatility
 information
 costs of listing
 annual reports/foreign currency
 financial statements compatible with GAAP

Domestic Issues

 Program Trading: Simultaneous buying of selling of a portfolio of at least 15

different stocks valued at more than $1 million.