LESSON: STOCK VALUATION

Concepts of Stocks
Stocks, defined
Corporations would normally raise funds by selling stocks. But what do we really mean by stocks and
how it becomes a source of financing or raising corporate capital requirements? Acquisition or buying
stocks from a corporate entity would allow an investor to own a part of the business firm. Corporation
would sell control of the company in the form of stocks to investors or stockholders to raise or acquire
funds to sustain or expand business operations.

Most commonly known types of stocks are common and preferred. Common or ordinary stocks give
the owner to exercise voting rights in corporate decisions while preferred stockholders don't. However,
preferred shareholders are legally entitled to receive a certain level of dividend payments before any
dividends can be issued to other shareholders. A convertible preferred stock refers to a type of stock that
has an option to be converted into a fixed number of common shares, usually any time after a
predetermined date.

Stock prices are dictated based on earnings generated by the company. If the business profits are high or
are inclined to rise in the future, companies will raise stock prices. Stockholders gain from their stock
investment when they buy a stock on a low price and later can sell it on higher price. If the business firm
does not perform well and the stocks' value decreases, then the stockholders might lose part or even all of
their investments when they sell.

Stockholders are also given a share in the company's profit in the form of dividends. This is done to
reward stockholders for their investment.

Advantages and Disadvantages of Stocks

One may wonder on what the advantages in investing in stocks are and among them are:
1. Contribution to economic growth - When company performance results in profit, it affects the
growth of the economy. In the same way that if the economy grows, it generates enough
purchasing power which allows people to have enough money to spend and thus results in
businesses to grow and generate profits.
2. Beats inflation - Dividends received from stocks range from 10%-12% which are normally
higher to an average inflation rate that ranges between 3%-5%.
3. Accessibility - Stocks can be bought in capital markets through a broker financial planner, or
online.
4. Return on Investment - Investors would normally buy stocks when the prices are low and later
sell them when the prices are high. Thus, aside from the dividends received from stocks, they can
also generate profit when investors resell them at the most appropriate time.
5. Liquidity and conversion to cash - Stocks may be sold at any given time as it does not carry a
maturity date.
But an investor may also consider some disadvantages of owning stocks.
1. Investment Risk - When a company performs poorly, stock price will decrease and thus investor
is at risk of losing on the investment made.
2. Priority for payment - When the company goes bankrupt, stockholders will receive payment
only after all third party creditors have been paid.
3. Time requirement - Time is needed to do research, read financial statements and annual reports,
follow company's developments in the news and monitor the stock market in order to arrive at a
decision on which company to buy stocks.
4. Stock prices volatility - Depending on the individual intention, this could result in some
emotional high since stocks' prices have a tendency to go high or low.
5. You compete against professionals. Institutional investors and traders have more time and
knowledge to invest. Find out how to gain an advantage as an individual investor.

Thus, it is always a wise and prudent decision to consult a professional stock market expert before
deciding to put investment in stocks.

Common Stock Valuation Models

Common stock valuation can be done either through absolute and relative valuation models. Under
absolute valuation, the focus will be on dividends, cash flow and growth rate of a single. Relative
valuation models involve calculating multiples or ratios, such as the price-to-earnings multiple, and
comparing them to the multiples of other comparable firms. The focus in this lesson will be the absolute
valuation methods since it is most commonly used by most companies.

Absolute Valuation Model

1. Dividend Discount Method (DDM)
One of the most basic absolute valuation models is the "dividend discount method" which
determines the worthiness of the business based on the dividends paid to shareholders. This
model is used since dividends represent the actual cash flows going to the shareholder, thus
valuing the present value of these cash flows should give you a value for how much the shares
should be worth. Under this model, the dividends should be actually paid. Companies that pay
stable and predictable dividends are best suited to use this type valuation method.

To illustrate, let us take the dividends and earnings of ADP company below (in Philippine Peso):

2012 2013 2014 2015 2016 2017

Dividends 0.50 0.53 0.55 0.58 0.61 0.64

Per Share

Earnings 4.00 4.20 4.41 4.63 4.86 5.11

Per Share
Based on the illustration above, it can be observed that the earnings per share and dividends grow at an
average rate of 5% which makes it stable and predictable. Thus, under this scenario, the company is fit to
use the dividend discount method.

2. Discounted Cash Flow Method (DCF)

Under the discounted cash flow method, it is suited for companies that don't pay a dividend or
payments are irregular. The DCF method uses a firm's discounted future cash flows to determine
the value of the firm.

The DCF model uses the free cash flows which are forecast for five to years, and then a terminal
value is calculated for all of the cash flows beyond the forecast period. The company should have
predictable positive free cash flows to be able to use this method.

Let us illustrate this method using the given example (in Philippine Peso):

2012 2013 2014 2015 2016 2017

Operating 438 789 1,462 890 2,565 510

Cash Flow

Capital 785 995 1,132 1,256 2,235 1,546

Expenditures

Free Cash -347 -206 330 -366 330 -1,036

Flow

Based on the example, the business shows an increasing positive operating cash flow but the high capital
expenditures indicate that the firm is putting back a lot of its cash into the business to support its
operation. As such the result is negative free cash flows for four of the six years which makes it difficult
(nearly impossible) to predict future cash flows. Thus, in order to use the DCF method most effectively,
the target company should generally have stable, positive and predictable free cash flows which is shown
in the illustration below.

2012 2013 2014 2015 2016 2017

Operating Cash Flow 438 789 1462 890 2565 510

Capital Expenditures 385 715 1355 745 2365 245

Free Cash Flow 53 74 107 145 200 265

Percentage of Increase 39.62% 44.59% 35.51% 37.93% 32.50%

Average 38.03%
There is no perfect valuation method as it changes for every situation, it is necessary to know the
company characteristics in order to determine the valuation method that best suits the situation.

Preferred Stock Valuation

The nature of preferred stocks is that it pays a fixed amount of dividends and this can be used to calculate
the value by discounting each of these payments to the present day. Taking all the dividend payments and
calculating the sum of the present value into perpetuity, then the value of stock can be determined.

Let us illustrate by looking at ADP Company that pays a 25 centavo-dividend every month with a
required rate of return of 6% per year. To calculate for the expected stock value of the stock,
P0.25/0.005 = P50. The discount rate of 6% was divided by 12 to get 0.005.

Where:
V = the value
D. = the dividend next period
r= the required rate of return

Considerations
If the company earnings are not adequate, it might result in a cut off in the payment of preferred stock
dividends. This risk of a cut payment needs to be accounted for. This risk increases as the dividend
payment compared to earnings gets higher.

Preferred shares do not have the voting rights such as those given to common shares. For investors who
have large amounts of shares, this seems to be valuable feature to individuals as compared to the average
investor who looks at this voting right and does not have much value. This feature is needed in evaluating
preferred shares marketability.

Preferred shares possess similar characteristics with that of the bond in terms of valuation. This means the
value will also move inversely with interest rates. When the interest rate goes up, the value of the
preferred shares will go down, holding everything else constant. This is to account for other investment
opportunities and is reflected in the discount rate used.