Financial Management

Dr Yen Chen
Topic 9: The Value of Stock (2)
Reading: Brealey, Ch.4

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 Basic performance measures of a firm

• One figure from financial statements, and the other

from the stock market (i.e. the firm’s stock price)
– earnings per share (EPS)
– price-earnings ratio (P/E)
– book-to-market ratio (B/M)
– dividend yield (D/P)
• These are summary measures from financial press.
Some of many ratios used by analysts and the
financial media.

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 Stock Market Reporting
52 WEEKS YLD VOL NET
HI LO STOCK SYM DIV % PE 100s HI LO CLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75
Gap pays a
dividend of 9 Gap ended trading at
Gap has cents/share $19.25, down $1.75
been as high
from yesterday’s close
as $52.75 in
the last year. Given the current
price, the
dividend yield is ½
%

Gap has been as Given the current

6,517,200 shares traded
low as $19.06 in price, the PE ratio is
15 times earnings hands in the last day’s
the last year.
trading

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 Stock Market Reporting
52 WEEKS YLD VOL NET
HI LO STOCK SYM DIV % PE 100s HI LO CLOSE CHG
52.75 19.06 Gap Inc GPS 0.09 0.5 15 65172 20.50 19 19.25 -1.75

Gap Incorporated is having a tough year, trading near their 52-week

low. Imagine how you would feel if within the past year you had
paid $52.75 for a share of Gap and now had a share worth $19.25!
That 9-cent dividend wouldn’t go very far in making amends.
Yesterday, Gap had another rough day in a rough year. Gap “opened
the day down” beginning trading at $20.50, which was down from
the previous close of $21.00 = $19.25 + $1.75
Looks like cargo pants aren’t the only things on sale at Gap.

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 Earnings per share (EPS)

• Definition: Net income of firm (after interest and tax) /

number of shares outstanding
• It measures how large net income is relative to the amount of
common shares: it’s a profitability measure.
• For example: a company in some year has the net income of
$80m and 40m number of shares outstanding, then its EPS =
80m/40m = $ 2.00 per share >>> profit attributable to each
share

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 Issues:
• Reported earnings are book or accounting earnings, and
reflect often arbitrary choices of accounting procedures. For
example:
– changes in depreciation methods used for reporting purposes directly
affects EPS but has no effect on cash flows (as depreciation is a non-
cash charge)
– valuation of inventories
– the procedures by which the accounts of two merging firms are
combined
– the way the tax liabilities of the firm are reported
– the choice between expensing or capitalising R&D
• EPS will also vary according to how many shares are issues by
the firm
• Difficulty in interpreting and comparing EPS across firms
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 Price Earnings Ratio
• Many analysts frequently relate earnings per share to
price.
• The price earnings ratio is a.k.a. the multiple
– Calculated as current stock price divided by annual EPS
– The Wall Street Journal uses last 4 quarter’s earnings
Price per share
P/E ratio =
EPS
Firms whose shares are “in fashion” sell at high multiples. Growth stocks for example.
Firms whose shares are out of favor sell at low multiples. Value stocks for example.

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 Price-earnings ratio (P/E)
• Definition: Price per share / earnings per share
• It measures the number of years for the current earnings of a
company to cover its share’s current price. With the
assumptions of the company keeping its current status and
distributing all its earnings in dividends, this number tells
investor how many years they can retrieve their investment.
• Example: Current share price = £4.46, EPS = £2; then P/E =
£4.46/£2=2.23. This implies that investors are willing to wait
2.23 years to cover their investment in the firm’s stock.
• The reciprocal of P/E (i.e. E/P) is often used as measure of the
cost of equity capital. (rule of thumb, but inaccurate)

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• Is the P/E ratio (as defined) useful to analysts?
– There are (accounting) issues in the measurement
of earnings.
– Investors are interested in price relative to future
earnings. The past is not relevant: the
expectations of future earnings are more
important.
• Generally, if the market is efficient, a relatively high
P/E ratio indicates that investors think the firm has
good future growth opportunities.

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 Other Price Ratio Analysis
• Many analysts frequently relate earnings per
share to variables other than price, e.g.:
– Price/Cash Flow Ratio
• cash flow = net income + depreciation = cash flow
from operations or operating cash flow
– Price/Sales
• current stock price divided by annual sales per share
– Price/Book (a.k.a. Market to Book Ratio)
• price divided by book value of equity, which is
measured as assets – liabilities

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 Market-to-Book Ratio (M/B)
• Book value: the net worth of the firm / the number of shares
outstanding
• Definition of M/B: Market price of share /Book value of equity
per share
• It measures the relationship between the accounting value of
a firm’s assets and the market price of its stock.
• Relatively low M/B indicates a value stock. Stock may be
undervalued (buy), or the market perceives the firm as in
danger of becoming distressed.
• Relatively high M/B indicates a growth stock. Stock may be
overvalued (sell), or the market perceives firm as having good
future prospects.

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 Dividend yield (D/P)
• Definition: Dividends per share / price per share.
• It’s usually expressed in percentage. Example:
£0.60/£4.46=0.135 or 13.5%
• Analysts may interpret a low D/P (relative to prevailing
interest rates) as indicating overvalued shares that should be
sold.
• A high D/P may trigger purchase orders, which, in turn, will
cause the share price to rise.
• If the prevailing interest rate is 5% and the D/P is even greater,
investors will buy the share, then its price will rise and the D/P
will fall to its equilibrium level.

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• However, a low D/P may also indicate
the market is expecting dividends to
increase in the future and have
incorporated this information into the
current price.
• Similarly, a high D/P may also indicate
the market is expecting dividends to
decrease in the future and have
incorporated this information into the
current price.
• The success of the analyst will depend
on his/her efficient interpretation of
the ratio.
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 Valuing Common Stocks
Expected Return - The percentage yield that an investor
forecasts from a specific investment over a set period
of time. Sometimes called the market capitalization
rate.

Div1 + P1 − P0
Expected Return = r =
P0

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 Valuing Common Stocks
Example: If Fledgling Electronics is selling for $100 per
share today and is expected to sell for $110 one year
from now, what is the expected return if the dividend
one year from now is forecasted to be $5.00?

5 + 110 − 100
Expected Return = = .15
100

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 Valuing Common Stocks
Another Example: You purchase an ownership
share in the Indianapolis Colts for $50,000, who
just won the Super Bowl. In one year you expect
the Colts to repeat as Super Bowl champions
and pay you a dividend of $3,000. You think you
will be able to sell your share for $58,000 at
that time. What is your expected return?

3,000 + 58,000 − 50,000

Expected Return = = .22
50,000

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the opportunity cost of capital
Capitalization Rate can be estimated using the
growth perpetuity formula, given minor algebraic
manipulation.

Div1
Capitaliza tion Rate : P0 =
r−g
Div1
→r= +g
P0
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The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

Div1 P1 − P0
Expected Return = r = +
P0 P0

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 Valuing Common Stocks
Return Measurements Div1
Restated P0 =
r−g
Div1
Dividend Yield = Div1
P0 r= +g
P0

Return on Equity = ROE

EPS
ROE =
Book Equity Per Share

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 Growth Rate
Growth can be derived from applying the
return on equity to the percentage of
earnings plowed back into operations.

g = return on equity X plowback ratio

Sustainable Growth Rate - Steady rate at

which a firm can grow: plowback ratio X
return on equity.
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 The Choice of Payout Policy
• If a firm elects to pay a lower dividend, and
reinvest the funds, the stock price may increase
because future dividends may be higher.

Payout Ratio - Fraction of earnings paid out as

dividends
Plowback Ratio - Fraction of earnings retained by
the firm.

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Example
Our company forecasts to pay a $8.33 dividend next
year, which represents 100% of its earnings. This will
provide investors with a 15% expected return. Instead,
we decide to plow back 40% of the earnings at the firm’s
current return on equity of 25%. What is the value of the
stock before and after the plowback decision?

No Growth With Growth

8.33 g = .25  .40 = .10

P0 = = $55.56
.15
5.00
P0 = = $100.00
.15 − .10
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Example - continued
If the company did not plowback some earnings, the
stock price would remain at $55.56. With the
plowback, the price rose to $100.00.

The difference between these two numbers is called

the Present Value of Growth Opportunities (PVGO).

Present Value of Growth Opportunities (PVGO) - Net

present value of a firm’s future investments.

PVGO = 100.00 − 55.56 = $44.44

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