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valuation of common stock

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Learning Objectives

Name two approaches to the valuation of common stocks used in fundamental security analysis. Explain the present value approach. Use the dividend discount model to estimate stock prices. Explain the P/E ratio approach. Outline other relative valuation approaches.

Fundamental Analysis

Two approaches to the valuation of common stocks used in fundamental security analysis are: 1. Present value approach Capitalization of expected income (capitalization of

income: A method of evaluating an investment by estimating future cash flows and taking into consideration the time value of money. also called Discounted Cash Flow (DCF) Analysis).

Intrinsic value based on the discounted value of the expected stream of future cash flows

2. Multiple of earnings approach

Intrinsic value of a security is

n

Required Inputs

Discount rate

Required rate of return: minimum expected rate to induce/stimulate purchase The opportunity cost of Rupees used for investment

Stream of dividends or other cash payouts over the life of the investment

Required Inputs

Expected cash flows

Retained earnings imply growth and future dividends Produces similar results as current dividends in valuation of common shares

Current value of a share of stock is the discounted value of all future dividends

D1 D2 D Pcs ... 1 2 (1 k cs ) (1 k cs ) (1 k cs ) Dt t t 1 (1 k cs )

Problems:

Must model expected growth rate of dividends and need not be constant

Assume no growth in dividends

Fixed rupees amount of dividends reduces the security to a perpetuity (A constant stream of identical cash flows with no end. The formula for determining the present value of a perpetuity is as follows):

Assume no growth in dividends (Cont.)

D0 P0 k cs

Assume constant growth rate in dividends

D1 P0 kg

Implications of constant growth

Stock prices grow at the same rate as the dividends 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

Multiple growth rates: two or more expected growth rates in dividends

Ultimately, growth rate must equal that of the economy as a whole Assume growth at a rapid rate for n periods, followed by steady growth

P0

D0 (1 g1 ) (1 k)

t

t 1

Dn (1 gc ) 1 n k - g (1 k )

Multiple growth rates

First present value covers the period of supernormal (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 Value at n must be discounted to time period zero

Example

Valuing equity with growth of 30% for 3 years, then a long-run constant growth of 6%

k=16%

g = 30% g = 30% g = 30% g = 6% D0 = 4.00 5.20 6.76 8.788 9.315 4.48 5.02 5.63 59.68 P3 = 9.315 74.81 = P0 .10

Is the dividend discount model only capable of handling dividends?

Price received in future reflects expectations of dividends from that point forward

Intrinsic Value

Fair value based on the capitalization of income process

If intrinsic value >(<) current market price, hold or purchase (avoid or sell) because the asset is undervalued (overvalued)

If intrinsic value = current market price, an equilibrium because the asset is correctly valued

Alternative approach often used by security analysts 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 $1 of earnings

To estimate share value

P/E ratio can be derived from

D1 D1/E1 Po or Po /E1 k-g k-g

Indicates the factors that affect the estimated P/E ratio

The higher the payout ratio, the higher the justified P/E

Payout ratio is the proportion of earnings that are paid out as dividends

The higher the expected growth rate, g, the higher the justified P/E The higher the required rate of return, k, the lower the justified P/E

Can firms increase payout ratio to increase market price?

Will the required return be affected? Are some growth factors more desirable than others?

A P/E ratio reflects investor optimism and pessimism

As interest rates increase, required rates of return on all securities generally increase P/E ratios and interest rates are inversely related

Market-to-book ratio (M/B)

Ratio of share price to per share shareholders equity as measured on the balance sheet Price paid for each $1 of equity

Ratio of companys market value (price times number of shares) divided by sales Market valuation of a firms revenues

Best estimate is probably the present value of the (estimated) dividends

Can future dividends be estimated with accuracy? Investors like to focus on capital gains not dividends

P/E multiplier remains popular for its ease of use and the objections to the dividend discount model

Complementary approaches?

P/E ratio can be derived from the constantgrowth version of the dividend discount model Dividends are paid out of earnings Using both increases the likelihood of obtaining reasonable results

Described as a perpetuity, and it will pay the indicated dividend forever Dividends are fixed when the stock is issued; these dividends are specified as an annul dollar amount or as a percentage of par value Less risky because the dividend is specified and must be paid before a common stock dividend can be paid

Copyright

Copyright 2005 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.

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