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10-1

Fundamental Analysis

**Present value approach
**

– Capitalization of expected income – Intrinsic value based on the discounted value of the expected stream of cash flows

**Multiple of earnings approach
**

– Valuation relative to a financial performance measure – P/E ratio

10-2

Present Value Approach Intrinsic value of a security is Value of security n Cash Flows t 1 ( 1 k)t Estimated intrinsic value compared to the current market price – What if current market price is different than estimated intrinsic value? 10-3 .

Required Inputs Discount rate – Required rate of return: minimum expected rate to induce purchase – The opportunity cost of dollars used for investment Expected cash flows – Stream of dividends or other cash payouts over the life of the investment 10-4 .

Required Inputs Expected cash flows – Dividends paid out of earnings Earnings important in valuing stocks – Retained earnings enhance future earnings and ultimately dividends Retained earnings dividends imply growth and future 10-5 .

.Dividend Discount Model Current value of a share of stock is the discounted value of all future dividends D1 ( 1 kcs ) 1 Pcs D2 ( 1 kcs ) t 1 2 . D ( 1 kcs ) Dt ( 1 kcs ) t 10-6 ..

Dividend Discount Model Problems: – Need infinite stream of dividends – Dividend stream is uncertain Must estimate future dividends – Dividends may be expected to grow over time Must model expected growth rate of dividends and need not be constant 10-7 .

Dividend Discount Model Assume no growth in dividends: – Fixed dollar amount of dividends reduces the security to a perpetuity D0 P0 kcs – Similar to preferred stock because dividend remains unchanged 10-8 .

Dividend Discount Model Assume a constant growth in dividends: – Dividends expected to grow at a constant rate. g. over time D1 P0 k g – D1 is the expected dividend at end of the first period – D1 =D0 (1+g) 10-9 .

the required rate of return – A lower required return or a higher expected growth in dividends raises prices 10-10 .Dividend Discount Model 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.

Dividend Discount Model Multiple growth rates: two or expected growth rates in dividends more – Assume growth at a rapid rate for n periods followed by steady growth P0 n D0( 1 g1 ) ( 1 k) t t t 1 Dn( 1 gc ) 1 n k-g ( 1 k) 10-11 .

Dividend Discount Model 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 10-12 .

00 4.20 2 g = 30% 3 g = 6% 4 9.10 .788 P3 = 9.81 = P0 6.315 g = 30% g = 30% D0 = 4.315 .76 8.48 5.68 74.Example: Valuing equity with growth of 30% for 3 years.02 5. then a long-run constant growth of 6% 0 k=16% 1 5.63 59.

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 10-14 .

hold or purchase (avoid or sell) because the asset is undervalued (overvalued) – Decision will always involve estimates 10-15 .Intrinsic Value “Fair” value based on the capitalization of income process – The objective of fundamental analysis If intrinsic value >(<) current market price.

P/E Ratio or Earnings Multiplier Approach 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 10-16 .

P/E Ratio Approach To estimate share value Po estimated earnings P/E ratio E1 Po /E1 P/E ratio can be derived from D1 D1/E1 Po or Po /E1 k-g k-g 10-17 .

k. the higher the P/E The higher the required rate of return.P/E Ratio Approach The higher the payout ratio. the lower the P/E 10-18 . g. the higher the P/E ratio – Payout ratio is the proportion of earnings that are paid out as dividends The higher the expected growth rate.

required rates of return on all securities generally increase P/E ratios and interest rates are indirectly related 10-19 .P/E Ratios and Interest Rates IR Related to the required rate of return As interest rates increase.

Which Approach Is Best? Best estimate is probably the present value of the (estimated) dividends – Can future dividends be estimated with accuracy? P/E multiplier remains popular for its ease in use and the objections to the dividend discount model 10-20 .

Which Approach Is Best? 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 Dealing with uncertain future is always subject to error 10-21 .

Other Multiples Price-to-book value ratio – Ratio of share price to stockholder equity as measured on the balance sheet – Price paid for each $1 of equity Price-to-sales ratio – Ratio of a company’s total market value (price times number of shares) divided by sales – Market valuation of a firm’s revenues 10-22 .

Preferred Stock Valuation 10-23 .

Preferred Stock Preferred stock is superior to common stock in the event of liquidation. Typically. 10-24 . preferred stock pays a fixed dividend periodically and the preferred stockholders are usually not entitled to vote as are the common shareholders.

the growth rate is 0%) Therefore. except that the dividends are constant (i..e. we can use the DDM with a 0% growth rate to find the value: 10-25 .Preferred Stock Valuation Preferred stock is very much like common stock.

Preferred Stock Valuation D VP k CS 0 k CS 10-26 D0 1 0 .

Preferred Stock: An Example Suppose that you are interested in purchasing shares of a preferred stock which pays a $5 dividend every year. what is the intrinsic value of this stock? 10-27 . If your required return is 7%.

Preferred Stock: An Example 5 VP 71.43 0.07 10-28 .

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