Chapter 8

Stock Valuation
 Stock Valuation

• Learning Goals
1. Explain the role that a company’s future plays in
the stock valuation process.
2. Develop a forecast of a stock’s expected cash
flow, starting with corporate sales and earnings,
and then moving to expected dividends and
share price.
3. Discuss the concepts of intrinsic value and
required rates of return, and note how they are
used.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-2

 Stock Valuation

• Learning Goals (cont’d)

5. Determine the underlying value of a stock using
the zero-growth, constant-growth, and variable-
growth dividend valuation models.
6. Use other types of present value-based models
to derive the value of a stock, as well as
alternative price-relative procedures.
7. Gain a basic appreciation of the procedures
used to value different types of stocks, from
traditional dividend-paying shares to more
growth-oriented stocks.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-3

 Valuing a Company and Its Future

• The single most important issue in the stock

valuation process is what a stock will do in
the future
• Value of a stock depends upon its future returns
from dividends and capital gains/losses
• We use historical data to gain insight into the
future direction of a company and its profitability
• Past results are not a guarantee of future results

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-4

 Table 8.1 Comparative Dollar-Based and
Common-Size Income Statements Universal
Office Furnishings, Inc. 2010 Income
Statements

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-5

 Steps in Valuing a Company

• Three steps are necessary to project key

financial variables into the future:
– Step 1: Forecast future sales & profits
– Step 2: Forecast future EPS and dividends
– Step 3: Forecast future stock price

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-6

 Step 1: Forecast Future Sales and
Profits

• Forecasted Future Sales based upon:

– “Naïve” approach based upon continued historical trends,
or
– Historical trends adjusted for anticipated changes in
operations or environment

• Forecasted Net Profit Margin based upon:

– “Naïve” approach based upon continued historical trends,
or
– Historical trends adjusted for anticipated changes in
operations or environment, or
– Earnings forecasts from brokerage houses, Value Line,
Forbes, or other sources

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-7

 Step 1: Forecast Future Sales and
Profits (cont’d)

• Example: Assume last year’s sales were $100

million, revenue growth is estimated at 8% and the
net profit margin is expected to be 6%.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-8

 Step 2: Forecast Future EPS

• Forecasted outstanding shares of common stock

based upon:
– “Naïve” approach based upon continued historical tends, or
– Historical trends adjusted for anticipated changes in
operations or environment
• Forecasted Earnings Per Share (EPS) based upon:

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-9

 Step 2: Forecast Future EPS (cont’d)

• Example: Assume estimated profits are

$6.5 million, 2 million shares of common
stock are outstanding, and the dividend
payout ratio is estimated at 40%.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-10

 Step 2: Forecast Future Dividends

• Forecasted Dividend Payout ratio based

upon:
– “Naïve” approach based upon continued
historical trends, or
– Historical trends adjusted for anticipated
changes in operations or environment

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-11

 Step 2: Forecast Future Dividends
(cont’d)

• Example: Assume estimated profits are

$6.5 million, 2 million shares of common
stock are outstanding, and the dividend
payout ratio is estimated at 40%.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-12

 Step 3: Forecast P/E Ratio

• Estimated P/E ratio based upon:

– “Average market multiple” of all stocks in the
marketplace, or
– “Relative P/E multiple” of individual stocks
– Adjust up or down based upon expectations of
economic conditions, general stock market
outlook in near term, or anticipated changes in
company’s operating results

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-13

 Step 3: Forecast P/E Ratio

• Estimated P/E ratio is function of several

variables, including:
– Growth rate in earnings
– General state of the market
– Amount of debt in a company’s capital structure
– Current and projected rate of inflation
– Level of dividends

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-14

 Step 3: Forecast Future Stock Price

• Example: Assume estimated EPS are $3.25 and the

estimated P/E ratio is 17.5 times.

• To estimate the stock price in three years, extend

the EPS figure for two more years and repeat the
calculations.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-15

 Table 8.3 Summary Forecast Statistics,
Universal Office Furnishings

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-16

 Using Stock Valuation

• Once we have an estimated stock price, we

can compare it to the current market price
to see if it may be a good investment
candidate:
current (prevailing) price<estimated price undervalued
current (prevailing)price=estimated price fairly valued
current (prevailing)price>estimated price overvalued

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-17

 The Valuation Process

• Valuation is a process by which an investor uses

risk and return concepts to determine the worth of
a security.
– Valuation models help determine what a stock ought to be
worth
– If expected rate of return equals or exceeds our target
yield, the stock could be a worthwhile investment
candidate
– If the intrinsic worth equals or exceeds the current market
value, the stock could be a worthwhile investment
candidate
– There is no assurance that actual outcome will match
expected outcome

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-18

 Required Rate of Return

• Required Rate of Return is the return

necessary to compensate an investor for
the risk involved in an investment.
– Used as a target return to compare forecasted
returns on potential investment candidates

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-19

 Required Rate of Return

• Example: Assume a company has a beta of

1.30, the risk-free rate is 5.5% and the
expected market return is 15%. What is the
required rate of return for this investment?

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-20

 Other Stock Valuation Methods

• Dividend Valuation Model

– Zero growth
– Constant growth
– Variable growth

• Dividend and Earnings Approach

• Price/Earnings Approach
• Other Price-Relative Approaches
– Price-to-cash-flow ratio
– Price-to-sales ratio
– Price-to-book-value ratio

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-21

 Dividend Valuation Model:
Zero Growth

• Uses present value to value stock

• Assumes stock value is capitalized value of
its annual dividends
• Potential capital gains are really based upon
future dividends to be received
• Assumes dividends will not grow over time

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-22

 Dividend Valuation Model:
Constant Growth

• Uses present value to value stock

• Assumes stock value is capitalized value of its
annual dividends
• Assumes dividends will grow at a constant rate
over time
• Works best with established companies with
history of steady dividend payments

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-23

 Dividend Valuation Model:
Variable Growth

• Uses present value to value stock

• Assume stock value is capitalized value of its
annual dividends
• Allows for variable growth in dividend growth rate
• Most difficult aspect is specifying the appropriate
growth rate over an extended period of time

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-24

 Dividends-and-Earnings Approach

• Very similar to variable-growth DVM

• Uses present value to value stock
• Assumes stock value is capitalized value of its
annual dividends and future sale price
• Works well with companies who pay little or
no dividends

Present value of
Present value of Present value of
= + the price of the stock
a share of stock future dividends
at date of sale

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-25

 Price/Earnings (P/E) Approach

• Future price is based upon the appropriate

P/E ratio and forecasted EPS
• Simple to use and easy to understand
• Widely used in stock valuation

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-26

 Price-to-Cash-Flow (P/CF) Approach

• Similar to P/E approach, but substitutes

projected cash flow for earnings
• Widely used by investors
• Many consider cash flow to be more
accurate than profits to evaluate a stock

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-27

 Price-to-Sales (P/S) Approach

• Similar to P/E approach, but substitutes

projected sales for earnings
• Useful for companies with no earnings or
erratic earnings

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-28

 Price-to-Book-Value (P/BV)
Approach

• Similar to P/E approach, but substitutes

book value for earnings

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-29

 Chapter 8 Review

• Learning Goals
1. Explain the role that a company’s future plays in
the stock valuation process.
2. Develop a forecast of a stock’s expected cash
flow, starting with corporate sales and earnings,
and then moving to expected dividends and
share price.
3. Discuss the concepts of intrinsic value and
required rates of return, and note how they are
used.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-30

 Chapter 8 Review (cont’ d)

• Learning Goals (cont’d)

4. Determine the underlying value of a stock
using the zero-growth, constant-growth, and
variable-growth dividend valuation models.
5. Use other types of present value-based models
to derive the value of a stock, as well as
alternative price-relative procedures.
6. Gain a basic appreciation of the procedures
used to value different types of stocks, from
traditional dividend-paying shares to more
growth-oriented stocks.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-31

Chapter 8

Additional
Chapter Art
 Figure 8.1 Average P/E Ratio of S&P 500
Stocks

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-33

 Table 8.2 Selected Historical Financial Data,
Universal Office Furnishings

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-34

 Table 8.4 Using the Variable-Growth DVM to
Value Sweatmore Stock

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-35