Common Stock Valuation
Chapter 10
Fundamental Analysis Approaches
Present value approach
Capitalization of expected income
Intrinsic value based on the discounted value of the expected stream of cash flows
Multiple of earnings (P/E) approach
- Stock worth some multiple of its future earnings
Present Value Approach (Capitalization of Income)
Intrinsic value of a security is
Ke = appropriate discount rate
In using model, to estimate the intrinsic value of the security must:
Discount rate (Capitalization Rate, Required Rate of Return)
Required rate of return: minimum expected rate to induce purchase given the level of risk
The opportunity cost of dollars used for investment
Expected cash flows and timing of cash flows
Stream of dividends or other cash payouts over the life of the investment
Dividends paid out of earnings and received by investors
Earnings important in valuing stocks
Retained earnings enhance future earnings and ultimately dividends
If use dividends in PV analysis, don’t use retained earnings in the model
- Retained earnings imply growth and future dividends
- Compared computed price to actual price
Dividend Discount Model
Current value of a share of stock is the discounted value of all future dividends
Problems:
Need infinite stream of dividends
- Dividends received 40-50 years in the future are worth very little in present value with the discount rate is sufficiently high (12%, 14%, 16%)
Dividend stream is uncertain
- Dividends not guaranteed
- Declared by Board of Directors
Must estimate future dividends
Dividends may be expected to grow over time
- Must model expected growth rate of dividends and the growth rate need not be constant
Dividend Discount Model-Zero Growth
Assume no growth in dividends
Fixed dollar amount of dividends reduces the security to a perpetuity
Kp = appropriate discount rate
Similar to preferred stock because dividend remains unchanged
Dividend Discount Model-Constant Growth-Gordon Model
Assumes a constant growth in dividends
Dividends expected to grow at a constant rate, g, over time
where
- g: growth rate
- ke: required return
Ke > g
D1 is the expected dividend at end of the first period
D1 =D0 (1+g)
Implications of constant growth
Stock prices grow at the same rate as the dividends (g)
- Problem: what if higher growth in price than dividends or visa versa
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
A lower required return or a higher expected growth in dividends raises prices
Reasons for Different Values of Same Stock
- Each investor may use their individual k
- Each investor has their own estimate of g
Dividend Discount Model-Multiple Growth
Multiple growth rates: two or more expected growth rates in dividends
Ultimately, growth rate must equal that of the economy as a whole
- The company/industry is maturing and when it reaches maturity –grows at the rate of the economy
Assume growth at a rapid rate for n periods followed by steady growth
Multiple growth rates approach:
First present value covers the period of super-normal (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 (time period m)
Value at m must be discounted to time period zero
Two Period Growth Model:
- m = length of time firm grows at g1
- g2 < k
- g1: growth rate for period 1
- g2 : growth rate for period 2
- ke: required return
- Example: required rate of return =18% Current dividend is 2.00 dividends are expected to grow at 12% for first 6 years then at 6%
- Present value of First 6-Years' Dividends:
Year
t / Dividend
Dt / P.V. Interest Factor
PVIF18.t = 1/(1 + .18)t / Present Value
Dt x PVIF18.t
1 / $ 2.240 / .874 / $ 1.897
2 / 2.509 / .718 / 1.801
3 / 2.810 / .609 / 1.711
4 / 3.147 / .516 / 1.624
5 / 3.525 / .437 / 1.540
6 / 3.948 / .370 / 1.461
PV (First 6-Years' Dividends / $10.034
- Value of Stock at End of Year 6:
- P6 = D7/(Ke - g2) where g2 = .06
- D7 = D6(1 + g2) = 3.948(1 + .06) = $4.185
- P6 = 4.185/(.18 - .06) = $34.875
- Present Value of P6
- PV(P6) = P6/(1 + ke)6 = $34.875/(1 + .18)6 = $34.875 x .370 = $12.904
- Value of Common Stock (Po)
- Po = PV(First 6-Year's Dividends) + PV(P6) = 10.034 + 12.904 = 22.94
- Example using the two period growth formulae:
- M= # of years growing at g1
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
No Dividend Model
Intrinsic Value Implications
“Fair” value based on the capitalization of income process
The objective of fundamental analysis
If intrinsic value >(<) current market price, hold or purchase (avoid or sell) because the asset is undervalued (overvalued)
Decision will always involve estimates
P/E Ratio
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 $1of earnings
P/E Ratio or Earnings Multiplier Approach
To estimate share value
where
- E1 = estimated earnings
- Justified P/E
- Using market or industry P/E multiples as benchmarks, the investor will try to establish a multiple that the investor feels that the stock will trade at in the future
P/E ratio can be derived from ( if constant growth)
Indicates the factors that affect the estimated P/E ratio
- Factors that Affect the estimated P/E
- Dividend Payout
The higher the payout ratio, the higher the justified P/E
Payout ratio is the proportion of earnings that are paid out as dividends
- Required Rate of return
The higher the required rate of return, k, the lower the justified P/E
- Expected growth rate
The higher the expected growth rate, g, the higher the justified P/E
Understanding the P/E Ratio
P/E should be higher for companies with earnings that are expected to grow rapidly
P/E should be higher for companies with less risk
Can firms increase payout ratio to increase market price?
P/E depends on the investors assumptions of future earnings (growth factor) and risk
Will future growth prospects be affected?
Does rapid growth affect the riskiness of earnings?
Will the required return be affected?
Are some growth factors more desirable than others?
P/E ratios reflect expected growth and risk
P/E Ratios and Interest Rates
A P/E ratio reflects investor optimism and pessimism
Related to the required rate of return
As interest rates increase, required rates of return on all securities generally increase
P/E ratios and interest rates are indirectly related
- As required rate increases, the price of stock drops, and the P/E must also fall
Which Approach Is Best?
Best estimate is probably the present value of the (estimated) dividends
- Problems
Can future dividends be estimated with accuracy?
Investors like to focus on capital gains not dividends
P/E multiplier remains popular for its ease in use and the objections to the dividend discount model
- Problems
- Must estimate earnings which is the first step in estimating dividends
Complementary approaches?
P/E ratio can be derived from the constant-growth 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
Other Multiples
Price-to-book value ratio
Ratio of share price to stockholder equity as measured on the balance sheet
- Asset book value and market value must be similar to be meaningful
- Sometimes used in valuing financial companies
- Comparison should be made to firm’s own ratio over time as well as to the industry’s ratio
Price paid for each $1 of equity
- Used as a Purchase Strategy
- Buy low price to book ratio stocks
- Comparison should be made to firm’s own ratio over time as well as to the industry’s ratio
Price-to-sales ratio
Ratio of a company’s total market value (price times number of shares) divided by its sales
Indicates what the market is willing to pay for the firm’s revenues
- Used as a Purchase Strategy
- Buy low Price to Sales stock
- EVA
- EVA = difference between operating profits and a company’s true cost of capital
- Positive—company has added value
Preferred Stock
- Order in bankruptcy (paid before common)
- Share ownership
- Mostly institutions—corporations
- Perpetuities
- Stated dividend amount
- Callable
- Many carry sinking funds to provide for potential liquidation
- Convertible (about half of the issues)
- Cumulative provision (usually)
- Typically no voting rights
- Tax Ramifications
- 70% of preferred dividends received by Co. A. on Co. B not taxable
- lower return
- Preemptive rights - first priority to purchase new stock.
STOCK PERFORMANCE
- Risk-adjusted returns
- Risk Measures
- β - systematic risk
- σ - total risk
- Sharpe Index
- Treynor Index
STOCK MARKET EFFICIENCY
- Weak-form:security prices reflect all market-related data from past.
- Semistrong:security prices reflect all past information but also public information.
- Strong: security prices reflect all information including private or insider info.
- Tests
- Weak-form:regression analysis---look for non-random patterns in security prices.
- Semistrong:Event studies
- Benchmark for abnormal returns
- abnormal return
- : estimated return
- rj: actual return
- e: is difference (error)
- Question: is e significantly different from zero
Determinants of Stock Price Movements
- Economic Factors
- Interest Rates
- Impact of the dollar
- Other
- Abnormalities
- Jan Effect
- Technical Analysis
Evidence on Factors Affecting Prices
- Schiller
- smart-money investors
- noise traders
- Roll
- APT
SEARCH FOR UNDERVALUED STOCK
- Targets for Acquisition
- Why acquire?
- synergistic affects
- tax-shields
- replace inefficient management
- diversify co.
- Investors reaction:
- Positive share price movement for target with some negative price movement for acquiring.
- ESOP
- Prevents takeover
- Employee ownership/productivity
- Inefficient companies avoid takeover & remain undervalued
- Overvalued - Companies issue new common stock
- Undervalued - Companies may repurchase (Treasury stock)
- LBO -group of managers form a group to purchase stock to buy company - Use debt to buy (retire) the company's stock.
- reduced agency cost
- large debt
- International markets (stock)
- higher returns but
- smaller markets rise volatility
- information
- costs of listing
- annual reports/foreign currency
- financial statements compatible with GAAP
Domestic Issues
- Program Trading: Simultaneous buying of selling of a portfolio of at least 15 different stocks valued at more than $1 million.