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.