Chapter 8 Stock Valuation. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 8-2 Stock Valuation Learning Goals 1.Explain the role that a

Chapter 8

Stock Valuation

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-2

Stock Valuation

• Learning Goals1. Explain the role that a company’s future plays in

stock valuation.

2. Develop a forecast of a stock’s cash flow, expected dividends and share price.

3. Discuss the concepts of intrinsic value and required rates of return, and note how they are used.

4. Determine the underlying value of a stock using various dividend valuation models.


Stock Valuation

• Learning Goals (cont’d)

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.


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.


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


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


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%.

Future after-taxearnings in year t

Estimated sales

for year t

Net profit marginexpected in year t

Future after-taxearnings next year

$108 million 0.06 $6.5 million


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:

Estimated EPSin year t

Future after-taxearnings in year t

Number of shares of common stockoutstanding in year t


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%.

Estimated EPSnext year

$6.5 million

2 million $3.25


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

Estimated dividendsper share in year t

Estimated EPS

in year t

Estimatedpayout ratio


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%.

Estimated dividendsper share next year

$3.25 .40 $1.30


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


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.

Estimated share priceat end of year t

Estimated EPS

in year t

Estimated P/Eratio

Estimated share priceat the end of next year

$3.25 17.5 $56.88


Using Stock Valuation

• Once we have an estimated future stock price, we can compare it to the current market price to see if it may be a good investment candidate:

current price < estimated price undervalued

current price = estimated price fairly valued

current price > estimated price overvalued


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


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

Requiredrate of return

Risk-free

rate

Stock'sbeta

Marketreturn

Risk-freerate


Required Rate of Return (cont’d)

• 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?

Required return 5.5% 1.30 15.0% 5.5% 17.85%


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


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

Value of ashare of stock

Annual dividends

Required rate of return


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

Value of ashare of stock

Next year's dividends

Required rateof return

Constant rate of

growth in dividends


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

Value of a shareof stock

Present value offuture dividendsduring the initial

variable-growth period

Present value of the priceof the stock at the end of

the variable-growth period


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 ofa share of stock

Present value offuture dividends

Present value of

the price of the stockat date of sale


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

Stock price EPS P/E ratio


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

P/CF ratio Market price of common stock

Cash flow per share


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

P/S ratio Market price of common stock

Sales per share


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

• Similar to P/E approach, but substitutes book value for earnings

P/BV Market price of common stock

Book value per share


Chapter 8 Review

• Learning Goals

1. Explain the role that a company’s future plays in stock valuation.

2. Develop a forecast of a stock’s cash flow, expected dividends and share price.

3. Discuss the concepts of intrinsic value and required rates of return, and note how they are used.

4. Determine the underlying value of a stock using various dividend valuation models.


Chapter 8 Review (cont’d)

• Learning Goals (cont’d)

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.

Documents

Chapter 8 Stock Valuation. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 8-2 Stock Valuation Learning Goals 1.Explain the role that a