07a. security evaluation
TRANSCRIPT
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Valuation Process Two approaches
1. Top-down, three-step approach 2. Bottom-up, stock valuation, stock picking
approach
The difference between the two
approaches is the perceived importanceof economic and industry influence onindividual firms and stocks
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Top-Down, Three-Step Approach
1. General economic influences Decide how to allocate investment funds among
countries, and within countries to bonds, stocks,
and cash2. Industry influences
Determine which industries will prosper and whichindustries will suffer on a global basis and within
countries
3. Company analysis Determine which companies in the selected
industries will prosper and which stocks are
undervalued
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Does the Three-Step Process Work? Studies indicate that most changes in
an individual firms earnings can be
attributed to changes in aggregatecorporate earnings and changes in thefirms industry
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Does the Three-Step Process Work? Studies have found a relationship
between aggregate stock prices and
various economic series such asemployment, income, or production
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Does the Three-Step Process Work?An analysis of the relationship between
rates of return for the aggregate stock
market, alternative industries, andindividual stocks showed that most ofthe changes in rates of return for
individual stock could be explained bychanges in the rates of return for theaggregate stock market and the stocks
industry
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Theory of Valuation The value of an asset is the present
value of its expected returns
You expect an asset to provide astream of returns while you own it
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Theory of Valuation To convert this stream of returns to a
value for the security, you must
discount this stream at your requiredrate of return
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Stream of Expected Returns Form of returns
Earnings Cash flows Dividends Interest payments Capital gains (increases in value)
Time pattern and growth rate of returns
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Required Rate of Return Determined by
1. Economys risk-free rate of return, plus 2. Expected rate of inflation during the
holding period, plus 3. Risk premium determined by the
uncertainty of returns
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Uncertainty of Returns Internal characteristics of assets Business risk (BR)
Financial risk (FR) Liquidity risk (LR) Exchange rate risk (ERR) Country risk (CR)
Market determined factors Systematic risk (beta) or Multiple APT factors
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Investment Decision Process: AComparison of Estimated Values and
Market Prices
If Estimated Value > Market Price, Buy
If Estimated Value < Market Price, Dont Buy
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Valuation of Alternative
InvestmentsValuation of Bonds is relatively easy
because the size and time pattern of
cash flows from the bond over its lifeare known 1. Interest payments usually every six
months equal to one-half the coupon ratetimes the face value of the bond
2. Payment of principal on the bondsmaturity date
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Valuation of Bonds Example: in 2000, a $10,000 bond due
in 2015 with 10% coupon
Discount these payments at theinvestors required rate of return (if therisk-free rate is 9% and the investor
requires a risk premium of 1%, thenthe required rate of return would be10%)
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Valuation of BondsPresent value of the interest payments is anannuity for thirty periods at one-half therequired rate of return:
$500 x 15.3725 = $7,686
The present value of the principal is similarlydiscounted:
$10,000 x .2314 = $2,314
Total value of bond at 10 percent = $10,000
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Valuation of BondsThe $10,000 valuation is the amount that
an investor should be willing to pay for
this bond, assuming that the requiredrate of return on a bond of this riskclass is 10 percent
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Valuation of Preferred Stock
Owner of preferred stock receives apromise to pay a stated dividend,
usually quarterly, for perpetuity Since payments are only made after the
firm meets its bond interest payments,
there is more uncertainty of returns Tax treatment of dividends paid to
corporations (80% tax-exempt) offsets
the risk premium
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Valuation of Preferred Stock
pR
Dividend=V
The value is simply the stated annualdividend divided by the required rate of
return on preferred stock (Rp)
Assume a preferred stock has a $100 par valueand a dividend of $8 a year and a required rate ofreturn of 9 percent
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Valuation of Preferred Stock
pR
Dividend=V
The value is simply the stated annualdividend divided by the required rate of
return on preferred stock (Rp)
Assume a preferred stock has a $100 par valueand a dividend of $8 a year and a required rate ofreturn of 9 percent
.09
$8=V 89.88$=
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Valuation of Preferred Stock
Given a market price, you can derive itspromised yield
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Valuation of Preferred Stock
Given a market price, you can derive itspromised yield
Price
DividendpR =
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Valuation of Preferred Stock
Given a market price, you can derive itspromised yield
At a market price of $85, this preferredstock yield would be
Price
DividendpR =
0941.$85.00
$8pR ==
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Approaches to theValuation of Common Stock
Two approaches have developed 1. Discounted cash-flow valuation
Present value of some measure of cash flow,including dividends, operating cash flow, andfree cash flow
2. Relative valuation techniqueValue estimated based on its price relative to
significant variables, such as earnings, cashflow, book value, or sales
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Approaches to theValuation of Common Stock
These two approaches have some factorsin common Investors required rate of return Estimated growth rate of the variable used
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Discounted Cash Flow Valuation Approach
The measure of cash flow used Dividends
Cost of equity as the discount rate
Operating cash flow Weighted Average Cost of Capital (WACC)
Free cash flow to equity Cost of equity
Dependent on growth rates and
discount rate
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Discounted Cash-Flow ValuationTechniques
=
= +
=nt
ttR
tCFjV
1 )1(Where:
Vj = value of stock j
n= life of the asset
CFt = cash flow in period tR= the discount rate that is equal to the investors
required rate of return for asset j, which is determinedby the uncertainty (risk) of the stocks cash flows
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Valuation Approachesand Specific Techniques
Approaches to Equity Valuation
Discounted Cash FlowTechniques
Relative ValuationTechniques
Present Value of Dividends (DDM)
Present Value of Operating Cash Flow
Present Value of Free Cash Flow
Price/Earnings Ratio (PE)Price/Cash flow ratio (P/CF)
Price/Book Value Ratio (P/BV)
Price/Sales Ratio (P/S)
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The Dividend Discount Model (DDM)
The value of a share of common stock is thepresent value of all future dividends
= +
=
+++
++
+++=
n
t tR
tD
R
D
R
D
R
D
R
DjV
1 )1(
)1(...3)1(
32)1(2)1( 1
Where:
Vj = value of common stock j
Dt = dividend during time period t
R= required rate of return on stock j
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The Dividend Discount Model(DDM)
If the stock is not held for an infiniteperiod, a sale at the end of year 2
would imply:
2)1(
2
2)1(
2
)1(
1
R
jSP
R
D
R
DjV
+
+
+
++
=
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The Dividend Discount Model (DDM)
If the stock is not held for an infiniteperiod, a sale at the end of year 2
would imply:
Selling price at the end of year two is thevalue of all remaining dividendpayments, which is simply an extension
of the original equation
2)1(
2
2)1(
2
)1(
1
R
jSP
R
D
R
DjV
+
+
+
++
=
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The Dividend Discount Model(DDM)
Stocks with no dividends are expected tostart paying dividends at some point
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The Dividend Discount Model(DDM)
Stocks with no dividends are expected tostart paying dividends at some point,
say year three...
+++
++
++
+=
)1(...
)1()1()1( 33
2
21
k
D
k
D
k
D
k
DVj
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The Dividend Discount Model(DDM)
Stocks with no dividends are expected tostart paying dividends at some point,
say year three...
Where:
D1 = 0
D2 = 0
+++
++
++
+=
)1(...
)1()1()1( 33
2
21
k
D
k
D
k
D
k
DVj
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The Dividend Discount Model(DDM)
Infinite period model assumes a constantgrowth rate for estimating future
dividends
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The Dividend Discount Model (DDM)
Infinite period model assumes a constantgrowth rate for estimating future dividends
Where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k= required rate of return on stock j
n = the number of periods, which we assume to be infinite
nR
ngD
R
gD
R
gD
jV)1(
)1(0...2)1(
2)1(0
)1(
)1(0
+
+
+++
+
++
+
=
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The Dividend Discount Model (DDM)
Infinite period model assumes a constantgrowth rate for estimating future dividends
nR
ngD
R
gD
R
gDjV
)1(
)1(0...2)1(
2)1(0
)1(
)1(0
+
+++
+
++
+
+=
gR
DjV
= 1This can be reduced to:1. Estimate the required rate of return (R)
2. Estimate the dividend growth rate (g)
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Infinite Period DDMand Growth Companies
Assumptions of DDM:
1. Dividends grow at a constant rate
2. The constant growth rate will continuefor an infinite period
3. The required rate of return (R) isgreater than the infinite growth rate (g)
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Infinite Period DDMand Growth Companies
Growth companies have opportunities to earn returnon investments greater than their required rates ofreturn
To exploit these opportunities, these firms generallyretain a high percentage of earnings forreinvestment, and their earnings grow faster than
those of a typical firmThis is inconsistent with the infinite period DDM
assumptions
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Infinite Period DDMand Growth Companies
The infinite period DDM assumesconstant growth for an infinite period,
but abnormally high growth usuallycannot be maintained indefinitely
Risk and growth are not necessarily
relatedTemporary conditions of high growth
cannot be valued using DDM
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Valuation with TemporarySupernormal Growth
Combine the models to evaluate theyears of supernormal growth and then
use DDM to compute the remainingyears at a sustainable rate
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Valuation with TemporarySupernormal Growth
Combine the models to evaluate theyears of supernormal growth and then
use DDM to compute the remainingyears at a sustainable rate
For example:
With a 14 percent required rate ofreturn and dividend growth of:
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Valuation with TemporarySupernormal Growth
Dividend
Year Growth Rate
1-3: 25%
4-6: 20%
7-9: 15%
10 on: 9%
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Valuation with TemporarySupernormal Growth
The value equation becomes
9
333
9
333
8
233
7
33
6
33
5
23
4
3
3
3
2
2
)14.1(
)09.14(.
)09.1()15.1()20.1()25.1(00.2
14.1
)15.1()20.1()25.1(00.2
14.1
)15.1()20.1()25.1(00.2
14.1
)15.1()20.1()25.1(00.2
14.1
)20.1()25.1(00.2
14.1
)20.1()25.1(00.2
14.1
)20.1()25.1(00.2
14.1
)25.1(00.2
14.1
)25.1(00.2
14.1
)25.1(00.2
+
++
++
++
++=iV
C f l f S k f C
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Computation of Value for Stock of Companywith Temporary Supernormal Growth
Discount Present Growth
Year Dividend Factor Value Rate
1 2.50$ 0.8772 2.193$ 25%
2 3.13 0.7695 2.408$ 25%
3 3.91 0.6750 2.639$ 25%
4 4.69 0.5921 2.777$ 20%
5 5.63 0.5194 2.924$ 20%6 6.76 0.4556 3.080$ 20%
7 7.77 0.3996 3.105$ 15%
8 8.94 0.3506 3.134$ 15%
9 10.28 0.3075 3.161$ 15%
10 11.21 9%
224.20$a
0.3075b
68.943$
94.365$
aValue of dividend stream for year 10 and all future dividends, that is
$11.21/(0.14 - 0.09) = $224.20bThe discount factor is the ninth-year factor because the valuation of the
remaining stream is made at the end of Year 9 to reflect the dividend in
Year 10 and all future dividends.
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Present Value ofOperating Cash Flows
Derive the value of the total firm bydiscounting the total operating cash
flows prior to the payment of interest tothe debt-holders
Then subtract the value of debt to arrive
at an estimate of the value of theequity
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Present Value ofOperating Cash Flows
=
= +=
nt
tt
j
t
j WACC
OCFV
1 )1(
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Present Value ofOperating Cash Flows
=
= +
=nt
t tjWACC
tOCFjV
1 )1(Where:Vj=value of firm j
n =number of periods assumed to be infinite
OCFt =the firms operating cash flow in period t
WACC =firm js weighted average cost of capital
(OCF and WACC to be discussed in Chapter 20)
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Present Value ofOperating Cash Flows
Assuming several different rates ofgrowth for OCF, these estimates can be
divided into stages as with thesupernormal dividend growth model
Estimate the rate of growth and the
duration of growth for each period This will be demonstrated in chapter 20
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Present Value ofFree Cash Flows to Equity
Free cash flows to equity are derivedafter operating cash flows have been
adjusted for debt payments (interestand principle)
The discount rate used is the firms cost
of equity (k) rather than WACC
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Present Value ofFree Cash Flows to Equity
Where:
Vj= Value of the stock of firmj
n= number of periods assumed to beinfinite
FCFt = the firms free cash flow in period t
= +
=n
t tjR
tFCFjV
1 )1(
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Relative Valuation Techniques
Value can be determined by comparingto similar stocks based on relative ratios
Relevant variables include earnings,cash flow, book value, and sales
The most popular relative valuation
technique is based on price to earnings
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Earnings Multiplier Model
This values the stock based onexpected annual earnings
The price earnings (P/E) ratio, or
Earnings Multiplier
EarningsMonth-TwelveExpected
PriceMarketCurrent=
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Earnings Multiplier Model
The infinite-period dividend discountmodel indicates the variables that
should determine the value of the P/Eratio
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Earnings Multiplier Model
The infinite-period dividend discountmodel indicates the variables that
should determine the value of the P/Eratio
gR
DiP
= 1
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Earnings Multiplier Model
The infinite-period dividend discountmodel indicates the variables that
should determine the value of the P/Eratio
Dividing both sides by expected earningsduring the next 12 months (E1)
gR
DiP
= 1
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Earnings Multiplier ModelThe infinite-period dividend discount
model indicates the variables thatshould determine the value of the P/E
ratio
Dividing both sides by expected earnings
during the next 12 months (E1)
gRDiP
= 1
gR
ED
E
iP
= 1
/1
1
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Earnings Multiplier Model
Thus, the P/E ratio is determined by 1. Expected dividend payout ratio
2. Required rate of return on the stock (R) 3. Expected growth rate of dividends (g)
gR
ED
E
iP
=
1/1
1
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Earnings Multiplier Model
As an example, assume: Dividend payout = 50% Required return = 12% Expected growth = 8% D/E = .50; R= .12; g=.08
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Earnings Multiplier Model
As an example, assume: Dividend payout = 50%
Required return = 12% Expected growth = 8% D/E = .50; R= .12; g=.08
12.5
.50/.04
.08-.12
.50
P/E
=
=
=
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Earnings Multiplier Model
A small change in either or both Ror gwill have a large impact on the
multiplier
gR
ED
E
iP
= 1
/1
1
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Earnings Multiplier Model
A small change in either or both Ror gwill have a large impact on the
multiplierD/E = .50; R=.13; g=.08
P/E = .50/(.13-/.08) = .50/.05 = 10
gR
ED
E
iP
= 1
/1
1
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Earnings Multiplier ModelA small change in either or both Ror g
will have a large impact on themultiplier
D/E = .50; R=.13; g=.08 P/E = 10
D/E = .50; R=.12; g=.09
P/E = .50/(.12-/.09) = .50/.03 = 16.7
gR
ED
E
iP
= 1
/1
1
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Earnings Multiplier Model
A small change in either or both Ror gwill have a large impact on the
multiplierD/E = .50; R=.13; g=.08 P/E = 10
D/E = .50; R=.12; g=.09 P/E = 16.7
gR
ED
E
Pi
= 11
1
/
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Earnings Multiplier ModelA small change in either or both kor gwillhave a large impact on the multiplier
D/E = .50; R=.13; g=.08 P/E = 10
D/E = .50; R=.12; g=.09 P/E = 16.7D/E = .50; R=.11; g=.09
P/E = .50/(.11-/.09) = .50/.02 = 25
gR
ED
E
iP
= 1/1
1
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Earnings Multiplier Model
Given current earnings of $2.00 andgrowth of 9%
You would expect E1 to be $2.18
D/E = .50; R=.12; g=.09 P/E =16.7
V= 16.7 x $2.18 = $36.41
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Earnings Multiplier Model
Given current earnings of $2.00 andgrowth of 9%
You would expect E1 to be $2.18
D/E = .50; R=.12; g=.09 P/E =16.7
V= 16.7 x $2.18 = $36.41
Compare this estimated value to marketprice to decide if you should invest in it
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The Price-Cash Flow Ratio
Companies can manipulate earnings
Cash-flow is less prone to manipulation
Cash-flow is important for fundamentalvaluation and in credit analysis
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The Price-Cash Flow Ratio
Companies can manipulate earnings
Cash-flow is less prone to manipulation
Cash-flow is important for fundamentalvaluation and in credit analysis
1
/+
=t
t
i
CF
PCFP
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The Price-Cash Flow Ratio
Companies can manipulate earnings
Cash-flow is less prone to manipulation
Cash-flow is important for fundamentalvaluation and in credit analysis
1
/+
=t
t
i
CF
PCFP
Where:P/CFj = the price/cash flow ratio for firm j
Pt = the price of the stock in period t
CFt+1
= expected cash low per share for firm j
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The Price-Book Value Ratio
Widely used to measure bank values(most bank assets are liquid (bonds and
commercial loans)Fama and French study indicated inverse
relationship between P/BV ratios and
excess return for a cross section ofstocks
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The Price-Book Value Ratio
1
/+
=t
tj
BV
PBVP
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The Price-Book Value Ratio
Where:
P/BVj= the price/book value for firmj
Pt = the end of year stock price for firmjBVt+1 = the estimated end of year book
value per share for firmj
1
/+
=t
tj
BV
PBVP
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The Price-Book Value Ratio
Be sure to match the price with either arecent book value number, or estimate
the book value for the subsequent year Can derive an estimate based upon
historical growth rate for the series or
use the growth rate implied by the(ROE) X (Ret. Rate) analysis
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The Price-Sales Ratio
Strong, consistent growth rate is arequirement of a growth company
Sales is subject to less manipulationthan other financial data
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The Price-Sales Ratio
1+=
t
t
S
P
S
P
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The Price-Sales Ratio
Where:
1+
=t
t
S
P
S
P
tjSjP
jS
P
t
t
j
j
Yearduringfirmforsharepersalesannualfirmforpricestockyearofend
firmforratiosalestoprice
1 ==
=
+
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The Price-Sales Ratio
Match the stock price with recent annualsales, or future sales per share
This ratio varies dramatically by industryProfit margins also vary by industry
Relative comparisons using P/S ratioshould be between firms in similarindustries
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Expected Growth Rate of Dividends
Determined by the growth of earnings the proportion of earnings paid in dividends
In the short run, dividends can grow at a differentrate than earnings due to changes in the payout ratio
Earnings growth is also affected by compounding ofearnings retention
g = (Retention Rate) x (Return on Equity)
= RR x ROE
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Breakdown of ROE
EquityCommon
AssetsTotal
AssetsTotal
Sales
Sales
IncomeNet
ROE
=
=
Profit Total Asset Financial
Margin Turnover Leverage= xx
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Estimating Growth Based on History
Historical growth rates of sales, earnings,cash flow, and dividends
Three techniques1. arithmetic or geometric average of
annual percentage changes
2. linear regression models
3. long-linear regression modelsAll three use time-series plot of data
Estimating Dividend Growth
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Estimating Dividend Growthfor Foreign Stocks
Differences in accounting practicesaffect the components of ROE
Retention Rate Net Profit Margin
Total Asset Turnover
Total Asset/Equity Ratio
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Some Analytical Factors
Caveats about the DDM: The DDM is at most a useful tool in security
analysis - it requires certain assumptions and it has
shortcomings.
False growth: False growth occurs when a firm acquires another
firm with a lower price-earnings ratio - historicaldata should always be scrutinized carefully whenused to determine a growth rate.
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Some Analytical Factors
A firms cash flow: The statement of cash flows is a useful analytical
tool - the cash flow from operations figures are
widely used as a check on a firms earnings quality. Small-cap, mid-cap, and large-cap stocks:
Another consideration in fundamental stockanalysis relates to the size of the firm - forexample, the small firm effect.
The fundamental analyst is necessarily interested inthe firms accounting statements and in the prevailinggeneral economic conditions.