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Chapter 13

Common Stock Valuation

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Name two approaches to the valuation ofcommon stocks used in fundamental securityanalysis.

Explain the present value approach.

Use the dividend discount model to estimatestock prices.

Explain the P/E ratio approach. Outline other relative valuation approaches.

Learning Objectives

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Two approaches to the valuation of common stocks

used in fundamental security analysis are:1. Present value approach

Capitalization of expected income (capitalization of

income: A method of evaluating an investment byestimating future cash flows and takinginto consideration the time value of money. also calledDiscoun ted Cash Flow (DCF) Analysis).

Intr ins ic value based on the discounted value ofthe expected stream of future cash flows

Fundamental Analysis
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2. Multiple of earnings approach

Valuation relative to a financial performancemeasure

P/E ratio

Fundamental Analysis (Cont.)

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Estimated intrinsic value compared to the

current market price What if market price is different than estimated

intrinsic value?

n

1ttk)(1

FlowsCash

securityofValue

Intrinsic valueof a security is

Present Value Approach

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Discount rate

Required rate of return: minimum expected rateto induce/stimulate purchase

The opportunity cost of Rupees used forinvestment

Expected cash flows

Stream of dividends or other cash payouts overthe life of the investment

Required Inputs

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Expected cash flows

Dividends paid out of earnings

Earnings important in valuing stocks

Retained earnings enhance future earnings andultimately dividends

Retained earnings imply growth and futuredividends

Produces similar results as current dividends invaluation of common shares

Required Inputs

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Current value of a share of stock is thediscounted value of all future dividends

1tt

cs

t

cs2

cs

21

cs

1cs

)k(1

D

)k1(D...

)k1(D

)k1(DP

Dividend Discount Model

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Problems:

Need infinite stream of dividends

Dividend stream is uncertain

Must estimate future dividends

Dividends may be expected to grow over time

Must model expected growth rate of dividends

and need not be constant


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Assume no growth in dividends

Fixed rupees amount of dividends reduces thesecurity to a perpetuity

(A constant stream of identical cash flows withno end. The formula for determining the

present value of a perpetuity is as follows):


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Assume no growth in dividends (Cont.)

cs

00

k

DP

Similar to preferred stock because dividendremains unchanged


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Assume constant growth rate in dividends

Dividends expected to grow at a constant rate,g, over time

gk

DP 10


D1 is the expected dividend at end of the firstperiod

D1 = D0 x (1+g)

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Implications of constant growth

Stock pricesgrow at the same rate as thedividends

Stock total returnsgrow at the required rate ofreturn

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


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Multiple growth rates

First present value covers the period of super-normal (or sub-normal) growth

Second present value covers the period ofstable growth

Expected price uses constant-growth model as ofthe end of super- (sub-) normal period

Value at n must be discounted to time period zero


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0 k=16% 1 2 3 4

g = 30% g = 30% g = 30% g = 6%D0 = 4.00 5.20 6.76 8.788 9.315

4.48

5.02

5.63

59.68 P3= 9.315

74.81 = P0 .10

Valuing equity with growth of 30% for 3 years, then along-run constant growth of 6%

Example

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Is the dividend discount model only capableof handling dividends?

Capital gains are also important

Price received in future reflects expectationsof dividends from that point forward

Discounting dividends or a combination of

dividends and price produces same results

What About Capital Gains?

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Fair value based on the capitalization of

income process

The objective of fundamental analysis

If intrinsic value >(

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Alternative approach often used by securityanalysts

P/E ratio is the strength with which investorsvalue earnings as expressed in stock price

Divide the current market price of the stock by

the latest 12-month earnings Price paid for each $1 of earnings

P/E Ratio or Earnings Multiplier

Approach

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To estimate share value

1o1

o

/EPEratioP/Ejustified

earningsestimatedP

P/E ratio can be derived from

g-k/ED/EPor

g-kDP 111o1o

Indicates the factors that affect the estimated

P/E ratio

P/E Ratio Approach

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The higher the payout ratio, the higher thejustified P/E

Payout ratio is the proportion of earnings thatare paid out as dividends

The higher the expected growth rate, g, thehigher the justified P/E

The higher the required rate of return, k, thelower the justified P/E

P/E Ratio Approach

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Can firms increase payout ratio to increasemarket price?

Will future growth prospects be affected?

Does rapid growth affect the riskiness ofearnings?

Will the required return be affected?

Are some growth factors more desirable thanothers?

P/E ratios reflect expected growth and risk

Understanding the P/E Ratio

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A P/E ratio reflects investor optimism andpessimism

Related to the required rate of return

As interest rates increase, required rates ofreturn on all securities generally increase

P/E ratios and interest rates are inversely

related

P/E Ratios and Interest Rates

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Market-to-book ratio (M/B)

Ratio of share price to per share shareholders

equity as measured on the balance sheet

Price paid for each $1 of equity

Price-to-sales ratio (P/S)

Ratio of companys market value (price times

number of shares) divided by sales Market valuation of a firms revenues

Other Valuation Techniques

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Best estimate is probably the present value ofthe (estimated) dividends

Can future dividends be estimated with

accuracy? Investors like to focus on capital gains not

dividends

P/E multiplier remains popular for its ease ofuse and the objections to the dividend discountmodel

Which Approach Is Best?

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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 alwayssubject to error

Which Approach Is Best?

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Appendix 13-A Analysis and

Valuation of Preferred Stocks

Described as a perpetuity, and it will pay theindicated dividend forever

Dividends are fixed when the stock is issued;these dividends are specified as an annuldollar amount or as a percentage of par value

Less risky because the dividend is specified

and must be paid before a common stockdividend can be paid

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Copyright 2005 John Wiley & Sons Canada, Ltd. All rightsreserved. Reproduction or translation of this work beyond thatpermitted by Access Copyright (The Canadian CopyrightLicensing Agency) is unlawful. Requests for further informationshould be addressed to the Permissions Department, John Wiley

& Sons Canada, Ltd. The purchaser may make back-up copiesfor his or her own use only and not for distribution or resale. Theauthor and the publisher assume no responsibility for errors,omissions, or damages caused by the use of these programs orfrom the use of the information contained herein.

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