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Chapter 8

Stock Valuation

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Stock Valuation

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.

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

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Stock Valuation

Learning Goals

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 understanding of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.

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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

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Comparative Dollar Based and Common-Size Income Statements

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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

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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

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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%.

So $100M x 8% = $8M Growth $100+$8 = $108M

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

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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

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Step 2: Forecast Future EPS

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

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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

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Step 2: Forecast Future Dividends

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

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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 (1) economic conditions, (2) general stock market outlook in near term, or (3) anticipated changes in company’s operating results

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Step 3: Forecast P/E Ratio

Estimated P/E ratio is function of several variables, including: Growth rate in earnings General state of the market Amount of debt in a company’s capital structure Current and projected rate of inflation Level of dividends

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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

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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

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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 to find How Much a stock ought to be worth

If expected rate of return equals or exceeds our target yield, the stock could be a worthwhile investment.

If the intrinsic worth equals or exceeds the current market value, the stock could be a worthwhile investment.

There is no assurance that actual outcome will match expected outcome

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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

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Required Rate of Return

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%

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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

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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

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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

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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

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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

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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

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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

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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

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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

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Review

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

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

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

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

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Review

5. Used other types of present-value-based models to derive the value of a stock as well as alternative price-relative procedures.

6. Gained a basic Understanding of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.

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T h e E n d !

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Chapter 8

Additional Chapter Art

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Average Market P/E Multiples 1977–2006

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Selected Historical Financial Data, Universal Office Furnishings

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Using the Variable-Growth DVM to Value Sweatmore Stock