CHAPTER TEN Common Stock Valuation
Equity Analysis and Valuation
Two approaches to the valuation of common stocks used in fundamental security analysis: 1. Present value approach 2. Multiple of earnings approach
Fundamental Analysis
Present value approach
Capitalization of expected income Intrinsic value based on the discounted value of the expected stream of future cash flows
Multiple of earnings approach
Valuation relative to a financial performance measure> Relative performance of stocks P/E ratio
Present Value Approach
Intrinsic value of a security is n Cash Flows Value of security ! t (1 k) t !1
Estimated intrinsic value compared to the current market price
What if market price is different than estimated intrinsic value? Strategy Intrinsic value > Market value Intrinsic value < Market value Intrinsic value = Market value Buy Sell Hold
Required Inputs
Discount rate
Required rate of return: minimum expected rate to induce purchase The opportunity cost of dollars used for investment
Expected cash flows
Stream of dividends or other cash payouts over the life of the investment
Dividend Discount Model
Assume no growth in dividends
Fixed dollar amount of dividends reduces the security to a perpetuity
D0 P0 ! k cs
Example: ABC Inc. is currently paying a dividend of $ 2 per share. Which is not expected to change in coming next years up to infinity. Investor required rate of return is 20%. Calculate the intrinsic value of the security. Assume the MV of the security is $12 should you buy this stock?
Dividend Discount Model
Assume constant growth rate in dividends
Dividends expected to grow at a constant rate, g, over time
D1 P0 ! kg
D1 is the expected dividend at end of the first period D1 = D0 (1+g)
Example: ABC Inc. is currently paying a dividend of $ 2 per share. Dividends are expected to grow at 5% rate to infinity. Investor required rate of return is 20%. Calculate the intrinsic value of the security. Assume the MV of the security is $12 should you buy this stock?
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
P/E Ratio or Earnings Multiplier Approach
Alternative approach often used by security analysts 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 12 Price paid for each $1 of earnings Ex. $100/$5= 20 times >> $100/$2.5= 40 times
Other Valuation Techniques
Market-to-book ratio (M/B) Market-to 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) Price-to Ratio of companys market value (price times number of shares) divided by sales Market valuation of a firms revenues
Other Valuation Techniques
Economic Value Added (EVA)
Difference between operating profits and cost of capital Technique for focusing on a firms return on capital in order to determine if shareholders are being rewarded EVA = (ROC - WACC) x Capital
Which Approach Is Best?
Best estimate is probably the present value of the (estimated) dividends P/E multiplier remains popular for its ease of use and the objections to the dividend discount model Dealing with uncertain future is always subject to error
