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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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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.