Investment and portfolio management

MGT 531

Investment and portfolio management

Lecture # 21

References

• The course assumes little prior applied knowledge in the area of finance.

• References

• Kristina Levišauskait (2010) ‘Investment Analysis and Portfolio Management’,

SUMMARY OF LAST LECTURE

• Financial ratios by category

• Market value ratios

• Stock valuation

Contents of today's lecture

• Stock valuation process

• fundamental and speculative value of stock

• stock market prices reflect the fundamental value.

• The distinction between fundamental and speculative value of stock is very important one.

• Fundamental value here we understand the value of an equity investment,

• that is held over the long term,

• as opposed to the value, speculative trading that can be realized by short term, speculative trading.

Stock valuation

• Stock valuation process:• 1. Forecasting of future cash flows for the stock.

• 2. Forecasting of the stock price.

• 3. Calculation of Present value of these cash flows.

• This result is intrinsic (investment) value of stock.

Stock valuation process:

• 4. Comparison of intrinsic value of stock and current market price of the stock and decision making: to buy or to sell the stock.

• Valuation methods:• 1. Method of income capitalization.

• 2. Discounted dividend models.

• 3. Valuation using multiples.

Valuation methods:

• This method is based on the use of Present and Future value concept well known in finance.

• The value of any investment could be estimated as present value of future cash flows generated by this investment, using formula:

• V = CF1 / (1 + k) + CF2/ (1 + k)2 + … + CFn / (1 + k)ⁿ =• = ΣCFt/ (1 + k)t

Method of income capitalization

• here CF - expected cash flows from the investment during period t;

• k - discount rate (capitalization rate or required rate of return for the• investor, which include the expected level of risk).

• Discounted dividend models

• The discounted dividends models (DDM) is based on the method of income capitalization and considers the stock price as the discounted value of future dividends,

• at the risk adjusted required return of equity, for dividend paying firms.

Discounted dividend models

• Important assumption behind the DDM:

• the only way a corporation can transfer wealth to its stockholders is through the payment of dividend,

• because dividends are the only source of cash payment to a common stock investor.

• Common stock value using DDM:• V = D1 /(1 + k) + D2 / (1 + k)2 + … + Dn/(1 + k)ⁿ = Σ Dt /

(1 + k)t

Discounted dividend models

• here D1,2 …,t is stock dividend for the period t.

• The forecasted dividends during long-term valuation period of dividends are the key factor influencing the stock value.

• Expected growth rate in dividends (g) is• calculated by formula:

• g = (Dt - Dt-1)/ Dt-1

Discounted dividend models

• Various types of DDM, depending upon the assumptions about the expected growth rate in dividends (g):

• “Zero” growth DDM

• Constant growth DDM

• Multistage growth DDM

Discounted dividend models

• “Zero” growth DDM• Assumption: D1 = D2 = D3 = ... = D∞, that

means Dt = Dt-1 and g = 0.

• The basic DDM formula for stock valuation using “zero” growth model

• becomes as follows:

• V = D1/ k or D0 / k0

Discounted dividend models

• Constant growth DDM

• Assumption: if last year (t0) firm was paying D0 dividends, then in period t=1 its

• dividends will grow at growth rate g:

• D1 = D0 (1 + g) or Dt = Dt-1 (1 + g) = D0(1 + g)

• The basic DDM formula for stock valuation using constant growth model becomes as follows:

• ∞• V = Σ D0 (1 + g)/ (1 + k)t (continuing series) (

Discounted dividend models

• V = D1/ (k - g) (Gordon formula)• Observed Price Earning Ratio (PER):. • Prices of stock and earnings measures, from which observed• PERs are derived, are publicly available.• Earnings per share are observed or estimates of analysts.

• The observed PERs for a firm, a group of firms, an industry, of the index derives directly from such data.

• What should be the PER, according to analysts, might differ from observed PER.

• It is important to make a distinction between observed PER with normative PER*, or what the PER should be.

Price Earning Ratio (PER):

• PER* = V / EPS0 , (4.11)• here: PER* - normative PER• V - intrinsic value of the stock;• EPS0 - earnings per share for the last period.

• Investor might consider that the PER* that should apply to the firm,

• of which stock value has to be estimated,

• should be in line with peer firms selected or the• industry average.

Price Earning Ratio (PER):

• Decision making for investment in stocks, using PER:• If PER* > PER - decision to buy or to keep the stock, because it

is• under valuated;• If PER* < PER - decision to sell the stock, because it is over

valuated;• If PER* = PER - stock is valuated at the same range as in the

market.

• In this case the decision depends on the additional observations of investor.

• There are remarkable variations of PERs across firms, industries, etc.

Decision making for investment in stocks PER: