Post on 13-Dec-2015
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: