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Transcript of CH13 Nobel
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Chapter 13
Common Stock Valuation
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Name two approaches to the valuation ofcommon stocks used in fundamental securityanalysis.
Explain the present value approach.
Use the dividend discount model to estimatestock prices.
Explain the P/E ratio approach. Outline other relative valuation approaches.
Learning Objectives
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Two approaches to the valuation of common stocks
used in fundamental security analysis are:1. Present value approach
Capitalization of expected income (capitalization of
income: A method of evaluating an investment byestimating future cash flows and takinginto consideration the time value of money. also calledDiscoun ted Cash Flow (DCF) Analysis).
Intr ins ic value based on the discounted value ofthe expected stream of future cash flows
Fundamental Analysis
http://www.investorwords.com/2599/investment.htmlhttp://www.investorwords.com/9809/future.htmlhttp://www.investorwords.com/768/cash_flow.htmlhttp://www.investorwords.com/1040/consideration.htmlhttp://www.investorwords.com/4988/time_value_of_money.htmlhttp://www.investorwords.com/4988/time_value_of_money.htmlhttp://www.investorwords.com/4988/time_value_of_money.htmlhttp://www.investorwords.com/4988/time_value_of_money.htmlhttp://www.investorwords.com/4988/time_value_of_money.htmlhttp://www.investorwords.com/4988/time_value_of_money.htmlhttp://www.investorwords.com/4988/time_value_of_money.htmlhttp://www.investorwords.com/4988/time_value_of_money.htmlhttp://www.investorwords.com/1040/consideration.htmlhttp://www.investorwords.com/768/cash_flow.htmlhttp://www.investorwords.com/768/cash_flow.htmlhttp://www.investorwords.com/768/cash_flow.htmlhttp://www.investorwords.com/9809/future.htmlhttp://www.investorwords.com/2599/investment.html -
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2. Multiple of earnings approach
Valuation relative to a financial performancemeasure
P/E ratio
Fundamental Analysis (Cont.)
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Estimated intrinsic value compared to the
current market price What if market price is different than estimated
intrinsic value?
n
1ttk)(1
FlowsCash
securityofValue
Intrinsic valueof a security is
Present Value Approach
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Discount rate
Required rate of return: minimum expected rateto induce/stimulate purchase
The opportunity cost of Rupees used forinvestment
Expected cash flows
Stream of dividends or other cash payouts overthe life of the investment
Required Inputs
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Expected cash flows
Dividends paid out of earnings
Earnings important in valuing stocks
Retained earnings enhance future earnings andultimately dividends
Retained earnings imply growth and futuredividends
Produces similar results as current dividends invaluation of common shares
Required Inputs
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Current value of a share of stock is thediscounted value of all future dividends
1tt
cs
t
cs2
cs
21
cs
1cs
)k(1
D
)k1(D...
)k1(D
)k1(DP
Dividend Discount Model
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Problems:
Need infinite stream of dividends
Dividend stream is uncertain
Must estimate future dividends
Dividends may be expected to grow over time
Must model expected growth rate of dividends
and need not be constant
Dividend Discount Model
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Assume no growth in dividends
Fixed rupees amount of dividends reduces thesecurity to a perpetuity
(A constant stream of identical cash flows withno end. The formula for determining the
present value of a perpetuity is as follows):
Dividend Discount Model
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Assume no growth in dividends (Cont.)
cs
00
k
DP
Similar to preferred stock because dividendremains unchanged
Dividend Discount Model
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Assume constant growth rate in dividends
Dividends expected to grow at a constant rate,g, over time
gk
DP 10
Dividend Discount Model
D1 is the expected dividend at end of the firstperiod
D1 = D0 x (1+g)
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Implications of constant growth
Stock pricesgrow at the same rate as thedividends
Stock total returnsgrow at the required rate ofreturn
Growth rate in price plus growth rate in
dividends equals k, the required rate of return A lower required return or a higher expected
growth in dividends raises prices
Dividend Discount Model
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Multiple growth rates
First present value covers the period of super-normal (or sub-normal) growth
Second present value covers the period ofstable growth
Expected price uses constant-growth model as ofthe end of super- (sub-) normal period
Value at n must be discounted to time period zero
Dividend Discount Model
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0 k=16% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%D0 = 4.00 5.20 6.76 8.788 9.315
4.48
5.02
5.63
59.68 P3= 9.315
74.81 = P0 .10
Valuing equity with growth of 30% for 3 years, then along-run constant growth of 6%
Example
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Is the dividend discount model only capableof handling dividends?
Capital gains are also important
Price received in future reflects expectationsof dividends from that point forward
Discounting dividends or a combination of
dividends and price produces same results
What About Capital Gains?
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Fair value based on the capitalization of
income process
The objective of fundamental analysis
If intrinsic value >(
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Alternative approach often used by securityanalysts
P/E ratio is the strength with which investorsvalue earnings as expressed in stock price
Divide the current market price of the stock by
the latest 12-month earnings Price paid for each $1 of earnings
P/E Ratio or Earnings Multiplier
Approach
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To estimate share value
1o1
o
/EPEratioP/Ejustified
earningsestimatedP
P/E ratio can be derived from
g-k/ED/EPor
g-kDP 111o1o
Indicates the factors that affect the estimated
P/E ratio
P/E Ratio Approach
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The higher the payout ratio, the higher thejustified P/E
Payout ratio is the proportion of earnings thatare paid out as dividends
The higher the expected growth rate, g, thehigher the justified P/E
The higher the required rate of return, k, thelower the justified P/E
P/E Ratio Approach
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Can firms increase payout ratio to increasemarket price?
Will future growth prospects be affected?
Does rapid growth affect the riskiness ofearnings?
Will the required return be affected?
Are some growth factors more desirable thanothers?
P/E ratios reflect expected growth and risk
Understanding the P/E Ratio
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A P/E ratio reflects investor optimism andpessimism
Related to the required rate of return
As interest rates increase, required rates ofreturn on all securities generally increase
P/E ratios and interest rates are inversely
related
P/E Ratios and Interest Rates
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Market-to-book ratio (M/B)
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)
Ratio of companys market value (price times
number of shares) divided by sales Market valuation of a firms revenues
Other Valuation Techniques
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Best estimate is probably the present value ofthe (estimated) dividends
Can future dividends be estimated with
accuracy? Investors like to focus on capital gains not
dividends
P/E multiplier remains popular for its ease ofuse and the objections to the dividend discountmodel
Which Approach Is Best?
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Complementary approaches?
P/E ratio can be derived from the constant-growth version of the dividend discount model
Dividends are paid out of earnings Using both increases the likelihood of
obtaining reasonable results
Dealing with uncertain future is alwayssubject to error
Which Approach Is Best?
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Appendix 13-A Analysis and
Valuation of Preferred Stocks
Described as a perpetuity, and it will pay theindicated dividend forever
Dividends are fixed when the stock is issued;these dividends are specified as an annuldollar amount or as a percentage of par value
Less risky because the dividend is specified
and must be paid before a common stockdividend can be paid
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Copyright 2005 John Wiley & Sons Canada, Ltd. All rightsreserved. Reproduction or translation of this work beyond thatpermitted by Access Copyright (The Canadian CopyrightLicensing Agency) is unlawful. Requests for further informationshould be addressed to the Permissions Department, John Wiley
& Sons Canada, Ltd. The purchaser may make back-up copiesfor his or her own use only and not for distribution or resale. Theauthor and the publisher assume no responsibility for errors,omissions, or damages caused by the use of these programs orfrom the use of the information contained herein.
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