Chapter 8 Stock Valuation. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 8-2 Stock...
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Transcript of Chapter 8 Stock Valuation. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 8-2 Stock...
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-2
Stock Valuation
• Learning Goals1. 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, and note how they are used.
4. Determine the underlying value of a stock using various dividend valuation models.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-3
Stock Valuation
• Learning Goals (cont’d)
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 appreciation of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-4
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.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-5
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-6
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-7
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%.
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-8
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-9
Step 2: Forecast Future EPS (cont’d)
• 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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-10
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-11
Step 2: Forecast Future Dividends (cont’d)
• 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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-12
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 economic conditions, general stock market outlook in near term, or anticipated changes in company’s operating results
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-13
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-14
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-15
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 determine what a stock ought to be worth
– If expected rate of return equals or exceeds our target yield, the stock could be a worthwhile investment candidate
– If the intrinsic worth equals or exceeds the current market value, the stock could be a worthwhile investment candidate
– There is no assurance that actual outcome will match expected outcome
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-16
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-17
Required Rate of Return (cont’d)
• 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%
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-18
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-19
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-20
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-21
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-22
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-23
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-24
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-25
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-26
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
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-27
Chapter 8 Review
• 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, and note how they are used.
4. Determine the underlying value of a stock using various dividend valuation models.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.8-28
Chapter 8 Review (cont’d)
• Learning Goals (cont’d)
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 appreciation of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.