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Stock Valuation Basics

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					I. CAREERS IN FINANCE

A career in finance can be separated into three areas – corporate finance, investment
management, and retail financial services.

A career in corporate finance involves analyzing, selecting, and funding investments for
financial and non-financial corporations. Positions in corporate finance include financial
analysts, reporting analysts, budget analysts, and planners. A career in corporate finance
requires extensive knowledge of accounting and the business and industry environment.

A career in investment management involves analyzing and selecting securities and
managing the overall return and risk profile of a portfolio. Positions in investment
management are often categorized and from office, middle office, and back office. The
front office includes portfolio managers, traders, researchers, and sales representatives.
The middle office includes risk managers, reporting analysts, and information systems
analysts. The back office includes compliance analysts and general support staff of other
offices. The BS in finance prepares students for all three areas. Positions in the front
office are very competitive and often require excellent grades and summer internships.

A career in retail financial services involves direct interaction with the public in their
need to save, invest, and borrow. Areas include retail banking, financial advising,
mortgage lending, credit cards, and stock brokerage services. Starting positions include
bank representatives, stock brokers, financial advisors, credit analysts, and financial
analysts and consultants at banks and other financial institutions.




                                                                                             1
II. STOCK VALUATION METHODS

  1. Technical Analysis: Use of price and volume graphs to predict stock changes.

     Key Terms:

     1. Momentum: Belief that stocks will continue in current price direction (up,
        down, sideways) because the market price does not fully reflect current events
        (products, profits, news).
     2. Reversal: Belief that stock will change its current direction because market
        has overreacted to current events.
     3. Support: stock price that you belief that stock cannot fall below. Some graph
        support levels by connecting previous lows (see graph below).
     4. Resistance: stock price that you belief that stock cannot exceed. Some graph
        support levels by connecting previous highs.
     5. Volume is the number of shares traded over a particular time period. Some
        suggest that increasing volumes is an indicator of momentum (continuation)
        and decreasing volumes is an indicator of reversal.




                        Resistance




                                          Support




  Activity: Look up RIMM and AAPL stock quotes on finance.yahoo.com. What are
  the support and resistance levels? Which would you buy?


  The problem with technical analysis is that there is little evidence that trading based
  on these principles is profitable.




                                                                                            2
2. Price Multiples: A price multiple is the stock price divided by a per share value of
   earnings, sales, or book “Accounting” value.

   Example: The Price-Earnings Ratio (PE) is the stock price divided by the earnings
   per share (EPS)




Apple PE = 142.36/5.56 = 25.6




RIM PE = 71.29 / 3.58 = 19.9

Activity: What is RIMM and AAPL’s current PE (finance.yaho.com) and which
would you buy?

The problem with multiples is that it is difficult to compare stock multiples because
stocks have different characteristics such as growth and risk.




                                                                                        3
 3. Discounted Free Cash Flow Method: A belief that stock value should be the sum
    of all its expected cashflows (adjusted for time) divided by the current number of
    shares

    Free cash flows (FCF) are the amount of cash that a company generates after all
 production costs and capital good expenditures (such as property, plant, equipment).
 One such measure of FCF for companies with no debt is:

Free Cash Flow (FCF) = Net Income – Capital
Expenditure + Depreciation
 Depreciation is the accounting recognition of prior year capital expenditures (aka,
 CAPEX). Depreciation is added to avoid the double counting of capital expenditures.

 Stock Value per share is:

      FCF (Yr _ 1) FCF (2) FCF (3)                   
     
      1  r 1                             
                                                      
  V                1  r 2 1  r 3              
                           Shares
 If you assume FCFs grow at some constant rate, g, then the formula for growth
 perpetuity is

      FCF (1) 
      r  g  
               
  V           
       Shares
 Where g is the perpetual growth rate and r is the discount rate that should account for
 the riskiness of the company.

 Where get g? often between -5% and long-term growth of the economy (4.5%)

 Where get r? at least the return on a risk-free long term security (such as the 10-year
 treasury which is about 4%, see finance.yahoo.com/bonds), plus 2 – 10%.

 r estimate: 10-yr yield plus 4% for average risk stock, 8% for high risk, and 2%
 for low risk




                                                                                           4
Valuation Exercise for Companies with Low and Stable Growth, and No Debt

TradeStation Group (TRAD) Exercise: (finance.yahoo.com)
Net Income: 30.6 Million (Annual Income Statement, Net Income)
Depreciation: 4.2 M (Annual Cash Flow Statement, Depreciation and Amortization)
CAPEX: 3.7 M (Annual Cash Flow Statement, Capital Expenditures)
Shares: 42 M (Key Statistics)
Debt: 0 (Annual Balance Sheet, Long-term + Short-term Debt)

g = ? (see analyst estimate of next 5-year’s growth in yahoo)
r=?
V=

Buy Sell of hold?
What if r off by +/- 2%

The problem with this method is that g, r, and FCF are often difficult to calculate and
it does not work if g > r. Remember ENRON?

Other companies with little or no debt: BBW




Yahoo StockScreen: Low Growth Firms with No debt and Positive Cash Flows




                                                                                      5
   4. Event/News Trading: see what stocks are in the news and take a view on the
      outcome of some uncertain event or the markets reaction to an announced event.

http://finance.yahoo.com/marketupdate/inplay

http://finance.yahoo.com/marketupdate/storystocks

http://blogs.barrons.com/stockstowatchtoday/

http://www.tradingmarkets.com/.site/stocks/commentary/fivesftm/TradingMarkets-7-
Stocks-You-Need-To-Know-For-Today.cfm


Activity: What are today’s top stock events or stories and how have their prices reacted?
What is your bet?




                                                                                            6
III. FREE CASH FLOW MODEL FOR COMPANIES WITH DEBT AND
LOW/STABLE GROWTH

A. FORECASTING FREE CASH FLOWS WITH DEBT


FCF=Net Income –CAPEX +Depr. +Interest Expense(1-Tax Rate)
and
    FCF (1) 
    r  g    Debt (1  tax)
             
V           
              Shares
Note: Interest is added to FCF and debt subtracted from the valuation to value the
stockholders claim to the firm. Tax is subtracted because interest payments are tax
deductible.

Data Sources:
NI: Annual Income Statement or Cash Flow Statement
CAPEX: Annual Cash Flow Statement
Depreciation: Annual Income Statement or Cash Flow Statement
Debt: Short-term + Long-term debt from Balance Sheet or Yahoo Key Statistics
Interest Expense: Annual Income Statement
Tax: 40% is a good estimate of the sum of local, state, and federal taxes.
r: 10-year Treasury Yield (finance.yahoo/bonds) + 2 – 10 depending on risk
g: estimate of long-term perpetual growth (often between -2% to 4.5%), look at prior.
Shares: Shares Outstanding from Yahoo Key Statistics

Exercise: Value WMT




                                                                                        7
IV. FREE CASH FLOW ESTIMATION MODEL FOR COMPANIES
WITH DEBT AND LOW/STABLE GROWTH (VERSION 2)

    FCF (1) 
   
    r  g    Debt (1  tax)
              
V           
              Shares

FCF=Net Income –CAPEX +Depr. +Interest Expense(1-Tax Rate)


  Since
                         NI
  Net Profit Margin 
                        Sales


  NI  Sales x Net Profit Margin

   1. Next Year Net Income = Next Year Sales x Net Profit Margin

   2. Sales can be estimated by multiplying last period sales x (1+expected growth rate)

          Next Year Sales = Prior Year Sales x (1 + growth)

   3. CAPEX + Depreciation can assume to grow at the same rate as sales.

Version 2 Valuation Formula

    Prior Sales (1  g) x Net Profit Margin - CAPEX  Dep  I(1 - t)        
   
                                                                      Debt 
                                                                             
                                  r  g                                   
V
                                       Shares
Getting Information in yahoo:

   1. Prior Year Sales: Key Statistics (Revenue, ttm “Trailing Twelve Months”)
   2. Sales Growth: Judgment using prior growth (key Stat), prior growth (key stat),
      economy, industry, and company factors.
   3. Profit Margin: Judgment using prior (key stat), industry costs and prices, and
      company factors.
   4. CAPEX: Use prior CAPEX + Depreciation from annual cash flow statement and
      grow at g%.
   5. See prior pages for g, r, and shares (be sure to keep all numbers in billions,
      millions, or thousands – especially shares)

Activity: What is WMT stock worth using this method?


                                                                                       8
BUILDING A GENERAL “ONE-STAGE” MODEL

Build an excel model that allows you to enter information for any stock.

Stock Name:                                                                 Walmart
Stock Symbol:                                                                 WMT

Item                            Source or calculation                         Value
Stock Price                     yahoo, quote                            $    48.41
Prior Sales, ttm                yahoo, key stat, Revenues               $   404.90
Denomination :Billion/Million   yahoo, key stat                             Billions
Prior Revenue Growth            yahoo, key stat                              -0.7%
Prior Profit Margin             yahoo, key stat                               3.3%
Total Debt                      yahoo, key stat                         $     43.2
Shares                          yahoo, key stat, Shs oustand.                 3.92
Prior CAPEX                     Yahoo, cash flow, annual                       11.5
Prior Deprecation               Yahoo, cash flow, annual                         6.7
Risk Free Rate                  Yahoo, Bonds, 10-year                         4.0%
Risk                            Low, Medium, or High                            Low
Risk Premium                    Low = 2%, Med = 4%, Hi = 8%                   2.0%
Interest Expense                Yahoo, Income Statement, annual                  2.2
tax                                                                              0.4

Initial Calculations
Prior (CAPEX + DEPREC) / Sales                                               1.19%
Discount Rate ( r )        Risk Free + Risk Premium                           6.0%

Judgments
Sales Growth                                                                  2.0%
Sales x (1+g)                                                           $   413.00
CAPEX % of Sales                                                             1.19%
CAPEX Estimate                  CAPEX % x Sales Estimate                $     4.90
Net Profit Margin                                                             3.3%
Free Cash Flows Estimate        Sales Est x Profit Margin - CAPEX Est   $    10.09
                                  + interest (1-t)

Valuation Calculation
Total Company Value             FCF Estimate / (r-g)                    $   252.36
Total Stock Value               Total Company Value - Debt              $   209.16
Stock Value                     Total Stock Value / Shares              $    53.36

Buy or Sell Stock?                                                              Sell

Activity: Value WMT, AMZN, YUM, MCD




                                                                                       9
V. BUILDING A GENERAL “MULTI-STAGE” VALUATION MODEL
GOOG
All numbers in billions
                                           Projected   Projected   Projected   Projected   Projected   Projected   Projected   Projected   Projected   Projected
Year                       Current Year            1           2           3           4           5           6           7           8           9          10
Sales (Income Stmt)         $ 16.600       $ 22.41     $ 29.13     $ 36.42     $ 43.70     $ 50.25     $ 55.28     $ 59.70     $ 63.28     $ 66.45     $ 69.11
  Rev Growth                   41.50%        35.00%      30.00%      25.00%      20.00%      15.00%      10.00%       8.00%       6.00%       5.00%       4.00%
Net Income                  $   4.200      $   5.67    $   7.37    $   9.21    $ 11.06     $ 12.71     $ 13.99     $ 15.11     $ 16.01     $ 16.81     $ 17.48
  Income/Sales%                   25%           25%         25%         25%         25%         25%         25%         25%         25%         25%         25%
CAPEX (Cap exp - dep)       $     1.43     $   1.93    $   2.51    $   3.14    $   3.76    $   4.33    $   4.76    $   5.14    $   5.45    $   5.72    $   5.95
  CAPEX %                          9%            9%          9%          9%          9%          9%          9%          9%          9%          9%          9%
Interest Exp (1-t)                         $    -      $    -      $    -      $    -      $    -      $    -      $    -      $    -      $    -      $    -
FCF=NI-CAPEX                $     2.77     $   3.74    $   4.86    $   6.08    $   7.29    $   8.39    $   9.22    $   9.96    $ 10.56     $ 11.09     $ 11.53
Present Value (PV)=FCF/(1+r)^Y             $   3.40    $   4.02    $   4.57    $   4.98    $   5.21    $   5.21    $   5.11    $   4.93    $   4.70    $   4.45


                      10.00% Discount Rate (risk free plus premium)


PV of Years 1-10              $    46.56   Add all 10 PV of Cashflows
PV of Years 11+               $    84.77   (Year-10_FCF*(1+g))/(r-g10)/(1+r)^10
Total Company Value           $   131.33   Add PV of Years 1-10 and PV of Years 11+
-Debt (Key Stats)             $      -     Key Statistics
Total Stock Value             $   131.33   Total Company Value - Debt
Shares Outstanding                 0.314   in billions from Key Statistics"
Per Share Stock Valuation     $   418.26   Total Stock Value / Shares




                                                                                                                                                         10
VI. LOAN AND CREDIT CARD PAYMENTS

A. AUTO LOAN PAYMENT CALCULATOR USING EXCEL PMT()
PMT(rate,nper,pv,fv,type)


For a more complete description of the arguments in PMT, see the PV function.


Rate is the interest rate for the loan.


Nper is the total number of payments for the loan.


Pv is the present value, or the total amount that a series of future payments is worth now; also known as the principal.


Fv is the future value, or a cash balance you want to attain after the last payment is made. If fv is omitted, it is assumed to be
0 (zero), that is, the future value of a loan is 0.


Type is the number 0 (zero) or 1 and indicates when payments are due.


Set type equal to      If payments are due
0 or omitted        At the end of the period
1                   At the beginning of the period



EXERCISE: GO TO KBB.COM AND SEARCH NEW CAR BY MAKE
AND MODEL AND CALCULATE ITS COST. CALCULATE THE
MONTHLY PAYMENT ASSUMING YOU MAKE A $1,000 DOWN
PAYMENT. USE A 4-YR LOAN AND YOU CAN GET THE CURRENT
AUTO LOAN RATES AT BANKRATE.COM.

B. CREDIT CARD PAYMENT CALCULATOR

THE AVERAGE COLLEGE STUDENT GRADUATES WITH $3,200 IN
CREDIT CARD DEBT. ASSUMING AN 18% ANNUAL INTEREST
RATE COMPUTE THE NUMBER OF MONTHS AND TOTAL COST IT
WILL TAKE TO PAYOFF THE LOAN.

A STANDARD CREDIT PAYMENT IS THE MAXIMUM OF $10 OR
(1% OF PRINCIPAL PLUS THE FINANCE CHARGE)
Avg coll
balance rate
    3,200           0.18                                                                               Max(Fin charge + 1%, $10)
                                                                 end
             Init. Bal.  PMT       int     princ                 bal         Interest                  Total Payments           $ 7,550.98
         1    $ 3,200.00 $   80.00 $ 48.00 $ 32.00                $ 3,168.00
         2    $ 3,168.00 $   79.20 $ 47.52 $ 31.68                $ 3,136.32
         3    $ 3,136.32 $   78.41 $ 47.04 $ 31.36                $ 3,104.96
         4    $ 3,104.96 $   77.62 $ 46.57 $ 31.05                $ 3,073.91




                                                                                                                                11
VII. YUM EARNINGS ESTIMATE

YUM ANNONCES EARNINGS AFTER THE MARKET CLOSE TODAY.

GO THE EARNINGSWHISPERS.COM AND YAHOO AND LOOK UP
YUM ESTIMATES FOR BOTTOM LINE (EPS) AND TOP LINE
(REVENUE).




                                                    12
VIII. VALUATION ASSIGNMENT AND PITCH

Each group of 3 students will analyze and value a group of stocks.

   Rank the following industry groups from the best to the worst performer in the next
   couple years. Think about what global, economic, social or industry trends favor or
   hurt these industries.

   Restaurants/Specialty Eateries (in Services Sector)
   Apparel Stores (in Services Sector)
   Department/Discount Stores (in Services Sector)
   Grocery/Drug Stores (in Services Sector)
   Broadcasting/CATV Systems (in Services Sector)
   Consumer Goods Sector
   Health Care Sector
   Technology Sector


   1. Value at least one stock per team member in your top ranked industry using the
      multistage growth model.
   2. Select the best buy and sell recommendation using the valuation and an insight
      about the company or industry.
   3. Create a stock pitch


Finding Stocks using Yahoo Stock Screener:

Restaurants (FCF, Profit Margin, and Sales Growth > 0)




                                                                                         13
IX. POWERPOINT AND PRESENTATION (5 MINUTES PER GROUP)




Presentation Essentials:
   (1) State Your Thesis Clearly (“XYZ stock is A Buy because of 1, 2, 3”)
   (2) Support: Support your thesis with logical arguments, evidence, models, etc.
   (3) Know your Audience: Anticipate concerns or questions




                                                                                     14
X. Demonstration of Automated Valuation Model
Lou Gattis (Discount Stores Ind. Group)                                                                                                         Valuation Summary (millions)
Company Name          Wal Mart                                                                                                 Present Value of 1-20 cashflows                   $ 159,240
Industry (for Beta)   Retail Store                                                                                             Present Value of Perpetuity                       $ 233,326
(from drop down menu)                                                                                                          =Value of Firm's Assets                           $ 392,566
                                                                                                                               - Current Value of Debt                           $ (31,349)
  My Valuation           $            93.80                                                                                    + Debt Tax benefit                                $   9,405
                                                                                                                               = Value of Equity                                 $ 370,622
                                                                                                                               Fully Dilluted Shares                                 3,951
 Current Price           $            48.00                                                                                    Stock Valuation (Using FCFF/Ku)                   $   93.80
                                                                                                                                                 Key Financial Ratio Trends
 1-Year Range             46.25 - 63.85                                                                                                                   2007        2008            2009
                                                                                                                               Debt/Equity                   0.44        0.46            0.48
                                                                                                                               CFFO/Sales                    5.7%        5.4%            5.7%
My                                                                                                                             Inc./Assets (ROA)             3.2%        3.4%            3.3%
Recommendation            Strong Buy                                                                                           Current Assets/Liab           0.90        0.82            0.88
                    Competitor Analysis (Yahoo Finance)                                           Company Profile                              Market - Industry Assumptions
                         Firm      Comp1 Comp2          Comp3   Industry            Walmart operates retail stores in the U.S. Equity Market Beta                                        1.00
Market Cap              187.04B         N/A   19.47B     27.97B    1.75B            and internationally. Walmart currently     Drop-Down Industry Menu                           Retail Store
Qtr. Sales Growth        -0.70%         N/A   -4.90%      0.20%    6.90%            operates 971 discount stores, 2,447        Industry Unl. Beta (Damodaran)                            0.87
Sales (Revenue)         404.91B 124.35B1      72.14B     64.98B    4.79B            supercenters , 132 neighborhood markets, Risk-Free Rate (10-Yr Treasury)                            3.91%
Net Income               13.26B     2.17B1     1.11B      2.13B       N/A           and 59 Sam's Clubs in the U.S. They also Equity Market Risk Premium                                 4.00%
Earnings Per Share     $ 3.40          N/A $ 2.52 $ 2.81 $          1.86            operate in many foreign markets such as Equity Market Required Return                               7.91%
Gross Profit Margin      24.63%         N/A 12.51% 28.40%         32.16%                                                       Industry Required Rate                                   7.39%
                                                                                    Japan and China.
Net Profit Margin         3.27%      1.75%     1.54%      3.28% #VALUE!                                                        Long-term Growth of Economy                              3.91%
P/S Ratio (Price/SPS)       0.46       N/A      0.28       0.44     0.40                                                       Year 10 Sales Growth Estimate                            5.54%
P/E Ratio (Price/EPS)     14.12        N/A     17.77      13.23    15.00                                                       Perpetual Sales Growth (Year 20+)                        3.91%
Strengths              What they do better than competitors
Weaknesses:            What they do worse than competitors
Opportunities          Possible Favorable Economy, Industry, Company developments that may affect cashflows
Threats                Possible Unfavorable Economy, Industry, Company developments that may affect cashflows
Financials               1/1/07       1/1/08     1/1/09     Est. Yr 1   Est. Yr 2   Est. Yr 3 Est. Yr 4    Est. Yr 5   Est. Yr 6 Est. Yr 7 Est. Yr 8    Est. Yr 9   Est. Yr 10    Est. Yr 20
Sales (Millions)         348,368      378,476    405,607    434,683     465,056     496,710     529,619    563,750     599,059    635,496    672,998     711,496     750,907         1,182,092
  Sales Growth               11.6%      8.6%       7.2%        7.2%         7.0%        6.8%      6.6%        6.4%        6.3%      6.1%       5.9%          5.7%        5.5%            3.9%
Net Income                   11,284    12,731     13,400     14,354       15,462      16,627     17,849     19,127      20,461     21,849     23,291      24,784       26,327          43,856
  % of Sales                  3.2%      3.4%       3.3%        3.3%         3.3%        3.3%      3.4%        3.4%        3.4%      3.4%       3.5%          3.5%        3.5%            3.7%
Net CAPEX & W/C              -6,062     -7,952     -1,776     -6,200       -6,633      -7,085     -7,554      -8,041     -8,545     -9,064     -9,599     -10,148      -10,711         -16,861
  % of Sales                 -1.7%      -2.1%      -0.4%       -1.4%       -1.4%       -1.4%      -1.4%       -1.4%      -1.4%      -1.4%      -1.4%        -1.4%       -1.4%            -1.4%
Interest Exp * (1-tax)        1,302     1,514      1,572       1,572        1,572       1,572     1,572       1,572       1,572     1,572      1,572        1,572        1,572           1,572
= Free CF (FCFF)        6,524  6,293 13,196                    9,726      10,402      11,115     11,867      12,658      13,488    14,357     15,264       16,209      17,189           28,567
Present Value (FCFF) XXXXXXXXXXXXXXXXXXXXX                    9,057        9,019       8,975      8,923       8,863      8,794      8,716      8,629        8,532       8,426           6,864




Note: In this valuation model, FCF = NI + Net CAPEX (CAPEX + Depr + working
capital) + Interest Expense.




                                                                                                                                                                                          15
XI: Other Topics

   1. Calculating Discount Rates using the Capital Asset Pricing Model (CAPM)



r = Risk-Free Rate + Beta x (Market Risk Premium)
   where
   Risk-Free Rate = 10-Year Treasury Yield
   Beta= Measure of Company Risk (See Yahoo Key Statistics)
   Market Risk Premium= Expected Return of Stock Market over Treasuries


   2. Options

   3. Exchange Traded Funds

   4. International Investments and Exchange Rates

   5. Valuing IPOs




                                                                                16

				
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