Common Stock Valuation Fundamental Analysis

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```					                         Common Stock Valuation
Chapter 10

Fundamental Analysis Approaches
   Present value approach
 Capitalization of expected income
 Intrinsic value based on the discounted value of the expected
stream of cash flows
   Multiple of earnings (P/E) approach
 Stock worth some multiple of its future earnings

Present Value Approach (Capitalization of Income)
   Intrinsic value of a security is


Dt
Po =              t
(1 + K e )
t 1
Ke = appropriate discount rate

   In using model, to estimate the intrinsic value of the security must:
 Discount rate (Capitalization Rate, Required Rate of Return)
 Required rate of return: minimum expected rate to induce
purchase given the level of risk
 The opportunity cost of dollars used for investment
 Expected cash flows and timing of cash flows
 Stream of dividends or other cash payouts over the life of
the investment
 Dividends paid out of earnings and received by
investors
 Earnings important in valuing stocks
 Retained earnings enhance future earnings and ultimately
dividends
 If use dividends in PV analysis, don’t use retained
earnings in the model
 Retained earnings imply growth and future
dividends
 Compared computed price to actual price
Dividend Discount Model
   Current value of a share of stock is the discounted value of all future
dividends
   Problems:
 Need infinite stream of dividends
 Dividends received 40-50 years in the future are worth very
little in present value with the discount rate is sufficiently
high (12%, 14%, 16%)
 Dividend stream is uncertain
 Dividends not guaranteed
 Declared by Board of Directors
 Must estimate future dividends
 Dividends may be expected to grow over time
 Must model expected growth rate of
dividends and the growth rate need not be
constant

Dividend Discount Model-Zero Growth
   Assume no growth in dividends
   Fixed dollar amount of dividends reduces the security to a perpetuity
Do
Po 
Kp
Kp = appropriate discount rate

   Similar to preferred stock because dividend remains unchanged

Dividend Discount Model-Constant Growth-Gordon Model
   Assumes a constant growth in dividends
   Dividends expected to grow at a constant rate, g, over time

D1
Po =               D1 = Do (1+ g)
Ke - g

where
       g: growth rate
       ke: required return
       Ke > g
       D1 is the expected dividend at end of the
first period
     D1 =D0 (1+g)
   Implications of constant growth
 Stock prices grow at the same rate as the dividends (g)
     Problem: what if higher growth in price than dividends or
visa versa
 Stock total returns grow at the required rate of return
 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

Reasons for Different Values of Same Stock
   Each investor may use their individual k
   Each investor has their own estimate of g

Dividend Discount Model-Multiple Growth
   Multiple growth rates: two or more expected growth rates in dividends
 Ultimately, growth rate must equal that of the economy as a whole
 The company/industry is maturing and when it reaches
maturity –grows at the rate of the economy
 Assume growth at a rapid rate for n periods followed by steady
growth
   Multiple growth rates approach:
 First present value covers the period of super-normal (or sub-
normal) growth
 Second present value covers the period of stable growth
 Expected price uses constant-growth model as of the end of
super- (sub-) normal period (time period m)
 Value at m must be discounted to time period zero

Two Period Growth Model:

m              t
Do (1+ g 1 )    1
Po =             t
+     m
( Dm+1 )
(1+ K e ) (1+ K e ) K e - g 2
t=1

   m = length of time firm grows at g1
   g2 < k
   g1: growth rate for period 1
   g2 : growth rate for period 2
   ke: required return
   Example: required rate of return =18% Current dividend is 2.00
dividends are expected to grow at 12% for first 6 years then at 6%

    Present value of First 6-Years' Dividends:

Year         Dividend            P.V. Interest Factor                                    Present Value
t              Dt              PVIF18.t = 1/(1 + .18)t                                  Dt x PVIF18.t
1          \$ 2.240                         .874                                             \$ 1.897
2           2.509                          .718                                              1.801
3           2.810                          .609                                              1.711
4           3.147                          .516                                              1.624
5           3.525                          .437                                              1.540
6           3.948                          .370                                              1.461
PV (First 6-Years' Dividends                                                   \$10.034
     Value of Stock at End of Year 6:
 P6 = D7/(Ke - g2) where g2 = .06
 D7 = D6(1 + g2) = 3.948(1 + .06) = \$4.185
 P6 = 4.185/(.18 - .06) = \$34.875
 Present Value of P6
 PV(P6) = P6/(1 + ke)6 = \$34.875/(1 + .18)6 = \$34.875 x .370 = \$12.904
     Value of Common Stock (Po)
 Po = PV(First 6-Year's Dividends) + PV(P6) = 10.034 + 12.904 = 22.94

      Example using the two period growth formulae:
1 + g1
D1 [1 - (            )M ]        D1 (1 + g1 )
M-1
(1  g 2)
1+ k
Po =                               +[
M
]
k - g1                    (1 + k )       (k - g 2)

     M= # of years growing at g1

1.12 6
2.24[1- (     ) ]
1.18       2.24(1.12) 5 (1.06)
P=                         +
.18 - .12        (.18 - .06)(1.18) 6

2.24[1- .7312] 2.24(1.76)(1.06)
+
.06        (.12)(2.6996)

4.18
10.04 +           = 10.04 + 12.90 = \$22.94
.3239
   Is the dividend discount model only capable of handling dividends?
 Capital gains are also important
   Price received in future reflects expectations of dividends from that point
forward
 Discounting dividends or a combination of dividends and price
produces same results

No Dividend Model

CAPM =ˆr j = rf + B j (r m - r f )

Intrinsic Value Implications
   ―Fair‖ value based on the capitalization of income process
 The objective of fundamental analysis
   If intrinsic value >(<) current market price, hold or purchase (avoid or
sell) because the asset is undervalued (overvalued)
 Decision will always involve estimates

P/E Ratio
   P/E ratio is the strength with which investors value earnings as expressed
in stock price
 Divide the current market price of the stock by the latest 12-month
earnings
 Price paid for each \$1of earnings

P/E Ratio or Earnings Multiplier Approach
   To estimate share value

P0
Po  E 1 ( Justified (      ))
E1
where
   E1 = estimated earnings
   Justified P/E
 Using market or industry P/E multiples as
benchmarks, the investor will try to establish
a multiple that the investor feels that the
stock will trade at in the future
   P/E ratio can be derived from ( if constant growth)
D1
P0 
kg

   Indicates the factors that affect the estimated P/E ratio

   Factors that Affect the estimated P/E
 Dividend Payout
 The higher the payout ratio, the higher the justified P/E
 Payout ratio is the proportion of earnings that are paid out
as dividends
 Required Rate of return
 The higher the required rate of return, k, the lower the justified P/E
 Expected growth rate
 The higher the expected growth rate, g, the higher the justified P/E

Retained
Earnings Earnings                Return
=          +[ Earnings*        ]
next year this year              on R.E.
this year

Retained
     E t +1 = E t + [              * R]
Earnings

Retained
E t+1 = E t + [      Earnings
                                    * R]
Et Et                    Et

       1+ g = 1+ [Retentionrate * R]

     g = (Retentionrate)* (Return on earnings)
Understanding the P/E Ratio
   P/E should be higher for companies with earnings that are expected to
grow rapidly
   P/E should be higher for companies with less risk
   Can firms increase payout ratio to increase market price?
 P/E depends on the investors assumptions of future earnings
(growth factor) and risk
 Will future growth prospects be affected?
 Does rapid growth affect the riskiness of earnings?
 Will the required return be affected?
 Are some growth factors more desirable than others?
   P/E ratios reflect expected growth and risk

P/E Ratios and Interest Rates
   A P/E ratio reflects investor optimism and pessimism
 Related to the required rate of return
   As interest rates increase, required rates of return on all securities
generally increase
   P/E ratios and interest rates are indirectly related
 As required rate increases, the price of stock drops, and the P/E
must also fall

Which Approach Is Best?
   Best estimate is probably the present value of the (estimated) dividends
 Problems
 Can future dividends be estimated with accuracy?
 Investors like to focus on capital gains not dividends
   P/E multiplier remains popular for its ease in use and the objections to the
dividend discount model
 Problems
 Must estimate earnings which is the first step in estimating
dividends
   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 always subject to error

Other Multiples
   Price-to-book value ratio
 Ratio of share price to stockholder equity as measured on the
balance sheet
 Asset book value and market value must be similar to be
meaningful
 Sometimes used in valuing financial companies
 Comparison should be made to firm’s own ratio over time
as well as to the industry’s ratio
 Price paid for each \$1 of equity
 Used as a Purchase Strategy
 Buy low price to book ratio stocks
 Comparison should be made to firm’s own ratio over time
as well as to the industry’s ratio
    Price-to-sales ratio
 Ratio of a company’s total market value (price times number of
shares) divided by its sales
 Indicates what the market is willing to pay for the firm’s revenues
 Used as a Purchase Strategy
 Buy low Price to Sales stock
    EVA
 EVA = difference between operating profits and a company’s true cost
of capital

Preferred Stock
   Order in bankruptcy (paid before common)
   Share ownership
 Mostly institutions—corporations
 Perpetuities
   Stated dividend amount
   Callable
 Many carry sinking funds to provide for potential liquidation
   Convertible (about half of the issues)
   Cumulative provision (usually)
   Typically no voting rights
   Tax Ramifications
 70% of preferred dividends received by Co. A. on Co. B not taxable
 lower return
   Preemptive rights - first priority to purchase new stock.
Dp
   Po 
Kp

STOCK PERFORMANCE

 Risk Measures
 β - systematic risk
 σ - total risk
   Sharpe Index

R - Rf
=


   Treynor Index

R - Rf
=


STOCK MARKET EFFICIENCY
       Weak-form: security prices reflect all market-related data from past.
       Semistrong: security prices reflect all past information but also public information.
       Strong:         security prices reflect all information including private or insider
info.
       Tests
 Weak-form: regression analysis---look for non-random patterns in
security prices.
 Semistrong: Event studies
 Benchmark for abnormal returns
) f r - m r( j B + fr = j ˆ = M PAC
r

   abnormal return
 r j r j  e
ˆ

    ˆ
rj :   estimated return
     rj: actual return
     e: is difference (error)
 Question: is e significantly different
from zero

Determinants of Stock Price Movements
       Economic Factors
       Interest Rates
       Impact of the dollar
       Other

       Abnormalities
 Jan Effect
       Technical Analysis
Evidence on Factors Affecting Prices
   Schiller
 smart-money investors
   Roll
 APT

SEARCH FOR UNDERVALUED STOCK
 Targets for Acquisition
 Why acquire?
 synergistic affects
 tax-shields
 replace inefficient management
 diversify co.
 Investors reaction:
 Positive share price movement for target with some negative
price movement for acquiring.

   ESOP
 Prevents takeover
 Employee ownership/productivity
 Inefficient companies avoid takeover & remain undervalued

   Overvalued - Companies issue new common stock

   Undervalued - Companies may repurchase (Treasury stock)

   LBO -     group of managers form a group to purchase stock to buy
company - Use debt to buy (retire) the company's stock.
 reduced agency cost
 large debt

   International markets (stock)
 higher returns but
 smaller markets rise volatility
 information
 costs of listing
 annual reports/foreign currency
 financial statements compatible with GAAP

Domestic Issues

   Program Trading: Simultaneous buying of selling of a portfolio of at least 15
different stocks valued at more than \$1 million.

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