Docstoc

Common Stock Valuation Fundamental Analysis

Document Sample
Common Stock Valuation Fundamental Analysis Powered By Docstoc
					                         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
             What About Capital Gains?
   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
                 Positive—company has added value

                               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-adjusted returns
        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
               noise traders
          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.

				
DOCUMENT INFO