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 kg 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.