Chapter 8 Stock Valuation

Stock Valuation Learning Goals Explain the role that a company’s future plays in stock valuation. Develop a forecast of a stock’s cash flow, expected dividends and share price. Discuss the concepts of intrinsic value and Required Rates of Return. Calculate the underlying value of a stock using various dividend valuation models.

Stock Valuation Learning Goals Use other types of present-value-based models to derive the value of a stock as well as alternative price-relative procedures. Gain a basic understanding of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.

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

Comparative Dollar Based and Common-Size Income Statements

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

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: Historical trends adjusted for anticipated changes in operations or environment, or Earnings forecasts from brokerage houses, Value Line, Forbes, or other sources

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%. So $100M x 8% = $8M Growth  $100+$8 = $108M

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:

Step 2: Forecast Future EPS 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%.

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

Step 2: Forecast Future Dividends 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%.

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 (1) economic conditions, (2) general stock market outlook in near term, or (3) anticipated changes in company’s operating results

Step 3: Forecast P/E Ratio Estimated P/E ratio is function of several variables, including: Growth rate in earnings General state of the market Amount of debt in a company’s capital structure Current and projected rate of inflation Level of dividends

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.

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

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 to find How Much a stock ought to be worth If expected rate of return equals or exceeds our target yield, the stock could be a worthwhile investment. If the intrinsic worth equals or exceeds the current market value, the stock could be a worthwhile investment. There is no assurance that actual outcome will match expected outcome

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

Required Rate of Return 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?

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

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

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

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

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

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

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

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

Price-to-Book-Value (P/BV) Approach Similar to P/E approach, but substitutes book value for earnings

Review Explained the role that a company’s future plays in stock valuation. Developed a forecast of a stock’s cash flow, expected dividends and share price. Discussed the concepts of intrinsic value and required rates of return, and noted how they are used. Calculated the underlying value of a stock using various dividend valuation models.

Review Used other types of present-value-based models to derive the value of a stock as well as alternative price-relative procedures. Gained a basic Understanding of the procedures used to value different types of stocks, from traditional dividend-paying shares to more growth-oriented stocks.

T h e E n d !

Additional Chapter Art

Average Market P/E Multiples 1977–2006

Selected Historical Financial Data, Universal Office Furnishings

Using the Variable-Growth DVM to Value Sweatmore Stock