Chapter 18 Investing in Stocks Lawrence J. Gitman Jeff Madura Introduction to Finance

18-1 Copyright © 2001 Addison-Wesley Explain how stocks can be valued using valuation models that are alternatives to the dividend discount model. Explain the valuation of the stock market. Describe the valuation and performance of initial public offering (IPO) stocks. Identify benchmarks commonly used for assessing investment performance. Describe the forms of stock market efficiency. Describe the valuation, performance, measurement, and efficiency of foreign stocks. Learning Goals

18-2 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models The Basic Stock Valuation Equation  Recall from Chapter 7, the basic stock valuation method (also referred to as the dividend discount model) can be expressed as:  Unfortunately, this model is not directly applicable to valuing firms that have low or zero dividends—so alternative methods must be used.

18-3 Copyright © 2001 Addison-Wesley P/E Multiples  This approach is popular because many investors believe earnings are a good proxy for a firm’s cash flows.  A firm’s stock can be valued using the P/E method by multiplying the industry average P/E ratio by the firm’s expected earnings. Alternative Stock Valuation Models

18-4 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models P/E Multiples  Critical to this approach is the determination of a firm’s forecasted earnings.  Unfortunately, it is not uncommon for these forecasts to be off by as much as 20 to 40 percent.  Earnings can be forecast using outside sources (Value Line), or can be forecast directly using pro forma income statements.  This is demonstrated on the following slide.

18-5 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models P/E Multiples Table 18.1

18-6 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models P/E Multiples

18-7 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models P/E Multiples  Limitations of applying P/E multiples include the following: Uncertainty surrounding the proper earnings forecast. Uncertainty surrounding the proper P/E multiple (see Table 18.2 on the following slide). P/E multiple is not applicable to firms with negative earnings.

18-8 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models P/E Multiples Table 18.2

18-9 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models Book Value Multiples  A book value multiple is the market value of the firm’s common stock in relation to (as a multiple of) the book value of the firm’s common stock as shown in the financial statements.  The market/book (M/B) ratio is the market value per share dividend by the book value per share and can be used for valuation purposes as shown below:

18-10 Copyright © 2001 Addison-Wesley Book Value Multiples  The M/B ratio is subject to error if an improper M/B is applied.  A second problem with this approach is that the book value of a firm does not reflect relevant information such as the firm’s potential for growth.  Investors may adjust the industry M/B ratio for firms differences.  However, these adjustments are also subject to error. Alternative Stock Valuation Models

18-11 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models Revenue Multiples  A common revenue multiple used for valuing a firm’s stock is the price/revenue (P/R) ratio, which is the ratio of the share price to a stock’s revenue per share.  Unfortunately, the P/R ratio generally suffers from the same shortcomings as the M/B ratio.

18-12 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models Revenue Multiples Table 18.3

18-13 Copyright © 2001 Addison-Wesley Alternative Stock Valuation Models Valuation During the Recent Market Run-Up  Explanations based on the dividend discount model  Explanations based on the speculative-bubble theory

18-14 Copyright © 2001 Addison-Wesley Valuation and Performance of IPO Stocks Valuation Performance

18-15 Copyright © 2001 Addison-Wesley Stock Performance Benchmarks for Investors Market Indexes  Dow Jones Industrial Average  Standard & Poor’s 500  New York Stock Exchange Index  Nasdaq Composite Sector Indexes Stock Price Quotations

18-16 Copyright © 2001 Addison-Wesley Stock Quotations Figure 18.2 (Panel 1)

18-17 Copyright © 2001 Addison-Wesley Stock Quotations Figure 18.2 (Panel 2)

18-18 Copyright © 2001 Addison-Wesley ADR Quotations Figure 18.3

18-19 Copyright © 2001 Addison-Wesley Stock Market Data Bank Figure 18.4 (Panel 1)

18-20 Copyright © 2001 Addison-Wesley Stock Market Data Bank Figure 18.4 (Panel 2)

18-21 Copyright © 2001 Addison-Wesley Stock Market Efficiency Table 18.4 Forms of Efficiency

18-22 Copyright © 2001 Addison-Wesley Stock Market Efficiency Evidence of Inefficiency  January effect  Monday and weekend effects  Size effect  Price/earnings effect

18-23 Copyright © 2001 Addison-Wesley Stock Market Efficiency Limitations on Capitalizing on Price Discrepancies  Trading commissions  Tax effects  Relationships are not applicable to all firms

18-24 Copyright © 2001 Addison-Wesley Foreign Stocks Valuing Foreign Stocks  Dividend discount model  Price/earnings (P/E) method Foreign Stock Performance Benchmarks Foreign Stock Market Efficiency

Chapter 18 End of Chapter Lawrence J. Gitman Jeff Madura Introduction to Finance