© K. Cuthbertson and D. Nitzsche Chapter 14 Stock Valuation and the EMH Investments

Explosive Growth Problem A company’s growth is estimated at 14% for the next 3 years, 12% for year 4&5; 7% in year six and then 4% forever. Last dividend was 1.05 and required return is estimated at 9%. What is the value of this company stock?  First calculate dividends year one to seven: © K. Cuthbertson and D. Nitzsche

Explosive Growth Problem Dividend 1-6 are future cash flows (returns) that have to be discounted at the required rate of return to their PV (part of the price): The sum of these PV’s =7.20 (keep this in memory) © K. Cuthbertson and D. Nitzsche

Explosive Growth problem Another component of the stock price is the PV of the stock price in year 6 ( constant growth model):  P6 = D7/(r-g)= 2.17/( )=43.42  PV = (P6 discounted for 6 years at 9%) The price of this stock is the sum of 7.20 and  P=33.09 © K. Cuthbertson and D. Nitzsche

Learning Objectives © K. Cuthbertson and D. Nitzsche To estimate the fair value of a stock using PV techniques and discounted cash flows. Dividend Discount model Use of ‘relative valuation’ and comparable Discuss the EMH and stock picking strategies

Fair Value and EMH © K. Cuthbertson and D. Nitzsche Discounted Future Cash Flow approach Investors price stock on the basis of anticipated inflows Since dividends are the only cash reward for investing, a popular valuation model is the dividend discount model

Present Value of Free Cash Flow to Equity The Constant Growth Formula where: FCFE = the expected free cash flow in period 1 r = the required rate of return on equity for the firm g FCFE = the expected constant growth rate of free cash flow to equity for the firm A multi-stage model similar to DDM can also be applied

Discount the firm’s operating free cash flow to the firm (FCFF) at the firm’s weighted average cost of capital (WACC). FCFF =EBIT (1-Tax Rate) + Depreciation Expense - Capital Spending -  in Working Capital -  in other assets Present Value of Operating Free Cash Flow

© K. Cuthbertson and D. Nitzsche Time V D1D1 D2D2 D3D3 V = fair value D 1, D 2, D 3, … = expected dividends D4D4 4 Figure 1 : Equity – cash flow

© K. Cuthbertson and D. Nitzsche Time P D1D1 D 1 (1+g) 4 D 1 (1+g) 2 Figure 2 : Dividend discount model

Present Value of Dividends Simplifying assumptions help in estimating present value of future dividends Constant Growth DDM Value of equity or price: P= D 1 /(R-g) and D 1 = D 0 (1+g) Growth Rate Estimates – Average Dividend Growth Rate – Sustainable Growth Rate g = RR X ROE

Internal Rate of Return © K. Cuthbertson and D. Nitzsche As we examined the feasibility of a physical investment project we used IRR (y) Similarly the IRR can be calculated using the observed market price P P= D1/(y-g) y=D1/P +g (D1/P is div. yield) Buy if >R

Calculating the Discount Rate (R) © K. Cuthbertson and D. Nitzsche Using CAPM and the security market line Beta of stock measures the market(systematic) risk in a stock and is estimated as:

SML Estimate expected market risk premium (slope) Determine the risk-free rate (intercept) Calculate beta of a stock Calculate the expected return on the stock (as a reward for the market risk in the stock). © K. Cuthbertson and D. Nitzsche

Average return R i =  i Beta,  i Q  i = M r = 5% SML 9% Figure 3 : Security market line

Company Data Market Timing Performance measures Value Line report © K. Cuthbertson and D. Nitzsche

Additional Measures of Relative Value Price/Book Value (PB/V) Ratio  Book value is a reasonable measure of value for firms that have consistent accounting practice  It can been applied to firms with negative earnings or cash flows  Should not attempt to use this ratio to compare firms with different levels of hard assets—for example, a heavy industrial firm and a service firm

Price/Cash Flow (P/CF) Ratio  The price/cash flow ratio has grown in prominence and use because many observers contend that a firm’s cash flow is less subject to manipulation  See Exhibit 9.9 Price/Sales (P/S) Ratio  Sales growth drives the growth of all subsequent earnings and cash flow and sales is one of the purest numbers available  See Exhibit 9.9 Additional Measures of Relative Value

Analysis of Growth Companies Generating rates of return greater than the firm’s cost of capital is considered to be temporary Earnings higher the required rate of return are pure profits How long can they earn these excess profits?

Value of No-Growth Firms A No-Growth Firm  E = r x Assets  E = r x Assets = Dividends (Firms has retention ratio, b, of 0) Firm Value  R Eb R E V   1 V E R 

21 Stock as a Present Value Investors price stock on the basis of anticipated inflows Since dividends are the only cash reward for investing, a popular valuation model is the dividend discount model

22 Valuation of Apple Computer Example Microsoft pays a $0.50 dividend. This is expected to grow at a rate of 7%. The required rate of return is 10%. Based on the dividend discount model, what is the value of Microsoft’s common stock?

23 Valuation of Apple Computer (con’d) Example Stock price = Next dividend / Required return in Excess of anticipated dividend growth rate Stock price= $0.50 (1.07) / [0.10 – 0.07] = $0.535 / 0.03 = $18

24 Valuation of Apple Computer (con’d) Example Small errors in estimation result in huge changes in estimated stock price value! Increase dividend growth rate by ten percent (to 7.7%) Stock price= $0.50 (1.077) / [0.10 – 0.077] = $ / = $23.41 That is a 30% increase!

25 Accounting Versus Finance Perspectives Account looks at past and present to determine:  Where firm is (balance sheet)  How it got there (income statement) Finance looks at the future

26 Present Value of Growth Opportunities Present value equals  Valuation of current earnings  Assuming earnings and required return stay constant  Present value of growth opportunities (PVGO) This technique essentially identifies PVGO PVGO is estimated and less certain Hence, investors tend to prefer stocks with lower PVGO values

27 Present Value of Growth Opportunities Example Abell Machines is priced at $34, had earning of $1.45 over the past year, and a required return of 9.5 percent. Bell Retailers is priced at $45, had earnings of $2.20 over the past year, and a required return of 12.3 percent. Which company has the lower PVGO value?

28 Present Value of Growth Opportunities (con’d) PV = E/K + PVGO Hence, PV – E/K = PVGO PVGO of Abell Machines: $34 - $1.45 / = $34 - $15.26 = $18.74 PVGO of Bell Retail: $45 - $2.2/0.123 = $45 – = $27.11 Since PVGO is uncertain, most investors would prefer Abell Machines, despite its lower level of earnings

29 EBITDA Earnings Before Interest, Taxes, Depreciation and Amortization Tool: Stock price / EBITDA Seek firms with lower stock price/EBITDA ratios Not as popular as others because firms may claim expenses as investments in assets, reducing EBITDA

30 Cash Flows Changes in cash arising from business operations Tool: Stock Price/Operating cash flow Generally seek firms with lower ratios Modification: Use Free Cash Flow  Operating cash flow less required investment in plant and equipment  Excess is money available to investors

31 PEG Ratios Price/earnings ratio dividend by dividend growth rate Investors seek PEG ratios less than 1.0 Problems:  Identifying earnings (Past? Forecast?)  Identifying growth rate (1-year forecast?, 5-year forecast?)

Additional Measures of Relative Value P/BV P/CF P/S

33 The Required Return Real Portion:  Return for saving instead of spending money  Relatively stable in the 3-4 percent range Inflation Adjustment:  Reflects changes in general price level  Relatively stable in the 3 percent range Risk Premium:Depends on  Firm conditions  Overall economic conditions Note: Small changes in any of these can result in large changes in firm valuation

34 Changes in Stock Price Primary Long-Term Driver of Change  Earnings – or lack thereof Primary Short-term Driver of Price Change  Changes in investor sentiment  Relatively stable in the 3 percent range Note: Both are difficult to predict

35 Equity Risk Premium Extra return on equity  8.4% higher than Treasury bills  6.7% higher than Treasury bonds  In any year stocks could be lower  After all, this is an equity “risk” premium Note: Beta is multiplied by the equity risk premium in the capital asset pricing model

36 Anticipated Equity Risk Premium Changes Forecasts suggest a diminishing equity risk premium  One reason is the anticipated higher costs for raw materials Note: The market sets these, not individual investors  Though investors could sell shares not providing sufficient returns  The sale increases supply, reducing price, and increasing returns to the buyer!

37 Greenspan Model General indicator of whether the stock market is over- or undervalued Mentioned in 1997 Federal Reserve Board publication Alan Greenspan was Chairman of the Federal Reserve Board at that time Model: Yield U.S. Treasury note less P/E S&P 500 Positive Result: Stock market overvalued Negative Result: Stock market undervalued

38 Changing PE Multiples The amount individuals are willing to pay for a dollar of earnings varies Long-run average is 16 Varies over time Returns will come from higher earnings and higher price/earnings ratios A companies earnings cannot be manipulated by investors However, investors can buy firms with lower P/E ratios  Yet, such firms are not expected to have as high a rate of earnings growth  Hence, the lower price/earning ratio

Company Analysis & Stock Valuation Which are the best companies? Are they overpriced? Good companies are not necessarily good investments Compare the intrinsic value of a stock to its market value Stock of a great company may be overpriced Stock of a growth company may not be growth stock

Growth companies have historically been defined as companies that consistently experience above- average increases in sales and earnings Financial theorists define a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return Growth Companies

Growth stocks are not necessarily shares in growth companies A growth stock has a higher rate of return than other stocks with similar risk Superior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks Growth Stocks

Defensive Companies  The firms whose future earnings are more likely to withstand an economic downturn  Low business risk  No excessive financial risk  Typical examples are public utilities or grocery chains—firms that supply basic consumer necessities Defensive Companies and Stocks

Defense Stocks  The rate of return is not expected to decline or decline less than the overall market decline  Stocks with low or negative systematic risk Defensive Companies and Stocks