Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 8 Stock Valuation

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-2 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-3 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-4 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: –“Naïve” approach based upon continued historical trends, or –Historical trends adjusted for anticipated changes in operations or environment, or –Earnings forecasts from brokerage houses, Value Line, Forbes, or other sources

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-5 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%.

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-6 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:

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-7 Step 2: Forecast Future EPS (cont’d) 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%.

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-8 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 8-9 Step 2: Forecast Future Dividends (cont’d) 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%.

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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 economic conditions, general stock market outlook in near term, or anticipated changes in company’s operating results

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved Figure 8.1 Average P/E Ratio of S&P 500 Stocks

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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 priceundervalued current price=estimated pricefairly valued current price>estimated priceovervalued

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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 determine what a stock ought to be worth –If expected rate of return equals or exceeds our target yield, the stock could be a worthwhile investment candidate –If the intrinsic worth equals or exceeds the current market value, the stock could be a worthwhile investment candidate –There is no assurance that actual outcome will match expected outcome

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved Required Rate of Return (cont’d) 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? Portfolio Beta and Return

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved Dividend Valuation Model: Growth Models 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved Preferred Stock Valuation (Zero growth) A preferred stock pays a dividend of $6. The required return of the stock is 12% –What is the growth rate? –What is the stock’s value? Stock Valuation

Copyright © 2011 Pearson Prentice Hall. All rights reserved Common Stock A common stock will pay a $3.50 dividend next year. Historically it has grown at a 9% growth rate. The required return for the stock is 17%. –What is the value of the stock

Copyright © 2011 Pearson Prentice Hall. All rights reserved Common stock The most recent dividend was $2.65. Dividends have historically grown at 5%. The required return on the stock is 20%. –What is the firm’s value?

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved Variable growth stock Supernormal Growth Stocks

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved Dividends-and-Earnings Approach Dividend and Earnings Model

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved Sustainable Growth Model to Estimate EPS Sustainable growth model

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved 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

Copyright © 2011 Pearson Prentice Hall. All rights reserved Price-to-Book-Value (P/BV) Approach Similar to P/E approach, but substitutes book value for earnings

Copyright © 2011 Pearson Prentice Hall. All rights reserved Multiplier Model Multiplier Models