1. 18 Investing in Stocks Introduction to Finance Chapter
Lawrence J. Gitman
Jeff Madura
Introduction to Finance
Investing in Stocks

2. Learning Goals
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.

3. 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.

4. Alternative Stock Valuation Models
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.

5. 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.

6. Alternative Stock Valuation Models
P/E Multiples
Table 18.1

7. Alternative Stock Valuation Models
P/E Multiples

8. 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.

9. Alternative Stock Valuation Models
P/E Multiples
Table 18.2

10. 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:

11. Alternative Stock Valuation Models
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.

12. 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.

13. Alternative Stock Valuation Models
Revenue Multiples
Table 18.3

14. 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

15. Valuation and Performance of IPO Stocks

16. 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

17. Stock Quotations
Figure 18.2 (Panel 1)

18. Stock Quotations
Figure 18.2 (Panel 2)

19. ADR Quotations
Figure 18.3

20. Stock Market Data Bank
Figure 18.4 (Panel 1)

21. Stock Market Data Bank
Figure 18.4 (Panel 2)

22. Stock Market Efficiency
Forms of Efficiency
Table 18.4

23. Stock Market Efficiency
Evidence of Inefficiency
January effect
Monday and weekend effects
Size effect
Price/earnings effect

24. Stock Market Efficiency
Limitations on Capitalizing on Price Discrepancies
Trading commissions
Tax effects
Relationships are not applicable to all firms

25. Foreign Stocks Valuing Foreign Stocks
Dividend discount model
Price/earnings (P/E) method
Foreign Stock Performance Benchmarks
Foreign Stock Market Efficiency

26. 18 End of Chapter Introduction to Finance Chapter Lawrence J. Gitman
Jeff Madura
Introduction to Finance
End of Chapter