1. Chapter 8
Stock Valuation

2. 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.

3. 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.

4. 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

5. Comparative Dollar Based and Common-Size Income Statements

6. 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

7. 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

8. 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

9. 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:

10. 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%.

11. 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

12. 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%.

13. 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

14. 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

15. 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.

16. 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

17. 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

18. 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

19. 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?

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

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

29. 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.

30. 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.

31. T h e E n d !

32. Additional Chapter Art

33. Average Market P/E Multiples 1977–2006

34. Selected Historical Financial Data, Universal Office Furnishings

35. Using the Variable-Growth DVM to Value Sweatmore Stock