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Chapter 10 Investment

There are two main approaches to valuing common stocks: 1) The present value approach discounts the expected future cash flows from dividends and residual value to calculate the intrinsic value. 2) The multiple of earnings approach values stocks relative to recent earnings using price-to-earnings (P/E) ratios. The present value approach is considered the best estimate but the P/E ratio is popular for its ease of use. Both approaches require estimating inputs that are uncertain.

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90 views

Chapter 10 Investment

There are two main approaches to valuing common stocks: 1) The present value approach discounts the expected future cash flows from dividends and residual value to calculate the intrinsic value. 2) The multiple of earnings approach values stocks relative to recent earnings using price-to-earnings (P/E) ratios. The present value approach is considered the best estimate but the P/E ratio is popular for its ease of use. Both approaches require estimating inputs that are uncertain.

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Maiden Disguised
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© Attribution Non-Commercial (BY-NC)
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CHAPTER TEN Common Stock Valuation

Equity Analysis and Valuation


Two approaches to the valuation of common stocks used in fundamental security analysis: 1. Present value approach 2. Multiple of earnings approach

Fundamental Analysis
Present value approach
Capitalization of expected income Intrinsic value based on the discounted value of the expected stream of future cash flows

Multiple of earnings approach


Valuation relative to a financial performance measure> Relative performance of stocks P/E ratio

Present Value Approach




Intrinsic value of a security is n Cash Flows Value of security ! t (1  k) t !1

Estimated intrinsic value compared to the current market price


What if market price is different than estimated intrinsic value? Strategy Intrinsic value > Market value Intrinsic value < Market value Intrinsic value = Market value Buy Sell Hold

Required Inputs
Discount rate
Required rate of return: minimum expected rate to induce purchase The opportunity cost of dollars used for investment

Expected cash flows


Stream of dividends or other cash payouts over the life of the investment

Dividend Discount Model


Assume no growth in dividends
Fixed dollar amount of dividends reduces the security to a perpetuity

D0 P0 ! k cs
Example: ABC Inc. is currently paying a dividend of $ 2 per share. Which is not expected to change in coming next years up to infinity. Investor required rate of return is 20%. Calculate the intrinsic value of the security. Assume the MV of the security is $12 should you buy this stock?

Dividend Discount Model


Assume constant growth rate in dividends
Dividends expected to grow at a constant rate, g, over time
D1 P0 ! kg

D1 is the expected dividend at end of the first period D1 = D0 (1+g)

Example: ABC Inc. is currently paying a dividend of $ 2 per share. Dividends are expected to grow at 5% rate to infinity. Investor required rate of return is 20%. Calculate the intrinsic value of the security. Assume the MV of the security is $12 should you buy this stock?

What About Capital Gains?


Is the dividend discount model only capable of handling dividends?
Capital gains are also important

Price received in future reflects expectations of dividends from that point forward
Discounting dividends or a combination of dividends and price produces same results

P/E Ratio or Earnings Multiplier Approach


Alternative approach often used by security analysts P/E ratio is the strength with which investors value earnings as expressed in stock price
Divide the current market price of the stock by the latest 12-month earnings 12 Price paid for each $1 of earnings Ex. $100/$5= 20 times >> $100/$2.5= 40 times

Other Valuation Techniques


Market-to-book ratio (M/B) Market-to Ratio of share price to per share shareholders equity as measured on the balance sheet Price paid for each $1 of equity

Price-to-sales ratio (P/S) Price-to Ratio of companys market value (price times number of shares) divided by sales Market valuation of a firms revenues

Other Valuation Techniques


Economic Value Added (EVA)
Difference between operating profits and cost of capital Technique for focusing on a firms return on capital in order to determine if shareholders are being rewarded EVA = (ROC - WACC) x Capital

Which Approach Is Best?


Best estimate is probably the present value of the (estimated) dividends P/E multiplier remains popular for its ease of use and the objections to the dividend discount model Dealing with uncertain future is always subject to error

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